Monopoly versus perfect markets Essay

This paper investigates the two extremes of market structures. A monopoly firm, and a firm which operates in a perfectly competitive market. We will compare features, similarities, differences, advantages and disadvantages. The monopoly firm I have chosen is Thames Water. This company is an accurate example, as it’s the sole supplier of the industry. The firm, is the industry. Thames Water supply water through peoples taps in and around London. Fyffe is my chosen firm in a perfectly competitive market. I think this is a good example. It sells bananas to supermarkets and food suppliers, who resell on to customers. The next two paragraphs explain the features of perfect competition, then a monopoly. â€Å"The theory of perfect competition illustrates an extreme form of capitalism. † (Sloman, 2007:113) There are many suppliers, who all only supply and produce a small fraction of the total output, of the whole industry. None of the firms have any power over the market. (Mankiw, 2001) Barriers to entry do not exist. Therefore firms can enter and leave the market freely. Apart from the money and time it takes to set up the business, there are no other obstacles. Both producers and consumers have perfect knowledge of the market. Therefore they both know prices which should be paid, quality which should be met, availability of the product. Market opportunities for expansion, and entry opportunities in the industry as a whole. The price Fyffe must charge for their bananas will depend upon the demand and supply of the whole market, not just Fyffe personal demand. Hence they have no power over prices. They must follow the market forces. (Sloman, 2007)Established firms in the banana industry have no advantage over firms who have newly entered the market. (Parkin, Powell, Matthews)â€Å"This means they can sell all the products they can produce at the market price, but none at a price which is higher. † (Sloman, 2007:114) If Fyffe raise their selling price above p1, their demand will drop to 0, because if Fyffe raise the price of their bananas, consumers will just buy from another firm selling at the current market price. Illustrated in diagram 2. (Beardshaw, 2001) All firms operating in the banana industry sell a homogenous product, all the firms in the industry sell an identical banana. The theory states there is not a great need for advertising or branding. (McConnell, 2008) I would agree with this statement in the context of bananas. Advertising is not needed as people will not look for a specific brand of banana. They all taste the same. However I think a firm in a market selling shampoos and conditioners would need a certain amount of branding and advertising so people choose their product and gain customer loyalty. In the shampoo industry products are not as homogenous. A pure monopoly owns 100% of the industry. Thames water have a great deal of power, and are price makers, thus they set the price to how much they want to charge. If the consumer cannot, or doesn’t want to pay the price, they have to go without the tap water. In the short run both perfect competition and monopolies can make economic profits, losses and supernormal profits. Only monopolies can manage to sustain super normal profits in the long run. â€Å"Persistant economic profits are called monopoly profits. † (Dobson, 2005:99) Monopolies can sustain supernormal profits and remain safe and unaffected by competition due to barriers to entry. Supply to the industry does not increase with new entrants. (Hunt, 1990). There are many types of barriers to entry. Thames water is known as a natural monopoly, meaning there are barriers to entry due to large economies of scale. (Sloman, 2007) Capital equipment is so expensive and large scale that only one sole supplier could manage to make a profit in the water industry. However Thames Water incurred low marginal costs once they are set up. â€Å"If average cost falls as output increases over the entire range of market demand its a natural monopoly. † (Dobson, 2006:100) â€Å"Each would have a very high average cost at a low output. † (Begg, 2005:134) Correspondingly Thames Water gain barriers to entry through lower costs. This is an artificial barrier. The firm is experienced in their field. Has good knowledge of their market, and will be able to gain the best rates of interest on finance, the best suppliers at the lowest costs, and lean methods of production. Other firms would struggle to compete. If a firm decided to set up and compete with Thames Water, and failed by going out of business there would be huge sunk costs. This occurs when high amounts are spent on capital expenditure, which cannot be used on another business venture. (Sloman, 2007) This is an example of exit costs. It would be a huge loss to the firm, and would discourage firms from entering the market. Thames water also have patents copywrite and licensing. The next two paragraphs explain the effect on demand for perfect competition, then a monopoly. For Fyffe the price charged for the bananas is equal to marginal revenue. Average revenue and demand are also equal to price. If average cost dips below average revenue the firm will earn supernormal profits. If demand is above where marginal costs and marginal revenue meet the firms will be making normal profit. See diagram 2. Normal profits cover opportunity costs of the owners money and time. If Fyffe set output below equilibrium marginal cost would exceed marginal revenue and profit would be lowered. If Fyffe raised output above equilibrium marginal costs would exceed marginal revenue and profits would also be lowered. See graph 1. (Dobson, 2005:99) The demand curve is elastic for the banana industry, but not perfectly elastic. Hence why it slopes downwards in diagram 1. If there is a rise in price for bananas, consumers will spend less on the product, and Fyffe will entail a fall in revenue. In contrast if the price of bananas drop, consumers will buy more of the product, and providing the firm is covering their costs they will receive an increase in revenue, because bananas can be relatively easily substituted by another cheaper fruit. Furthermore bananas will sell for a cheaper price when they are in season, due to a larger supply to the market in this period. Fyffe is perfectly elastic which is why their demand curve is horizontal. See graph 2. The firms prices are not affected by their output and their decisions do not affect the industry. (Ison, 2007) Firms must produce at equilibrium to maximise profits, which is where the market supply, meets the market demand, as illustrated in diagram 1. Short run â€Å"assumes the number of firms in the industry does not increase, as there is not enough time. † (Sloman 2007:114) When a firm produces quantity and price, where marginal costs, and average costs meet they are breaking even. See diagram 2. (Begg, 2005) Consumers are charged a price which is equal to what it costs the firm to produce the extra unit. See diagram 2. If the demand curve for bananas increases short term, the demand curve will shift to the right. See diagram 3. This results in a higher equilibrium and a higher selling price. As selling price has increased farmers will raise their output by increasing their variable costs such as labour and materials. This will result in a larger profit and profits are maximised. As illustrated in diagram 4. In contrast if the demand for bananas was to decrease, this would cause a shift to the left in the demand curve. See diagram 5. This results in a lower equilibrium for the industry, and a fall in the selling price. Consequently all firms in the industry including Fyffe would reduce output, by decreasing variable factors and the firm would suffer economic losses. As illustrated in diagram 6. (Dobson, 2005) If Fyffe or Thames Water are not covering their average total costs in the short run, they should carry on trading, but if they are not covering their short run average variable costs, it would be cheaper to temporarily close down. The theory is known as the short run supply decision. (Ison, 2007) In the long run any firm should close down if it is not covering its total average costs as it is loss making. Called the long run supply decision. (Begg, 2003) When demand increases and selling prices rise in the long term, existing firms are making supernormal profits. Several new firms will enter the market. The supply curve will shift to the right, and supply will increase, which will lower market price. As more new industries join firms reduce their output until they are making a normal profit again. Output of the whole industry will be larger now that more firms are in the market, and there is no incentive for firms to enter, or leave the market as breakeven profits are being made. Referred to as the entry or exit price. When there is a decrease in demand, prices will fall, and firms will reduce output to minimise losses. Eventually due to losses some firms will leave the market which lessens supply and the supply curve will shift to the left. This raises prices due to restricted output, and farmers will start to make normal profits again. So there are less firms and less output in the industry. (Dobson, 2005) In the long run there are no fixed costs in any industry, as firms can change their plant size or machinery. Resulting in a long run supply curve which is flatter than the short run. (Begg, 2003) If all firms operating in the industry restricted supply together increasing demand and prices, new firms would enter the market which would increase supply and lower prices. (Begg, 2005) Thames water are price inelastic, and have a low income elasticity of demand, because there are no close substitutes for their product, and water is a essential item. However they are not perfectly inelastic, as a rise in price will still amount to a small drop in quantity demanded. This means Thames water’s revenue will increase with a rise in price, and decrease with a fall in price. A profit maximising level of output is where marginal revenue is equal to marginal cost but rising up to the demand curve to obtain price. See diagram 9 (Sloman, 2007) The demand curve in diagram 9 represents the value of Thames water to customers, and the marginal curve shows the costs Thames water must pay. The marginal revenue curve must lie below the downward sloping demand curve as marginal revenue is less than price. The further the distance between the demand curve on the right hand side and the marginal revenue on the left the more inelastic the demand, see diagram 9. (Dobson, 2005) ) A firm cannot produce to the right of marginal revenue as this part of the diagram is inelastic. In order for the monopolist to sell a larger amount, the price must be lowered on all previous units, so to prevent this the monopolist may restrict output to keep a larger revenue. Creating scarcity and raising the equilibrium price. (Begg, 2005) â€Å"The excess of price over marginal costs shows the monopolies power† (Dobson, 2005:102) The power to raise prices by selling a smaller amount of output. Diagrams 8, 9, and 10 show long run economic profits, normal profits and losses. Thames water will then check weather the profit maximising level of output covers their total costs in the long run and variable costs in the short run. (Begg, 2003) Thames water is not a contestable market due to the fact it’s a natural monopoly, and has very high barriers to entry. This means they can charge high prices and make supernormal profits, without the threat of competition and new entrants. (Sloman, 2007) Thames water may want to behave ethically when setting prices. If they choose too high a price which people cannot afford this could lead to poverty, but if they charge too low a price this could lead to a wastage of water. Monopolies often use price discrimination when setting prices. Although Thames water do not. Perfect competition cannot use this method. Particular consumers are charged a higher price for an identical service so the monopoly can earn higher profits. (Ison, 2007) Revenue is not lost from previously sold units when price is reduced. More output can be sold ands firms can catch some of their consumer surpluses. See diagram 12. â€Å"Surpluses are the difference between actual price paid and what consumers will have been willing to pay. † â€Å"So the business is treating the demand curve as the marginal revenue curve† (Ison, 2007:138) Only works when consumers cannot buy the product for a cheaper price and sell on to others. (Begg, 2005) A firm operating in perfect competition will achieve allocative efficiency. This exists when price is equal to marginal costs. â€Å" Society is better off when resources are allocated to maximise the total surplus in the market. † (Dobson, 2005:91) Productive efficiency will also be achieved, meaning Fyffe will produce and sell their output for the lowest price they can in the long run giving consumers the best possible value for money. â€Å"Price equals minimum average total cost. † (Dobson, 2005:92) This is good for consumers and society as consumers get the best possible value for money. (Sloman, 2007) Perfectly competitive markets are critised for having a lack of variety, unable to fully satisfy consumers wants and needs. Furthermore the long term entry and exit of firms can be a waste of certain resources such as empty buildings. This is called competitive forces in action. (Dobson, 2005) Monopoly’s are in a position to give us a lower price if they decide to, due to economies of scale. The marginal cost curve is lower than the supply curve in their graph which means the firm can supply more output at a lower production cost. Supernormal profits can fund research and development which will improve the quality of the product. Therefore the monopoly can innovate and introduce new products. (Ison, 2007) However some firms may not do this as they do not need to fight to stay in the industry, with no competition around. (Mankiw, 2001) Joseph Schumpeter said in theory monopolies have more ability and incentive to innovate which can make them better for society. If you imagine a whole industry was taken over by a monopolist, they could eliminate competition and charge very high prices, by reducing output level to which raises price. Supernormal profits represent a redistribution of income from consumer to producer which can be critised on equity grounds† (Ison, 2007:137) Monopoly firms have been known to â€Å"engage in dirty tricks to protect themselves from competition. † They do not produce an output which minimises average costs. Making them productively efficient. â€Å"Perfect competition is rare due to larger companies expanding, gaining economies of scale and market power. Resulting in other firms being forced of the business. So if economies of scale did not exist any industry could have perfect competition. † (Dobson, 2006:94) Monopolies are also rare, and both are extremes of market structures. Most firms lie somewhere between the two. I think the two firms I picked are a fair comparism. They are both from a mixed economy. Thames water will have regulating agencies monitoring them. There are only 3 legal monopolies in Britain Thames Water included. In the past there was a significant amount of monopolies which were government owned. When Margaret Thatcher came into power she privitised these firms as she believed competition would lead to greater efficiency and lower prices which would benefit society as a whole. I agree with her decision and I think after researching, perfect competition appears to be the better option for consumers. Monopolys benefit society in certain situations such as retained profits ploughed back into research and development for medical reasons, and natural monopolies who could not survive in a perfectly competitive industry. Monoplies and perfect competition are becoming more rare as time goes on and who knows what will happen in the future.