BUSINESS ECONOMICS - UNIT IV

Markets
A “market” is not necessarily a geographical or physical location where people buy and sell like
at the city center market in Lusaka.

The modern usage of the word “market” is an exchange mechanism, an interpersonal institution
that brings together buyers and seller (both actual and potential) of particular products or
services.
Markets are classified according to number and size of buyers and sellers, the type of product
bought and sold, the degree of mobility of resources, and the extent to which information is
accessible.

Market Structures

Markets are categorized into either perfect or imperfect based primarily on the degree of
competition, the number of firms supplying or selling the product, whether the product bought is
homogeneous (identical) or differentiated and whether firms can easily enter or exit the market.

The perfect market structure is composed of perfect competition, while the imperfect market
structure is made up of monopoly, monopolistic competition and oligopoly.

Classification of markets

(i) Perfect competition

(ii) Monopoly
(iii) Monopolistic
competition
(iv)Oligopoly

(i) Perfect Competition Market

Perfect competition has the following characteristics:

- There are many sellers and buyers in the market, both buyers and sellers are “small”, they
lack market power to influence the price of product. The price is determined by the
market forces of demand and supply. Individual producers and consumers are “price
takers”.

1
 - The product being traded is homogenous each firm’s product is the same as what the
competitor is selling on the market.

- There are no barriers to entry, firms are free to enter and exit the market.

- There is perfect knowledge of market conditions. This perfect information is available to

everyone, buyers and sellers at no extra cost.

Only the stock exchange and the foreign exchange markets are often cited as the closest
examples of this market structure.

Demand curve of a firm under perfect competition

No individual firm has market power, the market forces of demand and supply for the product
determine the price. Note that the price = average revenue = demand curve (P = AR = D)

D D S

P P = AR = D

Quantity Quantity

The demand curve for the individual firm operating under a perfect market is a horizontal line.
At a given price of OP, the firm can sell as much as it can, whatever is taken to the market is
bought, and demand is infinite.

However, if an individual firm increases in price, even by a very small margin, demand reduces
to zero, since there is perfect market information, the product is homogenous and there are many
sellers.

2
 (ii) Monopoly Market

In this market structure, one firm is the sole supplier of a product or service that has no close
substitutes. The firm makes up the industry.

Characteristics

The following characteristics features must be met for a monopoly to exist.

- There is only one supplier of the product or services

- The product or service has no close substitutes
- There are barriers to entry

Demand curve

A monopolist being the sole supplier has market power and therefore the firm is a “price maker”.

However, the firm can only determine either the price or the quantity, but not both at the same
time. At high prices, few quantities are bought, while at low prices, demand is high. Therefore,
the monopolist is faced with a downward sloping “normal” demand curve.

P = D = AR
Price

Output

Barriers to entry

3
Barriers limit competition in the market. Firms are prevented from increasing the supply,
pushing the supply curve to the right or pushing the demand curve to the left, which reduces the
price, and eliminates the supernormal profits.

Barriers to entry explain why monopolies continue to exist. Some of the entry barriers are as
follows:-

- Government legislation.
Governments may play a major role in the creation of monopolies. A good example is the
Zambia Electricity Supply Corporation (ZESCO), which is the sole supplier of electricity.
The government may also be more comfortable when one organization is marketing an
essential product like maize. Such as the former grain marketing boards (NAMBOARD)
or the Food Reserve Agency (FRA).

- Control of the source of supply for raw materials.

This gives the firm an advantage, as the other firms do not have access to the necessary
raw
materials to produce a product.
- Legal barriers in terms of patent and copyrights
These grant a creative and innovative person or firm that has invented a product, written a
book, composed a song, the exclusive right to enjoy the benefits or profits from that
work, preventing others from exploiting that work.

- Immobility of factors of production.

Resources are not mobile, including labour. This is worsened by the formation of trade
unions and professional associations. In addition, a single firm may control a natural
resource such as copper, which is found in the copper belt, no close substitute, and no
other firm can set up a competing firm.

- Indivisibilities, the amount of fixed costs that a new firm would have to sustain would act
as a natural barrier to entry.
- The minimum efficiency scale, which is the level of output at which the average costs
first reach their minimum point, may be at a very high level. A new entrant might need
to spend a lot on advertising, and sales promotion in order to compete effectively with
existing companies and to increase the market share. The cost involved might again, act
as a natural barrier to entry.

Price discrimination

4
Price discrimination means charging different prices to different groups of consumers for the
same product or service. Price discrimination is the same product or service being sold at
different prices in different markets. A firm may increase its revenue by charging high prices in
some markets while lowering the price in other markets but the sales volume increases, given the
fact that TR = Quantity X Price. Either an increase in the quantity sold or an increase in the price
leads to an increase in the total revenue. A monopolist cannot control both the price and quantity
even if the firm is in an advantageous position and has market power.

Examples of price discrimination

- A car manufacturer who sells cars cheaply in export markets than on the local
market.

- Telephone charges during public holidays, weekends and at night are lower.
- Electricity and water charges are lower for domestic use than for commercial
use.

- The same electricity and water charges are lower in the high-density areas than
in the low-density areas.

- Rail fares and airfares practice price discrimination.

- A doctor or lawyer who varies fees depending on the wealth of the customer.

Generally, discrimination is by income, time, place or customer.

Basic conditions to practice price discrimination

For price discrimination to be possible, practicable and profitable, certain conditions must be
fulfilled.

- Control supply of product, which means imperfections in the market.

Discrimination is not possible under conditions of perfect competition.

- Consumers should be members of separate markets to prevent resale of the

product.

- Elasticities of demand must be different so that different prices may be charged.

- High prices are charged for inelastic markets and low prices for elastic markets,
and profits are maximized.

Regulations of monopolies
The barriers to entry explain the existence of monopolies, the question is whether monopolies are
harmful or beneficial. Monopolies operate against consumer interest and public policy. To this

5
end, governments regulate monopolies by forming monopoly regulation commissions to correct
the many inefficiencies resulting from lack of competition.

Arguments for monopolies

- To achieve economies of scale as a single firm supplies to the whole market. Large scale
production results in a reduction in average costs. The consumer is likely to benefit from
efficiencies through lower prices.
- The supernormal profits that monopolists make, enable the firm to be innovative and
spend on research and development. Society gains by having new products on the market.
- It is easier for a large firm to raise capital, again this enables the firm to be innovative and
spend on research and development.
- Through practicing price discrimination, monopolists ensure that the rich as well as the
poor benefit by enjoying the same or a similar product.
- Some monopolies are natural due to high ratio of fixed costs to variable costs there is less
contribution, which is less attractive, and as such, there are few competitors.
- Some governments feel that in some cases, production or distribution of, for example,
gas, electricity and water can be carried out more efficiently if it is in the hands of a
monopolist.
Where there is competition, it would be wasteful and result in higher prices to consumers.

Arguments against monopolies

- At the profit maximizing level of output, prices are likely to be higher while output is less
than in a more competitive firm.
- The supernormal profits, which monopolies make, are naturally at the expense of
customers.
- Monopolies are not technically efficient. At the profit maximizing level, the costs
are not at their lowest level since the marginal cost is not equal to the average cost. This
also implies that monopolies are not allocatively or Economically efficient.
- Price discrimination is a restrictive practice carried out by monopolists.
- Monopolies are not threatened by competition, they tend to adopt a complacent Attitude
known as ‘x’ inefficiency, and they may not be inclined to be innovative.
- The lower prices that monopolies charge once in a while because of lower costs are just
used to stifle competition.
- There may be diseconomies of large-scale production due to the size of the Monopoly
firm. The firm might become difficult to coordinate and control. Communication also
becomes difficult, the morale of workers is low etc.

(iii) Monopolistic Competition Market

Monopolistic Competition combines features of perfect competition and monopoly.

6
Characteristics of monopolistic competition

- A large number of sellers or firms in the market

- A large number of buyers
- There are no barriers to entry, firms are free to enter and leave the market.
- The products are not homogeneous but are differentiated through product differentiation
and non-price competition, such as the use of brand names, attractive packaging,
extensive advertising, offering guarantees, good after sales services etc.

Demand curve

Firms under monopolistic competition attempt to monopolise the industry through product
differentiation, this gives firms some influence on price charged, as a sign that they are ‘price
makers’. An individual firm is faced with a normal downward sloping demand curve, even if the
demand curve is more elastic due to competition from close substitutes.

Price

P = D = AR

Output

It is also argued that monopolistic competition is not wasteful as it provides consumers with
choices, the differentiated versions of the same product is for the benefit of consumers, besides,
rational buyers should opt for the least cost good.

7
 (v) Oligopoly Market

This is a market structure with a few large firms. The number of firms is few, but the capital
involved is large. The huge amounts of capital act as natural barriers to entry.

The oligopoly market structure is based on a number of assumptions, which makes it rather
different from the market structures studied earlier. It maybe a perfect oligopoly, which means
the product is homogeneous, such as the oil marketing companies in Zambia, British Petroleum,
Caltex, Mobil, Agip, Total, Engen, etc. Alternatively, the product maybe differentiated, this is
known as imperfect oligopoly. An example is the Japanese motor vehicle manufacturers like
Nissan, Toyota, Honda, Mitsubishi, Isuzu.

Characteristics

- Interdependence between firms, this is because an individual firm is uncertain of the

behaviour of rival firms.
- Price stability
- Non-price competition between firms

Demand curve

The shape of the demand curve depends on the assumption of the pricing policy of an individual
firm. A firm operating under conditions of oligopoly might adopt a number of pricing strategies
such as

- Firms collude on pricing and or output policies, they may form cartels or price rings,
known as collusive oligopoly.
- A firm may become a price leader, initiating a price change, then the rival firms follow
suit.
- A firm may decide simply to be a price follower, awaiting the pricing decisions of other
firms.
- The firm’s demand curve is based on the assumption that an oligopoly firm, which is
competing, with rival oligopoly firms decide on its own price and output levels. Even
then, the firm’s decisions are influenced by what the rival firms can do, hence the kinked
demand curve model.

Firms are few, and each firm has some market power, therefore the action of one firm affects the
market share of the rival firms. Suppose the firm increases the price above OP, and then if the
rival firms do not increase their prices, the result would be a reduction in sales and a fall in the
market share. This means that demand is elastic above OP, the price of the rival firms will be
relatively lower.

8
 Price
D
Elastic demand curve
P
D

O
Quantity
Note that there is no explanation as to how the price is actually determined to be at OP.

If the firm lowers the price in an attempt to increase the sales and the market share, then the rival
firms are likely to follow suit, as they would not like to lose their market share. This implies that
the whole industry would suffer, the same quantities would be sold, but at reduced prices!

Demand is therefore inelastic below OP

Price

Inelastic demand curve

P

0 Q Quantity

An oligopolist’s demand curve is a combination of the elastic and the inelastic demand curves,
where the two curves intersect, a kink is formed, hence the name kinked demand curve.

Price
D
Kink

9
 D = AR = P

Quantity
A more detailed diagram

Revenue and
Costs

MC1

MC2

0 Q
MR AR Q uantity

In the detailed diagram, the MR curve has a vertical discontinuity where the elastic demand
curve changes to inelastic demand curve (where there is a kink) on the AR/demand curve. The
discontinuity is explained by the fact that at prices higher than OP the MR curve corresponds to
the inelastic demand curve while at prices below OP the MR curve corresponds with an elastic
demand or AR curve.

The kinked demand curve reemphasizes why an oligopolist might have to accept price stability
in the market. An individual firm cannot afford either to reduce or to increase the price, as this
leads to a change in the market share

10