Price and quantity Determination in the market

A perfect market structure is the type of market structure with high degree of competition in the market. A market is said to be perfect when all the potential sellers and buyers are promptly aware of the price to which transactions take place.

This market structure is characterized by the following:

1. Large number of buyers and sellers Under this, there is a large number of sellers and buyers of the commodity in the market. Therefore, a single buyer or seller cannot influence anything in the market for example the price and the output.

2. Homogeneous Products The commodities produced by all firms are totally identical in all aspects. The commodities sold are similar in shape, colour, size, weight etc. Therefore a buyer has no specific preference to buy from a particular seller.

3. Free entry and exit Any new firm is free to join the market and any already existing firm is allowed to leave the market.

4. Perfect knowledge All sellers and buyers have full knowledge about the market condition such as the price of the commodity.

5. Perfect mobility of factors of production. Factors of production such as labor and capital are perfectly mobile both geographically and occupationally. Mobility of factors of production is essential to enable firms and the industry to achieve an equilibrium position.

6. Profit and utility maximization. The major goal of a firm is to maximize profit and that of the buyer is to maximize utility.

7. No transportation cost. Under this market structure it is also assumed that there is no transport cost for example in the movement of goods, raw materials and so on. If the cost of transport is to be there, the prices must differ to that existing in different sector of the market.

8. The price is constant. Under perfect market structure the price is constant, whereby: $P = AR$ $AR = (P \times Q)/Q$ $AR = P$ where by $AR =$ Average Revenue, $P =$ Price, $Q =$ Quantity

A perfect market is a theoretical concept that does not exist in real life situation. The conditions under which a perfect market exist are unrealistic due to the following reasons:

1. The number of buyers and sellers may be small
2. The commodities are differentiated or substitute for almost every commodity.
3. There are restrictions to entry and exit.
4. There is no perfect mobility. There are some limitations to the factor mobility.
5. There is preferential treatment. The suppliers discriminate price and provide special services to some customers.
6. For single sellers may be able to influence the price e.g. in a monopoly single sellers may influence price.
7. There is imperfect knowledge of the market situation hence there is a need to advertise.

1. There are some markets which have a perfect market e.g. the market for the agricultural products.
2. A perfect market provides a model for studying realistic market structure.
3. It is applied when adopting price control.

In short run profit maximization.

Under perfect market competition to maximize profit, the following conditions are most:

1. Marginal cost must be equal to marginal revenue i.e. $MC = MR$ (necessary condition but not sufficient).
2. Marginal cost curve must cut marginal revenue curve from below at highest level of output (sufficient condition).
3. $P > AC$

Note: The firm makes super normal profit due to limited firms in the market.

$TR = P \times Q$

Total revenue is a product of price and quantity. Average revenue is revenue per unit of output. The ratio between revenue and output.

$AR = TR/Q$

and

$TR = P \times Q$ $AR = (P \times Q)/Q$ $AR = P$

where by $TR =$ Total Revenue

Marginal revenue (MR)

Is the additional to the total revenue resulting from selling one extra unit of output.

The relation between change in total revenue and change in output. But price does not change hence $MR = P$.

6. In a perfect market there is perfect factor mobility i.e. the factors of production are free both occupation and geographically.
7. There is perfect knowledge of the product situation in the sense that buyers are aware of the price and quality of the commodities hence no need of advertising.
8. No transportation costs, in the sense that the price remains uniform across all the market.

The imperfect market structure is divided into the following markets:

• Monopoly
• Duopoly
• Oligopoly
• Monopolistic competition

Oligopoly is the market structure which is characterized by few firms operating with significant barriers to entry of the firm.

Oligopoly comes to exist when economies of scale or advantages of large scale production exist on such a large dimension that only a few firms have the advantage of extremely economic production which can produce on a large scale.

Features or characteristics of oligopoly

1. Few, unequal competition among firms. Each firm is faced with competition from other firms through market power and therefore cannot be a price taker.

2. Non-price competition or advertising. If one firm reduces the price others would do the same and all firms would end up losing.

3. Firms are closely dependent on each other. A firm can reduce the price when other firms reduce the price.

4. In most cases there is product differentiation.

5. No easy entry into the industry.

6. Price output decisions are very difficult.

7. Interdependency among various firms.

Types of oligopolies

There are two important sub types of oligopolies:

1. Pure oligopoly or perfect oligopoly
2. Imperfect oligopoly

Advantages of oligopolistic market

1. Existence of competition leads to production of goods with quality and great quantity.
2. Consumer enjoys a whole variety of product due to differentiation of product.
3. Stable prices are charged as there is price rigidity.
4. Abnormal profit are enjoyed both in the short run and in the long run.
5. It is a source of government's revenue through taxation.

Disadvantages of oligopoly market

1. Production of excess capacity leading to underutilization of resources.
2. There is unemployment of labour because of producing at excess capacity.

In the long run equilibrium is attained at a point where long run MC curve = MR. Output $OQ$ is produced and sold at $OP$ and normal profit is earned by all firms.

Because of free entry of new firms in the long run the demand for the product is shared more. Therefore, the demand curve is tangent to the AC.

Strategies used by oligopoly firm to avoid price war

1. Collusion refers to an agreement among firms in an industry to decide the market share and fix the price i.e. agree on the price and output rates in order to decrease competition and increase profit.

2. Formation of a cartel. A cartel is a group of firms that agree to avoid competition, so they can act as a single monopoly and earn monopoly profit. Cartels are more effective when the goods supplied are homogeneous e.g. oil, steel. Example of cartels is OPEC.

3. There is consumer exploitation because there are few firms and each firm has control or influence over the market conditions.

4. There is restriction of output because the supply of each firm depends on its allocation.

5. It incurs high selling cost in terms of advertising and sales promotion.

The theory of kinked demand curve has been developed to explain the price inflexibility that characterizes oligopoly.

A kinked demand curve is a curve in the oligopoly market whose price is elastic above administered price and inelastic below administered price.

The kinked demand curve

Diagram

From the graph $OP_0$ is administered price and $OQ_2$ is the output and $K$ is the kinked point.

• If a firm in the oligopoly market lowers the price (to $OP_1$), other firms will also follow and lower their prices. The curve shows that as the demand will be elastic.
• On the other hand, if a firm in an oligopoly market raises his price ($OP_2$) other firms will not thus raise their prices thus demand will be highly inelastic.

Is a type of market structure which is characterized by many firms which are fewer than in a perfect competition.

Features of monopolistic competitive market

1. There are many suppliers fewer than in perfect competition.
2. Non-homogeneous goods (product differentiation) but they are close substitutes. Its differentiation may be in form of packing, decision, quality, branding etc.
3. There are barriers to entry which are insufficient to prevent other firms from entering in the long run.
4. Firms have a degree of market power and therefore it forms a downward sloping demand curve.

Diagram

The demand curve in a monopolistic competition is more elastic than that of a monopoly because of the presence of substitutes. $MR$ is below the $AR$ as in case of monopoly, the demand curve is downward sloping because each firm has monopoly power over its product and is not a price taker.

• There is need for persuasive advertising in monopolistic competition.

Diagram

From the graph, the firm makes profit at output $OQ_C$. If the firm produces more than $OQ_C$ it would make $MC > MR$ thus equilibrium point is at $B$ where marginal cost is equal to marginal revenue i.e. $MC = MR$.

A monopolistic firm produces at excess capacity i.e. $OQ$ is below the lower point of $AC$ curve, which is at point $O$, since costs are still falling the firm could still produce more output to $OQ$ but in order to keep the price up, it produces less than optimum.

A monopolistic has no supply curve because it is the sole controller of all the output and there is no unique relationship between market price and quantity supplied. In other words, monopoly firms are the same as industry.

When monopolist firm make loss

Sometimes monopoly makes loss even though its curve. In the short run when demand and cost situation is not favorable the monopolist may undergo loss and it occurs when:

• $MC = MR$
• $P < AC$

Diagram

$MR = (160 - 100Q)Q$ $MR = 160Q - 100Q^2$ $MC = MR$ $-40 = 160Q - 100Q^2$ $-40 = 160 - 200Q$ $200 = 200Q$ $Q = 1$

For M: $TR = (360 - 4Q)Q$ $MR = 360Q - 4Q^2$ $MR = MC$ $360 - 8Q = -40$ $400 = 8Q$ $8 = 8$ $50 = Q$

$PK = 160 - 100Q$ $PK = 160 - 100$ $PK = 60$ Price of kanyama is 60 units.

$PM = 360 - 4Q$ But $Q = 50$ $PM = 360 - 200$ $PM = 160$ Price of msichoke is 160 units.

How Tanesco maximize profit

$MC = MR + MR_2$ $-40 = 160 - 200Q + 360 - 8Q^2$ $-40 = 520 - 208Q$ $208Q/208 = 560/208$ $Q = 2.69$

Advantages of monopolistic competition

1. Product differentiation enables consumers to get varieties of a product.
2. Firms compete to make improvement on the quality of product.
3. In case one firm collapses, substitutes are available.
4. The price change is lower than that of monopolist because of competition from the substitutes.

Disadvantages of monopolistic competition

1. There is underutilization of the firm in the short run and in the long run there is excess capacity.
2. In the long run there is no profit to enjoy economies of scale.
3. The price charged on buyers is higher than in perfect competition.
4. In the long run there are no profits to invest in research since the firms earn normal (zero) profit.
5. To maintain the market share the seller has to advertise thus increase cost and price.

Profit maximization under monopolistic competition

Competitive market (How price and output determine in monopolistic competition)

In the short run

A firm maximizes profit when:

• $P =$ Price
• $MC =$ Marginal Cost
• $MR =$ Marginal Revenue
• $AC =$ Average Cost

1. $MC = MR$
2. MC curve should cut MR curve at the highest level of output
3. $P > AC$ ($AR > AC$) and hence the firm earns abnormal profit
4. A firm produces at excess capacity because it produces less than the optimum point.

Diagram

From the graph the firm maximizes profit at equilibrium point where $MR = MC$.

Shows a firm making super normal profits

Losses arise when costs rise or demand decreases.

In the long run

In the long run firms maximize profit when:

1. $LMC = LMR$
2. LMC must cut LMR at the highest level of output
3. $P = LAC$

Diagram

$PQRS$ is the loss that is sustained by the monopolist in the short run period.

Monopoly is the market situation where there is one seller of a product which has no close substitute. Monopoly is a word derived from Greek word "mono" which means one (single) and "poly" means seller or firm. Monopoly is imperfect market structure where there is a single seller of a commodity.

NB: A monopoly firm is also an industry.

Conditions for monopoly

1. There is one firm (single seller) which deals with a product that has no close substitute e.g. TANESCO, DAWASCO etc. in Tanzania.
2. There are barriers/restrictions on entry by other firms into the industry.
3. Monopolist is the price maker i.e. the supplier is the one who determines the price of the commodity.
4. Demand curve slopes downward from left to right because the monopolist to increase revenue he has to reduce price so that $MR < AR$ because price is not constant.

Diagram

• From the curve the monopolist earns maximum profit at $M$ where if it produces above this point, it makes losses because $MC > MR$.
• If it produces below this point (less than $Q_0$) it would make less profit because of producing low output.

Thus, for the firm to maximize profit, it should produce an output where $MC = MR$.

Long run profit maximization

The firm maximizes profit in the long run when:

1. $MC$ must be equal to $MR$
2. $LP = LAC$

Because of free entry of the firms, other firms are attracted by the abnormal profit to join the market and hence form the industry. As a result total output would be increasing leading to fall in price and fall in profit until when firm earns normal profit.

Diagram

From the graph the firm maximizes profits at point $L$ where $LMC = LMR$ i.e. at an output $OQ_1$.

The monopolist maximizes profit when:

1. $MC = MR$
2. MC curve must cut MR curve from below at the highest level of output.
3. NB the firm makes super normal profit both in the short run as well as in the long run because there are barriers which restrict the entry of new firms in the market

The shut down point and break-even point

• Break-even point. Is a point which occurs when the firm covers all costs of production i.e., variable and fixed costs. That is firm's total revenue is equal to firm's total cost $TR = TC$.

• Shut down point. Is a point which occurs when the firm covers only the variable cost. At this point the firm is advised to close the firm.

Diagram

Price discrimination is a process of charging different prices for the same commodity to different buyers. Price discrimination exists when a commodity is sold at different prices irrespective of the cost of production.

Forms of discrimination

1. Discrimination according to personal income. Income differentiation among buyers e.g. doctors charging low price on the poor and high price on the rich for the same service.

2. Discrimination according to sex or age i.e. charging low price on the young people than old.

3. It may be geographical e.g. dumping where commodities are sold cheaply in another country to dispose of surplus.

4. Carried out according to the time of service e.g. tickets for videos are charged at higher price in afternoon where there are many people than in the morning hours where people are few.

5. Discrimination according to nature of product e.g. branded commodities are charged at higher price than unbranded commodities of the same type.

6. Discrimination according to use of the product e.g. low transport charge for input and high transport charges on luxuries.

7. Discrimination by differences of the commodities e.g. higher price on travelers in first class in the train and low charge for other classes.

Conditions for price discrimination

1. The commodities must be sold by the monopolist.
2. The price elasticity of demand should be different in different markets i.e. a higher price should be charged where demand is inelastic.
3. The cost to divide the market should be very low e.g. in case of dumping, cost of transportation should be low.
4. Buyers should not know how much is charged in another market. This is possible especially where goods and services are sold on the other.
5. It should be impossible for buyers to transfer the commodities from where the price is low to where the price is high.

NB:

• Price discrimination may also be used to sell units of the same commodity at different prices to the same customer e.g. telephone charges high on first 3 minutes and then low in the others.

Advantages of price discrimination

1. It enables the poor to get essential services at low prices e.g. cheap houses for civil servants, doctor charges low price on poor patient.
2. To the producer, it increases total revenue because output sold has increased.
3. It is one way in which the rich subsidize the poor thus a method of income redistribution.
4. It increases sale and consumption.
5. It helps countries to dispose surplus commodities e.g. dumping.

Tanesco offer electricity to two consumers kanyama and msichoke. The price of electricity of kanyama is given by the equation $PK = 160 - 100Q$ while that of msichoke is given by the equation $PM = 360 - 4Q$.

If the production cost for two consumers is given by the equation $TC = 100 - 40Q$, find:

1. Among the consumers who demanded at the industrial rate and the demand at a domestic rate.
2. Compute average fixed cost (AFC) in each market.
3. Briefly explain the five conditions necessary for price discrimination to take place.

Solution

$MR = (160 - 100Q)Q$ $MR = 160Q - 100Q^2$ $MC = MR$ $-40 = 160Q - 100Q^2$ $-40 = 160 - 200Q$ $200 = 200Q$ $Q = 1$

For M: $TR = (360 - 4Q)Q$ $MR = 360Q - 4Q^2$ $MR = MC$ $360 - 8Q = -40$ $400/8 = 8Q/8$ $50 = Q$

$PK = 160 - 100Q$ $PK = 160 - 100$ $PK = 60$ Price of kanyama is 60 units.

$PM = 360 - 4Q$ But $Q = 50$ $PM = 360 - 200$ $PM = 160$ Price of msichoke is 160 units.

1. Msichoke demanded electricity at domestic rate due to high price while Kanyama demanded electricity at industrial price due to low price.
2. Discrimination according to sex or age i.e. charging low price on the young people than old.
3. It may be geographical e.g. dumping where commodities are sold cheaply in another country to dispose of surplus.
4. Carried out according to the time of service e.g. tickets for videos are charged at higher price in afternoon where there are many people than in the morning hours where people are few.
5. Discrimination according to nature of product e.g. branded commodities are charged at higher price than unbranded commodities of the same type.
6. Discrimination according to use of the product e.g. low transport charge for input and high transport charges on luxuries.
7. Discrimination by differences of the commodities e.g. higher price on travelers in first class in the train and low charge for other classes.

1. There is no duplication of services. e.g. If there is one hydroelectric power plant, there may not be the need to set up another one in the same area.
2. Economies of scale can be exploited in firms because it is capable of expanding using an abnormal profit earned.
3. There is a possibility of price discrimination i.e. selling the same commodity at different prices which benefits low income earners.
4. Research can easily be carried out using the super normal profit.
5. There is no wastage of resources in persuasive advertising which leads to increase in price.
6. Public goods like road, telephone etc are easily controlled by the government as a monopolist.
7. Infant industries can grow when there is monopoly as they are protected from competition.

1. The firms can become inefficient and produce low quantity product because of absence of competition.
2. Monopolist firm produces excess capacity i.e. they under utilize their plant so as to produce less output and sell at a high price.
3. Monopoly firm may charge higher price hence affecting consumption for low income earners.
4. In case monopolist stop producing there will be shortage of commodities due to lack of substitutes.
5. Monopolists tend to extend pressure on the government at times as they can influence decision making because they are the controllers of production.

Diagram

The $MR$ curve for the monopolist firm slopes downward from left to right because when more commodities are put in the market the price falls therefore $MR$ decreases. Its demand curve is inelastic in nature because of changes of price in the market.

Ownership of natural resource E.g. Tanzania is the only supplier of tanzanite in the world because it is only found in Tanzania.

Function of monopoly association (Cartels) e.g. OPEC (organization of petroleum exporting countries).

Protectionism The barriers are imposed on the product to exclude foreign competitors so that the producers may become monopoly.

1. Protect rights e.g. writer of the book where the law forbids other firms dealing in the commodity.
2. Advantages of large-scale production which do not allow small competitors compete successfully against the large firm.
3. Long distance between producers where each producer monopolizes the market in his/her locality.

1. The government can fix prices of commodities.
2. Taxation. The government can impose taxes on monopolist firms to take away the abnormal profit. However the monopolist can shift the burden of taxes on to the buyers in the form of raised prices.
3. Anti-monopoly (anti-trust) legislation i.e. laws should be imposed to control monopoly by the firms to raise price to inhibit competition.
4. Nationalization of monopoly firms by the government.
5. Subsidization. New firms can compete with the monopolist firm.
6. Removing the basis of monopoly e.g. by removing tariffs so as to allow imported goods to compete with the home products.