What term do economists use to describe how competitive specific industries are?

(a)   Compare the characteristics of the market structures of monopolistic competition and oligopoly. [10]
(b)   Discuss whether firms in a highly competitive market are more vulnerable than firms in a less competitive market in a recession. [15]

Introduction

(a)   Market structure refers to the characteristics of a market such as the number of firms, the nature of their products, the availability of knowledge and the extent of barriers to entry which affect the behaviour of the firms in the market. The market structures of monopolistic competition (MPC) and oligopoly can be compared in terms of the number of firms, the extent of barriers to entry, the presence or absence of strategic interdependence, the nature of their products and the availability of knowledge.

Body

MPC and oligopoly differ in terms of the number of firms. MPC is a market structure where there are a large number of small firms each with a small market share. An example of MPC is the restaurant market. Due to the large number of firms in the market and hence the large number of substitutes, the demand for the good of an MPC firm is likely to be price elastic. Therefore, an MPC firm has limited market power as it is able to charge a price only modestly higher than its marginal cost.

Diagram

In the above diagram, due to the elastic demand which gives rise to the relatively flat demand curve (D), the price (P0) is modestly higher than the marginal cost (MC0). In contrast, oligopoly is a market structure where there are a small number of large firms each with a large market share. An example of oligopoly is the pharmaceutical market. Due to the smaller number of firms in the market and hence the smaller number of substitutes, the demand for the good of an oligopolistc firm is less price elastic. Therefore, an oligopolistic firm has greater market power as the difference between price and marginal cost is greater compared to an MPC firm.

MPC and oligopoly differ in terms of the extent of barriers to entry. In MPC, there are low barriers to entry which means that firms can make only normal profit in the long run. In other words, low barriers to entry in MPC preclude an MPC firm from charging a price higher than its average cost. If the firms in an MPC market are making supernormal profit, potential firms will enter the market in the long run due to the low barriers to entry. As the number of firms in the market increases, the market demand will be split among a larger number of firms and hence the demand for the good produced by each firm will decrease which will lead to a fall in the price and the quantity resulting in a fall in the profits of the firms. This process will continue until the firms in the market make only normal profit.

Diagram

In the above diagram, the supernormal profit represented by the shaded area induces potential firms to enter the market in the long run which leads to a leftward shift in the demand curve of each firm (D) from D0 to D1 resulting in a fall in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. At P1 which is equal to average cost (AC1), as the firms in the market make only normal profit, the incentive for potential firms to enter the market disappears. In contrast, there are high barriers to entry in oligopoly which means that firms can make supernormal profit in the long run. Although the supernormal profit will induce potential firms to enter the market, the high barriers to entry will prevent them from entering. In other words, high barriers to entry in oligopoly allow an oligopolistic firm to charge a price higher than its average cost in the long run.

MPC and oligopoly differ in terms of the presence or absence of strategic interdependence. In oligopoly, due to the small number of large firms and hence the large market share of each firm, the actions of one firm affect and are affected by the actions of the other firms in the market, and this is commonly known as strategic interdependence. When an oligopolist changes its price, it will have a significant effect on the other firms in the market. The rival firms will hence react by changing their prices which will affect the first firm. Therefore, when an oligopolist makes pricing and output decisions, it must take into consideration the reactions of the other firms in the market. In this sense, the pricing and output decisions of an oligopolist depend on the behaviour of competitors. In contrast, MPC firms are not strategically interdependent. In MPC, due to the large number of small firms and hence the small market share of each firm, the actions of one firm do not affect and are not affected by the actions of the other firms in the market. Therefore, the pricing and output decisions of an MPC firm do not depend on the behaviour of competitors.

Despite the differences, MPC and oligopoly share some similarities. MPC firms sell differentiated products that are close substitutes such as restaurant foods and bubble teas. Similarly, oligopolistic firms generally sell differentiated products such as cars and pharmaceuticals, although some oligopolistic firms sell homogeneous products such as steel and cement. In addition, there is imperfect knowledge in both MPC and oligopoly which means that consumers and firms do not have perfect knowledge about the price, quality, availability and production technology of the product. The implication of these similarities is that both MPC firms and oligopolistic firms are price-setters in the sense that they are able to set their prices by setting their output levels. In other words, these firms face a downward sloping demand curve.

Conclusion

In conclusion, MPC and oligopoly have both differences and similarities which have implications for pricing and output decisions.

Introduction

A recession is a fall in national output and hence national income for at least two consecutive quarters. The question on whether firms in a highly competitive market are more vulnerable than firms in a less competitive market in a recession can be discussed with reference to the concepts of normal good, inferior good, barriers to entry, cash reserves, shot-run shutdown condition, fixed costs, variable costs and debt. It is commonly believed that the degree of competition in a market is directly related to the number of firms. Therefore, I assume that MPC markets are highly competitive and oligopolistic markets are less competitive.

Body

MPC firms may be more vulnerable than oligopolistic firms in a recession as the former will make subnormal profit. When national income falls in a recession, the demand for normal goods will fall. When this happens, firms which produce normal goods will suffer a fall in profit. In MPC, there are low barriers to entry which means that firms can make only normal profit in the long run. Therefore, when MPC firms suffer a fall in profit in a recession, they will make subnormal profit. In contrast, there are high barriers to entry in oligopoly which means that firms can make supernormal profit in the long run. Therefore, when oligopolistic firms suffer a fall in profit in a recession, they may not make subnormal profit. It follows that MPC firms may be more likely to close down than oligopolistic firms in a recession.

MPC firms may be more vulnerable than oligopolistic firms in a recession as the former have less cash reserves. When a firm makes subnormal profit in a recession, a crucial factor which determines the likelihood of closure is the amount of cash reserves that it holds. If the firm holds a large amount of cash reserves, it is likely to be able to finance the subnormal profit with its cash reserves and hence is unlikely to close down and vice versa, other factors aside. As MPC firms can make only normal profit in the long run, they typically hold limited cash reserves. Furthermore, bank loans are the primary source of funding for MPC firms. Therefore, if banks reduce lending in a recession due to factors such as a rise in the default rate resulting in a credit crunch, MPC firms are likely to experience difficulty in raising funds to finance the subnormal profit. In contrast, as oligopolistic firms can make supernormal profit in the long run, they typically hold substantial cash reserves. Furthermore, in the event of a credit crunch, many oligopolistic firms are able to raise funds to finance the subnormal profit by issuing shares and bonds as they are listed companies.

MPC firms may be more vulnerable than oligopolistic firms in a recession as the former have a relatively high total variable cost. In the short run, a firm should shut down production if the total revenue is less than the total variable cost. If the firm shuts down production, it will make a loss equal to the total fixed cost. However, if it continues production, the shortfall will add to the loss. Therefore, the firm will make a loss greater than the total fixed cost. MPC firms are typically not capital-intensive. Therefore, they typically have a relatively low total fixed cost and a relatively high total variable cost. It follows that when MPC firms suffer a fall in total revenue in a recession, the total revenue is likely to fall below the total variable cost. In contrast, oligopolistic firms are typically capital-intensive. Therefore, they typically have a relatively high total fixed cost and a relatively low total variable cost. It follows that when oligopolistic firms suffer a fall in total revenue in a recession, the total revenue is unlikely to fall below the total variable cost.

Oligopolistic firms may be more vulnerable than MPC firms in a recession as the former have a relatively high total fixed cost. When a firm makes subnormal profit in a recession, a crucial factor which determines the likelihood of closure is the ability of the firm to cut costs. If the firm is able to cut costs by a large extent, it is likely to be able to reduce the subnormal profit by a large extent and hence is unlikely to close down and vice versa, other factors aside. Variable costs are generally easier to cut than fixed costs. As oligopolistic firms typically have a relatively high total fixed cost and a relatively low total variable cost, they are unlikely to be able to cut costs by a large extent. In contrast, as MPC firms typically have a relatively low total fixed cost and a relatively high total variable cost, they are likely to be able to cut costs by a large extent.

Oligopolistic firms may be more vulnerable than MPC firms in a recession as the former have a higher level of debt. When a firm makes subnormal profit in a recession, a crucial factor which determines the likelihood of closure is the level of debt of the firm. If the firm has a high level of debt, it is unlikely to be able to finance the interest payment and hence is likely to close down and vice versa, other factors aside. Oligopolistic firms typically have a high level of debt mainly due to high borrowing to finance expansion. Therefore, they are unlikely to be able to finance the interest payment. In contrast, MPC firms typically have a low level of debt and hence are likely to be able to finance the interest payment.

Oligopolistic firms may be more vulnerable than MPC firms in a recession as the former may be selling a normal good and the latter may be selling an inferior good. When national income falls in a recession, although the demand for normal goods will fall, the demand for inferior goods will rise. If the firms in an MPC market sell an inferior good, the demand for the good will rise in a recession which will lead to an increase in the profits of the firms. In contrast, if the firms in an oligopolistic market sell a normal good, the demand for the good will fall in a recession which will lead to a decrease in the profits of the firms possibly resulting in subnormal profits. Therefore, oligopolistic firms may be more likely to close down than MPC firms in a recession.

Evaluation

In the final analysis, although it is commonly believed that the degree of competition in a market is directly related to the number of firms, the number of firms in a market is not a perfect indicator of the degree of competition. In a market where there are a large number of firms, the degree of competition may be low if the bulk of the market share is concentrated in the hands of a few large firms. To overcome this problem, economists use the concentration ratio to show the degree of competition in the market, or more specifically, the extent of market control of a specified number of the largest firms in the market and hence the degree to which the market is oligopolistic. The market concentration ratio, or simply known as the concentration ratio, is a measure of the combined market share of a specified number of the largest firms in the market. In addition to the degree of competition in the market, another important factor which determines the vulnerability of a firm in a recession is the impact of the closure on the economy. If the closure a firm will affect the economy to a large extent, the firm is less likely to close down as it is likely to receive a financial bailout from the government and vice versa. For example, in the 2008-2009 Global Financial Crisis, it was believed that the closure of General Motors would lead to over a million job losses in the United States. Therefore, the US government provided a financial bailout of over US$50b in the form of loan and stock purchase to General Motors to help the firm stay afloat.

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