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Characteristics of the Various Market Structures

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Characteristics of the Various Market Structures

Characteristics of the Various Market StructuresThe market structures influence how price and output decisions are made by the firms in their respective structure. In all market structures, one of the primary goals is to maximize profits or minimize losses.One of the major differences between these market structures is how price and output decisions are made, which in turn depends on the characteristics of each market structure. There are four market structures:Perfect competitionMonopolistic competitionOligopolyMonopolyTasks:Using Template A, construct a table that describes the various characteristics of each market structure.Identify a firm for each of these market structures and explain why each firm belongs in the market structure identified.Using Microsoft Excel, construct a graph for each of the market structures and explain how price and output decisions are made in each structure and how they differ.How is marginal analysis used in the price and output decisions of firms in the various market structures?Template A:PerfectCompetitionMonopolisticCompetitionOligopolyMonopolyNumber of FirmsPricing DecisionsOutput DecisionsProfitDemand CurveEase of EntryProduct DifferentiationDeliverables:Prepare a 5-10 page Microsoft Word document that includes the tasks noted above and meets APA standards.Include a summary section in your report that contains 5-7 bullet pointsidentifying your major findings or conclusions of your paper.Submit this report as your initial post in theW4, Assignment 1 Discussion AreabySaturday, December 5, 2015.Comment on at least two other presentations submitted by your peers, identifying the strengths and weaknesses of each.All submissions must be original and all resources must be acknowledged.OUR READING MATERIAL:The Various Market StructuresMarket Structures: Price and Output DecisionsWhy Market Structures?The four basic market structures describe the basic behavioral patterns found in the economic arenas. This behavior differs because of the roles of buyers and sellers in each market and the circumstances in which they operate. Look at market structures on a continuum, similar to the one below. As one moves to the right, there is less and less competition.Adam Smith described how the perfect, capitalistic market would operate in a perfect environment. That was perfect competition. In the real world, the level of competition diminishes, depending upon the nature of the product being sold and the circumstances found in the primary markets.The Common Question: Price and OutputThere are several questions that are common for all the market structures, the answers to which provide the basic description as to how and why these markets operate. The most important question common to all the market structures concerns the price and output for the firm: “How Much Output and at What Price?”Perfect Competition and Monopolistic CompetitionPerfect CompetitionIn perfect competition, the price is determined in the market and all participants in the market face the same price. In other words, the demand curve is horizontal. Therefore, the only decision to make in this situation is “how much” to produce.Monopolistic CompetitionIn this market structure, there are many buyers and sellers, and each seller sells a differentiated product. The differences in these similar products may be real or they may be perceived, but they are there in the minds of the consumer.The sellers also have some control over price. Therefore, price can be lowered (or increased) depending on the product. A “sale” at a department store would be an example, or the lower prices on generic brands. But in any case, the result is a downward-sloping demand curve, which tells us that in order to sell more of product, the price must be lowered. The same question prevails: How much and at what price?Monopoly and OligopolyMonopolyIn monopoly, there is only one seller of a commodity. In other words, there is nocompetition! The world market for diamonds would be an example. The monopolist has complete control over price, with one constraint, demand. If the monopolist wants to maximize profits, they are still subject to the demands of the buyer.OligopolyIn oligopoly, there are a “few” sellers. The term “few” means that the number of firms is so small that each firm knows what the other firms are doing as soon as they do it!!The resulting effect is that competitors in an oligopolistic market tend to match any price decreases and ignore any price increases. Therefore, the tendency to change prices is minimal and prices tend to be more rigid. If the oligopolists form a cartel, then the resulting market behaves like a monopoly.Bottom line: prices tend to stay relatively fixed in a true oligopolistic market. Many theories have been developed to illustrate this type of market. For our purposes, let’s just say that the way an oligopolist arrives at the price and output decision is the same as that for the other market structures.The Common ThreadSo what is the common denominator in all these market structures when making the price and output decision? The answer: The firm should produce at the output where marginal cost is equal to marginal revenue.Regardless of the market structure, the point at which profits will be maximized, or losses minimized, is the output at which the marginal cost of a product is equal to the marginal revenue for the product. The price which corresponds with this quantity is given by the demand curve. MonopolyThe Nature of MonopolyToday monopoly exists in almost every capitalist economy of the world. Many large-scale industries and public utility services have a monopolistic market structure. Therefore analyzing monopoly is vital to understanding how it operates.Monopoly is a market form with one producer or seller of goods or services. A monopoly exists for two reasons—absence of a close substitute and a strong barrier to entry. The barrier to entry can be based on control of important raw materials, patents, market franchise, cost of establishing an efficient plant, and protection by the government from competition.To give a few examples, some monopolies that exist in today’s markets are the United States Postal Service (USPS), the Pacific Gas & Electric Company (PG&E), the National Aeronautics and Space Administration (NASA), and the Department of Motor Vehicles (DMV).Unlike a perfect competitor, a monopolist can influence the price of goods or services by varying output. A monopolist can choose to set a high price and sell a lower quantity or sell a large quantity at a lower price.A monopoly has a single producer of a good or service so the demand curves of firms and industry are the same. A monopolist can sell more output only at a lower price. Therefore the demand curve of the monopolist is downward sloping, as shown in the graph. At P0 the quantity demanded is Q0. However if a monopolist wants to sell Q1 quantity the price needs to be decreased to P1 as given by the demand curve. The demand curve of the monopolist is also its average revenue (AR) curve.Monopoly, page 2For a downward sloping demand curve, the marginal revenue (MR) curve is also downward sloping and lies below the demand curve at all levels of output. Let’s take a look at this with the help of an example. Consider a monopolist selling good A in a locality. The table shows the price, quantity, and MR of good A.Price, Quantity, Total Revenue, and MR of Good APriceQuantityTotal RevenueMR820160-66036054120480222505002/13A monopolist can sell 20 units of good A for $8. In this case, the total revenue is $160. At 60 units of good A, the AR, which is the price, is $6. The MR at this level of output is 5, which is less than the AR.MR is the change in total revenue due to an increase in sales by one additional unit. In a monopoly, an increase in output results in a decrease in price. As a result, two variables affect MR—the loss on previous units due to a lower price and the increase in revenue due to the sale of an additional unit at the market price. Due to this result, the MR is always less than the price at all levels of output.Monopoly, page 3Equilibrium for a MonopolyLet’s analyze the equilibrium of a monopolist in the short run using the cost and revenue curves of firms in monopoly. This will enable you to understand how a monopolist arrives at a short-run decision on price and output, which leads to maximum profit.Monopolists and perfect competitors aim at maximizing their profits. However differences in market conditions differentiate the results of their equilibrium. Let’s discuss this by analyzing the short-run and long-run equilibrium in a single-price monopoly. In a single-price monopoly, a monopolist sells goods or services at the same price to all buyers.Short-Run Equilibrium in a Single-Price MonopolyA monopolist maximizes its profit at the level of price and output at which MR is equal to marginal cost (MC). Let’s graphically represent the short-run equilibrium of a monopolist. At Q0 MR equals MC. Therefore the equilibrium price and output is P0 and Q0. The profit is maximized at this level of output.Unlike a perfect competitor, a monopolist can earn an economic profit, a normal profit, or incur loss in the short run. As seen in the graph, the monopolist is earning a supernormal profit equal to area AP0BC.Let’s now discuss long-run equilibrium in a monopoly and understand how a monopoly works in the long run.Long-run Equilibrium in a Single-Price MonopolyA monopoly has a barrier to entry. Therefore a monopolist can earn supernormal profit in the long run. A monopolist can decide the plant size at which it can earn the maximum profit. However if a monopolist continues to incur loss in the long run, and if there is no plant size at which it can earn profit, a monopolist might cease production in the long run.Next, let’s compare perfect competition with monopoly. This comparison will enable you to understand the behavior of a firm in monopoly or perfect competition. The comparison will also facilitate the analysis of other market forms because other market forms lie between the two extreme forms.Monopoly, page 4Let’s compare equilibrium under monopoly and perfect competition and then analyze the impact on efficiency due to variation in the behavior of firms in the two market forms.Comparing Equilibrium under Monopoly and Perfect CompetitionBoth a monopolist and a perfect competitor maximize profit at a level of output at which MR equals MC. However in monopoly, price is greater than MC at the equilibrium level of output, which is not the case in perfect competition.On the graph, the perfect competitor is at equilibrium at C. The equilibrium price and quantity is P0 and Q0 respectively. On the other hand, the monopolist is at equilibrium at D. The monopolist equilibrium quantity and output is Q1 and P1respectively. A monopolist charges a higher price than a perfect competitor by restricting output.Let’s now compare efficiency under monopoly and perfect competition.Monopoly, page 5Comparing Efficiency under Monopoly and Perfect CompetitionIn monopoly and perfect competition, efficiency can be explained with the help of consumer surplus and producer surplus. On the graph at the equilibrium level of output, consumer surplus and producer surplus in perfect competition is equal to area ABC.In monopoly, the sum of consumer surplus and producer surplus is equal to areas AFG and BEHI. Area EFGH is equal to monopoly gain, which occurs because the price paid by the consumers is higher than MC. A producer in monopoly gains at the cost of consumers. However, the gain to the producer in monopoly is less than the total loss because of restricted output. Monopoly results in deadweight loss equal to area GIC. Therefore, monopoly leads to lower efficiency.In perfect competition, a firm in the long-run can be in equilibrium only at the minimum level of its long-run average cost (LRAC) because a firm can only earn normal profit in the long-run. A perfect competitor produces goods by using the optimal plant size at the lowest cost possible. As a result, the allocation of resources is efficient. In monopoly, a firm is in equilibrium at a level of output at which LRAC is falling. A monopolist firm doesn’t use the optimal plant size, so the output is produced at a higher cost. Consequently, monopoly is not as efficient as perfect competition.However, a monopoly does provide some benefits to society as a whole. Granting patents to new inventions stimulates inventors to create new products. Moreover, to meet the demands of a large customer base and keep costs down, as in the case of economies of scale, a monopoly is the most viable market form.Often a producer charges different prices for different consumers. For example, private schools charge different fees for students. What type of market form are private schools? Private schools are a special type of monopoly called price discrimination. Let’s study this type of market form next.Monopoly, page 6Price DiscriminationPrice discrimination occurs when the same goods are sold at different prices to different consumers. An example of price discrimination is electricity. A different rate is charged for residential consumption and commercial consumption.Price discrimination is more profitable than a single price monopoly. Let’s try to understand this with the help of an example. Consider a monopolist producing good A. In addition, consider two submarkets X and Y for good A. Consider that a price discriminating monopolist is producing 2 units of good A. A monopolist can sell 1 unit at $10 and 2 units at $7 in submarket X. Likewise, the monopolist can sell 1 unit at $8 and 2 units at $6 in submarket Y.A price-discriminating monopolist can increase total profit more by selling one unit in submarket X at $10 and in submarket Y at $8, than by selling the entire output in submarket X or Y. However, price discrimination can be profitable only if the submarkets have different price elasticity of demand. As we discussed in Week 2, the price elasticity of demand measures the responsiveness of the quantity of a product demanded by consumers when the product’s price changes. For some products, consumers are highly responsive to price changes. Even small price changes cause very large changes in the quantity purchased. In this case, the demand for such products is said to be elastic.Let’s now analyze the equilibrium of a price-discriminating monopolist.Monopoly, page 7Equilibrium in Price DiscriminationTo maximize profit, a price-discriminating monopolist needs to decide how much total output to produce and how to allocate this output between the submarkets.A price-discriminating monopolist produces a level of output at which the aggregate MR of the submarkets is equal to MC. A horizontal summation of the MR curves of the submarkets gives the aggregate MR. The output is allocated to the submarkets in such a way that the MR in each submarket is equal.Let’s illustrate the equilibrium in price discrimination graphically. Consider two submarkets X and Y. Aggregate margin revenue (AMR) is the aggregate MR curve that is obtained by horizontally adding MRX and MRY, until quantity Q2 AMR is the same as MRX. This is because MRX is greater than MRY till Q2.As output increases both MRX and MRY enter AMR. A price discriminator maximizes its profit by producing Q level of output. At this output, AMR is equal to MC. This output is allocated between submarkets in such a way that the MRs in submarkets X and Y are equalized.At the level of output at which AMR equals MC, MR is equalized in submarkets X and Y at points N and M respectively. The price-discriminating monopolist will sell Q0 in submarket X and Q1 in submarket Y. The equilibrium prices, which are demonstrated by the points at the equilibrium output on the demand curve, are points P0 and P0 in submarkets X and Y respectively.A different form of price discrimination is perfect price discrimination. Let’s now discuss how a price-discriminating monopolist can attain the highest profit possible by selling each unit at the highest price.Perfect Price DiscriminationPerfect price discrimination occurs when each unit is sold at the highest price a consumer is willing to pay for it. As a result, a perfect price discriminator captures the entire consumer surplus. In perfect price discrimination, the area under the demand curve up to the quantity sold specifies the total revenue to the seller.Monopoly, page 8Social WelfareWe have learned that a monopolist tends to restrict output and charge a higher price than perfect competitors. This leads to inefficient resource allocation and loss of social welfare.Social welfare pertains to the well-being of the entire society. The social welfare function is analogous to an indifference-curve for an individual, except that the social welfare function includes the collection of individual preferences of everyone in the society regarding collective choices, which apply to everyone in that society, regardless of individual preferences.Social welfare is difficult to measure because it involves both objective and subjective, or value, judgments. It includes such things as the quality of the environment (air, soil, and water), the rate of crime, the accessibility of essential social services, as well as the spiritual aspects of life.Due to their effect on resource allocation and social welfare, monopolies often need regulation.Let’s continue our discussion and explore how regulation influences monopoly. Monopoly, page 9Let’s analyze regulation in a natural monopoly. Keep in mind, however, this analysis is applicable to all other forms of monopoly.Price Regulation in a Natural MonopolyA natural monopoly is a monopoly which occurs as a result of one firm being able to supply a market’s entire demand for a good or service at a price lower than two or more firms are able to because of a unique raw material, technology, or other similar factor. Such situations often occur in the case of utilities.Natural monopoly can be regulated through marginal-cost (MC) pricing and average-cost (AC) pricing. In MC pricing, the price is set equal to MC. Under AC pricing, setting the price equal to AC regulates the pricing of a natural monopolist. Let’s study how regulation affects a natural monopolist through AC and MC pricing.Monopoly, page 10Regulation through Marginal Cost PricingPrice regulation is often accomplished by way of government oversight or direct government control over the prices charged in a market, especially by a firm with market control, or a monopoly. Price regulation is most commonly used for such entities as public utilities, which are often characterized as natural monopolies.Price regulation is used by the government due to the fact that if such monopolies were allowed to maximize profit without restraint, the price charged would exceed the marginal cost and production would be highly inefficient. However, because such firms, e.g., public utilities, produce goods and services that are determined to be essential for the public welfare, the government intervenes by regulating or controlling the price. The two most common methods of price regulation are marginal-cost pricing and average-cost pricing.Let’s graphically illustrate the impact of MC pricing on a natural monopolist. Before price regulation, the equilibrium price and quantity for a natural monopolist is Q0and P0, respectively. Consider that the price is set at PM using MC pricing. Price regulation makes the monopolist’s AR equal to PMC until the Q1 level of output. This is because the monopolist now has to sell each unit until the Q1 output at the regulated price PM. Since each additional unit till Q1 earns the same revenue, the MR curve coincides with the AR curve.After price regulation, the firm maximizes its profit at C because MR is equal to MC at C. The equilibrium output is reached at point Q1. Price regulation has increased the total output by Q0Q1. However, as AC falls in the natural monopoly, the firm will incur loss equal to PMEDC. Therefore, the firm will stop production in the long run.One way to induce the firm to continue production is to allocate a subsidy equal to area PMEDC. The other way can be fixing the price at AC. Let’s study this option further.Monopoly, page 11Regulation through Average Cost PricingA price is set at PA as shown in the graph. Although the output is not efficient because it is less than the output of MC pricing it is better than before regulation. The natural monopolist earns a normal profit under this.We have analyzed perfect competition and monopoly. However these types of market forms are rarely found in the real world. Most real-life market forms are monopolistic competition and oligopoly, which we will study next. The analysis of monopolistic competition and oligopoly will help you understand the behavior of business firms in real life.Monopolistic Competition and OligopolyProduct DifferentiationMonopolistic competition has the characteristics of both perfect competition and monopoly. Monopolistic competition is a form of imperfect competition where many competing suppliers sell products that are somewhat differentiated from one another. The products are substitutes; however, they do have differences such as those provided by branding.In monopolistic competition, several firms produce similar goods. However each firm’s goods are different from the others in some respect. Firms in monopolistic competition compete with each other over quality, price, and marketing. An example of a monopolistic competition is bottled water, which is a multibillion dollar industry with many companies competing for the same market share. For example, Poland Spring, Seagram’s, Evian, Sierra Springs, Dannon, Coca-Cola, and Pepsi all sell bottled water.An important characteristic of monopolistic competition is product differentiation, which means that although the products of different firms are closely related, they are not homogenous. Take, for example, television. Several firms manufacture television sets. However each producer’s television set is different from others in some respect.Product differentiation may be real or imaginary. Real product differentiation is based on the differences in quality and services offered to consumers. Imaginary product differentiation is based on advertising, design, packaging, and brand name. In this type of product differentiation, only imaginary differentiation exists among the goods of different firms.Let’s now analyze how the monopolist competitor arrives at an equilibrium output and price in the short run.Short-Run Equilibrium in Monopolistic CompetitionA firm attains equilibrium under monopolistic competition in the same way as a monopolist. Like a monopolist, a firm under monopolistic competition faces downward sloping MR and AR curves. The firm maximizes output at a level of output at which MR = MC. Like a monopolist, the firm in monopolistic competition in the short run can earn a normal profit, a supernormal profit, or incur losses.Let’s graphically represent the short-run equilibrium of the firm in monopolistic competition.Consider a monopolistic competitive firm producing computers. The firm is in equilibrium at point A. The equilibrium price and quantity of the computers is $210 and 55 units, respectively. However, the short-run average cost (SRAC) is only $75. Therefore, the firm is making a supernormal profit of $135 ($210 – $75) on each computer sold.Let’s now analyze the long-run equilibrium of the firm in monopolistic competition.Long-Run Equilibrium in Monopolistic CompetitionIn the long run, a supernormal profit will cause the entry of new computer-manufacturing firms into the industry. This is because like perfect competition, there is no restriction on the entry and exit of firms in the industry under monopolistic competition.The entry of new firms will shift the demand curve of the firm to the right because industry output increases, which causes the price to fall. As long as the firm earns a supernormal profit, new firms will also continue to enter the industry. This will result in a rightward shift of the demand curve.In the long run, a firm will be in equilibrium at point A at which the long-run average cost (LRAC) curve is tangent to the demand curve of the firm. Because each firm is earning a normal profit, there is no incentive for new firms to enter the industry.The long-run equilibrium of the firm in monopolistic competition shows equilibrium to the left of the minimum LRAC. This is the result of an important characteristic attributable to monopolistic completion: excess capacity.Let’s now study this characteristic, which will help you to understand whether monopolistic competition is efficient or not.Excess Capacity in Monopolistic CompetitionThe ideal output of a firm is the one associated with the minimum LRAC. Excess capacity occurs when a firm’s plant resources are underutilized because a firm is producing less output than that associated with achieving the minimum average total cost.The difference between the output associated with the minimum LRAC and the actual output produced by the firm is excess capacity. Excess capacity will always occur when a firm faces a negatively sloping demand curve. Excess capacity is relevant only in the long run because all market forms can deviate from the ideal output in the short run. Both monopoly and monopolistic competition produce excess capacity.On the graph, QM is the output associated with the minimum LRAC. The actual output is QA. Therefore the excess capacity is QMQA.Excess capacity is the cost of product differentiation because people prefer variety. Like any other quality, product differentiation has a cost associated with it. The cost of product differentiation is represented by production to the left of the minimum LRAC.We have mentioned that there is intense competition among firms in monopolistic competition. Two crucial ways that firms in monopolistic competition survive are by way of product development and advertising. These are the key to success and longevity in this market form. Let’s analyze this now.Product Development and AdvertisingMonopolistic firms have the reputation of introducing innovative products that benefit consumers. Improvements in existing products increase efficiency and save time, which might increase the demand for a firm’s goods.Monopolist firms often use advertising to increase demand for their goods or services and to convince buyers that their goods or services are better than those of their rivals. Advertising can either shift the demand curve to the right or make the demand curve more elastic.Advertising can be informative or manipulative. In informative advertising, a producer informs consumers about the availability of goods or about the new features of old goods leading to better quality. In manipulative advertising, a firm tries to win over the consumers of rival firms.Advertisements by a firm with no other firms advertising is likely to result in a shift in the demand curve to the right. However, in monopolistic competition, the goods of different firms are closely related to each other. As a result, advertisements by a firm might induce rival firms to also advertise. As consumers become aware of the goods offered by other companies, the elasticity of demand for the firm’s goods increases.Increase in advertising shifts the AC curves upward because advertising is a fixed cost. This has the same impact on AC as fixed cost. Therefore, in the long run, advertisements might not benefit any firm in monopolistic competition.Another important market form prevalent in the real world is oligopoly. Let’s analyze this next. The analysis of oligopoly will enable you to understand the working of market forms in which a few firms producing close substitutes constitute the industry.Oligopoly MarketAs we have discussed so far, a monopoly consists of only one seller of a good or service. Whereas, in perfect competition and monopolistic competition, there are large numbers of sellers and entry to the industry is relatively easy. In these market forms, there exists no direct competition for access to the industry.On the other hand, oligopoly is a market form in which a few large firms sell identical goods, which are close substitutes of each other. There are strong barriers to entry. The simplest form of oligopoly is duopoly, which exists when only two firms sell the same goods.Because only a few firms sell similar goods, there is intense competition among firms for greater market share. The firms in oligopoly are interdependent decision makers. This is because a change in price or quantity by a firm will have a direct impact on the profits of all other firms, which might then retaliate by changing their prices or output.For example, consider that there are few restaurants in a small town in upstate New York. Therefore, if people like to have coffee and a bagel in the morning, they will have only a few options. In addition, if one of the restaurants closes down, there will be a subsequent increase in the profit of and demand for other restaurants left. If one raises its prices, the others might consider doing the same.Interdependence between rivals will result in different courses of action by firms. Rivals might engage in intense price wars or agree to compete with each other in pursuit of common objectives.For simplicity of analysis, let’s consider duopoly. However, because the fundamental problems are the same in most other forms of oligopoly, the analysis of duopoly is applicable to other forms of oligopoly.An important feature of oligopoly is price stability. It has been observed that in many oligopoly industries, prices remain stable. The “kinked-demand curve” model provides an explanation for a stable oligopoly price. Let’s study this model next.Kinked-Demand Curve ModelThe kinked-demand curve model provides the reason for the observed price stability in an oligopoly. In the kinked-demand curve model, the demand curve facing the oligopolist has a kink at the existing market price of the goods.In this model, each oligopolist believes that a reduction in the price of goods will be matched by a price decrease by its competitor. However an oligopolist believes that the price rise will not be matched by its competitor. This gives rise to the kinked-demand curve ABC as shown in the graph. P is the prevailing market price. Therefore, there is a kink in the demand curve at this market price.The segment of the demand curve that lies above the kink is more elastic because an increase in price by an oligopolist will result in no change in price by its competitors. As a result, a small increase in price will result in a large decrease in quantity demanded. Therefore, the segment of the demand curve above the kink is elastic.The segment of the demand curve below the kink is less elastic because a reduction in price by an oligopolist will be matched by a reduction in price by its competitor. Therefore, there will be a minor change in the market share of the firm. The quantity demanded also doesn’t increase as much because it’s the firm’s competitor that doesn’t change its price.Aggregate demand (AD) is the marginal revenue (MR) curve corresponding to segment AB of the kinked-demand curve as shown in the graph. EF is the MR corresponding to segment BC of the kinked-demand curve. The kinked-demand curve gives rise to the vertical segment DE.The intersection of MR and MC at any point on DE leaves price and quantity supplied unchanged. Therefore, an increase in cost by raising the SRAC curve upward to SRAC1 will not result in any change in price.An important model providing solutions to the problem of determining price and output in oligopoly is price leadership. It is an important form of collusive oligopoly in which firms enter into agreement in order to meet their common objectives. Understanding this model will enable you to appreciate how an agreement between oligopolists can help them achieve common objectives.Price LeadershipIn a price leadership structure, there is an implied or formal agreement among firms to establish and maintain a specific price structure. Price leadership can arise as a result of the lower costs enjoyed by a firm, or as a result of a dominating firm producing a large proportion of the total market share.Price Leadership as a Result of Lower Cost Enjoyed by a FirmIn price leadership as a result of lower costs, a firm with lower costs than others in the industry sets a price lower than the profit maximizing price of a higher-cost firm. This forces the higher cost firm to charge the price set by the lower cost firm.For example, consider two oligopolist firms, X and Y. Both produce homogenous goods and have an equal share of the market. Therefore, D and MR on the graph are the demand and MR curves of each firm. Consider that firm X has a lower cost. Its cost curve SRACX lies below the SRACY cost curve of firm Y. The profit maximizing price and output of firm X is P0 and Q0 respectively.Firm Y, however, would like to charge P1 for Q1 because it maximizes its profit at this price and output. Whereby, the low-cost firm X has the advantage of setting the price at P0. Firm Y in this case has to accept the price set by firm X because firm Y can’t sell its output at a higher price than firm X. In this case, firm Y will also sell Q0 output at P0 because both firms have the same demand curve.Let’s now discuss how to determine price and output in price leadership by a dominating firm. Dominating Firm StrategyIn this form of price leadership, a dominating firm has a much larger share of market output. All other firms have a small share of market output. The small firms follow the price that the dominating firm sets.Consider D as the market demand curve and SS as the supply curve of all the small firms together. At price P0, the small firm supplies Q0 quantity. Therefore, Q0Q1 is the demand for the dominating firm at price P0.By repeating this process for other prices, we derive the demand curve d of the dominating firm, as shown in the graph. The dominating firm maximizes its profit by setting P0 price and selling Q2 quantity. The small firm will accept this price and will together with dominating firm supply Q0 quantity at this price.The above models are equally applicable for multiple dominating firms and product differentiation.Why is Price Leadership Used?There are two primary reasons why price leadership is used. These include infrequent price changes and the avoidance of price wars.Because price changes always present the risk that competitors will not duplicate the change, price adjustments pose a risk and are made only infrequently. Under the price leadership model, prices remain somewhat constant and do not change to reflect minor day-to-day changes in costs and demand.Price is changed only when cost and demand conditions have been significantly changed across the industry. Examples would include industry wage increases, an increase in applicable taxes, or an increase in the price of some essential input such as fuel.The second reason is the avoidance of price wars. Price wars often are detrimental to industry profits as they result in consecutive price reductions as competitors try to maintain their market shares. Price leadership prevents such price wars by providing an orderly establishment of pricing.SummaryIn this module, we discussed how market forms such as monopoly, monopolistic competition, and oligopoly work in the real-world economy. We also looked at the costs of production in the various market structures and how pricing and output decisions are made.In Module 5,we will discuss the demand and supply and resource markets and how firms use resources efficiently. The week then addresses economic inequality—trends in income inequality and income redistribution in the U.S. Finally, your readings will cover further topics of concern to the question of how and/or why consumers make the choices they make. Factors such as a change in income or changes in budget constraints, indifference curves, and substitution effects will be discussed.REFERENCEMankiw, N. G. (01/2014). Principles of Economics, 7e, 7th Edition. [VitalSource Bookshelf Online]. Retrieved from https://digitalbookshelf.southuniversity.edu



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