A LEVEL ECONMICS 4

Market structures

   8.0    Introduction

In this chapter we will describe a structure or model as a simplified representation of reality. A model abstracts from reality. A model abstracts from reality by ignoring the finer details which are not essential to the purpose at hand. An example is a scale model, which is a miniature of the actual structure of an object being represented. Scale models are usually used in buildings e.g. architectural models and maps. Models play a pedagogical role in that they are used as a device for teaching individuals about the operation of complex systems. On the other hand, they are an explanatory device since they are a vehicle for relating separate objects and events in a logical manner. Market models seek to explain how firms behave in terms of their pricing, output and other forms of non-price competition. That is, the way in which various firms behave in either their output or pricing decisions gives rise to different market models. Economists envision four relatively distinct market situations: perfect competition, monopoly, monopolistic competition and oligopoly. This classification is base largely on the number of firms in the industry that supplies the product.

   8.1    Objectives of firms

A firm is an entity that produces and sells a product or service to consumers. Firm’s objectives help to develop theoretical generalisation about how firms behave. Below are some of the objectives that firms may pursue:

a)              To maximize profits where profit is what remains from the firm’s total revenue (TR) after it has covered all its costs (TC) that is π = TR – TC.

b)              Sales revenue maximization especially as viewed by managers who receive incentives related to their sales performance e.g. sales managers paid on commission

c)              To provide a service e.g. non governmental organisations (NGO)

d)              To establish a status quo e.g. some politicians or retirees who may want to keep themselves doing something.

e)              To increase the market share or achieve a certain growth rate.            

There are various theories on the above objectives of firms which can be outlined briefly as follows:

   8.1.1 The traditional theory

The theory was based on the assumption that firms will seek to maximise their profit, that is, they not only attempt to make a profit but attempt to make the last dollar of profit possible.

   8.1.2 The managerial theory

The theory takes as its starting point the split between shareholders as owners and managers as decision-makers in large modern business corporations.  It is argued that managers aim to maximise managerial objectives such as sales, growth and managerial career prospects rather than shareholders profits. This often results in agency problems, that is conflict between shareholder interests and management interests

   8.1.3 Organisational theory

The firm is viewed as an organisation or coalition of different groups such as managers, shareholders, employees, customers and suppliers.  The firm is a satisfier rather than a maximiser, attempting to satisfy the aspirations of the groups that make up the coalition.  It ensures a satisfactory level of sales, profits, wages or quality of products sought.

   8.2 Competitive versus imperfectly competitive markets

The distinction between perfectly competitive and imperfectly competitive markets can be made on the basis of;

a.           The number of competitors participating in the market.

b.          The ability of new firms to enter the market (or the presence of entry barriers).

c.           The type of product being produced.

d.          Information and knowledge on the conditions of the market.

On these four features, the four distinct market structures can be distinguished as summarised in the following table:

Table 8.1 Characteristics of the different market structures

FEATURE		MARKET STRUCTURE
		Perfect Competition	Monopolistic Competition	Oligopoly	Monopoly
Number of firms		A very large number	Many but less than in          perfect competition	Few	One
Type of product		Homogenous	Differentiated	Either homogeneous or differentiated	Unique that is no close substitutes
Conditions of entry		Free entry	Relatively easy	Significant obstacles	Barriers to entry
Control of product		None: firms are price takers	Some   butwithin limits	Made possible               by collusion	Either price or output but not both
Information knowledge	and	Perfect	Imperfect	Imperfect	Imperfect
Non-price competition		None	Emphasis is on advertising brand names	Typically a great deal with product differentiation	Mostly  public relations
Examples		Market for agric produce. e.g. Mbare Msika	Retail trade, clothing shops	Market for motor vehicles or bathing soap	Local          utilities such as NRZ

   8.3 Revenue and profit concepts

It is important to define the various revenue and profit concepts before looking at the individual market models.

  

   8.3.1 Revenue concepts

(a)             Total Revenue (TR)

This refers to the total amount of money that the firm receives from the sale of its output. It is given by: TR = Price x Quantity. 

(b)             Average Revenue(AR)

This is the total revenue divided by the number of units sold, that is,           AR = PQ / Q. Quite obvious, AR is the price of the commodity, that is,       AR = P. 

(c)             Marginal Revenue(MR)

This is the change in total revenue resulting from an increase of one unit in the rate of sales. That is, the extra revenue which results from selling one more unit of output. The marginal revenue resulting from the sale of the n^th unit of a commodity is thus the change in total revenue when sales rise from the rate n-1 to n units.  MR_n = TR_n – TR_{n – 1}

   8.3.2 Profit concepts

With the costs and revenue concepts we can be able to study how firms behave if they wish to maximise their profits. Profit is the difference between total revenue and total cost. It can also be calculated by subtracting average costs from average revenue. That is, Profit = TR - TC or   = AR - AC.

(a)             Normal profit

Normal profit is the minimum amount of profit which is necessary to keep a firm in the industry. It can be referred to as transfer earnings, that is, the payment which is necessary to keep a factor in its present use. If TR is equal to TC or AR= AC, the firm will be earning normal profit.

(b)             Abnormal profit.

Also known as supernormal profit or economic profit. If TR is more than TC or AC > AC, the firm will be earning abnormal profits. Abnormal profit represent economic rent which is any payment made to any factor of production over and above that which is necessary to keep the factor in its present use.

   8.4 Profit maximization conditions

Profit maximization remains the key objective of the firm. To arrive at the profit maximization conditions, we apply the concepts of total revenue and total costs. The firm maximizes profit when it is in equilibrium. At equilibrium, the firm would produce an output that maximizes the difference between total revenue and total costs. The equilibrium of the firm may be shown graphically in two ways. Either by using the TR and TC curves or the MR and MC curves.

   

   8.4.1 Total Revenue and Total Cost approach

    Costs /

    Revenue

   

                    O                        X_a              X_e           X_b              Output 

According to the diagram above, the total revenue curve is a straight line from the origin showing that the price is constant at all levels of output. Thus the firm is a price taker and can sell any amount of output at the going market price with its total revenue increasing proportionately with its sales. The slope of TR curve is the marginal revenue (MR). MR is constant and equal to the prevailing market price since all units are sold at the same price. Thus MR = AR=P.

The shape of the total cost curve reflects the law of diminishing marginal returns or variable proportions. The firm maximizes its profits at output X_e, where the distance between TR and TC curves is greater. At the lower and higher levels of output, total profit is not maximized. At output level below X_a and above X_b the firm makes losses as shown by the shaded areas.

   8.4.2 Marginal Revenue and Marginal Cost approach

From the previous diagram, at output level X_e the slopes of TR and TC curves are equal as indicated by the tangent TR¹. The slope of TR is the MR while the slope of TC is the MC. Thus at output X_e, MR = MC. Therefore the firm maximize its profits by producing output X_ewhere MR = MC

If MR>MC, it implies that an additional unit of output produced adds more to revenue than to cost and hence the firm will increase its output. Conversely, where MR The necessary condition is that MR = MC.

                 b. The sufficient condition is that the MC curve must cut the MR curve from below.

What is left is to apply these conditions as we investigate how price and output are determined in different market models.

   8.5   Perfect competition

A market is considered to be perfectly competitive when it fulfils the following conditions:

a.               Perfect competition requires large numbers of sellers and buyers such that each participant in the market, whether buyer or seller, is so small in relation to the entire market, that he or she cannot effect the product's price. As a result firms under perfect competition are price takers.

b.              Perfect competition requires that the product of any one seller be the same as the product of any other seller. That is products sold are homogeneous or perfectly identical and there is no need for non-price competition.

c.               Perfect competition requires that firms should be free to enter or leave the market depending on whether the market is profitable or not.

d.              Perfect competition requires that consumers firms and resource owners have perfect knowledge of the relevant economic and technological information.

e.              Perfect competition requires that factors of production be completely mobile.

   8.5.1 The output of a firm under perfect competition in the short run

Firms operating in a perfectly competitive market are price takers, that is, individual firms take price as given by the market. As a result they face a perfectly elastic demand curve. This horizontal demand curve is also equal to the average and marginal revenue curves: D = MR = AR = P.

As observed under the MR and MC approach to the derivation of the profit maximizing conditions, profit is maximized by adjusting output to the point where MR = MC. In the short run price is likely to be greater than average total cost hence firms will be earning abnormal profits as represented by the shaded rectangle on the following diagram.

  

                           O                                      Q_e           Output 

Given the price and cost shown in the diagram, the firm's equilibrium output is OQ_e because this is the output level which equates MR with MC. Details of MR and MC enables us to determine the firm's profit maximizing output but not the actual level of profit. It is the total revenue and total cost which can tell us the actual level of profit. With details shown in the diagram; price OP and output OQ_e, total revenue is equal to OP x OQ_e = rectangle OPRQ_e while total cost is equal to OT x OQ_e = rectangle OPRQ_e. Total revenue minus total cost gives total abnormal profit equal to shaded rectangle PRST. Thus in the short run the firm will produce output OQ_e and charge price OP, making an abnormal profit of rectangle PRST in the process.

   8.5.2 The output of a firm under perfect competition in the long run

The existence of abnormal profit in the short run will in the long run attract other firms into the industry. Perfect knowledge of market conditions will ensure that firms outside the industry are aware of the level of profits earned and the absence of barriers to entry will ensure they are able to enter the industry and undertake production. The entry of new firms in the industry will increase total supply and as a result prices fall. This may continue until the abnormal profits have been completed away and firm will earn only normal profit.

Fig 8.4 Long run equilibrium of a perfectly competitive firm

In the diagram, long run equilibrium is established when output OQ₁ is produced. Total revenue is equal to OP₁ x OQ₁ = OP₁UQ₁. Since profit equals TR minus TC zero profits are being earned. That is the firm is only earning normal profit. Normal profit is insufficient to attract additional firms into the industry but just sufficient to dissuade those firms already in the industry from leaving. Should supply continue to increase, the price may fall below AC and firms will run at a loss and may leave the industry, thus bringing the situation under control.

   8.5.3 Short run losses and the firm's shut-down position

The short run equilibrium might have losses if price is less than average total cost. These losses can be minimized by producing an output level where MR = MC. However, if the price is less than the average variable price (AVC), the firm will minimise its loss by producing no output.

Revenue

  

P₁

                   O Q₁    Q₂            Q₂     Q₁                      Output 

If price is between OP₁ and OP₂ the firms AR will be less than ATC. However the firm will be earning enough to cover all its variable costs and part of the fixed costs. To cease production would leave the firm with a loss equal to its fixed costs whereas if the firm undertakes production, it will at least have a surplus over variable cots to set off part of its fixed costs.

If price falls to below OP₂, AR will be less than AVC and the firm will be better off by ceasing production altogether. If it produces nothing the firm's total loss is equal to its fixed costs. This compares with a loss equal to the deficit on variable cost added to the fixed cost if it undertakes production.

It can therefore be concluded that the minimum acceptable price if the firm is to undertake production is that price which exactly equals the minimum short average variable cost of production. It is for this reason that the minimum AVC is sometimes referred to as the "shut-down' price.

Thus if price falls to levels below W, the firm will shut down the plant or stop producing. This does not mean that the firm goes out of business, but simply that the plant remains idle. However, no firm can sustain losses indefinitely and thus in the long run, loss-making firms will leave the industry.

   8.5.4 The short run supply curve of the firm

From the above discussion, we can state that as long as price is equal to or greater than AVC, the perfectly competitive firm will adjust its output by moving along that part of its marginal cost curve that lies above its AVC. This part of MC curve coincides exactly with the definition of a supply curve since the supply curve indicates the amount of a good that the producer is willing and able to provide to the market at different prices.

Fig8.6 Derivation of a perfectly competitive firm’s supply curve

                      0             Q₁        Q₂     Q₃                                  Output 

As price rises from OP₁ to OP₂ to OP₃ so the firm expands output from OQ₁ to OQ₂ to OQ₃ in each case equating MC with MR.

the part of the MC curve which lies above its average variable cost curve is the firm's supply curve.

   8.5.5 Perfect competition and resource allocation

Firms that are perfectly competitive allocate scarce resources efficiently between uses. This is because of the triple equality condition found in the long run, that is, P (=MR) = AC = MC. Efficiency is achieved when two conditions are satisfied. 

(a)         P = Minimum AC (Productive Efficiency). In the long rung competition forces forms to produce at the point of minimum AC of productions and charge that price which is just consistent with these costs.

(b)        P = MC (Allocative Efficiency).Again, the price charged in the long run is equal to marginal cost, a condition that is known as allocative efficiency.

   8.5.6 Critique of perfect competition theory

a.               Perfect competition assumes perfect information and knowledge. As a result, a firm can not expect to gain much competitive advantage over other firms by developing new technology. There is little incentive to develop new technologies since other firms can adopt the new technique. Since technological innovation is considered essential for economic growth, a perfectly competitive world, while promoting allocative efficiency, may well retard growth.

b.              Perfect competition assumes perfect information about technology. As a result a firm cannot expect to grow much competitively over other firms by developing new  technology. Thus there is little incentive to develop new technology in perfectly competitive markets.

c.               Competitive markets values are based on the private costs and benefits associate with  the        actions            of         individual consumers and producers. External costs and benefits of production and consumption are not captured.  This is referred to as market failure.

   8.5.7 Market failure and the role of the government

Market failure refers to the failure by the market or price mechanism to allocate resources efficiently. The common belief is that if left alone market forces may not allocate resources efficiently, for example, public goods such as roads may not be produced. Market failures arise from the existence of externalities and public good among others.

              a. Externalities 

Externalities refer to costs and benefits to society that arise from production or consumption that are not accounted for by the market. Externalities are said to exist when the action of producers or consumers affects not only themselves but also third parties, other than through the normal of the price mechanism. Externalities are referred to as external costs when they are harmful e.g. air pollution and external benefits when they are beneficial e.g. the reduced chance of spreading a communicable disease when an individual is inoculated against it.

i. Negative Externalities

The existence of negative or bad externalities suggest an over production or over consumption of a certain good. 

Fig 8.7 Effect of negative externalities

Cost /

                               O                        Q₂    Q₁               Output                              

The firm will produce at Q₁where PMC (Private Marginal Cost) equals the D = PMB (Private Marginal Benefit).  The firm considers only costs like cost of raw materials, labour, rent and utilities.  It does not consider external costs such as pollution, noise and congestion. If forced to do so, that is, if social marginal cost is considered instead, produced will be Q₂.

The triangleabc represent the welfare loss to society at the profit maximizing equilibrium Q₁ii. Positive Externalities

In the case of positive externalities, there would be under production or under consumption of the goods because firms would consider private benefits only.

 

                                 O                  Q₂       Q₁              Output

Private output will be at Q₂. However the optimum social output is at Q₁.where SMB (social marginal benefit) equals the SMC (social marginal cost). The gap Q₁ – Q₂ is the under consumption or under production. The shaded areaehk shows the welfare loss brought about by under production. This represents the society’s loss due to the missed opportunity of not having the additional output.

              b. Public goods

Public goods are defined as products whose consumption is non-exclusive and non-exhaustive. Non-exclusive means that a producer or seller can not separate non-payers from benefiting from the good. Non-exhaustive implies that the use by one person does not reduce the amount available to another. As a result, there is no rivalry in consumption.

8.6 Monopoly

A monopoly exist when the market is dominated by a single supplier of a product for which there are no close substitute and in which it is very difficult or impossible for another firm to exist. Thus, for monopoly to exist the following conditions must be fulfilled.

(i)          The firm must be the only supplier

(ii)         No close substitute for the firm's products must be in existence

(iii)        There must be restrictions or barriers to entry which make the survival of potential rivals extremely unlikely.

  

   8.6.1 Reasons for monopoly

Why do monopolies arise? There are many reasons which often are discussed as barriers to entry. Barriers to entry are obstacles to entry that protect the firm within a market from the threat of competition by potential entrants

(a)         A Single firm may control the entire supply of a basic input that is required to manufacture a given product. in this case the firm becomes a natural monopoly for example DeBeers in South Africa which control almost every piece of land on which diamonds are mined.

(b)         A firm may acquire a monopoly over the production of a good by having patents on the product or on certain basic processes that are used in the production. The patent laws to make a certain product as a way to encourage invention.

(c)         A firm may become a monopolist because it is protected by an Act of the Parliament for example government corporations such as ZBH.

(d)         When a firm is enjoying economies of scale, it may supply the market effectively at lowest possible cost making the entry of other firms extremely difficult.

(e)         If production requires an initial large capital requirement for example laying of rail tracks, a firm that will be ale to source the capital may become a monopoly e.g. NRZ.

   8.6.2 The demand curve for the monopolist

Since the monopolist is the only firm in the industry, it faces the industry market demand curve which is downward slopping.

Thus, to sell an additional unit of output, the firm has to reduce its price.

Fig 8.9 Monopoly firm’s demand curve

  

                                 O                                          Quantity 

The MR curve is also downward sloping because the addition to total revenue from the sale of additional units becomes progressively smaller and smaller with price being reduced in order to sell on extra unit. Another point to note is that the MR is less than AR at every level of output except for the first unit. This cane be illustrated by the following example. Assume a monopolist sells 100 units at a price of $2.50 each. In order to raise sales to 101 units, the price should be reduced $2.48. Thus average revenue falls to $2.48 but marginal revenue which is the difference in total revenue resulting from the increase in sales from 100 to 101 units can be calculated as: 

              TR1      =         100     @2.50 $250

              TR2      =         101     @2.48 $250.48

Therefore the increase in TR = 48c. Thus MR = $0.48 is less than AR = $2.48.

8.6.3 Monopoly output and price determination

A profit maximizing monopolist will employ the same rationale as a perfectly competitive firm, that is, it will produce an output level where MR=MC. In the short run, a monopolist can earn abnormal profits due to the fact that it will be charging very high prices since it faces no competition.

Fig 8.10 Short run monopoly output and price

   

      C 

           

A monopolist has the power to determine either the price at which to sell his product or the quantity he wishes to sell. He can not determine both because he can not control demand. If he decides on output level OQ_m using the MR = MC rule, the unique price at which OQ_m can b sold is found by extending a vertical line up from the profit maximizing output and then at right angle from the point at which it hits the demand curve to the price axis. The indicated price is OP_m. At output level OQ_m, average costs per unit equals OC. Total revenue equals rectangle OP_mAQ_mand total cost equals rectangle OCBQ_m. Therefore the monopolist is making abnormal profits represented by CP_mAB.

NB: Abnormal profits will continue in the long run because of the assumption of barriers to entry which exist. As a result the long run equilibrium is the same as the short run equilibrium. However, monopolists may earn losses in the short run, in which case they would strive to minimise their losses.

Fig 8.11 Monopoly loss

            Revenue / Cost                                                 

  

                                        O                         Q_m                     Output 

The absence of a unique price associated with each output level makes it difficult for use to define the supply curve for a monopolist,

8.6.4 Monopoly and resource allocation

Given the same costs, a monopolist will produce much less desirable results than a perfectly competitive firm. The monopolists will find it profitable to sell a smaller output and to charge a higher price than would a competitive producer. Therefore monopolists are allocative inefficient in the sense that they charge a price which is above marginal costs, that is P>MC. They are also productive inefficient because they produce less output at a high cost of production than producing at the minimum of average cost curve.

8.6.5 Monopoly price discrimination

Price discrimination is a situation where a firm charges different prices for the same product in different markets when there are no cost differences to justify this. The different prices are charged for reasons not associated with costs of production, for example, cell phone peak and off-peak call charges.

The conditions necessary for price discrimination to be successful are that (i)     Buyers fall into classes with considerable differences in the price elasticity of demand for the product.

(ii)         These classes can be identified and segregated at moderate cost and

(iii)        Buyers must be unable to transfer the commodity easily from one class to another, since otherwise it would be possible for persons to make money by buying the product from the low-price market and selling it tot he high price market, thus making it difficult to maintain the price differentials between classes.

The discriminating monopolist will proceed to charge a high price in the market where demand is inelastic and a low price where demand is elastic in order to exploit the consumers' surplus.

   8.7 Monopolistic competition

Perfect competition and monopoly are two polar extremes. There are an extremely large number of firms in a perfectly competitive industry but only one firm in monopoly. During the late 1920s and early 1930s, economists began to stress the need to develop models that will handle the important middle ground between perfect competition and monopoly, in which feel practically all of the empirically relevant cases.

One of the most noteworthy achievements that were then produced was the theory of monopolistic competition, put forth by

Harvard's Edward Chamberlin -The Theory of Monopolistic Competition (1933)

   8.7.1 Assumptions

The basic idea behind Chamberlin's theory is that most firms face relatively close substitute products and that most products are not completely homogenous from one seller to another. The assumptions underlying Chamberlin's theory are as follows: -

(i)          He assumes that the product which is produced is differentiated, with each firms' product being a fairly close substitute for the products of the other firms in the product group. Product differentiation refers to a situation where similar products are made distinct through packaging, branding, after sales services etc. for example, bathing soaps like Geisha, Jade and Image. 

(ii)         He assumes that the number of firms in the product group is sufficiently large so that each firm expects its actions to go unheeded by its rivals and to be unimpeded by any retaliatory measures on their part. Therefore, firms are price setters in respect of their individual products.

(iii)        There are no barriers to entry hence entry or exist in the industry is relatively easy.

(iv)        He assumes that both demand and cost curves are the same for all of the firms in the group. This, of course, is a very restrictive assumption since if the products are differentiated; one would ordinarily expect their demand and cost curves to be different too.

  

   8.7.2 Product differentiation and the firm's demand curve

Product differentiation plays a very important role in Chamberlin's theory in that it defines the scope of the firm's demand curve. If a product is well differentiated, it becomes unique and hence would have less close substitutes thus demand curve will approximate the monopoly's demand curve. On the other hand if products are less differentiated they tend to be substitutes hence the demand curve will approximate a perfectly competitive firm's demand curve. Thus the precise degree of elasticity embodied in the monopolistically competitive firm's demand curve will depend on the exact number of rivals and the degree of product differentiation. The large the number of rivals and the weaker the product differentiation the greater will be the elasticity of each seller's demand curve that is the closer the situation will be to perfect competition.

8.7.3 Price and output determination

The firm will maximise profits by producing that output level where MR=MC

    

Fig 8.12 Short run equilibrium of a monopolistically competitive firm

                                 O                   Q₀                      Output 

On the above diagram the firm produces an output OQ₀ and charges a price OP and realises a total abnormal profit of the size of the shaded rectangle CPAB. A less favorable cost and demand situation may exist, putting the monopolistically competitive firm in the position of realizing losses in the short run. This is illustrated by the shaded rectangle in the following diagram.  

Fig 8.13 Short run loss under monopolistic competition

               Cost     /                                                

                                   O                                     Q₁                Output 

Total costs are represented by the rectangle OC₁AQ₁ and total revenue by rectangle OP₁BQ₁. The firm is making losses as represented by the shaded rectangle P₁C₁AB. 

Thus in the short run, the firm may either realise an economic profit or loss. Abnormal profits will attract new rivals. Since entry is relatively easy, new firms will enter. As the number of rivals increase, the demand curve will become more elastic and each firm's market share becomes very small. Thus in the long run, the short run abnormal profits will disappear and firms earn normal profits.

Fig 8.14 Normal profit for a monopolistically competitive firm

                                  O            Q₀                                 Output 

When the demand curve is tangent to the average costs curve at the profit maximizing output as shown in the diagram above, the firm is earning normal profit. Losses in the short run will lead to an exodus of firms in the long run. Faced with few substitutes and blessed with an expanded market share, surviving firms will find that their losses disappear and gradually give way to approximately normal profit.

   8.7.4 Criticisms of the theory of monopolistic competition

A number of important criticisms have been made of the theory.

(i)              University of Chicago's George Stigler and others have argued that the definition of the large group of firms included in the product group is extremely ambiguous. It may contain only one firm or all of the firms in the economy. In other words the model assumes a large number of sellers but it does not define the actual number. How many firms should there be in an industry in order to classify it as monopolistic competition rather than as oligopoly? What is the crucial number that determines whether firms act independently or recognize interdependence? Such problems are not discussed in the model.

(ii)             The assumption of product differentiation is incompatible with the assumption of free entry. Some forms may achieve a measure of product differentiation which can not be duplicated by rivals even over a long span of time. Thus product differentiation can create a barrier to entry for new firms

(iii)            The assumption of independent action by the competitors is inconsistent with reality. In reality firms are continuously aware of the actions of competitors whose product is close substitute to their own product.

(iv)            The assumption of myopic behaviour of business owners is unrealistic. In reality firms do learn from past behaviour.

Those that do not, get competed out of business.

   8.8     Oligopoly 

Oligopoly is a market model characterized by a small number of firms and a great deal of interdependence, actual and perceived among them. Each firm formulates its policies with an eye to their effect on its rivals. Thus one firm's price decision is likely to cause a response which often leads to price wars. The interdependence of firms in oligopoly markets makes them not to depend on market forces. They worry about prices, spent fortunes on advertising and try to understand the behaviour of their rivals. Oligopolies may produce homogenous or differentiated. If the firms produce a homogenous producer, the industry is called a perfect or pure oligopoly. If the firms produce a differentiated product the industry is called an imperfect or differentiated oligopoly. It is easier to deal with the case of perfect or pure oligopoly. When two firms dominate the market as what used to exist when Circle Cement used to serve the northern part of the country while Portland Cement was serving the southern part, this is known as duopoly.

The interdependence of firms in oligopoly markets lead to a range of behaviour patterns bordering on one extreme, firms being engaging in fierce competition and on another, firms explicitly co-operating. As a result there is no single model of oligopoly behaviour. Here, we will examine three rather distinct models.

   8.8.1 Oligopoly with price leadership

This model of oligopoly behaviour is based on the assumption that one of the firms in the industry is the price leader. The price leader will set the price and the rest follow its lead, that is, the followers will adopt this price. Thus the followers behave like firms in perfect competition while the price leader behaves like a monopolist in the sense that it has freedom to set price.

Two forms of price leadership can be discussed: the dominant firm and the barometric - firm. The dominant firm leadership applies to industries in which there is a single large dominant firm in the industry and a number of minor firms. The dominant firm sets the price for the industry probably using the marginalist rule for profit maximization (MR = MC), but the assumption is that it lets the minor firms sell all they want at that price. Whatever amount the minor firms do not supply at that price is supplied by the dominant firm.

The barometric firm leadership applies to the industry in which one firm usually is the first to make changes in price that are generally accepted by other firms in the industry. The barometric firm may not be the largest or most powerful firm but a reasonable accurate interpreter of changes in basic cost and demand conditions in the industry. According to Kaplan, Dirlan and Lanilotti, a firm may emerge as a barometric firm through experienced stability during a period of violent price fluctuations and cutthroat competition in the industry during which many other firms suffer.

  

   8.8.2 The kinked demand curve model

This well known model designed to explain the rigidity of prices in oligopoly markets was advanced by Paul Sweezy (1939) "Demand under Conditions of Oligopoly", Journal of Political Economy, August 1939. In his theory he stated that if an oligopolist cuts its price, it can be pretty sure that its rivals will meet the reduction. On the other hand, if an oligopolist increases its price, it is likely to find that its rivals will not change their prices. In such a case, the demand curve for the oligopolist’s product would be much more elastic for price increases than for price decreases.

Fig 8.14 The kinked demand curve

     P₀ 

                     O                          Q₀                           Output 

The kinked demand curve is a combination of two types of demand curves with different elasticities. Because of the 'kink' in the demand curve, the marginal revenue curve is not continuous. Given that the firm's marginal cost curve is MC₀ marginal cost does not equal marginal revenue at any level of output. However output OQ₀ remains the most profitable output and OP₀ the most profitable price even if the marginal cost curve shifts to MC₁. Thus under these circumstances, one might expect price to be quite rigid at the level of the kink.

Although this model may be useful under some circumstances in explaining why price tends to remain at a certain level (OP₀), it is of no use in explaining why this level, rather than another currently prevails. In other words, the theory does not explain how the going price gets to be at OP₀ in the first place.

   8.8.3 Collusion and cartels 

Collusion occurs when the few firms composing an oligopolistic industry reach an explicit or unspoken agreement to fix prices, divide a market, or otherwise restrict competition among themselves. The advantages to the firms of collusion seem obvious: increased profits, decreased uncertainty, and a better opportunity to prevent entry. Conversely, collusive arrangements are often hard to maintain, since once a collusive agreement is made, any of the firms can increase its profit by cheating on the agreement. As a result, cartels are very unstable. 

When a collusive arrangement is made openly and formally, it is called a cartel. A cartel is a group of sellers of a product who have joined together to control its production, sale and price in hope of obtaining the advantages of monopoly. Thus when a cartel is successful it may end up more of a monopoly, but because they do not combine to produce together, they do not enjoy economies of scale. An example of a cartel is the Organisation of Petroleum Exporting Countries (OPEC). OPEC was formed in 1960 with the objective of controlling crude oil production. In 1973, members restricted output and prices of crude oil tripled. However, the cartel failed to keep prices high by the mid 1980s because the OPEC never established barriers to entry. As a result, when prices rose, non cartel members increased output and putting a downward pressure on prices. On the other hand, close substitutes for oil and energy efficient technologies were developed. Thus demand for oil became more elastic.

Members of the cartel have been in disagreement over quotas. By 1989, cheating among members became rampant, and production exceeded the total quota, putting pressure downward on prices. This destroyed the cartel’s ability to maintain high prices.

National income measurement

9.0   Introduction

During the course of the year economic agents engage in activities that produce various goods and service or national output. National output and national income are synonymous. In this chapter, we are going to explore how an economy can attach a monetary value to its output and outline some of the alternative uses of the obtained statistic or GDP. The aim of national income measurement or accounting is to place a monetary value on this year’s output. National income measurement is important in that it provides us with a basic indicator of the performance of the economy in the production of goods and services over a given period, usually a year.

   9.1 Methods of measuring national income

There are three methods of measuring national income, namely income method, output method and expenditure method. These methods must arrive at the same national income figure because they are measuring the same output in different ways.

9.1.1   Income method

The income method adds together income earnings in the form in which they are received, that is, income from employment and self-employment (wages and salaries), rent, interest, profits and dividends.  Note that only incomes earned from supplying factor services are counted.  Transfer payments are ignored and incomes are recorded gross hence the result is national income at factor cost.

   9.1.2 Output method

The economy is broken up into different sectors (e.g. manufacturing, agriculture, mining etc.).  The output method adds together the total value of all final goods and services produced in each sector or adding the value added at each stage of production to avoid double counting.

   9.1.3 Expenditure method

The method adds together all the money spent in buying this year’s output.  National income will be the total of consumption, investment, government expenditure and net exports (exports less imports).  The result is total expenditure at market prices hence deduct indirect taxes and add subsidies to get national income at factor cost.

   9.2 National income statistics

Gross Domestic Product (GDP) is the primary statistic of national income measurement and other measures or statistics can be derived from GDP.

   9.2.1 Gross Domestic Product (GDP)

GDP is the total value of all the final goods and services produced from all the resources within Zimbabwe. Final goods refer to goods produced for consumption unlike intermediate goods which are goods used as inputs to produce other goods and hence intermediate goods are excluded in the measurement of GDP. GDP measures the performance of the domestic economy because of its focus on output from resources located in the domestic economy regardless of their ownership.

   9.2.2 Gross National Product (GNP)

GNP is a measure of the total value of all final goods and services produced from resources owned by Zimbabweans regardless of where they are operating from. GNP measures the performance of a nation. Resource ownership is important because it determines the flow on factor income. Foreign ownership implies income flowing to abroad (factor income to abroad) while Zimbabwean citizens who own factors of production abroad will remit their incomes aback home (factor inflow from abroad).

GNP = GDP + Net factor income from abroad

Net factor income form abroad = Factor income from abroad – Factor income to abroad

   9.2.3 Net National Product (NNP)

The word ‘gross’ implies that the costs of producing that output are included. The cost is depreciation. Depreciation or capital consumption refers to that part of the year’s output needed to replace obsolete and worn-out capital. Depreciation is a cost of production and must be deducted from the GNP in order to arrive at the net national income. 

NNP = GNP – Depreciation

The NNP figure will be at market price.  That is, it is obtained using the prevailing market prices for the final goods and services which often are inclusive of indirect taxes such as VAT while being exclusive of any subsidies. To measure the amount of income paid to the factors of production for the services rendered in producing the output (NNP at factor cost), we deduct indirect taxes and add subsidies to NNP at market prices.  

NNP at factor cost = NNP at market price – indirect taxes + subsidies

   9.2.4 Personal Income (PY)

Personal income refers to income actually received by households and unincorporated business (personal sector). PY = NNP at factor cost less company tax, retained profits and social security payments plus transfer payments.

   9.2.5 Personal Disposable Income (PDY)

Personal disposable income is that part of personal income which is finally available for spending by households.

PDY = PY - Income tax (PAYE) and Property taxes (e.g. rates).

   9.3 Problems likely to be encountered when measuring national income

Estimation of the country’s GDP is the responsibility of the Central statistics Office (CSO). To obtain the GDP statistic the department conduct national income surveys through which representative samples of the population (households or firms in different sectors) make contributions that are then generalised on the economy. In this process of estimating national income, there are three sets of problems that are likely to be encountered.

   9.3.1 Data Reliability

National income accounts are as good as the data on which they are based. If the data is inaccurate, the resulting statistic will also be inaccurate. Data can be inaccurate due to:

a.     Sampling technique problems e.g. sampling bias or even bad luck.

b.     Individuals giving incomplete or inaccurate information.

c.     Guess work, especially in developing countries where there are no means of gathering the correct data e.g. output from subsistence farming is difficult to measure in Zimbabwe, resulting in conflicting reports on the contribution of communal farming to national agricultural output.

   9.3.2 Valuation

Final goods and services are measured in various physical units such as kilograms, hours, dollars etc. As a result, there is need to convert all these measures to monetary terms in order to come up with a monetary value of the year’s output. However, when making these valuations the following problems are likely to be encountered.

a.     Double counting which arises when adding the value of intermediate goods instead of final goods or ‘value added’ at each stage of production. For example, the value of wheat ($200mln) + value of flour ($500mln) + the value of bread ($800mln) giving a wrong national income of $1500mln instead of the correct $800mln which is the value of the final product (bread). In this case wheat and flour are intermediate goods.

b.     Public goods and services (e.g. defence) make a contribution to national income but they do not have a market value. As a result, it will be difficult to attach a monetary market value to public goods and services. However, the contribution of public goods and services should be measured ‘at cost,’ that is, add the salaries of soldiers as the value of defence’s contribution to national output.

   9.3.3 Omissions

When national income data is collected, several significant contributions to that income are likely to be omitted partly because of difficulties in measurement and non-availability of reliable data. The following are some notable omissions which are usually represented on national income figures by an imputed 10% of the value of GDP. 

a.     Self provided goods and services e.g. Do-It-Yourself kits or self provided services such as a meal prepared at home which is not included in national income statistics while a meal at a restaurant such as the Silver Spar at Holiday Inn will be included.

b.     Output from subsistence or communal farming which is excluded while output from the commercial farms is included. c.         Informal sector activities.

d. Black market or illegal activities for example individuals have managed to built houses and castles from dealing in foreign currency but the same individuals can not declare this source for fear of prosecution.

It may be important to note that these activities contribute substantially to the economy’s activities. In Zimbabwe the informal sector employs more than half of the country’s working population. An imputed 10% will grossly lead to the underestimation of the country’s GDP.

   9.4 National income and standards of living

The standards of living refer to the quality of life in a country or the wellbeing of a country’s citizens. One reason of measuring national income is that of wanting to make inference into the standards of living. That is, investigating whether the people are better off than they were in the previous year or to make comparisons of standards of living between different countries.

Apart from indicating the standards of living, national income statistics are used for planning purposes.

   9.4.1 Measurement of the standard of Living

The value of this year’s national income is a useful measure of how well-off a country is in material terms.  That is, the standard of living can be measured by the volume of goods and services consumed.  

a.     According to Alfred Marshall, national income gives a measure of economic prosperity.  A real increase in national income is an essential prerequisite to a rise in the general standard of living of people.

b.     A second method of measuring living standards is to count the percentage of people owning consumer durables such as cars, televisions, radio and so on.  An increase in ownership indicates an improved standard of living. 

c.     A third method of calculating living standards is by noting how long an average person has to work to earn money to buy certain goods.  If people have to work less time to buy goods, then, there has been an increase in the standard of living.

   9.4.2 Using GDP to interpret standards of living in a country over a period

"Economic statistics are like a bikini, what they reveal is important, what they conceal is vital" - Attributed to Professor Sir Frank Holmes, Victoria University, Wellington, New Zealand, 1967. 

A real increase in national income can, ceteris paribus, be interpreted as representing an improvement in the people’s standard of living.  If real GDP increases over a given period, this may imply that the volume of goods and services produced and consumed had increased which is interpreted as an improvement in the quality of life for the people. On the other hand, it is not automatic that an increase in national income results in an improvement in the standards of living for the majority. Increased GDP may not mean a better life style for the majority of people if:

a.     Income is unequally distributed that is, if there is a wide gap between the rich and the poor. The increased GDP will be in the hands of a few minorities leaving the majority worse off. Only a small minority of wealthy people consumes the extra goods.

b.     Increased output of certain goods results in more noise, congestion and pollution (externalities). The quality of life will be reduced by these negative externalities.

c.     Leisure time is reduced to achieve the production increase. That is, if the increased output was produced as a result of people working over time, travelling long journeys to work etc, all which reduces leisure which is an important aspect of the quality of life.

d.     Population is growing at a faster rate than the real GDP (population explosion). In this case, the cake of real GDP will have to be shared among a large population making the real GDP per head or per capita income small.

e.     Increased output is due to production of producer goods instead of consumer goods. Producer goods such as machines are used to produce consumer goods. As a result producer goods contribute to the future welfare and not the present welfare which largely depends on the volume of consumer goods produced and consumed.

f.     There is an increase in the amount of stress and anxiety in society. Increased output has its own fare share of social health problems which reduce the quality of life.

   9.4.3 Comparing standards of living between different countries.

Fairly accurate comparison of the national income statistics can be carried to compare the standard of living between different countries. For example a country with a higher per capita income can be concluded to have better standards of living.  However, the following qualifications need to be made before such a comparison is made. 

a.     Income may be fairly distributed in one country than the other. If a country has a higher per capita income but at the same time the income is unequally distributed, then the income will be in the hands of a few minorities leaving the majority worse off.

b.     The country with a higher income may be producing producer goods while the other country is producing consumer goods. The country with a low per capita income but producing consumer goods will have improved present standards of living than the country with a high per capita income.

c.     Citizens of one country may be working long hours resulting in a high real GDP per head. An example is the Japanese people who usually work long hours in shifts e.g. retail shops that open 24 hours a day. By working long hours, they forego leisure which is an important indicator of welfare.

d.     When make international comparisons there is need to first convert the national income s of the different countries to a convertible currency such as the United States dollar. The problem is that of the exchange rate to use since different countries use different exchange rate systems. For example which exchange rate will be used in Zimbabwe? The auction rate, the parallel market rate or the official fixed exchange rate?

   9.5   Economic growth

Economic growth can be defined as a sustained increase in the level of real national income (real GDP per head or per capita income). Economic growth implies an increased ability to produce goods and services.  Thus with economic growth, the quantity of goods and services produced overtime increases hence the people’s standards of living will improve. Economic growth can be represented by an outward shifting of the PPC.

     Fig 9.1 Balanced economic growth

Capital goods

                                      O                            Consumer goods

A complete outward shift of the PPC to the right represents balanced economic growth.  This means that the economy can now produce more of both consumer and capital goods than before.  Imbalanced economic growth can be represented by the pivot of the PPC in favour of the expanding sector while anchored on the sector with no expansion.

   9.5.1 Causes of economic growth

              a. Supply factors

Economic growth primarily results from an increase in the quantity of the available resources and an increase in the productivity of the existing resources. These are the supply factors. Supply factors that define an economy’s potential to expand include:

i.    An increase in the quantity and quality of an economy’s resources e.g. discovery of new resources.

ii.   Improvement in the quantity and quality of the economy’s human resources. (Human capital investment). iii.An increase in the economy’s stock of capital (capital accumulation).

iv.    Improvement in the level of technology.

v.     Research and development.

b.     Demand factors

The supply factors only present an economy with the potential to grow.  To realise growth, the nation must provide for the increased production through a growing level of aggregate demand in order to clear the production lines, thus facilitating further production and expansion.

c.      Allocative factors

The available resources must be fully employed. Underutilisation of resources retards economic growth. d.            Government policy

The objective of government policy should be to promote economic growth e.g. The Growth Point Policy.

   9.5.2 Is economic growth desirable or not?

The following arguments can be forwarded in favour of and against economic growth. The benefits are that economic growth,

a.     Is a path to material abundance hence the standards of living will improve where an economy experiences growth. In other words, economic growth is a prerequisite to an improvement in the standards of living.

b.     Reduces poverty. If developed countries do not experience growth, no excess income will result and hence there would be no means by which to provide funding in order to reduce poverty.

c.     Decreases unemployment. As the economy expands through increased economic activity, more job opportunities will be created.

d.     Increases ability to support a growing population. As the population increases the only feasible way to feed the increased population will be through economic growth. Without economic growth the population will be doomed according to Thomas Malthus.

e.     Is a catalyst to changing life styles or civilisation. TVs, DVDs, movies, mobile phones and other modern life items result from economic growth

f.     Widens the tax base hence tax rates will fall. That is, as the economy expands, other players come into production and the government stand to easily collect its tax revenue requirement which may culminate into lower individual taxation rates.

On the other hand the case against economic growth is that:

a.     If economic growth is caused by an improvement in technology, labour may become obsolete (technological unemployment). That is, machines will end up doing the jobs that people used to do. This may increase the levels of unemployment in the economy.

b.     Economic growth implies an increased use of the available resources some of which are non-renewable. Thus economic growth results in the depletion or exhaustion of natural resources.

c.     Growth results in serious problems of noise, ugly cities and other disamenities of modern life (externalities).

d.     Growth permits us to make a living but does not give us a good life. Economic growth gives us a bed but does not give us sleep. Good life is not measured in terms of wealth or riches or material things but other social elements including having a peace of mind or lack of anxiety. Sometimes poor people are the happiest persons in life.

e.     Economic growth is a catalyst to civilisation which may results in the destruction of the moral fibre.

f.     Increased anxiety hence health problems e.g. stress, ulcers, diabetes and high blood pressure.

   9.6 Economic development

Economic development is a multidimensional phenomenon that captures various aspects of improvement which are economic, social and political.  Development includes improvement in the living standards, sanitary conditions and other welfare indicators in the economy.  Thus, economic growth, which refers to a sustained increase in real GDP, is only a branch of economic development.

   9.6.1 Developed and less developed countries

World economies can be classified into developed countries (DCs) and less developed countries (LDCs). Developed countries are those that have taken significant steps towards developmental expectations such as achieving an economic growth rate above population growth rate, a high level of industrialisation and reducing poverty, unemployment and inequality. It is however, impossible to eradicate unemployment, poverty or inequality, but the developed countries have surpassed minimum expectations.  Developing countries are those that are still striving to record positive changes towards development and have not met the minimum expectations.

   9.6.2 Characteristics of developing countries

Developing countries are characterised by

a.     High unemployment levels.

b.     Poor standards of living.

c.     Low levels of industrialisation.

d.     Poor infrastructures such as roads and communication networks.

e.     Poverty, the majority of the people live below the poverty datum line.

f.     Population explosion, that is, population growing at a rate faster than growth in national income.

g.     Poor sanitary conditions (decaying health sector and over-crowding).

h.     Poor export base, that is, they export raw materials and other primary products instead of processed or manufactured goods. Primary products tend to have huge volumes but being of little value.

i.      High budget deficits and BOP deficits.

j.      Inappropriate economic reform programmes and sometimes lack of implementation of these programmes.

   9.6.3 Possible solutions to LDCs developmental problems

a.     Encourage foreign direct investment (FDI).

b.     Export promotions e.g. through trade exhibitions.

c.     Import substitution, that is, producing products that are close substitutes of the imported products.

d.     Stabilising the political situation and increasing investor confidence.

e.     Stabilising the exchange rate or removal of exchange controls.

f.     Expanding the manufacturing sector.

g.     Moral and infrastructure support to the growing informal sector.

h.     Promoting investment e.g. through policies such as growth point policy.