Market Models

Basic microeconomic theory states that firms should seek to maximize profits and that this is achieved where marginal revenue is equal to marginal cost. This basic theory has resulted in the development of four market models: pure competition, monopolistic competition, oligopoly, and pure monopoly.

Pure (or perfect) competition model
Perfect competition is a concept used by economists in constructing theoretical models of economics systems. It does not exist in the real world. Such an economy is supposed to work according to a number of ideal rules:
  1. there are large numbers of both buyers and sellers with no one a large enough buyer or seller to influence prices or supplies;
  2. products are homogeneous or identical, so that the buyer will always buy at the lowest price, thus forcing all suppliers to have the same low price;
  3. buyers and suppliers have perfect knowledge of prices and products throughout the economy;
  4. perfect freedom of entry to and exit from the market exists;
  5. its is assumed that there are no transportation or other such costs;
  6. there are no profits other than the minimum return to the factors of production necessary to ensure that they remain in the market.
Competition results, and if supply exceeds demand the ruling market price is forced down and only the efficient firms survive.
Monopolistic competition
Monopolistic competition is quite similar to perfect competition. A market characterized by a large number of producers and low barriers to entry. The major difference between monopolistic competition and pure competition is that in monopolistic competition consumers perceive important differences between the products offered by individuals firms. This gives firms at least some direction in setting prices.

However, the presence of many close substitutes limits the price-setting ability of individual firms, and drives profits down to normal rates of return in the long run. As in the case of perfect competition, above-normal profits are only possible in the short-run before rivals can take effective counter measures. The theory was developed almost simultaneously by the American economist Edward Hustings Chamberlin in his Theory of Monopolistic Competition (1933) and by the British economist Joan Robinson in her Economics of Imperfect Competition (1933).

A market in which there are only a few large sellers but many buyers, and that is characterized by limited or intermittent price competition. Each producer must consider the effect of a price change on the actions of the other producers. A cut in price by one may lead to an equal reduction by the others,with reaction approximately the same share of the market as before but at a lower profit margin. Therefore, the main forms of competition consist of advertising and product differentiation. Oligopolistic firms tend to be large and require significant capital investment to achieve economic of scale.
Pure monopoly
A market in which there is only one producer but many buyers and no substitute for that producer's product or service, which enables the single producer to exercise considerable power over the price, quantity, and quality of the product. Since a monopolist is the sole provider of a desired commodity, the monopolist is the industry. The absence of competition usually means that the consumer has to pay higher prices that would prevail with competition. The goal of monopolist is to maximize profits.

Profit-maximizing decision rules are relatively simple and straight forward in the cases of perfect competition, monopolistic competition, and monopoly. Under oligopoly, however, the rules become much more complex, almost to the point of being indeterminate.

However, only in oligopoly and monopoly markets is there real opportunity for 'super-normal' profits, in excess of what is required to stay in business. In all these models competition is a major determinant of profit potential and therefore objectives must be set with competitors in mind. In a monopoly (again somewhat theoretical in a pure sense) excess profits could be made if government did not act as a restraint.

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