Influence Of Product Market Externality On Economic Outcomes: An Essay On Different Market Structures.

Discuss about the Influence of Product Market Externality.

In the study essay, key features of four market structures i.e. monopoly, oligopoly, monopolistic competition, and the perfectly competitive market have been described. Using diagrams, the short run and long run profits and losses in the identified market structure is also elaborated (O'Sullivan, 2009). Also, the allocation of resources in the four types of markets has been compared. Furthermore, the study paper provides a brief description of negative externalities using the diagram. Providing a case study from Australia, the impact and government interventions have been identified to solve the problem of a negative externality. Lastly, the study investigates the effect of externality on monopoly and perfectly competitive market outcomes in the presence of negative externalities.

In a monopoly market structure, a single manufacturer or seller has the control over the market as no close substitute is available (Abdin, 2008). Therefore, the single firm is called monopolistic. As the single supplier produces products having no close substitute, the monopolistic firm can be termed as the price maker. In other characteristics, due to lack of close substitutes and infrastructural assistance, entry to the market is restricted for new participators. Non-price competition in monopoly market is somewhat in compared to other market structure whereas the market structure is efficient in terms of productive efficiency (Carlton, 2012). The identified market structure secures high profitability in the longer period of time. For instance, rural gas station can be identified as a monopolistic firm as there are no other market competitors (Baur, 2017). In the underlying figure, the long-term and short-term economic profits of monopoly market structure have been illustrated as follows:

In a monopoly market structure, super-normal profitability can be achieved in the long-term. In case of profit maximisation, marginal cost must be equal to marginal revenue considering the competition. In case of monopolistic market structure, competition is nil. As shown in the figure, profit maximisation is achieved when MC=MR, where P is price and output is Q. Given at a price AR is above ATC at point Q, PABC area can indicate the supernatural profit (Prescott, 2013). Precisely, no presence of close substitute and competition, a monopolistic firm can secure maximum profit at area PABC in the long run.

Monopolistic competitive market structure forms an imperferct competiton where many producers have offfered products or services differentiated by brinading ,design, or quality. Clearly, the offered products are not perfected substituables by each other (Brems, 2013). In a monopolistic competiton, the number of competitors are many but not as high as perfect competiton. In terms of control over the price, firms have got some control on prices whereas the entry to the market is relatively easy (Feenstra, 2010). In the monopolistic competition, production factors of manufactured goods/service are not absolutely transportable. Apparently, in sich market structure, more elastic demand curve can be seen as the manufacturers reduce price of goods/service to incresae sales. In the meanwhile, long-run profits for such market structure is nil (Feenstra, 2016). Invariably, retail stores and coffee shop businesses are examples of real life monopolistic competition. In the next section, the short-run economic profits and losses of monopolistic competiton have been described.

Monopolistic Competitive Market

In a monospolistic competition, firms engaged in the market structure maximises profits by manufacturing that partcilar quantity so that MR and MC will be equal in the short-run. Considerably, to achieve the economic proft in short-term, the avarage total cost must be below the market price. As described in the above graph, D is market demand, ATC is avarage total cost, MR is marginal revenue, and MC is marginal cost. As shown in the graph, the price offered by monomistic competitive enterprise is identical to the point on D where MR=MC. Therefore, the short-tern profit will be the difference between price and avarage total cost multiplied by quantity.

In case of short-run losses, if ATC is above market price as shown in the above figure, the firm suffers loss. The short term loss will be the difference between price and avarage total cost multiplied by quantity. As the avarge total cost will be negative, the figure will show loss. However, in a monopolistic market structure firms can minimise the loss in short run by manufacturing the quantity where MR is equal to MC (Keppler, 2014). In that particular case, the firm need to convest the loss in profit or should exit the market.

Perfect or pure competition is rare in the real life scenario, but the model is essential in analysing the industry that characterises similar to a perfect competition market. A perfectly competitive market is characterised by a huge number of sellers that means the decision of a single seller will not impact the price of the commodity in the market (Taylor, 2015). Furthermore, the products and services in the perfectly competitive market are standardise and homogenous in nature. Every product and service is a perfect substitute of the products and services of the rival company (Carlton, 2012). Furthermore, the firms in the perfectly competitive market are price takers and the decision of the price is made on the basis of the market mechanism such as demand and supply of product. Moreover, there are not significant barriers that may prevent a firm from leaving and entering the perfectly competitive industry (Carlton, 2012). Some of the examples of perfectly competitive market are stock market industry and agricultural industry because these industries have the same characteristics of a perfectly competitive market.

In a perfectly competitive market, the demand curve is horizontal to the market price, which is equal to average revenue and marginal revenue. Hence, in a perfectly competitive market D = P = AR = MR. Moreover, the quantity is MC = MR (Carlton, 2012). Furthermore, in the short run, rise in the demand leads to increase in the price that provides profit to the perfectly competitive firms. A diagram has been presented herein below for further understanding:

Perfectly Competitive Market

It can be seen from the above diagram that AR is above AC that leads to a profit of P1E1MC1. However, the demand may fall due to certain factors that may lead to loss or zero profit of the perfectly competitive firms in the short run (Kunieda & Shibata, 2014). A diagram has been presented herein below for further understanding:

It can be seen from the above diagram that AC is more than AR due to the fall in the demand. Hence, C2ME2P2 presents the loss for the perfectly competitive firm in the short run. It is important to note that the profit and loss in the perfectly competitive firms occurs in the short run due to no changes in the quantity supplied (Kunieda & Shibata, 2014). The firms cannot make changes in the quantity supplied due to stagnant factors of production in the short run. However, in the long run, the firms can make changes in the quantity supplied by adding or reducing the factors of production that leads to zero profit in the long run. A diagram has been presented herein below for further understanding:

The oligopoly market consists of a huge number of buyers and few sellers. For example, the tooth paste, steel and soft drinks companies come under the oligopoly market structure. The firms in the oligopoly market are much innovative in order to differentiate their products to beat the competitors (Taylor, 2015). The firms are interdependent in order to decide the price of the product. Moreover, the investment required to enter the oligopoly market is quite high and the companies have kinked demand curve in the long run. The quantity supplied is decided by MR to MC (Kamien & Schwartz, 2012).  Moreover, the price remains above the AC which always provides profits to the firms in the oligopoly market. In the short run, the changes in the demand and supply do not impact the revenue of the firms in the oligopoly market. However, in the long run, the firms have kinked demand that increases the interdependency of the firms in the oligopoly market (Taylor, 2015). For example, if Colgate Palmolive reduces the price for its products in the Australian market, the other competitors such as Oral B and Pepsodents also have to reduce their price to meet the competition in the market. A diagram has been presented herein below for further understanding:

It can be seen from the above diagram, that the firms in the oligopoly market has kinked demand in the long run (Kunieda & Shibata, 2014). Hence, in order to maintain its profitability and stabilise the demand for its product, the company has to change the price of the product on the basis of the price charged by the rivals. However, the company will never charge a lower price below the Average Cost as the products are differentiated through innovation (Kamien & Schwartz, 2012).

Oligopoly Market Structure

On the basis of the above analysis, the comparison of the four market structures has been presented in the table given below:

Table: Comparison of Four Market Structures

Source: (Yomogida, 2010)

However, in terms of resource allocation it is important to note that how the firms in different market structure use the allocated resources in order to produce the products and service in respective market. In the case of perfectly competitive firm, it can be seen that the companies earn normal profit in the long run. Hence, a fuller utilisation of resources can be evident in the perfectly competitive market (Salvatore, 2011). On the other hand, in the monopoly market, the firms produces relatively lesser amount of product to increase the demand and charge higher price for the products and services to maximise profit (Sutton, 2015). Therefore, it can be seen that monopolistic firms do not make fuller utilisation of the allocated resources.

Furthermore, in a monopolistic competitive market there are a huge number of buyers and sellers, but the products are identical in nature (Slavin, 2014). The companies in the monopolistic competitive market charge a higher price than the market price due to the differentiated characteristics of the products. Hence, it can be seen that firms in monopolistic competitive market do not product at their optimum level. In other words, the firms produce less than the installed capacity (Salvatore, 2011). Furthermore, the same happens with the firms in the oligopoly market. The interdependency characteristics of this market forces the oligopolistic firms to produce lesser amount as compared to their optimum level. However, to meet the changing policies of the competitors the firms need to produce on the basis of the market demand (Slavin, 2014). Therefore, it can be seen that oligopoly firms uses lesser resources as compared to the perfectly competitive firms and more resources as compared to the monopolistic firms.

To identify the macroeconomic status of free market, understanding the negative externalities associated with the market is a primary need. Negative externality is said to be occurred when production or consumption of a goods can create harmful consequences to a third party other than producers and consumers (Cho, 2013). Evidently, negative externalities can impose external costs on the third party as well. Therefore, negative externalities can contribute to a market failure as the social cost exceeds private costs in a given market. The receiver of negative externalities can be any individual or organisation other than the manufacturer and consumer of the goods. For instance, any type of pollution can impact the social population. Therefore, it is addressed as a negative externality (Wang & Tan, 2017). In the study, negative externality of production has been described using graphical representation as follows:

A negative externality that has taken place due to production or manufacturing of a product affecting the third party other than the producer and consumers in a harmful way, can be defined as negative externality of production. For example, burning of fossil fuel e.g. coal, oil, and LNG to produce electricity can contribute to air pollution. Clearly, air pollution during the production of electricity can create a harmful effect on the social population. As depicted in the above figure, Q1 can be identified as the production output where the demand status and supply status is equal. At Q1 position, the social marginal cost (SMC) is significantly higher than that of social marginal benefit (SMB) showing socially inefficiency (Sunderasan, 2012). At point Q2, SMC is equal to SMB notifying social efficiency at the point. The marked section in the figure is called deadweight welfare loss because the SMC is greater than PMC i.e. private marginal cost.

Emission of green house gas has become one of the leading challenges for Australia according to the data released by the Australian government. Hannam (2017) reviewed in the article stating that the carbon emission in the country has been continue to increase as the data released by the National Greenhouse Gas Inventory discloses that carbon emission in the country increased by 1.6% in the March quarter, biggest change in terms of quarterly increase in the previous nine years. The Australian carbon emission has reached 550.4 million tonne annually up by 1% in compared to the last year. Since the Coalition government has taken the charge, carbon emission in the country was up by 6% in compared to a decline of 10% during Labour government (Hannam, 2017).

Each of the data indicates how coal-powered energy sector and major industries have contributed towards increasing carbon emission affecting the social population. Clearly, the increase rate of carbon emission refers to the environment policy framework implemented by the Coalition government. According to the analysis, being a negative externality, pollution has affected the economy as well. Due to the increase in greenhouse gas, the social cost exceeds private costs. In the underlying figure, carbon emission trend in Australia has been represented as below:

As described in the above mentioned figure, since March quarter in 2013, the carbon emission trend is continuously increasing. Due to negative externalities such as pollution, government interventions are mandatory to correct the market failure due to the event (Hannam, 2017). Evidently, according to the economists, internalise exterior costs and benefits must be taken into account to avoid the sustainable impact of negative externalities. In Australia, the mining, oil and gas, and coal-powered electricity production sectors can be identified as the major contributors to greenhouse gas emission. In order to reduce the amount of pollution, one of the most common approaches is pollution tax i.e. the government should force polluters to pay massive charges for creating negative externalities.

In the meanwhile, negative externalities create adverse effect on the health of social people increasing social costs to that of private costs. Herein, introducing carbon tax will help to increase the private cost of production or/and consumption. Therefore, the rise in the private cost should reduce the quantity demanded as well as the output of the product causing negative externalities. In this way, government directed carbon tax can negate the adverse effect of negative externalities hurting the economic conditions.

Firstly, it is important to understand the impact of externalities over the monopoly and perfectly competitive market in order to know which market structure is socially beneficial (Arellano, 2007). Moreover, the social marginal cost for a perfectly competitive firm will be always higher than the private marginal cost in case of emission of carbon in the air that causes negative externalities (air pollution) (Gilman, 2016). Furthermore, a perfectly competitive firm will produce more than the socially optimal level at Qp in order to meet the high level of competition in the market and earn normal profit in the long run (O'Sullivan, 2009). A diagram has been presented herein below for further understanding:

It can be seen from the above diagram that a perfectly competitive firm will produce at Qp that will lead to negative externalities and deadweight welfare loss marked with the shaded section (Wang & Tan, 2017). However, in the case of a monopoly firm it is important to note that the output will always be lower than the socially optimum level of output to maximise the profit. In other words, the output level for the monopoly firms will be at S = PMC = MR (Carl, 2012). A figure has been given below for better understanding:

By utilising the formula of welfare, it can be seen from the above figure that the welfare at socially optimal price level is “A + B + C + D + E + F + G + H” and the welfare at monopoly price level is “A + B + C + D + F + G”. Hence, the deadweight welfare loss for monopoly firms is “E + H” that are presented with the shaded portion (Wang & Tan, 2017).

By considering both the market structures, it can be seen that perfectly competitive market makes fuller utilisation of resources and produces higher quantity of products as compared to monopoly market firms (Martin, 2016). It can be seen that the deadweight loss occurring from the negative externalities will be higher in the case of perfectly competitive market as compared to monopolistic market (Wang & Tan, 2017). Hence, monopoly market is socially preferred market structure over the perfectly competitive market with the occurrence of negative externalities.

Conclusion

By considering the above analysis, it can be seen that all four market structures differs from one another on the basis of number of sellers, similarities between the products, barriers of entry and exit, decision making of price and several other factors. The comparison made on the basis of allocation of resources, it can be seen that firms in the perfectly competitive market are found to use the available resources to its optimal level. However, other market structures do not present optimum utilisation of resources due to their profit maximisation, product differentiation and interdependency characteristics. Moreover, the negative externalities caused by the operations of the firms in different market structure leads to welfare loss. Hence, it is the role of the government to take care of the social cost that is incurred by the operations of the firms causing negative externalities. Finally, the research concludes by presenting that monopoly market is socially preferred market structure over the perfectly competitive market with the occurrence of negative externalities due to the production of output below the socially optimum level.

References

Abdin, M. (2008). Hidden Monopoly in the Free Market. SSRN Electronic Journal.

Arellano, F. (2007). Forecasting Profits in the Short Run: Using a More Reliable Profit Margin Ratio. SSRN Electronic Journal.

Baur, D. (2017). 'Monopoly' in Real Life - The Housing Market and Inequality. SSRN Electronic Journal.

Brems, H. (2013). Product equilibrium under monopolistic competition (3rd ed.). Cambridge: Harvard Univ Press.

Carl, S. (2012). Market Structure. Delhi: Orange Apple.

Carlton, D. (2012). Planning and Market Structure (5th ed.). Cambridge, Mass.: National Bureau of Economic Research.

Cho, M. (2013). Externality and information asymmetry in the production of local public goods. International Journal Of Economic Theory, 9(2), 177-201.

Feenstra, R. (2010). Measuring the gains from trade under monopolistic competition. Canadian Journal Of Economics/Revue Canadienne D'économique, 43(1), 1-28. https://dx.doi.org/10.1111/j.1540-5982.2009.01577.x

Feenstra, R. (2016). Gains from Trade Under Monopolistic Competition. Pacific Economic Review, 21(1), 35-44.

Gilman, L. (2016). Economics. Minneapolis: Lerner Publications.

Hannam, P. (2017). Australia's carbon pollution soars, government data shows. The Sydney Morning Herald. Retrieved August 2017, from https://www.smh.com.au/environment/climate-change/australias-carbon-pollution-soars-government-data-shows-20170804-gxpd71.html

Kamien, M., & Schwartz, N. (2012). Market structure and innovation (7th ed.). Cambridge: Cambridge University Press.

Keppler, J. (2014). Monopolistic competition theory (5th ed.). Baltimore: Johns Hopkins University Press.

Kunieda, T., & Shibata, A. (2014). Credit Market Imperfections and Macroeconomic Instability. Pacific Economic Review, 19(5), 592-611.

Martin, R. (2016). Externality regulation and the monopoly firm. Journal Of Public Economics, 29(3), 347-362.

O'Sullivan, A. (2009). Urban economics (3rd ed.). Boston: McGraw-Hill/Irwin.

Prescott, E. (2013). Market structure and monopoly profits: A dynamic theory. Journal Of Economic Theory, 6(6), 546-557.

Rozeff, M. (2009). Stiglitz, Externality and Government. SSRN Electronic Journal.

Salvatore, D. (2011). Microeconomics. New York: McGraw Hill.

Slavin, S. (2014). Microeconomics. New York, NY: McGraw-Hill Education.

Sunderasan, S. (2012). Externality (2nd ed.). New York: Nova Publishers.

Sutton, J. (2015). Technology and Market Structure. Cambridge: MIT Press.

Taylor, T. (2015). Economics. Chantilly, Va.: Teaching Co.

Wang, Y., & Tan, D. (2017). The Influence of Product Market Externality on Dynamic Decisions of Monopoly. Modern Economy, 8(6), 806-815.

Yomogida, M. (2010). Fragmentation and Welfare in Monopolistic Competition. Review Of International Economics, 18(3), 531-539.