Economic Analysis of Market Structure
Major economic activities that lead to growth and development are defined by the strength of the markets that operate within it. This is because markets have the biggest role to play in these economies. When a single firm makes a decision, it may not have much impact on the general economy. But when many companies within a market setup make a decision, for instance, to stop production, the whole market faces the impact, which extends to the whole economy.
Consider the events that led to the 2008-2009 financial crisis, for instance. The US economy has been booming over several years before this event. Therefore, the economic bubble seemed like a good idea for investors to take loans and take their investments to other levels, especially in the housing industry. Financial institutions were so confident in their clients that they flexed the requirements for taking loans. Many of them did not do a proper background check to ascertain borrowers' ability to repay the loans. The economy was at its peak, and many indicators showed it would continue on an upward scale for another long period. Until the worst happened and house prices dropped significantly. The banks that had taken these properties as collateral were unable to sell them, let alone give out at a price that would help recover the lent money.
And this was the beginning of trouble for many financial institutions. With things getting worse by the day, some failed to recover completely, which forced them to announce a state of bankruptcy. Financial markets were the worse hit by the situation, and even when some monetary policies were applied to salvage the economy, many of them were unable to recover. This was defined as the worse economic crisis faced within financial markets.
As we already know, financial markets are among the biggest contributors to the general economy. For instance, many banks in the developing world lend money to small scale businesses, helping them pick up the pace and grow at a pace they would not have expected. It is also the financial markets that determine how much money is given into the economy or how much is withdrawn. When interest rates go high, the financial markets are there to ensure borrowers are taking money they can pay back, and when the rates go down, the same markets give out money at a controlled rate to ensure everything flows smoothly.
Economic growth and development have been relying a lot on the events taking place within financial markets. And when we talk about financial markets, we are referring to all financial intermediaries and money lending institutions, including insurance companies, which play a crucial role in any given economy.
When the financial markets fell, the effect spread fast into other sectors of the world economy. It became hard to import and export different products as inflation rates rose, leading to higher or lower r exchange rates went through the roof. Businesses that relied on borrowed resources from banks were unable to access these resources, making some to close some branches. And those that defaulted in their loans were forced to sell off some of their assets to cover their premiums. Households went into a state of panic and started withdrawing money from banks at a high rate. Since some of the banks had already shown signs of struggle, these mass withdrawals further crippled the operations, making it even hard to recover.
When reports came about the crisis, the main headlines talked about an economic crisis and not much about banks' falling. In other words, the fall of these markets was viewed from their effects on the general economy. When governments came up with fiscal and monetary policies to salvage the situation, they also talked about saving the economy, even though many steps were towards rescuing major financial intermediaries.
This shows just how important markets are in economies. They begin with firms operating under similar rules, or selling the same type of products, growing into a large community of firms. But that is not all. In the market, there must be producers and consumers. In any case, consumers are the households who are the final users of these products. The relationship between these two players creates the perfection of the market.
All markets are structured in a specific way, with laws and policies that guide firms' operations with the system. The best way to define market structure is, it's the organizational and other characteristics of a market. There are different features that make markets unique of similar, mostly depending on the goods and services linked to that market. When a company wants to enter or exit a market, they have to follow a specific set of guiding rules that tell them what to do. Companies don't just operate as they want in any market. For instance, when it comes to setting prices, come markets are defined as price givers, and others as price takers. It is all about the organizational features of those markets.
Consider financial markets, for instance. It is the Central Banks that determine how much money a bank can hold at any given time, and they also determine the interest rates to be charged on borrowed money. In this case, Central Banks become the regulatory body that sets the standards for operating in financial markets. When the economy is booming, they raise interest rates to discourage excessive borrowing and shield banks from the aftermath. And when the economy is low, interest rates are reduced to encourage borrowing.
There is only an example of what market structure is, and an idea of what happens within them. There are many other characteristics that make up proper market structures. But the main ones concern features that affect the nature of competition and pricing. Many people put too much emphasis simply on the market share of the existing firms in an industry – which is also a good approach to market structure, but there is a lot more than needs to be carefully considered.
The features of a market structure
Traditionally, important features of a market structure include:
- The number of companies. As stated above, we are looking at market structure in terms of competition and pricing. In this case, a complete market is expected to carry a specific number of firms, including the scale and extent of foreign competition. As more companies join a market, the competition level increases, making it even easier to describe the market. But this also means increased competition, which affects even the pricing models.
- The markets share of the largest companies. In a perfect market, each firm operates on the same level, and there is no big or small. But such markets are only theoretical. Imperfect competition is major in many economies, especially developed ones. Hence, market structures are defined by these firms' market capitalization, who are also the main decision-makers. This is measured mainly by the concentration ratio – that is, how popular the firms' products are with different consumers.
- The nature of costs. The cost of production is among the main determining factors for pricing, and essentially the company's growth. In this case, the costs include the potential for firms to exploit economies of scale and also the presence of sunk costs that affect the contestability of markets in the long run.
- The extent to which the industry is integrated vertically. Vertical integration is the main feature for explaining the process by which different stages in production and distribution of a product are under ownership and control of one enterprise. One example of such integration is the oil markets in which large firms own the rights to extract from oil fields. They also run a fleet of tankers, operate refineries, and control the sales at their own filling stations. In such a case, it is very hard for new firms to join the industry since a few have already taken control of everything.
- Product differentiation degree. Even though some firms may be producing the same products, they come with different degrees of difference, which affect cross-price elasticity of demand. For instance, some manufactures may be making low-quality products, whereas others only make the highest quality.
- The structure of buyers in a market. It most industries, buyers are structured in different forms. For instance, a buyer will make more informed decisions if they have all the information they need about the manufacturer and the general industry. This is where the aspect of the brand loyalty comes in.
- The turnover buyers. This feature is also called 'market churn,' and it means how many product users are ready to switch their supplier over a specific period where there is a change in the market conditions. The degree of customer turnover is determined by the extent of consumer or brand loyalty. It is also impacted by the influence of persuasive advertising and the market. Many loyal customers will find it very hard to change unless the firm stops advertising, and the competition becomes very aggressive in this.
The type of competition in them defines market structures. And there are four main characteristics that determine these structures. They include:
A perfect competition market is one that has many firms selling homogenous products. The firms are price takers since price competition does not exist. There is no big or small company, and there is not a better or worse product. All consumers have perfect information about the products, and they will buy with a proper understanding of what they need.
Also, firms gain supernormal short-run profit but not supernormal long-run profit. All conditions are favorable for the joining and exit of other firms. In perfect competition, firms do not set prices since they don't have much control over this and their customers' consumption needs.
The best thing about the type of markets is that firms don't have to worry about too much marketing. Consumers already know the products, and the market is open for anyone who wishes to join. There are no barriers to entry. Most importantly, such industries are defined by high-economic output.
Perfect competition is, however, only in the books. We live in a world of imperfect information, which creates imperfect competition. Firms with access to more information are less willing to share, applying it only to the advantage.
This is another feature of market structure that defines an industry with few dominant firms. The products are differentiated, and there are many barriers to entry. Firms are established to gain supernormal short-term and long-run profits.
The firms are price makers, though they feature independent behavior. Non-price competition is very crucial in these markets, and the economic value is low allocative. These markets are the most common in modern economies.
A monopoly, as the name suggests, is a market that has one firm with pure monopoly. An effective duopoly is also common in many cases. Product type is limited since there is only one firm producing and supply the goods. Supernormal short-run and long-run profits are very high.
The firms are price makers, though the demand curve and possible regulations constrain them. There is a non-price competition, though not as important as in oligopoly markets.
These are markets that also have many firms. The products are differentiated, and there are low entry and exit barriers. They gain any profit possible in terms of supernormal short-run and long-run profits. The pricing power fall with the firms, who are the price maker – though the real power and potential competition limit pricing power. Non-pricing competition is very important in these markets.
In economics, markets are categorized based on the structure of the industry serving the market. On the other hand, the industry structure is categorized based on market variables that, many believed, determine how far the characteristics of competition go.
The four market structures explained above from an abstract (generic) in the characterization of a type of I real industry. Market structure affects the outcomes of that market due to its impact on the motivations, opportunities, and economic actors' decisions taking part in the market. Economic market structure analysis aims at setting apart these effects as they try to explain and predict market outcomes.
Author: James Hamilton