Using Economic theory, Explain how firms in imperfect markets determine price that would maximize profits.
Imperfect market structures are market structures that have imperfect market information and immobility of factors of production. The firms under these forms of market structures possess certain degree of market power which will affect the production equilibrium that will determine the price level set by the firm. Regardless of the types of market structures, the firm will base on the notion of profit maximization to determine production equilibrium when the firms aim to maximize profit.
1. Explain the various types of market structures
Under the imperfect market structures, it can be classified as monopolistic, oligopolistic or monopolistic competitive market where the industry may have one firm, few firms or many firms. For the monopoly, the produce of the firm is homogenous and there is high degree of market power while the product of the firm in the oligopoly is classified as homogeneous or differentiated and has strong market powers. However, the product of the firms in the monopolistic competitive market is classified as differentiated and there is small degree of market power.
2. Explain how the firms in the imperfect market is affected by the market power of the firms
Due to the influence of the market power, the firms in the imperfect market structure will have a downward-sloping MR and AR, indicating that the firm is capable of practicing price-setting whereby the firm can either decrease price to increase quantity demanded or increase price but face a lower level of quantity demanded. For the monopoly and oligopoly, the market power is derived from the barriers to entry while the market power for the monopolistic competition is based on product differentiation.
3. Explain how the price level is determined by the production equilibrium based on profit maximization
Based on this downward-sloping MR and AR, the firms in the imperfect market can set the price level when the production equilibrium is attained; abiding to the profit-maximising rule, Under this rule, the firm will increase production when the MR is greater than the MC since additional net profit can be earned and decrease production level when the MR is less than MC since additional net loss may be incurred. Thus, it will attain production equilibrium at the level of output where MR is equal to MC.
As seen from the diagram, it can be observed that the MR and AR are downward-sloping while the MC is upward-sloping as there is a higher rate of utilization of resource capacity. The production equilibrium is set at the quantity level of Q0 while the price level is set at P0.
The firms in the imperfect market structures will make different levels of profit in the short-run and long run when it attains production equilibrium. In the short run, it can make subnormal profit, normal profit or supernormal profit. But in the long run, the firm can make only normal or supernormal profit as the firm will have to shut down when it incurs subnormal profit.
It is imperative to note that the firm in the imperfect market structure will not be able to attain allocative efficiency as the price level is set at profit-maximising level does not equal to the marginal cost. It is not able to attain production efficiency in the short-run as the firm is producing at the excess capacity at the profit-maximising level of output though they are able to achieve production efficiency in the long run from the profit-maximising level of production.
In sum, the profit-maximising rule will influence how the firm determines its price strategy in the imperfect market structure. The downward-sloping AR and MR condition will mean that the firms may not satisfy other aims of the firms when it set price level based on profit-maximising rule.
This article is contributed by Mr. Simon Ng, founder and principal JC Economics Tutor of Economicsfocus, who has 20 years of teaching experience. Currently, Mr. Simon Ng provides specialized Economics Tuition and GP Tuition. To read more articles on Economics issues and skills development, please refer to the JC Economics Essays blog.