Firms that sell their products in a competitive market have limited pricing power because
2022 Curriculum CFA Program Level I Economics Show IntroductionThe purpose of this reading is to build an understanding of the importance of market structure. As different market structures result in different sets of choices facing a firm’s decision makers, an understanding of market structure is a powerful tool in analyzing issues such as a firm’s pricing of its products and, more broadly, its potential to increase profitability. In the long run, a firm’s profitability will be determined by the forces associated with the market structure within which it operates. In a highly competitive market, long-run profits will be driven down by the forces of competition. In less competitive markets, large profits are possible even in the long run; in the short run, any outcome is possible. Therefore, understanding the forces behind the market structure will aid the financial analyst in determining firms’ short- and long-term prospects. Section 2 introduces the analysis of market structures. The section addresses questions such as: What determines the degree of competition associated with each market structure? Given the degree of competition associated with each market structure, what decisions are left to the management team developing corporate strategy? How does a chosen pricing and output strategy evolve into specific decisions that affect the profitability of the firm? The answers to these questions are related to the forces of the market structure within which the firm operates. Sections 3, 4, 5, and 6 analyze demand, supply, optimal price and output, and factors affecting long-run equilibrium for perfect competition, monopolistic competition, oligopoly, and pure monopoly, respectively. Section 7 reviews techniques for identifying the various forms of market structure. For example, there are accepted measures of market concentration that are used by regulators of financial institutions to judge whether or not a planned merger or acquisition will harm the competitive nature of regional banking markets. Financial analysts should be able to identify the type of market structure a firm is operating within. Each different structure implies a different long-run sustainability of profits. A summary and practice problems conclude the reading. Learning OutcomesThe member should be able to:
SummaryIn this reading, we have surveyed how economists classify market structures. We have analyzed the distinctions between the different structures that are important for understanding demand and supply relations, optimal price and output, and the factors affecting long-run profitability. We also provided guidelines for identifying market structure in practice. Among our conclusions are the following:
Why don t firms in competitive markets have any market power?Firms experience no barriers to entry and all consumers have perfect information. There are so many firms producing the same products that none of the firms can attain enough power in the long run to influence the industry. Thus, eventually, all of the possible causes of profits are assumed away.
How does competition affect pricing power?If there are plenty of competitor products, the company will have weak pricing power. If a company has a unique product, it will have strong pricing power because the customer has no alternative supplier for that product and must pay the price charged.
What is the pricing power of perfectly competitive market?Perfect competition
Buyers in a perfectly competitive market will enjoy perfect information regarding the product or service. Since all products in the market are substitutes for one another, the demand for products is extremely elastic. All companies are price takers and hold zero market power.
Why do firms in a perfectly competitive market have little market power?Since perfect competition is so competitive, it has a very low level of market power. The companies in this market structure have no ability to raise prices above the equilibrium price. In fact, any attempt to do so would lead to a loss in sales and profits.
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