Negative Externalities, Monopoly, And Market Structures

Market Structures

Market Structures are the special forms that a market for a commodity or service may take based on its price system and the operational and relative efficiency in allocation of resources. The structure of the market has a great bearing on the achievement and maintenance of efficient allocation of resources. (McConell, Brue, & Flynn, 2009)

Market structures differ according to the number of buyers and sellers. Simply based on this differentiation, we can identify different types of market structures. These include monopoly, duopoly, perfect competition etc. (Samelson & NordHaus, 2004)

Given below are four forms of market structures and the difference between them::

1. Number of buyers and sellers : A market stricter is often characterized by the number of buyers and sellers that operation within the market. This is turn is determined by barriers to entry.
2. Type of product:The type of product sold in the market may be very homogenous or could be differentiated by way of size, color or other attributes. The type of product directly affects whether consumers have preferences for some products or not.

• Barriers to Entry: Barriers to entry determine how difficult it would be for new firms to sell in the market. Barriers to entry may be natural (such as high investment costs to production, pre-requisite high levels if technology) or could be government imposed (such as quota, licensing etc.)

1. Level of Control over price by Individual firms: This characteristic helps understand how much influence an individual seller may have in setting the price in the market. In pure completion, every individual is a price taker and in a monopoly, the firm sets the price.
2. Non –Price Competition: This refers to other means that firms could use in order to enhance demand without reduction in prices. Some forms of non-price completion are advertising, branding. Product differentiation could, also, be considered as non-price competition.
3. Real Life examples: These are examples of industries where the given market structure exists.

• Allocation of Resources:  This refers to whether the market is operating at its optimum operational efficiency i.e if all factors of production are operating to their maximum capacity at a normal price.

Table 1: Characteristics of Various Market Structures. Prepared by Author. Adapted from (McConell, Brue, & Flynn, 2009)

3.1) Monopoly

A monopoly is that market structure wherein there is one seller and many buyer. Examples of government held industries are examples of monopoly. Monopolists usually earn profits due to price determination. (McConell, Brue, & Flynn, 2009)

The given diagram is an example of the typical monopolist

The demand curve which is the Average revenue curve here slopes downwards. The average revenue decreases as the number of units sold increase. This implies that revenue falls as more units of output are sold, the marginal revenue is less than the average revenue. In other words, under monopoly.

The equilibrium in a monopoly is achieved at that level of output wherein marginal cost equals marginal revenue (Q). This is the point in production where the producer will or should stop producing since this is the point of maximum profits and from here profits continue to fall (to Q₁. )

In the long run, the monopolist can adjust the production to maximize profits.

3.2) Monopolistic Competition: Monopolistic competition refers to the market situation in which relatively large number of buyers and small producers offer similar but not identical products. All buyers act non-collusively. (McConell, Brue, & Flynn, 2009)

The firm will maximize its profits and minimize its losses in the short run by producing an output that is designated by intersection of marginal cost and marginal revenue.  This is represented in Figures A)  and B)

In the long run, firms in a monopolistic competition industry have a tendency towards reaching a break- even point.  The entry of new firms leads to a disappearance of normal profits. And average costs equates to the set price. (McConell, Brue, & Flynn, 2009)

An Oligopolistic market structure is a market wherein there are a more than two producers or sellers but not many.

• Oligopolistic markets have few firms and hence, the firms may collectively set together the price. This is known as ‘collusive oligopoly’. Oil cartels are ften cited as an example of such a structure.
• In reality, all oligopolies do not collude and set prices. Such a structure is known as non- collusive oligopoly. Price Determination:

Monopoly Market Structure and Negative Externalities

It is important to note that the long-run and short run equilibrium of oligopolistic firms are almost similar.

In a Non Collusive oligopolistic market, a kinked demand curve has been observed. It is assumed that there is always a ruling price. This is simple because, if a firm raises prices, it may lose customers. However, a firm also cannot reduce prices to a great extent since other firms may also follow suit. This may lead to  price wars where it would be a race to the bottom. E-commerce firms are an example of such behaviour.

The nature of a non Collusive oligopolist’s demand would depend on whether his competitors match D₂  D₂   and MR₂ MR₂    in the diagram above.. Any price change that he may initiate from the current price QP. In all likelihood an oligopolists rivals will ignore a price increase but follow a price cut. This causes the Oligopolist’s demand to be kinked i.e  D₂ P D₁ and his Marginal Revenue will have a break at MR₂  MR₁

The kinked demand curve DPD and the broken MR Curve MRMR help explain the price inflexibility which characterizes Oligopoly. Any shift in Marginal costs between MC₁ and MC₂   will cut the vertical (short dashed segment of the marginal revenue curve, no change in either price QP or Output Q will occur. 

A Collusive Oligopoly is when, the firms may decide to co-operate and form cartel. Oil cartels are good examples of this. The process of price setting in a collusive oligopoly is akin to monopoly pricing since all firms act like one firm.If Oligopolistic firms are faced with Identical or highly similar demand or cost conditions, they will tend to behave collusively and maximize joint profits. Each Oligopolist charges QP and Produces Output Q . This is optimum price.

‘Monopolistic Competition’ is a market structure wherein there are many producers and they have several close substitutes. Monopolistic competition experiences differentiation of products. These products are not homogenous (like perfect competition) but are close substitutes. In such a market, there is , in the long run, the freedom of entry and exit of firms.

In such a market, equilibrium is achieved when marginal revenue becomes equal to the marginal cost. At this level, the firm cannot expand it’s output anymore since more output would lead to losses on marginal products

Point MT is average cost curve while MP is average revenue. Since AR exceeds AC, profits are depicted by PT. This is super normal profits whereas total supernormal profits equal (PT X OM)If the AR is below AC (Diagram B) , there will be losses.  Total loss will be TP X OM.

Monopolistic Competition

 As newer firms enter the market (and demand or AR curve shifts left), the supernormal profits are eroded and firms will earn normal profits (depicted by AR = AC).  This is because in the long run, demand would be more elastic. There is a greater possibility of substitutes.

3.5 a) Short Run Equilibrium

Under perfect competition, the  price equals marginal costs or the average variable costs. (Fixed costs are not factored in). If price is fixed lower, a firm would incur losses (leading to shut-down) whereas if price is higher, the firm would be priced out of the market.  

Here, the market supply curve is the lateral summation of all the MC curve of every firm.

In the above diagram, if DD increases to D1D1, price rises from OP to OK (while supply remains unchanged). The increased demand will lead to the use of variable factors of production more intensively (since fixed factors cannot be increased).

The supply curve is a straight line in a single market period and slopes slightly upward in the short run market period. In the short run, the supply increases from OM to OM’

An increase in demand from DD to D₁ D₁    will cause the price to fall  to OL from OP. However, the supply remains the same.  The firms will correct this by shrinking the supply in the short term. In doing so, they will employ  less variable costs.  The normal price will be OT but firms will incur losses at this point. Additionally, if price drops below OD , it will lead to a shut down of the firm.

 In the long run, all factors can be changed . Hence, all costs become variable costs. The equilibrium is achieved at the point wherein the price equals the minimum point on the Long Run Average Cost (LAC)  Curve as well as marginal cost/

The firm will make ‘super normal profits if the price is set above the minima of the LAC curve. Following this, new firms would enter the market. As the competition rises, profits are eroded and the equilibrium of all firms settles at ‘normal profits’ .This is depicted in the diagram below.

  Conclusion

There are several types of markets. Efficient Allocation of resources, however, is possible only under pure or perfectly competitive markets. In case f imperfectly competitive markets, there is always a price setting agent. Hence, all resources are not fully utilized to their maximum capacity. (Samelson & NordHaus, 2004)

Oligopoly

Negative Externalities: A Case Study of Sardar Sarovar Dam Project in India

The generation of electricity often has externalities such as the social costs of providing electricity, social cost of acquisition of land, pollution etc. An ‘Externality’ is an economic phenomenon where the all costs of production and consumption of a product/ service are not included in the price paid for the given product/service. Externalities are also, referred to as “ spillover effects” or as “external economies/diseconomies”. (Samelson & NordHaus, 2004)

An Externality is, mathematically, a deviation of “Marginal private Cost”  (MPC) from the marginal social cost. For any externality to happen, the marginal social costs should be lower than the marginal private cost. According to Lipsey & Chrystal, (2011) “Private costs are those costs that are incurred by parties that are involved directly in the Economic activity” and “Social costs are those costs that are borne by the society”  .

Hence, the marginal private costs refers to the private cost of the last producing the last unit produced or providing services to the last consumer serviced. The marginal social costs is a valuation of the impact borne by the society in the production of the last unit of good or services. The production of goods or provision of services, generally, have an effect on the social good. Positive Externalities increase the social good or are beneficial to the public, in general. On the other hand, negative externalities decrease the social good i.e. they have harmful effects or cause inconvenience to the public, in general.  (Lipsey & Chrystal, 2011)

In the Diagram below Triangle ABC, depicts the loss of social good as a difference between The Marginal Private Benefit and the Marginal Social Cost. Both these costs are the Marginal Cost Curves and the above diagram is a simple , supply demand analysis with the marginal  cost being broken down in the above two parts.

The generation of electricity at every stage has negative externalities at every stage.  The following is a very brief (not exhaustive) list of some of the possible externalities that are a result of electricity generation in India. (The Energy and Resources Institute, 2004)

Table 1: Prepared by Author. Adapted from (The Energy and Resources Institute, 2004)

Apart from the above list, the setting up of nuclear or hydro electricity generation projects can lead to the displacement of local inhabitants.

One of the most controversial electricity projects in India has been the Sardar Sarovar HydroElectric Power Project built on the Narmada Dam in India. The construction of the dam started in the year 1979. It was expected that the dam would help in the provision of electricity to four states of India (Gujarat, Maharashtra, Madhya Pradesh, and Rajasthan).  It was expected that the dam would have the positive externalities due to the increased capacity of irrigation and electricity generation. The design of the project was done with the hope that the above mentioned positive externalities would outweigh the negative externalities of project. (Sahoo, Prakash, & Sahoo, 2014)

• However, it was observed that the negative externalities outweighed the positive externalities of the project. For example, by the 1990s, 40, 245 families were affected (due to displacement or loss of livelihood). These social impacts were not considered in the project.
• The Height of the dam was also meant to provide a serious environmental risk possing a serious threat to the ecology and inhabitants around.
• Large Scale deforestation to clear space for the dam. (Sahoo, Prakash, & Sahoo, 2014).

Perfect Competition

Some of the solutions to address these externalities included:

• A National Tribunal was set to provide monetary compensation for resettlement to those affected.
• The height of the dam was reduced to reduce the risk of flooding.
• The government mandated ‘Compensatory Afforestation’ to mitigate the loss of livelihood and environmental impact due to deforestation.  (Sahoo, Prakash, & Sahoo, 2014)

As it has been observed, the government provided remedial measure but did not address the problem of inherent ‘negative externalities’.

Infrastructure projects such as the dam are, generally, sanctioned by the State or the Union Government in India and then implemented with the help of some public private partnership. Hence, the government has a monopoly.

Let us take the negative externalities of pollution here. Sustainable growth is important for India. Hence, infrastructure projects must reduce pollution. On the other hand, infrastructure projects such as the SSP are needed for continued growth and development of the county. Hence, the government must decide an optimum level of taxation and levies which does not harm growth but also does not allow excessive pollution as an externality of such project. The loss caused due to such governmental interventionist measures is known as “deadweight loss”. It has been observed that “deadweight loss” is lower in monopoly situations such as the SSP than in a perfectly competitive market. This is simply because, the output level is lower under monopoly than under perfect competition. This makes the case for introducing taxes, fees and provision of mandatory compensation by such projects. (Lee & Brown, 2006) (Samelson & NordHaus, 2004) (Carlton & Perloff, 2000).

Dams and hydro electric projects, generally require greater investments and there are several entry barriers as infrastructure projects, generally, require clearance from various agencies. In a perfectly competitive market, the output would be greater and hence, the externalities would be greater. In addition, taxation and other government levies such as compensation to displaced people would lead to further losses to the producers and they may provide exit the industry. There is very little possibility of passing on the price increase due to taxes, caps and other expenditure to the consumer.

Laws can be introduced to ensure that the social costs of pollution and human displacement are borne in the project. For example, the government can impose carbon taxes on infrastructure projects and require the state/ private entities providing such services to provide re-settlement compensation to the displaced.  The price can be, therefore, absorbed by the producer or transferred to the consumer. Consumers can, in turn , choose to pay the higher price or adopt other substitutes to the goods (in this case, the substitute would be green energy) (Lee & Brown, 2006). 

MC_P  would be the marginal private cost. In a competitive market, this would be the marginal supply curve. Producers of such project would ignore the pollution. The ‘Pollution Costs Curve’ provides the monetary valuation of the losses that may be caused due to pollution (healthcare costs, loss of value of natural resources of the trees due to deforestation. The vertical summation of MC_P and Marginal Pollution Cost Curve (addition of pollution costs to the private costs) is MC_S. (Carlton & Perloff, 2000)

In the absence of government intervention , the demand D equals MC_P. Even in case of a monopoly, the pollution costs are ignored and Q_m outputs are sold at price P_{m  .}

However, a competitive market would produce a higher output and at a lower price than a monopoly. The damage caused due to pollution is greater than the competitive equilibrium E_C  than a monopolistic one E_m  simply because there is lower output. The total sum of negative externalities are further reduced when government intervention takes place. In that case, the price would be P_m  and Output would be Q_{m .}

Conclusion

It is important to understand the ‘negative externalities’ of any activity. Understanding negative externalities would help the process of electricity generation and distribution become more efficient in India. Modern economic theory can help in analysis and solution of such problems.

Carlton, D. W., & Perloff, J. M. (2000). Modern Industrial Organization. Reading , USA: HarperCollins College Publishers.

Lee, Y.-H. A., & Brown, D. J. (2006). Competition, Consumer Welfare and the Social Cost of a Monopoly. New Haven, Connecticut: Yale University.

Lipsey, R., & Chrystal, A. (2011). Economics. Oxford: Oxford University Press.

McConell, C. R., Brue, S. L., & Flynn, S. M. (2009). Economics. Irwin: McGraw Hill.

Riley, G. (2005). European Economy in Focus. BerkShire (UK) : Tutor 2 u online.

Sahoo, T., Prakash, U., & Sahoo, M. M. (2014). SardarSarovar Dam Controversy : A Case Study. Global Journal of Finance and Management , 887- 892.

Samelson, P. A., & NordHaus, W. R. (2004). Economics: Seventeenth Edition. New Delhi: Tata- McGraw Hill Publishing Company.

The Energy and Resources Institute. (2004). Electricity externalities: an overview. New Delhi: The Energy and Resources Institute, India.

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