Economics for Public Policy Assignment

CPR 606

C52/7542/2017

23/05/2018
QUESTION ONE: Discuss the key features of Competitive, Monopoly and Oligopoly Market
Structures

According to Mazzeo, (2002), a market structure describes the key traits of a market,
including the number of firms, the similarity of the products they sell, and the ease of entry into
and exit from. The take away from the above definition is that a market structure is best defined
as the organizational and other characteristics of a market. These characteristics affect the nature
of competition and pricing. The elements of a market structure include; the number and size, the
entry conditions as well as the extent of product differentiation. The type of market structure
influences the manner in which a firm behaves in terms of price, supply, barriers to entry,
efficiency and competition. The market structures in question are competitive, monopoly and
oligopoly. The key features of these market structures are:

Competitive Market Structure

Competitive market structure also referred to as perfect competition is a theoretical
market structure that has no barriers to enter and unlimited number of producers and consumers.
The market structure has a perfect elastic demand curve. Precisely, there is an infinitely large
number of buyers and sellers that operate freely and sell a homogenous commodity at a uniform
price. According to Mankiw & Taylor, (2006), perfect competitive markets are those where there
are large number of small buyers and sellers dealing with a homogeneous product and a single
small firm do not have influence on the price allocation and acts as a price taker.

Features of Competitive market structure

1. Infinitely Large number of Buyers and Sellers

In this market structure, there is very large numbers of buyers such that no individual buyer
can influence the market price. Similarly, when there are a very large number of sellers, each
firm or seller in a perfectly competitive market forms an insignificant part of the market. As
such, no single seller has the ability to determine the price at which the commodity is sold. It is
the forces of market demand and supply that determines the price of the commodity. Since each
firm accepts the price that is determined by the market, it becomes a price taker. As the market
determines the price, it is the price maker.

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 2. Homogenous Product
In a perfect competitive market, firms sell homogeneous products. Homogenous products
are those that are identical in all respects in that there is no difference in packaging or quality
colors. As the output of one firm is exactly the same as the output of all others in the market,
the products of all firms are perfect substitute for each other.

3. Free Entry in to and Exit from the market

The entry into this market structure is very easy since there are no barriers to entry. The
barriers could be financial, technical or government-imposed barriers in form of licenses,
permits and patents. The implication of this feature of perfect competition is that while in the
short run firms can make either supernormal profits or losses, in the long run all firms in
market earn only normal profits.

4. Perfect Knowledge of Market

Buyers and sellers have complete and perfect knowledge about the product and prices
of other sellers. This feature ensures that the market achieves a uniform price level.
Shape of the AR and MR curves under Perfect Competition
Since the firm under Perfect Competition is a Price Taker and cannot change the price
it can change for its product, the Average Revenue (which is equal to price) is the same for all
units of output sold. In this case, Marginal Revenue is also constant and equal to the Average
Revenue.

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 Average Revenue Curve is also a Demand Curve facing a perfectly competitive firm,
which is perfectly elastic. No real-world market exactly fits the features of perfect market
structure is a theoretical or ideal model, but some actual markets do approximate the model fairly
closely. Examples of Perfect Competition include firm products markets, the Stock Market and
Foreign Exchange Market, Currency Market, Bond Market.

Monopoly
Pure Monopoly is the form of market organization in which there is a single seller of a
commodity for which there are no close substitutes. Thus, it is at the opposite extreme
from perfect competition monopoly. Monopoly market structure is as a result of: Increasing
returns to scale; Control over the supply of raw materials; Patents; Government Franchise.
Features of Monopoly
1. A single seller
There is only one producer of a product. It may be due to some natural conditions
prevailing in the market, or may be due to some legal restriction in the form of patents,
copyright, sole dealership, state monopoly, etc. Since, there is only one seller; any change in
supply plans of that seller can have substantial influence over the market price. That is why a
Monopolist is called a Price Maker. A Monopolist’s influence on the market price is not total
because the price is determined by the forces of Demand and Supply and the Monopolist
controls only the supply.

2. No Close Substitute

The commodity sold by the Monopolist has no close substitute available for it. Since the
product has no close substitutes; the demand for a product sold by a monopolist is relatively
inelastic.
3. Barriers to the entry of new firms
There are barriers to entry into industry for the new firms. It may be due to following
reasons: Ownership of strategic raw material or exclusive knowledge of production; Patent
Rights; Government Licensing and natural Monopolies. The implication of barriers to entry is
that in the short run, monopolist may earn supernormal profit or losses. However, in the long run,
barriers to entry ensure that a monopolistic firm earns only super normal profits.

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 4. Price Discrimination

Price Discrimination exists when the same product is sold at different price to different
buyers. A monopolist practices price discrimination to maximize profits. For example, the price
of a bottle of Coca Cola are different for its consumers depending on the location and income
levels.

5. Abnormal Profits in the Long run

Being the single seller, monopolists enjoy the benefit of higher profits in the long run.
6. Limited Consumer Choice
As they are the single producer of the commodity, in the absence of any close substitute the
choice for consumer is limited.
7. Price in Excess of Marginal Cost
Monopolists fix the price of a commodity (per unit) higher than the cost of producing one
additional unit as they have absolute control over Price Determination.

Shape of the AR and the MR Curves under Monopoly

The AR Curve faced by the Monopolistic is Downward Sloping as the Monopolist can
increase sales by reducing price. If the AR Curve is declining, it implies that the MR is also
declining at a faster rate.

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Demand Curve facing the Monopolist
Since there is only one seller in the market, the AR Curve of a monopolist in nothing else
but the Market Demand Curve for the product. The demand is relatively inelastic as there is only
a single seller for the commodity and its product does not have close substitutes.

Oligopoly Market Structures

The term Oligopoly means ‘Few Sellers’. An Oligopoly is an industry composed of only
few firms, or a small number of large firms producing bulk of its output. Since, the industry
comprises only a few firms, or a few large firms, any change in Price and Output by an
individual firm is likely to influence the profits and output of the rival firms. Major Soft Drink
firms, Airlines and Milk firms can be cited as an example of Oligopoly.

Features of Oligopoly Market Structure

1. A Few Firms
Oligopoly as an industry is composed of few firms, or a few large firms controlling bulk of
its output.
2. Firms are Mutually Dependent

Each firm in oligopoly market carefully considers how its actions will affect its rivals and
how its rivals are likely to react. This makes the firms mutually dependent on each other for
taking price and output decisions.

3. Barriers to the Entry of Firms

The main cause of a limited number of firms in oligopoly is the barriers to the entry of firms.
One barrier is that a new firm may require huge capital to enter the industry. Patent rights are
another barrier.

4. Non-Price Competition

When there are only a few firms, they are normally afraid of competing with each other by
lowering the prices; it may start a Price War and the firm who starts the price war may ultimately
loose. To avoid price war, the firm uses other ways of competition like: Customer Care,
Advertising and Free Gifts. Such a competition is called non-price competition.

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QUESTION TWO: Compare and Contrast the Perfect Market Competition and Monopoly
Market Structures

Perfect market competition and monopoly present the two extremes in the market
structures. Perfect competition market typifies the attainment of efficiency in an industry with
extensive existence of competition with the absence of market control as evidenced in the
monopoly market structure. Monopoly on the other hand, represents the other extreme which is
demonstrated by inefficiency mainly brought about by the absence of competition and rigid
control of the market by a single market player (Machovec, 2002). The comparison and contrast
between perfect market and monopoly are on the premise of the characteristics that distinguish
these two forms of market structures.

To start off, perfect competitive market has a number of characteristics that distinguish it
from monopoly. Perfect competitive market firms and consumers are always price takes. The
implication is that neither the firm not the consumer has the control over the prevailing price in
the market since they are determined by the forces of demand and supply. Therefore, there is
non-exploitation between the consumers and the firms. The other difference is that firms in
perfect competition often sell as much as they want at the prevailing prices in the market.
Consequently, there is often a small supply by firms relative to the market. There is competition
in perfect competitive market because of the existence of many firms. The actions by individual
firms do not affect the market as there are many other firms in the same market.

Additionally, in perfect competitive market structure the marginal revenue of firms

equals the price in the market. Consequently, a firm attains profit maximization by equating the
marginal revenue with its marginal cost (MR = MC). The implication is that price equals
marginal cost in the perfect competitive market structure. For monopoly, there is complete
control by a single player or firm. The supply side of the market is fully controlled by a single
firm. The single firm has all the powers to determine the quantity and the price of its products.
This is made possible by the barriers of entry made by the single firm as well those made by
government in form of licenses, permits among others.

Furthermore, the monopoly market structure has a negatively slopped demand function.
The monopoly market does not present any chance for another player to enter as serious barriers
have been established. Contrary to the perfect competitive market where each individual firm has

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no control over the prices prevailing in the market, a monopolist firm fully determines the prices
prevailing in the market.

The number of firms in a perfect competitive market structure is infinite. The small firms
have absolutely no influence on the industry meaning that they are only price takers. Their lack
of market control means that they have to supply their products at the prices determined by
interaction of demand and supply. For monopoly, this single firm is extremely large in size and
typically boasts of extreme power and control in the industry. The firms in a perfect competitive
market do not produce goods that are regarded as substitutes. Therefore, the consumers can buy
from any firm without experiencing any form of shift in quality. On the contrary, the products of
a monopoly firm are perfectly unique and do not have any close substitutes whatsoever.

The mobility of firms in perfect competitive markets is perfect in that at any one given
moment, a firm can enter or exit the market at choice. No barriers exist for firms in perfect
competitive markets. This is however not the case with monopoly markets. A monopoly firm has
the full control of the industry and the market it exists implying that no other players can be able
to enter such a market. The monopoly firm has either amassed extensive strength to take over the
whole industry or possess the patents on the production of specific products produced by the
monopoly firm. The other distinction between perfect competition and monopoly market is the
information availability and awareness of the firms. Firms in perfect competition have the same
information as that possessed by other firms in the market. Additionally, the firms have similar
production technology. On the contrary, a monopoly firm possesses information that is unknown
to other firms. For example, the Coca cola company possesses information about the ingredients
of the soft drink that are unknown to other soft drink firms.

However, both perfect market competition and monopoly seek to maximize profits (Djolov,
2006). Without such profits, the firms cannot have the motivation to operate. The profit
maximization goal is attained through either attainment of normal profits or through supernormal
profits. Firms in perfect competition often enjoy normal profits warranting their continued
existence. On the other hand, the monopoly firm can make supernormal profits or normal profits
depending on the decisions it makes. In reality, monopoly markets enjoy supernormal profits as a
result of the inefficiencies they create in the market to ensure low supply thus increasing the

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demand for its products. Consequently, prices will rise for such products leading to supernormal
profits.

QUESTION THREE: What is the difference between Competitive, Monopoly and Oligopoly
Market Structures in terms of Price and Output Determination? Carefully Illustrate using suitable
diagrams

Competitive market structure

The market price and quantity of a product are determined exclusively by the forces of
market demand and market supply for the product and the firm is a price taker (i.e. it can sell any
quantity at that price).
There is a great number of buyers and sellers that are too small in relation to the market
to be able to affect the price of the product by their own actions. The product of each competitive
firm is homogeneous, identical, or perfectly standardized for instance cereals. There is also a
perfect mobility of resources.

The product price is constant, the change in the total revenue per unit change in output,
that means the change in marginal revenue (MR) is also constant and is equal to the product
price.

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Monopoly market structure
In the absence of government intervention, a monopolist is free to set any price it desires
and will usually set the price that yields the largest possible pro-t. Since the monopolist -rm is
assumed to be the only producer of a particular product, its demand curve is identical with the
market demand curve for the product. The market demand curve, which exhibits the total
quantity of a product that buyers will offer to buy at each price, also shows the quantity that the
monopolist will be able to sell at every price that he sets. If we assume that the monopolist sets a
single price and supplies all buyers who wish to purchase at that price, we can easily find his
average revenue and marginal revenue curves. The firm faces a downward sloping demand
curve, because if it wants to sell more it has to reduce the price of the product.

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Oligopoly market structure
In oligopoly, prices remain sticky or inflexible for a long time. They tend to change
infrequently, even in the face of declining costs. The reason for this is the kinked demand curve
hypothesis given by an American economist Paul A. Sweezy. The demand curve facing an
oligopolist, according to the kinked demand curve hypothesis, has a ‘kink’ at the level of the
prevailing price. It is because the segment of the demand curve above the prevailing price level
is highly elastic and the segment of the demand curve below the prevailing price level is
inelastic. A kinked demand curve dD with a kink at point P is shown below.

The prevailing price level is MP and the -rm produces and sells output OM. Now the
upper segment dP of the demand curve dD is relatively elastic and the lower segment PD is
relatively inelastic. This difference in elasticities is due to the particular competitive reaction
pattern assumed by the kinked demand curve hypothesis.

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 Each oligopolist believes that if it lowers the price below the prevailing level its
competitors will follow him and will accordingly lower prices, whereas if it raises the price
above the prevailing level, its competitors will not follow its increase in price. This is because
when an oligopolistic firm lowers the price of its product, its competitors will feel that if they do
not follow the price cut, their customers will run away and buy from the firm which has lowered
the price. Thus, in order to maintain their customers, they will also lower their prices. The lower
portion of the demand curve PD is price inelastic showing that very little increase in sales can be
obtained by a reduction in price by an oligopolist. On the other hand, if a firm increases the price
of its product, there will a substantial reduction in its sales because as a result of the rise in its
price, its customers will withdraw from it and go to its competitors which will welcome the new
customers and will gain in sales. These happy competitors will have therefore no motivation to
match the price rise. The oligopolist who raises its price will lose a great deal and will therefore
refrain from increasing price. This behavior of the oligopolists explains the elastic upper portion
of the demand curve (dP) showing a large fall in sales if a producer raises his price.

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QUESTION FOUR: Suppose the Government of Kenya decides to lower taxes in the Economy.
Show the impact of this policy on the IS-LM curve assuming that;
(i). The rate of interest is constant
When the rate of interest is constant, the level of income increases from Yx to Yi.
(ii). The rate of interest is flexible
In the event that the rate of interest is flexible, there is an increase in interest from rx to r1.
On the other hand, income increases from Yx to Yii

(iii). Comment with reasons

As evidenced in figure 2.1 below, there is an increase in the level of income when the
rate of interest is constant and when rate of interest is flexible. It is however evident that the
increase in the level of income is larger when the interest rate is constant as opposed to when it is

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flexible. The reason for this is that, when the interest rate is flexible, an increase in the rate of
interest from rx to rii crowds out a further increase in income causing crowding out effect.

QUESTION FIVE: Suppose the Government of Kenya decides to Freeze all the Development
Projects in the Economy. Show the impact of this policy on the IS-LM curve assuming that;

(i). The rate of interest is constant

The outcome is a decline in income from Yx to Yi

(ii). The rate of interest is flexible

From the point whereby the new IS curve meets the old LM curve, it is evident that the
interest rate has declined from rx to ri and the income has reduced from Yx to Yii.

(iii). Comment with reasons

Evidently, with both the rate of interest being constant and flexible, there is a notable
decline in the level of income. However, the reduction in income is greater when the rate of
interest is constant compared to when the rate of interest is flexible. This is because when the

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rate of interest is flexible, a reduction in the rate of interest from rx to ri crowds in a further
reduction in income causing a crowding in effect.

QUESTION SIX: Suppose the Central Bank of Kenya decides to increase the Legal Reserve
Requirements in the Economy. Show the impact of this policy on the IS-LM curve assuming that;

(i). The rate of interest is constant

The result is a decline in income from Yx to Yi.

(ii). The rate of interest is flexible

Level of income declines from Yx to Yii and the rate of interest increases from rx to ri.

(iii). Comment with reasons

When there is an increase in the legal reserve requirement in the economy, the
implication is that the commercial banks will have to deposit more with the central bank
meaning the will have less to borrow to individuals and in that cases, the rate of interest increases
from rx to ri. On the other hand, there is a decline in the level of income when the interest rate is

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both constant and flexible though the decline in income is greater when the rate of interest is
constant. The reason is that, when interest rate is flexible, an increase in rate of interest from rx
to ri crowds in a further reduction in income causing a crowd in effect.

QUESTION SEVEN: Suppose the Government of Kenya decides to Buy Securities from the
members of the Public in the Economy. Show the impact of this policy on the IS-LM curve
assuming that;

(i). The rate of interest is constant

The level of income increases from Yx to Yi because individuals will have money in
their hands after selling securities to government which implies an increase in income.

(ii). The rate of interest is flexible

The level of income increases from Yx to Yii while the rate of interest declines from rx to
ri.

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(iii). Comment with reasons
There is an increase in the level of income when the rate of interest is both constant and
flexible. Nonetheless, the increase in income is larger when the interest rate is constant compared
to when it is flexible. This is because when the interest rate is flexible, a reduction in the rate of
interest from rx to ri crowds out a further increase in income causing a crowding out effect.

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QUESTION EIGHT: Discuss the Role of State, Markets and Civil Society in Economic Growth
and Development in Kenya. In your view, which agent has contributed much to this process of
Growth and Development?

Arato and Cohen defined civil society 'as a sphere of social interaction between economy
and state, composed above all of the intimate sphere (especially the family), the sphere of
associations (especially voluntary organizations) social movements and forms of public
communication'. On the other hand, market opportunities enable people to go about their
economic activities independently without being dependent on the goodwill of officials and
bureaucrats. The state comprises the legislature that votes on public rules, the political system
that regulates elections, the role that is given to opposition parties, and the basic political rights
that are upheld by the judiciary

The state is responsible for guaranteeing freedom and enforcement of contracts, and for
introducing and maintaining laws supporting the market and market competition. The state
should establish a clear and transparent set of general rules or governance structure. A strong
state is needed to establish the right and supportive institutional environment in order to make
the introduction of a market economy successful.

Hoen further argues that a strong state needs participation of the society in the policy
decision making process. Without such participation the state is unable to identify the rules
needed to let markets function well. Participation is best guaranteed by way of having a ‘civil
society’. Hoen defines civil society as the capacity of individuals to organize themselves
voluntarily independent from the state, yet not necessarily without state participation.

In the Kenyan context, the civil society creates the conditions for the citizenry to take part
in civil life, elections, common-good problems such as prioritizing the areas that are important to
life on the ground be it be health, education, water, roads, power and sanitation. Besides, it
creates an environment for youth to learn from the experienced and to have good leaders as role
models. It is through good leaders that policies directed towards improving the economic
situations of Kenya are implemented.

Furthermore, the civil society which comprises NGOs keep a watch on the government
and fill the gaps that are not addressed by the state. For instance, the civil society are

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instrumental in improving quality of education through introduction of technology or training on
the supply side or helping the poor through scholarships on the demand-side.

Market opportunities enable people to go about their economic activities independently

without being dependent on the goodwill of officials and bureaucrats. However, markets may
also fail due to misuse of power in relationships for instance corruption, rent seeking behavior
and the existence of externalities and related problems of free riding. Finally, the market
outcome of the allocation of resources may be socially unacceptable. Again, institutions and
rules are needed to correct for these market failures and obtain an economically optimal and
socially acceptable allocation of scarce resources.

The state has contributed much to the process of growth and development in Kenya. To
start off the state plays a key role in ensuring organizational changes. The organizational changes
play an important role in the process of economic development. It includes the expansion of the
size of market and the organization of labor market. The state can develop the means of transport
and communications for expanding the size of market because private enterprise cannot be
capable of undertaking such schemes.

Moreover, the state can help the growth of agriculture and industries. The organization of
the labor market also falls under the functions of government. It increases the productivity of
labour. The government helps in organizing labour by recognizing labour unions. It fixes
working hours, payment of wages, establishes machinery for the settlement of labour disputes
and provides for social security’s measures.

Public health measures generally include the improvement of environmental sanitation in

both rural and urban areas, removal of Stagnant and polluted water, better disposal of sewage,
control of communicable diseases, provision for medical and health services particularly in the
field of maternity and child welfare, health and family planning education and the training of
health and medical personnel and all this requires planned efforts on the part of the state.

Furthermore, the process of development is accelerated by increasing the rate of

investment. The rate of savings in Kenya is highly inadequate as compared to their investment
requirements. Thus, it becomes essential for government to accelerate the rate of capital
formation in Kenya and the government can achieve this through taxation or inflation.

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 A proper monetary policy helps economic and industrial development by increasing the
volume of scarce resources, raising the productivity of factor of production, improving the
economic and social conditions and removing the various bottlenecks in the process of economic
development. In Kenya, control of money supply by the government is necessary as they had
ensured the full employment. From the ensuing discussion, it is evident that the state is the major
play in economic growth in Kenya.

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 References

Mazzeo, M. J. (2002). Product choice and oligopoly market structure. RAND Journal of
Economics, 221-242.

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