AEC 201: THE THEORY OF AGRICULTURAL PRODUCTION

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THE THEORY OF AGRICULTURAL PRODUCTION

1. Meaning of and factors of agricultural production.

Production is the process of transforming input into outputs.

Inputs are also referred to as resources or factors of production

Outputs and products are used interchangeably

There is nothing that is permanently an output or input because what someone considers as output could be another Man’s input.

Illustration

  • A maize farmer produces maize from his land using labour and his skill as a farmer. His inputs are land, labour, capital (hoes and cutlass) and his skill. His output is maize.
  • However, for a poultry feed mill, the maize (which is an output in the earlier illustration) is one of the inputs while poultry feed will be the output.
  • For a poultry farmer on the other hand, the feed is one of the inputs, while egg or chicken (poultry meat) are both his outputs.

Factors of Agricultural Production.

  1. Natural Resources: such as land, water and the local climate which are given by God, but which could be made more productive by man.
  2. Labour: Human resources or manual input. It describes the effort of human beings. It is the work done by human being. Labour in combination with other factors of production is utilized to produce outputs.
  3. Capital: Man made input or sometimes defined as a produced means of production. It represents resources which are the result of past human effort. Capital includes long life investments such as farm buildings, dams, roads on the farm, machinery as well as equipment such as tractors and their implements. Capital in Agricultural production includes tree crops, brooding stock of animals as well as money.
  4. Management/Entrepreneurship: a qualitative kind of input. It is simply the effective harnessing of land, labour and capital resources. It describes the function of taking decisions about how natural resources, labour and capital resources should be used and the process of carrying out those decisions. Management involves, decision making, supervision at implementation stage and coordination of all activities on the farm.

 

2. The concept of production function.

  • The production function for any commodity is an equation, table, or graph showing the (maximum) quantity of the commodity that can be produced per unit of time for each of a set of alternative inputs, when the best production techniques available are used.
  • The Production function refers to the technical relationship which shows the combination of inputs used to produce a specified amount of output at any given period.
  • This is achieved when the best method of production process is employed based on factorproduct, factor-factor and product-product relationship.

Factor Product Relationship: Only one output and one variable input such as labour (with fixed inputs).

Factor-Factor Relationship: one single output with two variable factors while others are held constant.

Product-Product Relationship: One variable input such as labour (others are held constant) to produce two commodities such as maize and yam

Lastly producing many products using many variable inputs such as the case in Nigeria

An Elementary Analysis of Factor-Product Analysis

A factor-product relationship is expressed under the following assumptions

  1. We are interested in only one product
  2. We are interested in the effect of variation of only one input such as labour while others are fixed.
  3. The inputs, both fixed and variable, and the products (Outputs) are all finely divisible
  4. The objective of the farmer is to maximize profit.

The last two assumptions also apply to all other types of relationships.

Mathematically, a factor –product production function can be expressed as

= (1)

Where Q is the quantity of output and X1 is the quantity of variable inputs, all others are fixed. If we want to relate the output of maize to the level of fertilizer application, for example, we shall assume that land, other types of capital, labour, management and other inputs are constant, only the level of fertilizer varies, if Q represents quantity of maize produced, while fertilizer, land, other types of capital, labour and management are represented by X1, X2, X3, X4, and X5 respectively, then the production function relating maize and fertilizer application will be given by Q= F(X1| X2, X3, X4, X5) or Q= F(X1)

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A Factor Product Production Function

The curve above is drawn on the assumption that both fertilizer and maize are finely divisible, hence is a smooth curve. There are also three possibilities in the relationship between an input and an output. The relationship could be one of constant marginal returns, increasing marginal returns or decreasing marginal returns.

Constant Marginal Returns: Constant marginal returns will obtain if increasing the level of input leads to a proportional change in the level of output i.e a percentage change in input could lead to the same percentage change in Output.

Table 1: Constant Marginal Returns

Quantity

Fertilizer (Bags)

of Quantity of maize

(Bags)

Change in quantity of Fertilizer Change in Quantity of Maize
0 200
10 400 10 200
20 600 10 200
30 800 10 200
40 1000 10 200
50 1200 10 200

 

 

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CONSTANT MARGINAL RETURNS

From the Table and Figure above, it can be seen that additional 200 bags of maize are produced for every additional 10 bags of fertilizer.

Increasing Marginal Returns: If a change in input utilization lead to a more than proportionate change in the output, then we have a case of increasing marginal returns. Additional units of variable input will result in a larger increase in product than the preceding unit. Table 2: Increasing Marginal Returns

Quantity

Fertilizer (Bags)

of Quantity of maize

(Bags)

Change in quantity of Fertilizer Change in Quantity of Maize
0 2
1 6 1 4
2 12 1 6
3 20 1 8
4 30 1 10
5 42 1 12
6 56 1 14
7 72 1 16
8 90 1 18

 

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INCREASING MARGINAL RETURNS

Table depict increasing marginal returns. Additional bags of fertilizer result in an increase in the quantity of maize produced. The product increases at an increasing rate when input increase by units(Bag)

Decreasing Marginal Returns: If a change in input results in less than proportionate change in output, we have a case of decreasing or diminishing marginal returns. Each additional unit of input results in a smaller increase in output than the preceding unit.

Quantity

Fertilizer (Bags)

of Quantity of maize

(Bags)

Change in quantity of Fertilizer Change in Quantity of Maize
0 2
1 25 1 23
2 45 1 20
3 60 1 15
4 70 1 10
5 75 1 5
6 76 1 1
7 74 1 -2

 

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DECREASING/DIMINISHING MARGINAL RETURNS

The table depict a case of decreasing marginal returns. In this case, the input (fertilizer) increases by one unit (bag) but the output increases at a decreasing rate. The additional units of fertilizer results in a decreasing addition to the quantity of maize produced. The decreasing addition to output continues until the output actually decreases at seven bags of fertilizer. This is the point where more than enough fertilizer has been applied.

Even though constant marginal returns, increasing marginal returns and diminishing marginal returns can all be observed in some cases, it is diminishing marginal returns that are most often observed. Constant marginal returns are, however, hardly observed for most inputs.

The Generalized Production Function

The three possibilities of a factor-product relationship can be combined into what is usually termed as a generalized production function. However, since constant marginal returns are not normally realized, it is hardly shown on the generalized production function.

Quantity

Fertilizer (Bags)

of Quantity of maize

(Bags)

Change in quantity of Fertilizer Change in Quantity of Maize
0 8
4 24 4 16
8 48 4 24
12 80 4 32
16 120 4 40
20 150 4 30
24 170 4 20
28 180 4 10
32 180 4 0

36

 

170

 

4

 

10

 

 

 

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GENERALIZED PRODUCTION FUNCTION

The Table and figure shows that additional bags of fertilizer first result in increasing addition to maize production until the POINT OF INFLEXION which occurs at 16bags of fertilizer use (Table) or at point b (Figure). The maximum production per unit of input is at this point. The region ab in the figure is the region of increasing marginal returns. After the point of inflexion, additional bags of fertilizer results in decreasing addition to maize production until maize production starts to decline after 32 bags of fertilizer have been used (Table) or point c (Figure). The region bc (fig) is one of decreasing or diminishing marginal returns where total production is increasing at a decreasing rate. The region after point c is one of decreasing total production or negative marginal productivity while the point c is a point of maximum production.

Law of Diminishing Marginal Returns: State that if the quantity of one variable factor is increased by equal amounts while the quantity of other factors are kept constant, the corresponding increments total product (Output) will start to decrease after a certain point (the point of inflexion) and will continue to decrease from that point.

Average Product (AP) and Marginal Product (MP)

The average product (AP) of an input is the ratio of the total product (TP) to the quantity of input used in producing that amount of output. It is the amount of product obtained per unit of input at a particular level of production or level of input use. Thus,

Marginal Product (MP), is the addition to total product due to the addition of one unit of a variable input. MP is the rate of change in total product as the quantity of input increases. That is,

 

A simple agricultural production function is obtained by using various alternative quantities of labor per unit of time to farm a fixed amount of land and recording the resulting alternative outputs of the commodity per unit of time. [We refer to cases such as this, where at least one factor of production or input is fixed, as the short run.] The average product of labor (APL) is then defined as total product (TP) divided by the number of units of labor used. The marginal product of labor (MPL) is given by the change in TP per unit change in the quantity of labor used.

EXAMPLE 1. The first three columns of Table 6.1 give a hypothetical short-run production function for wheat. Land is measured in acres, labor in worker-years, and total product (TP) in bushels per year. All units of land, labor, or wheat are assumed to be homogeneous or of the same quality. The average product of labor (APL) figures in column (4) are obtained by dividing each quantity in column (3) by the corresponding quantity in column (2). The marginal product of labor (MPL) figures in column (5) are obtained by finding the differences between the successive quantities in column (3)

The Shapes of the Average and Marginal Product Curve

The shapes of the APL and MPL curves are determined by the shape of the corresponding TP curve. The APL at any point on the TPL curve is given by the slope of the straight line from the origin to that point on the TP curve. The APL curve usually rises at first, reaches a maximum, and then falls, but it remains positive as long as the TP is positive.

 

Stages of Production

We can use the relationship between the APL and MPL curves to define three stages of production for labor. Stage I goes from the origin to the point where the APL is maximum. It is also known as irrational stage of production. At the point where APL is maximum, MPL is equal to APL. This stage is referred to as irrational because an additional unit of labour will increase the total product. Hence, it does not profit the firm to stop production.

Stage II is known as the rational stage of production; it goes from the point where the APL is maximum to the point where the MPL is zero. At this point, TPL is maximum. Thus it gives us the Traditional Production Function. The rational stage is the range over which the marginal product of labour is positive but declining.

Stage III covers the range over which the MPL is negative. The producer will not operate in stage III, even with free labor, because it would be possible to increase total output by using less labour on one acre of land. Similarly, the producer will not operate in stage I because, as shown in Problems 6.5 – 6.9, stage I for labor corresponds to stage III for land (the MPL and is negative). This leaves stage II as the only stage of production for the rational producer.

EXAMPLE 4. Fig. 6-2, with some modifications, is the same as Fig. 6-1 and shows the three stages of production for labour. Note that in stage II, the APL and the MPL are both positive but declining.

Thus, the rational producer operates in the range of diminishing returns within stage II.

 

5.3 The Concept of Isoquant.

The case where the firm has only two factors of production, labor and capital, both of which are variable. Since all factors are variable, we are dealing with the long run. An isoquant shows the different combinations of labor (L) and capital (K) with which a firm can produce a specific quantity of output. A higher isoquant refers to a greater quantity of output and a lower one, to a smaller quantity of output.

Table 6.2 gives points on three different isoquants.

Plotting these points on the same set of axes and connecting them by smooth curves we get the three isoquants shown in Fig. 6-3. The firm can produce the output specified by isoquant I by using 8K and 1L (point B) or by using 5K and 2L (point C) or any other combination of L and K on isoquant I. Isoquants (as opposed to indifference curves) specify cardinal measures of output. For example, isoquant I might refer to 60 units of physical output; isoquant II to 100 units of output, etc.

 

 

Characteristics of Isoquant

Isoquants have the same characteristics as indifference curves:

  1. Isoquants are negatively sloped: This implies that as the firm employs more unit of one input, it must employ less units of the other to produce the same amount of output or remain on the same isoquant.
  2. The higher the isoquants, the higher the level of output attained by the firm.
  3. Isoquants are convex to the origin: this shows that inputs can substitute for one another and the absolute value of its slope continue to decrease as we move from left to right along the curve. In other words, the marginal rate of technical substitution which represents the slope of the isoquant diminishes.
  4. Isoquants do not intersect.

 

 

 

 

 

 

 

 

THEORY OF COST

Basic definitions of cost. Social and private costs.

  • A cost is an expenditure required to produce or sell a product or get an asset ready for normal use.
  • In other words, it’s the amount paid to manufacture a product, purchase inventory, sell merchandise, or get equipment ready to use in a business process.
  • The amount of money paid to acquire something, or spent in producing something.

Concept of Costs

It is a commonly accepted fact that physical inputs or resources are important for enhancing production. We, however, tend to miss out on the financial aspect of this rule. Some of the most important decisions pertaining to business often relate to the cost of production, instead of physical resources themselves. Hence, it is important for producers to understand cost analysis.

In order to understand the general concept of costs, it is important to know the following types of costs:

 

  1. Accounting costs and Economic costs
  2. Outlay costs and Opportunity costs
  3. Direct/Traceable costs and Indirect/Untraceable costs
  4. Incremental costs and Sunk costs
  5. Private costs and Social costs
  6. Fixed costs and Variable costs

Concept of Costs in terms of Treatment

  1. Accounting costs: Accounting costs are those for which the entrepreneur pays direct cash for procuring resources for production. These include costs of the price paid for raw materials and machines, wages paid to workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc. Accounting costs are treated as expenses. Chartered accountants record them in financial statements.

 

  1. Economic costs: There are certain costs that accounting costs disregard. These include money which the entrepreneur forgoes but would have earned had he invested his time, efforts and investments in other ventures. For example, the entrepreneur would have earned an income had he sold his services to others instead of working on his own business. Similarly, potential returns on the capital he employed in his business instead of giving it to others, the output generated by his resources which he could have used for others’ benefits, etc. are other examples of economic costs. Economic costs help the entrepreneur calculate supernormal profits, i.e. profits he would earn above the normal profits by investing in ventures other than his.

 

Concept of Costs in terms of the Nature of Expenses

  1. Outlay costs: The actual expenses incurred by the entrepreneur in employing inputs are called outlay costs. These include costs on payment of wages, rent, electricity or fuel charges, raw materials, etc. We have to treat them are general expenses for the business.

 

  1. Opportunity costs: Opportunity costs are incomes from the next best alternative that is foregone when the entrepreneur makes certain choices. For example, the entrepreneur could have earned a salary had he worked for others instead of spending time on his own business. These costs calculate the missed opportunity and calculate income that we can earn by following some other policy.

 

Concept of Costs in terms of Traceability

  1. Direct costs: Direct costs are related to a specific process or product. They are also called traceable costs as we can directly trace them to a particular activity, product or process. They can vary with changes in the activity or product. Examples of direct costs include manufacturing costs relating to production, customer acquisition costs pertaining to sales, etc.

 

  1. Indirect costs: Indirect costs, or untraceable costs, are those which do not directly relate to a specific activity or component of the business. For example, an increase in charges of electricity or taxes payable on income. Although we cannot trace indirect costs, they are important because they affect overall profitability.

 

 

Concept of Costs in terms of the Purpose

  1. Incremental costs: These costs are incurred when the business makes a policy decision. For example, change of product line, acquisition of new customers, upgrade of machinery to increase output are incremental costs.
  2. Sunk costs: Suck costs are costs which the entrepreneur has already incurred and he cannot recover them again now. These include money spent on advertising, conducting research, and acquiring machinery.

 

Concept of Costs in terms of Payers

  1. Private costs: These costs are incurred by the business in furtherance of its own objectives. Entrepreneurs spend them for their own private and business interests. For example, costs of manufacturing, production, sale, advertising, etc.
  2. Social costs: it is the society that bears social costs for private interests and expenses of the business. These include social resources for which the firm does not incur expenses, like atmosphere, water resources and environmental pollution.

Concept of Costs in terms of Variability

  1. Fixed costs: Fixed costs are those which do not change with the volume of output. The business incurs them regardless of their level of production. Examples of these include payment of rent, taxes, interest on a loan, etc.
  2. Variable costs: These costs will vary depending upon the output that the business generates. Less production will cost fewer expenses, and vice versa, the business will pay more when its production is greater. Expenses on the purchase of raw material and payment of wages are examples of variable costs. Short-run and long-run cost.

In economics, the “short run” is the length of time over which a firm’s fixed costs are just that fixed. The “long run” is any length of time longer than the short run. Said differently, in the short run, some costs are variable, while others are fixed. In the long run, all costs are variable.

The nature of cost and cost curves.

Cost curves show the minimum cost of producing various levels of output. Both explicit and implicit costs are included. Explicit costs refer to the actual expenditures of the firm to purchase or hire the inputs it need. Implicit costs refer to the value of the inputs owned by the firm and used by the firm in its own production processes. The value of these owned inputs should be imputed or estimated form what they could earn in their best alternative use. In the short run, one or more (but not all) factor of production are fixed in quantity. Total fixed costs (TFC) refer to the total obligations incurred by the firm per unit of time for all fixed inputs. Total variable costs (TVC) are the total obligations incurred by the firm per unit of time for all the variable inputs it uses. Total costs (TC) equal TFC plus TVC Table 7.1 presents hypothetical TFC, TVC, and TC schedules. These schedules are plotted in Fig. 7-1

Table 7.1: hypothetical TFC, TVC, and TC schedules.

Q TFC ($) TVC ($) TC ($)
0 60 0 60
1 60 30 90
2 60 40 100
3 60 45 105
4 60 55 115
5 60 75 135
6 60 120 180

 

 

From Table 7.1, we see that TFC are $60 regardless of the level of output. This is reflected in Fig.

7-1 in a TFC curve which is parallel to the quantity axis and $60 above it. TVC are zero when output is zero and rise as output rises. The particular shape of the TVC curve follows directly from the law of diminishing returns. Up to point T0 (the point of inflection), the firm is using so few of the variable inputs together with its fixed inputs that the law of diminishing returns is not yet operating. So the TVC curve is concave downward and TVC increase at a decreasing rate. At point T0 , the law of diminishing returns beings to operate, so to the right of point T0 , the TVC curve is concave upward and TVC increase at an increasing rate. At every output level, TC equal TFC plus TVC. Thus the TC curve has the same shape as the TVC curve but is everywhere $60 above it.

Short Run per unit cost curves.

Although total cost curves are very important, per-unit cost curves are even more important in the short-run analysis of the firm. The short-run per-unit cost curves that we will consider are the average fixed cost, the average variable cost, the average cost, and the marginal cost curves. Average fixed cost (AFC) equals total fixed costs divided by output. Average variable cost (AVC) equals total variable costs divided by output. Average cost (AC) equals total costs divided by output; AC also equals AFC plus AVC. Marginal cost (MC) equals the change in TC or the change in TVC per unit change in output.

EXAMPLE 2. Table 7.2 presents the AFC, AVC, AC, and MC schedules derived from the TFC, TVC, and TC schedules of Table 7.1. The AFC schedule [columns (5) and (1)] is obtained by dividing TFC [column (2)] by the corresponding quantities of output produced [Q, in column (1)]. The AVC schedule [columns (6) and (1)] is obtained by dividing TVC [column (3)] by Q. The AC schedule [columns (7) and (1)] is obtained by dividing TC [column (4)] by Q. AC at every output level also equals AFC [column (5)] plus AVC [column (6)]. The MC schedule [columns (8) and (1)] is obtained by subtracting successive values of TC [column (4)] or TVC [column (5)]. Thus MC does not depend on the level of TFC.

The AFC, AVC, AC, and MC schedules of Table 7.2 are plotted in Fig. 7-2. Note that the values of the MC schedule [columns (8) and (1) in Table 7.2] are plotted halfway between successive levels of output in Fig. 7-2. Also note that while the AFC curve falls continuously as output is expanded, the AVC, AC, and MC curves are U-shaped. The MC curve reaches its lowest point at a lower level of output than either the AVC curve or the AC curve. Also, the rising portion of the

MC curve intersects the AVC and AC curves at their lowest point

 

 

The Long run Average cost Curve we defined the long run as the time period long enough to enable the firm to vary the quantity used of all inputs. Thus in the long run there are no fixed factors and no fixed costs, and the firm can build any size or scale of plant. The long-run average cost (LAC) curve shows the minimum perunit cost of producing each level of output when any desired scale of plant can be built. LAC is given by a curve tangent to all the short-run average cost (SAC) curves representing all the alternative plant sizes that the firm could build in the long run. Mathematically, the LAC curve is the envelope of the SAC curves.

EXAMPLE 4. Suppose that four of the alternative scales of plant that the firm could build in the long run are given by SAC1, SAC2 , SAC3 , and SAC4 , of Table 7.3 and Fig. 7-4. If the firm expected to produce 2 units of output per unit of time, it would build the scale of plant given by SAC1 and operate it at point A, where SAC is $17. If, however, the firm expected to produce 4 units of output, it would build the scale of plant given by SAC2 and would operate it at point B, where AC is $13. (Note that 4 units of output could also be produced at the lowest point on SAC1 but at the higher AC of $15.) If the firm expected to produce 8 units of output, it would build the larger scale of plant indicated by SAC3 and operate it at point C. Finally, for 12 units of output, the firm would operate at point D on SAC4. We could have drawn many more SAC curves in Fig.

7-4, one for each of the many alternative scales of plant that the firm could build in the long run.

By then drawing a tangent to all of these SAC curves, we would get the LAC curve.

The Shape of the Long Run Average Cost Curve

While the SAC curves and the LAC curve in Fig. 7-4 have been drawn as U-shaped, the reason for their shapes is quite different. The SAC curves decline at first, but eventually rise because of the operation of the law of diminishing returns (resulting from the existence of fixed inputs in the short run). In the long run there are no fixed inputs, and the shape of the LAC curve is determined by economies and diseconomies of scale. That is, as output expands from very low levels, increasing returns to scale cause the LAC, curve to decline initially. But as output becomes greater and greater, diseconomies of scale may become prevalent, causing the LAC curve to start rising.

Empirical studies seem to indicate that for some firms the LAC curve is either U-shaped and has a flat bottom (implying constant returns to scale over a wide range of outputs) or is L-shaped (indicating that over the observed levels of outputs there are no diseconomies of scale)

THE LONG-RUN MARGINAL COST CURVE

Long-run marginal cost (LMC) measures the change in long-run total cost (LTC) per unit change in output. The LTC for any level of output can be obtained by multiplying output by the LAC for that level of output. By plotting the LMC values midway between successive levels of output and joining these points, we get the LMC curve. The LMC curve is U-shaped and reaches its minimum point before the LAC curve reaches its minimum point. Also, the rising portion of the LMC curve goes through the lowest point of the LAC curve.

EXAMPLE 5. The LAC schedule given by columns (2) and (1) of Table 7.4 are read off or estimated from the LAC curve of Fig. 7-4. The (minimum) LTC to produce various levels of output [column (3)] is obtained by multiplying output by the corresponding LAC. The LMC values of column (4) are then obtained by finding the difference between successive LTC values. The resulting LMC schedule is plotted (together with its corresponding LAC schedule) in Fig. 7-5.

Note that when the LAC curve is declining, the LMC curve is below it; when the LAC is rising, the LMC curve is above it, and when the LAC curve is at its minimum point, LMC = LAC. The reason for this is that for the LAC to fall, the addition to the LTC to produce one more unit of output (i.e., the LMC) must be less than or below the previous LAC. Similarly, for the LAC to rise, the addition to LTC to produce one more unit of output (i.e., the LMC) must be greater than or above the previous LAC. For the LAC to remain unchanged, the LMC must equal the LAC

The Long run total Cost curve:

The LTC for any level of output can be obtained by multiplying output by the LAC for that level of output. By plotting the LTC values for various levels of output and joining these points, we get the LTC curve. The LTC curve shows the minimum total costs of producing each level of output when any desired scale of plant can be built. The LTC curve is also given by a curve tangent to all the short-run total cost (STC) curves representing all the alternative plant sizes that the firm could build in the long run. Mathematically, the LTC curve is the envelope to the STC curves.

 

Types of market.

 

Markets: A Market which can be defined as a total number of buyers and sellers in the region or area covered by the attention. The reason or area may include earth, states, country, or cities. The value of the items and cost or price is traded by people mainly depends on supply and demands in the markets. The nature of different markets can be a physical body or might be virtual, it may also be a global market or local market, perfect market, and imperfect market.

As we have different types of markets and all the different markets are not the same and similar. We can divide the market types based on different nature and competition level.

Different types of market structure will decide an economy. These kinds of market structures necessarily refer to the degree of competition in a market. Other components of market structures are the nature of product & services, a number of the seller, numbers of consumers, economics scale (types of market in economics).

Types of Market Structures

A variety of market structures will characterize an economy. Such market structures essentially refer to the degree of competition in a market.

There are other determinants of market structures such as the nature of the goods and products, the number of sellers, number of consumers, the nature of the product or service, economies of scale etc.

    • One thing to remember is that not all these types of market structures actually exist.
    • Some of them are just theoretical concepts.
    • But they help us understand the principles behind the classification of market structures.

 

 

 

7.1 Perfect Competitive market.

A market is said to be “perfectly competitive” if it meets several requirements, including: There are many firms in the market, each of which produces an identical product, and each of which represents only a very small portion of the total market. There are no “barriers to entry,” meaning that firms are free to enter (or leave) the market as they please. Buyers and sellers each have “perfect information,” meaning, for example, that each buyer knows exactly how much utility he/she would derive from purchasing the good and each seller knows the most efficient way to produce the good. There are no externalities. That is, the benefit of the good in question goes entirely to the buyers of the good, and the costs of production are borne entirely by the producers. Each firm in the market is chiefly concerned with maximizing profit. No market is perfectly competitive, but some get closer to the ideal than others. Agricultural commodities (e.g., oranges) are the classic example of a nearly perfectly-competitive market.

There are certain assumptions when discussing the perfect competition. This is the reason a perfect competition market is pretty much a theoretical concept. These assumptions are as follows,

  • The products on the market are homogeneous, i.e. they are completely identical
  • All firms only have the motive of profit maximization
  • There is free entry and exit from the market, i.e. there are no barriers  And there is no concept of consumer preference

 

Imperfect markets

Imperfect competition is a fairly common market structure in practice. It is defined by the following characteristics:

  • The goods that are sold are differentiated. That means, even though they mostly satisfy the same needs, there are minor differences that allow customers to distinguish the products from one another.
  • Due to the differentiated goods, customers develop preferences for some sellers. Thus, they are willing to spend more money on goods from specific sellers.
  • As a result, the sellers may exert a certain degree of market power and charge a price premium. Hence, they can directly influence the market price to a limited degree and are no longer pure price takers.

Imperfect competition is a generic description of all market structures that lie anywhere between perfect competition and a monopoly. Thus, monopolistic competition is a type of imperfect competition along with oligopolistic market structures.

Monopolistic Competition: This is a more realistic scenario that actually occurs in the real world. In monopolistic competition, there are still a large number of buyers as well as sellers. But they all do not sell homogeneous products. The products are similar but all sellers sell slightly differentiated products.

Monopolistic competition builds on the following assumptions:

  • all firms maximize profits
  • there is free entry, and exit to the market,
  • firms sell differentiated products
  • consumers may prefer one product over the other.

Now, those assumptions are a bit closer to reality than the ones we looked at in perfect competition. However, this market structures no longer results in a socially optimal level of output because the firms have more power and can influence market prices to a certain degree.

Now the consumers have the preference of choosing one product over another. The sellers can also charge a marginally higher price since they may enjoy some market power. So the sellers become the price setters to a certain extent. For example, the market for cereals is a monopolistic competition. The products are all similar but slightly differentiated in terms of taste and flavours. Another such example is toothpaste.

Oligopoly: In an oligopoly, there are only a few firms in the market. While there is no clarity about the number of firms, 3-5 dominant firms are considered the norm. So in the case of an oligopoly, the buyers are far greater than the sellers.

The oligopolistic market structure builds on the following assumptions:

  • all firms maximize profits,
  • oligopolies can set prices,
  • barriers to entry and exit exist in the market,
  • products may be homogenous or differentiated, and
  • only a few firms dominate the market. Unfortunately, it is not clearly defined what a “few firms” means precisely. As a rule of thumb, we say that an oligopoly typically consists of about 3-5 dominant firms.

The firms in this case either compete with another to collaborate together, they use their market influence to set the prices and in turn maximize their profits. So the consumers become the price takers. In an oligopoly, there are various barriers to entry in the market, and new firms find it difficult to establish themselves.

Monopoly: In a monopoly type of market structure, there is only one seller, so a single firm will control the entire market. It can set any price it wishes since it has all the market power. Consumers do not have any alternative and must pay the price set by the seller. The following assumptions are made when we talk about monopolies:

  • the monopolist maximizes profit,
  • it can set the price,
  • there are high barriers to entry and exit,
  • there is only one firm that dominates the entire market.

Monopolies are extremely undesirable. Here the consumer loose all their power and market forces become irrelevant. However, a pure monopoly is very rare in reality.

Monopsony: A monopsony is a market condition in which there is only one buyer, the monopsonist. Like a monopoly, a monopsony also has imperfect market conditions. The difference between a monopoly and monopsony is primarily in the difference between the controlling entities. A single buyer dominates a monopsonized market while an individual seller controls a monopolized market. Monosonists are common to areas where they supply most or all of the region’s jobs.

  • A monopsony refers to a market dominated by a single buyer.
  • In a monopsony, a single buyer generally has a controlling advantage that drives its consumption price levels down.
  • Monopsonies commonly experience low prices from wholesalers and an advantage in paid wages.

 

 

 

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