Introduction to Producer Theory & the Market Models of PC and Monopoly

Introduction

Say you want to open up an automobile manufacturing business, however you don’t know where to start. There are couple of things one needs to do before opening this business, such as finding out the level of production needed to create a car, including labor, materials, and equipment. Also, finding out at what point does your level of production move from the short run cost to the long run cost. One of the most important things one needs to do is to find out which market the automobile manufacturing business is in before deciding to branch into that market. When asking this question, it’s best to keep in mind that there are four types of Market Structures: Perfect Competition, Monopolistic Competition, Oligopoly, Pure Monopoly.

Perfect Competition

In this market, there is a very high number of firms. This is a guarantee that each firm has no market power. The products sold in this market are homogenous. The information in this market is perfect, meaning there are no information asymmetries. There is also free entry and exit into the industry, meaning there are no market barriers.

This does not suit the automobile industry because there are plenty of barriers into this market. Those barriers include, but are not limited to, product differentiation, economies of scale, switching cost, and government policies.

Monopolistic Competition

Monopolistic competition is the only market that can mimic both monopoly and perfect competition. In this market, there are a large number of firms, however, they consist of product differentiation. If there are barriers to entry, it is very limited.

The automobile industry consists of very few elite manufacturers that are well known; therefore, it does not fit into this category. Also, there are very high cost of entry into this market that new automobile manufacturers do not stand a chance in the industry.

Oligopoly: Car Manufacturer

In this market structure, there are very low number of firms, maybe two-to-ten maximum and none of which can keep the others from having significant influence over the market. This means that each producer must consider the effect of a price change on the actions of the other producers.

The automobile manufacturing industry is defined as an oligopoly because it is dominated by the few large firms that controls the majority of the market. The barriers of entry are high, such as production and distribution cost, as well as their reliance on brand loyalty and image. For example, an entire middle-class family may choose a brand like Toyota because of their good quality and price makes it liable and affordable. Whereas a high-class family may choose BMW because of the status. Both sides may have very few relatives that will branch into another market because of their family's brand loyalty to the current product line.

Producer Theory

The Production Theory looks at the firm as a rational actor, rather than the consumer. It analyses how businesses respond to demand by adjusting their level of output. The production function used for this is as follows:

Q= f(I#1, I#2…)

In the case of the automobile manufacturer, “Q” would be the number of cars produced and “I” would be the materials, machine hours, and workers used to produce the car.

Short Run

When an entrepreneur first sets out and open their business, they are in the short run. Say they decide to open up a location in Massachusetts. They need a couple of things to get the business up and running. Those being the materials, the workers and the equipment. The difference between the short run and the long run is one thing: short run has at least one fixed cost. The fixed cost in this case would be the equipment in this case. When a new company starts up, there is only one equipment to choose from because there is a low level of production. Until you start to generate more revenue and now one location is not enough because the demand is higher than what is supplied, now you need to open a new location and that location needs new equipment. Now you start to enter the Long Run.

Long Run

As mentioned, the long run cost curve is where all cost are variable costs. Now business is booming, and the original automobile manufacturer becomes 3. One located in Massachusetts, Rhode Island, and Maine. Each one of these locations is represented by their own short run cost curve because each location has only one equipment to turn raw materials into a car, which represents their fixed cost. However, the company itself can now operate on a long run cost curve. This is because they can choose which location, they want to produce their cars in. What is a fixed cost to one location, is now a variable cost to the entire company. Therefore, if it is cheaper to produce their order in Massachusetts, they now have access. Same goes for the rest of their other locations.

The location that the company chooses will all depend on the quantity that is needed for the company to produce. When looking at the short run cost curve, the lowest point of each of the curves are where the cost is cheapest to produce. Therefore, the Long Run Average Total Cost is made up of the lowest point of all the lowest points of the Short Run Average Total Cost.

Conclusion

When opening up a business, it is important to factor in all of these points. Before going into a market, first ask “what type of market is this?” This will answer a series of questions such as: barriers to entry/exit, product differentiation, and how many firms will it have to compete against. Then take a look at your competitors Long Run and Short Run cost curves to help understand what quantity is needed to produce and at what cost. These factors can all very much lead to the rise or fall of a new market.