ASSIGNMENT No.

01
Economic Analysis (5001)MSc Administrative Sciences
Spring, 2022
Q. 1 Explain the concept of microeconomics. Compare microeconomics and with examples.
(20)

The study of economics is divided into two major sections: microeconomics and macroeconomics.
Microeconomics focuses on the smaller parts of the economy while macroeconomics focuses on the
larger concepts of the economy. Microeconomics meaning is the study of economic activity for
individuals and businesses. Macroeconomics studies the larger scale economic factors like government
regulation, banking activity, independent agencies, and international finance. Most economists choose
which field of economics to study and become experts in it. Microeconomics is needed to analyze
information for the day-to-day economic activity. The field of microeconomics helps illuminate issues or
events that affect consumer and business spending.

Microeconomics Definition

The formal microeconomics definition is the branch of economics that studies the behavior of
individuals and businesses and how decisions are made based on the allocation of limited resources.
Studies in microeconomics show how businesses and individual households interact or cooperate. This
interaction creates a market for goods and services that greatly impacts the price level of products.

For example, the circular flow of economic activity is an important concept studied in microeconomics
to show the interaction between businesses and households. The flow of economic activity consists of:

 Flow of money as revenue for businesses and flow of income to households

 Flow of goods and services being received by households
 Flow of resources from private ownership being sold to businesses to create products
 Flow of expenditures of businesses and expenses of households
 Both this relationship and economic activity are studied closely in microeconomics to track the
overall output of businesses, income level of households, and overall household expenditure.

Microeconomics Examples

The situations below will display where the microeconomics definition and examples come into play:

First-time homebuyers shopping for the best loan interest rates

An individual choosing to purchase one product over another
A business investing in capital goods in order to expand
Two businesses competing in the same market
Customers' demand decreasing because price of a service has increased
Businesses lowering supply of a product because of cost increases

Microeconomics Topics

There are numerous microeconomics topics that economists use to better explain interactions of
businesses and individuals. The most common microeconomic terms are supply and demand, elasticity,
opportunity cost, market equilibrium, forms of competition, profit maximization, and cost-of-
production.

Supply, Demand, and Market Equilibrium

Supply is the number of products and services a business will offer in a market that has a direct
relationship with price. Meaning, the higher the price level, the more likely a business will increase
supply. Lower the price level, and supply will likely decrease.

1
Demand shows the desire of consumers to purchase products. Demand will decrease as prices increase
and vice versa.

In the context of supply and demand, equilibrium refers to a condition where the pressure for higher
prices is exactly balanced by the pressure for lower prices, so that the current state of exchange
between buyers and sellers can be expected to persist.

Elasticity

Elasticity refers to the degree of price, demand, or supply change. The larger of the changes in price
level, demand, or supply is known as elastic change. If there is just a small change in these factors,
then it is known as inelastic change.

Opportunity Cost

The opportunity cost is the value of the best alternative given up when a choice is made. This definition
captures the idea that the cost of something is not just its monetary cost but also the value given up.

Forms of Competition

Competition plays an important role in business and consumer interactions. Perfect competitive
markets are the most beneficial for prices and efficiency in the market. Monopolies are the least
favorable because the market is controlled by one business, which usually results in higher prices since
there is no competition. The term oligopoly refers to a situation in which a particular market is
controlled by a small group of firms.

Profit Maximization and Cost-of-production

Businesses must earn a profit to operate. To do this, businesses seek strategies to increase sales and
lower costs. They can analyze their cost-of-production systems to get a better understanding of where
they can cut costs and increase efficiency.

Economics is the science of choice:

Why is a specific alternative chosen out of a number of possibilities? Economists analyze the choices
that consumers make, such as the type of brand or the product they buy. For instance, why do some
consumers buy a mobile phone instead of a bike? Economists also analyze the optimal ways to finance
investment projects or to organize a business, a national economy or even a global economy.

This raises questions such as:

Does it make sense to borrow money to take over another business or is it better to use equity to
finance such a takeover? Should the national government raise interest rates to control inflation or to
keep currency exchange at a certain balance?

Again according to the Paul Samuelson who defined the economics on the basis of the modem
concept of growth criteria

“Economics is a study of how men and society `choose’ with of without the use of money, to employ
scarce productive uses resources which could have alternative uses, to produce various commodities
over time and distribute them for consumption, now and in the future among the various people and
groups of society. “

In Samuelson definition again economics is shown as the science of `choice’.

So, that is very clearly proven in the present age that, “Economics is the science of Choice”.

Conclusion
2
From various definitions and theories we are obviously able to understand why economics is called the
science of choice. Gradually we have explained the meaning and facts of choice, discussed about early
to modem definitions, proceeded for the proof with those definitions, theories and quotations, and
dramatized an example to make the concept of choosing in relation to the economic science.

In our everyday life we use our resources to satisfy our wants and make the decisions regarding the
use of our resources, choose between alternatives, give efforts and labor to gain those resources to
satisfy. These create the divisions of labor… problem of employment… create transactions of money or
resources… make the human civilization more complex with its unlimited wants! And for all these
problem there is a social science, economics, the science of choice.

Q. 2 Explain the concept of market economy. Critically discuss the impact of market
economy on common person with examples. (20)

In market economies, there are a variety of different market systems that exist, depending on the
industry and the companies within that industry. It is important for small business owners to
understand what type of market system they are operating in when making pricing and production
decisions, or when determining whether to enter or leave a particular industry.

Perfect Competition with Infinite Buyers and Sellers

Perfect competition is a market system characterized by many different buyers and sellers. In the
classic theoretical definition of perfect competition, there are an infinite number of buyers and
sellers. With so many market players, it is impossible for any one participant to alter the prevailing
price in the market. If they attempt to do so, buyers and sellers have infinite alternatives to pursue.

Monopoly with One Producer

A monopoly is the exact opposite form of market system as perfect competition. In a pure monopoly,
there is only one producer of a particular good or service, and generally no reasonable substitute. In
such a market system, the monopolist is able to charge whatever price they wish due to the absence
of competition, but their overall revenue will be limited by the ability or willingness of customers to
pay their price.

Oligopoly with a Handful of Producers

An oligopoly is similar in many ways to a monopoly. The primary difference is that rather than having
only one producer of a good or service, there are a handful of producers, or at least a handful of
producers that make up a dominant majority of the production in the market system. While
oligopolists do not have the same pricing power as monopolists, it is possible, without diligent
government regulation, that oligopolists will collude with one another to set prices in the same way a
monopolist would.

Monopolistic Competition with Numerous Competitors

Monopolistic competition is a type of market system combining elements of a monopoly and perfect
competition. Like a perfectly competitive market system, there are numerous competitors in the
market. The difference is that each competitor is sufficiently differentiated from the others that some
can charge greater prices than a perfectly competitive firm.

An example of monopolistic competition is the market for music. While there are many artists, each
artist is different and is not perfectly substitutible with another artist.

Monopsony with One Buyer

Market systems are not only differentiated according to the number of suppliers in the market. They
may also be differentiated according to the number of buyers. Whereas a perfectly competitive
market theoretically has an infinite number of buyers and sellers, a monopsony has only one buyer
3
for a particular good or service, giving that buyer significant power in determining the price of the
products produced.

As a small-business owner, you're probably an avid reader of financial and economic news. And like
many of your colleagues, you probably scratch your head over some of the headlines you read about
market conditions and competitive markets. Honing your knowledge of market structures may help
reduce the frustration, not to mention make sense of laws and regulations, how the economy helps
shape them and how economists analyze them.

Launch Your Learning Curve

In a competitive environment, there are four basic market structures:

Perfect competition. Monopolistic competition. Oligopoly.* Pure monopoly.

As you try to decipher the articles behind the headlines, it may help to remember that some of these
structures are simply “theoretical constructs,” Quickonomics says. In other words, not all of them
exist.

“Nevertheless, they are of critical importance because they can illustrate relevant aspects of
competition firms’ decision making. Hence, they will help you to understand the underlying economic
principles.”

The four basic market structures are defined by certain telling characteristics, including:

The number of companies in the market. The products they sell and how they differ. The number of
buyers and how they, together with sellers, influence price and quantity. The relationship that exists
between the sellers. The relative ease or difficulty of penetrating a market.

Reviewing the market structures in terms of their characteristics should crystallize the differences.

Hone Your Perfect Competition Definition

As its name implies, a perfect competition market structure is one in which many small companies
compete with each other for business. In this structure, also known as pure competition, no one
business claims any competitive advantage over another.

In a competitive market of this type:

The companies work to maximize their profits. The companies sell identical products. Consumers
demonstrate no preferences for products. Supply and demand dictate how many goods and services
are produced. The are no obstructions to entering and leaving the market.

For a reference point, the stock and agricultural markets represent the best examples of perfect
competition market structures.

Hone Your Monopolistic Competition Definition

Many small companies compete against each in a monopolistic competition market structure. But
unlike the perfect competition model, the companies sell similar products. The differences among
these products gives the companies the influence to charge higher prices – at least within the
comfort zone of consumers.

In a competitive market of this type:

The companies also work to maximize their profits. The companies sell similar products but ones whose
marketing seeks to differentiate them based on brand, style, image, price and packaging. Consumers
usually show a preference for certain products.* There are no no obstructions to entering and leaving
the market.
4
Businesses that operate within this competitive market structure include clothing stores, department
stores, fast food restaurants and beauty salons and spas.

Hone Your Oligopoly Definition

Limited competition among a handful of companies is the hallmark of an oligopoly market structure.
Working together, these companies can coalesce their power over the marketplace to command
higher prices and, in turn, make more money.

In a competitive market of this type:

The companies set prices to maximize their profits. The companies may sell products that are the same
or different. It is difficult to enter and leave such a market since the companies enjoy control over such
things as patents, raw materials and other physical resources.

Good examples of this limited competition market structure include the car and gasoline industries.

Hone Your Pure Monopoly Definition

You may wonder how a pure monopoly qualifies for inclusion in the group of competitive market
structures. After all, a single company enjoys free reign over the market, and consumers have no
alternative but to do business with this company. Try to look at it through the prism of supply and
demand. In other words, it's possible for the company that enjoys pure monopolistic status to be
supplanted by another company at some point.

In a market structure of this type:

The monopolizing company sets prices. The company emphasizes profit – and influence. There are
extreme obstructions to entering the market.

Public utility companies – those that supply gas and electric service – are natural contenders for the
category of pure monopolies. Some people would say the National Basketball Association represents
a pure monopoly, too, especially since it would require a massive sum of money to create a new
professional sports league with a full roster of teams, stadiums and players. It might be fun to dream
about, but it's unlikely to spawn a new market structure, which means that any news about
competitive market structures will continue to be confined to the financial pages, not the sports
pages.

Q. 3 Define Indifference Curve Analysis. How is Indifference Curve Analysis conducted?

Discuss with examples. (20)

The indifference curve analysis measures utility ordinally. It explains consumer behaviour in terms of
his preferences or rankings for different combinations of two goods, say X and Y. An indifferent curve is
drawn from the indifference schedule of the consumer. The latter shows the various combinations of
the two commodities such that the consumer is indifferent to those combinations.

According to Watson, “An indifference schedule is a list of combinations of two commodities

the list being so arranged that a consumer is indifferent to the combinations, preferring
none of any other.” The following is an imaginary indifference schedule representing the various
combinations of goods X and Y.

In the following schedule (Table 1), the consumer is indifferent whether he buys the first combination
of units of 18Y+1 unit of X or the fifth combination of 4 units of Y+5 units of X or any other
combination. All combinations give him equal satisfaction. We have taken only one schedule, but any
number of schedules can be taken for the two commodities. They may represent higher or lower
satisfaction of the consumer.

5
If the various combinations are plotted on a diagram and are joined by a line this becomes an
indifference curve, as f in the Figure 1. The indifference curve I1 is the locus of the points L, M, N, P,
Q, and R, showing the combinations of the two goods X and Y between which the consumer is
indifferent.

“It is the locus of points representing pairs of quantities between which the individual is indifferent, so
it is termed an indifference curve.” It is, in fact, an iso-utility curve showing equal satisfaction at all its
points. A single indifference curve concerns only one level of satisfaction. But there are a number of
indifference curves, as shown in Figure 2.

The curves that are farther away from the origin represent higher levels of satisfaction as they have
larger combinations of X and Y. Thus the indifference curve I4 indicates a higher level of satisfaction
than I3 which, in turn, is indicative of a higher level of satisfaction than I2 and so on.

Consumers would prefer to move in the direction indicated by the arrow in the figure. Such a diagram
is known as an indifference map where each indifference curve corresponds to a different indifference
schedule of the consumer. It is like a contour map showing the height of the land above sea-level
where instead of height, each indifference curve represents a level of satisfaction.

Assumptions of Indifference Curve Analysis:

The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others
and formulates its own.
6
The assumptions of the ordinal theory are the following:

(1) The consumer acts rationally so as to maximise satisfaction.

(2) There are two goods X and Y
(3) The consumer possesses complete information about the prices of the goods in the market.
(4) The prices of the two goods are given.
(5) The consumer’s tastes, habits and income remain the same throughout the analysis.
(6) He prefers more of X to less of Y or more of Y to less of X.
(7) An indifference curve is negatively inclined sloping downward.
(8) An indifference curve is always convex to the origin.
(9) An indifference curve is smooth and continuous which means that the two goods are highly divisible
and that level of satisfaction also change in a continuous manner.
(10) The consumer arranges the two goods in a scale of preference which means that he has both
‘preference’ and ‘indifference’ for the goods. He is supposed to rank them in his order of preference
and can state if he prefers one combination to the other or is indifferent between them.
(11) Both preference and indifference are transitive. It means that if combination A is preferable to B,
and В to C, then A is preferable to C. Similarly, if the consumer is indifferent between combinations A
and B, and В and C, then he is indifferent between A and C. This is an important assumption for
making consistent choices among a large number of combinations.

The indifference curves must slope downward from left to right. As the consumer increases the consumption of
X commodity, he has to give up certain units of Y commodity in order to maintain the same level of satisfaction.
DIAGRAM:

In the above diagram, two combinations of commodity cooking oil and commodity wheat is shown by the points
a and b on the same indifference curve. The consumer is indifferent towards points a and b as they represent
equal level of satisfaction.

(2) Higher Indifference Curve Represents Higher Level of Satisfaction:

Indifference curve that lies above and to the right of another indifference curve represents a higher level of
satisfaction. The combination of goods which lies on a higher indifference curve will be preferred by a consumer
to the combination which lies on a lower indifference curve.
7
Diagram:

In this diagram, there are three indifference curves, IC1, IC2 and IC3 which represents different levels of
satisfaction. The indifference curve IC3 shows greater amount of satisfaction and it contains more of both goods
than IC2 and IC1. IC3 > IC2> IC1.

(3) Indifference Curves are Convex to the Origin:

This is an important property of indifference curves. They are convex to the origin. As the consumer substitutes
commodity X for commodity Y, the marginal rate of substitution diminishes as X for Y along an indifference
curve. The Slope of the curve is referred as the Marginal Rate of Substitution. The Marginal Rate of Substitution
is the rate at which the consumer must sacrifice units of one commodity to obtain one more unit of another
commodity.
Diagram:

8
In the above diagram, as the consumer moves from A to B to C to D, the willingness to substitute good X for
good Y diminishes. The slope of IC is negative.In the above diagram, diminishing MRSxy is depicted as the
consumer is giving AF>BQ>CR units of Y for PB=QC=RD units of X. Thus indifference curve is steeper towards
the Y axis and gradual towards the X axis. It is convex to the origin.
If the indifference curve is concave, MRSxy increases. It violets the fundamental feature of consumer behaviour.
If commodities are almost perfect substitutes then MRSxy remains constant. In such cases the indifference
curve is a straight line at an angle of 45 degree with either axis.
If two commodities are perfect complements, the indifference curve will have a right angle.
In reality, commodities are not perfect substitutes or perfect complements to each other.Therefore MRSxy
usually diminishes.

(4) Indifference Curves cannot Intersect Each Other:

The indifference curves cannot intersect each other. It is because at the point of tangency, the higher curve will
give as much as of the two commodities as is given by the lower indifference curve. This is absurd and
impossible.
Diagram:

9
In the above diagram, two indifference curves are showing cutting each other at point B. The combinations
represented by points B and F given equal satisfaction to the consumer because both lie on the same
indifference curve IC2. Similarly the combinations shows by points B and E on indifference curve IC1 give equal
satisfaction top the consumer.
If combination F is equal to combination B in terms of satisfaction and combination E is equal to combination B
in satisfaction. It follows that the combination F will be equivalent to E in terms of satisfaction. This conclusion
looks quite funny because combination F on IC2 contains more of good Y (wheat) than combination which gives
more satisfaction to the consumer. We, therefore, conclude that indifference curves cannot cut each other.

(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:

One of the basic assumptions of indifference curves is that the consumer purchases combinations of different
commodities. He is not supposed to purchase only one commodity. In that case indifference curve will touch one
axis. This violates the basic assumption of indifference curves.
Diagram:

10
In the above diagram, it is shown that the in difference IC touches Y axis at point P and X axis at point S. At
point C, the consumer purchase only OP commodity of Y good and no commodity of X good, similarly at point S,
he buys OS quantity of X good and no amount of Y good. Such indifference curves are against our basic
assumption. Our basic assumption is that the consumer buys two goods in combination.

Q. 4 Explain the concepts of average fixed cost, average variable cost, average cost total
cost and marginal costs and their relationship to each other with examples. (20)

Refers to the per unit fixed costs of production. In other words, AFC implies fixed cost of production
divided by the quantity of output produced.

It is calculated as:
AFC = TFC/Output

TFC is constant as production increases, thus AFC falls.

Figure-6 shows the AFC curve:

In Figure-6 AFC curve is shown as a declining curve, which never touches the horizontal axis. This is
because fixed cost can never be zero. The curve is also called rectangular hyperbola, which represents
that total fixed costs remain same at all the levels.

11
v. Average Variable Costs (AVC):
Refer to the per unit variable cost of production. It implies organization’s variable costs divided by the
quantity of output produced.

It is calculated as:

AVC = TVC/ Output

Initially, AVC decreases as output increases. After a certain point of time, AVC increases with respect
to increase in output.

Thus, it is a U- shaped curve, as shown in Figure-7:

vi. Average Cost (AC):

Refer to the total costs of production per unit of output.

AC is calculated as:
AC = TC/ Output

AC is also equal to the sum total of AFC and AVC. AC curve is also U-shaped curve as average cost
initially decreases when output increases and then increases when output increases.

Figure-8 shows the AC curve:

vii. Marginal Cost:

Refer to the addition to the total cost for producing an additional unit of the product.

Marginal cost is calculated as:

MC = TCn = TCn-1

n= Number of units produced

It is also calculated as:

MC = ∆TC/∆Output

MC curve is also a U-shaped curve as marginal cost initially decreases as output increases and
afterwards, rises as output increases. This is because TC increases at decreasing rate and then
increases at increasing rate.

12
Variable costs include expenditures for wages, salaries, and raw materials — these costs
increase as output increases:

Total Cost = Total Fixed Cost + Total Variable Costs.

Fixed costs can be controlled in the long-run but do not vary with the level of output in the short-run.
They must be paid even if there is no output. A firm can only forgo its outlays on fixed costs when it
decides to go out of business.

Fixed costs are, therefore, an integral part of the decision-making process of the manager of a firm. To
decide how much to produce, managers of firms need to know how variable costs increase with the
level of output. To address this issue, we need to develop some additional cost measures. We will use
a specific example that explains the cost situation of many firms.

After each of the cost concepts are explained, we will describe how they relate to the production
process. Table 7.1 describes a firm with a fixed cost of £50. Variable cost increases with output, as
does the total cost. The total cost is the sum of fixed cost in column (1) and the variable cost in column
(2). From the cost figures given in columns (1) and (2), a number of additional cost variables can be
defined.

Average Cost (AC):

Average cost is the cost per unit of output. There are three types of average cost average fixed cost,
average variable cost and average total cost. Average fixed cost (AFC) is the total fixed cost (column
1) divided by the level of output, TFC/Q. Because fixed cost is constant, average fixed cost declines as
the rate of output increases.

Marginal Cost (MC):

MC, also called incremental cost, is the increase in cost that results from producing one extra unit of
output. Since FC does not change as the firm’s level of output changes, MC is just the increase in
variable cost that results from an extra unit of output.

We can thus write MC as MC = ΔVC/ΔQ. MC tells us how much it will cost to expand the firm’s output
by one unit. In Table 7.1, MC is calculated from either the VC (column 2) or the total cost (column 3).
13
Average Variable Cost (AVC):
AVC is the total variable cost divided by the level of output, TVC/Q. Finally, average total cost (ATC) is
the total cost divided by the level of output, TC/Q. The average total cost tells us the per-unit cost of
production. By comparing the ATC to the price of the product, we can determine whether production is
profitable.

Determinants of Short-Run Costs:

Table 7.1 shows that variable and total costs increase with output. The rate at which these costs
increase depends on the nature of the production process, and, in particular, on the extent to which
production involves diminishing returns to variable factors.

Let us look at the relationship between production and cost in more detail by concentrating on the
costs of a firm that can hire as much labour as it wishes at a fixed wage W.

We know that marginal cost (MC) is the change in variable cost for a one-unit change in output (i.e.,
ΔVC/ΔQ). But the variable cost is the per-unit cost of the extra labour IV times the amount of extra
labour AL. It follows that MC = ΔVC/ΔQ = WΔL/ΔQ.

The marginal product of labour MPL is the change in output resulting from a one-unit change in labour
input, or ΔQ/ΔL. Thus, the extra labour needed to obtain an extra unit of output is ΔL/ΔQ = 1/MPL. As
a result, MC = W/MPL ………….(1).
Equation (1) states that, in the short-run, MC = price of the input that is being varied divided by the
MP. When MP is high, the labour requirement is low, as is the MC. More generally, whenever the
MPL decreases, the MC of production increases, and vice versa. The effect of the presence of
diminishing returns in the production process can also be seen by looking at the data on MCS is Table
7.1.

The MC of additional output is high at first because the first few inputs to production are not likely to
raise output much in a large plant with a lot of equipment However, as the inputs become more
productive, the MC decreases substantially. Finally, MC increases again for relatively high level of
output, owing to the effect of diminishing returns.

The law of diminishing returns also creates a direct link between the APL and the AVC of production.
AVC is equal to the variable cost per unit of output, or VC/Q. When L units of labour are used in the
production process, the variable cost is WL. Thus, AVC – WL/Q. As we know that average production of
labour APL is given by the output per unit of input Q/L As a consequence, AVC = W/APL……………….. (2).

Since the wage rate is fixed for the firm, there is an inverse relationship between AVC and the AP of
labour. A lower MP of labour means that a substantial amount of labour is needed to produce the firm’s
output, which leads to a higher AVC. A high AP of labour means that the labour required for production
is low, as is the AVC.

We have seen that, with both MC and AVC, there is a direct link between factor productivity and the
costs of production. Marginal and average products tell us about the relationship between inputs and
output. The comparable cost variations tell us about the budgetary implications of the production
function.

Q. 5 Explain the concept of imperfect markets. Discuss the characteristics of imperfect

markets with examples. (20)

Definition: Imperfect competition is a competitive market situation where there are many sellers, but
they are selling heterogeneous (dissimilar) goods as opposed to the perfect competitive market
scenario. As the name suggests, competitive markets that are imperfect in nature.

Description: Imperfect competition is the real world competition. Today some of the industries and
sellers follow it to earn surplus profits. In this market scenario, the seller enjoys the luxury of
influencing the price in order to earn more profits.

14
If a seller is selling a non identical good in the market, then he can raise the prices and earn profits.
High profits attract other sellers to enter the market and sellers, who are incurring losses, can very
easily exit the market.

There are four types of imperfect markets:

- Monopoly (only one seller) - Oligopoly (few sellers of goods) - Monopolistic competition (many sellers
with highly differentiated product) - Monopsony (only one buyer of a product)

An imperfect market is an environment in which all parties do not have complete information, and
in which participants can influence prices. All markets are imperfect to some degree. The usual
effect of an imperfect market is that astute traders take advantage of the situation. This may be
monopoly owners who profit from excessively high prices, investors who buy or sell securities
based on insider information, or buyers who engage in arbitrage to buy goods at artificially low
prices and sell them elsewhere at higher prices.

Examples of Imperfect Markets

Here are several examples of imperfect markets:

 Monopolies and oligopolies. An organization could have established a monopoly, so it can

charge prices that would normally be considered too high. The same situation arises in an
oligopoly, where there are so few competitors that there is no point in competing on price.
 State intervention. Governments may intervene in a market, usually to set prices below the
actual market level (such as by subsidizing the price of oil). When this happens, an excessive
quantity is purchased. The reverse situation can also occur, where a government imposes such
high regulatory barriers that few companies are allowed to compete (see the preceding monopoly
and oligopoly discussion).
 Stock market. The stock market can be considered an imperfect market, since investors do
not always have immediate access to the most recent information about the issuers of securities.
 Differing product features. An imperfect market can exist when competing products contain
different features. When this is the case, buyers have a difficult time comparing the products, and
so may pay too much for them.
Market imperfections theory asserts that perfect competition doesn't exist between international
markets. See the common methods of correcting these imperfections, and explore foreign direct
investment, where investments cross national borders. Updated: 12/14/2021

Market Imperfections Theory

If you have ever purchased a foreign made vehicle, you are familiar with market imperfections theory
and foreign direct investment. The U.S. auto industry is one of the most competitive markets in the
world. American companies used to dominate the market. Now, these companies only make up half of
the market. Toyota, Honda, BMW, Nissan, Mazda, and Volkswagen are examples of automotive
companies that now have U.S.-based manufacturing. Market imperfections theory and foreign direct
investment explain how imperfections in the international trade market drove these companies to
invest in the United States.
Market imperfections theory is a trade theory that arises from international markets where perfect
competition doesn't exist. In other words, at least one of the assumptions for perfect competition is
violated and out of this is comes what we call an imperfect market. We know that a perfect market
isn't really attainable. Even in the United States, we have imperfect markets. Remember, the
assumptions for a perfect market are:

1. Buyers and sellers are both price takers

2. Companies sell virtually identical products
3. Buyers and sellers have perfect information
4. Multiple companies owns a small market share
5. There is no barrier of entry or exit
15
Common situations that violate perfect competition are market structures like monopolies,
monopolistic competition, and oligopolies. With international trade, firms are seen as price takers
because they are only a small part of a foreign market. They can't influence the price, have to deal
with government interference related to trade, and operate with imperfect information. This is why
foreign automotive companies moved some operations to the United States.
What is interesting about market imperfections theory is that it is an international trade theory. It tells
us that in international markets, certain protections are necessary to safeguard our interests. Free
trade is a function of perfect competition, and given that it doesn't exist, we need to look at ways to
get more desirable outcomes. This is where government interference enters.

Correcting for International Market Imperfections

Market imperfections theory states that various trade policies can correct for some market
imperfections. Examples of government instituted corrections are:

 Taxes
 Tariffs
 Quotas
 Licenses
 Local content requirements

Local content requirements, for example, prevent a market from being saturated with imports. They
require that a certain amount of product be created locally when a foreign company manufactures the
good.
Individual companies also find ways to remove other market imperfections and try to negate the
negative effects of government instituted corrections. These corrections can cost a company a great
deal of extra money. As we see with the automotive industry, a common technique used by companies
is foreign direct investment.

Perfect Competition vs. Imperfect Competition

Imperfect competition and perfect competition (pure competition) have a distinct sets of differences.
Perfect competition is the state where suppliers compete on an equal basis in a market. The key
factors of perfect competition relate to the price taker, homogenous products, market share, complete
information, entry barriers, and exit barriers.

 Price Taker: Newmarket participants are price takers since they do not have the influence to set
the price.
 Products: All the goods and services sold in the market are homogeneous (identical).
 Market Share: All the suppliers in the market have an equal market share, which balances
activity and supports equality.
 Information: Complete information about the market is available. This enhances honesty and
transparency.
 Entry: There are no large barriers to entry since there is not one company that can manipulate
the market to keep out competitors.
 Exit: Barriers to exiting such markets depend on exit costs, such as how difficult it is to sell
assets.

Imperfect Competition Examples

The most common types of imperfect competition include monopolies, monopolistic competition,
and oligopolies. These market features have a few characteristics in common in that they sell
heterogeneous products at their own prices. While in the battle for market share, they hold a
prominent advantage in barriers to entry. Imperfect competition naturally has its drawbacks in the fact
that it creates monopolies, monopolistic competition, and oligopolies. However, if these extreme
conditions can be avoided while accommodating imperfect competition, the economy can potentially
benefit greatly from market activity. Imperfect competition is a factor of the free market, and history
has continuously illustrated how it is the most efficient economic structure. This invites the
consideration that imperfect competition when regulated, is a necessary evil in any economy that aims
to effectively satisfy the needs and desires of its consumers. The concepts of monopolies, monopolistic
competition, and oligopolies are discussed as extremes in the following headers.

16
Monopoly

A monopoly refers to a market with only one seller. Monopolies are usually the result of one company
that completely outgrows its competitors in a certain industry. This can be the consequence of
innovation, better business practices, economic cycles, externalities, or any combination of these
factors. Microsoft and Google are real-life examples of monopolies since their influence far outweighs
that of other similar service providers.

17