Economics – Free Market System
Essay Preview: Economics – Free Market System
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In a Free market system, all the firms have liberty to behave on their own strategies and to compete with others so that the system is based on the competition since competition can lead market efficiency. However this efficiency only can be achieved when all the stage and products of firms are equal to each other, but real market is not equal to every firm. According to Anderton (2008), depending on the nature of competition and mode of pricing in the market, market structure can be varied. In short, the market structure can be changed according to the number of firms in market and their relative size, how homogeneous the goods each firm produces, how influential the action of one firm on other firms and how high the barriers to entry in the market, such as capital cost and economies of scale. Moreover, as the ultimate purpose of every enterprise is to maximize their profits by obtaining monopolistic power, firms struggle to expand its size and market share so that it can earn abnormal profit in each market structure. The strategies and behaviors of firms can be different depending on the market structures, but firms can invent new product or build more factory or merge with other companies to enlarge their companies and at last can obtain monopolistic power so that it can maximize its profit. Before growing, it can be assumed that firms start at the equivalent condition, perfect competition that according to Anderton (2008), all the goods are homogeneous and all the objectives of market are price taker since there are large number of producer. In this market structure every firm has same opportunity to grow. However, real market is not perfectly competitive since all the products are not perfectly homogeneous. According to Anderton (2008), firms in monopolistic competition pursue maximized profit but their goods are not homogeneous so that every firm in imperfect competition wants to obtain abnormal profit to maximize their profits. As shown in diagram 1 (Economics help, 2010), firms can obtain abnormal profit in the short run since if a firm introduce new product, the firm can get monopolistic power for a moment because there is only one producer who sell the new good. After the firm obtained the positive profit, then other new firms can enter to this new market since there are not barriers to entry and all firms have equivalent knowledge. Therefore, in the long run, the cost of original firm should be increase because it should invest more resources or cost of advertisement to compete with other new entrants so that the average cost increase until the price does not lower than normal profit which is point ‘P’ in the long run of diagram 1. In short, firms in competitive market can get abnormal profit for a moment, but lose it again since other firms which have equivalent conditions and same size enter the market. Thus firms start to pursue to expand their size of company to maintain the abnormal profits by enlarging their market share. [pic 1][pic 2] There are some ways for firms to expand their size maximize profits which are internal and external growth. According to Riley (2010), internal growth is achieved by the business’ own capabilities and resources. Usually firms develop new products, open new business location, train employees and invest in R&D to grow internally. Growing internally, firms can be financed through internal funds, builds on their brands and less risky than taking over other firms. However, internal growth might be dependent on growth of overall market. More over the growth is slower, but shareholders want rapid growth and if firms use franchises, it can be hard to manage effectively. Most importantly, it is cheaper and more fast to grow than internal growth so that most firms prefer external growth which means growth outside of the business, such as taking over and merging.
The representative method of external growing is the merger. Merger means that more than two firms integrate with each other to make more profitable and large firm so that it could obtain more profits. In short, firms merge with others since they can grow more easily by integrating another firm in same industry. More specifically, there are some reasons for merging. Anderton (2008) stated that as merger is the easiest way to enlarge the size of firms, it is easy for firms expanded by merging to get economies of scale which means that the more output, the lower average cost because of large fixed cost in the long run. Moreover, as larger firms are more likely to control its market and reduce the risks, profit of firms can be maximized. Since large firm can provide higher salary to manager and worker than small firm, companies pursue to grow through merging. There are two representative kinds of merger which are horizontal and vertical merger. According to Anderton (2008), horizontal merger occurs between two firms in the same industry at same stage of production. Through horizontal merger, the companies enable to benefit from larger economies of scale with higher output than other kinds of merger such as vertical and conglomerate merger since other types are set in different stage. Also by horizontal merger, firms are capable to obtain access to an efficient distribution network. And through the merging, the companies can acquire monopoly power. The representative example in South Korea is integration of Hyundai and Kia motors in 2001 which are in same stage and same industry. On the other hands, vertical merger occur between two firms at different production stage in the same industry. Vertically merged firm can role both manufacturing and distribution processes. There are two types of vertical merger which are forward merger and backward merger. Forward merger occurs when supplier purchase its distributor or buyer. The case that News Corporation which is multinational mass media purchases Direct TV which is a satellite TV company so that News Corporation could distribute more of its news is the example of forward merger. Backward integration occurs when buyer purchases its producer. The case that Amazon.com backward vertically integrated when it became a bookseller and a publisher both is the example of the backward merger (Sandilands, T., n. d.). Nonetheless, most important thing is that whatever the type of merger is, firms integrate to expand their size of firm so that it could obtain monopolistic power. Ultimately, pursuing to expand size of firm and maximize profit by merging means that firms want to control the market by acquiring monopolistic power. According to Anderton (2008), monopoly exists when there is only one firm which is price maker and market leader in the market. Also in the monopoly, as the barriers to entry are higher than other market structures, the monopolistic firm is able to obtain abnormal profit in both short run and long run. In the diagram 2 (Mankiw, 2011), Anderton (2008) explained that as there are only one firm, consumers have willingness to pay so that the firm set the quantity at 0Q where marginal cost and revenue has same value to maximize its profit and the firm charges higher price than normal profit which is called average total cost on the diagram 2. Consequently monopolistic firm obtain abnormal profit which is the difference between monopoly price and average cost on the diagram. When firms become monopoly by merging, the monopolistic power is come from two sources which are barriers to entry and price discrimination. Anderton (2008) noted that the higher barriers to entry such as capital cost and sunk cost, the stronger the power of monopoly. Moreover mergers can get monopoly powers by charging different prices on same products depending on some classification standards such as income, time, place and so on. In short, firms can maximize their abnormal profits by charging high price on consumers who have willingness to pay and lower price on customers who do not have. In addition, when firms become monopoly by merging, firms can get economies of scale and control the whole market. Therefore firms want to merge to become a monopoly to maximize their profit. [pic 3][pic 4]