Case Study 1

CASE STUDY 1 : Uses of credit cards for payment are increasing at the rate of 10% per year since 1997. Over $700 billion purchases were charged on credit cards in 1997.

It can be seen that credit card industry is having various characteristics of a perfect competition like the number of buyer and seller are very high, most cards are similar in appearance, used for the same purpose, entry and exit from industry is not very difficult, etc. CONCLUSION : Perfect Competition is a market structure where there is a perfect degree of competition and single price prevails. Nothing is 100% perfect in this world. So, this states that perfect competition is only a theoretical possibility and it does not exist in reality. The concept of Perfect Competition was introduced by Dr. Alfred Marshall. QUESTION 1) What are the characteristics of perfect competition exhibited by credit card industry?  ANSWER) There are various features of perfect competition:

1. Many Sellers and Buyers In this market, there are many sellers who form total of market supply. Individually, seller is a firm and collectively, it is an industry. In perfect competition, price of commodity is decided by market forces of demand and supply. i.e. by buyers and sellers collectively. Here, no individual seller is in a position to change the price by controlling supply. Because individual seller's individual supply is a very small part of total supply. So, if that seller  alone raises the price, his product will become costlier than other and automatically, he will be out of market. Hence, that seller has to accept the price which is decided by market forces of demand and supply. This ensures single price in the market and i n this way, seller becomes price taker and not price maker. Similarly the buyer are also very high so no buyer can affect the market demand and they are also price taker and not the price maker. It also ensures single price prevails in the market. There are currently 6000 institutions that currently offers credit cards to over 90 millions card holders. So here also the number of buyer and seller are very high and any buyer or seller can not affect the market demand or  supply.

2. Homogenous Product In this case, all sellers produce homogeneous i.e. perfectly identical products. All products are perfectly same in terms of size, shape, taste, colour, ingredients, quality, trade marks etc. This ensures the existence of single price in the market. In the case of credit cards it is same that all cards are similar in appearance and all cards are used for the same purpose i.e making payment for the purchases. However there can be some change in the schemes of discount, interest, reward points etc which can differentiate two cards choice.

3. Free Entry and Exit There are no restrictions on entry and exit of firms. This feature ensures existence of normal profit in perfect competition. When profit is more, new firms enter the market and this leads to competition. Entry of new firms

competing with each other results into increase in supply and fall in price. So, this reduces profit from abnormal to normal level. When profit is low (below normal level),

some firms may exit the market. This leads to fall in supply. So

remaining firms raise their prices and their profits go up. So again this ensures normal level of profit In the case of credit cards also the entry and exit from the market is easy as evidence by 6000 institutes providing cards currently. A new firm with sound financial position even of a modest size can obtain the right to provide credit cards.  And if the seller wants to leave the market there are many suppliers to whom he can sell his firm’s account.

BUT there are various other features of a perfect competition which the credit card industry probably donot hold like:

4. Perfect Knowledge On the front of both, buyers and sellers, perfect knowledge regarding market and pricing conditions is expected. So, no buyer will pay price higher than market price and no seller will charge lower price than market price.

It is not necessary in the case of credit card industry. It may be possible that the buyer donot haave adequate knowledge about the products prevailing in the market.

5. Perfect Mobility of Factors This feature is essential to keep supply at par with demand. If all factors are easily mobile (moveable) from one line of production to another, then it becomes easy to adjust supply as per demand. Whenever demand is more additional factors should be moved into industry to increase supply and vice versa. In this way, with the help of stable demand and supply, we can maintain single price in the Market.

6. No Government Intervention Since market has been controlled by the forces of demand and supply, there is no government intervention in the form of taxes, subsidies, licensing policy, control over the supply of raw materials, etc.

But in credit card case there is some govt intervention regarding whether the companies are doing the right things or not? It also have some legal control over the buyers that whether the buyers account is clear or there is any fault regarding the same.

7. No Transport Cost It is assumed that buyers and sellers are close to market, so there is no transport cost. This ensures existence of  single price in market.

It is not mandatory in the case of credit card that the buyers are close to the market. As visa and mastercard are acceptable worldwide so the buyer can be anywhere in the globe. So there exists transport cost in this industry.

8. Zero Advertisement Cost Since all products are identical in features like quality, taste, design etc., there is no scope for product differentiation. So advertisement cost is nil.

In card industry, there exists advertisement cost. We all have seen advertisement of  visa and mastercard where the tag line is that there is something money cant buy, for everything else there is a mastercard. So in this industry there is advertisement cost.

QUESTION.2

Discuss the price and output condition of a perfect competiton?

Establishing

price

and

output

in

the

short

run

under

perfect

competition

The previous diagram shows the short run equilibrium for perfect competition. In the short run, the twin forces of market demand and market supply determine the equilibrium “market-clearing” price for the industry. In the diagram below, a market price P1 is established and output Q1 is produced. This price is taken by each of the firms. The average revenue curve (AR) is their individual demand curve. Since the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total revenue (P1 x Q2). The total cost of producing this output can be calculated by multiplying the average cost of a unit of output (AC1) and the output produced. Since total revenue exceeds total cost, the firm in this example is making abnormal (economic) profits. This is not necessarily the case for all firms. It depends on their short run cost curves. Some firms may be experiencing subnormal profits if average costs exceed the market price. For these firms, total costs will be greater than total revenue.

Short run losses

The adjustment to the long-run equilibrium If most firms are making abnormal (or supernormal) profits , this encourages the entry of new firms into the industry, which if it happens will cause an outward shift in market supply forcing down the ruling market price. The increase in supply will eventually reduce the market price until price = long run average cost. At this point, each firm in the industry is making normal profit. Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. This is shown in the next diagram.

We are assuming in the diagram above that there has been no shift in market demand, i.e. we are considering an outward shift in market supply brought about by the entry of new competing firms each of whom is supplying a homogeneous product to the market. The effect of increased supply is to force down the market price and cause an expansion along the market demand curve. But for each supplier, the price they “take” is now lower and it is this that drives down the level of profit made towards the normal profit equilibrium. In an exam you may be asked to trace and analyse what might happen if  

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There was a change in market demand (e.g. arising from changes in the relative prices of  substitute products or complements) There was a cost-reducing innovation affecting all firms in the market or an external shock that increases the variable costs of all producers.

Effects of a change in market demand We now consider how a competitive market adjusts to a change in market demand in both the short and the long run. In the short run, businesses are operating with at least one fixed factor. Therefore the elasticity of the supply curve depends on the amount of spare capacity, the level of  existing stocks and also the time scale of the production process – in other words how fast and at what cost the industry can expand supply when d emand changes. In the long run, because of freedom of entry and exit into and out of the industry, we expect the market supply curve to be more elastic in response to a change in demand. The diagram below shows an outward shift of demand with short run market supply deemed to be relatively inelastic (in which case the short run adjustment in the market drives prices higher) but where long run market supply is elastic, putting downward pressure on price as market output increases.

QUESTION 3) Do you think that the same competitive state is applicable in the Indian scenario?  Answer) As India is a developing country where new players are trying to establish themselves effectively. So if they opt for perfect competition then they will not be able to differentiate themselves in the market. That’s why the same competitive state is not applicable in Indian scenario. In credit card industry is having a monopolistic competition where they are trying to differentiate themselves in respect of various facts like facilities provided, discount rate, reward points, ease of availability, etc. So the conclusion would be that perfect competition is not present in practical world. There can be some features of this competition which can be present in some industries like in vegetable market, currency market, etc. but it donot prevails 100% anywhere in the globe.

CASE STUDY 2. QUES 1) How can mergers in the banking industry results in economies of scale?  ANSWER) Merger of two banks result in economies of scale in the following ways: 1. The number of customer will increase which will lead to a large base of  customer and hence reduces the per customer cost. 2. It will lead to ease to both to the bank as well as customers as the number of  branches increases. 3. It will help the bank to develop more effectively. 4. It will increase the market power of the bank. 5. It will reduce the earning volatility. 6. It will help the bank to approach large number of customers. 7. It will lead to an increase in the number of branches and ATMs of the bank… 8. By merging, the bank will have more funds to provide loan. 9. Loan will be available at comparatively lower rate as there is economies of  scale in number of transactions of the bank.

QUES.2) Do you think the same factors will lead to economies of scale in India?  ANSWER) Yes merger will definitely lead to economies of scale in india also as india’s population is very large so if the bank is able to capture a large pool of customer  then definitely they will have economies of scale. It will increase the ease to customer. It will help the bank to provide higher loans to t he public. If there are very higher number of customers then the bank can provide loans at comparatively lower rates which will lead to higher profitability. Through merger a bank can increase its market position. It will increase the number of transaction of the business.

QUES.3) What are the other factors that lead to economies of scale?  ANSWER) Other factors that lead to economies of scale are: 1. Mass production. 2. Specialisation. 3. Expansion in size, etc.