Economics Mkt structure

1. Chapter 6
Market Structure
Prof. Dr M S Islam
9/12/2014 1

2. o Market: An arrangement through which the
buyers and the sellers can communicate or meet
each other in order to trade goods and services.
o Firm/ enterprise: A firm is an organization
under one management setup to earn profit for its
owners by making goods or service and selling
those in the market.
o Industry: An industry is a group of firms that
sell a similar product in the market.
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3. o The number of sellers of a product in a
market determines the nature and degree
of competition in the market.
o The nature and degree of competition
make the market structure.
o By market structure, we mean all the
characteristics of a market that influence
the behavior of buyers and sellers when
they come together to trade.
3

4. Market
Structure
Types of Market Structure
No. of firms &
degree of product
differentiation
Industry where
prevalent
Control
over price
Method of
marketing
Perfect
competition
Large no. of firms
with identical
product
Financial
markets and
some farm
products
None Market
exchange or
auction
Imperfect competition
Monopolistic
Competition
Many firms with
real or perceived
product
differentiation
Manufacturing:
toothpastes,
soaps, TV sets,
shoes.
Some Competitive
advertising,
quality rivalry
Monopoly A single producer
without close
substitute
Public utilities,
telephones,
Electricity, etc
Considerabl
e but
usually
regulated
Promotional
advertising if
supply is large
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5. o Total revenue of a firm is the selling price
(P) times the quantity (Q) sold.
o TR = (PQ)
o Average revenue: Total revenue (PxQ)
divided by the quantity (Q) sold. It is the price
of the product at which it is sold.
o Marginal revenue: The change in total
revenue from an additional unit sold.
MR =TR/ Q
o For competitive firms, marginal revenue
equals the price of the good.
5
Some Basic Concepts

6. 9/12/2014 6

7.  Perfectly Competitive Market:
 Perfectly competitive market is one with a large
number of firms, free entry and exit, a
homogeneous product, factor mobility, and
perfect information.
 In addition, each firm has an insubstantial share
of the market, and therefore its behavior cannot
influence the market price, so that each buyer
and seller is a price taker.
 Perfect competition is a market structure
characterized by a complete absence of rivalry
among the individual firms.
 In practice businessmen use the word
competition as related to rivalry. In theory,
perfect competition implies no rivalry among
firms.
7

8. The model of perfect competition is based
on the following assumptions:
1. Large number of sellers and buyers: The
industry or market includes a large number of
firms (and buyers), so that each individual firm,
however large, supplies only a small part of the
total quantity offered in the market. The buyers are
also numerous so that no monopsonistic power
can affect the working of the market.
2. Product homogeneity: There is no way in which
a buyer could differentiate among the products of
different firms. If the product were differentiated
the firm would have some discretion in setting its
price. This is ruled out in perfect competition. 8

9. o The assumptions of large numbers of sellers
and of product homogeneity imply that the
individual firm in pure competition is a price-taker:
its demand curve is infinitely elastic,
indicating that the firm can sell any amount of
output at the prevailing market price. The
demand curve of the individual firm is also its
average revenue and its marginal revenue
curve.
9
Market P P = AR = MR
X, Output
P, price
O

10. 3. Free entry and exit of the firms: Entry or exit
may take time, but firms have freedom of
movement in and out of the industry. This
assumption is supplementary to the assumption
of the large numbers. If the barriers exist the
number of the firms in the industry may be
reduced so that each one of them may acquire
power to affect the price in the market.
4. Profit maximization: The goal of all firms is
profit maximization. No other goals are pursued.
5. No government regulation: There is no
government intervention in the market (tariff,
subsidies, rationing of, production or demand
and so on are ruled out). 10

11. o The market structure in which the above
assumptions are fulfilled is called pure
competition. It is different from perfect
competition, which requires the fulfillment
of the following additional assumptions.
6. Perfect knowledge: All sellers and
buyers have complete knowledge of the
conditions of the market. This knowledge
refers not only to the prevailing conditions
in the current period but in all future
periods as well. Information is free and
costless.
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12. 7.Perfect mobility of factor of production:
The factors of production are free to move
from one firm to another throughout the
economy. It is also assumed that workers
can move between different jobs, which
implies that skills can be learned easily.
o Finally, raw materials and other factors are
not monopolized and labor are not
unionized. In short, there is perfect
competition in the markets of factors of
production.
12

13. In panel (a) the market supply and demand curves
intersect to determine a market price of $400 per ounce.
The typical firm in panel (b) can sell all it wants at that
price. The demand curve facing the competitive firm is a
horizontal line at the market price.
13
Demand and Supply Curve of Perfectly
Competitive Market

14. 14

15. • In order to determine the equilibrium of the
industry we need to derive the market supply.
This requires the determination of the supply
of the individual firms, since the market
supply is the sum of the supply of all the
firms in the industry.
• The firm is in equilibrium when it maximizes
its profits (Π), defined as the difference
between total cost and total revenue:
• Π = TR - TC
15
Short-run Equilibrium

16. • Π is the profit above the normal rate at return
on capital and the remuneration for the risk
bearing function of the entrepreneur. The firm
is in equilibrium when it produces the outputs
that maximize the difference between total
receipts and total costs.
• The equilibrium of the firm may be shown
graphically in two ways. Either by using the TR
and TC curves or the MR and MC curves.
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17. • The total revenue curve (TR) is a straight
line through the origin showing that the
price is constant at all levels of output.
The firm is a price-taker and can sell any
amount of output at the prevailing market
price, with its TR increasing
proportionately with its sales.
• The shape of the total cost curve reflects
the U shape of the avenge-cost curve,
that is, the law of variable proportions.
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18. The firm maximizes its profit at the output
XE when the distance between the TR and
TC curves is the greatest. At lower and
higher level of output total profit is not
maximized: it levels smaller than XA and
larger than XB, the firm has losses.
Figure : 2
18

19. • The total revenue—total cost approach is
awkward to use when firms are combined
together in the study of the industry.
• The alternative approach, which is based on
marginal cost and marginal revenue, uses price
as an explicit variable, and shows clearly the
behavioral rule that leads to profit maximization.
• The slope of the TR curve is the marginal
revenue. It is constant and equal to the prevailing
market price, since all units ate sold at the same
price.
• Thus in perfect competition MR = AR= P
19

20. Marginalistic Approach
• In figure 3 we show the AC and MC curves of
the firm together with its demand curve. The
demand curve is also the avenge revenue
curve and the marginal revenue curve of the
firm in a perfectly competitive market. The
marginal cost cuts the AC at its minimum
point.
P
C
P e
A
MC
B
AC
P=MR= AR
X
O
Figure : 3
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Xe

21.  The firm is in equilibrium (maximizes its profit) at the
level of output defined by the intersection of the MC and
MR curves (point e in figure 3).
 To the left of e profit has not reached its maximum level
because each unit of output to the left of Xe, brings to the
firm revenue which is greater than its marginal cost.
 To the right of Xe, each additional unit of output costs
more than the revenue earned by its sale, so that a loss is
made and total profit is reduced.
 In summary:
a. If MC < MR total profit has not been maximized
and it pays the firm to expand its output.
b. If MC> MR the level of total profit is being
reduced and it pays the firm to cut its
production.
c. If MC= MR shot run profits are maximized.
21

22. o However, this condition of MC= MR is not
sufficient, since it may be fulfilled and yet the
firm may not be in equilibrium.
o In figure 4 we observe that the-condition MC =
MR is satisfied at point e´, yet clearly the firm is
not in equilibrium, since profit is maximized at
Xe,> X´e.
P
C
P e
AC
MC
P=MR=AR
X
O
X Figure : 4 X´ e e
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23. o The second condition for equilibrium requires
that the MC be rising at the point of its
intersection with the MR curve. This means that
the MC must cut the MR curve from below, (i.e.
the slope of the MC must be steeper than the
slope of the MR curve).
o In figure 4 the slope of MC is positive at e while
the slope of the MR curve is zero at all levels of
output. Thus at e both conditions for equilibrium
are satisfied
(i) MC = MR
(ii) (Slope of MC) > (slope of MR).
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24. However, a firm is in (short-run) equilibrium does not
necessarily mean that it makes excess profits.
o Whether the firm makes -excess profits or losses
depends on the level of the AC (average cost) at the
short-run equilibrium.
o If the AC is below the price at equilibrium (figure 5)
the firm earns excess profits (equal to the area
PABe).
P
C
P e
A
MC
B
AC
X
O
P=MR
Figure : 5
Xe
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25. If however, the AC is above the price (figure
6) the firm makes a loss (equal to the area
FPeC).
25
P
C
F
C
P e
AC
MC
X
O
P=MR
Figure : 6
Xe

26. In the latter case the firm will continue to produce
only if it covers its variable costs. Otherwise it will
close down, since by discontinuing its operations
the firm is better off: maximizes its losses.
The point at which
the firm covers its
variable costs is
called the ‘closing-down
point’. In
figure 7 the closing
down point of the
firm is denoted by
point w. if price falls
below Pw the firm
does not cover its
variable costs and
is better off if it
closes down.
Figure : 7
26

27. Mathematical Derivation of the Equilibrium of the Firm
The firm aims at the maximization of its profit
Π= R- C Where, Π= profit R=total revenue C=total cost
Clearly R= ƒ1 (X) and C= ƒ2 (X), given the price P
The first- order condition for the maximization of a function is
that its first derivative (with respect to X in our case) be equal to
zero. Differentiating the total- profit function and equating to
zero we obtain
27
0


C
X


R
X

X




C


X
R
or 
X


The term

R

X

C

X
is the slope of the total revenue curve, that is,
the marginal revenue (MR).
The term is the slope of the total cost curve, that is, the
marginal cost (MC).

28. Thus the first-order condition for profit maximization is, MR=
MC
Given that MC > 0, MR must also be positive at equilibrium.
Since MR= P the first order condition may be written as MC= P.
The second order condition for a maximum requires that the
second derivative of the function be negative (implying that
after its highest point the curve turns downwards). The second
derivative of the total-profit function is negative-
C
0 2
2
R
2
2
 
2
2








X
X
X
Which yield the condition
C
2
2
R
2
2
<

X

X


Here
R
 is the slope of the MR curve and
2
2
X

C
2
2

X

is the slope of the MC curve
Hence the second order condition is (Slope of MC) > (slope of MR)
28

29. Thus the MC must have a steeper slope than the
MR curve or the MC must cut the MR curve from
below. In pure competition the slope of the MR curve
is zero, hence the second-order condition is
simplified as follows
 Which reads: the MC curve must have a
C

2
2
0 <
X
positive slope, or the MC must be rising.
29

30. Monopoly
Monopoly is a market structure in which there is a
single seller, there are no close substitutes for the
commodity it produces and there are barriers to
Tehnetrym.ain causes that lead to monopoly are:
1. Ownership of strategic raw materials, or
exclusive knowledge of production techniques.
2. Patent rights for a product or for a production
process.
3. Government licensing or the imposition of
foreign trade barriers to exclude foreign
competitors.
4. The size of the market may be such as not to
supports more than one plant of optimal size. 30

31. For example, in transport, electricity, communications,
there are substantial economies which can be realized
only at large scale of output. The size of the market
may not allow the existence of more than a single plant
and here the market creates a natural monopoly, and
it is usually the case that the government undertakes
the production of the commodity or of the service so as
to avoid exploitation of the consumers. This is the case
of the public utilities
Fifthly, the existing firm adopts a limit-pricing policy,
that is, a pricing policy aiming at the prevention of new
entry. Such a pricing policy may be combined with
other policies such as heavy advertising or continuous
product differentiation, which render entry
unattractive. 31

32. Monopolist’s Equilibrium
o The monopolist maximizes his short run profits if two
conditions are fulfilled:
1. The MC is equal to the MR.
2. The slope of MC is greater than the slope of MR at
the point of intersection.
C
B
P, Cost
Pm
AC
MC
X
A
MC=MR
O
D´
e
X Figure : 6.2 m
D
MR
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33. o In figure 6.2, the equilibrium of the monopolist is
defined at point e, at which the MC intersect the MR
curve form below.
o Thus both the conditions for equilibrium are fulfilled.
o Price is Pm and the quantity is Xm.
o The monopolist realizes excess profits equal to the
shaded area APmCB.
o The price is higher than the MR.
In pure competition the firm is a price taker, so that
its only decision is output determination. The
monopolist is faced by two decisions: setting his
price and his output.
o However, given the downward-sloping demand
curve, the two decisions are interdependent. 9/12/2014 33

34. The monopolist will either set his price and
sell the amount that the market will take at it,
or he will produce the output defined by the
intersection of MC and MR, which will be
sold at the corresponding price, P.
o The monopolist cannot decide independently
both the quantity and the price at which he
wants to sell it.
o The condition for the maximization of the
monopolist’s profit is the equality between
MC and MR provided that the MC cuts the
MR from below.
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35. Formal derivation of the equilibrium of monopolist
Given the demand function X= g(P)
which may be solved for P, P= ƒ1(X)
And given the cost function C= ƒ2 (X)
The monopolist aims at the maximization of his profit
Π= R- C
The first order condition for maximum profit  0


X
 0
C


R


X 
X
R





X
X
C
X



Or,
That is MR= MC
35

36. The second order condition for maximum profit
 
< 0 2
2
X
C
< 0 2
2
R
2
2
 
2
2

X 
X
X





C
2
2
R
2
2
<

X
Or 
X


That is (slope of MR) < (slope of MC)
36
Or

37. A Numerical Example
Given the demand curve of the monopolist, X= 50 - 0.5P
Which may be solved for P= 100 – 2 X
Given the cost function of the monopolist, C = 50 + 40 X
The goal of the monopolist is to maximize profit, Π = R – C
(i) We first find the MR
R  XP 
X (100 2 X)
R  100 X 
2
X

R
MR 100 4
X
X
2
 


(ii) We next find the MC
C 50 40X
40
 

C
X



MC
37

38. (iii) We equate MR and MC
MR MC
100  4 
40
15


X
X
(iv) The monopolist’s price is found by substituting X = 15
into the demand- price equation P = 100 – 2 X = 70
(v) The profit is Π = R – C = 1050 – 650 = 400
This profit is the maximum possible, since the second-order
condition is satisfied:

C


(a) Form 40
X
2

X
We have 
0 2

C

X
(b) Form 100- 4X

R
2

X
We have 
-4 2

R
Clearly - 4 < 0
38

39. Comparison: Pure Competition &Monopoly
o The comparison is done on the following grounds:
1.Goals of the firm.
2. Assumptions of models regarding:
a. Product
b. Number of sellers (and buyers)
c. Entry conditions
d. Cost conditions
e. Degree of knowledge
3. Implications of assumptions for the behavior of the
firm
a.Shape of demand
b. Atomistic behavior or interdependence
c. Policy variables of the firm and main decisions
39

40. Perfect Competition Monopoly
Goals of the firm Profit maximization Profit maximization
Product Homogeneous No close substitute
Number of sellers Large number Single
Number of buyers Large Many
Entry conditions Free entry Restricted
Cost conditions U shaped U shaped
Degree of knowledge Perfect Perfect
Shape of demand Horizontal Downward sloping
Atomistic behavior or
interdependence
No room for selling
activities since it can
sell any amount it can
produce.
May undertake heavy
advertising and or
selling activities
Policy variables of the
firm and main
decisions
Determines only
Can determine either
output, not price
his output or price,
9/12/2014 not both 40

41. o There is no incentive for R&D for the firms in
the competitive market. The monopolist may
change the style of his product and/or indulge
in R&D activities, if there is a danger of
development of close substitutes.
o In both the markets, firms act atomistically,
that is, it, takes the decisions which will
maximize its profit ignoring the reactions of
other firms (in the same or other industries). In
both markets the decisions are taken by
applying the marginalistic rule MC = MR
41

42. Monopolistic Competition
• It is also called Chamberlin’s large-group
model.
• A market structure in which there are many
firms selling products which are differentiated,
but close substitutes, and in which there is
free entry and exit.
• The basic assumptions it are the same as
those of pure competition with the exception
of the homogeneous product. We may
summaries a as follows:
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43. 1.There is a large number of sellers and buyers.
2.The products are differentiated, but close
substitutes of one another.
3.There is free entry and exit of firms in the
industry.
4.The goal of the firm is profit maximization,
both in the short run and in the long run.
5.The prices of factors and technology are
given.
6.The firm is assumed to behave as if it knew its
demand and cost curves with certainty.
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44. 7. The long run consists of a number of identical
short-run periods, which are assumed to be
independent of one another in the sense that
decisions in one period do affect future
periods and are not affected by past actions.
8. Finally, Chamberlin makes the ‘heroic’
assumption that both demand and cost curves
for all ‘products’ arc uniform throughout the
group. Chamberlin makes these assumptions in
order to be able to show the equilibrium of the
firm, and the ‘industry’ on the same diagram.
The above ‘heroic’ assumptions lead to a model
which is very restrictive, since it precludes the
inclusion in the ‘group’ of similar products which
have different costs of production. 44

45. • Product differentiation gives rise to a negatively
sloping demand curve for the product of the individual
firm. If the firm increases its price it will lose some but
not all of its customers, while if it reduces its price it will
increase its sales by attracting some customers from
other firms.
• In spite of downward-sloping, the demand is highly
elastic, because of the assumption of a large number of
sellers in the group. Since the firm is one of a very large
number of sellers, if it reduces its price the increase in its
sales will product loss of sales distributed more or less
equally over all the other firms, so that each one of them
will suffer a negligible loss in customers, not sufficient to
induct them to change their own price.
45
Equilibrium of the Monopolistic Firms

46. Thus the individual
demand curve, dd, is a
planned sales curve,
drawn on the assumption
that the competitors will
not react to change a in
the particular firm’s
price. (Of course the dd
curve is also drawn on
the usual ceteris paribus
assumptions, that tastes,
incomes and prices in
other industries do not
change.)
46

47. • In the short run the Chamberlinian firm
acts like a monopolist. The firm maximizes
its profit by producing the output at which
marginal cost is equal to marginal revenue
(MC = MR).
• In order to be able to analyze the
equilibrium of the firm and of the industry
on the same diagram Chamberlin made
two ‘heroic assumptions’, namely that
firms have identical costs, and consumers’
preferences are evenly distributed among
the different products.
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48. • Chamberlin develops three distinct models of
equilibrium. In the second model assumed that
the number of firms in the industry is optimal and
long run equilibrium is reached through price
adjustments (price competition) of the existing
firms. In the first model the existing firms are
assumed to be in short-run equilibrium realizing
abnormal profits; but long-run equilibrium is
attained by new entrants who are attracted by the
lucrative profit margins. The third model is a
combination of the previous two. From these first
two are explained here.
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49. Model 1: Equilibrium with new firms entering the
industry
• In this model it is assumed that each firm
is in short-run equilibrium, maximizing
profits at abnormally high levels.
• The firm having the cost structure depicted
by the SRAC and the LMC curves and
faced with demand curve dd’, will set the
price PM which corresponds to the
intersection of the MR and the MC curves.
This price yields maximum profits (equal to
the area ABCPM).
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50. The firm, being in equilibrium (at C), does
not have any incentive to change its
price. The abnormal profits will, however,
attract new competitors into the market.
50

51. • The result of new entry is a downward
shift of the demand curve dd´, since the
market is shared by a larger number of
sellers.
• Assuming that the cost curves will not shift
as entry occurs, each shift to the left of the
dd´ curve will be followed by a price
adjustment as the firm reaches a new
equilibrium position, equating the new
marginal revenue to its marginal cost.
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52. • The process will continue until the demand
is tangent to the average-cost curve. In
the final equilibrium of the firm the price will
be PE and the ultimate demand curve dE d´E.
• This is an equilibrium position, since price is
equal to the average cost.
• There will be no further entry into the
industry, since profits are just normal.
• The equilibrium is stable, because any firm
will lose by either raising or lowering the
price PE.
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53. Model 2: Equilibrium with price competition
In this model it is assumed that the number of firms in the
industry is that which is compatible with long-run
equilibrium, so that neither entry nor exit will take place. But
ruling price in the short run is assumed to be higher than
the equilibrium one.
In figure 8.3, which shows
the actual sales of the firm
at each price after
accounting for the
adjustments of the prices of
other firms in the group DD´
is sometimes called actual-sales
curve or share-of-the-market
curve, since it
incorporates the effects of
action of competitors to the
price changes by the firm. 53

54. • DD´ is thus the locus of points shifting dd´ curves
as competitors, acting simultaneously, changes
their price. It should be clear that the change in the
price as an independent action aiming at the profit
maximization of each acting independently of the
others.
• A movement along DD´ shows changes in the
actual sales of existing firms as all of them adjust
their price simultaneously and identically, with their
share remaining constant.
• A shift in the DD´ is caused by entry of new firms or
exit of existing firms from the ‘industry’ and shows a
decline or an increase in the share of the firm.
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55. • Assume that the firm is at the non-equilibrium
position defined by price P0 and quantity X0.
The firm in an attempt to maximize profits,
lowers the price at P1 expecting to sell, on the
basis of its individual demand curve, quantity
X’0.
• All firms acting independently, reduce their
price simultaneously to P1. As a result the dd’
curve shifts downwards (d1 d´1) and firm A,
instead of selling the expected quantity X’0,
sells actually a smaller quantity X1 on the
shifted-demand curve d1d’1 and along the share
curve DD’
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56. • Its new demand (d1d´1) wilt not shift further,
because the effect of its own decisions on other
sellers’ demand would be negligible. Thus the firm
lowers its price again in an attempt to teach
equilibrium, but instead of the expected sales X´0
the firm achieves actual sales X2, because all other
firms act identically, through independently.
• The process stops when the dd´ curve has shifted
so far to the left as to be tangent to the LAC curve.
Equilibrium is determined by the tangency of
dd´ and the LAC curve (point e in figure 8.3). Any
further reduction in price will not be attempted since
the average cost would not be covered.
56