Chapter 6Market Structure

Prof. Dr M S Islam

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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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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.

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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

Considerable but usually regulated

Promotional advertising if supply is large

Types of Market Structure

o Total revenue of a firm is the selling price (P) times the quantity (Q) sold.

o TR = (PTR = (PQ)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 =MR =TR/ TR/ QQo For competitive firms, marginal revenue

equals the price of the good.5

Some Basic Concepts

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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.

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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

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.

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P = AR = MRMarket P

X, Output

P, price

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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

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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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.

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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.

Demand and Supply Curve of Perfectly Competitive Market

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• 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

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Short-run Equilibrium

• 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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• 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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Figure : 2

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.

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• 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

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• 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.

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ePA B

ACMC

XO

PC

P=MR= ARFigure : 3

Xe

Marginalistic Approach

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

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.

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eP

ACMC

XO

PC

P=MR=AR

Figure : 4XeX´e

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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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).

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ePA B

ACMC

XO

PC

P=MR

Figure : 5

Xe

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If however, the AC is above the price (figure 6) the firm makes a loss (equal to the area FPeC).

ePF C

ACMC

XO

PC

P=MR

Figure : 6

Xe

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 : 726

Mathematical Derivation of the Equilibrium of the Firm

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The firm aims at the maximization of its profit ∏= R- C Where, ∏= 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

0X

C

X

R

X

X

C

X

R

or

The term X

R

X

C

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).

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-

02

2

2

2

2

2

X

C

X

R

XWhich yield the condition

2

2

2

2

<X

C

X

R

Here2

2

X

R

is the slope of the MR curve and

2

2

X

C

is the slope of the MC curve

Hence the second order condition is (Slope of MC) > (slope of MR)28

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

2

2

<0X

C

Which reads: the MC curve must have a

positive slope, or the MC must be rising.

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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 entry. The main 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

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

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.

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B

Pm

ACMC

XO

P, Cost

MC=MR

Figure : 6.2Xm

D´

D

C

A

MR

e

Monopolist’s Equilibrium

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. 04/13/23 33

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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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- CThe first order condition for maximum profit 0

X

0

X

C

X

R

X X

C

X

R

Or,

That is MR= MC 35

The second order condition for maximum profit

0<2

2

X

0<2

2

2

2

2

2

X

C

X

R

X

2

2

2

2

<X

C

X

R

Or

That is (slope of MR) < (slope of MC)

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Or

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

XMR

XXR

4100X

R

2100

X) 2 (100 X XP R2

(ii) We next find the MC40

X

C

40X50 C

MC37

(iii) We equate MR and MC

15404100

MC MR

XX

(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 = 400This profit is the maximum possible, since the second-order condition is satisfied:

(a) Form 40X

C

We have 02

2

X

C

(b) Form 4X-100X

RWe have -4

2

2

X

R

Clearly - 4 < 038

Comparison: Pure Competition &Monopoly o The comparison is done on the following grounds:1.Goals of the firm.2. Assumptions of models regarding:

a. Productb. Number of sellers (and buyers)c. Entry conditionsd. Cost conditionse. Degree of knowledge

3. Implications of assumptions for the behavior of the firm • Shape of demand• Atomistic behavior or interdependence• Policy variables of the firm and main decisions

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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 output, not price

Can determine either his output or price, not both

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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

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• 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:04/13/23 42

Monopolistic Competition

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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.

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

• 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.

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Equilibrium of the Monopolistic Firms

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.)

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• 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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• 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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• 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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Model 1: Equilibrium with new firms entering the industry

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.

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• 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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• 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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Model 2: Equilibrium with price competitionIn 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

• 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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• 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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• 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.

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