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Market Structure
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The Four Types of Market Structure
Monopoly Oligopoly Monopolistic
Competition
Perfect
Competition
Tap water
Cable TV
Tennis balls
Crude oil
Novels
Movies
Wheat
Milk
Number of Firms?
Type of Products?
Manyfirms
One
firm Fewfirms Differentiated
productsIdenticalproducts
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Profit Maximize ApproachProducers Equilibrium (Two Approach)
(i) TR and TC Approach
(ii) MR and MC Approach
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Firms equilibrium : Maximizing profits
Output TR TC TR-TC
1 45 50 -5
2 90 80 10
3 135 90 45
4 180 105 75
5 225 130 95
6 270 165 105
7 315 207 108
8 350 270 80
9 375 385 -10
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MR and MC Approachy MR means the addition made to the total revenue by
producing and selling an additional unit of output and
MC means the addition made to the total cost of producing and additional unit of output .
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Equilibrium conditionTwo Important Condition
(1) TC=TR or MC=MR
(2) Slope of MC curve should be> Slope of MR ( MCcurve should cuts MR curve from below)
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Marginal RevenueyA perfect competitor accepts the market price as given.
yAs a result, marginal revenue equals price (MR = P).
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Equilibriumy Short Run
y Long Run
SHORT RUN(1) Firms may earn normal profit
(2) Firms may earn supernormal profit
(3) Firm may incurring losses
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Profit case (b) Zero profit case (c) Loss case
Determining Profits Graphically
Quantity Quantity Quantity
Price656055
504540353025201510
50
656055
504540353025201510501 23 4 5 67 891012 1 23 4 5 67 891012
D
MC
A P = MR
B ATCAVC
E
Profit
C
MC
ATC
AVC
MC
ATC
AVC
Loss
656055
504540353025201510
50 123456789 1
0
12
P = MRP = MR
Price Price
The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-Hill
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The Shutdown Pointy The firm will shut down if it cannot cover average
variable costs.
y
A firm should continue to produce as long as price isgreater than average variable cost.
y If price falls below that point it makes sense to shutdown temporarily and save the variable costs.
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Market Structurey Market structure identifies how a market
is made up in terms of:y The number of firms in the industry
y The nature of the product producedy The degree of monopoly power each firm has
y The degree to which the firm can influence price
y Profit levels
y Firms behaviour pricing strategies, non-price competition, output
levelsy The extent of barriers to entry
y The impact on efficiency
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Market StructureCharacteristics: Look at these everyday products what type ofmarket structure are the producers of these products operatingin?
Remember tothink about thenature of theproduct, entry andexit, behaviour ofthe firms, numberand size of the
firms in theindustry.
You might evenhave to ask whatthe industry is??Canon SLR CameraBananas
Mercedes CLK Coupe
Vodka
Electric
Guitar
Jazz Body
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Perfect Competitiony One extreme of the market structure spectrumy Characteristics:
y Large number of firms
y Products are homogenous (identical) consumerhas no reason to express a preference for any firmy Freedom of entry and exit into and out
of the industryy Firms are price takers have no control
over the price they charge for their producty
Each producer supplies a very small proportionof total industry outputy Consumers and producers have perfect knowledge about the
market
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Perfect Competition
Diagrammatic representation
Cost/Revenue
Output/Sales
The industry price isdetermined by the demandand supply of the industryas a whole. The firm is avery small supplier withinthe industry and has nocontrol over price. They will
sell each extra unit for thesame price. Price therefore= MR and AR
P = MR = AR
MC
The MC is the cost ofproducing additional(marginal) units of output. Itfalls at first (due to the law ofdiminishing returns) then risesas output rises.
AC
The average cost curve is thestandard U shaped curve.MC cuts the AC curve at itslowest point because of themathematical relationshipbetween marginal and averagevalues.
Q1
Given the assumption of profitmaximisation, the firm producesat an output where MC = MR(Q1). This output level is afraction of the total industrysupply.
At this output the firm
is making normal profit.
This is a long run
equilibrium position.
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Perfect CompetitionDiagrammatic representationCost/Revenue
Output/Sales
P = MR = AR
MC
AC
Q1
Now assume a firm makessome form of modification toits product or gains some formof cost advantage (say a newproduction method). What
wouldh
appen?
AC1
MC1
AC1Abnormal profit
Q2
Because the model assumesperfect knowledge, the firmgains the advantage for only ashort time before others copythe idea or are attracted to theindustry by the existence ofabnormal profit. If new firms
enter the industry, supply willincrease, price will fall and thefirm will be left making normalprofit once again.
P1 = MR1 = AR1
The lower AC and MC wouldimply that the firm is nowearning abnormal profit(AR>AC) represented by thegrey area.
Average and Marginal costscould be expected to be lowerbut price, in the short run,remains the same.
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Monopolistic or Imperfect Competition
y Where the conditions of perfect competition do
not hold, imperfect competition will existyVarying degrees of imperfection give rise to
varying market structures
y Monopolistic competition is one of these not
to be confused with monopoly!
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Monopolistic or Imperfect Competition
y Characteristics:y Large number of firms in the industry
y
May have some element of control over price due to thefact that they are able to differentiate their product insome way from their rivals products are thereforeclose, but not perfect, substitutes
y Entry and exit from the industry is relatively easy few
barriers to entry and exity Consumer and producer knowledge imperfect
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Monopolistic or Imperfect Competition
Implications for the diagram:
Cost/Revenue
Output / Sales
MC
AC
Marginal Cost andAverage Cost will be thesame shape. However,because the products
are differentiated insome way, the firm willonly be able to sell extraoutput by lowering
price.
D (AR)
The demand curve facingthe firm will be downward
sloping and represents theAR earned from sales.
MR
Since the additionalrevenue received from
each unit sold falls, theMR curve lies under the
AR curve.
We assume that the firmproduces where MR = MC(profit maximising output).At this output level, AR>AC
and the firm makesabnormal profit (the greyshaded area).
Q1
1.00
0.60
Abnormal Profit
If the firm produces Q1 andsells each unit for 1.00 on
average with the cost (onaverage) for each unit being
60p, the firm will make 40p xQ1 in abnormal profit.
This is a short run equilibriumposition for a firm in a
monopolistic marketstructure.
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Monopolistic or ImperfectCompetitionImplications for the diagram:
Cost/Revenue
Output / Sales
MC
AC
D (AR)MR
Q1
Because there is relativefreedom of entry and exitinto the market, newfirms will enter
encouraged by theexistence of abnormalprofits.New entrants willincrease supply causing
price to fall. As price falls,the AR and MR curvesshift inwards as revenuefrom each sale is nowless.
AR1MR1
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Monopolistic or ImperfectCompetition
Implications for the diagram:
Cost/Revenue
Output / Sales
MC
AC
D (AR)MR
Q1
AR1MR1
Notice that the existenceof more substitutes makesthe new AR (D) curvemore price elastic. The
firm reduces output to apoint where MC = MR(Q2). At this output AR =AC and the firm will make
normal profit.
Q2
AR = AC
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Monopolistic or ImperfectCompetition
Implications for the diagram:
Cost/Revenue
Output / Sales
MC
AC
AR1MR1
This is the long runequilibrium positionof a firm in monopolisticcompetition.
Q2
AR = AC
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Monopolistic or Imperfect Competition
y Some important points about monopolisticcompetition:
y May reflect a wide range of marketsy Not just one point on a scale reflects many degrees
of imperfection
y Examples?
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Monopolistic or Imperfect Competition
y Restaurants
y Plumbers/electricians/local builders
y Solicitors
y Private schools
y Plant hire firms
y Insurance brokers
y Health clubs
y
Hairdressersy Funeral directors
y Estate agents
y Damp proofing control firms
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Monopolistic or Imperfect Competition
y In each case there are many firmsin the industry
y Each can try to differentiate its product
in some wayy Entry and exit to the industry is relatively free
y Consumers and producers do not have perfect knowledgeof the market the market may indeed be relatively
localised. Can you imagine trying to search out the details,prices, reliability, quality of service, etc for every plumber inthe UK in the event of an emergency??
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Oligopolyy Competition between the few
y May be a large number of firms in the industry but theindustry is dominatedby a small number of very large producers
y Concentration Ratio the proportion of totalmarket sales (share) held by the top 3,4,5, etcfirms:y A 4 firm concentration ratio of 75% means the top 4
firms account for 75% of allthe sales in the industry
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Oligopolyy Example:
y Music sales
The music industry hasa 5-firm concentrationratio of 75%.Independents make up
25% of the market butthere could be manythousands of firms thatmake up this
independents group.An oligopolistic marketstructure thereforemay have many firmsin the industry but it isdominated by a fewlarge sellers.
Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html
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Oligopolyy Features of an oligopolistic market structure:
y Price may be relatively stable across the industry kinked demand curve?
y Potential for collusion
y Behaviour of firms affected by what they believe their rivalsmight do interdependence of firms
y Goods could be homogenous or highly differentiated
y Branding and brand loyalty may be a potent source of competitive advantage
y Non-price competition may be prevalent
y Game theory can be used to explain some behaviour
y
AC curve may be saucer shaped minimum efficient scalecould occur over large range of output
y High barriers to entry
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Oligopoly The kinked demand curve - an explanation for price stability?Price
Quantity
D = elastic
D = Inelastic
5
100
Kinked D Curve
The principle of the kinked demandcurve rests on the principlethat:
a. If a firm raises its price, its
rivals will not follow suitb. If a firm lowers its price, its
rivals will all do the same
Assume the firm is charging a price of5 and producing an output of 100.
If it chose to raise price above 5, itsrivals would not follow suit and the firm
effectively faces an elastic demandcurve for its product (consumers would
buy from the cheaper rivals). The %change in demand would be greaterthan the % change in price and TRwould fall.
Total Revenue A
Total
Revenue B
If the firm seeks to lower its price togain a competitive advantage, its rivalswill follow suit. Any gains it makes will
quickly be lost and the % change indemand will be smaller than the %
reduction in price total revenuewould again fall as the firm now facesa relatively inelastic demand curve.
Total Revenue B
Total Revenue A
The firm therefore, effectively facesa kinked demand curve forcing it tomaintain a stable or rigid pricing
structure. Oligopolistic firms mayovercome this by engaging in non-
price competition.
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Duopolyy Market structure where the industry is
dominated by two large producersy Collusion may be a possible feature
y
Price leadership by the larger of the two firms may exist thesmaller firm follows the price leadof the larger one
y Highly interdependent
y High barriers to entry
y Cournot Model French economist analysed duopoly suggested long run equilibrium would see equal market shareand normal profit made
y In reality, local duopolies may exist
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Monopolyy Pure monopoly where only
one producer exists in the industryy In reality, rarely exists always
some form of substitute available!y Monopoly exists, therefore,
where one firm dominates the markety Firms may be investigated for examples of
monopoly power when market share exceeds25%
y Use term monopoly power with care!
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Monopolyy Origins of monopoly:
y Through growth of the firm
y
Through amalgamation, mergeror takeover
y Through acquiring patent or license
y Through legal means Royal charter, nationalisation,
wholly owned plc
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Monopolyy Summary of characteristics of firms exercising
monopoly power:y
Price could be deemed too high, may be set to destroycompetition (destroyer or predatory pricing), pricediscrimination possible.
y Efficiency could be inefficient due to lack ofcompetition (X- inefficiency) ory could be higher due to availability of high profits
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Monopolyy Innovation - could be high because
of the promise of high profits, Possibly encourages
high investment in research and development(R&D)
y Collusion possible to maintain monopoly powerof key firms
in industryy High levels of branding, advertising
and non-price competition
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Monopolyy Problems with models a reminder:
y Often difficult to distinguish between a monopolyand an oligopoly both may exhibit behaviour
that reflects monopoly powery Monopolies and oligopolies do not necessarily aim
for traditional assumption of profit maximisation
y Degree of contestability of the market may influence behaviour
y Monopolies not always bad may be desirablein some cases but may need strong regulation
y Monopolies do not have to be big could exist locally
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MonopolyCosts / Revenue
Output / Sales
AC
MC
ARMR
AR (D) curve for a monopolistlikely to be relatively priceinelastic. Output assumed tobe at profit maximising output(note caution here not allmonopolists may aim
for profit maximisation!)
Q1
7.00
3.00
MonopolyProfit
Given the barriers to entry,the monopolist will be able toexploit abnormal profits in thelong run as entry to themarket is restricted.
This is both the short run andlong run equilibrium positionfor a monopoly
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MonopolyCosts / Revenue
Output / Sales
AC
MC
ARMR
Welfareimplications ofmonopolies
A look back at the diagram forperfect competition will revealthat in equilibrium, price will be
equal to the MC of production.We can look therefore at acomparison of the differencesbetween price and output in acompetitive situation comparedto a monopoly.
Q1
3
The price in a competitivemarket would be 3 withoutput levels at Q1.
Q2
7The monopoly price would be7 per unit with output levelslower at Q2.
On the face of it, consumersface higher prices and less
choice in monopoly conditionscompared to more competitiveenvironments.
Loss of consumersurplus
The higher price and loweroutput means that consumersurplus is reduced, indicated by
the grey shaded area.
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MonopolyCosts / Revenue
Output / Sales
AC
MC
ARMR
Welfareimplications ofmonopolies
Q1
3
Q2
7The monopolist will beaffected by a loss of producersurplus shown by the grey
triangle but..
The monopolist will benefitfrom additional producersurplus equal to the grey
shaded rectangle.Gain in producersurplus
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MonopolyCosts / Revenue
Output / Sales
AC
MC
ARMR
Welfareimplications ofmonopolies
Q1
3
Q2
7
The value of the grey shadedtriangle represents the totalwelfare loss to society sometimes referred to asthe deadweight welfare loss.
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Contestable Markets Theory developed by William J. Baumol,
John Panzar and Robert Willig (1982)
Helped to fill important gaps in marketstructure theory
Perfectly contestable market thepure form not common in reality but a
benchmark to explain firms behaviours
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Contestable Markets Key characteristics:
Firms behaviour influenced by the threatof new entrants to the industry
No barriers to entry or exit
No sunk costs
Firms may deliberately limit profits madeto discourage new entrants entry limit
pricing Firms may attempt to erect artificial
barriers to entry e.g
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Contestable Markets Over capacity provides theopportunity to flood the marketand drive down price in the event
of a threat of entry Aggressive marketing and branding
strategies to tighten up the market
Potential for predatory
or destroyer pricing Find ways of reducing costs and
increasing efficiency to gain competitiveadvantage
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Contestable Markets Hit and Run tactics enter the
industry, take the profit and get
out quickly (possible because ofthe freedom of entry and exit)
Cream-skimming identifying
parts of the market that are highin value added and exploitingthose markets
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Contestable Markets Examples of markets exhibiting
contestability characteristics:
Financial servicesAirlines especially flights
on domestic routes
Computer industry ISPs, software,
web developmentEnergy supplies
The postal service?
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Market Structuresy Final reminders:y Models can be used as a comparison they are not necessarily meant to BE
reality!
y When looking at real world examples, focus on the behaviour of the firm inrelation to what the model predicts would happen that gives the basis for
analysis and evaluation of the real world situation.
y Regulation or the threat of regulation may well affectthe way a firm behaves.
y Remember that these models are based on certain assumptions in the realworld some of these assumptions may not be valid, this allows us to draw
comparisons and contrasts.y The way that governments deal with firms may be based on a general
assumption that more competition is better than less!