market structure new

8/8/2019 Market Structure New

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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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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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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


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


Cost/Revenue

Output / Sales

MC

AC

AR1MR1

This is the long runequilibrium positionof a firm in monopolisticcompetition.

Q2

AR = AC


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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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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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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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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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Output / Sales

AC

MC

ARMR


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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Output / Sales

AC

MC

ARMR


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!

market structure new

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