Market Structures

Page |1
Objectives of Firms Traditional theory Profit maximisation 1. MC = MR Marginal Revenue (MR) Alternative theories 1. Managerial theories 1. 2. 3. Managerial utility maximisation Sales revenue maximisation Growth maximisation MR = AR Revenue Curves Average Revenue (AR) 1. 2. Same as demand curve of product Perfectly elastic

Behaviourial theories 1. 2. A variety of goals, eg. production, sales, market share, profit Aim to achieve a satisfactory performance for each goal Total Revenue (TR) 1. Straight line from origin

Perfect markets 1. 2. Firms are price takers No market power for firms

Imperfect markets 1. 2. Firms are price setters Varying extent of market power of firms

Market structures differ in terms of 1. 2. 3. 4. Nature of product Ease of entry Concentration of firms Competition between firms Marginal approach Equilibrium output for all market structures at MC = MR Profits Normal profit 1. 2. 3. TR = TC Zero economic profit No incentive for firms to leave or new ones to enter Equilibrium Output

Supernormal profits 1. 2. 3. TR > TC Firms earns more than opportunity costs Entry of firms will depend on ease of entry a. b. If barriers exist, profit level remains high If no entry barriers, profit level goes down to normal profit Subnormal profits 4. 5. 6. TR < TC Firms makes less than opportunity cost Firms will cease production when a. b. Revenue < Variable Cost, firm leaves in short run Revenue > Variable Cost, firm continues in short run but leaves in long run Perfect Competition Characteristics 1. 2. 3. Homogeneous products No barriers to entry, hence a large number of small firms Firms have no market power, price takers

1. 2.

MC = MR Since P = MR, P = MC. Firm is allocative efficient.

Total approach 1. Point where vertical difference between TR and TC is the greatest

Short Run Profits Supernormal Profits

http://education.helixated.com An Open Source Education Project

2|Page
Pros 1. Allocative efficient, sum of consumer surplus and producer surplus is maximum

New firms will enter Industrys supply increases Price falls until normal profit Normal Profits

2. 3. 4. Cons 1. 2. Subnormal Profits 3.

Production at least cost output, minimum efficient scale Normal profit Ease of movement of resources

Social efficiency is not attainable without government intervention when externalities are present Little incentive to innovate Absence of product variety

Monopoly Characteristics 1. 2. 3. 4. No close substitutes Strong barriers to entry Only firm Strong market power

Barriers to Entry 1. Firms objective shifts to loss minimisation. Long Run Profits 1. 2. Normal profit Price = Minimum of AC (minimum efficient scale) Revenue Curves 2. 3. Cost condition a. b. Highly capital-intensive Minimum efficient scale occurs at high output

Legal barriers Contrived barriers a. b. Control of input supplies Brand loyalty

From supernormal profits to long run equilibrium, AR/MR moves down

Equilibrium Supernormal profits due to: 1. Evaluation of Perfection Competition 2. 3. P > MC Price discrimination Lower costs from economies of scale

Page |3
4. Incentive to innovate 3. Enables firms to supply otherwise unprofitable goods

Evaluation of Monopoly Pros 1. Cost advantage a. b. Shaded area = Supernormal profits Price Discrimination A practice of firms charging different prices for the same products, unsupported by cost reasons Conditions Necessary 1. 2. 3. Markets are separable Differing price elasticities of demand between markets Resale of product not possible Cons 1. 2. Allocatively inefficient Higher price, lower output a. b. Production at MC = MR and not P = MC Loss of consumer surplus 2. 3. c. Economies of scale and R&D will lead to lower MC Price can be lower and output (MC = MR) can be higher than allocative efficient level of PC (P = MC) Lower MC Larger consumer surplus Research and development Lower cost despite not producing at minimum efficient scale as MC is lower

1st Degree Price Discrimination 1. 2. 3. Different price for every customer No consumer surplus left Allocatively efficient (P = MC)

2nd Degree Price Discrimination 1. Charging differently according to blocks of consumption

3.

Income inequality

Theory of Contestable Markets 1. 2. 3. Price, output and behaviour in an industry is determined by the threat of competition Monopolies forced to be more efficient and lower price to prevent new entrants Factors favouring contestability: a. 3 Degree Price Discrimination 1. 2. Different types of consumers (with different price elasticity of demand) charged differently Less elastic market charged higher
rd

Free trade policy Deregulation trend

b.

Controlling Monopolies 1. 2. 3. 4. Regulation on pricing and output Transferring monopoly to government (nationalisation) Taxes Legislations and anti-trust policies

Monopolistic Competition Characteristics 1. 2. 3. Two effects: 1. 2. Pros 1. 2. Higher consumption level made possible Extra revenue is reinvested Absorption of consumer surplus by firm Allocatively efficient as in 1st degree 4. Slightly differentiated products Entry of firms is relatively easy Many small firms Mild market power due to slight product differentiation

Revenue Curve 1. Same as monopoly, with lower price elasticity

Short Run Profit 1. Supernormal profits

4|Page
Comparison between Monopolistic Competition and Monopoly 1. 2. Lack of R&D due to normal profits Monopolistic competitions smaller scale leads to higher costs

Oligopoly Characteristics 1. 2. Normal profits 2. 3. 4. Differentiated products Restricted entry of new firms Few large firms a. Two firms - Duopoly Interdependence among firms

Alternative Theories of Oligopolys Price-Output Non-collusive 1. Price rigidity with kinked demand a. b. 3. Subnormal profits a. Long Run Profit 1. Supernormal profits entry of new firms a. 2. 3. Decrease in demand for firms MR and AR shifts to the left and become more elastic Normal profits Output falls short of MES AC above AR Collusive 1. 2. 3. 4. I. II. III. IV. Small margin of P > MC Economies of scale lower LRAC, lower MC, higher output Product varieties Cartel Dominant firm price leadership Barometric firm price leadership Rule of thumb pricing Collusion best when: Few firms Identical products Awareness of methods and common costs No new competition Drop in price others follow revenue falls demand is inelastic Rise in price others do not follow revenue falls demand is elastic

Evaluation of Monopolistic Competition Pros 1. 2. 3. Cons 1. 2. 3. Allocative inefficient (P > MC) Excess capacity between LR output ant MES output Lack of R&D between Monopolistic Competition and Perfect

Evaluation of Oligopoly Pros 1. 2. Cons 1. 2. 3. 4. Allocatively inefficient (P > MC) Wastage of resources Smaller scale of production compared to monopoly Firms may collude and behave as a monopoly R&D Product differentiation

Comparison Competition

Non-Price Competition 1. 2. Product development and innovation Marketing

Monopolistic Competition leads to: 1. 2. 3. Higher price Lower output Higher AC