Four Market Structures

The focus of this lecture is the four market structures. Students will learn the
characteristics of pure competition, pure monopoly, monopolistic competition, and
oligopoly. Using the cost schedule from the previous lecture, the idea of profit
maximization is explored.
OBJECTIVES
1. Identify various market structures and their characteristics.
2. Be able to category firms into four market structures.
3. Describe the effects of imperfect competition upon the market and the firm.
4. Understand the pricing structure of the four structures.
TOPICS
Please read all the following topics.
PERFECT COMPETITION
PERFECT COMPETITION CONT.
PERFECT COMPETITION EXAMPLE
PURE MONOPOLY
MONOPOLY EXAMPLE
PRICE DISCRIMINATION
MONOPOLISTIC COMPETITION
OLIGOPOLY
TECHNOLOGICAL DEVELOPMENT
ECONOMIC EFFICIENCY

Perfect Competition
Pure or perfect competition is rare in the real world, but the model is important
because it helps analyze industries with characteristics similar to pure competition.
This model provides a context in which to apply revenue and cost concepts
developed in the previous lecture. Examples of this model are stock market and
agricultural industries.
Characteristics
1. Many sellers: there are enough so that a single sellers decision has no impact
on market price.
2. Homogenous or standardized products: each sellers product is identical to its
competitors.
3. Firms are price takers: individual firms must accept the market price and can
exert no influence on price.
4. Free entry and exit: no significant barriers prevent firms from entering or leaving
the industry.
Demand
The individual firm will view its demand as perfectly elastic. A perfectly elastic
demand curve is a horizontal line at the price. The demand curve for the industry is
not perfectly elastic, it only appears that way to the individual firms, since they
must take the market price no matter what quantity they produce. Therefore, the
firms demand curve is a horizontal line at the market price.
Marginal revenue (MR) is the increase in total revenue resulting from a one-unit

Profit-Maximizing Output

Short Run Analysis

In the short run, the firm has fixed resources and maximizes profit or minimizes loss by adjusting
output. Firms should produce if the difference between total revenue and total cost is profitable (EP
>0), or if the loss is less than the fixed cost (EP>- FC). The firm should not produce, but should shut
down in the short run if its loss exceeds its fixed costs. By shutting down, its loss will just equal
those fixed costs. Fixed cost in real life would be rent of the office, business license fees, equipment
lease, etc. These cost would have to be paid with or without any output. Therefore, fixed cost would
be the loss of shut down at any time. If by producing one unit of output, this loss could be lowered,
then this unit should be produced to minimize the loss. However, if by producing one unit of output,
this loss would be higher , then this unit should not be produced. The firm should shut down, just
pay for the fixed cost.
If EP< - FC firm should shut down. Then its lost will be the Fixed cost. EP = - FC. In order for EP < FC, market price, P, must be lower than the minimum AVC.
If EP> - FC, firm should produce. That is when market price is greater than minimum AVC.
Marginal revenue and marginal cost (MC) are compared to decide the profit-maximizing output.
If MR > MC, then the firm should continue to produce.
If MR = MC, then the firm should stop producing the additional unit. As the additional units MC
would be higher according to law of diminishing returns, MR would be less than MC; that is, the firm
would loss profit by producing additional units. Therefore, this is the profit maximizing output level.
If MR < MC, then the firm should lower its output.
In conclusion:
The shutdown point is the level of output and price at which the firm just covers its total variable
cost. If the MR of the product is less than the minimum average variable cost (min AVC), the firm
will shut down because this action minimizes the firms loss. In this case, the firms economic loss
equals its total fixed costs. If MR < min AVC, then each additional unit produced would increase the
loss. For pure competition, MR is equal to price as the firm is facing a perfectly elastic demand.
Therefore, for short run, if Price < min AVC, then the firm should shut down. If Price > min AVC,
then the firm should produce. Price and MC are compared to find the profit maximizing or loss
minimizing output level. The supply curve of the pure competition firms would be the portion of the

Perfect Competition Cont.

Following the rules discussed in the previous section. Here is an example.
Firms fixed cost is $100, its min AVC is $55.
If market price is 50 which is less than min AVC, the firm would loss $5 more by producing each
unit. If the firm produces one unit, its total loss would be $5 plus $100 fixed cost. If the firm decides
to shut down, its loss would be only $100 as the firm does not need to pay for the variable cost.
Shut down would be the loss minimization strategy.
If the market price is 60, the firm would lose $5 less by producing each unit. If the firm produces
one unit, its total cost would be fixed cost less $5, which is $95. The firm is better off by producing,
not shutting down. When the market price is higher than the minimum AVC, MR and MC should be
compared to find out the optimal level of output.
Long Run Analysis
Obviously, the firm cannot be in loss for long. Three assumptions are made for the long run
analysis:
1. Entry and exit are the only long run adjustments.
2. Firms in the industry have identical cost curves.
3. The industry is in constant return to scale.
In long run, if economic profits are earned, firms enter the industry, which increases the market
supply, causing the product price to go down. Until zero economic profits are earned, then the
supply will be steady. If losses are incurred in the short run, firms will leave the industry which
decreases the market supply, causing the product price to rise until losses disappear. This model is

Efficiency Analysis
1. Productive efficiency: occurs where P= min ATC. Perfect
competitive firms will achieve productive efficiency as firms must
use the least-cost technology or they won't survive.
2. Allocative efficiency: occurs where P = MC. Price represent the
benefit that society gets from additional units of a product, MC
represents the cost to society of other goods given up to produce
this product. Dynamic adjustments will occur in this market
structure when changes in demand, supply or technology occurs.
Perfect competitive firms will achieve this efficiency. Since no
explicit orders are given to the industry, "the Invisible Hand" works
in this system.
Even though both efficiencies are achieved in this system, the
consumers are facing standard products, making shopping to be no
fun at all. On the other hand, the consumers will receive the
highest consumer surplus in this structure as the long run market
price will be at the min ATC. Producers will receive the lowest
producer surplus as consumers can easily find substitutes.

An Example
The following data represents a cost function of
a perfect competitive firm:
TP or Q

AFC

AVC

ATC

MC

0
1

60

45

105

45

30

42.5

72.5

40

20

40

60

35

15

37.5

52.5

30

12

37

49

35

10

37.5

47.5

40

8.57

38.57

47.14

45

7.5

40.63

48.13

55

6.67

43.33

50

65

10

46.5

52.5

75

If the market price, P < 37; this firm's output Q

= 0; firm's economic profit, EP = -60

If the market price, P > 37, this firm's output Q

> 0; firms' economic profit , EP= TR - TC.

For example, when P = 65, Q = 9, EP = $65 x 9 50 X 9 = 135

An Example Cont.

By given the market demand at various price level, a market equilibrium price could
be found.
TP or Q
AFC
AVC
ATC
MC
One firm's output level (column 2 in the above
0
table) is obtained by comparing P and MC. Since
1
60
45
105
45
all firms are having the same cost function, the
2
30
42.5
72.5
40
market output level is the sum of individual firms'
3
20
40
60
35
output (column 4 in the above table).
4
15
37.5
52.5
30
By comparing the market supply and market
5
12
37
49
35
demand, we can find the market equilibrium at:
6

10

37.5

47.5

40

8.57

38.57

47.14

45

7.5

40.63

48.13

55

6.67

43.33

50

65

10

46.5

52.5

PRICE Qs (1 firm's output) PROFIT

26

-60

32

38

P= 46 and Q = 10500

At this level, each firm is losing 8 dollars, indicating

a contraction in this industry. Some firms may
leave in the long run, causing the market supply to
decrease and equilibrium price will increase to the
Qs(1500 firms in the market) / market supply Qd / market demand
break-even level.
75

17000

-60

15000

-55

7500

13500

41

-39

9000

12000

46

-8

10500

10500

56

63

12000

9500

66

144

13500

8000

(assuming identical cost function for all firms)

Pure Monopoly
Pure monopoly exists when a single firm is the sole producer of a product for which there are no
close substitutes. Examples are public utilities and professional sports leagues.
Characteristics
1. A single seller: the firm and industry are synonymous.
2. Unique product: no close substitutes for the firms product.
3. The firm is the price maker: the firm has considerable control over the price because it can
control the quantity supplied.
4. Entry or exit is blocked.
Barriers to Entry
Economies of scale is the major barrier. This occurs where the lowest unit cost and, therefore, low
unit prices for consumers depend on the existence of a small number of large firms, or in the case
of monopoly, only one firm. Because a very large firm with a large market share is most efficient,
new firms cannot afford to start up in industries with economies of scale. Public utilities are known
as natural monopolies because they have economies of scale in the extreme case. More than one
firm would be inefficient because the maze of pipes or wires that would result if there were
competition among water companies or cable companies. Legal barriers also exist in the form of
patents and licenses, such as radio and TV stations. Ownership or control of essential resources is
another barrier to entry, such as the professional sports leagues that control player contracts and
leases on major city stadiums. It has to be noted that barrier is rarely complete. Think about the
telephone companies a couple decades ago; there was no substitute for the telephone. Nowadays,
cellular phones are very popular. It creates a substitute for your house phone, causing the
traditional telephone companies to lose their monopoly position.
Demand Curve
Monopoly demand is the industry or market demand and is therefore downward sloping. Price will
exceed marginal revenue because the monopolist must lower price to boost sales and cannot price
discriminate in most cases. The added revenue will be the price of the last unit less the sum of the

Profit Maximizing Output &

Efficiency

Profit Maximizing Output:

The MR = MC rule will still tell the monopolist the profit maximizing output. The monopolist
cannot charge the highest price possible, it will maximize profit where TR minus TC is the greatest.
This depends on quantity sold as well as on price.
The monopolist can charge the price that consumers will pay for that output level. Therefore, the
price is on the demand curve. Losses can occur in monopoly, although the monopolist will not
persistently operate at loss in the long run.
Monopolies will sell at a smaller output and charge a higher price than would pure competitive
producers selling in the same market.
Income distribution is more unequal than it would be under a more competitive situation, unless
the government regulates the monopoly and prevents monopoly profits. If a monopoly creates
substantial economic inefficiency and appears to be long-lasting, antitrust laws could be used to
break up the monopoly.
Efficiency:
1. Productive efficiency: occurs where P= min ATC. Monopoly firms will not achieve productive
efficiency as firms will produce at an output which is less than the output of min ATC. X-inefficiency
may occur since there is no competitive pressure to produce at the minimum possible costs.
2. Allocative efficiency: occurs where P = MC. This efficiency is not achieved because price( what
product is worth to consumers) is above MC (opportunity cost of product).
It is possible that monopoly is more efficient than many small firms. Economies of scale (natural
monopoly) may make monopoly the most efficient market model in some industries. However, Xinefficiency and rent-seeking cost (lobbying, legal fees, etc.) can entail substantial costs, causing
inefficiency.

An Example

In this example, the cost function is the same as the

one used in the perfect competition example. You can
see from the following analysis that the output level
and market price are different in monopoly . The output
level is lower than output of the perfect competitive
firm; and price is higher than the price of perfect
competitive firm.

TP or Q

AFC

It is possible for this firm to continue earning this profit

in the long run as there are no competition in the

ATC

MC

0
1

60

45

105

45

30

42.5

72.5

40

20

40

60

35

15

37.5

52.5

30

12

37

49

35

10

37.5

47.5

40

8.57

38.57

47.14

45

7.5

40.63

48.13

55

6.67

43.33

50

65

10

46.5

52.5

75

Pd

By comparing the MR and MC unit by unit, we can find

this firm's output at:
Q = 4, and P= 63. This is the profit maximization
output level, with EP = 42.

AVC

Qd

TR

MR

EP

115

100

100

100

-5

83

166

66

21

71

213

47

33

63

252

39

42

55

275

23

30

48

288

13

42

294

-35.98

37

296

-89.04

33

297

-153

29

10

290

-7

-235

Price Discrimination
Price discrimination is selling a good or service at a number of
different prices, and the price differences is not justified by the cost
differences. In order to price discriminate, a monopoly must be able
to
1.be able to segregate the market
2.make sure that buyers cannot resell the original product or
services.
Perfect price discrimination is a price discrimination that extracts the
entire consumer surplus by charging the highest price that consumer
are willing to pay for each unit.
As a result, the demand curve becomes the MR curve for a perfect
price discriminator. Firms capture the entire consumer surplus and
maximize economic profit.

Monopolistic Competition
Monopolistic competition refers to a market situation with a relatively
large number of sellers offering similar but not identical products.
Examples are fast food restaurants and clothing stores.
Characteristics
1. A lot of firms: each has a small percentage of the total market.
2. Differentiated products: variety of the product makes this model
different from pure competition model. Product differentiated in style,
brand name, location, advertisement, packaging, pricing strategies,
etc.
3. Easy entry or exit.
Demand Curve
The firms demand curve is highly elastic, but not perfectly elastic. It
is more elastic than the monopolys demand curve because the seller
has many rivals producing close substitutes; it is less elastic than
pure competition, because the sellers product is differentiated from
its rivals.

Profit - Maximizing Output

The MR = MC rule will give the firms the profit maximizing output. The price they
charge would be on the demand curve.
In the long run, the situation will tend to be breaking even for firms. Firms can enter
the industry easily and will if the existing firms are making an economic profit. As
firms enter the industry, the demand curve facing by an individual firm shift down, as
buyers shift some demand to new firms until the firm just breaks even. If the demand
shifts below the break-even point, some firms will leave the industry in the long run.
Therefore, most monopolistic competitive firms should experience break-even in the
long run theoretically. In reality, some firms experience profit as they able to
distinguish themselves from the others and build a loyal customer base; such as
some name brand apparel companies. Some firms experience lost in long run but
may continue the business as they are still earning normal profit. These firm owners
usually like the flexible life style and willing to earn a normal profit that is lower than
their opportunity cost.
Price exceeds marginal cost in the long run, suggesting that society values additional
units which are not being produced. Average costs may also be higher than under
pure competition, due to advertising cost involved to attract customers from
competitors. The various types, styles, brands and quality of products offers
consumers choices. However, economic inefficiency is the result. The excess capacity
(producing at the quantity that a firm produces is less than the quantity at which ATC
is a minimum) exists in this industry.

Oligopoly
Oligopoly exits where few large firms producing a homogeneous or
differentiated product dominate a market. Examples are automobile
and gasoline industries.
Characteristics
1. Few large firms: each must consider its rivals reactions in
response to its decisions about prices, output, and advertising.
2. Standardized or differentiated products.
3. Entry is hard: economies of scale, huge capital investment may
be the barriers to enter.
Demand Curve
Facing competition or in tacit collusion, oligopolies believe that
rivals will match any price cuts and not follow their price rise. Firms
view their demands as inelastic for price cuts, and elastic for price
rise. Firms face kinked demand curves. This analysis explains the
fact that prices tend to be inflexible in some oligopolistic industries.

Efficiency & Advertisement

1. Productive efficiency: occurs where P= min ATC.
Monopolistic competitive firms will not achieve productive efficiency
as firms will produce at an output which is less than the output of
min ATC. Product differentiation is the major cause of excess
capacity.
2. Allocative efficiency: occurs where P = MC.
This efficiency is not achieved because price( what product is worth to
consumers) is above MC (opportunity cost of product).
Advertisement is very crucial for each firm in this market structure as
firms need exposure to get consumer's attention. However, too
much spending will result in higher cost, and lower profit. Price,
product attributes, and advertisement are three main factors that
producers have to consider. The perfect combination cannot be
forecasted easily.

Game Theory & Cartel

Game theory suggests that collusion is beneficial to the participating firms. Collusion reduces
uncertainty, increases profits, and may prohibit entry of new rivals.
Consider the following payoff matrix in which the numbers indicate the profit in millions of dollars
for a duopoly (GM and Ford) based on either a high-price or a low-price strategy. This example
illustrated that GM or Ford will earn the highest individual profit when each adopts low price
strategy while other firm continues with the higher price strategy (in B or C). But firms will earn the
highest total profit when both adopt the high price strategy (A). When firms form a cartel, they are
acting as one entity (A). They will perform as they are a large monopoly, earning the highest total
profit possible. However, members do have an incentive to cheat as individuals can increase their
own profits by cheating
in short run (B or C). WhenGM
other members are aware of the cheating, they
Duopoly
may carry out the same practice,
may result in a price war Low-price
and all members loss (D).
sometimes it High-price

Ford

High-price
Low-price

Profit Analysis

A:GM=$50MFord=$50M
C:GM=$20MFord=$60M

B:GM=$60MFord=$20M
D:GM=$30MFord=$30M

GM Profit
Earns$50M

FordProfit
Earns$50M

Total profit in the industry

$50+$50=$100M

B:GMlowerspriceandFordcontinueswith
highpricestrategy

Increasedto$60M

Droppedto$20M

$60+$20=$80M

C:FordlowerspriceandGMcontinueswith
highpricestrategy

Droppedto$20M

Increasedto$60M

$20+$60=$80M

D:Bothfirmsadoptlowpricestrategy

Earns$30M

Earns$30M

$30+$30=$60M

A:Bothfirmsadopthighpricestrategy

The Organization of Petroleum Exporting Countries (OPEC) is a cartel. The eleven countries
agreed on the output amount and working together to control the worlds crude oil supply. In US,
anti-trust law has set up guidelines for corporations to follow to avoid collusion of large firms in

Technological Development
Technological advance is a three-step process that shifts the economys production
possibilities curve outward enabling more production of goods and services.
1. Invention: is the discovery of a product or process and the proof that it will work.
2. Innovation: is the first successful commercial introduction of a new product, the
first use of a new method, or the creation of a new form of business enterprise.
3. Diffusion: is the spread of innovation through imitation or copying.
Expenditures on research and development (R&D) include direct efforts by business
toward invention, innovation, and diffusion. Government also engages in R&D,
particularly for national defense. Finding the optimal amount of R&D is an
application of basic economics: marginal benefit and marginal cost analysis.
Optimal R&D expenditures occur when the interest rate cost of funds is equal to the
expected rate of return.
Many projects may be affordable but not worthwhile because the marginal benefit is
less than marginal cost. Often the R&D spending decision is complex because the
estimation of future benefits is highly uncertain while costs are immediate and
more clear-cut.

The Role of Market

Structure
1. Pure competition: the small size of competitive firms and the fact hat
they earn zero economic profit in the long run leads to serious questions as
to whether such producers can finance substantial R&D programs. The
firms in this market structure would spend no significant amount. However,
firms of the same industry may gather their resources and develop R&D
programs.
2. Monopolistic competition: there is a strong profit incentive to engage
in product development in this market structure as the firms depend on
product differentiation to stand out from a large number of rivals. However,
most firms remain small which limits their ability to secure inexpensive
financing for R&D and any economic profits are usually temporary.
Therefore, spending on R&D is limited in this market structure.
3. Oligopoly: many of the characteristics of oligopoly are conducive to
technical advances including: their large size, ongoing economic profits, the
existence of barriers to entry and a large volume of sales. Firms in oligopoly
spent the highest amount on R&D among the four different market
structures.

Economic Efficiency
Economics is a science of efficiency in the use of scarce resources. Efficiency requires full
employment of available resources and full production. Full employment means all available
resources should be employed. Full production means that employed resources are providing
maximum satisfaction for our material wants. Full production implies two kinds of efficiency:
1. Allocative efficiency means that resources are used for producing the combination of goods
and services most wanted by society. For example, producing computers with word processors
rather than producing manual typewriters.
2. Productive efficiency means that least costly production techniques are used to produce
wanted goods and services.
Full efficiency means producing the "right" (Allocative efficiency) amount in the "right
"way (productive efficiency).
Pure competition:
Productive efficiency occurs where price is equal to minimum average total cost (min ATC); at
this point firms must use the lease-cost technology or they wont survive.
Under pure competition, this outcome will be achieved, as the long run equilibrium price of pure
competitive firms would be at the min ATC.
Allocative efficiency occurs where price is equal to marginal cost ( P=MC), because price is
societys measure of relative worth of a product at the margin or its marginal benefit. And the
marginal cost of producing product X measures the relative worth of the other goods that the
resources used in producing an extra unit of X could otherwise have produced. In short, price
measures the benefit that society gets from additional units of good X, and the marginal cost of
this unit of X measures the sacrifice or cost to society of other goods given up to produce more
of X.

Efficiency Cont.

Non-perfect competition:
Price of non-perfect competitive firms will exceed marginal cost, because price exceeds marginal
revenue and the firms produce where marginal revenue (MR) and marginal cost are equal. Then the
firms can charge the price that consumers will pay for that output level. Allocative efficiency is not
achieved because price (what product is worth to consumers) is above marginal cost (opportunity
cost of product). Ideally, output should expand to a level where P=MC, but this will occur only under
pure competitive conditions where P = MR. Productive efficiency is not achieved because the firms
output is less than the output at which average total cost is minimum.
Economies of scale (natural monopoly) may make monopoly the most efficient market model in
some industries. X-inefficiency, the inefficiency that occurs in the absence of fear of entry and
rivalry, may occur in monopoly since there is no competitive pressure to produce at the minimum
possible costs. Rent-seeking behavior often occurs as monopolies seek to acquire or maintain
government granted monopoly privileges. Such rent-seeking may entail substantial cost (lobbying,
legal fees, public relations advertising etc.) which are inefficient.
There are several policy options available when monopoly creates substantial economic
inefficiency:
1. Antitrust laws could be used to break up the monopoly if the monopolys inefficiency appears to
be long-lasting.
2. Society may choose to regulate its prices and operations if it is a natural monopoly.
3. Society may simply ignore it if the monopoly appears to be short-lived because of changing
conditions or technology.
Efficiency Vs technological advances:
Allocative efficiency is improved when technological advance involves a new product that increases
the utility consumers can obtain from their limited income. Process innovation can lower production
cost and improve productive efficiency. Innovation can create monopoly power through patents or
the advantages of being first, reducing the benefit to society from the innovation. Innovation can