Market Structures

The Degree of Competition
• Classifying markets
– number of firms – freedom of entry to industry – nature of product – nature of demand curve

• The four market structures
– perfect competition – monopoly – monopolistic competition – oligopoly

Features of the four market structures

Features of the four market structures

Features of the four market structures

Features of the four market structures

Features of the four market structures

Features of the four market structures

The Degree of Competition
• Classifying markets
– number of firms – freedom of entry to industry – nature of product – nature of demand curve

• The four market structures
– perfect competition – monopoly – monopolistic competition – oligopoly

• Structure → conduct → performance

Perfect Competition
• Assumptions
– firms are price takers – freedom of entry – identical products – perfect knowledge

• Short-run equilibrium of the firm
– price, output and profit

Short-run equilibrium of industry and firm under perfect competition
P
S

£

MC

AC

Pe

AR AC

D = AR = MR

D O Q (millions) O Qe Q (thousands)

(a) Industry

(b) Firm

Loss minimising under perfect competition
P
S

£

MC

AC

AC P1 AR1

D1 = AR1 = MR1

D O Q (millions) O Qe Q (thousands)

(a) Industry

(b) Firm

Perfect Competition
• Assumptions
– firms are price takers – freedom of entry – identical products – perfect knowledge

• Short-run equilibrium of the firm
– price, output and profit

• The short-run supply curve of the firm

Deriving the short-run supply curve

P
P1 P2 P3

S

£
a b c D1

MC = S D1 = MR1 D2 = MR2 D3 = MR3

D3 O Q (millions)

D2 O

Q (thousands)

(a) Industry

(b) Firm

Perfect Competition
• Long-run equilibrium of the firm
– all supernormal profits competed away – LRAC = AC = MC = MR = AR

Long-run equilibrium under perfect competition
Profits return Supernormal profits New firms enter to normal
P
S1 Se LRAC P1 PL AR1 ARL D O Q (millions) O QL Q (thousands) D1 DL

£

(a) Industry

(b) Firm

Long-run equilibrium of the firm under perfect competition
£ (SR)MC (SR)AC

LRAC

DL AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

O

Q

Perfect Competition
• Incompatibility of economies of scale with perfect competition • Benefits of perfect competition
– price equals marginal cost – prices kept low – firms must be efficient to survive

Monopoly
• Defining monopoly • Barriers to entry
– economies of scale – economies of scope – product differentiation and brand loyalty – lower costs for an established firm – ownership/control of key factors – ownership/control over outlets – legal protection – mergers and takeovers – aggressive tactics – intimidation

Monopoly
• The monopolist’s demand curve
– downward sloping – MR below AR

• Equilibrium price and output
– Equilibrium output, where MC = MR

Profit maximising under monopoly
£

MC

MR
O

Qm

Q

Monopoly
• The monopolist’s demand curve
– downward sloping – MR below AR

• Equilibrium price and output
– Equilibrium output, where MC = MR – Equilibrium price, found from demand curve

Profit maximising under monopoly
£

MC AC

AR

AC

AR MR
O

Qm

Q

Monopoly
• The monopolist’s demand curve
– downward sloping – MR below AR

• Equilibrium price and output
– Equilibrium output, where MC = MR – Equilibrium price, found from demand curve

• Profit
– Measuring profit

Profit maximising under monopoly
£

MC Total profit AC

AR

AC

AR MR
O

Qm

Q

Monopoly
• The monopolist’s demand curve
– downward sloping – MR below AR

• Equilibrium price and output
– Equilibrium output, where MC = MR – Equilibrium price, found from demand curve

• Profit
– Measuring profit – Supernormal profit can persist in long run

Monopoly
• Disadvantages of monopoly
– high prices / low output: short run

Equilibrium of industry under perfect competition and monopoly: with the same MC curve
£

MC

Monopoly
P1

AR = D

MR
O
Q1

Q

Equilibrium of industry under perfect competition and monopoly: with the same MC curve
£

MC ( = supply under
perfect competition)

P1 P2

Comparison with Perfect competition

AR = D

MR
O
Q1 Q2

Q

Monopoly
• Disadvantages of monopoly
– high prices / low output: short run – high prices / low output: long run

Monopoly
• Disadvantages of monopoly
– high prices / low output: short run – high prices / low output: long run – lack of incentive to innovate

Monopoly
• Disadvantages of monopoly
– high prices / low output: short run – high prices / low output: long run – lack of incentive to innovate – X-inefficiency

Monopoly
• Disadvantages of monopoly
– high prices / low output: short run – high prices / low output: long run – lack of incentive to innovate – X-inefficiency

• Advantages of monopoly

Monopoly
• Disadvantages of monopoly
– high prices / low output: short run – high prices / low output: long run – lack of incentive to innovate – X-inefficiency

• Advantages of monopoly
– economies of scale

Equilibrium of industry under perfect competition and monopoly: with different MC curves
£

MCmonopoly

P1

AR = D MR
O Q1 Q

Equilibrium of industry under perfect competition and monopoly: with different MC curves
£

MC ( = supply)perfect competition MCmonopoly

P2 P1 P3

x

AR = D MR
O Q2 Q1 Q3 Q

Monopoly
• Disadvantages of monopoly
– high prices / low output: short run – high prices / low output: long run – lack of incentive to innovate – X-inefficiency

• Advantages of monopoly
– economies of scale – profits can be used for investment

Monopoly
• Disadvantages of monopoly
– high prices / low output: short run – high prices / low output: long run – lack of incentive to innovate – X-inefficiency

• Advantages of monopoly
– economies of scale – profits can be used for investment – high profits encourage risk taking

Monopoly
• Contestable markets
– importance of potential competition – a perfectly contestable market – contestable markets and natural monopolies – importance of costless exit

• Contestable markets and the public interest

Monopolistic Competition
• Assumptions of monopolistic competition • Equilibrium of the firm
– short run

Short-run equilibrium of the firm under monopolistic competition
£

MC AC

Ps ACs

AR = D MR
O
Qs

Q

Monopolistic Competition
• Assumptions of monopolistic competition • Equilibrium of the firm
– short run – long run

Long-run equilibrium of the firm under monopolistic competition
£

LRMC LRAC
PL

ARL = DL MRL
O
QL

Q

Monopolistic Competition
• Assumptions of monopolistic competition • Equilibrium of the firm
– short run – long run – underutilisation of capacity in the long run

Long run equilibrium of the firm under perfect and monopolistic competition
£

LRAC P1 P2 DL under perfect
competition

DL under monopolistic
competition O

Q1

Q2

Q

Monopolistic Competition
• Assumptions of monopolistic competition • Equilibrium of the firm
– short run – long run – underutilisation of capacity in the long run

• Non-price competition

Monopolistic Competition
• Assumptions of monopolistic competition • Equilibrium of the firm
– short run – long run – underutilisation of capacity in the long run

• Non-price competition • The public interest

Monopolistic Competition
• Assumptions of monopolistic competition • Equilibrium of the firm
– short run – long run – underutilisation of capacity in the long run

• Non-price competition • The public interest
– comparison with perfect competition

Monopolistic Competition
• Assumptions of monopolistic competition • Equilibrium of the firm
– short run – long run – underutilisation of capacity in the long run

• Non-price competition • The public interest
– comparison with perfect competition – comparison with monopoly

Oligopoly
• Key features of oligopoly
– barriers to entry – interdependence of firms

• Competition versus collusion • Collusive oligopoly: cartels
– equilibrium of the industry

Profit-maximising cartel
£

Industry D = AR
O Q

Profit-maximising cartel
£

Industry MC P1

Industry D = AR Industry MR
O

Q1

Q

Oligopoly
• Key features of oligopoly
– barriers to entry – interdependence of firms

• Competition versus collusion • Collusive oligopoly: cartels
– equilibrium of the industry – allocating and enforcing quotas

$ per barrel 35 30 25 20 15 10 5 0 70 72 74 76

Oil prices
Iraq invades Iran OPEC’s first quotas Iraq invades Kuwait

Actual price
Impending war with Iraq

Revolution in Iran First oil from North Sea

World-wide recovery

World-wide slowdown Cease-fire in Iran-Iraq war Yom Kippur War: Arab oil embargo New OPEC quotas Recession in Far East

78

80

82

84

86

88

90

92

94

96

98

00

02

$ per barrel 35 30 25 20 15 10 5 0 70 72 74 76

Oil prices
Iraq invades Iran OPEC’s first quotas

Actual price Cost in 1973 prices
Impending war with Iraq

Revolution in Iran First oil from North Sea

Iraq invades Kuwait

World-wide recovery

World-wide slowdown Cease-fire in Iran-Iraq war Yom Kippur War: Arab oil embargo New OPEC quotas Recession in Far East

78

80

82

84

86

88

90

92

94

96

98

00

02

Oligopoly
• Tacit collusion
– price leadership: dominant firm

Price leader aiming to maximise profits for a given market share
£

Assume constant market share for leader

AR = D market

AR = D leader MR leader
O Q

Price leader aiming to maximise profits for a given market share
£

MC

PL

l

t
AR = D market

AR = D leader MR leader
O

QL

QT

Q

Oligopoly
• Tacit collusion
– price leadership: dominant firm – price leadership: barometric

Oligopoly
• Tacit collusion
– price leadership: dominant firm – price leadership: barometric – rules of thumb

Oligopoly
• Factors favouring collusion
– Few firms – Open with each other – Similar production methods and average costs – Similar products – Dominant firm – Significant entry barriers – Stable market – No government measures to curb collusion

Oligopoly
• The breakdown of collusion • Non-collusive oligopoly: game theory
– alternative strategies
• maximax and maximin

– simple dominant strategy games

Profits for firms A and B at different prices

X’s price
£2.00 £1.80

A
£2.00 £10m each

B
£5m for Y £12m for X

Y’s price
£1.80

C
£12m for Y £5m for X

D
£8m each

Oligopoly
• The breakdown of collusion • Non-collusive oligopoly: game theory
– alternative strategies
• maximax and maximin

– simple dominant strategy games
• Nash equilibrium

Profits for firms A and B at different prices

X’s price
£2.00 £1.80

A
£2.00 £10m each

B
£5m for Y £12m for X

Y’s price
£1.80

C
£12m for Y £5m for X

D
£8m each

Oligopoly
• The breakdown of collusion • Non-collusive oligopoly: game theory
– alternative strategies
• maximax and maximin

– simple dominant strategy games
• Nash equilibrium • the prisoners’ dilemma

The prisoners' dilemma
Amanda's alternatives
Not confess Not confess Confess

A
Each gets 1 year

B

Nigel's alternatives C Nigel gets
Confess
3 months Amanda gets 10 years

Nigel gets 10 years Amanda gets 3 months Each gets 3 years

D

Oligopoly
• The breakdown of collusion • Non-collusive oligopoly: game theory
– alternative strategies
• maximax and maximin

– simple dominant strategy games
• the prisoners’ dilemma • Nash equilibrium

– more complex non-dominant strategy games

Oligopoly
• The breakdown of collusion • Non-collusive oligopoly: game theory
– alternative strategies
• maximax and maximin

– simple dominant strategy games
• the prisoners’ dilemma • Nash equilibrium

– more complex non-dominant strategy games – the importance of threats and promises

Oligopoly
• The breakdown of collusion • Non-collusive oligopoly: game theory
– alternative strategies
• maximax and maximin

– simple dominant strategy games
• the prisoners’ dilemma • Nash equilibrium

– more complex non-dominant strategy games – the importance of threats and promises – the importance of timing of decisions

Oligopoly
• The breakdown of collusion • Non-collusive oligopoly: game theory
– alternative strategies
• maximax and maximin

– simple dominant strategy games
• the prisoners’ dilemma • Nash equilibrium

– more complex non-dominant strategy games – the importance of threats and promises – the importance of timing of decisions
• decision trees

A decision tree
r ate

Airbus 00 se 5 decides
te r

Boeing –£10m (1) Airbus –£10m

B1

400

sea

Boeing decides A

50 0

40

se a

ter

Boeing +£30m (2) Airbus +£50m

0s

ea

te

r

s 00 5

e

r ate

Boeing +£50m (3) Airbus +£30m

B2

Airbus decides

400

sea

ter

Boeing –£10m (4) Airbus –£10m

Oligopoly
• Non-collusive oligopoly: the kinked demand curve theory
– assumptions of the model

Kinked demand for a firm under oligopoly
£

P1

Current price and quantity give one point on demand curve

O

Q1

Q

Kinked demand for a firm under oligopoly
£

D
P1

D
O Q1

Q

Oligopoly
• Non-collusive oligopoly: the kinked demand curve theory
– assumptions of the model – stable prices

Stable price under conditions of a kinked demand curve
£

MC2
P1

MC1

a b
O Q1

D = AR
Q

MR

Oligopoly
• Non-collusive oligopoly: the kinked demand curve theory
– assumptions of the model – stable prices – limitations of the model

Oligopoly
• Non-collusive oligopoly: the kinked demand curve theory
– assumptions of the model – stable prices – limitations of the model

• Oligopoly and the public interest

Oligopoly
• Non-collusive oligopoly: the kinked demand curve theory
– assumptions of the model – stable prices – limitations of the model

• Oligopoly and the public interest
– advantages

Oligopoly
• Non-collusive oligopoly: the kinked demand curve theory
– assumptions of the model – stable prices – limitations of the model

• Oligopoly and the public interest
– advantages – disadvantages

Oligopoly
• Non-collusive oligopoly: the kinked demand curve theory
– assumptions of the model – stable prices – limitations of the model

• Oligopoly and the public interest
– advantages – disadvantages – difficulties in drawing general conclusions

Price Discrimination
• Meaning of price discrimination
– First degree – Second degree – Third degree (the most common form)

Third-degree price discrimination
P

Revenue from a single price

P1

D
Q

O

200

Third-degree price discrimination
P

P2 P1

Increased revenue from price discrimination A higher discriminatory price is now introduced

D
Q

O

150

200

Price Discrimination
• Meaning of price discrimination
– First degree – Second degree – Third degree (the most common form)

• Conditions necessary for price discrimination

Price Discrimination
• Meaning of price discrimination
– First degree – Second degree – Third degree (the most common form)

• Conditions necessary for price discrimination • Advantages to the firm

Price Discrimination
• Profit maximising prices and output under price discrimination

Profit-maximising output under third degree price discrimination

DX O MRX O O

(a) Market X

Profit-maximising output under third degree price discrimination

DY DX O MRX O MRY O

(a) Market X

(b) Market Y

Profit-maximising output under third degree price discrimination

DY DX O MRX O MRY O MRT

(a) Market X

(b) Market Y

(c) Total (markets X + Y)

Profit-maximising output under third degree price discrimination
MC

DY DX O MRX O MRY O MRT

(a) Market X

(b) Market Y

(c) Total (markets X + Y)

Profit-maximising output under third degree price discrimination
MC

DY DX O MRX O MRY O 3000 MRT

(a) Market X

(b) Market Y

(c) Total (markets X + Y)

Profit-maximising output under third degree price discrimination
MC

5 DX O MRX O

DY MRY O 3000 MRT

(a) Market X

(b) Market Y

(c) Total (markets X + Y)

Profit-maximising output under third degree price discrimination
MC

5 DX O 1000 O MRX

DY MRY O 3000 MRT

(a) Market X

(b) Market Y

(c) Total (markets X + Y)

Profit-maximising output under third degree price discrimination
MC

5 DX O 1000 O MRX 2000

DY MRY O 3000 MRT

(a) Market X

(b) Market Y

(c) Total (markets X + Y)

Profit-maximising output under third degree price discrimination
MC 9 5 DX O 1000 O MRX 2000 DY MRY O 3000 MRT

(a) Market X

(b) Market Y

(c) Total (markets X + Y)

Profit-maximising output under third degree price discrimination
MC 9 5 DX O 1000 O MRX 2000

7 DY MRY O 3000 MRT

(a) Market X

(b) Market Y

(c) Total (markets X + Y)

Price Discrimination
• Profit maximising prices and output under price discrimination • Price discrimination and the public interest
– competition

Price Discrimination
• Profit maximising prices and output under price discrimination • Price discrimination and the public interest
– competition – profits

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