Microeconomics: Chapter 7 & 8

MARKET STRUCTURE

 Definition of a Firm
– A firm is an institution that buys or hires factors of production and organizes them to
produce and sell goods and services.
– A firm is an independent unit of producing goods and services for sale.
 Objectives of a Firm
– The main goal or objective of a firm is to maximize profit and to minimize the cost.

Economic Profit
Economic profit is defined as the total revenue minus the implicit and explicit cost.
• Consider both explicit and implicit cost
pEC= TR – [Explicit Cost + Implicit Cost]

Accounting Profit
Accounting profit is defined as the firm’s total revenue minus the explicit cost.
• Consider only explicit cost
pAC = TR – Explicit Cost

Equilibrium of a Firm
Definition
A firm is in equilibrium when it earns maximum profits or incurs minimum losses.

Assumptions
1. A rational firm
2. Production of one product
3. Least cost combination

Method to determine the equilibrium:

1. Total approach
2. Marginal Approach

TOTAL APPROACH

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 MARGINAL APPROACH

MARKET STRUCTURE
 Definition of a Market
– An arrangement that facilitates buying and selling of a good, service, factor of production
or future commitment.
OR
– A market is a place where the buyers and sellers meet with one another and involves
transaction.

 Definition of a Market Structure

– Market structure refers to the number and distribution size of buyers and sellers in the
market of a good and service.
– Market structure is an indication of the number of buyers and sellers; their market shares;
the degree of product standardization and the ease of market entry and exit.

TYPES OF MARKET STRUCTURE

PERFECT COMPETITION
There are large numbers of buyers and sellers, buying and selling identical product without any restriction
on entry and exit, and having perfect knowledge of the market at a time.

MONOPOLY
There is a single seller and a large number of buyers; selling products that has no close substitution and
has a high entry and exit barrier.

MONOPOLISTIC COMPETITION
There are large numbers of sellers, large number of buyers; selling differentiated products due to branding
and labelling and there are no barriers to entry and exit.

OLIGOPOLY
There are only a few firms in the industry but a large number of buyers; products can be either identical
or differentiated, and there are barriers to entry and exit.

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 PERFECT COMPETITION

Characteristic:
1. Large number of buyers and sellers – no one can influence the price ( price taker)

2. Homogeneous product – consumer cannot differentiate the product in term of quality, packaging,
color or design.

3. Free entry and exit – can easily enter into the market and exit at any time.

4. Non-price competition – compete using advertising, free gifts, discount and promotion. cannot
compete using pricing strategies.

5. Perfect knowledge of the market – seller cannot influence buyers and buyers cannot influence
sellers.

6. Perfect mobility of factors of production. – Easily move from one occupation to another.

7. Absence of transport cost.-it is assuming that various firm work closely with each other.

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SHORT RUN EQUILIBRIUM

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SHUT –DOWN POINT

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LONG-RUN EQUILIBRIUM
1. Effect of entry

2. Effect of exit

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 MONOPOLY

Characteristics:
1. One seller and large number of buyers – the monopolist is a firm as well as an industry by itself
2. No close substitution – monopoly firm would sell a product which has no close substitute
3. Price maker – monopolist is a price maker since there is one seller or producer and it has the
market power to control over the price
4. Restriction of entry of new firms – barrier to entry
5. Advertising – advertising in monopoly market depends on the products sold

 Barriers to Entry
– Barriers to entry refer to restriction that prevents other sellers from entering into a market
1. Control over raw material – a monopoly status can also be maintained through control over the
supply of raw material
2. Patent and Copyright – a patent is an exclusive right to the production of an innovative
product. A copyright is an exclusive right to the author of a book or composer of a music or
producer of a movie
3. Cost of establishing an efficient plant – natural monopoly exists when one firm can meet the
entire market demand with lower price compared to two or more firms
4. Government Franchises – the government will give exclusive rights to a firm to sell a certain
goods and services in a certain area

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SHORT-RUN EQUILIBRIUM:

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LONG RUN EQUILIBRIUM

PRICE DISCRIMINATION
 Definition
– Price discrimination refers to the selling or charging of different prices by a firm to
different buyers for the same product.
 Necessary Conditions
– Existence of monopoly power – price discrimination can occur only if monopoly power
exists and there are no competitors in the market 
– Existence of different markets for the same commodity – a firm should be able to
separate customers according to price elasticity of demand
– Existence of different degree of elasticity of demand – monopolist can charge higher
price for inelastic market and lower price for elastic market
– Cost of separating market must be low
– No resale – product purchased in the low-priced market should not be resold in the high-
priced market
– Legal sanction – government allows the public utility firms such as electricity to charge
different prices from different consumers

 First-degree Price Discrimination

– Occurs when a firm charges each consumer the maximum price that he or she is willing
to pay for each unit.
– This price discrimination is also known as perfect price discrimination.
– The best example for first-degree price discrimination is auction.

 Second-degree Price Discrimination

– Occurs when the products are grouped into blocks and each block is charged at a
different price.
– This type of price discrimination is charged by public utilities such as electricity charges,
water charges, telephone charges and others.

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 Third-Degree Price Discrimination
– Under this price discrimination, the markets are divided into many submarkets or
subgroups.
– Each group is considered as a different market.
– The price charged on products depends on the price elasticity of demand.
– An example of third-degree price discrimination is the movie ticket where the adults are
charged higher price and children are charged at lower price.
– Other examples are transportation (air, railways, bus or LRT), medical, legal and
entertainment.

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 MONOPOLISTIC COMPETITION

 Characteristics
– Large number of and sellers – there is a large number of sellers under the monopolistic
competition and no individual firm can influence the market price. However, each firm
follows an independent price-output policy.
– Differentiated products – product differentiation could be through packaging, design,
labelling, advertising and brand name.
– Free of entry and exit into the market – not as easy as perfect competition because of
the existence of product differentiation.
– Role of non-price competition is significant – various methods used to attract the
customers to buy a particular brand.
– Selling cost – different types of expenditure on advertisement would incur additional
cost.

Pr
ic
e

A
substitutes.
R
are many firms and many
M=
monopolistic competition there
RP Q
monopolist firm because in
ua
than demand curve for
nt
competitive firm is more elastic
it
Demand curve for monopolistic
y

The demand curve for monopolistic competitive firm is downward sloping due to product
differentiation.

SHORT RUN EQUILIBRIUM

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LONG RUN EQUILIBRIUM

OLIGOPOLY

 Characteristics
– Few numbers of firms – the number of firms is small but size of the firms is large.
– Homogeneous or differentiated product
– Mutual interdependence – firms in an oligopoly market always consider the reaction of
their rivals when choosing price, sales target, advertising budgets and other business
policies
– Barriers to entry – restrict new entrants into the market through various types of barriers
to entry such as control of certain resources, ownership of patent and copyright, exclusive
financial requirements and other legal barriers.

 Price Rigidity and Kinked Demand Curve

– Since there is mutual interdependence between oligopoly firms, the prices in the market
are more stable. This is called price rigidity in oligopoly market.
– The price rigidity explains the behaviour of an oligopoly firm that has no incentive to
increase or decrease the price.
– The theory of the kinked demand curve is based on two assumptions.

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 1. First assumption: If an oligopolist reduces its price, its rivals will follow and cut their
prices to prevent losing the customers.
2. Second assumption: If an oligopolist increases its price, its rivals do not increase the price
and keep their prices the same, thereby they gain customers from the firm that increases the
price.

• Barometric price leadership

– One firm will be the first to announce price change. This firm does not
dominate the industry.
– Its price will be followed by others.
 Cartel
– A cartel is a group of firms whose objective is to limit the scope of competitiveness in the
market.
– Cartel arises because firms want to eliminate uncertainty and improve profits by
stabilizing market shares and prices, reducing competitiveness and eliminating
promotional cost.
– The most famous cartel is Organization of Petroleum Exporting Countries (OPEC).

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  Price Leadership
– Price leadership means the pricing strategy in which the firms in an oligopolistic industry
follow the price set by the leading firm.
– Price leadership is one form of collusion under oligopoly.
– There is no formal or tacit agreement.
– There are two types of price leadership:
• Dominant price leadership
– The dominant price leadership firm may be the largest firm that
dominates the overall industry.
– The dominant price leader firm can act as a monopoly where it sets its
price to maximize profits; other firms will set their prices at the same
level.

– Cartel agreement is an arrangement among the oligopoly firms to cooperate with one
another to act together as a monopoly.
– An ideal cartel will be powerful to establish monopoly price and earns supernormal
profits.
– Profits are divided among firms based on their individual level of production.
– Each firm sells at different quantities and obtains different profits depending on the level
of AC at the point of production.

 Non-price Competition
– Non-price competition is the means for growing market share and profitability in the face
of new rivals through advertising, marketing, after sales service, free gift and others.
– The difference with price cuts by oligopoly firm and non-price competition.
– Opting for price cut – If a firm reduces a price of a product, it can attract customers, and
establish in the industry.
• Reactions of competitors – the reaction from rivals are quick by reducing their
prices. There is a risk of price war if the price reduction continues. However,
customers are better off.

– Opting for non-price competition – This strategy will attract more customers to the firm.
• Reactions of competitors – the reaction from rivals toward non-price competition
is slow and less direct. The firms will gain more advantages if it practices non-
price competition because product variation, improvements in quality and
successful advertising techniques cannot be duplicated so easily. Some
consumers are more attracted to the advertisement and quality of the product
compared to price.

Perfect Monopolistic
Characteristics Monopoly Oligopoly
competition competition
Number of sellers Large One Many Few
Unique or no
Identical or Homogenous or
Type of product close Differentiated
homogenous differentiated
substitution
Entry condition Very easy Impossible Easy Difficult
Control over price None Some Some Considerable

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 Local phone
Automobiles,
Examples Wheat, corn service, Food, clothing
cigarettes
electricity
Profit maximization MR = MC MR = MC MR = MC MR = MC

Subnormal, Subnormal, Subnormal, Subnormal,

Short run
supernormal or supernormal or supernormal or supernormal or
equilibrium
normal profit normal profit normal profit normal profit

Supernormal
Supernormal Normal profit due
Long run Normal profit due to profit because
profit because of to free entry and
equilibrium free entry and exit of barriers to
barriers to entry exit
entry
Production
efficiency (at Yes No No No
minimum AC)
S/run: AR<AVC S/run AR<AVC S/run: AR<AVC S/run: AR<AVC
Shut down
L/run: AR< AC L/run: AR< AC L/run: AR< AC L/run: AR< AC

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