Economics

The firm & Market Structures

Study Session 3

Reading No –9
Version 2022
Learning Outcome Statements
The candidate Should be able to:
• a. describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly;
• b. explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity
of demand under each market structure;
• c. describe a firm’s supply function under each market structure;
• d. describe and determine the optimal price and output for firms under each market structure;
• e. explain factors affecting long-run equilibrium under each market structure;
• f. describe pricing strategy under each market structure;
• g. describe the use and limitations of concentration measures in identifying market structure;
• h. identify the type of market structure within which a firm operates.

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Los a:Characteristics of Market Structure

Characteristics Perfect Competition Monopolistic Oligopoly Monopoly

Competition
Number of Sellers Many Many Few One
Degree of Product Homogenous Differentiated Homogenous Unique Product
Differentiation
Barriers to Entry Very Low Low High Very High
Pricing Power of firm None – Price Taker Some Some or Considerable Considerable – Price
Maker
Non-price Competition None Advertising and Product Advertising and Product Advertising
Differentiation Differentiation

Nature of substitute Very good substitutes Good substitutes but Very good substitutes or No good substitutes
products differentiated differentiated

Nature of competition Price only Price, marketing, Price, marketing, Advertising

features features
Los a :Perfect Competition: Examples

In the real world it is hard to find examples of industries which fit all the criteria of
‘perfect knowledge’ and ‘perfect information’. However, some industries are close.

Foreign exchange markets- Here currency is homogeneous and traders have access to
many different buyers and sellers. Additionally, there is information about relative
prices and so while purchasing currency it is easy to compare prices.

Agricultural markets- In some cases, there are several farmers selling identical
products to a number of buyers. Thus, it is easy to compare prices.

Internet related industries- The internet has made it very easy to compare prices,
quickly and efficiently (perfect information). Also, it has lowered the barriers to entry.

If we take our example of Richies Coffee: Mr. Abhishek Jain can order the furniture for
his shop from e-bay. This way he can compare the design, price and quality of various
vendors and place his order having perfect knowledge.
Los b:Price, MR, MC and Elasticity of Demand
Firm Industry

• Price is determined by demand and supply of the industry (diagram on right).

• This sets market equilibrium price of Pe.
• For example if “Chocó Cocoa”, a coffee supplying firm, operates under perfect competition, then it
maximises profit at Q1 where, MC = MR
• Since there are many plantations like Chocó Cocoa in the vicinity, Price elasticity of demand is very
high because the goods are homogenous and have many close substitutes.
• For a price taker: marginal revenue = price because all additional units are sold at the same
(market) price.
• The market demand curve is downward sloping as consumers buy more at lower price.
Los c:Supply Analysis

Firm - 1 Firm - 2 Industry Supply

P P P

Q Q Q

• Now, as price of coffee increases, Chocó Cocoa and the other firms increase supply of their products.
• Thus, the curve is upward sloping.
• Market supply curve is the sum of the supply curves of individual firms.
Los d,e:Profit Maximization in Short Run

MC: Short-Run
Marginal Cost ATC: Average Total
Cost
Cost

P B Firm’s demand = AR = MR
P1 A

QC Quantity

• In the short run, all the coffee suppliers can maximizes profit at QC where MR = MC.
• The economic profit is covered by the area enclosed in P1 P B A.
Los d,e:Profit Maximization in Long Run

MC: Long-Run ATC: Average Total

Marginal Cost Cost
Cost

Firm’s demand = AR = MR

QE Quantity

• All the coffee plantations operate at a point where MC = minimum of ATC.

• Entry into the coffee plantation business is no longer profitable at this point.
• At TR = TC there is zero economic profit. Profit maximization would be at MR = MC
Los d,e:Short- Run Loss

• The plantations will start experiencing economic losses when the price is below average total cost (P < ATC)
• Now, Chocó Cocoa has to decide whether to keep operating or not.
• The losses can be minimized in the short run if price is less than ATC but greater than AVC.
• If the firm is:
• Covering its variable costs and some of its fixed costs=> Loss < Fixed costs.
• Covering its variable costs => P =AVC => firm is operating at its shutdown point.
• Not covering its variable costs => P < AVC => Loss > Fixed costs.

MC
ATC
Price
AVC

MR = P
Economic
loss
Quantity
 Los d,e:Changes in Demand, Entry and Exit and Changes in Plant Size

• In the short run if the market demand function increases (shifts from left to right) from D1 to D2 then equilibrium price
and quantity also rise to P2 and Q2.
• Now, this increased market price has a positive effect on Chocó Cocoa as there is higher profit maximizing output. Thus,
in the short run the firm will earn an economic profit.
• In the long run, Chocó Cocoa decides to increase their scale of operations (plant/firm size increases) in response to the
increase in demand and new firms might want to enter the market.
• If the market demand function decreases then the case is vice versa.

MC = SR Firm Supply
SR Industry
Price Price
Supply
P2 P2 D2
P1 P1 D1
D2
D1
Quantity Quantity
Q1 Q2
Q1 Q2
Los d,e:Monopolistic Competition: Example: Force Motors

• Different car producers in India are all trying

to identify the combination of features that
best appeals to customers' tastes, cultivate a
reputation for quality, and hold down costs,
all at the same time - a very difficult
balancing act.
• With the rising standard of living and other
factors, the demand curve for the
automobile industry has become relatively
elastic.
• Additionally, if the price of your personal
favorite increases, you are not likely to
immediately switch to another brand.
Los d,e:Price, MR, Elasticity of Demand and Supply

Demand curve for each firm is

downward sloping due to product
differentiation.
Price Level

Pricing power allows sellers to lower

price below market equilibrium.

Ranges of prices within which

demand is elastic (usually inelastic at
lower prices).

MR D Supply curve not well-defined.

Quantity
Los d,e:Profit Maximization in Short Run

Force Motors can maximize profit or minimize loss output

at:

MR = MC

The firm’s total profit increases if an additional unit of

output adds more to revenue than it adds to cost.

As long as the marginal revenue of an additional unit

exceeds marginal cost, producing that unit increases the
firm’s total profit, and the firm should continue to
produce more.

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Los d,e:Profit Maximization in the Long Run

• Similar to perfect competition.

• Now new firms have entered the engine

manufacturing business due to low entry
costs.
• These provide more differentiated
products.

• Demand and MR curves shift leftwards

indicating a fall in demand due to
availability of more substitutes.

• Thus, firms make zero economic profit.

• Here the profit maximizing point is less than

that of perfect competition.

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Los d,e Oligopoly: Examples

• 90% of U.S. media outlets are owned by

six corporations: Walt Disney, Time
National mass media
Warner, CBS Corporation, Viacom, NBC
and news outlets:
Universal and Rupert Murdoch’s News
Corporation.
• Apple iOS and Google Android dominate
Operating systems for
Smartphone operating systems, while
Smartphones and
computer operating systems are
computers:
overshadowed by Apple and Windows.

The Indian aviation • The leading airlines in India being

industry: IndiGo, Air India and SpiceJet.

The music • Is dominated by Universal Music Group,

entertainment industry: Sony, BMG, Warner and EMI Group.
Los d,e :Price, MR, MC and Elasticity of Demand and Supply Analysis

• Demand curves in this structure, depend on the degree of pricing as there is

interdependence in the firms.

We describe 4 oligopoly models and

their implications for price and
quantity

Kinked demand curve Nash equilibrium model Stackelberg dominant

Cournot duopoly model
model (prisoner’s dilemma) firm model

• Similar to a monopolistic competition, oligopolist does not have a well defined supply
curve.
• Hence no clear way to determine optimal output levels and price independent of
demand conditions and competitor strategies
Los d,e : Kinked Demand Curve: Example: IndiGo Airlines

• The kink price is at P, where the firm produces Q. Now for

instance, IndiGo Airlines wants to raise its price above P, it
assumes that its competitors will remain at P and it will lose
market share due to higher prices.
• Thus, above P the demand curve is considered to be
relatively elastic.
• On the other hand, if it decreases its price below P, other
firms will match the price cut.
• Thus, Q is the profit- maximizing level of output.
• It is important to note that there is a gap in the associated
marginal revenue curve, when there is a kink in the demand
curve.
• For any firm with a marginal cost curve passing through this
gap , the price at which the kink is located is the firm’s profit
maximizing price.
• The disadvantage of this model is that it is incomplete
because what determines the market price (where the kink is
located) is outside the scope of the model.

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Los d,e : Cournot Model

• The model considers an oligopoly with only 2 firms competing (i.e., duopoly) and both of identical
and constant marginal costs of production. For example- IndiGo Airlines and Spice Jet Airways.

• Each firm determines its profit maximizing production level by assuming other firm’s output will
not change. In this case the number of flights per day.

• Firms determine their quantities simultaneously each period and these quantities will change each
period until they are equal.

• When each firm selects the same quantity, there is no longer any additional profit to be gained by
changing quantity, and we have a stable equilibrium.

• As more firms are added to the model, the equilibrium market price falls towards marginal cost

• Cournot’s model was an early version of “strategic games” decision models in which the best
choice for a firm depends on the actions (reactions) of other firms.
Los d,e : Nash Equilibrium

A Nash equilibrium is reached when the choices of all the firms are such that there is no other choice
that makes the firm better off (increases profits or decreases losses).

We can design a 2 firm oligopoly where the equilibrium outcome is for both firms to cheat on a
collusion agreement by charging a low price, even though the best overall outcome is for both to
honour the agreement and charge a high price.

The table below shows the Nash equilibrium when both firms cheat on the agreement:

Spice Jet (SJ) Honors Spice Jet (SJ) Cheats

IndiGo Airlines (IA) IA earns economic profit IA has economic loss
Honors SJ earns economic profit SJ earns increased economic profit

IndiGo Airlines (IA) IA earns increased economic profit IA earns zero economic profit
Cheats SJ has an economic loss SJ earns zero economic profit
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Los d,e : Profit Maximization in Short-Run and Long-Run

• Rationale: One dominant firm (example IndiGo Airlines) having a huge

cost advantage exists who acts like price maker with other firms acting
like price takers.

• Optimal price is determined where MR = MC.

• In long-run:

• Market share of IndiGo Airlines drops; new firms enter market

• New entrants adopt more efficient production techniques and manage

to lower costs

• IndiGo’s profitability drops

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Los d,e : Monopoly: Examples

Electric power
distribution

Zenith Fibres Ltd is the

only one to produce
"Polypropylene Staple
Fibre (PPSF) used as raw
material in 100% PP Yarn, Indian railways
and they are the only
manufacturer of this
product in India with
100% market share.
Los d,e : Price, MR, MC and Supply Analysis

• Monopolist’s demand curve represents aggregate

demand for the product in the relevant market.

• Demand curve is downward sloping indicating

negative relationship with price.

• Marginal revenue curve is steeper than demand

curve: increase in quantity requires lower price.

• Supply analysis is based on cost structure.

• Does not have well-defined supply function.

Los d,e : Profit Maximization in Short-run and Elasticity of Demand

• Monopolists are price searchers and have

imperfect information about market
demand.
• Thus, they must experiment with different
prices to find the one that maximizes profit.
• Profit maximization at MR= MC.
• Profit earned = TR (PE * QE ) – TC ( ACE * QE)
• Monopolist maximizes profit on elastic
portion of demand curve.
• Demand is elastic where MR = MC.
Los f:Price Discrimination

This is the practice of charging different consumers different prices for the
same product or service.

Example, different prices for airline tickets based on whether a Saturday-

night stay is involved.

For price discrimination to work, the seller must:

• Face a downward- sloping demand curve.

• Have at least 2 identifiable groups of customers with different price
elasticities of demand for the product.
• Be able to prevent the customers paying the lower price from reselling the
product to the customers paying the higher price.

As long as these conditions are met, firm profits can be increased through
price discrimination.
Los f:Effects of Price Discrimination on Output and Operating Profit
Price
• Assumption: no fixed costs & constant variable costs so Profit = $2,400
that MC = ATC.
• In figure 1, the single profit- maximizing price is $100 at a 100 DWL MC = ATC
quantity of 80 (where MC =MR), which generates a profit
of $2,400. 70
• In figure 2, the firm is able to separate consumers,
charges one group $110 and sells them 50 units, and sells D
an additional 60 units to another group (with more
elastic demand) at a price of $90. total profit is increased MR
to $3,200, and total output is increased from 80 units to Price
110 units. 80 $2,000 Quantity
• The quantity produced by a monopolist reduces the sum $1,200
of consumer and producer surplus by an amount 100
represented by the triangle labeled deadweight loss 90 DWL
(DWL). 70 MC = ATC
• DWL is smaller in the 2nd figure as the firm gains from
those customers who have inelastic demand while still
providing goods to customers with more elastic demand. D
This may even cause production to take place when it
would not otherwise.
50 110 190 Quantity
Los f: Natural Monopoly

• Natural monopolies arise due to

significant economies of scale
and declining cost structure.
• Three possible price and output
solutions
• Point A: Without regulation,
monopolist maximizes profit
where MR = MC.
• Point B: Like a perfect
competition, equilibrium occurs
where P = MC (where ATC
intersects D).
• Point C: Regulator sets price where
LRAC = AR(D).

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Los f: Profit Maximization in Long-Run

• Unregulated monopoly can produce economic profits

• To maintain market position in LR, monopoly must be protected by substantial and ongoing barriers to entry

• For regulated monopolies, variety of long-run solutions exist

• Set P = MC: But price might not be high enough to cover AC; solution provide a subsidy sufficient to compensate
firm

• National ownership of monopoly: unpopular if government starts to hike price once it has been fixed

• Establish a government entity to regulate an authorized monopoly: regulator sets P = LRAC, investors earn a
normal return for risk, challenge for regulator is determining risk-related return and monopolist’s LRAC

• Franchise monopoly through bidding war: is successful only if franchise is able to meet goal of pricing its
products at a level = LRAC
Los g: Uses and Limitations of Concentration Measures in
Identifying Market Structure
Econometric measures

• Involves estimating elasticity of demand and supply in a market

• If demand is elastic, market is a perfectly competitive one
• Problem of lack of reliable data and continuously changing elasticity

Simpler measures

• Concentration ratio: sum of market shares of largest N firms

• Always between 0 (perfect competition) and 100 (monopoly)

Advantage: easy to compute

Disadvantage: does not directly compute market power; tends to be affected by mergers among top
market incumbents
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Los f: Monopoly: Profit Maximization in Long-run

Simpler measures

Herfindahl-Hirschman index (HHI)

Market shares of top N firms are squared and then added

If one firm controls entire market, HHI = 1

If there are N firms in market with equal market share, HHI =

1/N, e.g. if HHI = 0.5, market share is shared by 2 firms

Disadvantage: does not take into account possibility of entry

and elasticity of demand

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Los g: Uses and Limitations of Concentration Measures in
identifying Market Structure
• Example: Calculate concentration ratio and HHI of top 3 firms in a market with 10 suppliers having a
market share of 20%, 15% and 12% respectively.

• Solution: Concentration ratio = 20 + 15 + 12 = 47%

• HHI = (0.20)2 + (0.15)2 + (0.12)2 = 0.04 + 0.0225 + 0.0144 = 0.0769

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PRACTICE PROBLEMS
1.A market structure characterized by many sellers with each having some pricing power and product
differentiation is best described as:
A)oligopoly.
B)perfect competition.
C)monopolistic competition

2. A market structure with relatively few sellers of a homogeneous or standardized product is best
described as:
A)oligopoly.
B)monopoly.
C)perfect competition

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PRACTICE PROBLEMS

3.Market competitors are least likely to use advertising as a tool of differentiation in an industry structure
identified as:
A)monopoly.
B)perfect competition.
C) monopolistic competition

4.Upsilon Natural Gas, Inc. is a monopoly enjoying very high barriers to entry. Its marginal cost is $40 and its
average cost is $70. A recent market study has determined the price elasticity of demand is 1.5. The
company will most likely set its price at:
A)$40.
B)$70.
C)$120

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PRACTICE PROBLEMS

5. Companies most likely have a well-defined supply function when the market structure is:
A. oligopoly.
B. perfect competition.
C. monopolistic competition.

6. Aquarius, Inc. is the dominant company and the price leader in its market. One of the other companies in
the market attempts to gain market share by undercutting the price set by Aquarius. The market share of
Aquarius will most likely:
A. increase.
B. decrease.
C. stay the same.

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SOLUTION

1. C is correct. Monopolistic competition is characterized by many sellers, differentiated products, and

some pricing power.
2. A is correct. Few sellers of a homogeneous or standardized product characterizes an oligopoly.
3. B is correct. The product produced in a perfectly competitive market cannot be differentiated by
advertising or any other means.
4. C is correct. Profits are maximized when MR = MC. For a monopoly, MR = P[1 – 1/Ep]. Setting this equal
to MC and solving for P: $40 = P[1 – (1/1.5)] = P × 0.333 P = $120
5. B is correct. A company in a perfectly competitive market must accept whatever price the market
dictates. The marginal cost schedule of a company in a perfectly competitive market determines its
supply function.
6. A is correct. As prices decrease, smaller companies will leave the market rather than sell below cost.
The market share of Aquarius, the price leader, will increase.

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