5.

Factors affecting long-run equilibrium under each market structure

Perfectly Competitive Markets

If firms under perfectly competitive markets start earning higher profits, more entrepreneurs
will be attracted to such business ventures. As a result, production will increase. This translates
to an increase in the aggregate supply. Consequently, the supply curve will shift outwards the
right. When the supply curve shifts to the right, the equilibrium price will fall to the same
demand curve.

In the long run, all firms will operate at a point where marginal cost (MC) intersects at the
lowest level on the average total cost (ATC) curve. This means that new firms entering the
market won’t post profits at this point from an economic profit standpoint because total
revenue equals total cost. In the long run, perfectly competitive markets operate at practically
zero economic profit. Also, note that the demand curve at this point is perfectly elastic. This
elasticity is represented by a horizontal line.

Monopolistic Competitive Market

As firms under this market structure start reporting higher profits, more firms will venture into
the market. Since entrant prices are low, customers will shift to buying products from these
new firms. This will reduce the demand for firms that produce similar goods.

As a result, the economic profits realized by monopolistically competitive firms will fall. Further,
firms will incur advertising costs for product differentiation. This can be seen from consumer
products such as clothing, in which advertising costs are quite high. For example, large sporting
brands pay lucrative contracts to professional sports personalities to differentiate themselves
from the competition.

Oligopoly Markets

In the long run, there is a possibility for economic profits in oligopoly markets. However, the
market share of a dominant firm will decline in the long run. As is always the case, profits will
attract more firms to enter the oligopoly market.

Marginal costs incurred by entrant firms fall. Likewise, the profitability of the dominant firm
declines. The reactions of entrant firms are included in the optimal pricing strategy.

Some firms may decide to incorporate innovation as a way of maintaining market leadership.
For example, Shell’s gasoline is said to clean the engine valves and fuel injectors. However,
these innovations are usually not very effective at maintaining the market share of the
dominant firm.

Monopolistic Markets
Monopolies can make economic profits even in the long-run. This is because the long-run
equilibrium creates room for every input to change. A monopoly must be protected by entry
barriers.

For monopolies that are regulated, there exist a number of solutions to long-run equilibrium.
Below are a few examples of the solutions.

Setting the price to be equal to the marginal cost, just like in perfectly competitive markets.
The monopoly can be owned by a nation (country, state, province, etc.). The economic profit
can then be used to finance social programs such as health services.
Tasking a governmental entity with the responsibility of regulating an authorized monopoly.
This can be seen in Canada with regulatory bodies overseeing state-owned energy producers.
Franchise-bidding for natural monopolies.

Source: https://analystprep.com/cfa-level-1-exam/economics/factors-affecting-long-run-
equilibrium-under-each-market-structure/
6. Pricing strategy under each market structure

Perfectly Competitive Market Pricing Strategy

This is determined by the market demand and supply curves of the product under discussion.
The demand curve clearly indicates the total amount of a product that consumers are both
willing and able to buy. On the other hand, the supply curve indicates the amount of a product
that suppliers are willing and able to supply at certain market prices.

Suppliers can only supply what the consumers can consume at given prices. In a perfectly
competitive market structure, the market sets the price and firms are merely price takers and
therefore operate for as long as production costs fall below revenue.

Monopolistic Competitive Market Pricing Strategy

In a monopolistic competitive market, companies set prices for their products. Since every
company sells a product that might be the same as that of another company, each company
can successfully set its prices. However, these prices will be dependent on the quantity they
desire to produce. Since there are many producers, this will not affect the market as a whole.

A company will use branding, advertising, and packaging to sell seemingly different products.
Consequently, there exist many prices in the market due to differentiated products.

Also, since there are many competitors, a firm won’t be affected by another firm’s strategy. As
a result, companies will have control over their own prices.

Oligopolistic Competition Market Pricing Strategy

Here, prices are determined by competitors. Firms in this market structure are highly
dependent on one another when setting prices. With only a few sellers in an oligopoly, a
company can affect the market prices but cannot control the whole market. As a result,
competition is based on product differentiation and services, but not on price wars.

Generally, an optimal pricing strategy, in the long run, incorporates the reactions of rival firms
to changes in prices effected by competitors.

Monopoly Market Structure

The pricing strategy here is relatively simple. A monopoly can comfortably set prices due to the
absence of competitors. However, monopolists are careful not to set their prices too high and
consequently attract competitors or excite a change of consumer behavior or consumption
habits, if you may, in favor of substitute products. Besides, raising prices may also lead to a fall
in sales since prices depend on demand.
Source: https://analystprep.com/cfa-level-1-exam/economics/describe-pricing-strategy-under-
each-market-structure/#:~:text=Pricing%20strategy%20can%20be%20described,structure
%20in%20which%20they%20operate.

7. Use and limitations of concentration measures in identifying market structure

Concentration Ration

The concentration ratio is the sum of market shares covered by the largest N firms. It is
determined by finding the sum of sales value for the largest firms and dividing it by the total
market sales. Therefore, the resulting figure lies between zero (for perfect competition) and
100 (for monopolies).

The main advantage of this concentration measure is the simplicity of its calculation. However,
there are some limitations to the usage of this method.

Ex. Suppose there are 10 producing companies in a market. The production percentages for the
top three companies are 35%, 20%, and 10%. Calculate the concentration ratio for these three
companies.

Sol.
The concentration ratio is the sum of market shares covered by the largest N firms. So, the
concentration ratio for the first 3 companies are:

Concentration ratio = (35%+20%+10%)/100 = 65

Limitations of Concentration Ratio

This method cannot quantify market power directly. The big question should be whether high
concentration levels can be interpreted as an indication of monopoly power. An example is the
case of only one sugar company in a country. This company enjoys monopoly power. However,
the problem comes in when there exist large wholesalers in, say, the food sector. These
wholesalers may decide to import sugar alongside their range of products. As a result, this will
most likely compel the sugar company to adjust its prices as if it’s in perfect competition.

The concentration ratio tends not to be affected by mergers among the top market incumbents.
If there exists a merger between the largest and second-largest companies, their combined
pricing power is most likely to be larger than that of the two pre-existing companies, which the
concentration ratio will not accurately represent.

The Herfindahl–Hirschman Index (HHI)

Economists O.C. Herfindahl and A.O. Hirschman came up with an index that first squares the
market shares of top N companies. These squares are then summed up. For a monopoly firm,
the Herfindahl-Hirschman Index (HHI) should be equal to 1.

Consequently, in the case of M firms with equal market shares, the HHI should be equal to 1/M.
This is a very useful gauge for interpreting the HHI. This measure was developed to try and
overcome some issues associated with the concentration ratio.

Ex. Using the same example in the Concentration Ratio, the HHI for the top three companies
can be calculated as:

HHI = 0.352 + 0.202 + 0.102 = 0.1725

Limitations of the HHI

The HHI does not consider the elasticity of demand, and thus it cannot approximate the
potential profitability of a single company or a group of companies.

Source: https://analystprep.com/cfa-level-1-exam/economics/describe-the-use-and-limitations-
of-concentration-measures-in-identifying-market-structure/
8. Identify the type of market structure within which a firm operates

Factors That Influence the Behavior of Individual Firms

The structure of a market has a big influence on the behavior of individual firms. This influence
mainly revolves around pricing.

The market structure also affects how different goods are supplied, as well as market entry
barriers. Remember that market entry barriers are high for monopolies but non-existent in
perfect competition.

Efficiency also has some influence on the behavior of different market structures. Firms under
perfect competition exhibit the highest efficiency level, whereas monopolies are the least
efficient from an economic standpoint.

Features for Identifying a Market Structure

a. Number of Firms Under a Given Market

In a monopoly, there is only one producer in an entire market. An oligopoly will exist in a
market where several firms produce the same goods. Besides, a duopoly is made up of
only two firms in a market. And lastly, for a monopsony, there exists only one buyer.
Most monopsonies tend to be government-based. A good example is the military.

b. The Concentration Ratio of a Firm or Company

 The concentration ratio lies between zero (for perfect competition) and 100 (for
monopolies).

c. The Amount and Nature of Market Costs

This feature covers the economies of scale and sunk costs (costs incurred and which the
firms cannot recover) if any.

d. The Degree of Vertical Integration

Vertical integration refers to how different production and distribution stages are
combined and put under the management of one enterprise. This is often seen in a
monopoly – the manufacturing firm is also the distributor, the retailer, and the one
responsible for after-sales services.

e. The Level of Product Differentiation

The existence of relatively large firms selling differentiated products is referred to as
monopolistic competition. On the other hand, only a few sellers selling basically the
same product, such as in the oil industry, are in oligopolistic competition.

f. Demand Elasticity
A market exhibiting inelasticity in demand entails firms in a monopoly market. On the
other hand, when there is a perfectly elastic demand curve, firms operating in such a
market are in perfect competition with each other.

Source: https://analystprep.com/cfa-level-1-exam/economics/market-structure-within-which-
a-firm-operates/#:~:text=A%20market%20exhibiting%20inelasticity%20in,perfect
%20competition%20with%20each%20other.