Chapter 8

Market structures
 Learning objectives
8.1 understand what economists means by
‘competition’ and ‘market structures’ and the
relationship between them
8.2 identify when a perfectly competitive firm will
maximise profit, break-even and shut down in the
short-run
8.3 explain why perfectly competitive firms will tend to
break-even in the long-run
 Learning objectives
8.4 understand the operation of a market where there
is no competition at all (i.e. monopoly)
8.5 understand imperfect competition and explain the
model of monopolistic competition
8.6 understand the model of oligopoly and how it helps
to explain the operation of imperfectly competitive
markets where there are only a few firms
8.1 Competition & Market structures
• For most economists competition is about how many rivals
there are in the market and how evenly matched they are.
• The principal criteria according to which the structure of a
market can be defined:
1. Number of buyers & sellers in the market
2. Degree of differentiation (homogeneity)
3. Degree of knowledge possessed by buyers and sellers
4. The extent of barriers to entry
Four market structures
 8.2 Perfectly competitive firms
in the short-run
• In the case of perfect competition, the firm’s AR(P) curve is
horizontal (because the price is fixed no matter what Q is
produced), and therefore the MR curve will also be
horizontal — after all if the AR curve is perfectly flat, it has
zero slope, so the MR curve will also have zero slope
because doubling zero equals zero.
 8.3 Perfectly competitive firms
in the long-run
• A perfectly competitive market leads to a situation
where all firms in a market end up producing output
at the lowest possible price they can afford — i.e.
they all end up breaking even.
What is the underlying cause of this
“Problem” of zero long run profits?
Many new rival businesses producing an
identical product can freely enter the market in
the long-run.
LO 8.4 Monopoly
• Monopoly: the operation of a market where there is no
competition at all.
• So the monopolist who doesn’t face competition (and like
any other firm try to maximise its profit) can benefit from
much higher selling prices (the market power is maximised
under monopoly condition).
• Monopoly faces a downward sloping demand curve, so
setting higher prices at a lower level of output is possible.
• Under a monopoly the marginal revenue is not equal to
market price.
 Then they would
have all the
Ideally, an buyers of their
entrepreneur product to
wants to be a themselves.
monopolist.
That is, they
That is, where would have the
they face no entire market
rivals at all. demand for that
product for
themselves.
 Monopolist
Have to develop a unique
product (good or service)
that consumers want.
That is, radically
differentiate product
from existing rivals.
Always a risk that people
won’t be interested, so
requires market research
into untapped wants.
 Monopolist
• If successful, the business can choose the price and
output level that will maximise “monopoly profit”.
• And because the business has no competitors, it can
sustain those profits in the long run.
o That is, their customers will not be “stolen” by rivals, so
their revenue will not fall over time.
• We can show this situation graphically (of course).
• But first, some important technicalities…
 Monopolist’s demand
550
Price Quantity
500 0

Price (Average Revenue)

500
484 1
468 2 450
452 3
436 4 400
420 5
404 6 350
388 7
372 8 300
356 9 0 1 2 3 4 5 6 7 8 9
Output demanded
Monopolist’s marginal revenue
And it turns out that as change in TR
the price charged falls, the Q x P = TR = MR
business’s marginal Output Price TR MR
revenue falls twice as
0 500 0
fast.
1 484 484 484
Marginal revenue =
amount added to total 2 468 936 452
revenue by selling an 3 452 1356 420
additional increment of 4 436 1744 388
output.
The pattern is clearer on a graph…
 550

500
Price & Marginal Revenue

450 Price falls by $16 per unit

400

350
MR falls by $32 per unit
300 (double!)
250
So MR [always] has double
200 the slope!
0 1 2 3 4 5 6 7 8 9
Output demanded
 Maximising monopoly profit
Now let’s include the average cost and marginal cost
curves to find the price & output which maximises
monopoly profits in the long run.

Recall the decision-rule for the profit-maximisation:

“Keep producing more whilst ever revenue from an
additional unit of output (MR) is greater than cost of
an additional unit of output (MC).”
500

400

300 P
MR
200 AC
MC

100

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
output
500

400
340
300 P
MR
200 AC
MC

100

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
output
 The monopolist can make this profit
500 in the long-run because no new
competitors can enter the market to
“steal away” demand.
400
340
300 P
TOTAL PROFIT $1300
MR
210 AC
200
MC

100

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
output
 Price discrimination
A firm with monopoly-power may discover that it
can make even larger profits by segmenting its
consumers.
That is, by identifying distinct sub-groups of
potential customers who have different purchasing
capacities, and then charging them different
prices for the same product.
This is called price discrimination.
Adult $20.50 Student $17.00
Senior $14.50

Lower income groups are charged lower

prices. Why?
 Price discrimination
Is the cinema motivated by charitable thoughts? Don’t
be so naïve!
By charging only one price ($20.50), the cinema would
be “pricing out of the market” some lower income
customers.
By offering lower prices to certain groups  these
groups will buy tickets  more revenue for the
business. Profit is the motive!
 Price discrimination
45 $25 x 300 = $7500 Profit
maximising
40 revenue from adults.
price to
35 charge
30
[wealthy]
adults.
25

20
Marginal
15 cost

10
Adult
5 Marginal Demand
revenue
0
0 100 200 300 400 500 600
 Price discrimination
45 Price too high
$0 revenue from students. for [poor]
40
students.
35

30

25

20 Student
Demand Marginal
15 cost

10
Adult
5 Marginal Demand
revenue
0
0 100 200 300 400 500 600
 Price discrimination
45 The cinema
40 Now: $17 x 300 = $5100 charges a
revenue from students. special
35 ‘student’ price.
30 $7500(adult) +
$5100(student) = $12600
25

20 Student
Demand Marginal
15 cost

10 Marginal
revenue
5

0
0 100 200 300 400 500 600
There are many ways a business can try to ensure
and protect its monopoly profits.
All these methods aim at keeping or driving other
businesses out who could “steal” some of its
customers.
That is, the business erects
barriers to entry to
potential rivals.
 Restricting competition
Warning! Some of these methods are illegal under the
Competition and Consumer Act 2010.

See if you can guess which ones are illegal.

 Restricting competition
Consumer perceptions
• Generating brand
loyalty: customers
become psychologically
attached to a brand;
won’t even try a rivals
product.
• False or misleading
advertising (about own
or rivals’ products).
 Restricting competition
Aggressive pricing strategies
•Predatory pricing: charging a very low (even loss-
making) price designed to send rivals bankrupt.

•Resale price maintenance: supplier dictates to retail

outlets the (low) price they must charge.
 Restricting competition
Mergers and acquisitions • De Beers diamond company
would buy all newly
• Vertical integration: discovered diamond
purchase the essential deposits.
inputs, or the outlets of • Have you noticed that you
sale. can’t buy Pepsi on campus?
• Horizontal integration:
buy-out rivals, absorb • Google has acquired at least
them or shut them 189 companies to date!
down.
 Restricting competition
Develop related products Apple “life”

• Complements: to fully
enjoy a product,
customers have to buy a
complementary
product. Wrigley

• Substitute proliferation:
produce substitutes for
own product to beat out
competitors.
 Natural monopoly
Sometimes it is inevitable that there will only be one seller in
the market; a monopoly will “naturally” occur.
This is called a natural monopoly.
• Sometimes giant: Sydney Water; Sydney trains
• Sometimes small: petrol station in a country town.
What they have in common? Demand is only sufficient to
efficiently support one business in the area.
A business usually does not need to construct barriers to
entry in this case.
 LO 8.5 Monopolistic competition
• Relatively few industries in the Australian economy
that conform to the model of monopoly previously
outlined.
• Most industries lie somewhere between Perfect
Competition and Monopoly, i.e. there is some
competition but it is not ‘perfect’.
Monopolistic competition
In reality, very often, attempts to erect barriers to entry
are unsuccessful.
A business can differentiate its product from potential
rivals and so have its “own” downward-sloping demand
curve (like a monopolist)…
but it still faces many competitors producing similar
products because there is freedom of entry into the
market (like perfect competition).
This is called monopolistic competition.
 Monopolistic competition
Examples of monopolistic competition include:
Restaurants, cafés, hotels, pubs, hairdressers in a city

Note: if we were examining a small country town, these

might be natural monopolies!
Monopolistic competition
in the long run
Alas, because there are no barriers to entry, a business
cannot protect itself from new rivals who “steal” some
of its customers.
So, in the long-run, the business’s demand will fall,
“squeezing” profits until it breaks-even:
where average revenue (price) = average cost
This is just like the long-run outcome for perfect
competition. The difference is that the firm’s demand
curve is still slightly downward-sloping. Graphically…
 Monopolistic competition
New rivals enter, stealing
500
customers (demand)
400

300 P
MR
200 AC
MC
100

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
output
 Monopolistic competition
This tends to Breakeven
500 P=AC
be the fate of
400 small
businesses
300 P
MR
200 AC
MC
100

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
output
 LO 8.6 Oligopoly
What about a situation where barriers to entry are
moderately successful or where there is only enough
consumer demand to sustain a few businesses?
This is called an oligopolistic market.
o A few businesses dominate the market.
o E.g. 10 or fewer firms supply 50% or more of a national
market.
Australia has more oligopolistic markets than most developed
countries because of our relatively small population.
 Australian Examples
Industry Number Market share
Cars top 5 53%
Banks top 4 80%
Life insurance top 4 70%
Instant coffee top 3 88%
Supermarkets top 5 99%
Cola top 2 99%
Who are the industry leaders?
 Oligopoly
Because there are only a few rivals, the
behaviour of rivals can have a big effect on
demand (and thus revenue) for a particular
business’s product.
E.g. if your rivals decrease their prices, or launch
big advertising campaigns, you might loose
many, many customers, and thus lots of
revenue.
 Collusion and reaction
• Collusion: when firms act jointly (more nearly as they
would if they were a monopolist) to increase overall
profits.
• Cartel: a group of producers with an agreement to
collude in setting prices and output.
• Game theory (to model collusion): theory designed to
understand strategic choices, that is, to understand
how people or organisations behave when they expect
their actions to influence the behaviour of others.
Game theory to model collusion

Thus, each business has to pay

close attention to how rivals
behave, and then react in a
rational way to maximise
profits (or minimise losses).
Like playing checkers or chess.
Game theory is about such
strategic decision-making.
 My partner in crime might…

Rat me out Stay silent

Rat him out
What should I
or stay
do?
silent?

Rat: 5y Rat: 1y
Silent: 10y Silent: 2y
“Rational” to always rat out my partner in crime!
But if my partner is also rational, he will also rat me out!
If we had both been “irrational” and stayed silent…wah!
Exemplified by The Prisoner’s Dilemma
44
 Why might you end up in a
price war?
Same when roles reversed, so…

Your options
Low P: $2m
Low P
High P: $0m
Your
rivals
might Low P: $6m
High P
charge… High P: $4m
 Why do Cornetto vs
Drumstick advertise?
Same when roles reversed, so…

Drumstick’s
Advertise: $4m
Advertise

options
Don’t: $1m
Cornetto
might… Advertise: $8m
Not
Don’t: $5m
 Paradox of these games
Price war example
•If everyone had agreed to charge “High P”, then all would
have made $4m profit each (instead only on $2m).
Advertising war example
•If Cornetto & Drumstick had agreed to “Not advertise”, then
both would have made $5m profit (instead of only $4m).
This makes for a perverse incentive against competing…
 Restrictive practices
• The ongoing pursuit of restrictive and entry
deterrence practices are also a typical characteristic
of the behaviour of firms in an oligopolistic market
• Firms engage in a number of restrictive practices to
limit competition
• Many restrictive practices are aimed at the
wholesalers and retailers who sell a producer’s
goods – called ‘Vertical restrictions’, where as price
fixing is called ‘Horizontal restrictions’.
 Entry deterrence
• Another way to reduce competition — to
prevent other firms from entering the market
• Intended to limit the number of firms — the
fewer the firms, presumably the weaker the
competitive pressure.
• E.g. Natural barriers to entry, predatory pricing,
building more production facilities than needed
i.e. ‘excess capacity’
Collusion, cartel, restrictive
practices & entry deterrence
Bid rigging: rivals communicate before lodging their bids and
agree among themselves who will win and at what price.
Market sharing: rivals agree to divide customers between
them.
Price fixing: rivals agree on a pricing structure rather than
competing against each other.
Price signalling: rivals disclose future price changes to each
other for the purpose of lessening competition.
Collective bargaining & boycott: rivals act as a block to
“blackmail” lower prices from suppliers.
 “As if” a monopoly
When businesses collude, they ideally seek to maximise
the group’s profits – not any single individual firm’s
profits.
When this occurs, the legally separate businesses,
economically speaking, resemble a single firm.
In that case, one can treat the industry as if it were a
monopoly.
But does collusion happen in real life? You betcha.
 Thus, as Adam Smith said
way back in 1776…

“People of the same trade

seldom meet together, even
for merriment and
diversion, but [when they
do,] the conversation ends
in a conspiracy against the
public, or in some
contrivance to raise prices.”
52
The end