11/1/23

Week 8

The Theory of
markets

Overview of the Lecture

• In this sec*on, we are beginning to think about firms’ behaviour and the factors
that determine this. Why do we see constant adver*sing and innova*on in some
products, while others are rarely promoted and see li?le development?
• Why do prices fall in some industries and rise in others? Why is government
more concerned with the behaviour of firms in just some industries? We see
markets with many compe*tors and others with few. Why does this happen?
• All of these ques*ons can be answered by looking at the structure of the
industry and, in par*cular, at the degree of compe**on.
• Before we look at the economic theory behind the different market structures,
let us look at some specific industries and consider the different ways that firms
behave.
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Issues Covered in this Lecture

• How does the structure of an industry affect firms’ behaviour and performance?
• What determines the degree of market power of a firm?
• Why does operating under conditions of perfect competition make being in business a constant battle for
survival?
• What is the short-run equilibrium for firms under perfect competition and by what process do they move to a
long-run equilibrium?
• How do firms get to become monopolies and remain so?
• At what price and output will a monopolist maximise profits and how much profit will it make?
• How well or badly do monopolies serve the consumer compared with competitive firms?
• Why will the size of entry barriers to an industry (the degree of ‘contestability’ of a market) affect the amount of
profit a monopolist can make?

Competition in Different Markets

The degree of compe--on in different markets
The importance of compe//on. Most markets have a number of firms compe*ng
against each other. Go into your local town or city and look around. If you want to
buy shoes, there are probably many shops, all selling shoes of different types,
quality and price.
• Alterna*vely, you could go online and there will be a very high number of
suppliers. If you want lunch or a cup of coffee, there are lots of cafés providing
choice. The same thing applies for birthday cards, wrapping paper, food,
electronic devices and many other products, including services.
• That is how we define the structure of the market

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Competition in Different Markets

The degree of competition in different markets
• Markets where there are few competitors. In practice, most markets have a
number of competitors, each trying to gain customers, though how they do it,
and the market outcomes, can vary significantly. However, in some markets,
there are very few competitors, sometimes just two or three – or occasionally
just one firm with no competitors. This is what economists call monopoly.
• Or there might be lots of small firms, but with a few big ones dominating. This is
a form of imperfect competition that economists call oligopoly.

Competition in Different Markets

The degree of compe--on in different markets
• Markets with many compe/tors. There are countless places you can go to buy
clothes: these shop are usually next to each other. The clothing retailers do
compete on price, it is not a market where we see as much adver*sing. Retailers
here compete in other areas, such as the quality of the product and are less
responsive to the strategies employed by their rivals as, although we s*ll see
some big firms, there are many more of them, each with a smaller share of the
market.
• There are other markets with a similar degree of compe**on to that of clothing:
hairdressers, restaurants, builders, plumbers and many more. Economists call
this market structure monopolis/c compe//on
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Competition in Different Markets

Factors Affecting Competition.
So what influences the degree of competition in an industry? There are four key
determinants:
v The number of firms.
v The freedom of entry and exit of firms into the industry.
v The nature of the product.
v The shape of the demand curve.

Market Structures
Tradi*onally, we divide industries into categories based on the factors above, which
determine the degree of compe**on that exists between the firms. There are four
such categories.
• At the most compe**ve extreme is a market structure referred to as perfect
compe**on. This is a situa*on where there are a large number of firms
compe*ng. No firm has the power to influence market price. It is a price taker.
• At the least compe**ve extreme is monopoly, where there is just one firm in the
industry and hence no compe**on, oTen due to very high barriers to entry.

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Market Structures
Traditionally, we divide industries into categories based on the factors above, which
determine the degree of competition that exists between the firms. There are four
such categories.
In the middle there are two forms of imperfect competition.
• Monopolistic competition is the more competitive, which involves quite a lot of
firms competing and freedom for new firms to enter the industry.
• The other type of imperfect competition is oligopoly, where there are only a few
firms and where the entry of new firms is difficult. Some or all of the existing
firms will be dominant – that is, they will tend to have a relatively high

Market Structures

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Market Structures
Structure, Conduct and Performance
• The market structure under which a firm operates will deter- mine its behaviour.
Firms under perfect compe**on behave quite differently from firms that have
market dominance, such as a monopolist. As we have already seen, the
behaviour of firms is different again when there are lots of small firms compe*ng
(monopolis*c compe**on) and when there are only a few big firms (oligopoly).
• This behaviour, or ‘conduct’, will, in turn, affect the firm’s performance: its prices,
profits, efficiency, etc. In many cases, it will also affect other firms’ performance:
their prices, prof- its, efficiency, etc. The collec*ve conduct of all the firms in the
industry will affect the whole industry’s performance.
Some economists thus see a causal chain running from market structure, through
conduct, to the performance of that industry.
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Perfect Competition
The theory of perfect competition illustrates an extreme form of capitalism. Firms
have no power whatsoever to affect the price of the product.

Assumptions: The model of perfect competition is built on four assumptions:

• 1. Firms are price takers. There are so many firms in the industry that each one
produces an insignificantly small proportion of total industry supply and,
therefore, has no power whatsoever to affect the price of the product. Hence it
faces a horizontal (perfectly elastic) demand ‘curve’ at the market price: the
price determined by the interaction of demand and supply in the whole market.

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Perfect Competition
Assump3ons: The model of perfect compe**on is built on four assump*ons:

2. There is complete freedom of entry and exit into the industry for new firms.
Exis*ng firms are unable to stop new firms se^ng up in business.
3. All firms produce an iden/cal product. The product is ‘homogeneous’, meaning
they are all perfect subs*tutes for each other and hence firms do not engage in
any branding or adver*sing.
4. Producers and consumers have perfect knowledge of the market. That is,
producers are fully aware of prices, costs, technology and market opportuni*es.
Consumers are fully aware of price, quality and availability of the product.
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Perfect Competition
The Short-run Equilibrium of the Firm

• In the short run, the

number of firms in
the industry cannot
be increased;
• there is simply no
time for new firms
to enter the market.

Short-run equilibrium of industry and firm under perfect compe88on

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Perfect Competition
The Short-run Equilibrium of the Firm
Let us examine the determina*on of price, output and profit in turn.
• Price: The price is determined in the industry by the intersec*on of market
demand and supply. The firm faces a horizontal demand (or average revenue)
‘curve’ at this price. It can sell all it can produce at the market price (Pe). It would
sell nothing at a price above Pe, however, since compe*tors would be selling
iden*cal products at a lower price.
• Output: The firm will maximise profit where marginal cost equals marginal
revenue (MR = MC), at an output of Qe. Note that, since the price is not affected
by the firm’s output, marginal revenue will equal price

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Perfect Competition
The Short-run Equilibrium of the Firm
Let us examine the determina*on of price, output and profit in turn.
• Price: The price is determined in the industry by the intersec*on of market
demand and supply. The firm faces a horizontal demand (or average revenue)
‘curve’ at this price. It can sell all it can produce at the market price (Pe). It would
sell nothing at a price above Pe.
• Output: The firm will maximise profit where marginal cost equals marginal
revenue (MR = MC), at an output of Qe. Note that, since the price is not affected
by the firm’s output, marginal revenue will equal price.
• Thus the firm’s MR ‘curve’ and AR ‘curve’ (= demand ‘curve’) are the same
horizontal straight line.
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Perfect Competition
The Short-run Profits

• Profit: If the average cost (AC)

curve (which includes normal
profit) dips below the average
revenue (AR) ‘curve’, the firm will
earn supernormal profit.
• Profit per unit at Qe is the ver*cal
difference between AR and AC at
Qe.
• Total super-normal profit is the
shaded rectangle
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Perfect Competition
The Short-run Profits
• What happens if the firm cannot make
a profit at any level of output? This
situaAon would occur if the AC curve
were above the AR curve at all points.
• In this case, the point where MC = MR
represents the loss-minimising point
(where loss is defined as anything less
than normal profit).
• This amount of the loss is represented
by the shaded rectangle.

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Perfect Competition
The Short-run Profits
• Whether the firm is prepared to con*nue making a loss in the short run or
whether it will close down immediately depends on whether it can cover its
variable costs (as we saw in Chapter 10).
• Provided price is above average variable cost (AVC), the firm will con*nue
producing in the short run: it can pay its variable costs and go some way to
paying its fixed costs.
• It will shut down in the short run only if the market price falls below P2 in the
Figure: i.e. when variable costs of produc*on cannot be covered.

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Perfect Competition
The Long-run Profits
• In the long run, if typical firms are making supernormal prof- its, new firms will
be a?racted into the industry. Likewise, if exis*ng firms can make supernormal
profits by increasing the scale of their opera*ons, they will do so, since all factors
of produc*on are variable in the long run.
• The effect of the entry of new firms and/or the expansion of exis*ng firms is to
increase industry supply, meaning that at every price level the quan*ty produced
would be higher

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Perfect Competition
The Long-run Profits

Long-run equilibrium
of the firm under
perfect compe88on

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Perfect Competition
Who Benefits From Competition?

How does perfect competition affect the firm? Under perfect competition the firm
faces a constant battle for survival. If it becomes less efficient than other firms, it
will make less than normal profits and be driven out of business. If it becomes more
efficient, it will earn supernormal profits, but they will not last for long.
• Soon other firms, in order to survive themselves, will be forced to copy the more
efficient methods of the new firm, once the other firms respond, in order to
avoid making a loss and being driven from the market, supply will rise.
• This will drive down the price and eliminate the supernormal profits.
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Perfect Competition
Who Benefits From Competition?
How does perfect competition affect the consumer? Firms adopt improved
technology to ensure survival and, in the long run, they must also produce at the
least-cost output to ensure that at least normal profits are made. This is productive
efficiency. Therefore, prices are kept at a minimum, which benefits consumers.
• Under perfect competition, we also see firms producing the level of output
where price equals marginal cost. It could be argued that this is the optimum
level of output. When they are equal (MC = P),production levels are just right
and this is referred to as allocative efficiency. Perfectly competitive firms are
allocatively efficient in the short and long run.
• Perfectly competitive markets thus result in economic efficiency though, as we
shall see, it is not always best for the consumer any more than it is for the firm.
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Monopoly
What is Monopoly?
A monopoly exists when there is only one firm in the industry. To some extent, the
boundaries of an industry are arbitrary. What is more important for a firm is the
amount of monopoly power it has and that depends on the closeness of substitutes
produced by rival industries. Therefore, Monopoly is usually due to barriers to entry
of other firms.

Barriers to entry: For a firm to maintain its monopoly position, there must be
barriers to the entry of new firms. Barriers also exist under oligopoly, but, in the
case of monopoly, they must be high enough to block the entry of new firms.
Barriers can take various forms.
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Monopoly
Causes of Monopoly?

1. Economies of scale. If the monopolist’s average costs go on falling significantly up

to the output that satisfies the whole market, the industry may not be able to
support more than one producer. This case is known as natural monopoly.
2. Economies of scope. These are the benefits in terms of lower average costs of
production, because a firm produces a range of products.
3. Product differentiation and brand loyalty. If a firm produces a clearly
differentiated product, where the consumer associates the product with the
brand, it will be very difficult for a new firm to break into that market.
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Monopoly
Causes of Monopoly?

4. Lower costs for an established firm. An established monopoly is likely to have

developed the most efficient way of producing and marketing its product and this
will be very difficult for other competitors to replicate. It may also be aware of the
cheapest suppliers and have access to cheaper finance.
5. Legal protection. The firm’s monopoly position may be protected by patents on
essential processes, by copyright, by various forms of licensing and by tariffs (i.e.
customs duties) and other trade restrictions to keep out foreign competitors.
6. Mergers and takeovers. The monopolist can put in a takeover bid for any new
entrant. The sheer threat of takeovers may discourage new entrants.
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Monopoly
Causes of Monopoly?
7. Retained profits and aggressive tactics. An established monopolist is likely to
have some retained profits behind it. It can use these profits to help it sustain
losses over a period of time, while it engages in a price war, mounts an
advertising campaign or offers consumers various deals to compete with a new
entrant until that firm is forced out of the market
8. Switching costs. New entrants may struggle to access customers, if customers
incur costs when moving to another supplier. Consumers may also decide not to
switch due to network economies.
9. High Sunk Costs. If the initial investment costs are very high, these can restrict a
other firms from joining the industry
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Monopoly
Equilibrium Price and Output Under Monopoly?
Since there is, by definition, only one firm in the industry, the firm’s demand curve
is also the industry demand curve. Compared with other market structures,
demand under monopoly will be relatively inelastic at each price. The monopolist
can raise its price and consumers have no alter- native firm to turn to within the
industry. They either pay the higher price or go without the good altogether.
• Unlike the firm under perfect competition, the monopolist is thus a ‘price
maker’. It can choose what price to charge. Nevertheless, it is still constrained by
its demand curve. A rise in price will reduce the quantity demanded.
• As with firms in other market structures, a monopolist will maximise profit
where MR = MC.
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Monopoly
Equilibrium Price and Output
Under Monopoly?

As with firms in other market

structures, a monopolist will
maximise profit where MR = MC.
Profit is maximised by producing
a quantity of Qm.
The supernormal profit obtained
is shown by the shaded area.
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Imperfect Competition
Very few markets in practice can be classified as perfectly competitive or as a pure
monopoly. The vast majority of firms do compete with other firms, often quite
aggressively, and yet they are not price takers: they do have some degree of market
power.
Most markets, therefore, lie between the two extremes of monopoly and perfect
competition, in the realm of ‘imperfect competition’.
There are two types of imperfect competition: namely
vMonopolistic competition
vOligopoly

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Monopolistic Competition
What is Monopolistic Competition?
Monopolistic competition is towards the competitive end of the spectrum (as we saw
in Perfect Competition).
It can best be understood as a situation where there are a lot of firms competing, but
where each firm does, nevertheless, have some degree of market power (hence the
term ‘monopolistic’ competition).
Each firm has some discretion as to what price to charge for its products because they
are differentiated from those of other firms. The differences can be in form of product
characteristics.

Ø Petrol stations, restaurants, hairdressers and builders are all examples of

monopolistic competition
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Monopolistic Competition
Assumptions of Monopolistic Competition?

v Quite a large number of firms. As a result, each firm has only a small share of the
market and, therefore, its actions are unlikely to affect its rivals to any great extent.
This means that when a firm makes its decisions, it will not have to worry about how
its rivals will react. It assumes that what its rivals choose to do will not be influenced
by what it does. This is known as the assumption of independence.
v Freedom of entry of new firms. If any firm wants to set up in business in this market,
it is free to do so.

In these two respects, therefore, monopolistic competition is like perfect competition. 32

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Monopolistic Competition
Assumptions of Monopolistic Competition?
v Differentiated products. Each firm now produces a product or provides a service
that is in some way different from its rivals. This is known as the assumption of
product differentiation. This gives the firm some degree of market power, meaning it
can raise its price without losing all its customers. Thus its demand curve is
downward sloping, albeit relatively elastic given the large number of competitors to
which customers can turn.

When considering monopolistic competition, it is important to take account of the

distance consumers are willing to travel to buy a product. In other words, the
geographical size of the market matters. So, in any one local area, there is competition
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Monopolistic Competition
Equilibrium of a firm under
Monopolistic Competition?

Short run: As with other market

structures, profits are maximised at
the output where MC = MR.
The diagram will be the same as for
the monopolist, except that the AR
and MR curves will be more elastic,
due to more competition.
This is illustrated as seen
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Monopolistic Competition
Equilibrium of a firm under Monopolistic Competition?
• As with perfect competition, it is possible for the monopolistically competitive
firm to make supernormal profit in the short run. This is shown as the shaded
area.
• Just how much profit the firm will make in the short run depends on the strength
of demand: the position and elasticity of the demand curve. The further to the
right the demand curve is relative to the average cost curve, and the less elastic
the demand curve is, the greater will be the firm’s short-run profit.
• Thus a firm facing little competition and whose product is considerably
differentiated from its rivals may be able to earn significant short-run profits.

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Monopolistic Competition
Equilibrium of a firm under
Monopolistic Competition?
• Long run: If typical firms are earning
supernormal profit, new firms will
enter the industry in the long run.
• As new firms enter, they will take
some of the customers away from
established firms.
• The demand for the established
firms’ products falls and the demand
(AR) curve will shift to the left.
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Monopolistic Competition
Equilibrium of a firm under Monopolistic Competition?
• Long-run equilibrium will be reached when only normal profits remain: when there
is no further incentive for new firms to enter.
• This is illustrated in Figure 12.1(b). The firm’s demand curve settles at DL, where it is
tangential to (i.e. just touches) the firm’s LRAC curve. Output will be QL: where ARL
= LRAC. (At any other output, LRAC is greater than AR and thus less than normal
profit would be made.)

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Monopolistic Competition
Equilibrium of a firm under Monopolistic Competition?
• It is important to note that there is a difference between the transition from the
short run to the long run under perfect competition and monopolistic competition
even though in long-run equilibrium, firms in both market structures earn just
normal profits.
• Under perfect competition, when new firms enter (or leave) the market, it is the
industry supply curve that shifts, which changes the market price and leaves just
normal profits. Under monopolistic competition, however, the entry of new firms is
reflected by shifting an established firm’s demand curve inwards and this eliminates
the supernormal profits.

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Monopolistic Competition
Limitations of the Monopolistic Competition Model
As all firms under monopolistic competition are producing a slightly differentiated
product, each firm is different and hence we cannot create an industry demand or
supply curve. Instead, we have to focus on the effect on a given firm when new firms
enter the market.
• Information may be imperfect. Firms will not enter an industry if they are unaware
of the supernormal profits currently being made or if they underestimate the
demand for the particular product they are considering selling.
• Firms will differ from each other, not only in the product they produce or the service
they offer, but also in their size and in their cost structure. What is more, entry may
not be completely unrestricted.
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Monopolistic Competition
Limitations of the Monopolistic Competition Model
• Existing firms may make supernormal profits, but, if a new firm entered, this might
reduce everyone’s profits below the normal level. Thus a new firm will not enter and
supernormal profits will persist into the long run.
• The monopolistic competition model concentrates on price and output decisions. In
practice, firms under monopolistic competition will also need to decide the exact
quality, variety of products, and advertising expenditure. This will lead the firm to
take part in non-price competition.

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Oligopoly
What is Oligopoly
• Oligopoly occurs when just a few firms share a large proportion of the market
share in the industry amongst them. Some of the best-known companies are
oligopolists, including Coca-Cola, Pepsi, Apple, e.t.c.
• One of the key differences between oligopolies is in the degree of product
differentiation. The firms may produce a virtually identical product (e.g. sugar,
petrol). In some cases, however, oligopolists produce highly differentiated
products (e.g. cars, soap powder, soft drinks, electrical appliances).
• Much of the competition between such oligopolists is in terms of the marketing
of their particular brand. Marketing practices may differ considerably from one
industry to another.
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Oligopoly
Features of Oligopoly
Despite the differences between oligopolies, there are two crucial features that
distinguish an oligopoly from other market structures.
1. Barriers to entry: Unlike firms under monopolistic competition, there are various
barriers to the entry of new firms. These are similar to those under monopoly (see
pages 191–4). The size of the barriers, however, will vary from industry to industry.
In some cases, entry is relatively easy, whereas in others it is virtually impossible,
perhaps due to patent protection or prohibitive research and development costs.

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Oligopoly
Features of Oligopoly
2. Interdependence of the firms: With only a few firms under oligopoly, each firm will
need to take account of the behaviour of the others when making its own
decisions. This means that they are mutually dependent: they are interdependent.
Each firm is affected by its rivals’ actions. If a firm changes the price or specification
of its product, for example, or the amount of its advertising, the sales of its rivals
will be affected.
The rivals may then respond by changing their price, specification or advertising. No
firm can therefore afford to ignore the actions and reactions of other firms in the
industry and it is this feature that differentiates oligopolies from the other market
structures.

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Oligopoly
Features of Oligopoly
2. Interdependence of the firms: With only a few firms under oligopoly, each firm will
need to take account of the behaviour of the others when making its own
decisions. This means that they are mutually dependent: they are interdependent.
Each firm is affected by its rivals’ actions. If a firm changes the price or specification
of its product, for example, or the amount of its advertising, the sales of its rivals
will be affected.
The rivals may then respond by changing their price, specification or advertising. No
firm can therefore afford to ignore the actions and reactions of other firms in the
industry and it is this feature that differentiates oligopolies from the other market
structures.

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Oligopoly
Oligopoly: Competition and Collusion
• The interdependence of oligopolists means firms are pulled in two different directions: to
compete and to collude.
• Firms will want to maximise their share of industry profits. Having analysed its rivals’
strategies, a firm may decide to compete with its rivals, perhaps by cutting prices or
undertaking advertising with the aim of increasing sales. However, if all firms cut prices,
they earn less revenue; if all firms increase advertising, average costs will rise. Either way,
profits are likely to fall.
• Thus, the firm may conclude that, rather than competing with its rivals, collusion will be a
more profitable strategy. If it can come to agreements with the other firms on price, output,
product design, etc., the firms may jointly be able to maximise industry profits. They can
then split these maximum profits between them. Of course, this may be bad for the
consumer and most countries have competition laws that try to prevent open collusion
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Oligopoly
Oligopoly: Competition and Collusion
Collusive Oligopoly: When firms under oligopoly engage in collusion, they may agree
on prices, market share, advertising expenditure, etc. Such collusion reduces the
uncertainty they face. It reduces the fear of engaging in competitive price cutting or
retaliatory advertising, both of which could reduce total industry profits and probably
each individual firm’s profit.
A formal collusive agreement is called a cartel. The cartel will maximise profits by
acting like a monopolist, with the members behaving as if they were a single firm. The
cartel members may somehow agree to divide the market between them. Each
member would be given a quota. This is done to limit production so as to maintain high
prices and profits.

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Oligopoly
Oligopoly: Competition and Collusion
• Another form of collusion is tacit collusion: where firms keep to the price that is set
by an established leader. The leader may be the largest firm: the firm that
dominates the industry. This is known as dominant firm price leadership.
• Alternatively, the price leader may simply be the one that has proved to be the most
reliable to follow: the one that is the best barometer of market conditions. This is
known as barometric firm price leadership.

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