Managerial Economics

Module 4
Market Structure – Perfect and imperfect competition;
monopoly, duopoly, oligopoly; Monopolistic
competition, pricing methods under these competitive
environments.
 Market
• A market is a set of conditions under which
sellers and buyers sell and buy a commodity.
• It is a group of people and firms who are in
contact with one another for the purpose of
buying and selling some commodity.
 Market Structure
• Market structure – identifies how a market is made up in terms of:
– The number of firms in the industry
– The nature of the product produced

– The degree of monopoly power each firm has

– The degree to which the firm can influence price

– Profit levels

– Firms’ behaviour – pricing strategies, non-price competition, output levels

– The extent of barriers to entry
– The impact on efficiency
 Market Structure
Perfect Pure
Competition Monopoly

More competitive (fewer imperfections)

 Market Structure
Perfect Pure
Competition Monopoly

Less competitive (greater degree

of imperfection)
 Market Structure
Pure
Perfect
Monopoly
Competition

Duopo Monop
Monopolistic Competition Oligopoly ly oly

The further right on the scale, the greater the degree

of monopoly power exercised by the firm.
 Types of Markets – Based on
Competition
• Perfect Competition
• Imperfect Competition
– Monopolistic Competition
– Oligopoly
– Duopoly
– Monopoly
 Perfect Competition
• One extreme of the market structure spectrum
• Characteristics:
– Large number of firms
– Products are homogenous (identical) – consumer
has no reason to express a preference for any firm
– Freedom of entry and exit into and out of the industry
– Firms are price takers – have no control over the price they charge for
their product
– Each producer supplies a very small proportion of total industry
output
– Consumers and producers have perfect knowledge about the market
 Perfect Competition
The average cost curve is the
Diagrammatic representation Given
standard
TheTheMC
the
is‘U’
industry
assumption
the– shaped
cost
price
of profit
curve.
ofisfirm
AtMC
this output
maximisation,
cuts the AC thethe
curve firm atproduces
its
producing
determined additional
by the demand
Cost/Revenue islowest
making
at an output
pointunits
(marginal)
and supply normal
where
because
of of
MC
theoutput. profit.
=
of the
industry ItMR
MC (Q1).
This
falls
asatisThis
mathematical
a a long
first
whole.
output level
torun
relationship
(dueThe firm
the law isisaaof
fraction
between of the
marginal totaland industry
average
diminishing
very small
equilibrium returns)
supplier
position. then
within rises
supply.
values.
asthe
output
industryrises.and has no
control over price. They will
AC sell each extra unit for the
same price. Price therefore
= MR and AR

P = MR = AR

Q1 Output/Sales
 Perfect Competition
Because the model assumes
Diagrammatic representation perfect
The lowerknowledge,
AC and MCthewould
firm
Average
gains the and Marginal
advantage for costs
only a
imply
Now that
assume the afirm
firmis now
makes
could
short be
time expected
before others to be lower
copy
Cost/Revenue earning abnormal profitrun,
MC some
but form
price, of the
in modification
the idea orrepresented
(AR>AC)
itsremains
productthe
short
are attracted
or same.
gains some
to
bytothethe
form
MC1 industry
grey
of cost area.by the existence
advantage (say a new
abnormal profit. If new firms
of
production method). What
enter the industry, supply will
AC would happen?
increase, price will fall and the
firm will be left making normal
profit once again.
AC1

P = MR = AR
Abnormal profit
AC1
P1 = MR1 = AR1

Q1 Q2 Output/Sales
 Monopolistic or Imperfect Competition

• Where the conditions of perfect competition do

not hold, ‘imperfect competition’ will exist
• Varying degrees of imperfection give rise to
varying market structures
• Monopolistic competition is one of these – not to
be confused with monopoly!
 Monopolistic or Imperfect Competition

• Characteristics:
– Large number of firms in the industry
– May have some element of control over price due to the
fact that they are able to differentiate their product in
some way from their rivals – products are therefore close,
but not perfect substitutes
– Entry and exit from the industry is relatively easy – few
barriers to entry and exit
– Consumer and producer knowledge imperfect
 Monopolistic or Imperfect Competition
Implications for the diagram:
MC We
Since
Marginal
assume
the additional
Cost
that and
the facing
firm
Cost/Revenue The demand curve
If the
revenue
producesfirmreceived
Average produces
where
Cost will
MR Q1
frombe
= MCand
the
the firm will be downward
sells
each
This iseach
(profit
same
unit unitrun
amaximising
shape.
sold
short for
falls, Rs100
However,
output).
the the
equilibrium on
sloping and represents
average
MR
At because
this
curve
position with
output
lies
thethe
for a from cost
level,
under
products (on
AR>AC
firm insales.
a the
AR earned
AC average)
ARare
and curve.
the formarket
each unit
differentiated
monopolistic firm makes in being
structure.
Rs.100 Rs60,
abnormal the
some way, firm
profit will
the(the make
firmgrey
will
Rs40onlyxbe
shaded Q1 in abnormal
area).
able to sell extra
profit.
output by lowering price.
Abnormal Profit
Rs.60

MR D (AR)
Q1
Output / Sales
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC Because there is relative
Cost/Revenue
freedom of entry and exit
into the market, new
firms will enter
AC encouraged by the
existence of abnormal
profits. New entrants will
increase supply causing
price to fall. As price falls,
the AR and MR curves
shift inwards as revenue
from each sale is now
less.

MR1 AR1 D (AR)

MR
Q1 Output / Sales
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC Notice that the existence
Cost/Revenue
of more substitutes makes
the new AR (D) curve
more price elastic. The
AC firm reduces output to a
point where MC = MR
(Q2). At this output AR =
AC and the firm will make
AR = AC
normal profit.

MR1 AR1 D (AR)

MR
Q2 Q1 Output / Sales
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC This is the long run
Cost/Revenue
equilibrium position
of a firm in monopolistic
competition.
AC

AR = AC

MR1 AR1
Q2 Output / Sales
 Monopolistic or Imperfect Competition

• Some important points about monopolistic

competition:
– May reflect a wide range of markets
– Not just one point on a scale – reflects many
degrees
of ‘imperfection’
– Examples?
 Monopolistic or Imperfect Competition

• Restaurants
• Plumbers/electricians/local builders
• Solicitors
• Private schools
• Plant hire firms
• Insurance brokers
• Health clubs
• Hairdressers
• Funeral directors
• Estate agents
• Damp proofing control firms
 Monopolistic or Imperfect Competition

• In each case there are many firms

in the industry
• Each can try to differentiate its product
in some way
• Entry and exit to the industry is relatively free
• Consumers and producers do not have perfect knowledge of
the market – the market may indeed be relatively localised.
Can you imagine trying to search out the details, prices,
reliability, quality of service, etc for every plumber in the India
in the event of an emergency??
 Oligopoly
• Competition between the few
– May be a large number of firms in the industry but the
industry is dominated
by a small number of very large producers
• Concentration Ratio – the proportion of total market
sales (share) held by the top 3,4,5, etc firms:
– A 4 firm concentration ratio of 75% means the top 4 firms
account for 75% of all
the sales in the industry
 Oligopoly
• Example:
The music industry has
• Music sales – a 5-firm concentration
ratio of 75%.
Independents make up
25% of the market but
there could be many
thousands of firms that
make up this
‘independents’ group.
An oligopolistic market
structure therefore
may have many firms
in the industry but it is
dominated by a few
large sellers.
Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html
 Oligopoly

• Features of an oligopolistic market structure:

– Price may be relatively stable across the industry –
kinked demand curve?
– Potential for collusion
– Behaviour of firms affected by what they believe their rivals
might do – interdependence of firms
– Goods could be homogenous or highly differentiated
– Branding and brand loyalty may be a potent source of competitive advantage
– Non-price competition may be prevalent
– Game theory can be used to explain some behaviour
– AC curve may be saucer shaped – minimum efficient scale
could occur over large range of output
– High barriers to entry
 Oligopoly
Price The kinked demand curve - an explanation for price stability?

Assume the firmofisthe charging

kinkedademand
price of
The principle
£5If and
thefirmproducing
firm seeks an output of 100.to
The curve reststoon
therefore, lower its price
the principle
effectively faces
Ifgain athat:
ait‘kinked
chose competitive
to raise price
demand advantage,
curve’ above
forcing itsitits
£5, rivals
to
will
rivals follow
would
maintain suit.
not
afirm
stableAny
follow gains
or rigidsuit it makes
and
pricing the will
firm
a.
quickly If a
befaces raises
lost and its
the firmsprice,
% change its
effectively
structure.rivals
an elastic
Oligopolistic
will not follow may in
demand
suit
demand
curve
overcomefor itswill beby
product
this smaller thaninthewould
(consumers
engaging %
reduction
buyb. If
from the
non-price a in
firmprice –
lowers total
its revenue
price,
cheaper rivals). The %
competition. its
£5 would rivals
change again
in demand fall all
will aswould
thethe
do firm
be now
same
greaterfaces
a relatively inelastic
than the % change in price and TR demand curve.
Total would fall.

Revenue
B
Total Revenue A
D = elastic
Total Revenue B Kinked D Curve
D = Inelastic

100 Quantity
 Duopoly
• Market structure where the industry is dominated
by two large producers
– Collusion may be a possible feature
– Price leadership by the larger of the two firms may exist – the
smaller firm follows the price lead
of the larger one
– Highly interdependent
– High barriers to entry
– Cournot Model – French economist – analysed duopoly –
suggested long run equilibrium would see equal market share and
normal profit made
– In reality, local duopolies may exist
 Monopoly
• Pure monopoly – where only
one producer exists in the industry
• In reality, rarely exists – always
some form of substitute available!
• Monopoly exists, therefore,
where one firm dominates the market
• Firms may be investigated for examples of
monopoly power when market share exceeds 25%
• Use term ‘monopoly power’ with care!
 Monopoly
• Monopoly power – refers to cases where firms influence
the market in some way through their behaviour –
determined by the degree
of concentration in the industry
– Influencing prices
– Influencing output
– Erecting barriers to entry
– Pricing strategies to prevent or stifle competition
– May not pursue profit maximisation – encourages unwanted
entrants to the market
– Sometimes seen as a case of market failure
 Monopoly
• Origins of monopoly:
– Through growth of the firm
– Through amalgamation, merger
or takeover
– Through acquiring patent or license
– Through legal means
 Monopoly
• Summary of characteristics of firms exercising
monopoly power:
– Price – could be deemed too high, may be set to destroy
competition (destroyer or predatory pricing), price
discrimination possible.
– Efficiency – could be inefficient due to lack of competition
(X- inefficiency) or…
• could be higher due to availability of high profits
 Monopoly
• Innovation - could be high because
of the promise of high profits, Possibly encourages
high investment in research and development (R&D)
• Collusion – possible to maintain monopoly power of
key firms in industry
• High levels of branding, advertising
and non-price competition
 Monopoly
• Problems with models – a reminder:
– Often difficult to distinguish between a monopoly
and an oligopoly – both may exhibit behaviour
that reflects monopoly power
– Monopolies and oligopolies do not necessarily aim
for traditional assumption of profit maximisation
– Degree of contestability of the market may influence behaviour
– Monopolies not always ‘bad’ – may be desirable
in some cases but may need strong regulation
– Monopolies do not have to be big – could exist locally
 Monopoly

Costs / Revenue
This(D)
AR
Given isthe
both
curve
barriers
the
forshort
a to
monopolist
entry,
run and
MC likely
the
long monopolist
run
to be
equilibrium
relatively
will be
position
price
able to
inelastic.
exploit
for a monopoly
abnormal
Output assumed
profits in the
to
£7.00
be atrun
long profit
as maximising
entry to the output
(note caution
market is restricted.
here – not all
AC monopolists may aim
Monopoly for profit maximisation!)

Profit

£3.00

MR AR
Output / Sales
Q1
 Monopoly
Welfare
Costs / Revenue implications of
monopolies
MC
The
Thehigher
Amonopoly
look back
price
inprice
at
andthelower
would
diagrambe for
£7 The price a competitive
output
£7 per
perfect
means
unit competition
with
thatoutput
consumer
£3levels
will
market would be withreveal
output
AC surplus
lower
that
at
isin
Q2.
reduced,
equilibrium,
levels at Q1.
indicated
price will
by be
Loss of consumer the grey
equal shaded
to the area.
MC of production.
On the face of it, consumers
surplus faceWe can look
higher pricestherefore
and lessat a
comparison
choice in monopoly of the differences
conditions
£3 between
compared toprice
moreand output in a
competitive
competitive situation compared
environments.
to a monopoly.

AR
MR
Output / Sales
Q2 Q1
 Monopoly
Welfare
Costs / Revenue implications of
monopolies
MC The monopolist will benefit
be
£7 affected
from additional
by a loss
producer
of producer
surplus equal
showntobythe
thegrey
grey
AC triangle but……..
shaded rectangle.
Gain in producer
surplus
£3

AR
MR
Output / Sales
Q2 Q1
 Monopoly
Welfare
Costs / Revenue implications of
monopolies
MC
£7
The value of the grey shaded
AC triangle represents the total
welfare loss to society –
sometimes referred to as
the ‘deadweight welfare loss’.
£3

AR
MR
Output / Sales
Q2 Q1
 Price Discrimination
Price discrimination exists within a market when the
sales of identical goods or services are sold at different
prices by the same provider. The goal of price
discrimination is for the seller to make the most profit
possible. Although the cost of producing the products is
the same, the seller has the ability to increase the price
based on location, Criteria
Price Discrimination consumer financial status, product
demand,
Within etc.
commerce there are specific criteria that must be met
in order for price discrimination to occur:
The firm must have market power.
The firm must be able to recognize differences in demand.
The firm must have the ability to prevent arbitration, or resale
of the product.
 Types of Price Discrimination

Pigou has identified three degrees of price discrimination on the basis of

seller’s estimation of consumers’ paying capacity and their willingness to pay.
The seller can make a good assessment of consumer surplus and can
discriminate on that basis.

First Degree Price discrimination

Here, the seller is able to charge different prices for different units of the
same product from the same consumer. It is also referred to as perfect
discrimination by monopolist.

In this case, the firm charges the maximum price (also refereed to as
“reservation price”) from the buyer for each unit sold in a ‘take it or leave it’
kind of situation and thus, takes away the entire consumer surplus.

The seller must know the absolute maximum price that every consumer is
willing to pay.
Second degree price discrimination:

The price of a good or service varies according to the quantity demanded.

Larger quantities are available at a lower price (higher discounts are given to
consumers who buy a good in bulk quantities).

Third degree price discrimination:

The price varies according to consumer attributes such as age, sex, location,
and economic status.

Eg., Different rates of tickets for different seats in a movie theatre.

 Examples of Price Discrimination
Travel industry: airlines and other travel companies use price discrimination
regularly in order to generate commerce. Prices vary according to seat selection,
time of day, day of the week, time of year, and how close a purchase is made to
the date of travel.
Coupons: coupons are used in commerce to distinguish consumers by their
reserve price. A manufacturer can charge a higher price for a product which most
consumers will pay. Coupons attract sensitive consumers to the same product by
offering a discount.
Premium pricing: uses price discrimination to price products higher than the
marginal cost of production. Regular coffee is priced at Rs.50 while premium
coffee is Rs 150. The marginal cost of production is only 25 and 50. The
difference in price results in increased revenue because consumers are willing to
pay more for the specific product.
Gender based prices: uses price discrimination based on gender. For example,
bars that have Ladies Nights are price discriminating based on gender.

Age discounts: age discounts are a form of price discrimination where the
price of a good or admission to an event is based on age. Age discounts are
usually broken down by child, student, adult, and senior. In some cases,
children under a certain age are given free admission or eat for free. Examples
of places where age discounts are given include restaurants, movies, and other
forms of entertainment.

Occupational discounts: price discrimination is present when individuals receive

certain discounts based on their occupation. An example is when active military
members receive discounts.

Retail incentives: this includes rebates, discount coupons, bulk and quantity
pricing, seasonal discounts, and frequent buyer discounts.