Market structure

Why are we interested in market structures?

• How much market What factors might cause
share a firm has?
Structure • Do product differ or variation in the structure,
are they the same? conduct, and performance
• Do firms work in
of different business?
isolation?
• Are their action
Conduct interdependent?
• How do they compete?

• Do they seek to maximize profit?

• Are they satisficiers?
• Efficiency? (productive &
Performance allocative)
• Dynamism?
 Markets
• A market facilitates the interaction of a buyer and a seller as they
complete a transaction
• Buyers, as a group, determine the demand
• Sellers, as a group, determine the supply
• Type of market structure influences how a firm behaves:
• Pricing
• Supply
• Barriers to Entry
• Efficiency
• Competition
Price taker
firm that has no influence over market price and
thus takes the price as given.

Because each individual firm sells a sufficiently small

proportion of total market output, its decisions have no impact
on market price.

Product Homogeneity
firms produce identical, or nearly identical, products.

When the products of all of the firms in a market are perfectly

substitutable with one another.

Why it is important? Because it ensures single market price

Free entry (or exit)

Condition under which there are no special costs that make it
difficult for a firm to enter (or exit) an industry.

As a result, buyers can easily switch from one supplier to another,

and suppliers can easily enter or exit a market.
Market Structures determinants

Number of Firms
Influence on Price
Product Differentiation
Advertising
Barriers to Entry
Market Structures
Number of Influence on Product Barriers to
Advertising
Firms Price Differentiation Entry

Perfect
Many None No No None
Competition

Monopolistic
Many Limited Some Yes Limited
Competition

Oligopoly Few Some Some Yes Significant

Pure Monopoly One Extensive No Yes Complete

Perfectly competitive market

What it is?
WHAT ARE THE BASICS OF PERFECT COMPETITION?

• Perfect competition is a market structure in economics that

represents an idealized and theoretical model of a market.
• Perfect competition is a theoretical market where prices reflect
complete mobility of resources and freedom of entry and exit, full
access to information by all participants, homogeneous products, and
where no one buyer or seller has any advantage over another.
Assumptions for analysing
perfect competition?
PERFECT COMPETITION – KEY ASSUMPTIONS
1. Homogenous products (perfect substitutes) ensures single market price
2. All firms have equal access to factors of production
3. Many buyers & sellers (no monopoly or monopsony power)
4. Sellers must act independently (no price collusion)
5. Free (costless) entry into and exit out of the market
6. Perfectly elastic demand curve for each individual firm
7. Perfect knowledge / information for buyers/sellers about prices
and quality of what is being sold
8. Profit maximization is assumed as the default objective of firms –
(MC=MR) and consumers are assumed to be utility maximisers
when making purchasing decisions.
Marginal Revenue, Marginal Cost, and Profit Maximization
● Profit Difference between total revenue and total cost.
π(q) = R(q) − C(q)
● Marginal revenue Change in revenue resulting from a
one-unit increase in output.
Figure 8.1

Profit Maximization in the Short Run

A firm chooses output q*, so that

profit, the difference AB
between revenue R and cost C,
is maximized.
At that output, marginal revenue
(the slope of the revenue curve)
is equal to marginal cost (the
slope of the cost curve).

Δπ/Δq = ΔR/Δq − ΔC/Δq = 0

MR(q) = MC(q)
Marginal Revenue, Marginal Cost, and Profit Maximization

Demand and Marginal Revenue for a Competitive Firm

Because each firm in a competitive industry sells only a small fraction of the
entire industry output, how much output the firm decides to sell will have no
effect on the market price of the product.

Because it is a price taker, the demand curve d facing an individual

competitive firm is given by a horizontal line.
Are there markets that come close
to meeting the assumptions of
perfect competition?
 MARKET STRUCTURES
EXAMPLES OF (NEAR) PERFECT COMPETITION

Flower sellers at a
wholesale market

Forex markets for

currencies
Fruit sellers in a street
market
How is price and output
established in a perfectly
competitive market?
Demand and Marginal Revenue for a Competitive Firm

Figure 8.2
Demand Curve Faced by a Competitive Firm

A competitive firm supplies only a small portion of the total output of all the firms in an
industry. Therefore, the firm takes the market price of the product as given, choosing its
output on the assumption that the price will be unaffected by the output choice.
In (a) the demand curve facing the firm is perfectly elastic,
even though the market demand curve in (b) is downward sloping.
MARKET STRUCTURES
PERFECT COMPETITION – CONSIDER A REPRESENTATIVE FIRM

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S
MC

P1

AC

Output Output
 Price Taking Firms
Price-taking firms are firms that do not have the
ability to influence the price of the product they
produce. In perfect competition, firms are said to be
price-takers because they must accept the market
price for their product - they can't charge more or
less than the market price. In other words, firms are
price-takers because they must "take" the market
price as given.
 MARKET STRUCTURES
PERFECT COMPETITION – EACH FIRM IS A PRICE TAKER

Cost & Market Supply and Cost & Costs and Profits for a
Revenues,
Revenue Demand RevenueCompetitive Firm Firms are assumed to
be passive price-
takers in this market
S
MC
Price-taking firms are firms
that do not have the ability to
influence the price of the
Each firm takes product they produce. In
P1 this price perfect competition, firms are
said to be price-takers because
AC they must accept the market
price for their product - they
can't charge more or less than
the market price. In other
words, firms are price-takers
D
because they must "take" the
market price as given.
Output Output
 MARKET STRUCTURES
PERFECT COMPETITION – MARKET PRICE BECOMES AR = MR

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S
MC

P1 P1 AR=MR

AC

Firms are assumed to

be passive price-
D
takers in this market

Output Output
 MARKET STRUCTURES
PERFECT COMPETITION – ASSUME PROFIT MAXIMISATION

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S
MC

P1 P1 AR=MR

AC

Firms are assumed to

be passive price-
D
takers in this market

Output Q1 Output
 MARKET STRUCTURES
PERFECT COMPETITION – PROFIT = (P1 – C1) Q1

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S
MC

P1 P1 AR=MR

AC
C1

Firms are assumed to

be passive price-
D
takers in this market

Output Q1 Output
 MARKET STRUCTURES
PERFECT COMPETITION – TOTAL PROFIT SHOWN (SHADED)

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S
MC

P1 P1 AR=MR

AC
C1

Firms are assumed to

be passive price-
D
takers in this market

Output Q1 Output
 MARKET STRUCTURES
PERFECT COMPETITION – SHORT RUN PROFITS SINCE P > AC

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S
MC
Supernormal profits
in short run

P1 P1 AR=MR

AC
C1

Firms are assumed to

be passive price-
D
takers in this market

Output Q1 Output
Will all firms in perfect competition
necessarily make a profit at the
prevailing market price?
If the market price is lower than the average cost
of production, firms will incur losses, and if the
market price is higher than the average cost of
production, firms will earn profits.
MARKET STRUCTURES
PERFECT COMPETITION – MARKET PRICE MIGHT BE LOW

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

Output Output
MARKET STRUCTURES
PERFECT COMPETITION – MARKET PRICE MIGHT BE LOW

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

P1

Output Output
MARKET STRUCTURES
PERFECT COMPETITION – FIRM MUST ACCEPT PRICE P1

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

P1

Output Output
MARKET STRUCTURES
PERFECT COMPETITION – PRICE IS BELOW AVERAGE COST

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

AR=MR
P1

Output Output
MARKET STRUCTURES
PERFECT COMPETITION – NORMAL PROFIT MAX RULE APPLIES

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

AR=MR
P1

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – AC HIGHER THAN P1

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

AR=MR
P1

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – MEANS LOSSES IN THE SHORT RUN

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

C1
AR=MR
P1

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – LOSSES SHOWN BY SHADED AREA

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

C1
AR=MR
P1

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – PROFIT MAX IS SAME AS MIN LOSS

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

MC
AC

C1
LOSS AR=MR
P1

Output Q1 Output
 Each firm is a passive price taker

Key takeaway
points on P = AR = MR (there is a perfectly elastic
demand for each firm)
perfect
competition Profit/loss depends on (i) ruling market price
in the short and (ii) the short run costs of each seller

run
The number of firms in the market in the
long run will adjust to profits being made
If most firms are making losses, what would
you expect to happen to the number of
firms in the market going forward?
CHOOSING OUTPUT IN THE SHORT RUN
The Short-Run Profit of a Competitive Firm
Figure 8.4

A Competitive Firm Incurring Losses

A competitive firm should shut

down if price is below AVC.

The firm may produce in the short

run if price is greater than average
variable cost.

Shut-Down Rule: The firm should shut down if the price of the
product is less than the average variable cost of production at the
profit-maximizing output.
How does a perfectly
competitive market
adjust to a long run
equilibrium?
MARKET STRUCTURES
PERFECT COMPETITION – SHORT RUN PROFITS

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1

AC

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – SHORT RUN PROFITS

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC
Supernormal profits
in short run

AR1=MR1
P1

AC
C1

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – SHORT RUN PROFITS

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1

AC

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – SHORT RUN PROFITS

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1 S2

AC

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – SHORT RUN PROFITS

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1 S2

AC

Output Q1 Output
MARKET STRUCTURES
SHORT RUN PROFITS ATTRACT NEW FIRMS INTO THE MARKET

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1 S2

AC

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – NEW FIRMS CAUSE PRICE TO DROP

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1 S2

AC

P2

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – NEW FIRMS CAUSE PRICE TO DROP

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1 S2

AC

P2 P2

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – NEW FIRMS CAUSE PRICE TO DROP

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1 S2

AC

P2 P2 AR2=MR2

Output Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – NEW FIRMS CAUSE PRICE TO DROP

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1 S2

AC

P2 P2 AR2=MR2

Output Q2 Q1 Output
MARKET STRUCTURES
PERFECT COMPETITION – NEW FIRMS CAUSE PRICE TO DROP

Cost & Market Supply and Cost & Revenues, Costs and Profits for a
Revenue Demand Revenue Competitive Firm

S1
MC

AR1=MR1
P1 S2

AC

P2 P2 AR2=MR2

Output Q2 Q1 Output
The entry of new firms in markets can “compete
away” the supernormal profits of existing
businesses. This important insight can be applied in
many scenarios both domestic and international.
The Long Run: Market Supply with Entry and Exit
The Long Run: Market Supply
Panel (a) of Figure 7 shows a firm in such a long-run equilibrium. In this figure, price P equals marginal cost MC, so the
firm is maximizing profit. Price also equals average total cost ATC, so profit is zero. New firms have no incentive to enter
the market, and existing firms have no incentive to leave the market.
From this analysis of firm behavior, we can determine the long-run supply curve for the market. In a market with free
entry and exit, there is only one price consistent with zero profit—the minimum of average total cost. As a result, the
long-run market supply curve must be horizontal at this price, as illustrated by the perfectly elastic supply curve in
panel (b) of Figure 7. Any price above this level would generate profit, leading to entry and an increase in the total
quantity supplied. Any price below this level would generate losses, leading to exit and a decrease in the total quantity
supplied. Eventually, the number of firms in the market adjusts so that price equals the minimum of average total cost,
and there are enough firms to satisfy all the demand at this price.
Why the Long-Run Supply Curve Might Slope Upward
There are, however, two reasons that the long-run market supply curve might slope upward.
The first is that some resources used in production may be available only in limited quantities.

For example, consider the market for farm products. Anyone can choose to buy land and start a farm,
but the quantity of land is limited. As more people become farmers, the price of farmland is bid up,
which raises the costs of all farmers in the market. Thus, an increase in demand for farm products
cannot induce an increase in quantity supplied without also inducing a rise in farmers’ costs, which
in turn means a rise in price. The result is a long-run market supply curve that is upward sloping,
even with free entry into farming.

A second reason for an upward-sloping supply curve is that firms may have different costs.

For example, consider the market for painters. Anyone can enter the market for painting services, but not
everyone has the same costs. Costs vary in part because some people work faster than others and in part
because some people have better alternative uses of their time than others. For any given price, those
with lower costs are more likely to enter than those with higher costs. To increase the quantity of painting
services supplied, additional entrants must be encouraged to enter the market. Because these new entrants
have higher costs, the price must rise to make entry profitable for them. Thus, the long-run market supply
curve for painting services slopes upward even with free entry into the market.
Choosing Output in the Long Run
Long-Run Competitive Equilibrium
Entry and Exit

In a market with entry and exit, a firm enters when it can earn a positive long-
run profit and exits when it faces the prospect of a long-run loss.

● long-run competitive equilibrium All firms in an

industry are maximizing profit, no firm has an incentive
to enter or exit, and price is such that quantity supplied
equals quantity demanded.

Firms Having Identical Costs

To see why all the conditions for long-run equilibrium must hold, assume that
all firms have identical costs.
Now consider what happens if too many firms enter the industry in response
to an opportunity for profit.
The industry supply curve will shift further to the right, and price will fall.
Choosing Output in the Long Run
Long-Run Competitive Equilibrium

Firms Having Different Costs

Now suppose that all firms in the industry do not have identical cost
curves.
The distinction between accounting profit and economic profit is
important here.
If the patent is profitable, other firms in the industry will pay to use it.
The increased value of the patent thus represents an opportunity cost
to the firm that holds it.
The Opportunity Cost of Land
There are other instances in which firms earning positive accounting
profit may be earning zero economic profit.
Suppose, for example, that a clothing store happens to be located near a
large shopping center. The additional flow of customers can substantially
increase the store’s accounting profit because the cost of the land is
based on its historical cost.