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4 MARKET STRUCTURES

MIDTERMS LECTURE NO. 3


THE 4 MARKET STRUCTURES

PERFECT COMPETITIVE MARKET;


MONOPOLY;
OLIGOPOLY, AND
MONOPOLISTIC COMPETITION
DETERMINANTS OF MARKET STRUCTURE IN
AN INDUSTRY
NUMBER OF FIRMS;
EASE OF ENTRY OF GOODS, AND
SUBSTITUTABILITY.
INDUSTRY

A COLLECTION
OF FIRMS
PRODUCING THE
SAME
GOOD/SERVICE.
THE PERFECT MARKET COMPETITION
GENERAL DESCRIPTION:
A VERY LARGE NUMBER OF SMALL FIRMS IN THE INDUSTRY;
ENTRY AND EXIT TO THE INDUSTRY IS EASY;
GOODS SOLD ARE PERFECT SUBSTITUTES (FIRMS PRODUCE AN IDENTICAL
PRODUCT), AND
EACH BUYER AND SELLER HAS NO CONTROL OVER THE MARKET PRICE (THIS
MEANS THAT EACH FIRM IS A PRICE TAKER THAT FACES A HORIZONTAL
DEMAND CURVE FOR ITS PRODUCT).
DEMAND CURVE IN A PERFECT COMPETITIVE MARKET

P Supply
Demand

70
Demand
curve
50

30

20

Q
1,000 2,000 3,000 10 20 30 40
Industry Output Firm output
Demand curve perfectly
THE PROFIT-MAXIMIZING LEVEL OF OUTPUT
THE GOAL OF A FIRM IS TO MAXIMIZE PROFITS;
A FIRM NEEDS TO KNOW AT WHAT QUANTITY OF OUTPUT IT EARNS PROFIT
MOST.
PROFIT IS THE DIFFERENCE OF TOTAL REVENUE (TR) AND TOTAL COST (TC).
TO KNOW THE RATE OF CHANGE IN PROFIT FOR EVERY EXTRA
OUTPUT IS PRODUCED, WE CALCULATE MARGINAL REVENUE (MR) AND
MARGINAL COST (MC).
MR- IS THE CHANGE IN TR ASSOCIATED WITH A CHANGE IN QUANTITY.
MC- IS THE CHANGE IN TC ASSOCIATED WITH A CHANGE IN QUANTITY.
MR AND MC ARE THE KEY CONCEPTS IN DETERMINING PROFIT-
MAXIMIZING OR LOSS-MINIMIZING LEVEL OF OUTPUT OF ANY FIRM.
PROFIT MAXIMIZATION IN A PERFECT
COMPETITIVE MARKET
IN A PERFECT COMPETITIVE MARKET, A FIRM MAXIMIZE PROFIT
WHEN MC = MR OR MC = P.
SINCE EVERY FIRM IN THIS MARKET STRUCTURE IS A PRICE
TAKER, THE MR OF THE FIRM IS SIMPLY THE MARKET PRICE, MR =
P.
MARGINAL REVENUE, MARGINAL COST, AND
PRICE
Price = Q TFC AFC TVC AVC TC MC ATC TR TF
MR
P35 0 P40 - 0 P40 - 0 -P40

35 1 40 P40 P28 P28 68 P28 P68 P35 -33

35 2 40 20 48 24 88 20 44 70 -18

35 3 40 13.33 64 21.33 104 16 34.67 105 1

35 4 40 10 78 19.5 118 14 9.5 140 22

35 5 40 8 90 18 130 12 26 175 45

35 6 40 6.67 107 17.83 147 17 24.5 210 63

35 7 40 5.71 129 18.43 169 22 24.14 245 76

35 8 40 5 159 19.88 199 30 24.88 280 81

35 9 40 4.44 199 22.11 239 40 26.56 315 76

35 10 40 4 253 25.3 293 54 29.3 350 57


MONOPOLY
A SINGLE SELLER PRODUCING A PRODUCT WITH NO CLOSE SUBSTITUTES IN AN
INDUSTRY,
EFFECTIVE BARRIERS TO ENTRY INTO THE MARKET, AND
THE FIRM IS A PRICE MAKER, ALSO CALLED A PRICE SEARCHER BECAUSE IT
FACES A DOWNWARD SLOPING DEMAND CURVE FOR ITS PRODUCT (IN FACT,
NOTE THAT THIS DEMAND CURVE IS THE MARKET DEMAND CURVE).

NATURAL MONOPOLY
A MONOPOLY THAT ARISES BECAUSE OF THE EXISTENCE OF ECONOMIES OF
SCALE OVER THE ENTIRE RELEVANT RANGE OF OUTPUT.
A LARGER FIRM WILL ALWAYS BE ABLE TO PRODUCE OUTPUT AT A LOWER COST
THAN COULD A SMALLER FIRM.
ONLY A SINGLE FIRM CAN SURVIVE IN A LONG-RUN EQUILIBRIUM.
FINDING A MONOPOLISTS OUTPUT, PRICE AND
PROFIT
1. DRAW THE MARGINAL REVENUE

Price

D MR

Quantity
FINDING A MONOPOLISTS OUTPUT, PRICE AND
PROFIT
1. DRAW THE MARGINAL REVENUE
2. DETERMINE THE OUTPUT THE MONOPOLIST WILL PRODUCE: THE PROFIT
MAXIMIZING LEVEL OF OUTPUT IS WHERE MR & MC CURVES INTERSECT.

Price

MC

D MR

Quantity
FINDING A MONOPOLISTS OUTPUT, PRICE AND
PROFIT
3. DETERMINE THE PRICE THE MONOPOLIST WILL CHARGE: EXTEND A LINE
FROM WHERE MR = MC UP TO THE DEMAND CURVE. WHERE THIS INTERSECTS
THE DEMAND CURVE IS THE MONOPOLISTS PRICE.

P
m

MR
Q
m
FINDING A MONOPOLISTS OUTPUT, PRICE AND
PROFIT
4. DETERMINE THE PROFIT THE MONOPOLISTS WILL EARN: SUBTRACT THE ATC
FROM PRICE AT THE PROFIT MAXIMIZING LEVEL OF OUTPUT TO GET PROFIT
PER UNIT. MULTIPLY PROFIT PER UNIT BY QUANTITY OF OUTPUT TO GET THE
TOTAL PROFIT.

ATC
P
m
Cm

MR
Q
m
FINDING A MONOPOLISTS OUTPUT, PRICE AND
PROFIT
MONOPOLIT HAS 0 PROFIT/BREAK EVEN

ATC

P
m

MR
Q
m
FINDING A MONOPOLISTS OUTPUT, PRICE AND
PROFIT
MONOPOLIT MAKE A LOSS

ATC

P
m

MR
Q
m
MONOPSONY
MONOPOLY OCCURS WHEN THERE IS A SINGLE SELLER; THERE ARE ALSO MARKETS
IN WHICH THERE IS A SINGLE BUYER. SUCH MARKETS ARE CALLED MONOPSONIES.
AN EXAMPLE OF A MONOPSONY IS A COMPANY TOWN IN W/C A SINGLE FIRM IS
THE ONLY EMPLOYER. WHEREAS A MONOPOLIST TAKES INTO ACCOUNT THE FACT
THAT IF IT SELLS MORE IT WILL LOWER THE MARKET PRICE, A MONOPSONIES TAKES
INTO ACCOUNT THE FACT THAT IT WILL RAISE THE MARKET PRICES IF IT BUYS MORE.
THUS, IT BUYS LESS AND PAYS LESS.

Price discriminating monopolists. Price discrimination happens when it charges different


prices to different individuals or group of individuals. It charges individuals high up on the
demand curve higher prices and those low on the demand curve lower prices.
BARRIERS TO ENTRY AND MONOPOLY
NATURAL ABILITY- THIS REFERS TO THE ABILITY OF FIRMS TO PRODUCE
MORE SUPERIOR QUALITY OF GOODS.
ECONOMIES OF SCALE- WHEN A SINGLE FIRM CAN PRODUCE AT A LOWER
COST THAN 2 OR MORE FIRMS. SUCH INDUSTRIES ARE CALLED NATURAL
MONOPOLIES.
GOVERNMENT RESTRICTIONS. THERE ARE MONOPOLIES BECAUSE THE
GOVERNMENT CREATED THEM.

Normative arguments against monopoly include:

1. Monopolies are inconsistent with freedom;


2. The distributional effects of monopoly are unfair, and
3. Monopolies encourage people to waste time and money trying to get monopolies.
MONOPOLISTIC COMPETITION
A LARGE NUMBER OF FIRMS,
THE PRODUCT IS DIFFERENTIATED (I.E., EACH FIRM PRODUCES A
SIMILAR, BUT NOT IDENTICAL, PRODUCT),
ENTRY IS RELATIVELY EASY, AND
THE FIRM IS A PRICE MAKER THAT FACES A DOWNWARD SLOPING
DEMAND CURVE.
MULTIPLE DIMENSIONS OF COMPETITION
PRODUCT DIFFERENTIATION- REFLECTS FIRMS ATTEMPT TO COMPETE ON
PERCEIVED ATTRIBUTES;
ADVERTISING;
SERVICE, AND
DISTRIBUTION OUTLETS
OUTPUT, PRICE & PROFIT OF A MONOPOLISTIC
COMPETITOR
A. A MONOPOLISTICALLY COMPETITIVE FIRM PRICES IN THE SAME MANNER AS
A MONOPOLIST. IT SETS QUANTITY WHERE MR = MC.

MC

Pm

D
M
R
Qm
OUTPUT, PRICE & PROFIT OF A MONOPOLISTIC
COMPETITOR
B. A MONOPOLISTIC COMPETITOR IS NOT ONLY A MONOPOLIST BUT ALSO A
COMPETITOR. COMPETITION IMPLIES ZERO (0) ECONOMIC PROFIT IN THE LONG RUN.
ECONOMIC PROFITS ARE DETERMINED BY ATC CURVE. IN THE LONG-RUN EQUILIBRIUM,
ATC IS EQUAL TO PRICE. IT EQUAL TO PRICE ONLY IF ATC CURVE IS TANGENT TO THE
DEMAND CURVE AT THE OUTPUT IT CHOOSES.

MC ATC

Pm

D
M
R
Qm
COMPARING MONOPOLISTIC COMPETITION WITH
MONOPLY
AN IMPORTANT DIFFERENCE BETWEEN A MONOPOLIST AND MONOPOLISTIC
COMPETITOR IS IN THE POSITION OF THE ATC CURVE IN LONG-RUN
EQUILIBRIUM. FOR A MONOPOLIST, ATC CURVE SHOULD BE A POSITION
BELOW
OLIGOPOLY
A SMALL NUMBER OF FIRMS PRODUCE MOST OUTPUT (BECAUSE THERE ARE
SO FEW FIRMS, EVERY COMPETITOR MUST THINK CONTINUALLY ABOUT THE
ACTIONS OF ITS RIVALS WHAT EACH DOES COULD MAKE OR BREAK THE
OTHERS)
THE PRODUCT MAY BE EITHER STANDARDIZED OR DIFFERENTIATED,
THERE ARE SIGNIFICANT BARRIERS TO ENTRY, AND
RECOGNIZED INTERDEPENDENCE EXISTS (I.E., EACH FIRM REALIZES THAT ITS
PROFITABILITY DEPENDS ON THE ACTIONS AND REACTIONS OF RIVAL FIRMS).
OLIGOPOLISTIC FIRMS ARE MUTUALLY INTERDEPENDENT.
MODELS OF OLIGOPOLY BEHAVIOR

1. CARTEL
A CARTEL IS A COMBINATION OF FIRMS THAT ACTS AS IF IT WERE A
MONOPOLY
THE LEADING FIRMS IN AN INDUSTRY BAND TOGETHER TO RESTRICT OUTPUT
AND, CONSEQUENTLY, INCREASE PRICES AND PROFITS
IF THE DEMAND IS THERE, OLIGOPOLISTIC FIRMS CAN OPENLY COLLUDE TO
CONTROL SUPPLY AND, TO A LARGE DEGREE, MARKET PRICE
A CARTEL IS THE MOST EXTREME CASE OF OLIGOPOLY.
IMPLICIT PRICE COLLUSION

MULTIPLE FIRMS MAKE THE SAME PRICING DECISIONS EVEN THOUGH THEY
HAVE NOT EXPLICITLY CONSULTED ONE ANOTHER.
ONE OF THE CHARACTERISTICS OF INFORMAL COLLUSIVE BEHAVIOR IS THE
PRICE TEND TO BE STICKY.
PRICE IS STICKY BECAUSE OF THE PERCEIVED KINKED DEMAND CURVE. IF
THE FIRM RAISES ITS PRICE, OTHER FIRMS WONT GO ALONG AND THE FIRM
WONT GAIN MARKET SHARE. THUS, THE FIRM HAS STRONG REASONS NOT
TO CHANGE ITS PRICE IN EITHER DIRECTION.
CONTESTABLE MARKET MODEL

THE 2ND MODEL OF OLIGOPOLY IS A MODEL IN W/C BARRIERS TO ENTRY AND


EXIT, NOT THE STRUCTURE OF MARKET, DETERMINE A FIRM'S PRICE AND
OUTPUT DECISIONS.
IT PLACES EMPHASIS ON ENTRY AND EXIT CONDITIONS, AND SAYS THAT THE
PRICE THAT AN OLIGOPOLY WILL CHARGE WILL EXCEED THE COST OF
PRODUCTION ONLY IF FEWS FIRMS CANNOT EXIT AND ENTER THE MARKET.
COMPARISON OF THE CONTESTABLE
MARKET AND CARTEL MODEL
AN OLIGOPOLY MODEL CAN TAKE INTO 2 EXTREMES: THE CARTEL MODEL, IN
W/C AN OLIGOPOLY SETS A MONOPOLY PRICE; AND A CONTESTABLE MODEL,
IN W/C AN OLIGOPOLY WITH NO BARRIERS TO ENTRY SETS A COMPETITIVE
PRICE.

Strategic Pricing decision- firms set price based on the expected reactions of the other
firms.

Duopoly- an oligopoly with only 2 firms.

Game theory- application of economic principles to interdependent situations.


TWO MEASURES OF THE DEGREE OF
OLIGOPOLIZATION
1. CONCENTRATION RATIO- IS THE PERCENTAGE SHARE OF INDUSTRY SALES OF
THE FOUR LEADING FIRMS IN THE INDUSTRY. INDUSTRIES WITH HIGH
CONCENTRATION RATIOS ARE VERY OLIGOPOLISTIC.
2. HERFINDAHL- HIRSCHMAN INDEX- IS THE SUM OF THE SQUARES OF THE
INDIVIDUAL MARKET SHARES OF ALL FIRMS IN THE INDUSTRY.
CALCULATE THE CONCENTRATION RATIO

FIRM PERCENT OF SALES


A 14 %
B 4
C 23
D 5
E The2 concentration ratio is
F 8
23 + 17 + 15 + 14 = 69
G 17
H 10
I 2
J 15
TOTAL 100 %
HERFINDAHL-HIRSCHMAN
INDEX (HHI)
THE HHI IS THE SUM OF THE SQUARES OF THE
MARKET SHARES OF EACH FIRM IN THE INDUSTRY
A MONOPOLY HAS 100 PERCENT OF THE MARKET
SHARE

100 = (100 X 100) = 10,000


You cant get a bigger HHI number than 10,000. Every
monopoly would have an HHI of 10,000
HERFINDAHL-HIRSCHMAN INDEX (HHI)

THE HHI IS THE SUM OF THE SQUARES OF THE MARKET SHARES OF


EACH FIRM IN THE INDUSTRY

Find the HHI in an industry with just two firms


Each firm has 50 percent of the market

50 + 50 = 2,500 + 2,500 = 5,000

Courtesy of The McGraw-Hill Companies, Inc.


THE HHI IS THE SUM OF THE SQUARES OF THE
MARKET SHARES OF EACH FIRM IN THE INDUSTRY

Find the HHI in an industry that has four firms


Each firm has 25 percent of the market

252 + 252 + 252 + 252


625 + 625 + 625 + 625
2500
MAJOR FEATURES OF DIFFERENT MARKET
STRUCTURE