Chapter 5

Market Structures
Market Structure: Introduction
 Market structure:
◦ A set of market characteristics such as number of
firms, ease of firm entry, and substitutability of
goods.

◦ It is the particular environment of firm that would

influence the firm’s pricing and output decisions.

◦ Four (4) distinct market structure:

 Perfect competition ( Pure competition)

◦ A large number of firms, standardized product, and
easy entry (or exit) by new or existing firms.
Market Structure: Introduction
 Monopoly
◦ One firm that is the sole seller of a product or
services with no close substitutes, entry is
blocked for other firms.

 Monopolistic competition
◦ Close to pure competition, except the product is
differentiated among sellers rather than
standardized and there are fewer firms.

 Oligopoly
◦ An industry in which only a few firm exist, so
each is affected by the price- output decisions of
its rivals.
Perfect competition
 A theory of market structure based on 4
assumptions:
◦ Large number of buyers and seller
 There are many sellers (supply) and many buyers
(demand).
 None of which is large in relation to total sales or
purchases. – each buyer and seller acts independently
of others and has no influence on price.

◦ Homogenous product
 Each firm produces and sells a homogeneous product.
 Product from firm A’s and firm B’s are identical and
cannot be distinguish.
Perfect competition
◦ Perfect information
 Buyers and sellers have all relevant
information about prices, product quality,
sources of supply, and so forth. – they
know everything that relates to buying,
producing and selling of product.

◦ No barrier of entry and exit

 Firms have easy entry and exit. – there are no
barriers to entry and exit.
Perfect competition
◦ Zero transaction cost
 Buyers and sellers do not incur costs in making an
exchange of goods in a perfectly competitive market.

◦ Rational buyers
 Buyers capable of making rational purchases based on
information given.

◦ Perfect factor mobility

 In the long run factor of production are perfectly
mobile, allowing free long term adjustments to changing
market conditions.
Market power
 Is the ability of a firm to profitably raise
the market price of a good or service
over marginal cost.

 Firms in perfect competition market have

no market power.

 This is because of its characteristic.

 As result, all firms in perfect competition

market are price taker.
Price taker
 Is a seller that does not have the ability to control the
price of the product it sells;

 it takes the price determined in the market.

 A firms is restrained from being anything but a price

taker if :

◦ It finds itself one among many firms where its

supply is small relative to the total market supply.

◦ It sells a homogeneous product in an

environment.

◦ Where buyers and sellers have all relevant

information.
Market demand curve and firm demand
curve in perfect competition

Px Px
SS

Pe Pe dd

DD

0 Qe Qx 0 Qx

Market Single Firm

Market demand curve and firm demand
curve in perfect competition
 When the equilibrium price has been
established, a single perfectly competitive
firm faces a horizontal demand curve at
the equilibrium price.

 In other word, demand curve for firms in

perfect competition is perfect elastic.

 Perfect elastic – change in price will result an

infinite change in quantity.
Why firms in perfectly competition sell
at market equilibrium price?
 If a perfectly competitive firm tries to charge
a price higher than the market-established
equilibrium price, it won’t sell any of its
product.

 If the firm wants to maximize profits, it will

not sell its good at a price lower than Pe.

 The equilibrium price, Pe, is the only relevant

price for the perfectly competition firms.
Marginal revenue for firms in perfect
competition
 The firm’s marginal revenue (MR) is the
change in total revenue that results from selling
one additional unit of output:
MR = TR / Q

 For a Perfectly Competitive Firm: Marginal

Revenue = Average Revenue (TR/Q) =
Equilibrium Price = Demand.

 The reason why MR=AR=DD=P in perfectly

competition market is because all firms sell at
market equilibrium price.
 The Demand Curve and the Marginal Revenue
Curve for a Perfectly Competitive Firm

Column 4 shows:
That the firm’s MR is RM5 at any output
level is equal to the equilibrium price at
RM5 (in column 1)
P = MR
Theory and Real World Markets
 Perfect competition assumptions closely met
in some industries:
◦ Wheat Market
◦ Stock Market

 Other markets approximate perfectly

competitive behavior, because they have
negligible control over price.

 There is no pure perfect competition market

in the economy.
Theory and Real World Markets
 This is because:
◦ Perfect information
 Consumers and producers has no perfect knowledge on
price, utility, quality and production methods of products.
◦ Zero transaction cost
 There are always cost incurs in making exchange of goods in
market as there are limitation such as geographical, time and
etc.
◦ Rational buyers
 Most of the time, buyers are irrational. They are influence by
emotion rather than rational mind.
◦ Perfect capital mobility
 Factors of production aren’t perfectly mobile. There is a cost
incur in mobilizing factors of production such as training,
abolishment.
Profit maximization
 Profit Maximization Rule:
◦ Produce the quantity of output at which:
MR= MC
 The firm will continue to increase its quantity of
output as long as marginal revenue is greater than
marginal cost.

 The firm will stop increasing its quantity of output

when marginal revenue and marginal cost are equal.
Profit maximization
 What level of output does the profit maximizing
for perfectly competition firm?
◦ Price taker
◦ P=MR=DD

 For the perfectly competition firm, the profit-

maximization rule is:
P = MR = MC = DD
Or
P = MC
The Quantity of Output the Perfectly
Competitive Firm Will Produce

The firm’s demand

curve is horizontal
at the equilibrium
price. Its demand
curve is its
marginal revenue
curve. The firm
produces that
quantity of output
at which MR=MC
or P=MC
Resource allocative efficiency and
productive efficiency
 Resource Allocative Efficiency
◦ A firm that produces the quantity of output at
which:
Price = Marginal Cost
◦ Resources are allocated in the most efficient
what to produce the mix of product and
services that is most wanted by society
(consumers).
◦ In other word, it’s achieved when market
equilibrium occur where consumer and
producer surplus is maximize.
Resource allocative efficiency and
productive efficiency
 Productive Efficiency
◦ A firm that produces its output at the lowest
possible per unit cost (minimum amount of
resources will be used to produce any particular
output).

P= minimum ATC (unit cost)

◦ To charge a price that is just consistent with
the cost.
Resource allocative efficiency and
productive efficiency
 A perfectly competition firm is resource
allocative efficient (P = MR = MC) – uses
the limited amounts of resources available
to society in a way that maximizes the
satisfaction of consumers.

 Productive efficiency alone doesn’t ensure

the efficient allocation of resources. Least –
costs production must be used to provide
society with the “right-good” – the goods
that consumers want most.
 The perfectly competitive firm and
resource allocative efficiency

For the Because P=MR and MR=MC, it follows that P=MC,

perfectly that is the perfectly competitive firm exhibits
competitive resource allocative efficiency.
firm, P=MR.
Also, the firm
maximizes
profits or
minimizes
losses by
producing that
quantity of
output at
which
MR=MC.
Profit Maximization and Loss Minimization
for the Perfectly Competitive Firm: Three
Cases
To produce or not to produce?
 3 cases application of the profit maximizing
(loss minimization) rule by a perfectly
competition firm (MR=MC):

1) Case 1 – P > ATC > AVC

2) Case 2 – P < AVC < ATC
3) Case 3 – ATC > P > AVC
Profit Maximization and Loss Minimization
for the Perfectly Competitive Firm: Three
Cases
Profit Maximization and Loss Minimization
for the Perfectly Competitive Firm: Three
Cases
How to Read Diagram?
 Determine the point at which MR=MC.
 Determine Pe and Qe.
 Calculate TR and TC to identify profit and loss.
 Make decision : a) Shut Down
b) Continue Operation
 Profit Maximization and Loss Minimization
for the Perfectly Competitive Firm: Three
Cases
Case 2: Case 3:
P<AVC(<ATC) ATC>P>AVC
Continue to Lose RM450 Lose RM80
produce

Shut down Lose its fixed cost Lose its fixed

of RM400 cost of RM400

Produce/ shut Shut down SR :Continue

down to produce
LR:Shut down
Profit Maximization and Loss Minimization
for the Perfectly Competitive Firm: Three
Cases
 A firm produces in the short run as long as price is above
average variable cost (P>AVC). ( Case 1 & 3)

 A firm shuts down in the short run if price is less than

average variable cost (P<AVC). Example: In Case 2, if the firm
produces in the short run, it will take a loss of RM450. If it
shuts down, its loss will be less. (Fixed costs = RM400)

 A firm produces in the short run as long as total revenue is

greater than total variable costs (TR > TVC). (Case 1 & 3)

 A firm shuts down in the short run if total revenue is less

than total variable costs (TR < TVC). If the firm shuts down,
it only has to pay off fixed costs. If the firm continues to
produce, it will lose not only its fixed costs, but part of its
variable costs as well. (Case 2)
What should a firm do in short-run?
 A firm produces in the short run
◦ price > average variable cost (P > AVC)
◦ total revenue > total variable costs (TR > TVC)
 A firm shuts down in the short run
◦ price < average variable cost (P < AVC)
◦ total revenue < total variable costs (TR < TVC)
Perfect competition firm’s short-run
supply curve
 The perfectly competition firm produces
(supplies output) in the short-run if P > AVC
(P=MR=MC).
 It shut down if P<AVC.
 Short-Run (Firm) Supply Curve:
◦ the portion of the firm’s marginal cost curve that
lies above the average variable cost curve.
◦ Only a price above average variable cost will induce the
firm to supply output.
Perfect competition firm’s short-run
supply curve
Perfect competition firm’s short-run
supply curve
 Short-Run Market (Industry) Supply Curve:
the horizontal “addition” of all existing firms’
short-run supply curves.
Perfect competition firm’s short-run
supply curve
 Why market supply curve upward-sloping?
◦ Because the market supply is the horizontal “addition” of
firms’ supply curves which are upward sloping.

◦ Each firm’s supply curve is that portion of its marginal

cost curve which lies above the average variable cost
curve.

◦ Marginal cost curves have an upward sloping portion

because of the law of diminishing marginal returns.
Perfect competition in long-run
 3 Conditions Characterize of Long-Run
Equilibrium
1. Economic profit is zero (normal profit): Price (P)
is equal to short-run average total cost (SRATC).

◦ If P > SRATC : positive economic profits attract new

firms to enter the industry.

◦ If P < SRATC : positive economic losses some firms

will exit the industry.

◦ If P = SRATC : zero economic profit (normal profit)

no incentive to enter or exit the industry (LR
equilibrium exists).
Perfect competition in long-run
2. Firms are producing the quantity of output at
which Price (P) is equal to Marginal Cost (MC).

3. No firm has an incentive to change its plant size

to produce its current output; that is,
SRATC=LRATC at the quantity of output at which
P=MC.
Perfect competition in long-run
 Long-run perfect competition equilibrium exists
when:
◦ There is no incentive for firms to enter or exit the
industry- normal profit to be earned in the LR.

◦ There is no incentive for firms to produce more or less

output:
P =MC

◦ There is no incentive for firms to change plant size:

min SRATC = min LRATC

◦ LR competitive equilibrium exists when:

P=MC= min SRATC = min LRATC
Perfect competition in long-run
Perfect competition and productive
efficiency
 Productive Efficiency is the situation that
exists when a firm produces its output at
the lowest possible per unit cost (lowest
ATC).

 The perfectly competitive firm is

productively efficient in Long-Run
Equilibrium.
The Process of Moving from One Long-Run
Competitive Equilibrium Position to Another
What happens as firms enter an
industry in search of profits?
 New firms bring down the prices for
consumers; the market can affect price and
profits.

 The potential benefits that existing firms

can enjoy if they can successfully limit entry
into the industry.

 But in perfectly competition, firms are freely

enter of exit the market.
What happens as firms enter an
industry in search of profits?
 Thus, new firms enter the market will bring down
the price (shifting the market supply curve to right).

 As result, existing firms are suffering losses.

 Because of economic losses, some firms will leave

the industry.

 Market Supply shifts leftward.

 Equilibrium price rises.

 Firms will continue to leave, causing price to rise,

until economic profits are zero.
Monopoly
 Characteristic of monopoly:
◦ There is one seller
 Firm in monopoly is a sole seller in the market

◦ Produce and sell unique product

 The single seller sells a product for which there is
no close substitute

◦ There are extremely high barriers to entry

Monopoly
◦ Market power
 Firm in monopoly has market power. Hence, they
are able to set the price more than marginal cost
(P>MC).

 Example: Public Utilities (Electricity, Water

and Gas)
Barriers to entry
 In monopoly, the firm is the industry (The
industry is the firm)
 It is very hard and impossible to enter the
industry
 3 types of barriers to entry:
◦ Legal barriers
◦ Economies of scale
◦ Exclusive ownership of a necessary resources
Barriers to entry
 Legal Barriers
◦ Public Franchise:
 A right granted to a firm by government that permits the
firm to provide a particular good or service and excludes all
others from doing the same
◦ Patents
 Granted to investors of a product or process for certain
period of time
 During this time, the patent holder is protected legally from
competitors, no one else can legally produce and sell the
patented product/process
 Rationale behind patent is to encourage innovation in an
economy
◦ Government Licenses
 Entry into some industries and corporation required
government-granted license.
 Example: Radio and TV Stations
Barriers to entry
 Economies of Scale
◦ In some industries, low ATC are obtained ONLY
through large scale production. (i.e. public
utilities that provide water & electricity such as
TNB require large set-up costs)

◦ So if new entrants are to be competitive in the

industry, they must enter it on a large scale – will
be very risky and costly

◦ Natural Monopoly: the condition where

economies of scale are so pronounced in an
industry that only one firm can survive
Barriers to entry
 Exclusive Ownership of a Necessary
Resource:
◦ Existing firms may be protected from entry of
new firms by the exclusive or near-exclusive
ownership of a resource needed to enter the
industry

◦ DeBeers company of South Africa controls a

large % of diamond production and sales
Government monopoly vs market
monopoly
 Government Monopoly: monopolies that
are legally protected from competition in
form of public franchises, patents

 Example: TNB, Syabas

 Market Monopoly: monopolies that are

not legally protected from competition. (
through EOS or exclusive ownership of a
resources

 Example: DeBeers
Natural monopoly
 Exist when there are the largest supplier in
an industry, often the first supplier in a
market

 Has an overwhelming cost advantage over

other actual or potential competitors

 They can supply to the whole market at a

lower cost per unit as compared to two or
more firms in the market
Monopoly pricing and output
decision
 A monopolist is a price searcher/price
maker

 Price Searcher:
◦ a seller that has the ability to control to some
degree the price of the product it sells
The monopolist demand and
marginal revenue
 In the theory of monopoly, a monopoly firm is the
industry and the industry is the monopoly firm

 Since the monopolist is the sole supplier in its market,

the monopoly firm faces the (downward-sloping) market
demand curve

 The monopoly has the market power to control the

price

 Unlike the perfectly competitive firm, the monopolist can

raise its price and still sell its product (though not as
much)

 If the monopolist wants to sell additional output, it must

lower price in order to do so. If the monopolist wants to
charge a higher price, it will do so at the expense of a
reduction in quantity sold
The monopolist demand and
marginal revenue
 A single monopoly firm faces a inelastic
demand curve

 Because, he is the sole producer and no

close substitution for its product

 inelastic – change in quantity is smaller than

a change in price
The monopolist demand and
marginal revenue
 The firm’s marginal revenue (MR) is the
change in total revenue that results from
selling one additional unit of output
MR = TR / Q

 For a Monopoly Firm: Marginal Revenue

is different than demand curve as the firm
have market power

 The monopolist’s demand curve lies above

its marginal revenue curve
The monopolist demand and
marginal revenue
Price and output for profit
maximizing
 Profit Maximization Rule:
◦ Produce the quantity of output at which
MR= MC

 To maximize profit – monopolist charge the

highest price per unit at which this quantity of
output can be sold
P > MC
 Monopolist is not resources allocative efficient
because it charge price more than marginal
cost
P> MC
 Price and output for profit
maximizing
The monopolist
produces the
quantity of
output (Q1) at
which MR=MC,
and charges the
highest price per
unit at which the
quantity of
output can be
sold (P1). Notice
that at the profit
maximizing
quantity of
output, price is
greater than
marginal cost,
P>MC.
Price and output for profit
maximizing
 If a firm maximizes revenue, does It
automatically maximize profit too?

 The price that maximizes total revenue is not

necessarily the price that maximizes profit

 Maximizing profit is not consistent with

maximizing revenue when variable cost exist

 Maximizing revenues is the same as maximizing

profits only when a firm has no variable costs
Price and output for profit
maximizing
 Suppose TR = RM100, TFC = RM40 and TVC = RM20

 Because TC = TFC + TVC = RM(40 + 20) = RM60

 The firm’s profit = TR – TC = RM(100-60) = RM40

 Suppose the firm can sell one more unit of a good: TR and TVC rises to
RM105 and RM30 respectively

 TC = TFC + TVC TC = RM70

 The firm’s new profit = TR – TC = RM(105-70) = RM35

 Selling one more unit of the good raises TR from RM100 to RM105, but
it lowers profit form RM40 to RM35. A firm seeks to maximize profit,
not TR

 Maximizing revenue = maximizing profit only if TC is constant (TC =

TFC and TVC = 0)
Monopoly profit and loses
For monopoly profits are earned depends on:
1) P>ATC (profit - P1CAB) 2) P<ATC (loss – P1ABC)
Price discrimination
 Price Discrimination:
 Is the practice of charging different buyers
different prices for essentially the same good
or service even though the cost is the same

 There are 3 types of price discrimination:

◦ Perfect Price Discrimination (first degree)
◦ Second Degree Discrimination
◦ Third Degree Discrimination
Price discrimination
 Perfect Price Discrimination:
◦ This is also called as discrimination among units

◦ Seller charges the highest price each consumer would be

willing to pay for the product

◦ Example:
◦ Suppose a monopolist produces and sells 1000 units of good
A. It sells each units separately and charges the highest price
each consumer would be willing to pay for the good

 Often happen in professional sector (e.g engineering,

medical and lawyer service)

 Example:
◦ A doctor might charge different price for his service to
different patient
Price discrimination
 Second Degree Discrimination:
◦ Called discrimination among quantity

◦ Seller charges a uniform price per unit for one

specific quantity, a lower price for an additional
quantity, and so on

 Example:
The monopolist might sell the 1st 10 units
for RM10 each, the next 20 units at RM9
each and so on.
i.e. Parking Fee.
Price discrimination
 Third Degree Discrimination:
◦ Called discrimination among buyers

◦ Seller charges a different price in different

markets or charges a different price to different
segments of the buying population

 Example:
◦ Bus Fare – Children and Adult, Air Ticket –
Senior Citizen has 50% Discount
Condition of price discrimination
 To price discrimination, the following
conditions must hold:
◦ The seller must exercise some control over
price; it must be a price searcher/maker

◦ The seller must be able to distinguish among

buyers who would be willing to pay different
prices

◦ It must be impossible or too costly for one

buyer to resell the good at other buyers. The
possibility of arbitrage, or “buying low and selling
high” must not exist
Why price discrimination?
 The perfectly price-discriminating monopolist tries
to get the highest price for each customer,
irrespective of what other customers pay

 However, a single-price monopolist does not

 Example:
Suppose these are the max. price at which the
following units of a product can be sold: 1st RM10,
2nd RM 9, 3rd RM 8 and 4th RM7

 For single-price monopolist TR = RM7 x4 = RM28

 For perfectly price-discrimination monopolist’s TR is

RM34
(RM10 + RM9 + RM8 + RM7)
Why price discrimination?
 For the monopolist who practices perfect price
discrimination, price equals marginal revenue

 Because he know exactly what is the reservation

price that consumer willing to pay on certain
quantity

 Because each unit is sold at its maximum reservation

price, P = MR. The demand curve is thus identical to
MR

 The perfectly price discriminating monopolist and

the perfectly competitive firm both exhibit resource
allocative efficiency (producing at quantity where P =
MC)