Market Structure

Types of Market Structure

In order to develop principles and make predictions about
markets and how producers will behave in them,
economists have developed four principal models of
market structure:
perfect competition
monopoly
oligopoly
monopolistic competition
 Types of Market Structure

This system of market structures is based on two dimensions:

The number of producers in the market (one, few, or many)
Whether the goods offered are identical or differentiated .
Differentiated goods are goods that are different but considered somewhat substitutable by
consumers (think Coke versus Pepsi).
 Perfect Competition
•A price-taking producer is a producer whose
actions have no effect on the market price of the
good it sells.
•A price-taking consumer is a consumer whose
actions have no effect on the market price of the
good he or she buys.
•A perfectly competitive market is a market in
which all market participants are price-takers.
•A perfectly competitive industry is an industry in
which producers are price-takers.
 Two Necessary Conditions for Perfect
Competition
•1) For an industry to be perfectly competitive, it
must contain many producers, none of whom
have a large market share.
 A producer’s market share is the fraction of the total industry output
represented by that producer’s output.

•2) An industry can be perfectly competitive only

if consumers regard the products of all producers
as equivalent.
 A good is a standardized product, also known as a commodity, when consumers
regard the products of different producers as the same good.
 Free Entry and Exit
•There is free entry and exit into and from an
industry when new producers can easily enter
into or leave that industry.

•Free entry and exit ensure:

that the number of producers in an industry can
adjust to changing market conditions, and,
 that producers in an industry cannot artificially
keep other firms out.
 Perfectly Competitive Markets
A Perfectly Competitive Firm Cannot Affect the Market Price
Price taker A buyer or seller that is
unable to affect the market price.

A Perfectly Competitive Firm

Faces a Horizontal Demand
Curve
How a Firm maximizes Profit in a Perfectly
Competitive Market
Profit Total revenue minus total cost.
Profit = TR - TC
The Market Demand for Wheat
versus the Demand or One
Farmer’s Wheat
How a Firm maximizes Profit in a Perfectly
Competitive Market
Revenue for a Firm in a Perfectly Competitive Market

Average revenue (AR) Total revenue divided by the

number of units sold.

TR TR P  Q
AR  so, AR   P
Q Q Q

Marginal revenue (MR) Change in total revenue from

selling one more unit.

Change in total revenue TR

Marginal Revenue  , or MR 
Change in quantity Q
How a Firm maximizes Profit in a Perfectly
Competitive Market
Revenue for a Firm in a Perfectly Competitive Market
Farmer Douglas’s Revenue
from Wheat Farming

NUMBER OF MARKET PRICE TOTAL AVERAGE MARGINAL

BUSHELS (PER BUSHEL) REVENUE REVENUE REVENUE
(Q) (P) (TR) (AR) (MR)
0 $4 $0 - -
1 4 4 $4 $4
2 4 8 4 4
3 4 12 4 4
4 4 16 4 4
5 4 20 4 4
6 4 24 4 4
7 4 28 4 4
8 4 32 4 4
9 4 36 4 4
10 4 40 4 4
Profit for a Firm in a Perfectly Competitive Market

Farmer Douglas’s Profits from

Wheat Farming

QUANTITY TOTAL TOTAL PROFIT MARGINAL MARGINAL

(BUSHELS) REVENUE COSTS (TR-TC) REVENUE COST
(Q) (TR) (TC) (MR) (MC)
0 $0.00 $1.00 -$1.00
1 4.00 4.00 0.00 $4.00 $3.00
2 8.00 6.00 2.00 4.00 2.00
3 12.00 7.50 4.50 4.00 1.50
4 16.00 9.50 6.50 4.00 2.00
5 20.00 12.00 8.00 4.00 2.50
6 24.00 15.00 9.00 4.00 3.00
7 28.00 19.50 8.50 4.00 4.50
8 32.00 25.50 6.50 4.00 6.00
9 36.00 32.50 3.50 4.00 7.00
10 40.00 40.50 -0.50 4.00 8.00
The Profit-Maximizing Level
of Output
 When Is Production Profitable?
 If TR > TC, the firm is profitable.

 If TR = TC, the firm breaks even.

 If TR < TC, the firm incurs a loss.

 At point C (the minimum
average total cost), the
market price is $14 and
output is 4 bushels of
tomatoes (the minimum-
cost output).
This is where MC cuts
the ATC curve at its
Costs and Production in minimum.
the Short-Run Minimum average total
cost is equal to the firm’s
break-even price.
 The farm is profitable
because price exceeds
minimum average total
cost, the break-even
price, $14.
The farm’s optimal
output choice is (E)
 output of 5 bushels.
The average total cost
of producing bushels is
(Z on the ATC curve)
$14.40
The vertical distance
between E and Z:
farm’s per unit profit,
$18.00 − $14.40 =
Profitability and Market $3.60
Price Total profit: 5 × $3.60
= $18.00
 The farm is unprofitable
because the price falls
below the minimum
average total cost, $14.
The farm’s optimal
output choice is (A)
 output of 3 bushels.
The average total cost
of producing bushels is
(Y on the ATC curve)
$14.67

The vertical distance

between A and Y:
farm’s per unit loss,
Profitability and Market $14.67 − $10.00 =
Price $4.67
Total profit: 3 × $4.67
= approx. $14.00
 Profit, Break-even or Loss
•The break-even price of a price-taking firm is
the market price at which it earns zero profits.

Whenever market price exceeds minimum

average total cost, the producer is profitable.
Whenever the market price equals minimum
average total cost, the producer breaks even.
Whenever market price is less than minimum
average total cost, the producer is unprofitable.
 •Losing Money in the Medical Screening
Industry

Providing preventive
medical scans turned
out not to be a
profitable business.
Deciding whether to produce in the
Short Run
In the short run a firm suffering losses has
two choices:

 Continue to produce

 Stop production by shutting down

temporarily

Sunk cost A cost that has already been

paid and that cannot be recovered.
 The Short-Run Production
Decision

A firm will cease production in the The short-run individual

short run if the market price falls
below the shut-down price, which
is equal to minimum average variable
cost.
supply curve shows how an
individual producer’s optimal
output quantity depends on
the market price, taking fixed
cost as given.
 Industry Supply Curve
•The industry supply curve shows the
relationship between the price of a good and
the total output of the industry as a whole.
 The Short-Run Market
Equilibrium

There is a short-run The short-run industry

market equilibrium supply curve shows how the
when the quantity supplied quantity supplied by an industry
equals the quantity depends on the market price
demanded, taking the given a fixed number of
number of producers as producers.
given.
11 - 2
•When to Close a Laundry

Keeping a business open even

when suffering losses can
sometimes be the best decision
in the short run.
 “If Everyone Can Do It, You Can’t Make Money At It” –
The Entry and Exit of Firms in the Long Run
Economic Profit and the Entry or Exit Decision

Economic profit A firm’s revenues

minus all its costs, implicit and
explicit.

Economic loss The situation in

which a firm’s total revenue is less
than its total cost, including all implicit
costs.
 “If Everyone Can Do It, You Can’t Make Money At It” –
The Entry and Exit of Firms in the Long Run
Economic Profit and the Entry or Exit Decision

Farmer Appleseed’s Costs per

Year

EXPLICIT COSTS

Water $25,000
Wages $35,000
Organic fertilizer $14,000
Electricity $5,000
Payment on bank loan $6,000
IMPLICIT COSTS
Foregone salary $30,000
Opportunity cost of the $100,000 she has invested in her farm $10,000
Total Cost $125,000
 “If Everyone Can Do It, You Can’t Make Money At It” –
The Entry and Exit of Firms in the Long Run
Economic Profit and the Entry or Exit Decision
ECONOMIC PROFIT LEADS TO ENTRY OF NEW FIRMS
The Effect of Entry on Economic Profits
 “If Everyone Can Do It, You Can’t Make Money At It” –
The Entry and Exit of Firms in the Long Run
ECONOMIC LOSSES LEAD TO EXIT OF FIRMS

The Effect of Exit on Economic Losses

 “If Everyone Can Do It, You Can’t Make Money At It” –
The Entry and Exit of Firms in the Long Run
Long-Run Equilibrium in a Perfectly Competitive Market

Long-run competitive equilibrium

The situation in which the entry and
exit of firms have resulted in the typical
firm just breaking even.
The Long-Run Market Equilibrium

A market is in long-run market equilibrium when the quantity supplied

equals the quantity demanded, given that sufficient time has elapsed for
entry into and exit from the industry to occur.
•The Decline of Apple Production in New York
State

When apple growers in New

York State stopped breaking
even, many sold their land to
housing developers.
6 LEARNING OBJECTIVE

Perfect Competition and Efficiency

Productive Efficiency

Productive efficiency The situation

in which a good or service is produced
at the lowest possible cost.
Perfect Competition and Efficiency
Allocative Efficiency
Firms will supply all those goods that provide consumers
with a marginal benefit at least as great as the marginal
cost of producing them:
 The price of a good represents the marginal benefit
consumers receive from consuming the last unit of the
good sold.
 Perfectly competitive firms produce up to the point where
the price of the good equals the marginal cost of
producing the last unit.
 Therefore, firms produce up to the point where the last
unit provides a marginal benefit to consumers equal to
the marginal cost of producing it.
Perfect Competition and Efficiency
Allocative Efficiency

Allocative efficiency A state of the economy

in which production reflects consumer
preferences; in particular, every good or service is
produced up to the point where the last unit
provides a marginal benefit to consumers equal to
the marginal cost of producing it.
The Meaning of Monopoly
Our First Departure from Perfect Competition…
A monopolist is a firm that is the only producer of a good
that has no close substitutes. An industry controlled by a
monopolist is known as a monopoly. e.g. De Beers
The ability of a monopolist to raise its price above the
competitive level by reducing output is known as market
power.
What do monopolists do with this market power? Let’s
take a look at the following graph…
 What a
Monopolist Does

Under perfect competition, the price and quantity are determined by

supply and demand. Here, the equilibrium is at C, where the price is PC
and the quantity is QC. A monopolist reduces the quantity supplied to QM,
and moves up the demand curve from C to M, raising the price to PM.
35
 Why Do Monopolies Exist?
A monopolist has market power and as a result will charge
higher prices and produce less output than a competitive
industry. This generates profit for the monopolist in the
short run and long run.
Profits will not persist in the long run unless there is a
barrier to entry. This can take the form of
control of natural resources or inputs,
economies of scale,
technological superiority, or
legal restrictions imposed by governments,
including patents and copyrights.
Economies of Scale and Natural Monopoly
A monopoly created and sustained by economies of scale
is called a natural monopoly.
It arises when economies of scale provide a large cost
advantage to having all of an industry’s output produced
by a single firm.
Under such circumstances, average total cost is declining
over the output range relevant for the industry.
This creates a barrier to entry because an established
monopolist has lower average total cost than any smaller
firm.
 Economies of
Scale Create
Natural
Monopoly

A natural monopoly can arise when fixed costs required to operate are
very high  the firm’s ATC curve declines over the range of output at
which price is greater than or equal to average total cost. This gives the
firm economies of scale over the entire range of output at which the firm
would at least break even in the long run. As a result, a given quantity of
output is produced more cheaply by one large firm than by two or more
smaller firms. 38
 Comparing the Demand Curves of a Perfectly
Competitive Firm and a Monopolist
An individual perfectly competitive firm cannot affect the market price of the
good  it faces a horizontal demand curve DC , as shown in panel (a). A
monopolist, on the other hand, can affect the price (sole supplier in the
industry)  its demand curve is the market demand curve, DM, as shown in
panel (b). To sell more output it must lower the price; by reducing output it
39
raises the price.
The Monopolist’s Profit- Maximizing Output and
Price
To maximize profit, the monopolist compares marginal
cost with marginal revenue.
If marginal revenue exceeds marginal cost, De Beers
increases profit by producing more; if marginal revenue
is less than marginal cost, De Beers increases profit by
producing less. So the monopolist maximizes its profit
by using the optimal output rule:
At the monopolist’s profit-maximizing quantity of
output,
MR = MC
 The Monopolist’s
Profit- Maximizing
Output and Price

The optimal output rule: the profit maximizing level of output for the
monopolist is at MR = MC, shown by point A, where the marginal cost
and marginal revenue curves cross at an output of 8 diamonds. The
price De Beers can charge per diamond is found by going to the point on
the demand curve directly above point A, (point B here) —a price of
$600 per diamond. It makes a profit of $400 × 8 = $3,200.
41
Monopoly versus Perfect Competition
P = MC at the perfectly competitive firm’s profit-
maximizing quantity of output
P > MR = MC at the monopolist’s profit-maximizing
quantity of output
Compared with a competitive industry, a monopolist does
the following:
 Produces a smaller quantity: QM < QC
 Charges a higher price: PM > PC
 Earns a profit
 The Monopolist’s
Profit
Profit = TR − TC

= (PM × QM) −
(ATCM × QM)

= (PM − ATCM) × QM

In this case, the marginal cost curve is upward sloping and the average total cost curve is U-
shaped. The monopolist maximizes profit by producing the level of output at which MR = MC,
given by point A, generating quantity QM. It finds its monopoly price, PM , from the point on the
demand curve directly above point A, point B here. The average total cost of QM is shown by
point C. Profit is given by the area of the shaded rectangle.

43
Monopoly and Public Policy

By reducing output and raising price above marginal

cost, a monopolist captures some of the consumer
surplus as profit and causes deadweight loss. To avoid
deadweight loss, government policy attempts to
prevent monopoly behavior.
When monopolies are “created” rather than natural,
governments should act to prevent them from forming
and break up existing ones.
 Monopoly Causes Inefficiency
Panel (a) depicts a perfectly competitive industry: output is QC and market price, PC , is equal is
to MC. Since price is exactly equal to each producer’s cost of production per unit, there is no
producer surplus. Total surplus is therefore equal to consumer surplus, the entire shaded area.

Panel (b) depicts the industry under monopoly: the monopolist decreases output to QM and
charges PM. Consumer surplus (blue area) has shrunk because a portion of it is has been
captured as profit (green area). Total surplus falls: the deadweight loss (orange area) represents
the value of mutually beneficial transactions that do not occur because of monopoly behavior.
Preventing Monopoly
Dealing with Natural Monopoly
Breaking up a monopoly that isn’t natural is clearly a
good idea, but it’s not so clear whether a natural
monopoly, one in which large producers have lower
average total costs than small producers, should be
broken up, because this would raise average total cost.
Yet even in the case of a natural monopoly, a profit-
maximizing monopolist acts in a way that causes
inefficiency—it charges consumers a price that is higher
than marginal cost, and therefore prevents some
potentially beneficial transactions.
Dealing with Natural Monopoly

What can public policy do about this? There are two

common answers…
One answer is public ownership, but publicly owned
companies are often poorly run.
A common response in the United States is price
regulation. A price ceiling imposed on a monopolist
does not create shortages as long as it is not set too
low.
There always remains the option of doing nothing;
monopoly is a bad thing, but the cure may be worse
than the disease.
Regulated and Unregulated Natural Monopoly
In panel (a), if the monopolist is allowed to charge PM, it makes a profit, shown by the
green area; consumer surplus is shown by the blue area. If it is regulated and must charge
the lower price PR, output increases from QM to QR, and consumer surplus increases.

Panel (b) shows what happens when the monopolist must charge a price equal to average
total cost, the price PR*. Output expands to QR*, and consumer surplus is now the entire
blue area. The monopolist makes zero profit. This is the greatest consumer surplus
possible when the monopolist is allowed to at least break even, making PR* the best
regulated price.
The Meaning of Monopolistic Competition

Monopolistic competition is a market structure in which

there are many competing producers in an industry,
each producer sells a differentiated product, and
there is free entry into and exit from the industry in the
long run.
Product Differentiation

There are three important forms of product

differentiation:
Differentiation by style or type
Differentiation by location – Dry cleaner near home vs.
Cheaper dry-cleaner far away
Differentiation by quality – Ordinary vs. high quality
products
Economics in Action:
Case: “Any Color, So Long as It’s Black”
Ford’s strategy was to offer just one style of car,
which maximized his economies of scale but made
no concessions to differences in taste Model T

Alfred P. Sloan of GM challenged this strategy by

offering a range of car types, differentiated by
quality and price Chevrolet, Cadillac, Buick…

By the 1930s the verdict was clear: Customers

preferred a range of styles!
Understanding Monopolistic Competition: The
Monopolistically Competitive Firm in the Short Run

The following figure shows two possible situations that a

typical firm in a monopolistically competitive industry might
face in the short run.
In each case the firm looks like any monopolist: it faces a
downward-sloping demand curve, which implies a
downward-sloping marginal revenue curve.
We assume that every firm has an upward-sloping
marginal cost curve but that it also faces some fixed costs,
so that its average total cost curve is U-shaped.

52
The firm in panel (a) can be profitable for some
output levels: the levels at which its ATC, lies
below its demand curve, DP. The profit-
maximizing output level is QP, the output at
which marginal revenue, MRP, is equal to
marginal cost. The firm charges price PP and
earns a profit, represented by the area of the
shaded rectangle.
The firm above can never be profitable
because the ATC lies above its demand
curve, DU. The best that it can do if it
produces at all is to produce output QU and
charge PU. This generates a loss, indicated
by the area of the shaded rectangle. Any
other output level results in a greater loss.
53
Monopolistic Competition in the Long Run
If the typical firm earns positive profits, new firms will enter
the industry in the long run, shifting each existing firm’s
demand curve to the left. If the typical firm incurs losses,
some existing firms will exit the industry in the long run,
shifting the demand curve of each remaining firm to the
right.
In the long run, equilibrium of a monopolistically
competitive industry, the zero-profit-equilibrium, firms just
break even. The typical firm’s demand curve is just tangent
to its average total cost curve at its profit-maximizing
output.
Entry and Exit into the Industry Shift the Demand Curve of Each Firm
Entry will occur in the long run when existing firms are profitable. In panel (a), entry causes
each firm’s demand curve and marginal revenue curve to shift to the left. The firm receives
a lower price for every unit it sells, and its profit falls. Entry will cease when remaining firms
make zero profit.

Exit will occur in the long run when existing firms are unprofitable. In panel (b), exit out of
the industry shifts each remaining firm’s demand curve and marginal revenue curve to the
right. The firm receives a higher price for every unit it sells, and profit rises. Exit will cease
55
when the remaining firms make zero profit.
 The Long-Run
Zero-Profit
Equilibrium
A monopolistically
competitive firm is like a
monopolist without
monopoly profits.

If existing firms are profitable, entry will occur and shift each firm’s
demand curve leftward. If existing firms are unprofitable, each firm’s
demand curve shifts rightward as some firms exit the industry. In long-run
zero profit equilibrium, the demand curve of each firm is tangent to its
average total cost curve at its profit-maximizing output level: at the profit-
maximizing output level, QMC, price, PMC, equals average total cost, ATCMC.
56
Monopolistic Competition versus
Perfect Competition
In the long-run equilibrium of a monopolistically
competitive industry, there are many firms, all earning
zero profit.
Price exceeds marginal cost so some mutually beneficial
trades are exploited.
The following figure compares the long-run equilibrium of
a typical firm in a perfectly competitive industry with that
of a typical firm in a monopolistically competitive industry.
Panel (a) shows the situation of the typical firm in long-run equilibrium in a perfectly competitive
industry. The firm operates at the minimum-cost output QC , sells at the competitive market price
PC , and makes zero profit. It is indifferent to selling another unit of output because PC is equal to its
marginal cost, MCC .
Panel (b) shows the situation of the typical firm in long-run equilibrium in a monopolistically
competitive industry. At QMC it makes zero profit because its price, PMC, just equals average total
cost. At QMC the firm would like to sell another unit at price PMC, since PMC exceeds marginal cost,
MCMC. But it is unwilling to lower price to make more sales. It therefore operates to the left of
the minimum-cost output and has excess capacity. 58
Is Monopolistic Competition Inefficient?

Firms in a monopolistically competitive industry have

excess capacity: they produce less than the output at
which average total cost is minimized.
The higher price consumers pay because of excess
capacity is offset to some extent by the value they receive
from greater diversity.
Hence, it is not clear that this is actually a source of
inefficiency.
Controversies about Product Differentiation

No discussion of product differentiation is complete

without spending at least a bit of time on the two related
issues—and puzzles—of:
advertising
and
brand names
The Role of Advertising

In industries with product differentiation, firms advertise

in order to increase the demand for their products.

Advertising is not a waste of resources when it gives

consumers useful information about products.

Either consumers are irrational, or expensive advertising

communicates that the firm's products are of high quality.
Brand Names

Some firms create brand names.

A brand name is a name owned by a particular firm that
distinguishes its products from those of other firms.
As with advertising, the social value of brand names can be
ambiguous.
The names convey real information when they assure
consumers of the quality of a product.