READING NO.

15
THE FIRM AND MARKET STRUCTURES

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Institute. The following is the source for these materials: “CFA® Program Curriculum
Level I Volume 2, Page No. 110 to 115”
READING NO. 15
THE FIRM AND MARKET STRUCTURES
Perfect Competition
 Large number of buyers and sellers

 Homogenous in all respect

 Free to entry the market
 Perfect knowledge of the market conditions on the part of buyers and sellers
 Very low transaction costs
 All firms individually are price takers

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Price determination under perfect competition
• All individual firms are price
taker
• Demand curve is perfectly elastic

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Conditions for equilibrium of a
firm
MR = MC
MC should have a positive slope

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Permanent Decrease in Demand for a Product

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Short run supply curve of the firm in a competitive market
MC curve of a firm depicts the firm’s supply curve.

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If companies earn economic profits in a perfectly competitive market, over the long run the
supply curve will most likely:
A. shift to the left.
B. shift to the right.
C. remain unchanged.

B is correct. The economic profit will attract new entrants to

the market and encourage existing companies to expand
capacity.

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Companies most likely have a well-defined supply function when the market structure is:
A. oligopoly.
B. perfect competition.
C. monopolistic competition.

B is correct. A company in a perfectly competitive market

must accept whatever price the market dictates. The
marginal cost schedule of a company in a perfectly
competitive market determines its supply function.

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Monopolistic Competition
Large number of sellers
Product differentiation
Freedom of entry and exit
Non-price competition

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Supernormal Profits Losses

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The long-term equilibrium of a firm in perfect
competition
Optimal allocation of resources
Output produced at the minimum feasible cost
The long-term equilibrium of a firm in
monopolistic competition
Individual firm which is in equilibrium in the
long run, will be operating at levels at which it
does not fully realize economies of large scale
production. In other words, the plants are not
used to optimum capacity.
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 Perfect competition Monopolistic competition
Large number of buyers and large number of firms in Large number of buyers and large number of firms in
the industry the industry
Homogenous products which are perfect substitutes Differentiated products which are close substitutes,
but not perfect substitutes
Insignificant market share Each firm is small relative to the market
Normal profits in the long run Normal profits in the long run
Competition among firms is perfect Imperfect competition
Complete absence of monopoly Some degree of monopoly power due to product
differentiation
Free entry and exit Free entry and exit
Price-taker Some control over price cost
Price less than other market forms Price is high compared to perfect competition
Demand curve is infinitely elastic Downward sloping and more elastic demand curve
MR and AR represented by the same curve MR starts at the same point as AR and falls more
than AR
Product is produced at the minimum average cost Produced at the declining portion of average cost
curve
Efficient allocation of resources Inefficient allocation of resources

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A market structure characterized by many sellers with each having some pricing power and
product differentiation is best described as:
A. oligopoly.
B. perfect competition.
C. monopolistic competition.

C is correct. Monopolistic competition is characterized by

many sellers, differentiated products, and some pricing
power.

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A company doing business in a monopolistically competitive market will most likely
maximize profits when its output quantity is set such that:
A. average cost is minimized.
B. marginal revenue equals average cost.
C. marginal revenue equals marginal cost.

C is correct. The profit maximizing choice is the level of

output where marginal revenue equals marginal cost.

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Monopoly
Single seller of the product
Barriers to entry
No close substitutes
Market power
How do monopoly arises?
Strategic control over a scare resources
Governments granting exclusive rights to produce and sell a good or a service.
 Natural monopoly arises when there are very large economies of scale. A single firm can produce the industry’s whole
output at a lower unit cost than two or more firms could. It is often wasteful (for consumers and the economy) to have more
than one such supplier in a region because of the high costs of duplicating the infrastructure. For e.g. telephone service,
natural gas supply and electrical power distribution.

Patents and copyrights given by the government to protect intellectual property rights and to encourage innovation.

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Monopolist’s revenue curves

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Short run equilibrium

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Can a monopolist incur losses? If ATC>AR

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Long run equilibrium: need not reach the minimum of LAC curve

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Regulation of Natural Monopolies

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Price Discrimination: Condition for price discrimination:
The firm should have price setting power.
The seller should be able to divide his market into two or more sub-markets.
It should not be possible for the buyers of low-priced market to resell the product to the buyers of high- priced
market i.e. there must be no market arbitrage.
• First degree price discrimination: the monopolist separates the market into each individual consumer and
charges them the price they are willing and able to pay and thereby extract the entire consumer surplus.
• In second-degree price discrimination, the monopolist offers a variety of quantity-based pricing options that
induce customers to self-select based on how highly they value the product (e.g., volume discounts, product
bundling).
• Third-degree price discrimination can occur when customers can be separated by geographical or other traits.
One set of customers is charged a higher price, while the other is charged a lower price (e.g., airlines charge
higher fares on one day roundtrip tickets as they are more likely to be purchased by business people).

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Price Discrimination
Q P TR TC MR MC Profit New TR New MR MC Profits
0 - - 12.2 - 12.2 -12.2 - - 12.2 -12.2
1 10.0 10.0 12.7 10.0 0.5 -2.7 10.0 10.0 0.5 -2.7
2 9.0 18.0 13.9 8.0 1.3 4.1 19.0 9.0 1.3 5.1
3 8.0 24.0 16.0 6.0 2.1 8.0 27.0 8.0 2.1 11.0
4 7.0 28.0 20.0 4.0 4.0 8.0 34.0 7.0 4.0 14.0
5 6.0 30.0 26.0 2.0 6.0 4.0 40.0 6.0 6.0 14.0
6 5.0 30.0 35.0 - 9.0 -5.0 45.0 5.0 9.0 10.0
7 4.0 28.0 48.0 -2.0 13.0 -20.0 49.0 4.0 13.0 1.0

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Relationship between AR, MR, TR and price elasticity of demand

MR = P *(1 - )

TR is maximum when
• MR is zero
• Price elasticity of demand is 1

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Upsilon Natural Gas, Inc. is a monopoly enjoying very high barriers to entry. Its marginal
cost is $40 and its average cost is $70. A recent market study has determined the price
elasticity of demand is 1.5. The company will most likely set its price at:
A. $40.
B. $70.
C. $120.

C is correct.

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A government entity that regulates an authorized monopoly will most likely base regulated
prices on:
A. marginal cost.
B. long run average cost.
C. first degree price discrimination.

B is correct. This allows the investors to

receive a normal return for the risk they are
taking in the market.

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Oligopoly
Small number of sellers.
The products offered by sellers are close substitutes for each other. Products may be
differentiated by brand (e.g., Coke® and Pepsi®) or be homogenous (e.g., oil).
There are high costs of entry and significant barriers to competition.
Firms enjoy substantial pricing power.

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Demand Analysis and Pricing Strategies in Oligopoly Markets
Dominant firm model: Assumes that decision-making is sequential. The leader or
dominant firm determines its profit-maximizing level of output, the price is determined
from the demand curve for its product (the dominant firm is the price-maker) and then
each of the follower firms determine their quantities based on the given market price
(they are price-takers).

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Demand Analysis and Pricing Strategies in Oligopoly Markets
Kinked demand curve model: The demand curve has two contrasting shapes. It is
relatively elastic above current prices, and relatively inelastic below current prices. This
results in a kink in the firm's demand curve and a break in its marginal revenue curve.
 Firms will not follow a price increase but will cut their prices in response price decrease by
competitor.

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Demand Analysis and Pricing Strategies in Oligopoly Markets
Nash equilibrium: Market are interdependent, but their actions are
noncooperative: firms do not collude to maximize profits.
 Maximum joint profits occur when both firms charge HP.
 However, B will be able to increase its profits (from $400 to $450) if it
charges LP when A charges HP.
 A can only maximize its profits if B agrees to charge HP. In order to
• There are fewer firms in the
incentivize B to charge HP, A must pay B at least $51. Such behavior industry or if one firm is
is known as collusion and is unlawful in most countries. When dominant. Collusion becomes
difficult as competition between
collusive agreements are made openly and formally, the firms involved
firms in the industry increases.
are said to have formed a cartel (e.g., OPEC). • The firms produce similar
products.
• The firms have similar cost
structures.
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Demand Analysis and Pricing Strategies in Oligopoly Markets
Cournot assumption: each firm determines its profit-maximizing level assuming that
other firms’ output will not change. In equilibrium, no firm has an incentive to change
output. In the long run, prices and output are stable
The Cournot solution falls between competitive and monopoly equilibrium.

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LOS 15g: Describe the use and limitations of concentration measures in identifying market
structure.
N-firm concentration ratio:
 Computes the aggregate market share of the N largest firms in the industry.
 It is unaffected by mergers in the top tier.

Herfindahl-Hirschman Index (HHI):

 Adds up the squares of the market shares of each of the largest N companies in the market.

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[Example: Calculating HHI and the Concentration Ratio] There are 7 producers of a
certain good in an economy whose market shares are given in the following table:
Calculate:
The four-firm concentration ratio
HHI of the four largest firms
Now suppose that the two largest firms merge. Based on the new market shares, calculate
The four-firm concentration ratio
HHI of the four largest firms
Comment on the change in the two ratios before and after the merger.

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Before the merger:
Four-firm concentration ratio = 0.3 + 0.25 + 0.15 + 0.12 = 82%
HHI = + + + = 0.1894
After the merger:
Four-firm concentration ratio = 0.55 + 0.15 + 0.12 + 0.08 = 90%
HHI = + + + = 0.3458
Notice that after the merger, the four-firm concentration ratio rises by only a small amount
(10%) even though now there is a large entity that dominates the market (controls 55%).
The HHI on the other hand, rises by a substantial amount (by almost 83%), which indicates
that there has been a significant change in market structure.

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