MICROECONOMICS

Chapter 03

Market Structures

Presented By : Sudharma Priyadarshani

Lecturer

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 Market

❖ Market : Any arrangement that enables buyers and sellers to

contact for transactions.

❖ The term market is derived from the Latin word “Marcatus”

which means merchandise or trade.

Market is an area or atmosphere of potential exchange

- Philip Kotler-

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 Market Structure
Market structure is the interconnected characteristics of a market,
such as the number and relative strength of buyers and sellers,
degree of freedom in determining the price, level and forms of
competition, extent of product differentiation and ease of entry
into and exit from the market
Market Structure – identifies how a market is made up in terms of:
• The number of firms in the industry
• The nature of the product produced
• The degree of monopoly power each firm has
• The degree to which the firm can influence price
• Firms’ behavior
• The extent of barriers to entry

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 Determinants of Market Structure

• Freedom of entry and exit

• Nature of the product
• Number of sellers
• Control over price

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 Forms of Market

• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly

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 1. Perfect Competition Market

• Perfect competition is a market structure where an

infinitely large number of buyers and sellers operate
freely and sell a homogeneous commodity at a
uniform price.

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 Features of Perfect Competition

❖ Large number of buyers and sellers

In a perfectly competitive market, it is the forces of market
demand and market supply that determines the price of the
commodity

❖ Homogenous Products
Homogenous products are those that are identical in all
aspects (there is no different in packaging, colour, quality
etc.…)

❖ Free entry in to and exit from the market

Very easy entry into a market means that a new firms faces no
barriers to entry

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 ❖Perfect knowledge of market
Buyers and sellers have complete and perfect knowledge about
the products and prices of other sellers.

❖A Price Taker:
In a perfectly competitive market, there are many buyers
and sellers, since all the buyers and sellers know the aspects
of the market, goods are homogenous, so no individual seller
can affect the market price, because his output just takes up
a little part of the whole market output. Firms are price
takers as they have no control over the price they charge for
their product. Each producer supplies a very small
proportion of total industry output.
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 Demand Curve

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 Demand Curve

➢ The demand curve for an individual firm is different from a

market demand curve. The market demand curve slopes
downward, while the firm's demand curve is a horizontal
line.

➢ The market demand curve is a downward sloping line,

reflecting the fact that as the price of an ordinary good
increases, the quantity demanded of that good decreases.

➢ Price is determined by the intersection of market demand

and market supply; individual firms do not have any
influence on the market price in perfect competition.

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 Demand Curve

➢ Once the market price has been determined by market

supply and demand forces, individual firms become price
takers.

➢ Individual firms are forced to charge the equilibrium price of

the market or consumers will purchase the product from the
numerous other firms in the market charging a lower price.

➢ The demand curve for an individual firm is thus equal to

the equilibrium price of the market .

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 Price Determination

▪ The twin forces of market demand and market supply

determine price.
▪ The level of price at which demand and supply
curves interact each other will finally prevail in the
market.
▪ Thus the interaction of demand and supply
curves determines price-quantity equilibrium.
▪ At the equilibrium price the buyers and sellers are
satisfied.

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 AR and MR Curves

AR(Average revenue) curve and MR(Marginal Revenue) curve

under perfect competition becomes equal to D(Demand) curve
and it would be a horizontal line or parallel to the X-axis
The curve simply implies
that a firm under perfect
competition can sell as Perfectly Elastic Dema
Demand
much quantity as it likes at Curve(AR=MR=D)
the given price Price D
determined by the
industry
I.e. Perfectly elastic
demand curve
0 1 2 3 4
Commodity
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 Firm Equilibrium & Profit maximization

“Firm’s Equilibrium means, “the level of output

where the firm is maximizing its profits and
therefore, has no tendency to change its output”.

In this situation either the Firm will be earning maximum

profit or incurring minimum loss i.e. it refers to the profit
maximization

“In the words of Hansen, “A Firm will be in

equilibrium when it is of no advantage to increase
or decrease its output”.

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 Profit maximization of perfectly competitive Firm

There are two approaches to explain the equilibrium or profit

maximization of the firm.

1. Total revenue and total cost approach

2. Marginal Analysis

▪ Profit of a Firm is equal to the difference between its total

revenue (TR) and the total cost (TC) i.e., (Profit=TR-TC) and
for the equilibrium of the Firm it should be maximum

▪ Marginal cost should be equal to Marginal revenue (MC=MR).

And when these are equal profit is maximum

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1. Total Approach
 2. Marginal Analysis

In order to attain equilibrium, a firm has to satisfy 2

conditions:

1. MR= MC since profits are maximum at this point.

2. MC curve should cut MR curve from below i.e.

MC should have a positive slope.

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 MC curve in the figure cuts MR at two place i.e. T and R. At T,
it is cutting MR from above and its not the equilibrium point
as it does not satisfy 2nd condition. At R, MC is cutting MR
Curve from below. Hence R is the point of equilibrium.

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 Can a Perfect Competitive firm earn profit?

• In a short run, a firm can attain equilibrium and earn

supernormal profits, normal profits or losses depending upon
the cost conditions.

• Normal profit is defined as the minimum reward that is just

sufficient to keep the entrepreneur supplying their enterprise.
In other words, the reward is just covering opportunity cost -
that is, just better than the next best alternative. This exists
when total revenue TR, equals total cost TC.

• If a firm makes more than normal profit it is called super-

normal profit. Supernormal profit is also called economic
profit, and abnormal profit, and is earned when total revenue
is greater than the total costs.

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 Short run equilibrium: Supernormal profits

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 Short run equilibrium : Normal Profits

When a business just meets its ATC, it earns normal profit.

Here AR = ATC. MR = MC at E. The equilibrium output is OQ.
Since AR = ATC or OP = EQ, the firm is earning just normal
profits.

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 Loss in Short Run

Some firms may be experiencing losses because their average

costs exceed the current market price.

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 Long run equilibrium

• If they are making super normal profits in the short run, new
firms will be attracted in the industry which will lead to a fall in
price and an upward shift of the cost curves due to increase in
the prices of the factors as the industry expands.
• If the firm makes losses in the short term, they will leave the
industry in the long run. This will raise the price and costs may fall
as the industry contracts.
• Firms are responding to the profit motive and supernormal profit
as a signal for a reallocation of resources within the market. The
addition of new supplies would result in an increase in supply.
Making the assumption that market demand remains same,
higher market supply will reduce the equilibrium market price
until the price equal to long run average cost.
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 Long run equilibrium & Profit maximization for
Perfectly Competitive Market

The following conditions are associated with the long run

equilibrium :
• The output is produced at the minimum feasible cost.
• Consumers pay the minimum possible price which just
covers the Marginal cost i.e. MC=AC
• Firms earn only normal profits i.e. AC=AR
• Firms maximize profits (i.e. MC=MR) but the level of
profits will be just normal.

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 2. Monopoly

➢ Monopoly is a situation in which there is a single seller of a

product which has not close substitute.
➢ Under monopoly there is no rival or competitors. The degree
of competition in monopoly is nil. Thus if the buyers is to
purchase the commodity, he can purchase it only from that
seller.
➢ The seller dictates the price to consumers. Unlike perfect
competition a monopolist can fix up the price.
➢ As monopoly is a form of imperfect market organization,
there is no difference between firm and industry. A
monopoly firm is said to be an industry.
Eg: Railways, electricity
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 Features of Monopoly

▪ Single Seller of the product

In a monopoly market there is only one firm producing and
selling a product. This single firm constitutes the industry as
there is no distinction between firm and industry

▪ Restrictions to entry
There are strong barriers to entry to this market. It could be
economic, Institutional or legal. Entry is almost blocked. It may
be due to following reasons

✓ Ownership of strategic & raw material

✓ Patent rights or government licensing
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 Features of Monopoly

▪ Information of market is imperfect

No perfect information in the market. Neither the sellers nor
buyers know all aspects of the market.

▪ Monopolistic is price maker

A monopolistic faces the entire market demand. He needs to
find Out the price that he can earn the most and sell most of it.

▪ Price Discrimination
The monopolist may use his monopolistic power in any manner
in order to realize maximum revenue. He may also adopt price
discrimination.

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 Price Discrimination in monopoly

▪ One of the important feature of monopoly is price

discrimination i.e. charging different prices for same product
from different consumers.

▪ Price discrimination is a method of pricing adopted by the

monopolistic in order to earn abnormal profits.
Eg : Electricity companies sell electricity at cheaper rates
for home consumption than for industrial uses.

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 The price elasticity of the product should be different in
different sub markets. The monopolist fixes a high price for his
product for those buyers whose price elasticity of demand for
the product is less than one. This means that if monopolist
charges high price from them, they do not significantly reduce
their purchases in response to high price.

➢ A monopolist charges higher price in a market which has a

relatively inelastic demand.

➢ The market which is highly responsive to price changes is

charged less.

➢ On the whole, the monopolist benefits from such a

discrimination.
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 Professor Pigou classified 3 degrees of price discrimination.

❖ First degree Price Discrimination

Under the first degree price discrimination, the monopolist
will fix a price which will take away the entire consumer’s
surplus i.e. their maximum willingness to pay. It is also known
as perfect price discrimination.

❖ Second-Degree Price Discrimination

Under the second-degree price discrimination, he will take
away only a part of the consumer’s surplus. Here price
varies according to the quantity sold. Larger quantities are
available at a lower unit prices.

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 ❖ Third-Degree Price Discrimination
Under third-degree price discrimination, the price varies by
attributes such as location or by consumer segment. Here the
monopolist, will divide the consumers into separate submarkets
and charge different prices in different submarkets.

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 Price and Output determination

The aim of a monopolist is to maximize his profits. For that, he

has 2 choices:
1. He can fix the price for his good and leave the market to
decide what output will be required.
2. He can fix the output and leave the price to be determined
by the interaction of supply and demand.

In other words, he can either fix the price or the output

If the demand for the commodity is elastic, the monopolist
cannot fix a very high price because a rise in price may result in
a fall of demand. So he cannot sell much and he may not get
large profits. In such a case, the monopolist will fix a low price.

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 If the commodity has inelastic demand, the monopolist may fix
a high price. Even if the price is high, there will not be a fall in
demand. Then the monopolist will get maximum profits by
fixing a high price.
A monopolistic not only has to determine his output but also
price of that product.

He will try to reach the level of output at which the profits are
maximum i.e. he will try to attain the equilibrium level of
output.

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 Demand Curve of Monopoly
• Since the monopolist firm is assumed to be the only producer of a
particular product, its demand curve is identical with the market
demand curve for the product.
• The demand curve is downward sloping because of law of demand.

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 Short run equilibrium and profit

Condition for equilibrium

I. MC = MR
II. MC Curve must cuts MR Curve from below.

The below figure shows that MC curve cuts MR curve at E point.

That is the equilibrium.

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 Can a monopoly market incur losses ?

• One of the misconceptions about a monopolist is that it

always makes profit.
• It is to be noted that nothing guarantees that a monopoly
market makes profit.
• It all depend on his demand and cost conditions.
• If he faces very low demand for his product and his cost
conditions are such that ATC>AR, he will not be making
profits, rather he will incur losses.

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 • In order to know whether the monopolist is making profits or losses in
the short run, we need to introduce the ATC curve.
• MC cuts MR at E to give equilibrium output as OQ. At OQ, price charged
is OP ( we find it by extending line EQ till it touches AR/demand curve).
Also, at OQ, the cost per unit is BQ. Therefore, profit per unit is AB and
total profit is ABCP.

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 Long run equilibrium
• Long run is a period long enough to allow the
monopolist to adjust his plant size or use his
existing plant at any level that maximises his
profit.
• In the absence of competition, the monopolist
need not produce at optimal level.
• The monopolist will not continue if he makes
losses in the long run.
• He can make super normal profits in the long
run as the entry of outside firms are blocked.

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 ▪ Monopolies can maintain super-normal profits in the long
run.
▪ At profit maximization MC = MR, and output is Q and price P.
Given that price (AR) is above ATC at Q supernormal profits
are possible (area PABC)

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 3. Monopolistic Competition

▪ Monopolistic competition is another type of imperfect

competition other than monopoly.

▪ Monopolistic Competition refers to a market situation in

which there are large numbers of firms which sell closely
related but differentiated products. Markets of products like
soap, toothpaste AC, etc. are examples of monopolistic
competition.

Monopoly + Competition = Monopolistic Competition

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 Features of Monopolistic market

Features of both perfect competition and monopoly are present.

1. A large no. of sellers and buyers :

In a monopolistic market, there are large number of sellers who
individually have a small share in the market.

2. Free entry and exit :

New firms have to compete with existing firms for business. Entry
and exit is not restricted.

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 3. Imperfect information of the market:
Neither the sellers nor buyers know all aspect of the market.

4. The goods sold are heterogeneous:

The product sold by different sellers are different. The
differentiation may rise from differences in quality, package
design, advertisements, etc. Product differentiation gives rise to
an element of monopoly to the producer over the to competing
product. The producer of a brand can raise the price of his
product knowing that he will not lose all the customers to other
brands because of lack of perfect substitutability.

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 5. Non price competition:
In addition to price competition, non-price competition also
exists under monopolistic competition. Non-Price Competition
refers to competing with other firms by offering free gifts,
making favorable credit terms, etc without changing prices of
their own products. Firms under monopolistic competition
complete in a number of ways to attract customers

6. Pricing Decision :
A firm under monopolistic competition is neither a price – taker
nor a price maker. However, by producing a unique product or
establishing a particular reputation, each firm has partial control
over the price. The extent of power to control price depends
upon how strongly the buyers are attached to his brand.
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 Demand Curve in Monopolistic market

Under monopolistic competition, large number of firms selling

closely related but differentiated products makes the demand
curve downward sloping. It implies that a firm can sell more
output only by reducing the price of its product.

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 At OP price, a seller can sell OQ quantity. Demand rises to OQ1,
when price is reduced to OP1. So,
demand curve under monopolistic competition is negatively
sloped as more quantity can be sold only at a lower price. As a
result, revenue generated from every additional unit is less than
price of the product. Hence MR < AR just like it is in monopoly.

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 Price and output determination
• In a monopolistically competitive market, each firm is a price maker
since the product is differentiated.
• The 2 conditions of price and output determination and equilibrium of a
firm are MC = MR and MC curve should cut MR curve from below.
• At E, the equilibrium price is OP and the equilibrium output is OM. Per
unit cost is SM, per unit super normal profit is QS and the total
supernormal profit is PQSR.

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 Can a monopolistic Competition market incur losses ?

• Monopolistic firms may also incur losses in short term.

• Per unit cost HN is higher than OT/KN and the loss per unit
in KH. The total loss is GHKT.

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 Long run equilibrium

If the firms in the industry earn super normal profits in the

short run, there will be an incentive for new firms to enter the
industry.
As more firms enter, profits per firm will go on decreasing as the
total demand for the product will be shared among large number
of firms.
This will happen till all the profits are wiped away and all the
firms earn only normal profits. Thus in the long run all the firms
will earn only normal profits.

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 4. Oligopoly
Oligopoly is described as competition among the few.

An oligopoly is a market structure in which a few firms

dominate.

▪ When a market is shared between a few firms, it is said to be

highly concentrated. Although only a few firms dominate, it
is possible that many small firms may also operate in the
market
▪ An oligopoly is similar to a monopoly, except that rather than
one firm, two or more firms dominate the market. There is no
precise upper limit to the number of firms in an oligopoly, but
the number must be low enough that the actions of one firm
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significantly impact and influence the others.
 Features of oligopoly

1. Interdependence:

The most important feature of oligopoly is the interdependence

in decision making of the few firms which comprise the industry.
This is because when the number of competitors is few, any
change in price, output, product etc. by a firm will have a direct
effect on the fortune of its rivals, which will then retaliate in
changing their own prices, output or products as the case may
be. It is, therefore, clear that the oligopolistic firm must consider
not only the market demand for the industry’s product but also
the reactions of the other firms in the industry to any action or
decision it may take.
Oligopolies tend to compete on terms other than price. Loyalty
schemes, advertisements, and product differentiation are all
examples of non-price competition.
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 2. Group Behavior:
Oligopoly market is about group behavior not of mass or
individual behavior. There are few firms in a group which are very
much interdependent. Each oligopolist closely watches the
business behavior of other oligopolists in the industry and designs
his moves on the basis of how they behave or likely to behave.

3. Barriers to entry:
The main reason for few firms under oligopoly is the barriers,
which prevent entry of new firms into the industry. Patents,
requirement of large capital, control over crucial raw materials,
etc are some of the reasons which prevent new firms from
entering into industry. Only those firms enter into the industry
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which are able to cross these barriers
 4. Importance of advertising and selling costs:

In an oligopoly market, firms have to employ various aggressive

and defensive marketing weapons to gain a greater share in the
market or to prevent a fall in their market share. For this various
firms have to incur a good deal of costs on advertising and on
other measures of sales promotion.

Under oligopoly, advertising can become a life-and-death matter

where a firm which fails to keep up with the advertising budget of
its competitors may find its customers drifting off to rival
products.

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 Types of Oligopoly

1. Pure or Perfect Oligopoly:

If the firms produce homogeneous products, then it is called pure
or perfect oligopoly. Though, it is rare to find pure oligopoly
situation, yet, cement, steel, aluminum and chemicals producing
industries approach pure oligopoly.

2. Imperfect or Differentiated Oligopoly:

If the firms produce differentiated products, then it is called
differentiated or imperfect oligopoly. For example, cigarettes or
soft drinks. The goods produced by different firms have their own
distinguishing characteristics, yet all of them are close substitutes
of each other.

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 3. Open Vs Closed Oligopoly:
This classification is made on the basis of freedom to enter into
the new industry. An open oligopoly is the market situation
wherein firm can enter into the industry any time it wants,
whereas, in the case of a closed Oligopoly, there are certain
restrictions that act as a barrier for a new firm to enter into the
industry.
4. Partial Vs Full Oligopoly:
This classification is done on the basis of price leadership. The
partial Oligopoly refers to the market situation, wherein one large
firm dominates the market and is looked upon as a price leader.
Whereas in full Oligopoly, the price leadership is conspicuous by
its absence.
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 5. Collusive Vs Non-Collusive Oligopoly:
This classification is made on the basis of agreement or
understanding between the firms. In Collusive Oligopoly, instead
of competing with each other, the firms come together and with
the consensus of all fixes the price and the outputs. Whereas in
the case of a non-collusive oligopoly, there is a lack of
understanding among the firms and they complete against each
other to achieve their respective targets.

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 Collusive Oligopoly

Collusion refers to the agreement between a few firms in the

industry. It may either be a formal tacit agreement. If it is a tacit
one the firms follow a secret agreement. There is no direct
conduct among firms. But in a formal agreement all conditions
and conducts are open. So, they take decisions jointly by a direct
discussion or meeting.
WhyCollusion?: Few firms in an Oligopoly industry collude
on the basis of certain agreements. So, they may have the
following purposes.
a) Reduce the competition between themselves
and increase profits.
b) To create a collective or group monopoly and
thereby create a barrier for new firms which want
to enter to the industry.
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 Pricing Under Perfect Collusion

There are two types of collusion in a oligopoly market.

Cartel:
An oligopoly industry can be said to be cartel when all the individual
firms are running on the basis of the agreements. So, each firm can
earn monopoly profits by cooperating with other firms in the
agreement. It may be either an international or domestic cartel. Oil
and Petroleum Exporting Countries (OPEC) is an example of an
international cartel.
PriceLeadership:
Price leadership is another form of collusion of Oligopoly firms. One
firm assumes the role of a price leader and fixes the price of the
product on the entire industry. All the firms in the Oligopoly
industry will follow the rules fixed by the leader. Here there is no
possibility of competition between the leader and individual firms.
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 Demand Curve of oligopoly

The demand curve dD has a kink at a point P. Upper portion from

point P is more elastic because it is made on the assumption that
when one firm changes its price, others will keep their price
constant. Firm loses market share.

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 Lower portion from point P is less elastic because it is made on the
assumption that all the firm will change their price. Hence there
will be little increase in the sale of the firms. Little gain in market
share.

When an oligopolistic firm changes its price, its rival firms will
retaliate/react and change their prices which in turn effects the
demand of the former firm. Therefore an oligopolistic firm can
not have sure and definite demand curve, since it keeps shifting
as the rivals change their prices in reaction to the price charges
made by it.

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 A Quick comparison

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