LESSON 4: MARKET STRUCTURES

Learning Outcomes
1. Define and describe a market and its environment.
2. Describe each of the classification under market structure.
3. Identify industries for different business environments considering the market structure of the
company.
MARKET
A market is any organization whereby buyers and sellers of a good are kept in close touch with each other.
It is precisely in the context that a market has four basic components.
 Consumers
 Sellers
 A commodity
 A price
Price determination is one of the most crucial aspects in microeconomics.
Since, every economic activity in the market is measured as per price, it is important to know the
concepts and theories related to pricing under various market forms.
Types of Market
1. Perfect Competition
2. Monopoly
3. Oligopoly
4. Monopolistic Competition

PERFECT COMPETITION
Perfect Competition is a market structure characterized by a complete absence of rivalry among the
individual firms.
In practice, businessmen use the world competition as synonymous to rivalry. In theory, perfect
competition implies no rivalry among firms.
Assumptions in Perfect Competition
1. Large numbers of sellers and buyers.
 Each individual firm, however large, supplies only a small part of the total quantity
offered in the market.
 The buyers are also numerous so that no monopolistic power can affect the working of
the market.
2. Product homogeneity:
 The technical characteristics of the product as well as the services associated with its sale
and delivery is identical.
3. Free entry and exit of firms
 There is no barrier to entry or exit from the industry.
 Entry or exit may take time but firms have freedom of movement in and out of the
industry.
 4. Profit maximization
 The goal of all firms is profit maximization.
5. No government regulation:
 There is no government intervention in the market (tariffs, subsidies, rationing of
production or demand and so on are ruled out).
If your firm fulfills assumptions 1 to 5, then you are in a pure competition market. A perfect competition
market requires nos. 6 and 7 assumptions be fulfilled.
6. Perfect mobility of factors of production:
 The factors of production are free to move from one firm to another throughout the
economy. It is also assumed that workers can between different jobs.
7. Perfect knowledge
 It is assumed that all the sellers and buyers have complete knowledge of the conditions of
the market.
Firms in the perfect competition and pure competition environment are PRICE TAKERS. The prevailing
market price dictates their products’ prices.
Market Condition of a Perfect Competition
 The demand curve is a normal downward sloping demand curve showing that for the
industry as a whole quantity demanded increases as price falls.
 If a higher price is charged, customers would know immediately that a lower price is
available elsewhere, and that the product for sale at the lower price is a perfect substitute
for the more expensive product.
 At a lower than P the firm would not maximize its profit.
Shutdown Decision
At a price P, the firm is incurring a loss, but it does not shut down because of fixed cost. In the short run, a
firm knows it must pay these fixed costs regardless of whether or not it produces. The firms only consider
the costs it can save by stopping production and those costs are its variable costs.
As long as a firm’s total revenue is covering its total variable cost, temporarily producing at a loss is the
firm’s best strategy because it is making less of a loss than it would make it if were to shut down.

MONOPOLY
Monopoly is said to exist when one firm is the sale producer or seller of a product which has no close
substitute. No close substitutes for the product of that firm should available.
The following conditions are essential:
 One and only one firms produces and sells a particular commodity or a service.
 There are no rivals or direct competitors of the firm.
 No other seller can enter the market for whatever reasons.
 Monopolist is a price maker. He tries to take the best of whatever demand and cost conditions
exist without the fear of new firms entering to complete away his profits.
Market Conditions in Monopoly
  There is only one firm in the industry and so there is no difference between the demand curve for
the industry and the firm.
 Since a normal demand curve is assumed, it is necessary for the monopolist to reduce price in
order to increase the quantity sold.
 In other words, in order to increase sales the monopolist must reduce the price of all goods sold.
Sources of Monopoly
Legal Restrictions
 Some public sector services are statutory monopolies, which means their position is
protected by law.
 A monopoly position might also be protected by a patent which prevents other firms
from producing an identical good during the life of the patent.
Capital Costs
 Certain businesses, such as international airlines and chemical companies, have relatively
high set-up costs.
Natural Factor Endowment
 A particular country has a monopoly in the supply of a particular commodity due to
natural factor endowments and it is impossible to obtain supply of the commodity from
any other source.

Tariffs and Quotas

 A tariff raises the price of goods imported into the domestic economy and a quota
restricts the volume that can be imported. They, therefore, protect domestic industry from
international competition.
Price Discrimination
 Price discrimination is ‘personal’ when different prices are charged from different
persons, ‘local’ when different prices are charged from people living in different
localities, and ‘according to use’ when, for example, higher rates are charged for
commercial use of electricity as compared to domestic use.
 Price discrimination is possible when the seller is able to distinguish individual units
bought by single buyer or to separate buyers into classes where resale among classes is
not possible.
 Price discrimination is possible in case of personal services of doctors and lawyers.
 It is also possible when markets are too distant or are separated by tariff barriers.
 There may be a legal sanction for price discrimination as in the case of electricity charges
from domestic and industrial users.
Monopoly Underproduction
 Monopoly underproduction results when a monopoly curtails output to a level at which
the marginal value of resources employed, as measured by the marginal cost of
production, is less than the marginal social benefit derived.
 Marginal social benefit is measured by the price that customers are willing to pay for
additional output.
 Deadweight Loss from Monopoly
 The tendency for monopoly firms to restrict output to increase prices and earn economic
profits gives rise to a deadweight loss from monopoly problem.
 Like any restriction on supply, the reduced levels of economic activity typical of
monopoly markets create a loss in social welfare due to the decline in mutually
beneficial trade activity.
Economies of Scale of Monopoly
 Monopoly naturally evolves in markets subject to overwhelming economies of scale in
production created by extremely large capital requirements, scarce inputs, insufficient
natural resources, and so on.
 A natural monopoly is capable of producing the goods and services desired by customers
at lower cost than could a number of smaller competing firms.
 There is a chance that an established natural monopolist could use its dominance of the
marketplace to unfairly restrict production and raise prices to further enhance economic
profits.
Inventions and Innovations
 To achieve the benefits flowing from dynamic, innovative, leading firms, public policy
sometimes confers explicit monopoly rights.
 Example is a patent.
Buyer Power
 Oligopsony exists when there are only a handful of buyers present in a market.
 Monopsony exists when a market features a single buyer of a desired product or input.
 Monopsony power enables the buyer to obtain lower prices than those that would prevail
in competitive markets.
 Monopsony power characterizes local labor markets with a single major employer and
local agricultural markets with a single feed mill or grain buyer.
 Monopsony is least harmful, and is sometimes beneficial.
 Monopsony buyer faces a monopoly seller, a situation called bilateral monopoly arises.

OLIGOPOLY
Oligopoly is a situation in which only a few firms (sellers) are competing in the market for a particular
commodity.
Characteristics of Oligopoly
 Under oligopoly, the number of competing firms being small, each firm controls an important
proportion of the total (industry) supply.
 Consequently, the effect of a change in the price or output of one firm upon the sales of its rival
firms is noticeable and not insignificant.
 The demand curve of an individual firm under oligopoly is not known and is indeterminate
because it depends upon the reaction of its rivals which is uncertain.
 Oligopolistic firms find it advantageous to coordinate their behavior through explicit agreement
(cartel) or implicit, hidden, understanding (collusion).
  Also, because the number of firms is small, it is feasible for oligopolists to establish a cartel or
collusive arrangement.
 Under oligopoly, new entry is difficult. It is neither free nor barred.
 Oligopolistic firms may not aim at maximization of profits. Modern theories of oligopoly take
into account the following alternative objectives of the firm:
a. Sales maximization with profit constraint.
b. Target or “fair” rate of profit and long-run stability.
c. Maximization of the managerial utility function.
d. Limiting (preventing) new entry.
e. Achieving “satisfactory” profits, sales, etc. That is, the firm is a “satisfier” and not
“maximizer”.
f. Maximization of joint (industry) profits rather than individual (firm) profits.
Theories on oligopoly are divided in three groups:
1. Models of non-collusive oligopoly
a. Cournot Model
It is a model wherein firms choose quantities simultaneously and independently
and industry output determines price through demand.
Larger firms with larger market shares, have a larger deviation from competitive
behavior.
b. Kinked Demand Curve
There are two versions, the Sweezy model and the Hall and Hitch model.
The essential difference between these two versions is that Sweezy’s model is
based on the marginalist approach, with the hypothesis that even an oligopolistic
firm aims at profit maximization.
In contrast, the Hall and Hitch version rejects the marginalist approach of profit
maximization. It argues that, under oligopoly, firms aim at ‘fair’ profit and follow
the full cost principle in determining the price.

2. Models of collusive oligopoly

a. Joint Profit Maximization
Cartels where firms jointly fix a price and output policy through agreement.
A cartel is a formal collusive organization of the oligopoly firms in an industry.
There may either be an open or secret collusion.
A perfect cartel is an extreme form of collusion in which member firms agree to
abide by the instructions from a central agency in order to maximize joint profits.
b. Price Leadership
Price Leadership where one firm sets the price and others follow it.
It occurs when a pre-eminent firm (the price leader) sets the price of goods or
services in its market.
Has three types:
 Barometric – a firm is more adept than the others at identifying shifts in
applicable market forces.
 Collusive – a result of explicit agreement among a handful of dominant
firms to keep their prices in mutual agreement.
 Dominant – one firm controls the vast majority of the market share in its
in its industry.

3. Managerial theories
a. Sales maximization with profit constraint
 b. Maximization of managerial utility function
Barriers to Entry
JS Bain (1956) argues that entry barriers should be defined in terms of any advantage that existing firms
hold over potential competitors.
GJ Stigler (1968) contends that for any given rate of output, only those costs that must be borne by new
entrants but that are not borne by firms already in the industry should be considered in assessing entry
barriers.
Four important sources of barriers to entry are:
1. Product Differentiation
A firm may have convinced consumers that its product is significantly better than the product of
new entrants.
The new entrant will then be forced to sell at lower price and reduce profit due to its inferiority.
2. Control of inputs by existing suppliers
Examples are scarcity of natural resources, locational advantages and managerial talent.
3. Legal restrictions
Examples are patents, licenses, exclusive franchises granted by government.
4. Scale economies
A new firm entering the industry on a small scale will have higher average cost of production. On
the other hand, large scale entry may require gouge, capital organization, etc.
Strategic Behavior
These are the strategic behavior that a firm does to lessen new entrants and their action
1. Limit Pricing
2. Price retaliation
3. Capacity expansion
4. Market saturation
Limit Pricing
JS Bain pointed out that when an existing firm --- be it a monopolist or oligopolist --- is making positive
economic profit, it may decide to set the price below the profit maximizing level in order to reduce the
possibility of entry of new firms into the market.
The low-price level over a long period of time will deter entry of new firms producing at an output rate
higher than that of existing firms and thus cannot earn a normal profit.
Price Retaliation
Firms may retaliate by reducing prices when entry actually occurs or if it appears imminent. When the
danger has diminished, prices can be increased to appropriate level.
If a firm establishes a consistent pattern of reacting to entry by drastically reducing prices, then potential
rivals may become convinced that they will face the same response and decide not to compete.
Capacity Expansion
In a rapidly growing market, a new entrant may be able to survive by serving new customers that the
existing firms cannot supply with their present production capacity.
A strategic response by established firms to prevent this from occurring would be to invest in additional
capacity.
Market Saturation
The geographic location of the productive capacity can also cause barriers to entry.
When costs of transporting a good are high relative to its value, consumers who are not close to a
production facility may be required to pay substantially higher prices to have the good delivered to their
location.

MONOPOLISTIC COMPETITION
It can define a monopolistic competitive market as a market in which there are a large number of firms
and the products in the market are close but not perfect substitute. Examples are retail trade, including
restaurants, clothing stores, and convenience stores. Each firm is, therefore, the sole producer of a
particular brand or “product”.
It is monopolist as far as that particular brand is concerned. However, since the various brands are close
substitutes, a large number of “monopoly” producers of these brands are involved in keen competition
with one another.
The differentiation among competing products or brands may be based on real or imaginary differences in
quality. Real differences among brands refer to palpable differences in quality such as shape, flavor, color,
packing, after sales service, warranty period, etc. In contrast, imaginary differences mean quality
differences which are not really palpable but buyers are made to imagine or are “conditioned” to believe
that such differences exist and are important.
Advertising often has the effect of making buyers imagine or believe that the advertised brand has
different qualities. When there is product differentiation.
Basic characteristics of a monopolistic competition.
1. There are a large number of independent sellers (buyers) in the market.
2. The relative (proportionate) market shares of all sellers are insignificant and more or less equal.
That is, seller concentration in the market is almost nonexistent.
3. There are neither any legal nor any economic barriers against the entry of new firms into the
market. New firms are free to enter the market and existing firms are free to leave the market.
If we take a closer look, we find that in some industries they, have it many differentiated brands and
create an illusion of competition and providing a barrier to entry. For example, so many brands of soaps
are there, but most of these brands are owned by 2 companies, Unilever and Proctor and Gamble. Such
type of brand proliferation put barriers for new entry in the market. There is less chance of getting a good
market share with so many brands.