ECO 111: PRINCIPLES OF ECONOMICS

MARKET STRUCTURES
What is market? Most people define market as a definite physical location where buyers and sellers meet
face to face and exchange goods or services for money. This is a narrow conception of market. In
economics, a market is defined as any arrangement in which buyers and sellers get into touch with each
other to exchanger goods or services using money as the medium of exchange. Buyers and sellers may be
anywhere in the world and instead of actually meeting in a place they may deal with one another by
telefax, telephone and any forms of media means.
There is no unique classification of markets.
Markets are distinguished by factors such as:
1. the type of commodity or service being traded
2. the number of buyers or sellers
3. the ease with which firms enter or leave the market and
4. the extent to which participants are aware of opportunities in all parts of the market.
We shall be looking the profit maximizing behaviours of firms operating in four main types of market
structures: perfect competition, monopoly, monopolistic competition and oligopoly.
PERFECT COMPETITION (PC)
Characteristics of a PC
1. Large number of buyers and sellers
2. Homogeneous product
3. Perfect mobility of resources
4. Perfect knowledge of all relevant information
The only industry where these conditions are meant is the farming industry. Eg. Egg production or raw
agricultural products are perfectly the same and there is no room for product differentiation.
Short-Run Equilibrium of the Perfect Competitive Firm
A firm is in equilibrium at the output level where profit is maximized. We can as well refer to the short-
run equilibrium as the short-run profit-maximization. The firm maximizes profit at the output level where
marginal revenue (MR) is equal to marginal cost (MC). Since price and MR are equal for the perfectly
competitive firm, the profit-maximizing rule can be redefined as the output level where MC=MR=P and
the MC is rising. It is also necessary that the firm will be operating at the minimum point of its short-run
average total cost curve (SAC) because cost-minimization is a prerequisite for profit-maximization.

SMC
SAC
T
AVC
P1 MR=AR

Profits
R S

0 Q Output
1

Figure 1: Short Run Equilibrium for a Perfectly Competitive Firm

Positive economic profit:

TR = Area OP1TQ1
TC = Area 0RSQ1
Profit = TR – TC = Area P1RST
Note that the demand curve of the firm is equal to the price, MR and AR
The Short-Run Supply Curve for a Perfectly Competitive Firm
A firm supply curve shows how much the firm is willing to produce and sell at each alternative prices.
Since each firm is assumed to be a profit-maximizing firm, it follows logically that each successive
additional output level will correspond to a marginal cost of production. But the minimum price that a
firm can accept for its product is that which is equal to its average variable cost (AVC). A firm will short
down and produce nothing if on each unit of output it cannot cover at least its AVC or if its loss will
exceed its total fixed cost (TFC). This is the only way by which the firm can minimize it loss. A firm should
operate to minimize loss if it can cover its total fixed cost (TFC) p0lus a fraction of its total variable cost
(TVC).

SMC S
AVC
P3 C MR3 P3
P2 B MR2 P2
A P1
P1 MR1

0 Q1 Q2 Q3 Q 0 Q1 Q2 Q3 Q

Figure 2: Marginal Cost Curve and Firm’s Supply Curve

The supply curve of a perfectly competitive firm is the portion of its MC curve that lies about the
minimum point of its AVC curve. The MC curve above point A (minimum point of AVC) on AVC curve is
identical to the supply curve.
Long-Run Equilibrium of the Perfectly Competitive Firm
The presence of positive economic profit in the short-run encourages new firms to enter the industry. It
is a wise economic decision for entrepreneurs to shift their resources away from those lines of production
where variables costs cannot be covered to the one where economic profits can be earned. Since there
are not barriers to entry, the industry will continue to receive new entrants. This will lead to increase in
the market supply of the product and the price will fall continuously until all economic profits are
eliminated. Then there will be no further incentives for entry. Therefore, in the long run, a perfectly
competitive firm will earn normal profits (that is, zero economic profit). The firm still stays in business
because its resources could earn just as much somewhere else.
LMC
LAC

S MR=AR=D
LAC=Pe

0 Qe Output
Figure 3: Long-Run Equilibrium for a Perfectly Competitive Firm

TR=TC=Area OPeSQe
Zero profit.
Advantages of Perfect Competition
1. Consumers pay the lowest possible price
2. Resources are most efficiently utilized
3. Minimum cost are incurred on sales promotion
Disadvantages of Perfect Competition
1. Firms make little or no profit
2. Inventions and innovation are rare
3. Social costs are disregarded
4. Problem of income inequality are worsened

MONOPOLY
Characteristics of Monopoly
Monopoly is a market structure that is the extreme opposite of perfect competition. Simply defined,
a monopoly is the form of a market organization in which there is a single firm producing a commodity
for which there are no close substitutes. The monopolist is a price-setter because the single firm
constitutes the industry. By reducing its output it can force the price up and by increasing it, it price
can be forced down. Therefore, the monopolist determines simultaneously both its rate of output and
its price. This is unlike perfect competition in which the firm is a price-taker and can only influence its
output.
Since the firm is the only one in the industry, its demand curve is also the market curve. The firm
demand curve is downward sloping because lower prices are required if larger quantities are to be
sold. That is, each successive additional unit of output will be sold at a lower price. Consequently,
marginal revenue is less than the price at each level of output. This explains why both the demand
curve and the marginal revenue curve slope downward but the MR curve falling under the demand
curve.
Sources of Monopoly Power
1. Control of the entire supply of a basic input
2. Large-scale production and economies of scale
3. Franchises and patients
4. State monopoly
5. Merger and acquisition
The Short run equilibrium for a Monopolist
SMC
C SAC
Pe
Profit
A B
D

0 Qe
MR

Figure 4:
Economic Profits
TR=Area OPeCQe
TC=Area 0ABQe
Profit=Area PeABC (Shaded)
Loss Minimization by the Monopolist in the short-run
A loss is incurred when the price is less than the average total cost. If the price is equal to the average
cost (AC) , the loss is equal to the firm’s fixed cost. Therefore, if the price is even less than the average
total cost, the firm can produce as long as it is greater than the AVC; to incur a loss less than the fixed
costs (TFC). This implies that the monopolist can operate at a loss in the short run in order to minimize
loss.
 SMC

SAC
AVC
H
C0
Loss G
Pe

E F D

0 Qe
MR

The Long-Run Equilibrium for a Monopolist

With entry blocked naturally or artificially, the monopoly firm is not likely to expand output to the
level where profit will be zero, even in the long-run. Recall that what reduces the profit of a perfectly
competitive firm to zero is the absence of barriers to entry and the existence of positive economic
profits acting as a lure. Therefore, in the long-run, a monopoly firm will maximize profit by producing
where its long-run marginal cost (LMC) is equal to marginal revenue (MR), as long as price (P) is higher
than or equal to long-run average cost (LAC). The monopoly will earn positive economic profits in the
long-run.

LMC
C LAC
Pe
Profit
A B
D

0 Qe
MR

MONOPOLISTIC COMPETITION
Monopolistic competition combines certain features of both perfect competition and monopoly. For
instance, like the perfect competition, monopolistic competition is generally characterized by a large
number of buyers and sellers each accounting for a very small proportion of the total output. There are
also no significant or effective barriers to entry into the industry. But unlike perfect competition, each
firm produces a product that is differentiated that is similar but not identical to the products of other
firms in the industry. Another point of difference between perfect competition and monopolistic
competition is that, in monopolistic competition, buyers and sellers does not possess adequate
information about market conditions and opportunities.
From another perspective, monopolistic competition is similar to monopoly in the sense that each firm
produces a product that no other firm produces. Each firm is a monopolist as far as its product is
concerned.
The model of monopolistic competition is more realistic than either the PC or the Monopoly model.
Product development and advertising are very important features of monopolistic competition.
Short-Run Equilibrium for Monopolistically Competitive Firm
The short run equilibrium is exactly the same as that of a monopoly. To sell greater quantity the firm must
cut its price. To maximize profits will also require that the firm adjust its rate of production to the point
where MC equal MR. The firm will be shut down completely in the short-run to minimize its losses, if it is
unable to cover all of it variable cost of production at any positive rate of output.
Long-Run
The analysis of long run profit max under conditions of monopolistic competition is exactly analogous to
PC. The main point of difference is that each monopolistically competitive firm faces a downward sloping
demand curve, whereas each firm under PC faces an horizontal or perfectly elastic demand curve. As
result of the earning of positive economic profits in the short run, other firms are also attracted to the
monopolistically competitive industry. The entry of new firms reduces the market share of each firm so
that each firm’s demand curve will shift to the left. The monopolistically competitive firm will reach a long
run equilibrium position whereby it receives a price that is equal to long run average cost, so that it will
be earning only a normal profit.

LAC
LMC
C
LAC=Pe
MC=MR
D

0 Qe
MR

OLIGOPOLY
Oligopoly is a market structure characterized by a few number of firms with recognized mutual.
interdependence. There is mutual interdependence because any change in the price or output of one firm
has a significant influence on the sales and profits of other firms in the industry and firms produce either
homogenous or differentiated products. If the products are homogenous like cement and steel, the
market is described as perfect or pure oligopoly. On the other hand, if the products are differentiated
such as cars and cigarettes, the market is called a differentiated oligopoly.
Another feature of the oligopolistic industry is that a sizeable proportion of the industry’s ouput may be
produced by a few large firms. This is the case for the Nigerian steel industry in which three large steel
rolling mills at Osogbo, Jos and Katsina predominate. When a large percentage of an industry’s output is
produced by a few firms, such industry is described as a concentrated industry.
The kind of barriers to entry that are common in oligopolistic industries are: Large scale operations of a
few firms which give them low-cost productive capacity or economies of scale; technical or cost advantage
or cost secured by a patent right or exclusive access to resources; intensive advertising campaigns and
sales promotional measures that render the products of the competitors to be relatively unknown to the
consumers. Note that a market structure is specifically referred to as a monopoly if there are only two
firms in the industry.
Collusion and Cartels
The characteristics of oligopolistic industries tend to promote collusion among the firms. Collusion takes
the form of agreement by some firms to establish “rules of conduct” that are mutually beneficial. A
notable type of collusion is called cartel. A cartel is a formal arrangement that involves written agreements
among firms about the product’s price, the size of the industry’s output, and each firm’s share of the
industry’s output. The formation of a cartel makes it easier for those firms that are involved to charge
reasonable prices for their products making their operations more profitable. It also provides a better
opportunity to prevent entry. The most famous cartel is the international cartel of the Organization of
Petroleum Exporting Countries (OPEC).
Short-Run and Long-Run prices and output determination
The firm tend to charge higher prices and produce a smaller total industry output relative to firms in
perfect and monopolistic competitions. The firms in an oligopoly earn positive economic profits both in
the short run and the long run due to barriers to entry. If the products are differentiated, the demand
curve facing the firms will be downward sloping and the analysis of the short run equilibrium position will
be similar to the one encountered under monopoly.