Economic Analysis: Module-III Market Structure: Price & Output Decisions

AMITY BUSINESS SCHOOL (ABS)
Economic Analysis
Module-III
Market Structure: Price & Output
decisions
SESSION-VIII
12/08/21 Dr Arun Bhadauria, Asst Professo 2

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Perfect Competition
• Market structure analysis begins with the study of perfect
competition. Competition is said to be perfect when
producers offer what buyers want at prices just sufficient
to cover the marginal cost of production.
• Market structure describes the competitive environment
in the market for any good or service.
• A market consists of all firms and individuals willing and
able to buy or sell a particular product. This includes
firms and individuals currently engaged in buying and
selling a particular product, as well as potential entrants.
• A potential entrant is an individual or firm posing a
sufficiently credible threat of market entry to affect the
price/output decisions of incumbent firms.
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Perfect Competition
• Real or perceived differences in the quality of goods and services
offered to consumers lead to product differentiation. Sources of
product differentiation include actual physical differences, such as
those due to superior research and development, plus any
perceived differences due to effective advertising and promotion,
Price competition tends to be most vigorous for homogenous
products with few actual or perceived differences in hotly
competitive markets.
• A barrier to entry is any factor or industry characteristic that
creates an advantage for incumbents over new arrivals. Legal rights
such as patents and local, state, or federal licenses can present
formidable barriers to entry in pharmaceuticals, cable television,
television and radio broadcasting, and other industries.
• A barrier to mobility is any factor or industry characteristic that
creates an advantage for large leading firms over smaller
nonleading rivals.
• A barrier to exit is any restriction on the ability of incumbents to
redeploy assets from one industry or line of business to another.

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Perfect Competition
• Perfect competition is a market structure characterized by a large
number of buyers and sellers of essentially the same product.
– Each market participant is too small to influence market prices.
– Individual buyers and sellers are price takers. Firms take market prices
as given and devise their production strategies accordingly.
• A normal profit, defined as the rate of return necessary to attract
capital investment, is included as part of the financing costs
included in total costs and therefore, is defined as economic profit
and represents an above-normal rate of return.
• The firm incurs economic losses whenever it fails to earn a normal
profit. In general, a firm might show a small accounting profit but be
suffering economic losses because these profits are insufficient to
provide an adequate return to the firm’s stockholders.

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Perfect Competition
• Discovering the point of optimal production is made easier with marginal
analysis. Total profit is maximized when the difference between marginal
revenue and marginal cost, called marginal profit equals zero, Mπ = MR –
MC = 0. Because this point of profit maximization occurs where marginal
revenue is set equal to marginal cost, an equivalent expression that must be
met for profit maximization is that MR = MC. What is unique about the
perfectly competitive market setting is that all firms are price takers. In this
vigorously competitive market setting, profit maximization occurs when P =
MR = MC. An added condition for profit maximization, sometimes referred to
as a second order condition, is that total profits must always be decreasing
beyond the point where MR = MC.
• The marginal cost curve is the competitive form short-run supply curve
so long as P> AVC. The sustainable level of output is given by the
competitive firm long-run supply curve. Give the need to cover all fixed
costs and earn a fair rate of return, the marginal cost curve is the
competitive firm’s long-run supply curve so long as P>ATC.
• Many real-world markets do in fact closely approximate the perfectly
competitive ideal. As a result, competitive market concepts provide a
valuable guide to economic decision making.

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Problem
• Historically, the regional bell operating companies
(RBOCs) had a monopoly on the provision of local voice
phone service. Regulation has now been eased to permit
competition from competitive local exchange carriers
(CLECs), cable companies, satellite operators and
wireless competitors. Is the local phone service market
likely to become a vigorously competitive market.?
• One way of inferring competitive conditions in a market
is to consider the lifestyle enjoyed by employees and
owners. In vigorously competitive markets, employee
compensation tends to be meager and profits are apt to
be slim. Describe the perfectly competitive market
structure and provide some examples.
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Problem
• Competitive firms are sometimes criticized for costly but
superfluous product differentiation. Is there an easy
means for determining is such efforts are in fact
wasteful?
• The worker Adjustment and Retraining Notification Act
(WARN) requires employers with 100 or more employees
to provide notification 60 calendar days in advance of
plant closings and mass layoffs. Advance notice gives
workers and their families transition time to adjust to the
prospective loss of employment, seek other jobs, or get
necessary training. Some employers complain the WARN
reduces necessary flexibility and makes them reluctant to
open new production facilities. How are barriers to entry
and exit similar? How are they different?

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Problem
• “A higher minimum wage means some low-wage workers will get
fired because there will be less money available for labor costs. An
international minimum wage, scaled according to the working
conditions and cost of living in a particular country, would allow local
workers to benefit without significant trade disruption.” Discuss this
statement and explain why the demand curve is apt to be horizontal
in the unskilled labor market.
• “For smaller firms managed by their owners in competitive markets,
profit considerations are apt to dominate almost all decisions.
However, managers of giant corporations have little contact with
stockholders and often deviate from profit-maximizing behavior. Get
real. Look at Tyco, for Pete’s sake.” Discuss this statement.
• “If excess profits are rampant in the oil business, why aren’t the
stockholders of industry giants like ExxonMobil, ChevronTexaco,
and Royal Dutch Petroleum making huge stock market profits?”
Discuss this statement.

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Problem
• “Airline passenger service is a terrible high fixed-cost business
featuring fierce price competition. With uniform safety, customers
pick the lowest airfare with the most convenient departures. Except
for pilots, nobody in the airline business makes any money.” Use the
competitive firm short-run supply curve concept to explain entry and
exit in the airline passenger business. Why are pilots well paid?
• Suppose that a competitive firm long-run supply curve is given by
the expression Qf = - 500 + 10p. Does this mean that the firm will
supply -500 units of output at a zero price? If so, what does output
of -500 units mean?
• The long-run supply curve for a given competitive firm can be
written as Qf = 250 +8P or P = $31.25 +$0.125Qf. Explain why the
amount supplied by 50 such competitors is determined by
multiplying the first expression by 50 rather than by multiplying the
first expression by 50 rather than by multiplying the second
expression by a similar amount.

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SESSION-VIII OVER

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SESSION-IX

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Market Analysis
From a theoretical perspective,
competitive markets represent an
ideal form of market structure in the
sense that equilibrium market
price/output solutions maximize social
welfare through a perfect balance of
supply (cost) and demand (revenue)
considerations.

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Market Analysis
• Welfare economics is the study of how the allocation of
economic resources affects the material well-being of
consumers and producers.
• Equilibrium prices and quantities that create an exacting
balance between supply and demand in perfectly
competitive markets also maximize the total social
welfare derived from such activity. The measurement of
social welfare is closely related to consumer surplus and
producer surplus.
• Consumer surplus is the amount that consumers are
willing to pay for a given good or service minus the
amount that they are required to pay. Producer surplus is
the net benefit derived by producers from production.

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Market Analysis AMITY BUSINESS SCHOOL (ABS)
• There is a deadweight loss problem associated with deviations from

competitive market equilibrium. A deadweight loss is any loss suffered by
consumers or producers that is not transferred, but is instead simply lost
as a result of market imperfections or government policies. Because
deadweight losses are often depicted as triangles when linear supply and
demand curves are employed, deadweight losses are often described as
the welfare loss triangle.
• In the case of sellers, market power is reflected in their ability to restrict
output below competitive norms and their ability to obtain above-normal
prices and profits for extended periods. In the case of buyers, undue
market power is indicated when buyer influence results in less than
competitive prices, output, and profits for sellers.
• Generally speaking, market failure occurs when competitive market
outcomes fail to sustain socially desirable activities or to eliminate
undesirable ones.
– A first cause of market failure is failure by market structure, and due to the
absence of a sufficiently large number of buyers and sellers, Differences
between private and social costs or benefits are called externalities.
– Failure by incentive, a second important type of market failure, is always a
risk in markets where social values and social costs differ from the private
costs and values of producers and consumers.
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Market Analysis
• Economic consideration relate to the cost and efficiency
implications of tax and regulatory methods. From an
economic efficiency standpoint, a given mode of tax or
economic regulation is desirable to the extent that
benefits exceed costs. In terms of efficiency, the question
is whether market competition by itself is sufficient, or if it
needs to be supplemented with government regulation.
Social equity, or fairness, criteria must also be carefully
weighed when social considerations bear on the tax or
regulatory decision-making process.
• Preservation of consumer choice or consumer
sovereignty is an important feature of competitive
markets. A second social purpose of taxation or regulatory
intervention is to limit concentration of economic and
political power.

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Market Analysis
• Government sometimes responds to positive externalities by
providing subsidies. Subsidy policy can be indirect, like
government construction and highway maintenance grants
that benefit the trucking industry. Tradable emission
permits are pollution licenses granted by the government to
firms and individuals.
• Tax revenues only partially compensate for the attendant
losses in consumer surplus and producer surplus caused by
a tax. Imposition of a per unit tax creates a net loss in social
welfare, or a deadweight loss of taxation. The question of
who pays the economic cost of taxation can seldom be
determined merely by identifying the taxed, fined, or
otherwise regulated party. Although the point of tax collection,
or the tax incidence, of pollution charges may be a given
corporation, this tax burden may be passed on to customers
or suppliers.

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Market Analysis
• Competitive markets are subject to the forces of supply and demand. In
some instances, public policy sets a price floor in an effort to boost
producer incomes. Price floors can result in surplus production and a
significant loss in social welfare. In other instances, public policy sets a price
ceiling. A price ceiling is a costly and seldom used mechanism for
restraining excess demand. Price ceilings can result in excess demand,
shortage, and a significant loss in social welfare.
• Business profit rates are best evaluated using the accounting rate of return
on stockholders’ equity (ROE). ROE is net income divided by the book
value of stockholders’ equity, where stockholders’ equity is total assets
minus total liabilities. Profit margin is accounting net income expressed as
a percentage of sales revenue and shows the amount of profit earned per
dollar of sales. Total asset turnover is sales revenue divided by the book
value of total assets. When total asset turnover is high, the firm makes its
investments work hard in the sense of generating a large amount of sales
volume. Leverage is often defined as the ration of total assets divided by
stockholders’ equity. It reflects the extent to which debt and preferred stock
are used in addition to common stock financing.

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Market Analysis
• In competitive markets, the tendency of firm profit rates
to converge over time toward long-term averages is
called reversion to the mean. In the short run, above-
normal profits in perfectly competitive industries are
sometimes simply disequilibrium profits that exist in
the time interval between when a favorable influence on
industry demand or cost conditions first transpires and
the time when competitor entry or growth finally
develops. Disequilibrium losses are below-normal
returns suffered in the time interval between when an
unfavorable influence on industry demand or cost
conditions first transpires and the time when exit or
downsizing finally occurs

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Market Analysis
• Firms in some competitive markets enjoy above normal
returns stemming from economic luck, or temporary
good fortune due to some unexpected change in industry
demand or cost conditions. The search for an economic
advantage or a favorable competitive position in an
industry or line of business is called competitive
strategy. If a competitive firm can offer products that are
faster, better, or cheaper than the competition, then it will
be able to earn economic rents, or profits due to
uniquely productive inputs.
• Competitive markets are sometimes burdened by real
world imperfections that limit productive and allocative
efficiency. As such, microeconomic concepts and
methodology offer a valuable guide to both public policy
and business decision making.
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SESSION-IX OVER

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SESSION-X

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Monopoly
• In most markets, dozens of firms fight for market share.
However, some big markets are controlled by a single
monopoly seller. This chapter considers how such firms
come to dominate these markets, and the economic risks
involved with government regulation or a “hands off”
attitude.
• Monopoly exists when a firm is the sole producer of a
distinctive good or service that has no close substitutes.
In other words, under monopoly the firm is the industry.
Like competitive firms, the pricing discretion of monopoly
firms is constrained by the customer’s overall willingness
to pay as reflected by downward-sloping market demand
curves. Still, the absence of close substitutes gives
monopoly firms a significant amount of discretion when it
comes to setting prices. Monopoly firms are price
makers as opposed to firms in competitive market firms
who are price takers.
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Monopoly
• All monopoly markets share the common characteristics of
having the market dominated by a single seller of a distinctive
product. Blockaded entry and/or exit is also common. Finally,
cost, price, and product quality information is withheld from
uninformed buyers.
• From a social perspective, the most closely focused upon
source of inefficiency tied to monopoly stems from the fact
that monopoly firms have incentives to restrict output so as to
create scarcity and earn economic profits. 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, where marginal social benefit
is measured by the price that customers are willing to pay for
additional output. Under monopoly, marginal cost is less than
price at the profit-maximizing output level.
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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 or monopoly markets creates a loss in
social welfare due to the decline in mutually beneficial
trade activity.
• In addition to the deadweight loss from monopoly
problem, there is a wealth transfer problem associated
with monopoly. The creation of a monopoly results in the
transformation of a significant amount of consumer
surplus into producer surplus.

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Monopoly
• On rare occasion, monopoly is the natural result of vigorous
competitive forces. A natural monopoly does not arise from
government intervention of any artificial barriers to entry, but can be
a predictable result given the current state of technology and cost
conditions in the industry. Monopoly naturally evolves n markets
subject to over whelming economies of scale in production created
by extremely large capital requirements, scare inputs, insufficient
natural resources, and so on. In such instances, the market
dominant firm is called a natural monopoly, because the market
clearing price, where P = MC, occurs at a point at which long run
average total costs are still declining.
• To achieve the benefits flowing from dynamic, innovative, leading
firms, public policy some times confers explicit monopoly rights. For
example, patents grant an exclusive right to produce, use, or sell an
invention or innovation for a limited period of time.

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Monopoly
• During the 1970s and 1980s, inflation exerted constant upward
pressure on costs. At the same time consumers and voters were
able to reduce, delay, or deny reasonable rate increases. This
caused severe financial hardship for a number of utilities and their
stockholders. More recently, rapid changes in technology and
competitive conditions have rendered obsolete many traditional
forms of regulation in the electricity and telecommunications
industries. When regulators are slow to react to such changes, both
consumers and the industry suffer due to regulatory lag, or the delay
between when a change in regulation is appropriate and the date it
becomes effective.
• If only a few buyers exist in a given market, there will tend to be less
competition than if there are many buyers. Oligopsony exists when
a market features a single buyer of a desired product or input. When
a single buyer is confronted in a market with many sellers,
monopsony power enables the buyer to obtain lower prices than
those that would prevail in a competitive market.

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Monopoly
• In terms of economic efficiency, monopsony is least
harmful, and is sometimes beneficial, in those markets in
which a monopsony buyer faces a monopoly seller, a
situation called bilateral monopoly.
• Only new and unique products or services have the
potential to create monopoly profits. Imitation of such
products may be protected by patents, copyrights, or
other means. In many instances, these above-normal
profits reflect the successful exploitation of a market
niche. A market niche is a segment of a market that can
be successfully exploited through the special capabilities
of a given firm or individual. To be durable, above normal
profits derived from a market niche must not be
vulnerable to imitation by competitors.

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Monopoly
• Antitrust laws are designed to promote competition and
prevent unwarranted monopoly. By itself, large firm size
or market dominance is no offense; it is any unfairly
gained competitive advantage that is against the law.
• Without superior capability or distinctive performance,
the economic profits of pure monopoly are typically
viewed as unwarranted. On the other hand, the above-
normal returns of dynamic leading firms are often seen
as a just reward for superior performance. Balancing the
public desire for markets that are free and open with the
social need for dynamic, innovative firms makes the
study of monopoly a vital part of microeconomics.

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Problem
• Describe the monopoly market structure
and provide some examples.
• Why are both industry and firm demand
curves downward sloping in monopoly
markets?

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SESSION-X OVER

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SESSION-XI

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Pricing in Imperfect Competition
• Profit maximization always requires finding the firm’s
price/output combination that will set MR = MC. For firms
in competitive markets, the competitive market pricing
rule-of-thumb for profit maximization is to set P = MR =
MC. When price is a function of output in imperfectly
competitive markets, the imperfectly competitive
market pricing rule-or-thumb for profit maximization is
to set P = MC/[1+(1/ep)].
• Markup on cost is the profit margin for an individual
product or product line expressed as a percentage of
unit cost. The numerator of this expression, called the
profit margin, is the difference between price and cost.
The optimal markup-on-cost formula is (P-MC)/MC =
-1/(ep +1).

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• Profit margins, or markups, are sometimes calculated as a
percentage of price instead of cost. Markup on price is the profit
margin for an individual product or product line expressed as a
percentage of price, rather than unit cost as in the markup-on-cost
formula. The optimal markup-on-price formula is (P-MC)/P =
-1/ep. Either optimal markup formula can be used to derive profit-
maximizing prices solely on the basis of marginal cost and price
elasticity of demand information.
• In a competitive market, P = MC, so the markup on price tends to
converge toward zero as competitive pressures increase.
Conversely, P>MC in monopoly markets, so the markup on price
can be expected to rise as competitive pressures decrease.
Economist Abba Lerner proposed that the markup on price be used
as an indicator of market power. The Lerner Index of monopoly
Power is defined as Lerner Index = (P – MC)/P = -1/ep’ and is
another interpretation of the optimal markup on price formula.

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• During peak periods, facilities are fully utilized. A firm
has excess capacity during off-peak periods. Successful
firms that employ markup pricing typically base prices on
fully allocated costs under normal conditions but offer
price discounts or accept lower margins during off-peak
periods when substantial excess capacity is available.
• Price discrimination occurs whenever different
customers or customer groups are charged different
price markups for the same product. A market segment
is a division or fragment of the overall market with
essentially different or unique demand or cost
characteristics. Price discrimination is evident whenever
identical customers are charged different prices, or when
price differences are not proportional to cost differences

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• The extent to which a firm can engage in price discrimination is classified
into three major categories. Under First-degree price discrimination, the
firm extracts the maximum amount each customer is willing to pay for its
products. Each unit is priced separately at the price indicated along each
product demand curve. Second-degree price discrimination involves
setting prices on the basis of the quantity purchased. Quantity discounts
that lead to lower markups for large versus small customers are a common
means for second-degree price discrimination. The most commonly
observed form of price discrimination, third-degree price discrimination,
results when a firm separates its customers into several classes and sets a
different price for each customer class.
• A by-product is any output that is customarily produced as a direct result of
an increase in the production of some other output. Profit maximization
requires that marginal revenue be set equal to marginal cost for each by-
product. Although the marginal costs of by-product. Although the marginal
costs of by-products produced in variable proportions can be determined, it
is impossible to do so for by-products produced in fixed proportions.
Common costs, or expenses that are necessary for manufacture of a joint
product, can-not be allocated on any economically sound basis.

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• A vertical relation is one where the output of one division or company is
the input to another. Vertical integration occurs when a single company
controls various links in the production chain from basic inputs to final
output.
• Transfer pricing deals with the problem of pricing intermediate products
transferred among divisions of vertically integrated firms. When transferred
products cannot be sold in competitive external markets, the marginal cost
of the transferring division is the optimal transfer price. When transferred
products can be sold in perfectly competitive external markets, the external
market price is the optimal transfer price. When transferred products can be
sold in imperfectly competitive external markets, the optimal transfer price
equates the marginal cost of the transferring division to the marginal
revenue derived from the combined internal and external markets.
• Efficient pricing practices require a careful analysis of marginal revenues
and marginal costs for each relevant product or product line. Rule-of-thumb
pricing practices employed by successful firms can be reconciled with profit-
maximizing behavior when the costs and benefits of pricing information are
properly understood.

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Problem
• “Marginal cost pricing, as well as the use of incremental
analysis, is looked upon with favor by economists,
especially those on the staffs of regulatory agencies. With
this encouragement, regulated industries do indeed
employ these rational techniques quite frequently.
Unregulated forms, on the other hand, use marginal or
incremental cost pricing much less frequently, sticking to
cost-plus, or full-cost, pricing except under unusual
circumstances. In my opinion, this goes a long way
toward explaining the problems of the regulated firms
toward explaining the problems of the regulated firms vis-
à-vis unregulated industry.” Discuss this statement.
• What conditions are necessary before price
discrimination is both possible and profitable? Why does
price discrimination result in higher profits?
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SESSION-XI OVER

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Economic Analysis: Module-III Market Structure: Price & Output Decisions

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Economic Analysis: Module-III Market Structure: Price & Output Decisions

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AMITY BUSINESS SCHOOL (ABS)

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• There is a deadweight loss problem associated with deviations from

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