MARKET

STRUCTURES
CHAPTER 5-6
ACEC 30

PREPARED BY: TENGKU NURHAZWANI TENGKU HARUDDIN

 Market Structure
 Market structures are the characteristics of a market which determine firms’
behaviour within the market.
 Key characteristics:
i. The number of firms in the market and their relative size
ii. The number of firms which might enter the market
iii. The ease or difficulty with which these new entrants might come in
iv. The extent to which goods in the market are similar
v. The extent to which all firms in the market share the same knowledge
vi. The extent to which the actions of one firm will affect another firm
 Four Market Models
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly

Pure Monopolistic Pure

Competition Competition Oligopoly Monopoly
 MARKET CONCENTRATION
• The degree to which large firms dominate an industry is known as MARKET
CONCENTRATION.
• This can be measured using concentration ratios, which consider the MARKET
SHARE of the leading firms in an industry.
 Characteristics of the Four Basic Market Models

Pure Monopolistic
Characteristic Competition Competition Oligopoly Monopoly
Number of firms A very large Many Few One
number

Type of product Standardized Differentiated Standardized or Unique; no

differentiated close subs.

Control over None (Price Some, but within rather Limited by mutual Considerable
price takers)  have narrow limits inter-dependence;
perfectly considerable with
elastic demand collusion

Conditions of Very easy, no Relatively easy Significant Blocked

entry obstacles obstacles

Nonprice None Considerable emphasis Typically a great Mostly public

Competition on advertising, brand deal, particularly relation
names, trademarks with product advertising
differentiation

Examples Agriculture Retail trade, dresses, Steel, auto, farm Local utilities
shoes implements
 BARRIERS TO ENTRY
Barriers to entry prevent potential competitors from entering a market.
 Capital costs – car plant, shop (larger companies are capable)
 Sunk costs
o costs which are not recoverable if a firm leaves the industry.
o High sunk costs will act as a barrier to entry because the cost of failure for firms entering the
industry will be high.
o Low sunk costs will encourage firms to enter an industry because they have little to lose from failure

o Eg; advertising cost

 BARRIERS TO ENTRY
• Scale economies
o Act as a barrier to entry because any new firm entering the market is likely to produce less
and therefore have much higher average costs than the few established producers.
• Natural cost advantages
o Some producers possess advantages because they own factors which are superior to others
and which are unique (i.e. have no close substitutes)
o Eg; Saudi Arabia – oil
• Legal barriers
o Patent laws
o Exclusive rights to production
 BARRIERS TO ENTRY
• Marketing barriers
o High barriers through high spending on advertising and marketing(existing companies at
advantage)
• Limit pricing
o Set lower prices to earn normal profit
o So new firms will not be attracted
• Anti-competitive practices
o Firms may be deliberately restrict competition through restrictive practices.
o exp: refuse to sell goods to a retailer which stocks the products of a competitors firm.
 Barriers to Exit
• Factors which make it difficult or impossible for firms to cease production and leave
an industry.
• Include the cost and time of making employees redundant, selling premises and
stock or notifying customers and suppliers.
Product Homogeneity and Branding
• Goods which are identical are called HOMOGENEOUS GOODS.
• Firms find it much easier to control their markets if they can produce goods which
are NON-HOMOGENEOUS.
• Differentiating their product from their competitors, and creating BRANDS allows
them to build up brand loyalty.
• This in turn leads to a reduction in the elasticity of demand for their product.
 Knowledge
• Perfect knowledge or imperfect knowledge may exist in an industry.
• Perfect knowledge only means that all firms have the same access to information.
• There is asymmetric information in a market when there is imperfect knowledge in
the market and some firms have more information than others.
Interrelationships within Markets

• Firms may be independent or interdependent.

• Independent: the actions of any one firm will have no significant impact on any
other single firm in the industry.
• Interdependent: the actions of one firm will have an impact on other firms.
 PERFECT
COMPETITION
 Features of Perfect Competition
1. Many small firms.
 Each firm is relatively very small compared to all the firms in the
market
 Firms only contribute a small percentage of production into the market

2. Freedom of entry and exit

 this will require low sunk costs.
 It is assumed that there are no barriers to the movement of firms both
into and out of the industry, and that this movement is a costless
process. 
3. All firms produce an identical or homogenous product.
 The is no difference between the product
 Consumers cannot differentiate the product from one producer to
another, because the product is similar and identical.
 The product is perfect substitute
 There is no reason for a firm to use non price competition such as
promotion and advertising because consumer knows that the
product is same.
4. Perfect information and knowledge. It is a assumed that all
participants in the market have perfect knowledge: customers
know the price being charged by each firm and firms know
how much profit each firm is making. 
5. All firms are price takers; therefore a firm’s demand curve is
perfectly elastic.
 Firms cannot determine or change the market price
 Any decision or reaction by the firm will not influence the
market price to change
 Interaction by all the producers/sellers and buyers will
determine the market price
 Each produce has very limited influence over the price because
they only produce a very small portion of goods which is sold
in the market (the market share is small)
a)If the firm charged a higher price than P it would lose all its customers,
who would act rationally and buy the identical good from another
supplier at a lower price.
b)Conversely, there is no point selling at a lower price because the firm can
sell all of its output at the market price and thereby gain higher profits.
 PC: BARRIER TO ENTRY
• Firms can easily enter or exit the market
• Firms which are facing loss can leave the market easily and
new firms which seek to earn profit can easily excess into the
market
• This is because most business in perfect competition uses very
small capital, limited technology, low labor skills and minor
rules and regulations which prohibits the firms to conduct its
business
• However there are some potential issues here:
 A lack of choice for consumers
 In the long run no firm can earn more than normal profits.
 In the long run, any firm whose costs were above average (high
x-inefficiency) would make losses and go out of business.
 In the short run, a firm may not shut down production, even if it
is making a loss. As long as a firm receives enough revenue to
cover its variable costs, it will continue production. 
Average, Total, and Marginal Revenue
TR
Firm’s Firm’s
Demand Revenue
Schedule Data
(Average
Revenue)
QD TR MR
P
0 $131 $0
] $131
1 131 131
] 131
2 131 262
] 131
3 131 393
] 131
4 131 524
] 131
5 131 655
] 131
6 131 786
] 131 D = MR = AR
7 131 917
] 131
8 131 1048
] 131
9 131 1179
10 131 1310
] 131
Profit Maximization: TR–TC Approach

Total cost : total fixed cost + total variable

cost
Total revenue : price x output sold (quantity)
Profit = TR-TC
Normal profit: AR = AC
Abnormal profit: AR > AC
Loss : AR < AC
 Profit Maximization: TR–TC Approach
The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue –
Total Cost Approach (Price = $131)
(1) (2) (3) (4) (5) (6)
Total Product Total Fixed Cost Total Variable Total Cost Total Revenue Profit (+)
(Output) (Q) (TFC) Costs (TVC) (TC) (TR) or Loss (-)
0 $100 $0 $100 $0 $-100
1 100 90 190 131 -59
2 100 170 270 262 -8
3 100 240 340 393 +53
4 100 300 400 524 +124
5 100 370 470 655 +185
6 100 450 550 786 +236
7 100 540 640 917 +277
8 100 650 750 1048 +298
9 100 780 880 1179 +299
10 100 930 1030 1310 +280
Profit Maximization: TR–TC Approach
 Profit Maximization: MR-MC Approach
The Profit-Maximizing Output for a Purely Competitive Firm: Marginal
Revenue – Marginal Cost Approach (Price = $131)

(5) (6)
(1) (2) (3) (4) (5) Price = Total
Total Average Average Average Marginal Marginal Economic
Product Fixed Cost Variable Total Cost Cost Revenue Profit (+)
(Output) (AFC) Costs (AVC) (ATC) (MC) (MR) or Loss (-)
0 $-100
1 $100.00 $90.00 $190 $90 $131 -59
2 50.00 85.00 135 80 131 -8
3 33.33 80.00 113.33 70 131 +53
4 25.00 75.00 100.00 60 131 +124
5 20.00 74.00 94.00 70 131 +185
6 16.67 75.00 91.67 80 131 +236
7 14.29 77.14 91.43 90 131 +277
8 12.50 81.25 93.75 110 131 +298
9 11.11 86.67 97.78 130 131 +299
10 10.00 93.00 103.00 150 131 +280
Economic profit
 Loss-Minimizing Case

•Loss minimization
•Still produce because P > min AVC
•Losses at a minimum where MR=MC
Loss-Minimizing Case
Shutdown Case
Marginal Cost and Short-Run Supply
Firm and Industry: Equilibrium
• Shutting down in the short run does not mean shutting down
forever
• Low prices can be temporary
• Some firms switch production on and off depending on the
market price
• Examples: oil producers, resorts, and firms that shut down
during a recession
NOW PRACTICE DRAWING!!
ECONOMIC PROFIT ECONOMIC LOSS
Profit Maximization in the Long Run

•Easy entry and exit

The only long run adjustment we consider
•Identical costs
All firms in the industry have identical costs
•Constant-cost industry
Entry and exit do not affect resource prices
Long-Run Equilibrium

• Entry eliminates profits

Firms enter
Supply increases
Price falls
• Exit eliminates losses
Firms exit
Supply decreases
Price rises
Entry Eliminates Economic Profits
Exit Eliminates Losses
Diagram Perfect Competition
(Long Run)
• In the industry, the market price will be set at the
intersection of supply and demand (Pe).
• Firms are price takers. They can’t sell higher than Pe so
their demand curve is perfectly elastic.
• The individual firm will maximise output where MR = MC
at output Q1
 Changes in Equilibrium
If there is an increase in market demand there will be an increase
in the market price.
Therefore the individual demand curve and hence AR will shift
upwards.
This will cause firms to temporarily make supernormal profits.
This will attract new firms into the market, causing prices to fall
back to Pe.
If firms are making a loss, some firms will close down, causing
the market price to rise.
Therefore in the long run, firms will make normal profits
(AR=AC).
Efficiency Of Perfect Competition
1. Allocative Efficiency: This is because the long
run equilibrium occurs where P = MC.
2. Productive Efficiency: This is because firms
produce at the lowest point on the AC.
3. X efficient: Competition between firms will act
as a spur to increase efficiency and make sure
firms use the best combination of inputs.
4. Resources will not be wasted through advertising
because products are homogenous.
Disadvantages of Perfect Competition
1. No scope for economies of scale; this is because there
are many small firms producing relatively small
amounts. Industries with high fixed costs would be
particularly unsuitable to perfect competition.
2. Undifferentiated products are boring giving little
choice to consumers.
3. Lack of supernormal profit may make no investment
in R&D.
4. With perfect knowledge, there is no incentive to
develop new technology.
MONOPOLISTIC
COMPETITION
 Monopolistic Competition
• Relatively large number of sellers - not as large as in perfect
competition
• Imperfect knowledge, but can spot firms making supernormal
profit.
• Differentiated products - by service or with brand names and
packaging
• Easy entry and exit - not as easy as with perfect competition
• Advertising – non price competition
 Price and Output in Monopolistic
Comp
• Demand is highly elastic
• the firm has some control over price.

• Short run profit or loss

• Produce where MR=MC

• Long run normal profit

• Entry and exit

• Inefficient – why?
• Product variety – why?
The Short Run: Profit
The Short Run: Loss
The Long Run: Normal Profit
OLIGOPOL
Y
 Oligopoly
• A few large producers
 five firm concentration ratio of more than
50%.
• Homogeneous or differentiated products
• Limited control over price
 Mutual interdependence - firms will be affected by how other firms
set price.

• Entry barriers
• Mergers
 Market Conduct (strategy)
• Non Price Competition
1. Advertising. This creates product differentiation
and brand loyalty.
2. Product Development. This could be an effort to
improve the quality of the product.
3. Loyalty cards. A reason for customers to come
back.
4. Quality of service. Increasing loyalty through
better quality.
5. Location. Better location for firms
 Price Wars
• Price wars are more likely in a recession when demand is
falling and markets become more competitive.
• Price wars tend to be short term because otherwise firms will
make a loss.
• Price wars can be in the public interest, but only if firms don’t
get forced out of business by the low prices.
 Predatory Pricing
• This occurs when a firm lowers price in some sections of the
market with the intent of forcing another firm out of
business.
• This is clearly against the public interest because the
dominant firm can increase prices when its rival has left.
• Therefore there is legislation to make predatory pricing
illegal.
 Limit Pricing
• This occurs when a firm sets price sufficiently low to deter
entry.
• For example, if a monopolist set a very high price, he would
maximise his profits but new firms may enter. Limit pricing
means he reduces prices a little - making less profit, but
maintaining his monopoly position.
 Mark-up or Cost Plus Pricing
• This occurs when the firm sets price = to average
cost + a profit margin
 Collusive Behaviour
• Collusion occurs when firms agree to limit competition by
setting output quotas and fixing prices.
• Overt (formal) collusion
 A cartel
 Price fixing
 illegal
• Tacit(informal) collusion
 is an unwritten agreement where firms observe unwritten rules,
 Price leadership
 legal
• Through collusion firms are able to maximise the profits of the
industry.
 Breakdown Of Collusion
• Under collusion there is always an incentive for a firm to
cheat because an individual firm could increase its profits by
exceeding its quota and undercutting its rivals.
• However this may lead to the breakdown of the cartel as
other firms retaliate by also cutting price.
 Evaluation of Collusion

• Collusion enables higher profits.

However, if firms found guilty of collusion
they can be fined and so end up with lower
profits.
oTacit collusion through dominant price
leadership may be an effective way to increase
profits and avoid detection.
 Efficiency of Oligopoly
• This depends upon the way that firms compete and
behave.
 In collusion, the industry acts like a monopolist,
therefore there will be:
Allocative inefficiency P > MC
Productive inefficiency; production is not at the lowest point on SRAC.
X inefficiency, there is less incentive for firms to cut costs
 Efficiency of Oligopoly
 Oligopoly means that there are a few large firms and
therefore they are likely to benefit from economies of scale,
leading to lower average costs.
 If there are low barriers to entry in an oligopoly, it will be
more contestable, therefore firms have incentives to cut
costs and be productively efficient. Also prices are more
likely to be competitive and therefore closer to MC.
MONOPOLY
EXAMPLES
 An Introduction to Pure Monopoly
is only ONE firm in the industry.
In the UK a firm is said to have monopoly power if it has
more than 25% of the market share.
 If > 40% = dominant
No close substitutes – unique product
Price maker – control over price
Blocked entry – strong barriers to entry block potential
competition
Non-price competition – very little non-price
competition since there are not any rival firms. (mostly
advertising the product)
Output and Price Determination
Output and Price Determination
Monopoly Loss
 Natural Monopoly
• A natural monopoly is a distinct type of monopoly that may
arise when there are extremely high fixed costs of
distribution, such as exist when large-scale infrastructure is
required to ensure supply
• A natural monopoly is a monopoly that exists because the
cost of producing the product (i.e., a good or a service) is
lower due to economies of scale if there is just a single
producer than if there are several competing producers.
Natural Monopoly
Economic effects of Monopoly
Pure competition is efficient
Monopoly is inefficient
 Advantages of Monopolies
1. Economies of scale.
 If the industry has high fixed costs and economies of scale, then a
large monopolist can bring benefits of lower average costs.
 Economies of scale will occur most in industries with high fixed
costs or scope for specialisation.
 e.g. airlines and car companies tend to have high-fixed costs and
therefore there tends to be a small number of large firms.
2. Research and development
• A monopolist can use its supernormal profits to invest
in developing new products which may require high
investment.
3. International competition
• A domestic monopoly may be necessary to compete
internationally. For example, Corus is the only steel
producer in the UK, but it faces competition from
overseas competitors.
4. Monopolies may be efficient.
• A firm may gain monopoly power because it is
efficient and innovative, e.g. Google. A monopoly
isn’t necessarily inefficient.
 Disadvantages of Monopoly
• Allocative inefficiency because P > MC
• Productive inefficient because not lowest point on AC
curve.
• X inefficient because a monopolist doesn’t have
incentives to cut costs, therefore AC curve is higher
than it could be.
• Less choice for consumers.
• Quality of product will be worse because there are
fewer incentives for a monopolist to develop new
products.
 Monopsony
• A situation where there is only ONE buyer
• A monopoly may also have monopsony power in
employing workers and buying products. This means the
firm can pay workers lower wages, e.g. supermarkets can
pay farmers lower prices.
CONTESTABLE MARKET
• For a contestable market to exist there must be low barriers to entry and
exit so that new suppliers can come into a market to provide fresh competition
to established businesses
• For a perfectly contestable market, entry into and exit out must be costless
(perfect competition)
• This can have implications for the behaviour (conduct) of existing firms and
then affects the performance of a market in terms of allocative, productive and
dynamic efficiency.
• A contestable or competitive environment is common in most industries even
when there appears to be one or more dominant businesses with significant
market power
 OTHER EXAMPLES
• LOCAL BUS AND RAIL
SERVICES
Through
• ELECTRICITY, GAS AND deregulation
and
WATER SUPPLIES privatisation
• TELECOMMUNICATION
• BANKING AND FINACE