MARKET

STRUCTURES

1
NEWS!

2
 LEARNING OUTCOMES
• After this lecture, you will be able to
• Understand the basics of market
morphology
• Examine the nature of a perfectly
competitive market.

3
 Market
• Defined as the institutional relationship between buyers
and sellers.

4
 Market Morphology
 Markets may be characterized on the basis of:
 Number, size and distribution of sellers in any market
 Nature of product
 Number and size of buyers:
 Freedom to entry and exit

5
 Market Morphology
Type of Number Nature of Number Freedom of Examples
market of firms product of entry and
buyers exit
Perfect Very Homogeneous Very Unrestricted
competition Large (undifferentiated) Large

Monopolistic Many Differentiated Many Unrestricted

competition
Oligopoly Few Undifferentiated Few Restricted
or differentiated

Monopoly Single Unique Many Restricted

6
 Features of Perfect Competition

• Presence of large number of buyers and sellers

 Homogeneous product
 Freedom of entry and exit
 Perfect knowledge
 Perfectly elastic demand curve
 Perfect mobility of factors of production
 Price determined by market and Firm is a price taker.
 No selling costs

7
 Market Demand Curve and Firm’s
Demand Curve
• The market demand curve for the whole industry is a
standard downward sloping curve.
• The demand curve for an individual firm is a horizontal
straight line showing that
– the firm can sell infinite volume of output at the same price.

8
 Market Demand Curve and Firm’s
Demand Curve
• Market equilibrium is at the point of intersection (E) of the market
demand and market supply curves, where equilibrium output for the
industry is given at Q* and price at P*.
• Each perfectly competitive firm, being a price taker, takes the
equilibrium price from the market as given at P*.

INDUSTRY
Market
Demand S Market
Price
FIRM
Price Supply
D

E
P* P=AR=MR

S
D
O Q* O
Output Output 9
 Equilibrium of Firm

• Two conditions must be fulfilled for a profit

maximizing firm to reach equilibrium:
– First order condition: MR=MC
– Second order condition: Slope of MR curve < MC
curve or

10
 Short Run Price and Output for the
Competitive Industry and Firm

• In short run an individual firm may be in

equilibrium and may earn
– Supernormal profit: AR>AC
– Normal profit: AR=AC
– Losses: AR<AC

11
 Supernormal Profit
• Firm is in equilibrium at OQ*
output at market price P*,
where both the conditions of
AR>AC equilibrium are fulfilled.
Price • TR= OP*EQ* (TR= AR.Q)
MC
AC • TC= OABQ* (TC=AC.Q)
• Profit = AP*EB
P* E AR=MR = (OP*EQ*-OABQ*)
A B • This is the supernormal profit
made by the firm in the short
run, because the market price
P* (AR) is greater than
average cost.
O Q* Quantity

12
 Supernormal Profit
• Firm is in equilibrium at OQ*
output at market price P*,
where both the conditions of
AR>AC equilibrium are fulfilled i.e.
Price point E.
MC
AC • TR= OP*EQ* (TR= AR.Q)
• TC= OABQ* (TC=AC.Q)
P* E AR=MR • Profit = AP*EB
A B = (OP*EQ*-OABQ*)
• This is the supernormal profit
made by the firm in the short
run, because the market price
P* (AR) is greater than
O Q* Quantity average cost.

13
 Normal Profit
• In the short run some firms
may earn only normal profit
AC=AR=MC=MR (when average revenue is
equal to average cost).
Price • Firm is in equilibrium at OQ*
MC output at market price P*,
AC where both the conditions of
equilibrium are fulfilled.
P* E AR=MR • TR= OP*EQ*
• TC= OP*EQ*
• TR=TC
• Firm makes normal profit, and
actually ends up producing at
the break even level of output.
O Q* Quantity

14
 Subnormal Profit (or Loss)
• Firm is in equilibrium at OQ*
output at market price P*,
Price AR<AC where both the conditions of
equilibrium are fulfilled (point
AC E).
MC
• TC= OABQ*
• TR= OP*EQ*
A B
• Loss= P*ABE
P* AR=MR
E = OP*EQ* - OABQ*
• The firm incurs loss or
subnormal profit in the short
run because the AC of
producing this output is more
O than the market price hence
Q* Quantity
TR<TC.
• The firm continues to produce
at loss in the short run in
anticipation of price rise.
15
 Exit or Shut Down of Production

FIRM • A firm incurring losses in the

short run will not withdraw from
Price the market, but will wait for
MC
AC market conditions to improve in
AVC the long run.
AVC’ • Firm would continue production
till price > average variable
A cost (P>AVC or AR>AVC).
P* AR=MR • Point A denotes the shut down
point, where price P* =
AVC=AR.
• Any increase in VC above A or
any fall in market price below
O P* will cause the firm to shut
Q* Quantity down.

16
 MONOPLOY

 A monopoly (from the Greek word “mono” meaning

single and “polo” meaning to sell) is that form of market
in which a single seller sells a product (good or service)
which has no substitute.

17
 Features
 Single seller

 Single product
 No difference between firm and industry
 Independent decision making
 Restricted entry

18
 Types of Monopoly
 Legal Monopoly
 Economic Monopoly
 Natural monopoly
 Regional Monopoly

19
 Demand and MR Curves

 The demand curve of the

Revenue, monopolist is highly price
Cost
inelastic because there is no
close substitute and
consumers have no or very
little choice.
 It is not perfectly inelastic
because pure monopoly does
AR not exist in real life.
MR
O  Hence it faces a normal
Quantity downward sloping demand (AR)
curve.
 MR curve corresponds.

20
 Price and Output Decisions in Short Run
• Firm maximizes profit where Price, AR>AC
Revenue, MC
(i) MR=MC (ii) MC cuts MR from Cost
below, at point E. B AC
PE

A
E AR
MR
O QE Quantity

21
 Price and Output Decisions in Short Run
Price,
Revenue, AR=AC Price, AR<AC
Cost Revenue,
MC Cost MC AC
AC
A B
PE B PE C

E
E
AR
AR MR
MR

O QE O QE Quantity
Quantity

Total revenue= OPEBQE Total revenue= OPECQE

Total cost = OPEBQE Total cost = OABQE
Profit = Nil Loss = ABCPE
Firm makes normal profit. Firm makes loss. 22
 Price Discrimination
 Discrimination among buyers on the basis of the price charged for
the same good (or service).
 Objective is to maximise sales

23
 Bases of Price Discrimination
 Personal
 Geographical
 Time
 Purpose of use

24
 Degrees of Price Discrimination

Pigou has identified three degrees of price discrimination.

 First Degree
 Joan Robinson referred to it as perfect discrimination.
 Second Degree
 Takes away the major (but not entire) portion of consumer surplus.
 Third Degree
 Takes away only a small portion of consumer surplus.

25
 MONOPOLISTIC
COMPETITION
• Introduced by Joan Robinson (The Economics of Imperfect
Competition, 1933) and Edward H. Chamberlin (The
Theory of Monopolistic Competition, 1933)
• It is a market situation in which a relatively large number of
producers offer similar but not identical products.
• A combination of perfect competition and monopoly.
 Features of Monopolistic
Competition
• Large number of buyers and sellers:..
• Heterogeneous products.
• Selling costs exist
• Independent decision making.
• Imperfect knowledge.
• Unrestricted entry and exit.
 Demand and Marginal Revenue
Curves of a Firm
•Demand is highly elastic and
slope of demand curve is flatter
Price,
Revenue •MR curve lies below AR curve

AR

MR
O
Quantity
 Price and Output Decisions in
Short Run
• Joan Robinson: Each firm has a monopoly over its
product.
– When product is differentiated, firm has some monopoly power.
• Firms have limited discretion over price, due to the
existence of consumer loyalty for specific brands.
• Negative slope of the demand curve that is instrumental
for chances of monopoly profits in the short run.
• The reason for supernormal profit in short run, is supplying
a product which is differentiated, or at least perceived to
be different by the consumer.
 Price & Output Decisions in Short Run
Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR
when MC is rising.
Profit maximising output OQE and Price OPE

Price,
Revenu MC
e, Cost Total revenue = OPEBQE
AC
Total cost =OAEQE
PE B
E
Supernormal profit
A
=APEBE
AR
since price OPE > OA
MR
(AR>AC)
O Quantity
QE
 Price & Output Decisions in Short Run
Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR
when MC is rising.
Profit maximising output OQE and Price OPE

Price,
Revenu MC
e, Cost Total revenue = OPEBQE
AC
A E
Total cost =OAEQE
PE B
Loss =APEBE
AR since price OPE < OA
MR (AR<AC)
O Quantity
QE
 Monopolistic Competition and
Advertising
• It is more profitable to attract customers through
advertising rather than by lowering price.
• Advertising is to shift the demand curve of one particular
firm, at the expense of other firms that are offering similar
products.
 Monopolistic Competition and
Advertising
Optimal Level of Advertising
MR derived from advertising=MC of advertising
MRA=MCA
 OLIGOPOLY
• Derived from Greek word: “oligo” (few) “polo” (to sell)
• A few dominant sellers sell differentiated or homogenous products
under continuous consciousness of rivals’ actions.
• Oligopoly looks similar to other market forms; as there can be many
sellers (like in monopolistic competition), but a few very large
sellers dominate the market.
 Features of Oligopoly
• Few Sellers
• Product
• Entry Barriers: No legal barriers; only economic
in nature
– Huge investment requirements
– Strong consumer loyalty for existing brands
– Economies of scale
 Features of Oligopoly

• Non Price Competition

• Two firms A & B sell a homogenous

product and sell at P1.
• Firm A lowers the price to gain
market share.
• B fears loss of its customers and
P1 retorts by lowering the price below
that of A.
A B • A further reduces the price and this
process continues.
P2
• The two firms reach P2.
• Both realize that this price war is not
O
Market share of A Market share of B helping either of them and decide to
end the war.
• Price again stabilises at P2.
 Features of Oligopoly
• Indeterminate Demand Curve
• Price and output determination is
very complex as each firm faces
Price D1 two demand curves.
• Demand is not only affected by its
D own price or advertisement or
quality, but is also affected by the
price of rival products, their quality,
packaging, promotion and
placement.
D
D1 • When the firm increases the price it
faces less elastic demand (D1D1)
O Quantity • When it reduces the price it faces
highly elastic demand (DD)
 Duopoly

• Duopoly is that type of oligopoly in which only two players

operate (or dominate) in the market.
• Used by many economists like Cournot, Stackelberg,
Sweezy, to explain the equilibrium of oligopoly firm, as it
simplifies the analysis.
 Cournot’s Model

• Augustin Cournot illustrated with an example of two firms

engaged in the production and sale of mineral water.
• Each firm owns a spring of mineral water, which is
available free from nature.
Assumptions
• Each firm maximizes profit.
• Cost of production is nil because the springs are available free
from nature, i.e. MC=0.
• Market demand is linear; hence the demand curve is a downward
sloping straight line.
• Each firm decides on its price assuming that the other firm’s
output is given (i.e. the other firm will continue to produce and sell
the same amount of output in next period).
• Firms sell their entire profit maximizing output at the price
determined by their demand curves.
 Stackelberg’s Model

• Developed by German Economist H. V. Stackelberg

• Popularly known as the Leader Follower Model.
• An extension of the model of Cournot.
• One of the players is sufficiently sophisticated to
recognize that the rival firm acts.
• The sophisticated firm is able to determine the reaction
curve of the rival and is also able to incorporate it in its
own profit function. Thus it acts as a monopolist.
• Naïve firm will act as follower.
 Kinked Demand Curve
• Paul Sweezy (1939) introduced concept of kinked demand curve to
explain ‘price stickiness’.
• Assumptions
– If a firm decreases price, others will also do the same. So, the
firm initially faces a highly elastic demand curve.
– A price reduction will give some gains to the firm initially, but due
to similar reaction by rivals, this increase in demand will not be
sustained.
– If a firm increases its price, others will not follow. Firm will lose
large number of its customers to rivals due to substitution effect.
– Thus an oligopoly firm faces a highly elastic demand in case of
price fall and highly inelastic demand in case of price rise.
• A firm has no option but to stick to its current price.
• At current price a kink is developed in the demand curve
• The demand curve is more elastic above the kink and less elastic
below the kink.
 Kinked Demand Curve
(price and output determination)
• Discontinuity in AR (D1KD2)
Price,
Revenue, D1 creates discontinuity in the MR
Cost curve.
K MC1
P • At the kink (K), MR is constant
MC2
between point A and B.
A
S • Producer will produce OQ,
whether it is operating on MC1 or
T D2
B MC2, since the profit maximizing
O
conditions are being fulfilled at
Q Quantity points S as well as T.
• D1K = highly elastic MR
portion of the • If MC fluctuates between A and
demand curve (AR) when rival B, the firm will neither change its
firms do not react to price rise output nor its price.
• KD2 = less elastic portion, when • It will change its output and price
rival firms react with a price only if MC moves above A or
reduction. below B.
• Kink is at point K.
 Collusive Oligopoly
• Rival firms enter into an agreement in mutual interest on
various accounts such as price, market share, etc.
• Explicit collusion: When a number of producers (or sellers)
enter into a formal agreement.
• Tacit collusion: A collusion which is not formally declared.
• Cartel
• A formal (explicit) agreement among firms on price and output.
• Occurs where there are a small number of sellers with
homogeneous product.
• Normally involves agreement on price fixation, total industry
output, market share, allocation of customers, allocation of
territories, establishment of common sales agencies, division of
profits, or any combination of these.
• Immidiate impact is a hike in price and a reduction in supply.
• Two types:
• centralized cartels
• market sharing cartels.
 Price Leadership
• Dominant Firm: a leader in terms of market share, or
presence in all segments, or just the pioneer in the
particular product category.
– May be either a benevolent firm or an exploitative firm.
• Benevolent leader
– Allows other firms to enter by fixing a price at which
small firms may also sell.
• so that it does not have to face allegations of
monopoly creation;
• Earns sufficient margin at this price and still retains
market leadership
 Price Leadership
• Exploitative leader: fixes a price at which small
inefficient players may not survive and thus it gains large
share of the market.
– At times results in monopoly type conditions
• Barometric Firm: has better industry intelligence and
can preempt and interpret its external environment in a
more effective manner than others.
– No single player is so large to emerge as a leader, but
there may be a firm which has a better understanding
of the markets.
– Acts like a barometer for the market.
 Summary

• Oligopoly is a market with a few sellers, differentiated or

homogenous product, interdependent decision making by firms,
non price competition and indeterminate demand curve.

• Duopoly is a special case of oligopoly, in which only two players

operate (or dominate) in the market. All the characteristics of
duopoly are same as those of oligopoly.

• Difficulty in determining the demand curve, tendency to influence

market conditions and fear of price war resulting in price rigidity are
some of the reasons which pose a major constraint in developing a
model to explain oligopoly.