CHAPTER IV:

Market Structure:
 Market Structure
• One of the most important decisions made by a
manager is how to price the firm’s product. If the
firm is a profit maximizer, the price charged must
be consistent with the realities of the market and
economic environment within which the firm
operates.
• Remember, price is determined through the
interaction of supply and demand. A firm’s ability
to influence the selling price of its product stems
from its ability to influence the market supply and,
to a lesser extent, on its ability to influence
consumer demand, as, say, through advertising.
 Market Structure…
• One important element in the firm’s ability to
influence the economic environment within which
it operates is the nature and degree of
competition.
• A firm operating in an industry with many
competitors may have little control over the selling
price of its product because its ability to influence
overall industry output is limited.
• In this case, the manager will attempt to maximize
the firm’s profit by minimizing the cost of
production by employing the most efficient mix of
productive resources.
 Market Structure

• On the other hand, if the firm has the ability

to significantly influence overall industry
output the manager will attempt to maximize
profit by employing an efficient input mix and
by selecting an optimal selling price.

• Definition: Market structure refers to the

environment within which buyers and sellers
interact.
 Market Structure
CHARACTERISTICS OF MARKET STRUCTURE

There are, perhaps, as many ways to classify a firm’s

competitive environment, or market structure, as there
are industries.
Characteristics of market structure include:

 The number and size distribution of sellers,

 The number and size distribution of buyers,
 Product differentiation, and
 The conditions of entry into and exit from the industry.
 PERFECT COMPETITION
• Firms in perfectly competitive markets may be described
as price takers.
• The inability to influence the market price through
output changes means that the firm lacks market power.

• Definition: Perfect competition refers to the market

structure in which there are many utility-maximizing
buyers and profit-maximizing sellers of a homogeneous
good or service in which there is perfect mobility of
factors of production and buyers, sellers have perfect
information about market conditions, and entry into and
exit from the industry is very easy.
 PERFECT COMPETITION…
Assumptions
 Large number of buyers and Sellers.
 Homogenous goods and Services.
 Free mobility of resources.
 Free entry and Exit of firms.
 Market participants have perfect knowledge (information)
regarding market conditions. i.e. decision is made with full
certainty.
 No government intervention.
 The goal of the firm is profit maximization.
 The goal of the buyer is utility maximization.
 PERFECT COMPETITION…
• SHORT-RUN PROFIT MAXIMIZATION PRICE AND OUTPUT
• If we assume that the perfectly competitive firm is a profit maximizer, the
pricing conditions under which this objective is achieved are straightforward.
• First, define the firm’s profit function as:

• To determine the optimal output level that is consistent with the profit
maximizing objective of this firm, the first-order condition dictates that we
differentiate this expression with respect to Q and equate the resulting
expression to zero. This procedure yields the following results:

• or

• That is, the profit-maximizing condition for this firm is to equate marginal
revenue with marginal cost, MR = MC.
 PERFECT COMPETITION…
• To carry this analysis a bit further, recall that the definition of
total revenue is TR = PQ. The preceding analysis of a perfectly
competitive market reminds us that the selling price is
determined in the market and is unaffected by the output
decisions of any individual firm. Therefore,

• where the selling price is determined in the market and

parametric to the firm’s output decisions. Thus, the profit-
maximizing condition for the perfectly competitive firm
becomes
 PERFECT COMPETITION…
• Assuming that the firm has U-shaped average total and
marginal cost curves, the figure below illustrates that the
perfectly competitive firm maximizes profits by producing 0Qf
units of output, that is, the output level at which P* = MC. The
economic profit earned is illustrated by the shaded area APBC
in the figure.

Fig. Short-run competitive equilibrium with positive(above normal) economic profit.

 PERFECT COMPETITION…
• Problem: Consider the firm with the following total
monthly cost function, which includes a normal profit.

The firm operates in a perfectly competitive industry and

sells its product at the market-determined price of $10.

Required:
To maximize total profits, what should be the firm’s
monthly output level, and how much economic profit
will the firm earn each month?
PERFECT COMPETITION…
PERFECT COMPETITION…
PERFECT COMPETITION…
PERFECT COMPETITION…
PERFECT COMPETITION…
 PERFECT COMPETITION…
ECONOMIC LOSSES AND SHUTDOWN
For firms earning economic profits, the only meaningful
decision facing management is the appropriate level of
output. When firms are posting economic losses, however,
the manager must decide whether it is in the long-run
interests of the shareholders to continue producing that
particular product.

The course of action to be adopted by the manager will be

based on a number of alternatives. The manager may
decide, for example, to continue producing at the least
unprofitable rate of output in the hope that prices will
rebound, or the manager might decide to shut down
operations completely.
 PERFECT COMPETITION…
Whether the firm makes profit or no depends up on the level
of ATC.
a) If P>ATC, the firm makes profit.
b) When P<ATC, the firm is incurring losses.
c) When P=ATC, the firm is at a short-run break even point.

Fig. Short-Run Competitive Equilibrium: Economic loss(below normal profit)

 PERFECT COMPETITION…
SHUTDOWN
Firms shut down occurs when: P=AVC
At minimum AVC, MC intersects AVC, therefore at shut down, AVC=MC.
If total loss is less than total fixed cost, the firm should continue.

a) If price is greater than AVC, then the firm should continue. Profit
maximization is equal to loss minimization.
b) When price is just equal to AVC, then the firm should shut-down.

Fig. Shutdown price and output level.

PERFECT COMPETITION…
PERFECT COMPETITION…
 PERFECT COMPETITION…
LONG-RUN PROFIT MAXIMIZATION PRICE AND OUTPUT

We have already mentioned that a key characteristic of a

perfectly competitive industry is ease of entry and exit by
potentially competing firms.
The existence of economic profits in an industry will attract
productive resources into the production of that particular
good or service. This transfer of resources will not, however,
be instantaneous. It takes time for new firms to build
production facilities and for existing firms to increase output.
Nevertheless, in the long run all inputs are variable, and the
increased output by new and existing firms will result in a
right-shift of the market supply curve.
 PERFECT COMPETITION…

Hence, in the long run:

• The output is produced at the minimum possible cost
i.e. resources will be allocated efficiently.
• Consumers pay the minimum possible price which just
covers the cost of production.
• Plants are used, at their full capacity, so that no wastage
of resources.
• Firm’s earn normal profit.
Long run equilibrium occurs when:

MC=MR=AC=P=dd
 MONOPOLY

Definition: The term “monopoly” is used to describe the

market structure in which there is only one producer of a
good or service for which there are no close substitutes and
entry into and exit from the industry is impossible.
In the case of a monopoly, the number and size distribution of
buyers is largely irrelevant, since the buyers of the firm’s
output have no bargaining power with which to influence
prices.
Such bargaining power is usually manifested through the
explicit or implicit threat to obtain the desired product from
a competing firm, which is nonexistent in a market sewed by
a monopoly.

INDUSTRY=FIRM
 MONOPOLY….
Characteristics of a Monopoly
• There is only one seller.
• Barrier to entry.
• Highly differentiated products.
For the firm to continue as a monopolist in the
long run, there must exist barriers that
prevent the entry of other firms into the
industry.
 MONOPOLY….
Such restrictions may be the result of:
• the monopolist’s control over scarce productive resources,
• patent rights,
• access to unique managerial talent,
• economies of scale,
• location
• The size of the market. The market may create a natural
monopoly.
• Pricing policy of the existing firm.
- pre-emptive prices.
- extinction.
• Government franchise to be the sole provider of a good or
service.
 MONOPOLY….
The selling price of the
monopolist output is
determined along the
market demand function at
Pm.
At this price–quantity
combination, the economic
profit earned by the firm is
illustrated by the shaded
area APmBC. Fig. Monopoly: short-run and long-run
profit-maximizing price and output.
 MONOPOLY….
SHORT-RUN PROFIT-MAXIMIZING PRICE AND OUTPUT

The monopolist maximizes profit when the following two

conditions are met:
1. The equality of MC and MR
2. The slope of MC > the slope of MR i.e the slope of MR-
the slope of MC< 0.
Example: A monopoly firm is facing a demand curve given by:

Determine:
i. The monopolists equilibrium.
MONOPOLY….
 Price discrimination
Price discrimination occurs when the same product is
sold at different prices to different consumers or
sections of consumers.

Consumers are discriminated on the basis of:

a) Their income(purchasing power)

b) Geographic location.
c) Age.
d) Quantity purchased.
e) Time of purchase.
 Price discrimination
Degree of price discrimination
Refers to the extent to which the monopolist could
divide consumers and extract their surplus.
Consumers surplus
Is the difference between the amount of money that
a consumer is willing to pay and what actually is
paid.
Producers surplus
Is the difference between the amount that
producers have received and the amount that
they are willing to receive.
 Price discrimination

Fig. Consumer and Producer Surplus

 Price discrimination
First degree price discrimination
• Take it or leave it approach.
• The monopolist takes away all consumer’s surplus.

Second degree price discrimination

• Discrimination of consumers on the basis of quality bought.
• Consumers purchasing the same quantity are charged the
same price.
• Most utility company use:
- declining-block-tariff.
- Progressing-block-tariff.
Examples
- Water and sewerage,
- Electric bills.
 Price discrimination
Necessary conditions for price discrimination
i. The market must be divided into sub-
markets.
ii. Re-selling of the product should not be
possible.
The firm has to make the following decisions:
• The total output produced.
• The amount sold in each market and the
price to be charged.
 OLIGOPOLY
The word Oligopoly is derived from a couple of Greek
words:
• Oligos- means few.
• Polien- Means sellers.

Therefore oligopoly is a market structure in which few

firms control the industry supply.
When there are only two firms they are referred to as
“Duopoly”.
The product traded by oligopolists can be
differentiated(hetrogeneous)or homogeneous products.
 Oligopoly…..
Characteristics of oligopoly market
a) Intensive competition: there is a keen competition
among oligopoly firms.
b) Interdependency in decision making: deals with move
and counter move actions.
c) Barrier to entry: there is a strong barrier to entry.
Major sources of Barrier
 Economies of scale.
 Large capital requirement.
 Pricing policy of existing firms.
 Control over strategic raw materials.
 Patent rights etc.
 Oligopoly…..

Theoretical problem in analyzing oligopoly market

i) Uncertainty in their behavioral patterns.
ii) Diverse behavioral patterns may emerge:
• They might come in collision.
• They will not cooperate rather they might fight to death.
iii) In oligopoly markets price and output happen to be
indeterminate.
The oligopoly market can be classified as:
a) Non-collusive oligopoly.
b) Collusive oligopoly.
 Oligopoly…..

Non collusive oligopoly

The cournot’s model.
The Kinked demand model.
Bertrand’s model.
Chamberlin's model.
 Oligopoly…..
A Kinked demand Model
Two demand curves
i) Individual dd curve(perceived dd curve).
ii) The actual sales curve(share of the market curve).
Equilibrium occurs when the above two demand curves
intersect(the intersection point).

E
d
 Oligopoly…..

Firms may react in three possible ways for the

price changes initiated by one firm:
i) The rival firms will follow both price hike and
price cut.
ii) The rival firms will not follow both price hike
and price cut.
iii) The rivals will react for price cut but not to
price hike.
 Oligopoly…..

Reaction I- The rival firms follow both price cut

and hike.
The relevant demand curve
P
A
will be AD, and the firm’s
initiation to price change will
B
create no loss or gain.
p
D d
Q
 Oligopoly…..
Reaction II- The firms will not react for both price hike
and price cut.
a) When a firm increases its price and rivals do not
follow, then the firm will lose part of its market
share and the firm will move on the BE segment of
individual dd curve.
P
A

B
p E
D d
 Oligopoly…..

b) When a firm cuts its price and rivals do not

follow, the firm will capture part of the rivals
market share, and it moves on Ed part of the
individual dd curve.
P
A

B
p E
D d
 Oligopoly…..
Reaction III: The rival firms will not follow price hike but
follow price cut.
a) When the rivals do not price increase, the firm will lose its
share remain on BE.
b) When a firm cuts its price and rivals follow by cutting their
price, the firm will not get anything and move on the ED part
of the actual sales curve.
P
Note: If the two relevant
A curves are put together, the
dd curve will be BED, and
this has a kink at point E.
B
p E
D d
 Oligopoly…..
The Cournot’s Duopoly Model
Assumptions
 There are only two firms.
 Both operate at zero marginal cost.
 Each of them face a negatively shaped DD curve.
 It’s counter part will not react to its decision to change output
and price.
 Each firm will supply 1/3rd of the market demand and charges
same prices.
Criticisms
 Cournot’s assumption of no reaction is unrealistic.
 MC=0 is unrealistic.
 It is a closed system(only two firms).
END OF THE CHAPTER