1 market structures. 2 market structure refers to the competitive environment in which buyers and...

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Market Structures

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Market Structures

Market structure refers to the competitive environment in which buyers and sellers of a product operate.

Major Types-

• Perfect competition

• Monopoly

• Monopolistic competition

• Oligopoly

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Perfect Competition

• Large number of undifferentiated buyers and sellers

• Each one is so small as to be insignificant to influence the market

• The seller is a price-taker

• Homogeneous products

• No barriers to entry and exit- survival of the fittest

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Perfect Competition

• Well organised and continuous markets

• Flexible market prices to keep responding to changing conditions of supply and demand

• Perfect Knowledge on market condition, product and present and future prices, costs and economic opportunities- eliminates price differences

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Perfect Competition

• Perfect mobility of factors of production (raw materials, labour and capital)-this results in factor price equalisation.

• No Government interference: No rationing, administered prices, subsidies etc.

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Perfect Competition

Presumption that free market operates in social interest-

• “Invisible hand” and self-regulatory mechanism• Provides an effective check on the power of the

sellers, safeguards consumer and makes it unnecessary for the State to intervene

• Stock market is the closest example of a perfectly competitive market

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Equilibrium Under Perfect Competition

Note:

Equilibrium is at the point of intersection between MC and MR

MC cuts AC from below at its lowest point

Firm may make profits, losses or break even in the short run- depends on its cost of production

If firm makes abnormal profit, more firms will enter- Increase in supply- lower price and profit

Opposite in case of losses

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Firm Making Profit in Short Run

AC

MC

Q

AR=MRE

P

Output

Output

A C

P=AR=MR as represented by the horizontal line

OP and OQ are equilibrium price and output.

OPEQ represents Total Revenue

OACQ is total cost.

Here, TR>TC

PECA is the short run supernormal profit.

O X

Y

Cos

t/R

even

ue

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Firm Breaking Even in Short Run

AR=MR

MC

AC

E

QO

P

Cos

t/R

even

ue

Output

Firm breaks even where AC curve is tangent to AR. TR and TC are the same and given by rectangle OPEQ. There is neither loss, nor profit

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Firm Making Loss in Short Run

AR=MR

QO

MCAC

O

P

B

E

C

Output

Total Revenue=OPEQ

Total Cost=OBCQ

Loss= BCEP

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Case of Exit or Shut Down Point

• If prevailing market price is more than average variable cost (AVC) of production, the firm will continue production.

• If prevailing market price is less than average variable cost (AVC) of production, the competitive firm will shut down production

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Firm Making Loss in Short Run

AR=MR

QO

MC

SAVC

O

P

B

E

L

Output

Total Revenue=OPEQ

TVC= OKLQ

TR < TC at price OP

TFC= LKAB (Lost entirely)

Operating Loss= OKLQ-OPEQ = PKLE

At OP price, firm decides to shut down.

SACA

K

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Perfect Competition

Key lessons of perfect competition for managers

• Important to enter the market as far ahead of the competitors as possible - when supply is low and price is high- this requires entrepreneurial skill

• A firm earning an economic profit (as distinguished from normal profits) can not afford to be complacent because economic profit will attract new entrants

• Only way for a firm to survive is to keep costs as low as possible

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Perfect Competition

• With growing globalisation, new competitive cost pressures are being felt by firms around the world

• Indian companies have the advantage of low –cost labour but disadvantage of technology lag

• (Obama on outsourcing)

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Global Competitiveness Index

Market Distortions

– Efficiency of legal framework – Extent and effect of taxation – Number of procedures required to start a

business – Time required to start a business

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Global Competitiveness Index

Competition Intensity of local competition Effectiveness of antitrust policy Imports Prevalence of trade barriers Foreign ownership restrictions

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QUIZ

• Elasticity of demand for a perfectly competitive firm is equal to _____.

• Free entry and exit of firms is responsible for ________ _____ in the long run.

• A perfectly competitive firm has all the following features EXCEPT: a) Price Taker

b) Quantity adjuster C) Perfectly informed d) Price discriminator

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• Elasticity of demand for a perfectly competitive firm is equal to infinity

• Free entry and exit of firms is responsible for normal profits in the long run

• A perfectly competitive firm has all the following features EXCEPT: a) Price Taker

b) Quantity adjuster C) Perfectly informed d) Price discriminator

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QUIZ

• In a perfectly competitive market, a firm in the long run operates at:

A) AC=MC B) AR=MR

C)MR=MC D) P=AR=MR=AC=MC

QUIZ

TRUE OR FALSE?• The government sets the price of the product

in a perfectly competitive market.• A perfectly competitive firm produces a

substantial portion of the aggregate output.• There is no cost for entering a perfectly

competitive market.• Factors of production can freely move in and

out of the industry.20

• The government sets the price of the product in a perfectly competitive market.F

• A perfectly competitive firm produces a substantial portion of the aggregate output. (F)

• There is no cost for entering a perfectly competitive market. (T)

• Factors of production can freely move in and out of the industry. (T)

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MONOPOLY

Features of Monopoly:

• Single seller of a particular good or service

• No difference between firm and industry

• Large number of buyers

• No close substitutes -cross elasticity of demand is zero

• High entry barriers

• Monopolist is a price setter/maker

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• Strength of a monopolist’s power depends on how much he can raise the price without losing all his customers- this depends on elasticity of demand, which in turn, depends on availability of substitutes

• Before liberalisation, in India telephones, electricity, post& telegraph, oil &gas, railways were all monopolies.

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Causes and Forms of Monopoly

Barriers to entry-• Legal: Result of statutory regulation by government:

Copy right, trade marks, government regulation, licence, tariffs and non-tariff barriers against import of goods

• Technical; Technical know-how is available with only one person

• Natural: Control over supply of raw materials or natural resources such as minerals, (De Beers produced 90% of entire world’s diamonds)

• High costs of capital investment or economies of scale

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• Joint Monopoly: Through voluntary agreement, business companies jointly acquire monopoly power. e.g., Trusts, syndicates, cartels

• Public Monopoly: Created for the welfare of the public- e.g., public utilities like water supply, electricity, railways, telephones

• Private Monopoly: Owned an operated by private individuals or organisations- objective is profit maximisation

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• Simple Monopoly: Charges uniform or single price for a product to all the consumers- no discrimination between buyers or uses.

• Discriminating Monopoly : Act of selling the same commodity produced under single control, at different prices to different buyers or different uses at the same time- not related to difference in cost of production

• Regional Monopoly-

• Geographical Indication under WTO creates a barrier for global competitors

• Covers plants, seeds, herbs etc

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Pricing& Output Decisions Under Monopoly

MR

AR= D

SMC

SAC

P

E

Q

L

KM

O X

Y Monopolist’s demand curve is downward sloping (AR=D).

MR curve is below AR curve.

Equilibrium tis MR=MC (at E)

An ordinate drawn from E to X axis determines profit maximising output t OQ

Given the demand curve AR, output OQ can be sold at a given time only at one price, ie., QL (= OP)

Thus determination of outputsimultaneously determines the price.

PLMK is the profit

Monopolist’s Profit

Whether a monopolist makes a supernormal or economic profit depends on:

• Its cost and revenue conditions• Threat from potential competitors• Government policy.• If monopoly firm operates at MC=MR, its

profit depends on the relative levels of AR and AC

Monopolist’s Profit

• if AR>AC, there is economic profit

• if AR= AC, there is normal profit

• if AR<AC, theoretical possibility of the monopoly firm making losses

Measuring Monopoly Power

• Number of firms criterion- Simplest- Fewer the number, higher the degree of monopoly power

• Excess Profit Criterion- here, opportunity cost of the owner’s capital and a margin for risk are deducted from the actual profit made by the firm.

• Triffin’s cross elasticity criterion - lower the cross elasticity of the product of the firm, greater the monopoly power.

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• Concentration ratio of an industry is used as an indicator of monopoly power - relative size of firms in relation to the industry as a whole.

• Cn is the percentage of market output generated by the n largest firms in the industry

• Herfindahl- Hirschman Index(HHI) is a measure of the amount of competition in an industry

Herfindahl- Hirschman Index (HHI)

• Measure of the size of firms in relation to the industry

• Indicator of the amount of competition among them.

• An economic concept widely applied in competition law and antitrust laws.

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• The index involves taking the market share of the respective market competitors, squaring it, and adding them together.

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Herfindahl- Hirschman Index(HHI)

• It can range from 0 to 10,000, moving from a huge number of very small firms to a single monopolistic producer.

Interpretation of H- index:• Below 0.10 (or <1,000): No concentration• Between 0.10 to 0.18 (or 1,000 to 1,800):

Moderate concentration.• Above 0.18 (> 1,800) : High concentration• .

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• The United States uses the Herfindahl index to determine whether mergers are equitable to society;

• The Antitrust Division of the Department of Justice considers Herfindahl indices as discussed above.

• As the market concentration increases, competition and efficiency decrease and the chances of collusion and monopoly increase.


• While the threshold is considered to be "0.18" in the US, the EU prefers to focus on the level of change.

• Increases in the HHI generally indicate a decrease in competition and an increase of market power, whereas decreases indicate the opposite.

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• In Europe, concern is raised if there's a "0.025" change when the index already shows a concentration of "0.1".

• E.g., if in a market , company B (with 10% market share) suddenly bought out the shares of company C (which also has 10%) then if this new market concentration makes the index jump to "0.172".

• This would not be relevant for merger law in the U.S. (being under 0.18) but would in the EU (because there's a change of over 0.025)

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Monopoly Power

The usefulness of this statistic to detect and stop harmful monopolies is directly dependent on a proper definition of a particular market

E,g., If we were to look at a hypothetical financial services industry as a whole, and found that it contained 6 main firms with 15 % market share each, then the industry would look non-monopolistic….

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Monopoly Power

But suppose that one of those firms handles 90 % of the savings accounts and physical branches (and overcharges for them because of its monopoly), and the others primarily do commercial banking and investments.

• In this scenario, people would be suffering due to a market dominance by one firm; the market is not properly defined because savings accounts are not substitutable with commercial and investment banking.

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Monopoly Power

• The problems of defining a market work the other way as well.

• For example, one cinema may have 90% of the movie market, but if movie theatres compete against video stores, pubs and nightclubs, then people are less likely to be suffering due to market dominance of the cinema.

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Monopoly Power

• Another typical problem in defining the market is choosing a geographic scope.

• For example, 5 firms may have 20% market share each, but may occupy five areas of the country in which they are monopoly providers and thus do not compete against each other.

• A service provider or manufacturer in one city is not easily substitutable with a service provider or manufacturer in another city

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Case of New York City Taxi Industry

Market Value of Monopoly Profits• Like most US cities, New York city requires a

medallion (license) to operate a taxi.• Medallions are limited in number and this

confers monopoly power to owners.• Value of owning a medallion is equal to the

present discounted value of the future stream of earnings from the ownership of a medallion.

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Market Value of Monopoly Profits in New York City Taxi Industry

• No of medallions in New York city remained at 11,787 from 1937 to 1996 when it was increased by only 400 to 12,187. Value of medallion rose from $10 to $250000 by 1999 or 18% per year.

• Proposals to increase the number of medallions was blocked by the taxi industry lobby. If licenses to operate were freely granted, then the price of medallions would drop to zero.

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Market Value of Monopoly Profits in New York City Taxi Industry

• Instead of doing that, New York city allowed a sharp growth in the number of radio cabs, which can respond only to radio calls and can’t cruise the streets for passengers.

• This sharply increased the competition in NY taxi industry and reduced profits to the taxi owners from 33% in 1993 to 11% in 1999

- from Wall Street Journal quoted in Salvatore

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Discriminating Monopoly/ Price Discrimination

3 forms:

• 1st Degree: Different rate for every unit of output- discrimination between buyers / between units

• Monopolist forces every consumer to part with his entire consumer surplus-Full benefit of trade goes to trader.

(Auction is one example, but it is for special products)

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2nd degree Discrimination

• 2nd Degree: Buyers are divided into different blocks or groups and then different rates charged for each block or group:

• Here, consumers enjoy a part of the consumer surplus and monopolist is also able to get a part of the surplus;

E.g., electricity charges, Quantity discounts

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3rd degree Discrimination

• 3rd degree: Most common type-Seller divides his buyers into sub-markets and charges a different price for each market-

• Dumping is an example: High price in domestic market and low in international market.

• Reasons: To dispose off surplus; to remove rivals; to take advantage of increasing returns to scale; to create new demand abroad.

• As demand is elastic in international market, he has to reduce price but charges a higher price in the domestic market as domestic demand is inelastic

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When is Price Discrimination Possible?

Conditions of Price Discrimination ( When is Price discrimination possible?)

1. Consumers are unaware of the difference in prices charged

2. Price difference so small that consumers don’t bother

3. Price illusion/ irrationality4. Markets are situated far from one another and

so it is expensive to transfer goods from one market to another (Geographical distance)

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Conditions of Price Discrimination

5) When elasticities of demand in the two markets are different: higher price for low elasticity market and lower price for high elasticity market.

6) Direct personal services such as those of doctors and lawyers where resale is not possible

7) Legal sanction provided by government: e.g., lower prices in army canteen

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Forms of Price discrimination

• Personal Discrimination: Occurs when different prices are charged to different consumers – doctors and lawyers may charge different fees for the rich and the poor

• Local Discrimination: Lower prices in one locality and higher in another. e.g., dumping by charging higher prices in domestic market and lower prices in foreign markets

• Trade Discrimination: Charging different rates, based on use e.g., electricity charges for domestic/ industrial/agricultural uses

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Forms of Price Discrimination

• Quality Discrimination: Hard cover editions being sold at higher prices than paper back editions of books; business class travel vs economy class in air travel

• Time Discrimination: Different charges for the same commodity at different points of time- off-season air tickets; happy hours in restaurants

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Indian Railway & Price Discrimination

• On the basis of passenger categories: senior citizens, children, students, handicapped, escorts, employees---

• Class of Travel (Basis: Comfort)

• Category of Train:9 categories- rajdhani, superfast, mail, Garib Rath, passenger, shuttle (Basis: time taken for travel)

QUIZ

• TRUE OR FALSE?

• Charging different prices for similar goods is pure price discrimination.

• Difference in elasticities is a necessary condition for price discrimination.

• Tatkal facility provided by Indian Railways is an example of ----------degree price discrimination.

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QUIZ

• Charging different prices for similar goods is pure price discrimination (F. same, not similar)

• Difference in elasticities is a necessary condition for price discrimination.(T)

• Tatkal facility provided by Indian Railways is an example of second degree price discrimination.

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• In comparison with a perfectly competitive market, a monopoly market would usually generate

• A) Higher output at higher price

• B) Higher output at lower price

• C) Lower output at higher price

• D) Lower output at lower price

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• In comparison with a perfectly competitive market, a monopoly market would usually generate

• C) Lower output at higher price

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• A monopoly is

• A) One of the few producers of a homogeneous product

• B) A single producer of a single product

• C) One of the many producers of a homogeneous product

• D) One of the many producers of a differentiated product

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Monopolistic Competition

Chamberlin and Joan Robinson

In reality, monopoly and competition are not mutually exclusive, but markets have both elements in differing degrees

Most economic situations are composites of both competition and monopoly

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Characteristics of Monopolistic Competition

Large no of firms/ sellers -Consequently no individual has any significant control over the market

Absence of interdependence: (Independent decision Making) -Since the number is large and size of each firm is small, no firm can influence or is influenced by others in the market.

Example of FMCG product marketFreedom of entry: No barriers to entry- this leads

to occurrence of only normal profits in the long run

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• In Monopolistic Competition firms compete with each other mainly not on the basis of price but on the basis of non price elements

• Product differentiation and selling costs are known as non-price competition

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Product Differentiation: Core of monopolistic competition- Different firms produce similar, but not homogeneous products.

Even minor changes in the same generic product , by which a seller can charge a different price e.g., tooth paste, tooth brush

Cross elasticity of demand for products is very high (not infinite) in this market

Product differentiation may relate to A) Quality, design, packaging, trade names,

raw materials used

B) Conditions surrounding sale of the product- courteous approach, efficiency, credit availability, after-sale service etc

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Product differentiation gives firms some monopoly power i.e., power to control the price in a narrow circle, but in the wider circle the firm faces competition from rival producers.

• Firms in effect are competing monopolies

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Selling Costs: Expenditure incurred on changing the demand and preference of the consumers - Expenditure on advertising, promotion, displays, salaries of salesmen, free samples etc.-

• Unique to monopolistic competition

..

• Imperfect knowledge- about cost, quality, prices .

• As Joan Robinson puts it: “ the imperfect market is characterised by distortions of market conditions by sellers”

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• Identification of product groups:• A product group comprises of products that

are “good” but no perfect subsitutes of each other.

• E.g., Lux, Lifebuoy. Dove, Cinthol can be classified as the product group of “soaps”

• Ariel, surf, Nirma and Tide can be classified as the product group of “detergents”

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Monopolistic Competition & Advertising

• Advertising: No need in monopoly and perfect competition

• In this situation, makes sense for the firm to attract customers through advertising than by lowering prices

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Monopolistic Competition

Wastes of Monopolistic Competition

1. Competitive advertising ( as opposed to constructive advertising) to attract consumers to pay a premium for a particular brand

• Criticised by several economists because:• Advertising induces customers to spend more

money because of name, rather than rational factor

• Adds no value to the product being offered• Leads to brand confusion in the consumers

minds• Ads by rivals may even cancel out each other,

leading to increase in the AC of each firm, without corresponding increase in sales.

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2. Excess capacity- resources are not fully utilised, leading to higher costs

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QUIZ

• Slope of DD curve for a monopolistic competition is flatter than that of a monopoly firm. (T)

• A firm in monopolistic competition can not practice price discrimination. (F)

• Firms under monopolistic competition will have limited discretion over price because of Customer loyalty.

• If a firm in monopolistic competition increases its price slightly it will lose some customers.

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Oligopoly: Definition and Features

• Few Sellers : Naturally each seller has a sizeable share of market-

• Homogeneous or differentiated products• Close Interdependence- decision of a single

firm to expand or contract output affects entire market- moves and counter moves- need to predict and analyse every possible reaction of rivals before a firm takes decisions

• Automobiles, steel, consumer electronics

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Oligopoly: Definition and Features

• Indeterminate demand curve: because of extreme interdependence

• Price Rigidity- Price remains stuck at a certain level-No desire for a departure from prevailing price in either direction- price cutting will be followed by rival but price hike may not be and hence “sticky” prices

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Oligopolistic Pricing

Oligopolistic pricing can take 3 different forms:1. Independent Pricing2. Collusion Model3. Price Leadership1.Independent Pricing: Method of pricing its

differentiated product – result of the fact that each firm has a certain monopoly power, but there is fear of retaliation by rivals

- Various possibilities occur: Price wars and price rigidity

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Collusive Oligopoly

2. Collusion Model: • When there are only a small no of firms in a

market, they have a choice between cooperative and non cooperative behaviour.

• Tacit or explicit collusion• A Cartel agreement represents the most

complete form of collusion among oligopolists-here firms are in a cooperative mode and minimise competition among themselves- due to explicit agreement between firms –

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Collusive Oligopoly

• Joint decisions on output / price / market share or quotas-

• Example of OPEC- decides on output rather than price-Has a board of control which determines the market share of each member

• Sometimes tacit collusion occurs between firms without explicit agreement- Here firms quote identical prices

• Example: Indian cement and steel markets

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Collusive Oligopoly

Barriers to Collusive Oligopoly:• Considered illegal as it converts oligopoly into

monopoly- Firms may cheat by giving secret price

concessions and thereby increasing the market share

• Slow and lengthy process of cartel negotiations• Rigidity of negotiated prices- Some cartel members may be political rivals

such as Iraq, Kuwait and Iran in OPEC

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Price Leadership

3. Price Leadership: It is an informal position in most oligopolistic markets.

It may emerge spontaneously due to technical reasons such as size, efficiency, economies of scale, brand image or the firm’s ability to forecast market conditions accurately

• Typically, leadership role is played by a dominant firm (largest in the industry) and smaller ones follow-(Example- Bajaj scooter, Camlin ink)

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Price Leadership

• Sometimes price leadership is barometric-Here one of the firms (not necessarily the dominant one) takes lead in announcing a price change, especially when a change is due but is not implemented due to uncertainty in the market –The barometric firm is supposed to have a better knowledge of the changing environment of the market than others

• Price leadership often serves as a means to price discipline and price stabilisation

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Kinked Demand Curve

• Once a general pricing decision is taken under any of the above models, it remains fixed for an extended period.

• Kinked demand curve theory by Paul Sweezy explains price rigidity under oligopoly

• 2 parts of demand curve of a firm have different elasticities- one for price increase and another for price decrease- Former is more elastic than latter

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Kinked Demand Curve

D1

K

Q

MC1

MRM

MR

output

Cos

t/R

even

ue

P

The AR curve or demand curve has a kink at the point K at which it operates and price is OP.

DK: Demand is elasic. Raising price above OP will cause sizeable decline in demand

KD1: Inelastic segment. Price cut will be followed by rivals

D

MM

M1

MC1

MC2

OO

Elastic

more

Less Elastic

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Kinked Demand Curve

• MR Curve is discontinuous as a result of kink in AR curve

• MC passes through the dotted portion of the MR curve. Hence , a change in MC has no effect on price and output

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Industrial Concentration in US

Industry Four Firm Ratio

Cigarettes 93

Breakfast cereals 85

Household Refrigerators 82

Newspapers 25

Men’s clothing 18

Women’s Dresses 11

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Game Theory

• First systematic attempt was made by von Neumann and Morgenstern

• Martin Shubik is considered the most prominent proponent of game theory

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• Nature of the problem faced by an oligopolistic firm is best explained by Prisoner’s Dilemma:

• A and B are arrested by CBI on suspicion of involvement in a crime and interrogated separately by the CBI, with the following conditions disclosed to them:

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1. If you confess your involvement in the crime, you will get 5 years imprisonment.

2. If you deny your involvement and your partner denies it too, you will be set free for lack of evidence.

3. If one of you confesses and turns approver, and the other does not, then the one that confesses will get 2 years imprisonment and one who does not confess gets 10 years imprisonment .

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• Given the conditions, each suspect has 2 options-

i) To confess

ii) Not to confess

• Both have a dilemma

• While taking a decision both have a common objective- to minimise the period of imprisonment

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Game Theory

• Game Theory models include players, strategies and payoffs

• Players : Decision makers• Strategies: Choices to change price, develop

new products, undertake new advertising campaigns etc

• Payoff: Outcome or consequence of a strategy• Payoff Matrix: Table giving the payoffs from all

the strategies open to the firm and the rival’s responses

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• A firm needs to anticipate-

• Counter moves by rivals

• Pay-off when

• a) rival firm does not react

• B) rival makes a counter move by raising its ad expenditure

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OPEC’s Price Making Power

• 12 members- Saudi largest producer• The Organization of Petroleum Exporting

Countries (OPEC) is a cartel of twelve countries made up of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. The organization has maintained its headquarters in Vienna since 1965, and hosts regular meetings among the oil ministers of its Member Countries. Indonesia 's membership from OPEC was voluntarily suspended recently as it became a net importer of oil.

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• During 1970s undisputed power-In 1980s OPEC was accused of behaving like a “clumsy cartel” –

• Non cooperative behaviour from members with lower reserves such as Qatar, Indonesia and Venezuela. Because of their lower reserves and intention of making quick profits, these often produced in excess of the stipulated individual quota

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• When prices nosedived abnormally in 1998, OPEC successfully executed 2 successive production cuts

- But since then erosion of OPEC’s monopoly power as a price maker

-Surge in non OPEC production and

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• Core problem is price of oil is no more fixed in the spot market where physical trading takes place but on futures market where only paper barrels are traded

• Only an insignificant part of oil traded on NYMEX is ever physically delivered.

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• Many players are involved in futures trading that are not involved in physical trading of crude (true of all commodities)- floor traders, fund managers, refiners, producers, financial institutions and speculators- complicates process of decision making within OPEC

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OPEC’s ability to influence prices depends on-• Its ability to influence so many players, including

level of stocks and inventories that the refineries are holding

• Size of speculative positions• Flow of hedge funds in and out of the market• Traders’ bearish or bullish sentiments• Existence or erosion of spare capacity

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Comparison of different Market Structures

Feature Perfect competition

Monopoly Monopolistic competition

No of sellers

Many One Large

Nature of goods

Homogeneous

Homogeneous

Differentiated

Entry Free Barriers Unrestricted

Degree of monopoly power

Zero Absolute Limited

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Comparison of different Market Structures



Cost Elements

Production cost

Production cost

Production cost+ Selling cost

Long run Profits

Normal Super- normal

Normal

Nature of Demand

Elastic Inelastic Relatively inelastic

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Pricing Price taking Price-making:

i) Uniform ii) Price discrimination

Price-making:

Uniform price

1 market structures. 2 market structure refers to the competitive environment in which buyers and...

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