market structure

Market Structures

Perfect Competition

Alternative Market StructuresClassifying markets by degree of competitionnumber of firms freedom of entry to industry nature of product nature of demand curve

The four market structuresperfect competition monopoly monopolistic competition oligopoly

Features of the four market structuresType of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Plumbers, restaurants Cement cars, electrical appliances gas and electricity in many countries

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Monopoly

One

Restricted or completely blocked

Unique

Perfect CompetitionAssumptionslarge number of firms firms are price takers freedom of entry and exit identical products perfect knowledge

Distinction between short and long run ShortShort-run equilibrium of the firmP = MCpossible supernormal profits

ShortShort-run equilibrium of industry and firmFirm is a price taker. Price is given by the market.

PS

MC

AC

Pe

AR AC

D = AR = MR

D O Q (millions) Qe

(a) Industry

Loss minimising under perfect competitionPSLoss is minimised where MC = MR.

MC

AC

AC P1 AR1

D1 = AR1 = MR1

D O Q (millions) O Qe Q (thousands)

(a) Industry

(b) Firm

ShortshutShort-run shut-down pointPS MC AC

AVC P2 D2 O Q (millions) O Q (thousands) AR2 D2 = AR2 = MR2

(a) Industry

(b) Firm

Deriving the short-run supply curve shortPP1 P2 P3 D1 D3 O Q (millions) D2 O S a b c

MC = S D1 = MR1 D2 = MR2 D3 = MR3

Q (thousands)

(a) Industry

(b) Firm

Perfect CompetitionShortShort-run supply curve of industry LongLong-run equilibrium of the firmall supernormal profits competed away

Long-run equilibrium under perfect competition LongNew firms enter Supernormal profitsPS1 Se P1 PL AR1 ARL

Profits return to normal MCLRAC D1 DL

D O Q (millions) O QL Q (thousands)

(a) Industry

(b) Firm

LongLong-run equilibrium of the firm(SR)MC (SR)AC

LRAC

DL AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

O

Q

Perfect CompetitionShortShort-run supply curve of industry LongLong-run equilibrium of the firmall supernormal profits competed away long-run industry supply curve

Various long-run industry supply curves under perfect competitionP

b

S1

S2

a

c

Long-run S

D1O(a) Constant industry costs

D2Q


b

S1

S2Long-run S

c a

D2 D1O Q(b) Increasing industry costs: external diseconomies of scale


b

S1

S2

a cLong-run S

D1

D2

O (c) Decreasing industry costs: external economies of scale Q


Incompatibility of economies of scale with perfect competition


Incompatibility of economies of scale with perfect competition Does the firm benefit from operating under perfect competition?

Market Structures

Monopoly

MonopolyDefining monopoly Only one seller Barriers to entryeconomies of scale product differentiation and brand loyalty lower costs for an established firm ownership/control of key factors or outlets legal protection mergers and takeovers aggressive tactics

Monopoly: Why?Natural monopoly (increasing returns to scale). Artificial monopoly a patent sole ownership of a resource formation of a cartel; e.g. OPEC

Monopoly: AssumptionsMany buyers priceOnly one seller i.e. price-maker Homogeneous product Perfect information Restricted entry and possibly exit

Monopoly: FeaturesThe monopolists demand curve is the (downward sloping) market demand curve The monopolist can alter the market price by adjusting its output level.

MonopolyThe monopolist's demand curvedownward sloping MR below AR

Equilibrium price and outputMC = MR

Profit maximising under monopolyP/R

MC

MRO

Qm

Q


MC

AR

a

AR MRO

Qm

Q


Equilibrium price and outputMC = MRmeasuring level of supernormal profit


MC

AC

AR

a

AC

b

AR MRO

Qm

Q


MC

AC

AR

AC

AR MRO

Qm

Q

Price DiscriminationWhy do business week offer bargain rates to students? PRICE DISCRIMINATION Charging different prices for a product when the price differences are not justified by cost differences. Objective of the firm is to attain higher profits than would be available otherwise.

Monopoly - Price DiscriminationDifferent prices at different marketsPersonal, Local or Trade use

First degreeCharge maximum from able and willing to Pay

Second DegreeBuyers divided into groups, based on demand

Third DegreeEntire market divided into submarkets

Price DiscriminationFirm must be an imperfect competitor (a price maker) Price elasticity must differ for units of the product sold at different prices Firm must be able to segment themarket and prevent resale of units across market segments

FirstFirst-Degree Price DiscriminationEach unit is sold at the highest possible price Firm extracts all of the consumers surplus Firm maximizes total revenue and profit from any quantity sold

SecondSecond-Degree Price DiscriminationCharging a uniform price per unit for a specific quantity, a lower price per unit for an additional quantity, and so on Firm extracts part, but not all, of the consumers surplus

FirstSecondFirst- and Second-Degree Price Discrimination

In the absence of price discrimination, a firm that charges Rs.2 and sells 40 units will have total revenue equal to Rs.80.


In the absence of price discrimination, a firm that charges Rs.2 and sells 40 units will have total revenue equal to Rs.80. Consumers will have consumers surplus equal to Rs.80.


If a firm that practices firstdegree price discrimination charges Rs.6 and sells 40 units, then total revenue will be equal to Rs.160 and consumers surplus will be zero.


If a firm that practices seconddegree price discrimination charges Rs.4 per unit for the first 20 units and Rs.2 per unit for the next 20 units, then total revenue will be equal to Rs.120 and consumers surplus will be Rs.40.

ThirdThird-Degree Price DiscriminationCharging different prices for the same product sold in different markets Firm maximizes profits by selling a quantity on each market such that the marginal revenue on each market is equal to the marginal cost of production

ThirdThird-Degree Price Discrimination


Equilibrium price and outputMC = MRmeasuring level of supernormal profit Price Discrimination

Comparing monopoly with perfect competition


Equilibrium price and outputMC = MRmeasuring level of supernormal profit

Comparing monopoly with perfect competitionlower output at a higher price

A monopolist producing less than the social optimumMC = MSC

P1 P2 = MSB= MSC

MC1

AR = MSB MRO Q1 Q2

QPerfectly competitive output

Monopoly output

MonopsonyMonopoly: the only seller. Monopsony: the only buyer, pricechooses a price-quantity combination on the industry supply curve that max its profit it exercises its market power by buying at a price below the price that competitive buyers would pay

Monopsonyw, per worker

60

When supply curve linear and upward sloping, the marginal expenditure curve is twice as steep as the supply curveME, Marginal expenditure Supply

ME = 40 ec wc = 30 wm = 20 Suppose a firm is the sole employer in a town, and the firm uses one factor, labour, to produce a final good em

Average expenditure the monopsony pays to hire a certain number of workersDemand for labour

0

20

30

60

L, Workers per day

MonopsonyMonopsony power (ME w)/w 1/ = 1/ w, Rs. per worker

Remember a firm will hire workers up to the point where the marginal value of the last unit of the worker = the marginal cost to the firm ie where the demand (for labour) curve = ME curve60 ME, Marginal expenditure Supply If the market for labour were perfectly competitive and the firm faced a horizontal supply curve, than the equilibrium would be at ec Demand for labour

Monopsonist values labour Rs.40, at Rs.40, but it pays only Rs.20

ME = 40 ec wc = 30 wm = 20 20 em

Monopsonist hires fewer workers and pays a lower wage

0

20

30

60

L, Workers per day

Bilateral MonopolyUncontrolled monopoly gets higher than competitive market prices. Uncontrolled monopsony gets lower than competitive market prices. Monopoly/monopsony confrontation breeds compromise. One buyer : One seller

Bilateral Monopolyy ME MC

Monopsony EquilibriumP1 P* b

Bilateral Monopoly EquilibriumD

e1 Monopoly Equilibrium P2 a

o

x2

x1

X*

x MR

Monopolistic Competition

Monopolistic CompetitionMonopolistic competition occurs if many firms serve a market with free entry and exit, but in which one firms products are not perfect substitutes for the products of other firms.

Monopolistic CompetitionAssumptions of monopolistic competitionlarge number of firms freedom of entry differentiated product (product differentiation) Chamberlain SELLING COST downward-sloping demand curve

Monopolistic CompetitionSelling Cost Demand is not determined by price aloneStyle, services, Selling activities Shift in demand due to these factors

U Shaped Product DifferentiationReal (inherent characteristics different) and Fancied (product is same; consumer is persuaded) Firm is NOT a price taker but the price determination is limited

Monopolistic CompetitionIndustry and Product GroupIndustry: Same products Product Group: Closely related products High price and cross elasticities

Short run equilibrium of the firmRs

MC AC

Ps

AR D MRO Qs Q


MC AC

Ps ACs

AR D MRO Qs Q


MC AC

Ps ACs

AR D MRO Qs Q

Monopolistic CompetitionAssumptions of monopolistic competitionlarge number of firms freedom of entry differentiated product downward-sloping demand curve

Equilibrium of the firmshort run long run

Long run equilibrium of the firmRs

LRMC LRAC

Ps PL

SAR

ARL DLSMR O QL Qs

MRL

Q

Monopolistic CompetitionAssumptions of monopolistic competitionlarge number of firms freedom of entry differentiated product downward-sloping demand curve

Equilibrium of the firmshort run long run underutilization of capacity in long run

Excess capacity in the long runRs

LRMC LRAC aPL

b ARL DL MRL

O

QL

Q

Monopolistic CompetitionLimitations of the modelimperfect information difficulty in identifying industry demand curve entry may not be totally free indivisibilities importance of non-price competition

Comparing monopolistic competition with perfect competition and monopolycomparison with perfect competition

Monopolistic CompetitionGroup Equilibrium Product groupTechnical substitutability Economic substitutability

Within group each firm has its own demand curve Slight product differentiation

Long run equilibrium of the firmRs

LRAC

P1

DL under perfectcompetition

O

Q1

Q

Long run equilibrium of the firm perfect and monopolistic competitionRs

LRAC P2 P1 DL under perfectcompetition

DL under monopolisticcompetition O

Q2

Q1

Q

Identifying Monopolistic CompetitionTwo indexes:The four-firm concentration ratio The Herfindahl-Hirschman Index

The four-firm concentration ratioThe percentage of the value of sales accounted for by the four largest firms in the industry. The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly. oA ratio that exceeds 40 percent: A indication of oligopoly. oA ratio of less than 40 percent: A indication of monopolistic competition.

HerfindahlThe Herfindahl-Hirschman Index (HHI)The square of the percentage market share of each firm summed over the largest 50 firms in a market. Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent. HHI = 502 + 252 + 152 + 102 = 3,450 A market with an HHI less than 1,000 is regarded as competitive. An HHI between 1,000 and 1,800 is moderately competitive.

Limitations of Concentration Measures The two main limitations of concentration measures alone as determinants of market structure are their failure to take proper account of oThe geographical scope of a market The oBarriers to entry and firm turnover Barriers

Oligopoly

OligopolyKey features of oligopolybarriers to entry interdependence of firms incentives to compete versus incentives to collude Collusive Non Collusive

Duopoly: Limiting case of OligopolyNon Collusive Oligopoly Cournots Duopoly Model What is Dupoloy? Two sellers Two firms owing mineral water well Operating with zero costs; MC = 0 Straight line DD Rivals output constant

DuopolyP D Firm A Period 1: OA; ie, 2 : (1-1/4) = 3/8

P

e=1 Firm B Period 1: AB; ie of = 2: (1-3/8) = 5/16 A MRa B MRb D X

P`

o

OligopolyBertrands model Rivals keep price constant Price war

OligopolyNonNon-collusive oligopoly: the kinked demand curve theoryassumptions of the model

Kinked demand for a firm under oligopolyRs

P1

D

O

Q1

Q

Kinked demand for a firm under oligopoly NonNon-collusive oligopoly: the kinked demand curve theoryassumptions of the model the shape of the demand and MR curves

The MR curveRs

P1 MR

aD = AR

O

Q1

Q

The MR curveRs

P1

a bO Q1 MR D = AR

Q

The MR curveRs

P1

a bO Q1 MR D = AR

Q

OligopolyNonNon-collusive oligopoly: the kinked demand curve theoryassumptions of the model the shape of the demand and MR curves stable prices

Price Stability in kinked demand curveRsMore Elastic MC3 MC2 MC1 More In elastic

P1

aD = AR

bO Q1 MR

Q

OligopolyNonNon-collusive oligopoly: the kinked demand curve theoryassumptions of the model the shape of the demand and MR curves stable prices limitations of the model

OligopolyNonNon-collusive oligopoly: game theoryalternative strategies: maximax and maximin simple dominant strategy games

OligopolyNonNon-collusive oligopoly: game theoryalternative strategies: maximax and maximin simple dominant strategy games the prisoners dilemma

The prisoners' dilemmaA's alternatives B's alternativesNot confess Not confessEach gets 1 year (1,1) B gets 3 months A gets 10 years

ConfessB gets 10 years A gets 3 months Each gets 3 years (3,3)

Confess

Collusive Oligopoly CartelsDirect agreements among competing oligopolist firms with the aim of reducing uncertainty

Two forms of catrtelsJoint profit maximisation Sharing of market share

Equilibrium of the industry

Collusive Oligopoly CartelsDirect agreements among competing oligopolist firms with the aim of reducing uncertainty

Two forms of catrtelsJoint profit maximisation Sharing of market share

Equilibrium of the industry

ProfitProfit-maximising cartelRs

Industry D ARO Q


Industry MC

Industry D AR Industry MRO Q


Industry MC

P1

Industry D AR Industry MRO

Q1

Q

OligopolyTacit collusionprice leadership: dominant firm (large orlow cost)

price leadership: barometric (oldexperienced)

aggressive

Price Leadership: Dominant firmmarket P P1 P0 P2 P3 X D1 S1 P C P1 P0 P2 P3 X X2 MR X3 DL X leader

MC AC

A

B

A price leader aiming to maximise profits for a given market shareRs

AR = D market

O

Q


Assume constant market share for leader

AR = D market

AR = D leader

O

Q


AR = D market

AR = D leader MR leaderO Q


AR = D market



MC

AR = D market



MC

PL

lAR = D market

AR = D leader MR leaderO QL Q


MC

PL

l

tAR = D market

AR = D leader MR leaderO QL QT Q

OligopolyTacit collusionprice leadership: dominant firm (large) price leadership: barometric (oldexperienced)

Aggressive other forms of tacit collusion: rules of thumbo average cost pricing

OligopolyTacit collusionprice leadership: dominant firm price leadership: barometric other forms of tacit collusion: rules of thumbo average cost pricing o price benchmarks

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market structure

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