MARKET STRUCTURE

Market Structure
Market structure identifies how a market is made up in terms of:

 The number of firms in the industry

 The nature of the product produced
 The degree of monopoly power each firm has
 The degree to which the firm can influence price
 Profit levels
 Firms behaviour – pricing strategies, non-price competition, output levels
 The extent of barriers to entry
 The impact on efficiency

Models
– Market structure deals with a number of economic ‘models’
– These models are a representation of reality to help us to understand what
may be happening in real life
– There are extremes to the model that are unlikely to occur in reality
– They still have value as they enable us to draw comparisons and contrasts
with what is observed in reality
– Models help therefore in analysing and evaluating – they offer a
benchmark

More competitive (fewer

imperfections)
Characteristics of each model:

 Number and size of firms that make up the industry

 Control over price or output

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 Freedom of entry and exit from the industry

 Nature of the product – degree of homogeneity (similarity) of the products

in the industry (extent to which products can be regarded as substitutes

for each other)

 Diagrammatic representation – the shape of the demand curve, etc.

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Perfect Competition
In economics, perfect competition occurs in markets in which no participant has market
power. Because the conditions for perfect competition are strict, there are few if any
perfectly competitive markets. Nonetheless, the concept of perfect competition can
serve as a useful benchmark against which to measure real life, imperfectly competitive
markets.
It is one extreme of the market structure spectrum
• Characteristics:
• Large number of firms

• Products are homogenous (identical) – consumer has no reason to express a

preference for any firm

• Freedom of entry and exit into and out of the industry

• Firms are price takers – have no control over the price they charge for their

product

• Each producer supplies a very small proportion of total industry output

• Consumers and producers have perfect knowledge about the market

• Diagrammatic representation

Q1
 The MC is the cost of producing additional (marginal) units of output. It falls at
first (due to the law of diminishing returns) then rises as output rises.
 The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC
curve at its lowest point because of the mathematical relationship between
marginal and average values.
 The industry price is determined by the demand and supply of the industry as
a whole. The firm is a very small supplier within the industry and has no
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control over price. They will sell each extra unit for the same price. Price
therefore = MR and AR
 Given the assumption of profit maximisation, the firm produces at an output
where MC = MR (Q1). This output level is a fraction of the total industry
supply.
 At this output the firm is making normal profit. This is a long run equilibrium
position.

 Now assume a firm makes some form of modification to its product or gains
some form of cost advantage (say a new production method).
 Average and Marginal costs could be expected to be lower but price, in the short
run, remains the same.
 The lower AC and MC would imply that the firm is now earning abnormal profit
(AR>AC) represented by the coloured area.
 Because the model assumes perfect knowledge, the firm gains the advantage for
only a short time before others copy the idea or are attracted to the industry by
the existence of abnormal profit. If new firms enter the industry, supply will
increase, price will fall and the firm will be left making normal profit once again.

Example:
Though perfect competition is an extreme and is not realized in reality, a very near
example of perfect competition would be the fish market and the vegetable/fruit
market who sell at the same place. This is because -
1) There are large number of buyers and sellers.
2) There are no entry or exit barriers.
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3) There is perfect mobility of the factors, i.e buyers can easily switch from one seller
to the other.
4) The products are homogenous

Imperfect Competition
• Where the conditions of perfect competition do not hold, ‘imperfect competition’
will exist
• Varying degrees of imperfection give rise to varying market structures
• These are Monopolistic competition, Oligopoly and Duopoly

Monopolistic Competition
• Characteristics:
• Large number of firms in the industry

• May have some element of control over price due to the fact that they are able to

differentiate their product in some way from their rivals

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• Entry and exit from the industry is relatively easy

• Consumer and producer knowledge is imperfect

Diagrammatic representation

Abnormal Profit

 This is a short run equilibrium position for a firm in a monopolistic market

structure.
 If the firm produces Q1 and sells each unit for £ 1.00 on average with the cost
(on average) for each unit being 60p, the firm will make 40p x Q1 in abnormal
profit.
 We assume that the firm produces where MR = MC (profit maximising output). At
this output level, AR>AC and the firm makes abnormal profit.
 Marginal Cost and Average Cost will be the same shape. However, because the
products are differentiated in some way, the firm will only be able to sell extra
output by lowering price.
 Since the additional revenue received from each unit sold falls, the MR curve lies
under the AR curve.
 The demand curve facing the firm will be downward sloping and represents the
AR earned from sales.
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MR1
 Because there is relative freedom of entry and exit into the market, new firms will
enter encouraged by the existence of abnormal profits. New entrants will
increase supply causing price to fall. As price falls, the AR and MR curves shift
inwards as revenue from each sale is now less.

 The existence of more substitutes makes the new AR (D) curve more price
elastic. The firm reduces output to a point where MC = MR (Q2). At this output
AR = AC and the firm will make normal profit.

 This is the long run equilibrium position of a firm in monopolistic competition

• Example:
Monopolistic competition can be seen in the fast food industry.
1) There is large number of restaurant chains (mcdonalds, wimpys, kfc, etc.)

2) All services are basically the same, but are marketed differently (product
differentiation)

3) There exists a perception that some fast food restaurants must be better than
others ( imperfect knowledge)

Oligopoly
• Competition between few. May be a large number of firms in the industry but the
industry is dominated by a small number of very large producers
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• Concentration Ratio – the proportion of total market sales (share) held by the top
3,4,5, etc firms:
– A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of
all the sales in the industry
• Features of an oligopolistic market structure:
– Price may be relatively stable across the industry
– Potential for collusion
– Behaviour of firms affected by what they believe their rivals might do –
interdependence of firms
– Goods could be homogenous or highly differentiated
– Branding and brand loyalty may be a potent source of competitive
advantage
– Non-price competition may be prevalent
– Game theory can be used to explain some behaviour
– AC curve may be saucer shaped – minimum efficient scale could occur
over large range of output
– High barriers to entry

Example:
Oligopoly can be seen in the music industry –
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 The music industry has a 5-firm concentration ratio of 75%.

 Independents make up 25% of the market but there could be many thousands of

firms that make up this ‘independents’ group.

 The music industry as an oligopolistic market structure may have many firms in

the industry but it is dominated by a few large sellers.

Diagrammatic representation

Total Revenue A

 Assume the firm is charging a price of Rs 5000 and producing an output of 100.
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If it chose to raise price above Rs 5000, its rivals would not follow suit and the

firm effectively faces an elastic demand curve for its product (consumers would

buy from the cheaper rivals). The % change in demand would be greater than the

% change in price and TR would fall.

 If the firm seeks to lower its price to gain a competitive advantage, its rivals will

follow suit. Any gains it makes will quickly be lost and the % change in demand

will be smaller than the % reduction in price – total revenue would again fall as

the firm now faces a relatively inelastic demand curve.

 The principle of the kinked demand curve rests on the principle that:

a. If a firm raises its price, its rivals will not follow suit

b. If a firm lowers its price, its rivals will all do the same

 The firm therefore, effectively faces a ‘kinked demand curve’ forcing it to maintain

a stable or rigid pricing structure. Oligopolistic firms may overcome this by

engaging in non-price competition.

Duopoly
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Market structure where the industry is dominated by two large producers

– Collusion may be a possible feature

– Price leadership by the larger of the two firms may exist – the smaller firm
follows the price lead of the larger one

– Highly interdependent

– High barriers to entry

– In reality, local duopolies may exist

• Example:
Duopoly can be seen in the beverage company, where it is dominated by Pepsi and
Coca Cola.

Monopoly
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• Pure monopoly – where only one producer exists in the industry

• In reality, rarely exists – always some form of substitute available

• Monopoly exists, where one firm dominates the market

• Firms may be investigated for examples of monopoly power when market share
exceeds 25%

• Monopoly power – refers to cases where firms influence the market in some way
through their behaviour determined by the degree of concentration in the industry

– Influencing prices

– Influencing output

– Erecting barriers to entry

– Pricing strategies to prevent or stifle competition

– May not pursue profit maximisation – encourages unwanted entrants to the

market

– Sometimes seen as a case of market failure

• Origins of monopoly:

– Through growth of the firm

– Through amalgamation, merger or takeover

– Through acquiring patent or license

– Through legal means – Royal charter, nationalisation

• Characteristics of firms exercising monopoly power:

– Price – could be deemed too high, may be set to destroy competition

(destroyer or predatory pricing), price discrimination possible.

– Efficiency – could be inefficient due to lack of competition or could be

higher due to availability of high profits
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– Innovation - could be high because of the promise of high profits,

Possibly encourages high investment in research and development

– Collusion – possible to maintain monopoly power of key firms in industry

– High levels of branding, advertising and non-price competition

• Diagrammatic representation
–

Monopoly
Profit

 This is both the short run and long run equilibrium position for a monopoly
 Given the barriers to entry, the monopolist will be able to exploit abnormal profits in
the long run as entry to the market is restricted.
 AR (D) curve for a monopolist likely to be relatively price inelastic. Output assumed
to be at profit maximising output

Example:
Perfect monopoly is also an extreme of market structure and is not seen in today’s
time. One of the examples of a market showing monopoly structure can be
considered to be that in mining of coal where Coal India Ltd. has the monopoly in the
market.