Managerial Economics Topic 4 Market types

Chapter 9: Perfect competition, monopoly, and price discrimination.

The concentration ratio

The concentration ratio measures the market share of the largest firms in the market. The higher the
concentration ratio, the more a market is dominated by a few firms influences the degree of
competition and rivalry.

If one firm dominates a market, it is called a monopoly. If a few firms dominated, it is an oligopoly. If
there are many thousands of firms and none of them are particularly large, it is known as a competitive
market. In monopolistic competition there are many firms, but they differentiate their products in some
way to gain some market power. In perfect competition there may be firms offering very small products
and buyers can easily switch from one to the other so that firms cannot charge more than their rivals.

sales of your product∨business

market share= ∗100
total market sales
A small producer may be in a much weaker position and be trading on less favorable items more
difficult for it to survive and grow.

The conditions within a market will affect a manager's ability to control the price, the likely level of
output that a business will be producing, and how it competes. These decisions will affect many other
aspects of the business, such as:

o It’s workforce planning.

o The likely profits of the business.
o The desired level of capacity.
o The level of investment in marketing and research and development.

The threat of entry may influence a firm’s behavior as much as its existing rivals.

Market structures

Barriers to entry

The number of businesses competing in a market will depend on how easy or difficult it is to enter. The
more difficult it is to enter, the greater the power of established firms and the less likely it is that it will
be a competitive firm.

Barriers to entry are factors that make it difficult for new firms to enter the market and include the
following:

o Access to suppliers and distributors. New businesses need to be able to access the required
materials or components; without them, they cannot produce or sell. Vertical integration by
existing firms is another way of creating barriers to entry by controlling elements of supply and
distribution and not allowing newcomers access to suppliers to distribution channels.

1
Managerial Economics Topic 4 Market types

o The costs of entering a market. The setup costs for some industries can be so high that it will
deter entrants.
o Legal requirements. In some markets, the existing firms are legally protected and entry by other
businesses is prevented. Quotas or tariffs are often used. Quotas limit the amount of units that
foreign producers can sell in a country; a tariff places attacks on foreign goods, making them
relatively expensive compared with domestic products. This makes it difficult for overseas firms
to enter these markets.
o Fear of retaliation. Firms may be wary of entering a market if they are afraid of what's existing
firms might do. The way in which firms react will depend in part of the size of the market and
whether or not it is growing. A sunk cost represents spending that cannot be covered if a
business leaves the market. If there are some costs, existing firms will fight harder to protect
their market share.
o The learning curve. As a firm gains experience in a market, it is likely to become better at
producing it. as a result of the learning curve, entering a market can be difficult and therefore
this acts as a barrier to entry.

Barriers to entry can change over time and make it more or less difficult to enter a market. Barriers to
entry may also be avoided or made obsolete overtime by technology. The extent to which barriers to
entry exist will influence the level of profits that a business can make. If you are making high profits, this
will attract other firms into the industry. If they are able to enter easily, they will compete away we have
normal profits.

Types of market

Each market structure leads to a different price and quantity outcomes.

Perfect competition

In a perfect competition, we imagine a market in which there are hundreds of thousands of providers of
smaller products. You manage one business, which offers goods or services that are exactly the same as
the others. This means that the product is a commodity- not differentiated from other products. There
is no difference in what each producer is offering. The assumption of a perfectly competitive market is
that:

o There are many producers offering similar products (homogeneous products), each of which is a
small part of the market- supply is insignificant relative to the total supply of the market.
o Customers have perfect information, which means that they know what is on offer from all
other producers and what prices are being offered.
o There is no switching costs so customers can move from one product to another easily.
o There is freedom of movement of other producers into and out of this market. This is important
because there are no barriers to entry. This means that if existing businesses are making
abnormal profit they will attract firms in from other industries.

By examining the outcomes of perfect competition, you see the effects of an extremely high level of
competition.

Each firm is a price taker; this means that it can sell as much as it wants at the given market price. A firm
is a price taker because it is so small relative to the industry as a whole that changes in its output do not

2
Managerial Economics Topic 4 Market types

shift the supply in the industry to any significant extent and so its output decisions do not change the
market equilibrium price.

If every unit can be sold at the same price, this means that the price is equal to the marginal value.

Each business will profit maximize at some output at which the marginal revenue equals the marginal
cost, there is no extra profit to be made. And perfect competition, the price equals the marginal
revenue, and so a business profit maximization where:

price=marginal revenue=marginal cost

Abnormal profit- when the price is greater than the average cost show abnormal profit is higher per
unit.

Changes in output by one firm on its own cannot shift the industry supply curve enough to move the
equilibrium price, if many firms enter the market produce more output, this will shift the industry
supply curve to the right. This increase in supply in the industry will lead to a fall in the price.

The firm in perfect competition is a price-taker:

The adjustment process from short run abnormal profit to long run equilibrium in a perfectly
competitive market:

The long run equilibrium in perfect competition

Freedom of entry into a market is good for customers but competes away the abnormal profits of the
existing businesses. Firms will keep entering this market until normal profits are earned. Once this level
of profit is achieved, firms are earning the level of rewards that they would expect to make, given the
risk and resources involved; there is no further incentive for businesses to move into this industry. The
industry will be in the long run equilibrium.

3
Managerial Economics Topic 4 Market types

However, if businesses were making a loss in this industry firms would leave. As they leave the industry,
this reduces the total number of supplies. One firm cannot shift the supply curve, if many firms leave
the market, the effect is significant enough to shift the industry supply to the left. With less being
supplied in the industry, the market price increases; this process continues until the price has risen
sufficiently to enable these firms that are left to make normal profits.

Therefore, in the long run equilibrium in perfect competition firms make normal profits. This means
that they are making sufficient rewards to keep their resources in the industry without there being an
incentive to leave or others to enter. There are two main types of efficiency: allocated and productive.
In the long run equilibrium in perfect competition, businesses are both allocatively efficient and
productively efficient.

o Allocative efficiency - occurs when the number of units being produced maximizes the welfare
of society. Every unit for which the extra benefit (price) is greater than the extra cost should be
made-up to the output at which the extra benefit equals the extra cost.
o Productive efficiency- occurs when firms produce at the maximum of the average cost curve-
lowest possible cost per unit.

The adjustment process from short run losses to long run equilibrium in a perfectly competitive market

Long run equilibrium in a perfectly competitive industry. In long run equilibrium we have P=MR=MC=AC

Monopoly

This occurs when one firm dominates the industry. In a monopoly market structure, it is assumed that:

o There are barriers to entry- that is, the existing firm is protected from competition by
mechanisms such as illegal protection, the need for specialist skills, or high costs of entry.
o The firm's product is differentiated from the competition- there are no producers with a similar
product which means that the business is in a much more powerful position than in perfect
competition.

4
Managerial Economics Topic 4 Market types

It is possible for a business to earn abnormal profit in the long run as well as the short run. Although
other firms will be attracted by these high rewards, they will not be able to enter the market because of
the barriers to entry that the monopolistic business can continue to enjoy high rewards even in the
long run.

In a monopoly the business is a price maker; it does not have to charge what everyone else is charging
because it has a monopoly position. This generally leads to higher prices and lower outputs than in a
perfectly competitive industry. The lack of competition means that the business can drive up prices by
restricting what is on offer.

The present outputs outcome in a monopoly

Monopolies are allocatively inefficient; at Q1, the price paid

by the customer is greater than the marginal cost of providing
it. The price represents the extra benefit to the customer of
consuming this unit; this is greater than the extra cost of
producing it and so the welfare of society could increase if
this unit were produced.

The reason that a monopolist does not provide these

additional units is because the impact of lowering the price on
these and on all proceeding units would be reduced profits.
Profits are maximized where marginal revenue equals
marginal cost, so that is where the monopolist wants to be, regardless of social welfare.

A monopolist is productively inefficient because it is not producing at the minimum of average cost
curve. The business restricts output and pushes up the price to compensate for the higher cost.

The one from monopoly may produce on a much larger scale than any one firm in a perfect
competition; this may mean that it benefits from internal economies of scale and therefore that the
average costs are lower than they would be in a competitive market, which can bring the price down.

The higher profits of monopolies may provide the finance needed for expensive investment in research
and development. its profits are either reinvested into the business, funding further research, or are
paid out to the investors, many of whom are likely to be pension funds and banks.

Creative destruction - a monopoly position may be created by innovation but will be swept away by
further innovation unless the original firm keeps developing and improving its offering to stay ahead of
the competition.

Gaining market share may give firms power in the short run, but in the long run this may spur on more
competition and in this situation, to keep alive, you have to keep looking for ways of staying ahead of
rivals.

However, a monopolist can influence demand through its operation and marketing activities; it's can try
to shape the demand and make it less sensitive to price- it's going to be a price maker- to try to boost its
profits.

How can a business create a monopoly position?

5
Managerial Economics Topic 4 Market types

You must differentiate your product buy:

o Developing new technology which then can be patented, providing legal protection.
o Developing a unique selling proposition (USP) , but the problem with this type of offering is
that over time it can be imitated by others and so maintaining a monopoly position may be a
continuous process of continually raising the barrier.
o Building brand loyalty so that customers perceive your product as different from the rest-
requires heavy investment.
o Gaining government protection
o Forcing competitors out of business via a price war or through a takeover and making it clear
that further entry will be responded to aggressively, but the competition authorities will
probably prevent this behavior.

Price discrimination

Businesses operate in many market segments. A segment is a group of similar needs within an overall
market. Managers may segment a market in many different ways, including the following:

o age
o region
o reason for purchase
o income

Each of these segments may face its own demands and conditions.

Charging a different price for the same product is known as price discrimination. The ability to price
discriminate occurs if a business has some monopoly power and therefore the ability to set price in
those different market segments.

When the month conditions vary in different markets, the profit maximizing price and output occur
when the overall marginal revenue equals the marginal cost and when the marginal revenue in each
market is equal.

Profits maximizing by setting different prices and markets with different demand conditions

The combined marginal revenue in the two market segments is calculated by horizontally adding the
marginal revenue in each of these markets. The profit maximizing output is found where the combined
marginal revenue equals the marginal cost. This determines the level of marginal revenue in each

6
Managerial Economics Topic 4 Market types

market. From this, the relevant price can be identified. The higher price occurs in the market in which
demand is more price inelastic.

This form of price discrimination is called third degree discrimination. For third degree price
discrimination to work, markets must be kept separate, you need to avoid someone buying at least the
low price and then reselling it at the higher price in the other segment. The separation of markets may
be based on factors such as time, status, region or age.

Price discrimination boosts the profits of the business by reducing consumer surplus. This will mean
that they completely remove all consumer surplus but charge a different price for every unit sold. This is
called a first-degree price discrimination.

Perfect price discrimination

A business will profit maximize where marginal revenue equals

marginal cost (Q1). At this output, the cost per unit is AC1 and
therefore the total cost is shown by the area 0AC1EQ1. Given
that the cost per unit is higher than any other price, a business
charging one price of all its units will make a loss and would not
provide this product in the long run. By removing all consumer
surplus, the business makes more profits than a single price
consumer, which may mean that it can cover high costs.

With first degree price discrimination, the business maximizes

its own producer surplus and completely removes or consumer surplus.

There is also another form of price discrimination called second degree discrimination. This occurs
when a business is trying to use up any excess capacity that it has, such as last-minute deals in the
airline. In these sectors, fixed costs are high, but the marginal cost of serving a customer or passenger is
very low, so the price can fall a lot and the business can still make a contribution to its fixed costs.

By price discriminating, a business can make more profits, but consumer surplus is reduced however
one possible benefit for the consumer is that businesses may cross subsidize using profits made in one
segment to finance losses and other segments.