Market Structures and The Decision of a Firm

Market is a structure in which the buyers and sellers of a commodity remain in close contact.

 Basic factors for determination of market structure:

 number of buyers and sellers,
 nature of the product,
 knowledge of buyers and sellers about prices in the market,
 freedom of entry or exit of the firms,
 degree of price influence,
 degree of competition among firms in the market.
 the mobility of goods and factors of production, and
 Main market forms are:
1. Perfectly competitive market,
2. Pure monopoly,
3. Monopolistically competitive market,
4. Oligopoly.

1 PERFECTLY COMPETITIVE MARKET

Characterized by the following features

Assumptions of a perfectly competitive market are:

 very large number of buyers and sellers-
 no single seller or buyer can influence the market price
 sellers and buyers are not price makers rather they are price takers-
 price is determined by the interaction of the market supply and demand forces
 homogeneous product,
 products supplied by the different firms are the same
 they are identical in all respects, including quality, colour, size, weight, design, etc.
 They are perfect substitutes for one another.
 Since a buyer cannot distinguish between the product of one firm from that of another,
he/she becomes indifferent as to the firms from which he/she buys.
 The product being homogeneous, no seller can charge a higher price.
 The characteristics of a good or service do not vary between suppliers.
 freedom of entry and exit,
 No restriction or market barrier on entry of new firms to the industry
 No restriction on exit of firms from the industry
 Buyers and sellers are free to enter or leave the market at any time they like.
 perfect mobility of resources,
 There is perfect mobility of goods and factors of production without any hindrance or
obstruction.
 The factors are free to enter the industry, if considered profitable, and to leave the
industry when remuneration is inadequate.
 perfect knowledge about market condition
 The buyers and sellers have perfect knowledge about the prices and costs prevailing in
the different parts of the market.
 All firms have equal access to knowledge about the market and technology, resulting
in same per-unit cost of production
 Clearly, this leads to the emergence of uniform price of the product.
 absence of transport costs.
 it is assumed that there is no transport cost for consumers who may buy from any
firm.
 This ensures the existence of a single uniform price of the product.
 Firms Aim to Maximize Profit:
 the objective of firms in perfect competition is profit maximization.
 Firms try to increase revenue and reduce (minimize) costs so as to increase profit.
 profit is maximum when TR – TC is maximum.
 Also, TR > TC → Profit
 TR = TC → Neither profit nor loss(break-even point)
 TR < TC → Loss
 a competitive firm’s profit is maximized at the point where the price line intersects
the MC curve, which is where Price = Marginal Cos, MR = MC and MC is rising
 No government interference
 No discriminator taxes or subsidies
 No allocation of inputs by the procurement or any kind of direct or indirect control
 The government follows the free enterprise policy
 no long-term economic profits.
 In the short-run, it is possible for a firm’s economic profits to be positive, negative, or zero.
Economic profits will be zero in the long-run.
 In the short-run, if a firm has a negative economic profit, it should
continue to operate if its price exceeds its average variable cost. It
should shut down if its price is below its average variable cost.
 In the short-run, if a firm has a negative economic profit, it should continue to operate if its
price exceeds its average variable cost. It should shut down if its price is below its average
variable cost.

Perfect competition demand and revenue functions

a. Demand

 a competitive firm faces a completely horizontal demand curve for its product,
indicating that it can sell any amount of output only at the ongoing market price (P)
b. Revenue Function
 obtained from selling products.
 the curve depicting the amounts of revenue that it receives by selling the various
quantities of a commodity is called the revenue curve.
 Revenues have three main categories:
I. Total Revenue: refers to the total amount of income received by the firm by
selling a given amount of output (TR = P × Q)
II. Average Revenue: is the total revenue (TR) divided by the quantity sold (Q),
Or is the revenue earned per unit of the product:
TR PXQ
AR= = =P
Q Q
Note that average revenue (AR) and price of the product (P) have the
same meaning.
 Average revenue means per unit revenue received by the seller from the
sale of the commodity.
 On the other hand, price means per unit payment made by the purchaser
to purchase the commodity.
 Since the seller receives what the purchaser pays, the per unit revenue
and per unit price are the same. That is why, the AR curve and Demand
curve for a firm’s product are also the same.
III. Marginal revenue: is the addition to total revenue which results from the
∆ TR ∆ ( PXQ )
sale of one additional unit of output. MR= = =P
∆Q ∆ (Q)
Remember: In perfect competition,
 MR= (P) or (AR). Hence, average revenue and marginal revenue
become equal and constant in the given situation.
 the AR and MR curves are the same and would be horizontal or parallel
to the X-axis. This is also called the price line.
Assuming that price per unit of a commodity is Birr 5, the behaviour of and relationship between
TR, MR and AR of a firm under perfect competition, are shown in the following schedule.
Units of a TR MR (birr) AR or Price(birr)
Commodity (birr)
0 0 0 0
1 5 5 5
2 10 5 5
3 15 5 5
4 20 5 5
5 25 5 5
 The TR curve under perfect competition passes through the origin because, at zero
output, total revenue is also zero.
 Moreover, TR under perfect competition is a straight line.
 average revenue (AR) and marginal revenue (MR) are both equal to market price.
  TR increases as quantity increases.
 AR remains constant and equal to price.
 MR remains constant and equal to price.
Key Relationship: Price = AR = MR in a perfectly competitive market.
Profit maximization conditions of a perfectly competitive market:
 In the short run: TR – TC is maximum or MR = MC and MC is rising
 In the long run: P = LMC = LAC

4.2 Pure Monopoly Market

 “monopoly= mono(single) + Polus(seller)
 A monopoly is a market structure in which
there is only one supplier in a given market
(industry), and that product has no close
substitutes.
 It is difficult to find a pure monopoly.
 However, there is only one firm producing and supplying electric power in Ethiopia and
this can be considered one example of monopoly.
Assumptions (Features) of Monopoly
 Single Producer many buyers: There is a single firm producing the commodity in the
market. Since there is a single firm, the difference between firm and industry vanishes.
 No Close Substitutes: the product is unique
 consumers have no alternative choices to substitute one product for another.
 So, the monopoly firm would not face competition from new or existing products.
 Barriers to the Entry:
 Entry into the industry is completely banned or otherwise made impossible.
 If new firms are admitted into the industry, the condition of monopoly breaks
down.
 This ban on entry may be legal, natural or institutional, but it must essentially be
there.
 Independent Price Policy: A monopolist firm can adopt an independent price policy —
i.e., it can increase or decrease prices as it likes. It is in this sense that a seller under
monopoly is said to be the price maker or price setter.
 Price Discrimination is Possible: Under the conditions of monopoly, price discrimination
is possible. It implies that a monopolist can sell its product at different prices to different
customers.
  Profit Maximization: A monopolist will produce where MR=MC to maximize profits.
Barriers to entry permit firm to earn profits in the long-run. AR > MR ( ... P > ∆P)
 Example: Electricity market in Ethiopia and Ethio Telecom.
Reasons for the Existence of Pure Monopoly
 Absence of close substitutes.
 Ownership of strategic or key inputs.
 Economies of scale in production
 Patent rights for products or production processes give legal monopoly rights to firms.
 Exclusive knowledge of technology by the firm;
The Demand and Revenue Functions of the Monopoly Firm
a. Demand
 a monopolist faces a negatively sloping demand curve or average revenue curve.
 the market demand curve makes that outcome impossible.
 In particular, the market demand curve describes the combinations of price and
quantity that are available to a monopoly firm.
 P = a – bQ
 Where P – is the market price
 Q – is the quantity of sales (quantity demanded)
 ‘a’ and ‘b’ are any positive constants

b. Revenue Function: represents the total income a company generates from selling goods or
services.

 Revenues have three main categories:

1. Total Revenue (TR):
 is the total amount of money a company receives from the sale of a given quantity of its
product.
 obtained by multiplying the unit price of the commodity and the quantity of that product
sold.

TR=P X Q; From demand function P = a – bQ , Substituting (a – bQ) for P

TR = (a - bQ) Q
TR = aQ – b Q2

2. Average Revenue (AR):

 is the revenue per unit of item sold.
 It is calculated by dividing the total revenue by the amount of the product sold.
TR Q bQ 2
AR= =P . =aQ− =a−bQ
Q Q Q

 AR=P
 3. Marginal Revenue (MR).
 is the change in total revenue resulting from one unit increase in sales.
 It is the additional amount of money or revenue the monopolist firm receives by selling
one more unit of the product.
 It is calculated as the ratio of the change in total revenue to the change in the sale of the
product.
∆ TR ∆( PxQ )
MR= = =TR n – TR n – 1 .
∆Q ∆Q

Remarks:

 Both AR and MR are falling, and MR falls at a greater rate than AR. In
other words, the AR and MR curves are downward sloping curves, and
the MR curve always remains below the AR curve.
 MR can be negative, but AR is always positive. In other words, the MR
curve can go below the X-axis, but the AR curve always remains above
the X-axis.
 the total revenue curve of the monopolist firm has an inverse U-shape.

4.3 Monopolistically Competitive Market

 A combination of perfect competition and pure monopoly market situations
 refers to a situation where there are many sellers of a differentiated product.
 There is competition which is keen, though not perfect, between many firms making
very similar products, which are close but not perfect substitutes. Example: Hotel,
Barber shops ...
 Has the following Characteristics
 Differentiated Products: Products are similar but not identical, allowing firms to
establish a degree of brand loyalty and influence over pricing. Differences can be real or
perceived, such as in packaging, features, or service.
 The differentiation makes the products of different firms heterogeneous; but these
products are close substitutes of each other.
 each seller can independently decide his/her own price-output policies.
  Many sellers and buyers: Each seller pursues an independent output-price policy.
 Free Entry and Exit of Firms: New firms can enter the market if they find it profitable.
Similarly, if any firm believes that it is not worth staying in the business, it is free to exit.
 Selling Cost: firms compete with each other by incurring selling costs or expenditures
for sales promotion. Selling cost is the expenditure incurred by the firm to promote the
sale of its product through various sales promotion measures. The sales promotion
measures may take the form of persuasive or competitive advertisement like
advertisement in newspapers, T.V. commercials, etc.
 Non-Price Competition: take the form of product quality, advertising, brand name,
customer service, etc.
 Independent Price Policy: A firm can follow an independent price policy. This means
that a firm is a price-maker for its product.
 close substitutes.
 Imperfect Information: Buyers and sellers may not have complete knowledge of all
market conditions, contributing to the imperfect competition.
 Downward-Sloping Demand Curve: Each firm faces a downward-sloping demand
curve, meaning that if a firm increases its price, it will sell less output.
 Elastic Demand: While firms have some control over pricing, the demand for their
product is relatively elastic due to the availability of close substitutes.
The Demand and Revenue Functions
a. Demand
The demand curve or AR curve faced by a firm under perfect competition is perfectly elastic. It
is somewhat elastic under monopoly. It is more elastic under monopolistic competition.
the demand curve of a firm under monopolistic competition is flatter than that of a monopoly
firm.

The figure shows the demand curve faced by the monopolistic competitive firm is not horizontal
as is the case with perfect competition. It is also not the market demand curve, as in the case of
monopoly.
b. Revenue Function: determined by the interaction of price and quantity sold, influenced by
the firm's downward-sloping demand curve. Firms in this market structure face a less elastic
 demand curve than perfect competitors, but more elastic than a monopolist, meaning they
have some pricing power but also face competition from similar products.

4.5 OLIGOPOLY MARKET

a market situation where a few large firms compete against each other and there is an element of
interdependence in the decision-making of these firms.
Characteristics of Oligopoly Markets
The automobile industry (Volkswagen, Toyota, Chrysler, Daimler, Ford, GM)
The steel industry (China Baowu, ArcelorMittal, Ansteel, Nippon Steel)
The mobile phone manufacturing industry (Apple, Samsung, LG)
The wireless phone provider industry (Verizon, T-Mobile, AT&T)
The aircraft manufacturing industry (Boeing, Airbus)