Unit III

 Market structure  Methods of pricing

 Characteristics  Differential pricing
 Pricing and output  Government
decision intervention &pricing
Market classification

Area wise Time wise Trade wise

• Local • Market • Competition

• National period • Monopoly
• International • Short period
• Long period
Types of Competition
Perfect • Demand=Supply
Competition
• Monopolistic
Imperfect competition
competition • Oligopoly
• Duopoly

• Simple
Monopoly • Discriminating
Different Types of Market Structures
 Perfect Competition

Features of perfect competition

◦ Free entry and exit to industry
◦ Homogenous product – identical so no consumer
preference
◦ Large number of buyers and sellers – no individual
seller can influence price
◦ Sellers are price takers – have to accept the market
price
◦ Perfect information available to buyers and sellers
The Perfectly Competitive Firm and
Industry in Short-Run Equilibrium

Draw economic loss

 The Long Run adjustments in Perfect
Competition
D1 MC
P D P
S S1
ATC

P1

P P=MR

Q Q1

The Individual firm 7

Advantages of Perfect
Competition
 High degree of competition helps allocate
resources to most efficient use
 Price = marginal costs
 Normal profit made in the long run
 Firms operate at maximum efficiency
 Consumers benefit
What happens in a competitive
environment?
◦ New idea? – firm makes short term abnormal
profit
◦ Other firms enter the industry to take
advantage of abnormal profit
◦ Supply increases – price falls
◦ Long run – normal profit made
◦ Choice for consumer
◦ Price sufficient for normal profit to be made
but no more!
 Imperfect or Monopolistic
Competition
 Imperfect or Monopolistic Competition
◦ Many buyers and sellers
◦ Products differentiated
◦ Relatively free entry and exit
◦ Each firm may have a tiny ‘monopoly’ because of the
differentiation of their product
◦ Firm has some control over price
◦ Examples – restaurants, professions – solicitors, etc.,
building firms – plasterers, plumbers, etc.
 Short-Run and Long-Run Equilibrium
for a Monopolistic Competitor
Short-Run Profits Short-Run Losses

Long-Run Equilibrium

Visual 3.13
http://apeconomics.ncee.ne
t
What happens to the demand
curve with more competition?
The demand curve for an
existing firm will become more
elastic and shift to the left as
entry occurs
Oligopoly

Competition between the few

May be a large number of firms in the industry but the industry is
dominated by a small number of very large producers
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 –
kinked demand curve?
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
oligopoly

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D = Inelastic

100 Quantity
Duopoly
 There are only 2 sellers
 Limiting case of oligopoly
 Each firms knows that whatever it does will
affect its rival’s policies.
 There are two extremes in a duopolistic :
i) Each firm engages in cut throat
competition and
 ii) the firms realise the evils of competition
and agree to corporate
Characteristics
 Only two firms
 Two firms may either resort to
compete or collusion
 Only non price competition exists
 Producers are homogenous
 Same price will exist in the long run
 Action of one firm will have reations
by the other.
Models of duopoly

Cournot’s Chamberlin’s
model model
Cournot’s model
 Assumptions
 Two independent sellers sells homogenous
product
 The cost of production is identical ( water spring
– zero cost of production)
 Each seller aims maximum profit
 The number of buyer is large
 They face straight line demand curve
 Each firm decides their output assuming rival will
not change his output.
The model
 Two firms A & B
 Owning spring of mineral water
 It is nature’s gift – zero cost of
production
 The duopolists face a straight line dd
curve, their output is given
 Explained with diagram
Price and output in monopoly
 Monopoly, single firm, no c
lose substitutes, barriers to entry
According to Chamberlin, “ the
essence of monopoly is control
over supply”
In monopoly, firm is a price maker
 Market Structure

 Monopoly:
◦ High barriers to entry
◦ Firm controls price OR output/supply
◦ Abnormal profits in long run
◦ Possibility of price discrimination
◦ Consumer choice limited
◦ Prices in excess of MC
What is a Price Maker?
A firm that has the ability
to choose among
combinations of price
and output, attempting to
find the profit maximizing
combination
How does a Monopoly determine
Price & Output to maximize profits?

MR = MC
©1999 South-Western College Publishing
Why are profits maximized
MR = MC?
MR > MC (keep producing)
MR < MC (stop producing)
MR = MC (no $ gained or lost on the last unit)

©1999 South-Western College Publishing

 Monopoly: Positive Profit
ATC
$ P
MC
P
Profit

ATC
D
MR
Q
Q 27
 Monopoly: Loss Case
ATC ATC
$ MC
Loss
P
P
D
MR
Q 28
Q
 Advantages and disadvantages of
monopoly

 Advantages:
◦ May be appropriate if natural monopoly
◦ Encourages R&D
◦ Encourages innovation
◦ Development of some products not likely without
some guarantee of monopoly in production
◦ Economies of scale can be gained – consumer may
benefit
Disadvantages:
◦ Exploitation of consumer – higher
prices
◦ Potential for supply to be limited -
less choice
◦ Potential for inefficiency –
X-inefficiency – complacency
over controls on costs
What does the Demand Curve
look like for a Monopoly?

It is the same as the market demand

curve
Demand curve in Monopoly, same as the
market demand

D
32
Q
What is Marginal Revenue?

TR
MR = Q

©1999 South-Western College Publishing

MR < P for all but the first unit of output

P Demand

Marginal Revenue

34
Q
Profit maximization in monopoly
Put in the marginal cost
curve, best output is where
MR=MC, best price for that
output is found by going up
to the demand curve
 Best price and output for
monopoly
$
MC
P

D
MR
Q
Q 36
Short run profit possibilities

As always in the short run,

can make positive profits,
losses, or zero economic
profits-to show profit, must
add in the average total cost
curve.
 Monopoly: Positive Profit
ATC
$ P
MC
P
Profit

ATC
D
MR
Q
Q 38
 Monopoly: Loss Case
ATC ATC
$ MC
Loss
P
P
D
MR
Q 39
Q
 Monopoly: Zero Profits Case
ATC
$ MC
ATC

P
P
D
MR
Q 40
Q
When will a firm continue to
operate even when making a loss?
When its losses are less than its fixed
costs: in other words, as long as Price
exceeds AVC, can stay in business in
the short run
When will a firm shut down when
making a loss?
When its losses are greater than its fixed
costs
How does Monopoly compare to
Perfect Competition ?
 Higher prices & less output
under monopoly
 Long run profits possible in
monopoly due to barriers to
entry
Why are demand curves
downward sloping in
Monopolistic Competition?
Because a firm can distinguish itself from
competitors and therefore has some control
over price
What happens to the demand
curve with more competition?
The demand curve for an
existing firm will become more
elastic and shift to the left as
entry occurs
©1999 South-Western College Publishing
P

D2
D1
Q
46
©1999 South-Western College Publishing
What is Normal Profit?

The minimum profit a

business owner will
accept to continue
operating the business
( same as zero economic
profit)
What is Economic Profit?
Money made above and beyond a normal
profit

©1999 South-Western College Publishing

In Monopolistic Competition, can
Economic Profit be made in the
short run?
Yes! Positive or negative
economic profit can
be made in the short
run
Why is Normal Profit the long run
equilibrium in Monopolistic Competition?

Because when positive

economic profit is made,
firms will enter the industry
eliminating the economic
profit
In monopolistic competition, what
happens as more firms enter in search of
profits?

The demand curve of other firms shifts to

the left

©1999 South-Western College Publishing

Now move from monopolistic
competition to perfect competition

Recall the characteristics of

perfect competition: many
firms, each a tiny share of the
market, producing identical
products, free entry and
perfect information
Why does a Perfectly Competitive firm
face a horizontal demand curve?

Because it can sell all it brings to market

at the market price, therefore P always
equals MR

©1999 South-Western College Publishing

Why is a firm that is a part
of a Perfectly Competitive
Market a price taker?

Because if the firm charges higher

than the market price it will not sell
one unit

©1999 South-Western College Publishing

Why is this so?

Because consumers will buy the same

thing at a lower price from its
competitors

©1999 South-Western College Publishing

 The Market and the firm in Perfect
Competition

P D P
S

P=MR

The Market Individual firm

56
 Profits are maximized where
MR = MC
P MC
MR1=P1
MR1=MC
MR2=P2
MR2=MC
Q
Q2 Q1
57
Why is a firm’s MC curve above its
AVC curve its Supply Curve?

Because it always produces where

MR = MC

©1999 South-Western College Publishing

Why don’t we include the MC
curve below its AVC curve as a
part of its Supply Curve?

Because below the AVC the firm will close

down

©1999 South-Western College Publishing

What is the Market’s Supply
Curve?
It is the aggregation of the long-run MC
curves of the firm’s in the market

©1999 South-Western College Publishing

In Perfect Competition, can
Economic Profit be made in the
short run?
Yes! Positive or negative
economic profit can
be made in the short
run
Why is a Normal Profit (zero
economic profits) made in the
long run?

Because of the easy entry - easy exit

feature in a Perfectly Competitive
Market

©1999 South-Western College Publishing

 Zero Profits in Perfect Competition

MC

ATC
P P = MR

P = ATC

Q1
63
What happens when a firm makes
more than a Normal Profit?

More firms enter the

industry pushing prices
down toward a normal
profit
©1999 South-Western College Publishing
 Right Shift in Supply
S1
P1 S2
P2
D
Q1 Q2
©1999 South-Western College Publishing 6
5
What happens when a firm makes
less than a Normal Profit?

Some firms leave the industry pushing prices

up toward a normal profit

©1999 South-Western College Publishing

 Left Shift in Supply
S2
P2 S1
P1
D
Q2 Q1
©1999 South-Western College Publishing 6
7
Explanation of long run adjustments
 Start at price P, typical firm making zero
profits
 Suppose demand increases to D1
 Price rises to P1
 Typical firm making positive profits
 What happens in the long run?
 Assuming perfect information and free
entry, new firms enter the market
 Supply shifts right until profits eliminated
 Price comes down—but how far depends
on whether costs are affected
Long Run, continued
 Constant cost industry: no change in
costs as new firms enter the market, price
returns to P, original price
 Increasing cost industry: all firms
experience rising costs as new firms enter
the market, final price will be higher than
original price P
 Decreasing cost industry: all firms
experience lower costs as new firms enter
the market, final price will be lower than
original price
 Zero Profits in Perfect Competition

MC

ATC
P P = MR

P = ATC

Q1
70
Are big firms necessarily more
innovative?
Not necessarily: some small
firms are very innovative-
this is still a controversial
area in economics.
END