Market Structures

Lecturer’s Detail
Name: Lucie Ingram

Contact details: [email protected]

 Business Issues Covered in this Lecture

 What determines the degree of market power of a firm?

 Why does operating under conditions of perfect
competition make being in business a constant battle for
survival?
 How do firms get to become monopolies and remain so?
 At what price and output will a monopolist maximize profits
and how much profit will it make?
 How well or bad do monopolies serve the consumer
compared with competitive firms?
 Why will the size of entry barriers to an industry (the
degree of ‘contestability’ of a market) affect the amount of
profit monopolist can make?

April 2014 3
 Alternative Market Structure
Industries are divided into categories according to the degree of
competition that exist between the firms within the industry.
Perfect Competition: A firm structure in which there are many
firms, where there is freedom of entry to the industry, where all
firms produce identical product; and where all firms are price
takers.
Monopoly: A market structure where there is only one firm in the
industry.
Monopolistic Competition: A market structure where, like perfect
competition, there are many firms and there are freedom of entry
into the industry, but where each firm produces a differentiated
product and thus has some control over its price.
Oligopoly: A market structure where there are few enough firms
to enable barriers to be erected against the entry of new firms.

April 2014 4
 Alternative Market Structure
To distinguish between these four categories the
following must be considered:
How freely the firm can enter the industry: is entry
free or restricted? If it is restricted, just how great
are the barriers to the entry of new firms?.
The nature of the product. Do all firms produce
identical product, or do firms produce their own
particular brand or model or variety?
The degree of control the firm has over price. Is
the firm a price taker or can it choose its price, and
if it can, how will changing its price affects its
profit?
April 2014 5
Features of the four market structures
Features of the four market structures
Features of the four market structures
Features of the four market structures
Features of the four market structures
Features of the four market structures
 Perfect Competition
Assumptions: The model of perfect competition is built on four
assumptions:
1. Firms are price takers. There are many firms in the Industry, no
power to affect the price of product. The demand ‘curve’ is
horizontal at the market price: the price determined by the
interaction of demand and supply in the whole market.
2. There is complete freedom of entry into the industry for new
firms.
3. All firms produce an identical product. So there is no brand for
advertising.
4. Producers and consumers have perfect knowledge of the
market. Producers are aware of prices, costs and market
opportunities. Also, consumers are aware of the prices, quality, an
availability of the product.

April 2014 12
The Short-Run Equilibrium of the Firm

 In the short run:

We assume that:
1- The number of firms in the industry cannot be
increased.
2- No time for new firms to enter the market.
The short run under perfect competition: The
period during which there is too little time for new
firms to enter the industry.

April 2014 13
Short-Run Equilibrium of Industry and Firm
Under Perfect Competition

April 2014 14
The Short-Run Equilibrium of the Firm
Price: The price is determined by the intersection of demand
and supply.
The firm faces a horizontal demand (or AR) curve at this
price. It can sell all it can produce at the market price (Pe),
but nothing above Pe.
Output: Firm Maximize profit when MR= MC at an output of
Qe
Since the price is not affected by the firm output MR=P.
Thus the firm MR curve and AR curve = Demand Curve
are the same horizontal straight line.
Profit: If the average cost (AC) curve dips below the average
revenue (AR) curve, the firm will earn profit. The profit per
unit at Qe is the vertical difference between AR and AC at
Qe.
April 2014 15
 Long-Run Equilibrium Under Perfect
Competition

April 2014 16
 The Long-Run Equilibrium of the Firm
 If firms are making profits, new firms will be attracted into
the industry.
 Existing firms can make more profits by increasing the
scale of their operations, they will do so, because factors
of production are variable in the long run.
 The effect of the entry of new firms and/or the expansion of
existing firms is to increase industry supply.
 The industry supply curve shifts to the right, and the price
will fall.
 Supply will go on increasing, and price falling, until firms
make profits.
 This will be where the demand curve for the firm just
touches the bottom of its LRAC curve.
 QL is the long run equilibrium output of the firm and PL is
the long run equilibrium price.
April 2014 17
 Long-Run Equilibrium under Perfect
Competition

April 2014 18
 Monopoly
Barriers to entry
– Economies of scale: If the monopolist’s costs go on falling
significantly up to the output that satisfies the whole market,
the industry may not be able to support more than one
producer. This is known as natural monopoly.
– Product differentiation and brand loyalty: If a firm produces
a clearly differentiated product, where the consumer
associates the product with the brand, it will be very difficult
for a new firm to break into that market.
– Lower costs for an established firm: An established
monopoly is likely to have developed specialised production
and marketing skills.
– Ownership/control of key inputs or outlets: The firm can
control suppliers and consumers.
April 2014 19
 Monopoly

Barriers to entry
– Legal protection: The firm’s monopoly position
may be protected by patents on essential
processes, by copyright, by various forms of
licensing and by tariffs and other trade restrictions
to keep out foreign competitors.
– Aggressive tactics: An established monopolist can
sustain losses for longer than a few entrant. Thus it
could start a price war, mount massive advertising
campaign, offer attractive after- sales service,
introduce new brands to compete with new entrants,
and so on.
April 2014 20
 Equilibrium Price and Output
Under Monopoly the firm’s demand curve is also the
industry demand curve.
The demand will be inelastic at each price.
The monopolist can raise its price and consumers have
no alternative firm to turn to within the industry.
They either pay the higher price, or go without the good
altogether.
Unlike the firm under perfect competition, the monopoly
firm is a ‘price maker’.
It can choose what price to charge.
A rise in the price will reduce the quantity demanded.
April 2014 21
 Profit Maximising Under Monopoly

April 2014 22
 Profit Maximising Under Monopoly
A monopolist will maximize profit where MR=MC.
Profit is maximized at Qm.
The profit is shown by the shaded area.
These profits will tend to be larger, the less elastic
the demand curve the bigger is the gap between
MR and price (AR).
The actual elasticity will depend on whether
reasonably close substitute are available in other
industries.
The demand for a rail service will be much less
elastic ( profit greater) if there is no buss service to
the same destination.
April 2014 23
 Monopolistic Competition

Assumptions of monopolistic competition

Large number of firms
Independence of firms, each firm has only a small
share of the market.
Freedom of entry of new firms into the industry.
Differentiated product (product differentiation)
Downward-sloping demand curve
Elasticity depends on degree of product
differentiation.

April 2014 24
 Monopolistic Competition

Equilibrium of the firm

A. Short run
Profit were maximized at the output where MC = MR
Level of profit depends on the strength of demand
1. Position of demand curve
2. Elasticity of demand curve

The further to the right the demand curve is relative

to the average cost curve, and the less elastic the
demand curve is, the greater will be the firm’s short run profit.

April 2014 25
 Short-run Equilibrium of the Firm Under Monopolistic
Competition
£ MC

AC

Ps
Economic Profit
ACs

AR D)

MR
0 Q
April 2014 Qs 26
 Monopolistic Competition
 Equilibrium of the firm
B. Long run
 If firms are earning profits, new firms will enter the industry
in the long run.
 The demand for the established firm’s products will therefo
re fall.
 Their demand (AR) curve will shift to the left, and will conti
nue
doing so as long as profits remain and thus new firms conti
nue entering.
 From the next figure the firm’s demand curve settles at D1,
where
its tangential to the firm’s LRAC curve. Output will be QL : wh
ere
ARL = LRAC.
April 2014 27
 Long-run Equilibrium of the Firm Under Monopolistic
Competition
£

LRMC

LRAC

PL

ARL DL)

MRL
Q
0 QL
April 2014 28
 Oligopoly
Oligopoly occurs when few firms between them share
a large proportion of the industry.
Some of the best known companies, including Ford,
Coca-cola, BP and Nintendo.
The two key features of Oligopoly:
Barriers to Entry: The size of the barriers will vary from
industry to industry. In some cases entry is relatively
easy, whereas in others it is virtually impossible.
Independence of the firm: Each firm will be affected by
its rivals’ decisions. Likewise its decisions will affect its
rivals.
Firms recognise this interdependence because it will
affect their decisions.
Kinked Demand Curve

ELASTIC. Firm increases

price, competitors don’t.
Firm losses from increasing
prices

INELASTIC. Firm lowers

price. Competitors cut
prices. Firm looses from
lowering prices
Kinked Demand Curve & Profit
Maximisation
 An Alternative Approach:
Game Theory

Not all economists accept the “kink” explanation

 How do prices arrive at the kink in the first place?

Game Theorists
 Used by economists & military strategists.

Each firm has one of two options:

 Either co-operate,
 Or begin a price war
Profits for firms A and B at different prices

X’s price
£2.00 £1.80

A B
£2.00 £10m each £5m for Y
£12m for X
Y’s price
C D
£1.80 £12m for Y £8m each
£5m for X
 Game theory

Non-collusive oligopoly: game theory

Single-move games

 alternative strategies
 maximax and maximin

 simple dominant strategy games

 the prisoners’ dilemma
 The prisoners’ dilemma

Amanda's alternatives
Not confess Confess

Not
A B Nigel gets
Each gets 10 years
confess Amanda gets
1 year
Nigel's 3 months
alternatives C Nigel gets D
3 months Each gets
Confess 3 years
Amanda gets
10 years
 Nash Equilibrium

Will firms compete or cooperate?

 In Nash equilibrium, each firm will make an optimal

choice given the potential response of its rivals.

 each firm considers what its rivals can do before

deciding on its own strategy.