Market Structures

Perfect Competition

Alternative Market Structures

Classifying markets by degree of competition
number of firms freedom of entry to industry nature of product nature of demand curve

The four market structures

perfect competition monopoly monopolistic competition oligopoly

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Plumbers, restaurants Cement cars, electrical appliances gas and electricity in many countries

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Monopoly

One

Restricted or completely blocked

Unique

Perfect Competition
Assumptions
large number of firms firms are price takers freedom of entry and exit identical products perfect knowledge

Distinction between short and long run ShortShort-run equilibrium of the firm
P = MC
possible supernormal profits

ShortShort-run equilibrium of industry and firm

Firm is a price taker. Price is given by the market.

P
S

MC

AC

Pe

AR AC

D = AR = MR

D O Q (millions) Qe

(a) Industry

Loss minimising under perfect competition

P
S
Loss is minimised where MC = MR.

MC

AC

AC P1 AR1

D1 = AR1 = MR1

D O Q (millions) O Qe Q (thousands)

(a) Industry

(b) Firm

ShortshutShort-run shut-down point

P
S MC AC

AVC P2 D2 O Q (millions) O Q (thousands) AR2 D2 = AR2 = MR2

(a) Industry

(b) Firm

Deriving the short-run supply curve shortP

P1 P2 P3 D1 D3 O Q (millions) D2 O S a b c

MC = S D1 = MR1 D2 = MR2 D3 = MR3

Q (thousands)

(a) Industry

(b) Firm

Perfect Competition
ShortShort-run supply curve of industry LongLong-run equilibrium of the firm
all supernormal profits competed away

Long-run equilibrium under perfect competition LongNew firms enter Supernormal profits
P
S1 Se P1 PL AR1 ARL

Profits return to normal MC

LRAC D1 DL

D O Q (millions) O QL Q (thousands)

(a) Industry

(b) Firm

LongLong-run equilibrium of the firm

(SR)MC (SR)AC

LRAC

DL AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

Perfect Competition
ShortShort-run supply curve of industry LongLong-run equilibrium of the firm
all supernormal profits competed away long-run industry supply curve

Various long-run industry supply curves under perfect competition

P

S1

S2

Long-run S

D1
O
(a) Constant industry costs

D2
Q

Various long-run industry supply curves under perfect competition

P

S1

S2
Long-run S

c a

D2 D1
O Q
(b) Increasing industry costs: external diseconomies of scale

Various long-run industry supply curves under perfect competition

P

S1

S2

a c
Long-run S

D1

D2

O (c) Decreasing industry costs: external economies of scale Q

Perfect Competition
ShortShort-run supply curve of industry LongLong-run equilibrium of the firm
all supernormal profits competed away long-run industry supply curve

Incompatibility of economies of scale with perfect competition

Perfect Competition
ShortShort-run supply curve of industry LongLong-run equilibrium of the firm
all supernormal profits competed away long-run industry supply curve

Incompatibility of economies of scale with perfect competition Does the firm benefit from operating under perfect competition?

Market Structures

Monopoly

Monopoly
Defining monopoly Only one seller Barriers to entry
economies of scale product differentiation and brand loyalty lower costs for an established firm ownership/control of key factors or outlets legal protection mergers and takeovers aggressive tactics

Monopoly: Why?
Natural monopoly (increasing returns to scale). Artificial monopoly a patent sole ownership of a resource formation of a cartel; e.g. OPEC

Monopoly: Assumptions
Many buyers priceOnly one seller i.e. price-maker Homogeneous product Perfect information Restricted entry and possibly exit

Monopoly: Features
The monopolists demand curve is the (downward sloping) market demand curve The monopolist can alter the market price by adjusting its output level.

Monopoly
The monopolist's demand curve
downward sloping MR below AR

Equilibrium price and output

MC = MR

Profit maximising under monopoly

P/R

MC

MR
O

Qm

Profit maximising under monopoly

P/R

MC

AR

AR MR
O

Qm

Monopoly
The monopolist's demand curve
downward sloping MR below AR

Equilibrium price and output

MC = MR
measuring level of supernormal profit

Profit maximising under monopoly

P/R

MC

AC

AR

AC

AR MR
O

Qm

Profit maximising under monopoly

P/R

MC

AC

AR

AC

AR MR
O

Qm

Price Discrimination
Why do business week offer bargain rates to students? PRICE DISCRIMINATION Charging different prices for a product when the price differences are not justified by cost differences. Objective of the firm is to attain higher profits than would be available otherwise.

Monopoly - Price Discrimination

Different prices at different markets
Personal, Local or Trade use

First degree
Charge maximum from able and willing to Pay

Second Degree
Buyers divided into groups, based on demand

Third Degree
Entire market divided into submarkets

Price Discrimination
Firm must be an imperfect competitor (a price maker) Price elasticity must differ for units of the product sold at different prices Firm must be able to segment themarket and prevent resale of units across market segments

FirstFirst-Degree Price Discrimination

Each unit is sold at the highest possible price Firm extracts all of the consumers surplus Firm maximizes total revenue and profit from any quantity sold

SecondSecond-Degree Price Discrimination

Charging a uniform price per unit for a specific quantity, a lower price per unit for an additional quantity, and so on Firm extracts part, but not all, of the consumers surplus

FirstSecondFirst- and Second-Degree Price Discrimination

In the absence of price discrimination, a firm that charges Rs.2 and sells 40 units will have total revenue equal to Rs.80.

FirstSecondFirst- and Second-Degree Price Discrimination

In the absence of price discrimination, a firm that charges Rs.2 and sells 40 units will have total revenue equal to Rs.80. Consumers will have consumers surplus equal to Rs.80.

FirstSecondFirst- and Second-Degree Price Discrimination

If a firm that practices firstdegree price discrimination charges Rs.6 and sells 40 units, then total revenue will be equal to Rs.160 and consumers surplus will be zero.

FirstSecondFirst- and Second-Degree Price Discrimination

If a firm that practices seconddegree price discrimination charges Rs.4 per unit for the first 20 units and Rs.2 per unit for the next 20 units, then total revenue will be equal to Rs.120 and consumers surplus will be Rs.40.

ThirdThird-Degree Price Discrimination

Charging different prices for the same product sold in different markets Firm maximizes profits by selling a quantity on each market such that the marginal revenue on each market is equal to the marginal cost of production

ThirdThird-Degree Price Discrimination

Monopoly
The monopolist's demand curve
downward sloping MR below AR

Equilibrium price and output

MC = MR
measuring level of supernormal profit Price Discrimination

Comparing monopoly with perfect competition

Monopoly
The monopolist's demand curve
downward sloping MR below AR

Equilibrium price and output

MC = MR
measuring level of supernormal profit

Comparing monopoly with perfect competition

lower output at a higher price

A monopolist producing less than the social optimum

MC = MSC

P1 P2 = MSB
= MSC

MC1

AR = MSB MR
O Q1 Q2

Q
Perfectly competitive output

Monopoly output

Monopsony
Monopoly: the only seller. Monopsony: the only buyer, pricechooses a price-quantity combination on the industry supply curve that max its profit it exercises its market power by buying at a price below the price that competitive buyers would pay

Monopsony
w, per worker

60

When supply curve linear and upward sloping, the marginal expenditure curve is twice as steep as the supply curve
ME, Marginal expenditure Supply

ME = 40 ec wc = 30 wm = 20 Suppose a firm is the sole employer in a town, and the firm uses one factor, labour, to produce a final good em

Average expenditure the monopsony pays to hire a certain number of workers

Demand for labour

20

30

60

L, Workers per day

Monopsony
Monopsony power (ME w)/w 1/ = 1/ w, Rs. per worker

Remember a firm will hire workers up to the point where the marginal value of the last unit of the worker = the marginal cost to the firm ie where the demand (for labour) curve = ME curve
60 ME, Marginal expenditure Supply If the market for labour were perfectly competitive and the firm faced a horizontal supply curve, than the equilibrium would be at ec Demand for labour

Monopsonist values labour Rs.40, at Rs.40, but it pays only Rs.20

ME = 40 ec wc = 30 wm = 20 20 em

Monopsonist hires fewer workers and pays a lower wage

20

30

60

L, Workers per day

Bilateral Monopoly
Uncontrolled monopoly gets higher than competitive market prices. Uncontrolled monopsony gets lower than competitive market prices. Monopoly/monopsony confrontation breeds compromise. One buyer : One seller

Bilateral Monopoly
y ME MC

Monopsony Equilibrium
P1 P* b

Bilateral Monopoly Equilibrium

D

e1 Monopoly Equilibrium P2 a

x2

x1

X*

x MR

Monopolistic Competition

Monopolistic Competition
Monopolistic competition occurs if many firms serve a market with free entry and exit, but in which one firms products are not perfect substitutes for the products of other firms.

Monopolistic Competition
Assumptions of monopolistic competition
large number of firms freedom of entry differentiated product (product differentiation) Chamberlain SELLING COST downward-sloping demand curve

Monopolistic Competition
Selling Cost Demand is not determined by price alone
Style, services, Selling activities Shift in demand due to these factors

U Shaped Product Differentiation

Real (inherent characteristics different) and Fancied (product is same; consumer is persuaded) Firm is NOT a price taker but the price determination is limited

Monopolistic Competition
Industry and Product Group
Industry: Same products Product Group: Closely related products High price and cross elasticities

Short run equilibrium of the firm

Rs

MC AC

Ps

AR D MR
O Qs Q

Short run equilibrium of the firm

Rs

MC AC

Ps ACs

AR D MR
O Qs Q

Short run equilibrium of the firm

Rs

MC AC

Ps ACs

AR D MR
O Qs Q

Monopolistic Competition
Assumptions of monopolistic competition
large number of firms freedom of entry differentiated product downward-sloping demand curve

Equilibrium of the firm

short run long run

Long run equilibrium of the firm

Rs

LRMC LRAC

Ps PL

SAR

ARL DL
SMR O QL Qs

MRL

Monopolistic Competition
Assumptions of monopolistic competition
large number of firms freedom of entry differentiated product downward-sloping demand curve

Equilibrium of the firm

short run long run underutilization of capacity in long run

Excess capacity in the long run

Rs

LRMC LRAC a
PL

b ARL DL MRL

QL

Monopolistic Competition
Limitations of the model
imperfect information difficulty in identifying industry demand curve entry may not be totally free indivisibilities importance of non-price competition

Comparing monopolistic competition with perfect competition and monopoly

comparison with perfect competition

Monopolistic Competition
Group Equilibrium Product group
Technical substitutability Economic substitutability

Within group each firm has its own demand curve Slight product differentiation

Long run equilibrium of the firm

Rs

LRAC

P1

DL under perfect
competition

Q1

Long run equilibrium of the firm perfect and monopolistic competition

Rs

LRAC P2 P1 DL under perfect

competition

DL under monopolistic
competition O

Q2

Q1

Identifying Monopolistic Competition

Two indexes:
The four-firm concentration ratio The Herfindahl-Hirschman Index

The four-firm concentration ratio

The percentage of the value of sales accounted for by the four largest firms in the industry. The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly. oA ratio that exceeds 40 percent: A indication of oligopoly. oA ratio of less than 40 percent: A indication of monopolistic competition.

HerfindahlThe Herfindahl-Hirschman Index (HHI)

The square of the percentage market share of each firm summed over the largest 50 firms in a market. Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent. HHI = 502 + 252 + 152 + 102 = 3,450 A market with an HHI less than 1,000 is regarded as competitive. An HHI between 1,000 and 1,800 is moderately competitive.

Limitations of Concentration Measures The two main limitations of concentration measures alone as determinants of market structure are their failure to take proper account of oThe geographical scope of a market The oBarriers to entry and firm turnover Barriers

Oligopoly

Oligopoly
Key features of oligopoly
barriers to entry interdependence of firms incentives to compete versus incentives to collude Collusive Non Collusive

Duopoly: Limiting case of Oligopoly

Non Collusive Oligopoly Cournots Duopoly Model What is Dupoloy? Two sellers Two firms owing mineral water well Operating with zero costs; MC = 0 Straight line DD Rivals output constant

Duopoly
P D Firm A Period 1: OA; ie, 2 : (1-1/4) = 3/8

e=1 Firm B Period 1: AB; ie of = 2: (1-3/8) = 5/16 A MRa B MRb D X

P`

Oligopoly
Bertrands model Rivals keep price constant Price war

Oligopoly
NonNon-collusive oligopoly: the kinked demand curve theory
assumptions of the model

Kinked demand for a firm under oligopoly

Rs

P1

Q1

Kinked demand for a firm under oligopoly NonNon-collusive oligopoly: the kinked demand curve theory
assumptions of the model the shape of the demand and MR curves

The MR curve
Rs

P1 MR

a
D = AR

Q1

The MR curve
Rs

P1

a b
O Q1 MR D = AR

The MR curve
Rs

P1

a b
O Q1 MR D = AR

Oligopoly
NonNon-collusive oligopoly: the kinked demand curve theory
assumptions of the model the shape of the demand and MR curves stable prices

Price Stability in kinked demand curve

Rs
More Elastic MC3 MC2 MC1 More In elastic

P1

a
D = AR

b
O Q1 MR

Oligopoly
NonNon-collusive oligopoly: the kinked demand curve theory
assumptions of the model the shape of the demand and MR curves stable prices limitations of the model

Oligopoly
NonNon-collusive oligopoly: game theory
alternative strategies: maximax and maximin simple dominant strategy games

Oligopoly
NonNon-collusive oligopoly: game theory
alternative strategies: maximax and maximin simple dominant strategy games the prisoners dilemma

The prisoners' dilemma

A's alternatives B's alternatives
Not confess Not confess
Each gets 1 year (1,1) B gets 3 months A gets 10 years

Confess
B gets 10 years A gets 3 months Each gets 3 years (3,3)

Confess

Collusive Oligopoly Cartels

Direct agreements among competing oligopolist firms with the aim of reducing uncertainty

Two forms of catrtels

Joint profit maximisation Sharing of market share

Equilibrium of the industry

Collusive Oligopoly Cartels

Direct agreements among competing oligopolist firms with the aim of reducing uncertainty

Two forms of catrtels

Joint profit maximisation Sharing of market share

Equilibrium of the industry

ProfitProfit-maximising cartel
Rs

Industry D AR
O Q

ProfitProfit-maximising cartel
Rs

Industry MC

Industry D AR Industry MR
O Q

ProfitProfit-maximising cartel
Rs

Industry MC

P1

Industry D AR Industry MR
O

Q1

Oligopoly
Tacit collusion
price leadership: dominant firm (large or
low cost)

price leadership: barometric (old

experienced)

aggressive

Price Leadership: Dominant firm

market P P1 P0 P2 P3 X D1 S1 P C P1 P0 P2 P3 X X2 MR X3 DL X leader

MC AC

A price leader aiming to maximise profits for a given market share

Rs

AR = D market

A price leader aiming to maximise profits for a given market share

Rs

Assume constant market share for leader

AR = D market

AR = D leader

A price leader aiming to maximise profits for a given market share

Rs

AR = D market

AR = D leader MR leader
O Q

A price leader aiming to maximise profits for a given market share

Rs

AR = D market

AR = D leader MR leader
O Q

A price leader aiming to maximise profits for a given market share

Rs

MC

AR = D market

AR = D leader MR leader
O Q

A price leader aiming to maximise profits for a given market share

Rs

MC

PL

l
AR = D market

AR = D leader MR leader
O QL Q

A price leader aiming to maximise profits for a given market share

Rs

MC

PL

t
AR = D market

AR = D leader MR leader
O QL QT Q

Oligopoly
Tacit collusion
price leadership: dominant firm (large) price leadership: barometric (old
experienced)

Aggressive other forms of tacit collusion: rules of thumb

o average cost pricing

Oligopoly
Tacit collusion
price leadership: dominant firm price leadership: barometric other forms of tacit collusion: rules of thumb
o average cost pricing o price benchmarks

Thank you..