Market Structure

What is a Market The determination of Price and Output of

various products depends upon the type of market structure in which the goods are sold and produced.

A Market is a whole of a region where buyer and seller interact with each other and price of the same good tends to be equity.

Essentials of a Market- Commodity which is dealt- Existence of Buyer and seller- a Place- Communication between buyer and seller

that only one price should prevail.

Classification of Market forms

Market structure are classified on:

1) Number of firms producing a product

2) The nature of product produced by the firm

3) The ease at which the new firms can be a part of

the existing Industry.

4) Degree of control over price.

Classification of Market forms

Market Structure

No of Firms

Nature of Product

Control over price

Entry Condition

ep

a) Perfect Competition

Large Homogeneous

None Free entry, exit

Infinite

b) Imperfect Competition

i) Monopolistic Competition

Large Differentiated (close substitute)

Some Barrier – product differentiation

Large

ii) Oligopoly Few Firms

Homogeneous/ Differentiated

Some Barriers –firms dominating

Small

iii) Monopoly One Unique (No substitute)

Very Large

Barriers Very Small

Perfect Competition Demand curve for the single firm will be infinite (perfectly

elastic) The maximum output an individual firm can produce is small. Products are standardized commodities

No single firm can influence the price of the product(price taker)

Many small sellers More sellers, more substitutes the consumer has Market power is none

Homogenous product the substitutes are "perfect substitutes."

Sufficient knowledge When customers know the prices offered by other sellers, they will be better able to switch – increasing elasticity further.

Perfect Competition Free entry

companies may even enter the market to provide still more substitutes

Long-run economic profit (above normal) is none No Government intervention

Example: Agricultural products, Precious metals, Financial

instruments, global petroleum industry DP

Q

ep = ∞

Imperfect Competition

Individual firm exercise control over the price

Can be caused by

- Fewness of firms

- Product differentiation

Sub- categories Monopolistic Competition Pure Oligopoly Differentiated Oligopoly

i) Monopoly Existence of a single producer Has no close substitutes Large control over prices Market power : High Long run economic profit : High

Kind of business

Govt sanctioned regulated monopolies

Public utilities, Telephones, Electricity The expansion and contraction of output will

have a

effect on the prices of the product

Q Q’

P

P’ ep < 1

i) Monopolistic Competition

Large no of Firms Relatively easy barrier Product differentiation which are close

substitutes Start up capital is low Market power – low to high Long run economic profit : none Kind of Business

Small business- retail and services

Boutiques, shoe store, restaurants, laundries

Demand curve of a firm is going to be highly elastic,

firm has some control over price.,

ep > 1

DP’

P

Q’Q

ii) Oligopoly Competition among few large firms producing

Homogenous – Pure Oligopoly Products differentiation – Differentiated Oligopoly

Fewness of firms / size of the firm ensures that each of them have some control over the price

Market entry: Difficult Market Power : Low to High Long run economic profit : Low to high Pricing behaviour is of mutual interdependence (Each seller is setting its price on the basis of reaction from the

competitor) Demand curve slopes downwards and ep is small ( Relatively Inelastic) Kind of firms:

Manufacturing sector-, oil refineries, tobacco, steel automobile, soft drinks

AR and MR under Perfect competition

Demand curve is perfectly elastic Price is beyond the control of the firm AR remains constant If price or AR remains the same , then MR = AR As with addition of one more unit, price does not fall

No of Units Q

Price (AR)

TRP*Q

MR

1 16 16 16

2 16 32 16

3 16 48 16

4 16 64 16

5 16 80 16

The price or average remain the same at OP level TR slopes upwards

AR = MR

O

P

TR

AR and MR under Perfect competition

Demand curve is downward sloping

Firm increases production and sale of its product, price starts falling

AR starts falling MR falls more rapidly MR is +ve as long as

TR is increasing MR is -ve when TR

starts declining

No of Units Q

Price (AR)

TRP*Q

MR

1 16 16 16

2 15 30 14

3 14 42 12

4 13 52 10

5 12 60 8

6 11 66 6

7 10 70 4

8 9 72 2

9 8 72 0

10 7 70 -2

AR and MR under Perfect competition

TRM

MR

AR

QOM

P

AR and MR under Perfect competition

AR and MR under Imperfect competition

In all forms of imperfect competition AR curve of a firm slopes downwards

i.e If firms lowers the price of the product, the

quantity demanded and sales would increase

MR is zero TR is maximum

Equilibrium of the Firm and Industry under Perfect Competition

Meaning and Condition of Perfect Competition

Large Number of Firms

- Individual firm exercises no control over the prices

- Output constitutes a very small fraction of total output

- Price taker and output adjuster

Homogenous Product

- Perfect substitutes

- Cross elasticity is Infinite

Meaning and Condition of Perfect Competition

Perfect Information about the prevailing Price

- Buyer and seller are fully aware about the price in the market

- Buyer would shift if seller increase the price

- Seller are aware and will not charge less price.

Free entry and Exit- - If firms are making super normal profit in short run, in long run - new firms will enter and compete away the profits- - If firms are making losses in the short run, some of the existing - firm will leave the industry in the long run and the firms left will- make normal profit.

Equilibrium of the Firm - Short Run

In short run perfect competition we are assuming that

All firms are working under identical cost condition Shapes of AR and MR curve are same All firms are of equal efficiency The MC= Price to attain

equilibrium output At point F the firm can further

increase its profits as MR > MC At point E, MC = MR MC cuts MR from below

F

AR =-MR

SMC

E

MO

Profit per unit of output = AR – AC

It should produce at that level of output at which the additional revenue received from the last unit is equal to the additional cost of producing that unit.

MC = MR

It depends upon the average cost curve ( AC)

Which determine whether the firm earns Super normal profit Normal profit Losses Shut down

How much profit does the firm earn in the short run?

a) Super Normal Profit

Equilibrium output of OM Average Revenue = ME Average Cost = MF Profit per unit is EF

( AC- AR) Total profit is HFEP Super normal profit in short run As normal profits are included in

average cost

E

H

P

F

AR = MR

SMC

MO

SAC

E

Super Normal Profit

b) Normal Profit

When AC is tangent to AR and MR curve

i.e AR = AC Then firm makes normal profit

AR =-MR

SMC

E

MO

SAC

H

P

c) Losses

If the AR and MR curve lies below the AC curve Firm would be making a loss since AR < AC Loss is of PEFH

H

P

F

EAR =-MR

MO

SMC

SAC

AVC

Losses

Will the firm decide to shut down?

Why do they not suspend production if they are making loss?

The firm cannot dispose of the fixed capital equipment in the short run The firm has to incur losses equal to fixed cost So if the firm shuts down it can avoid only variable cost

Therefore if the firm earn revenue which covers variable cost as well as part of fixed cost, its quite rational for to be in business

Two instances in which it can operate If AVC curve lies below the Price If AVC = P

i) When AVC = Price

If the AVC = Price The firm is able to recover its variable cost of OMEP No Fixed cost (PEFH) is recovered The firm should operate and bear

losses equal to its fixed cost

FAR =-MR

SMC

MO

SAC

H

PE

AVC

ii) When AVC is below the Price

The firm is able to recover its variable cost of OMBA And a part of Fixed cost of ABEP The firm should operate and bear

losses of PFEH

FAR =-MR

SMC

MO

SAC

H

PE

AVC

BA

d) Shut Down

If the price falls below the AVC. Then it makes losses greater than total fixed cost It will be rational for the firm to close down As the firm is not able to recover even

its variable cost

F

AR =-MR

MO

SMC

SAC

H

P

AVC

Long Run

It is a period of time which is sufficient to allow firm to have a change in all the factors of production.

Long run the market price will settle at the point where the firms earn Normal profit.

Price that enable firm to earn above normal profit would induce other firms to enter the market

Whereas prices below the normal level would cause firms to leave the market.

Price = Marginal Cost = Average cost

Long Run

Price = Marginal Cost = Average cost

LAC

LMC

AR = MRP

OUTPUT

Long run equilibrium is established at the minimum point of the long run average cost curve.

i.e working a the minimum efficient scale.

With utmost technical efficiency and the resources are used efficiently.

Why to competitors stay in business if they make Zero economic profit

The producers are earning fair rate of return in the long run

Earlier the firm enters a market, the better the chance of earning above normal profit.

Firms can innovate to earn positive economic profit

Or to survive firms must find ways to produce at the lowest possible cost or atleast at cost levels below those of their competitors.

Equilibrium of the Firm and Industry under Monopoly

Meaning

Monopoly is said to exist when one firm is the sole producer or seller of a product which has no close substitutes.

- One single producer

- No close substitutes should be available in the market.

- Strong barriers to the entry into the industry.

That is there is NO COMPETITION.

Sources / Reasons of Monopoly Power

1. Patent / Copyright

For a certain period of time, firm can attain a patent right on the new

product from the government.

2. Control over an essential Raw – material.

3. Grant of Franchise by the Government

A firm is granted the exclusive legal rights by the Government to

produce a given product. Government keep with itself the right to

regulate its price and quality.

Sources / Reasons of Monopoly Power

4. Advertising and Brand Loyalties of the established Firms.

Strong loyalties to the brands of the established firms . And their

heavy advertising campaigns, to enhance the market power of the

producer and prevent the entry of potential competitors.

5. Economies of Scale: Natural Monopoly

When significant economies of scale are present, the AC of production

goes on falling over a wide range of output, which (output) meets the

demand of entire market.

Natural monopoly are regulated by the Government so that the Firm

does not charge a high prices and exploit the consumers.

Nature of MR and AR Curve

Both AR and MR curve are Downward sloping

MR curve lies below the AR curve. As when the monopolist sells more, the price of the product falls and the MR would be less than the price.

Monopolist has to choose a price –quantity combination which yields him maximum possible profits.

Monopolist ability to set its price is limited by the demand curve of its product i.e Price elasticity of demand for its product.

Nature of MR and AR Curve

MR

AR

QO

M

P

Monopoly Equilibrium and Price Elasticity of Demand

Monopolist ability to set price is limited by the demand curve for its product i.e the price elasticity of demand.

The price elasticity of demand indicates how much more or less people are willing to buy in relation to price decrease or increase.

Monopolist will never be in an equilibrium at a point on demand curve where price elasticity of demand is less than one.

As when price elasticity is less than one, marginal revenue is negative.

Monopoly equilibrium will always lie where price elasticity is greater than one if marginal cost is positive.

Monopoly Equilibrium and Price Elasticity of Demand

TR

MR

AR

O

M

M

Pe=1

e<1

e >1

Price – Output Equilibrium under Monopoly

Short Run

Monopolist will go on producing as long as MR > MC Profits will be maximum at which MR = MC

The price under perfect competition is equal to marginal cost But price under monopoly is greater than marginal cost

In Monopoly equilibrium MR = MC P > MC

Price – Output Equilibrium under Monopoly

Q P TR TC AC MC MR Remarks Profit or

Loss

0 200 0 100 - - - -

1 200 200 250 250 150 200 MR > MC -50

2 180 360 350 175 100 160 MR > MC +10

3 160 480 420 140 70 120 MR > MC +60

4 140 560 500 125 80 80 MR = MC +60

5 120 600 600 120 100 40 MR < MC 0

6 100 600 720 120 120 0 MR < MC _80

7 80 560 870 120 150 -40 MR < MC -20

Price / Output Equilibrium

a) Super Normal Profits

Price / Output Equilibrium

b) Losses

Long Run Equilibrium under Monopoly

In long run monopolist make adjustments to the plant size

The monopolist would choose that plant size which is most appropriate with particular level of demand.

In the Long run the equilibrium would be at the level of output where given MR cuts the long run MC curve

The firm will operate where LAC is tangent to SAC

MR = LMC = SMC SAC = LAC P = > LAC

As the price cannot fall below LAC, in long run the monopolist will quit the industry if it is not even able to make normal profits.

Long Run Equilibrium under Monopoly

MR

AR

QO

P

LMC LAC

SMC

SACG

HF

Difference

Perfect Competition Monopoly

1. In equilibrium P= MC

1. In equilibrium P > MC

2. In long run MR / P= MC= minimum AC

2. In long run equilibrium Average cost is still declining

3. In long run they make normal profits

3. In long run they can also make super normal profits

4. Price Discrimination is not there 4. Price Discrimination is there if elasticity's of demand are different in different market.

5. In equilibrium price and output are determined by demand and supply curve

5. In equilibrium price is higher and output smaller

Is there Price Discrimination in Monopoly?Yes

Meaning

It refers to the practice of a seller selling the same product at different prices.

Sellers does this when it is possible and profitable.

i.e

“ Sales of technically similar products at prices which are not

proportional to Marginal cost”.

Types

First Degree – Personal

When the monopolist is able to sell each separate unit of output at different prices

Second Degree - Local

When monopolist is able to charge separate prices for different blocks or quantities of commodity from buyers.

Third Degree - According to use or Trade

When the seller divides his buyers into two or more than two sub- market depending upon the price elasticity of demand

( A manufacture who sells his product at a higher price at home and at

a lower price abroad)

When is Price Discrimination Possible?

If its not possible to transfer any unit of the product from one market to another.

It should not be possible for the buyer in the dearer market to transfer themselves into the cheaper market to buy the product at lower price.

The nature of the commodity ( Surgeon or lawyer) Long distance / Tariff Barrier (Distance increases the cost) Legal Sanction ( Electricity supplied at different prices in

Residential / Commercial areas) Ignorance of Buyers Preferences of Buyers

Equilibrium Under Price Discrimination

Monopolist will charge different prices in different sub- markets.

Which is on the basis of differences in price elasticity of demand.

Monopolist can divide his total market into several sub – market.

For example Two market – Relatively Elastic and Relatively Inelastic Higher price in relatively inelastic market, so profit margin high Lower price relatively elastic market, so profit margin are low So put together higher profits collectively by Price discrimination

Managerial Decision Making in Monopoly

Monopoly can earn economic profits in the short run or long run.

It depends upon demand for its product

It can earn higher profits by discriminating prices

Dumping the products at lower rate in international market and charging higher profits in domestic market can maximise profits.

But the changes in economies of business ( customers, technology and competition) can break down the a dominating company’s monopolistic power.

Equilibrium of the Firm and Industry under

Monopolistic Competition

Introduction

The difference between the price and MR at equilibrium output is

regarded as the Degree of Imperfection

The relative magnitudes of price and MR at equilibrium output help

us to distinguish between different degrees of Imperfection or

Monopoly power in various market structure.

The product differentiation is a distinguishing feature of monopolistic

competition which makes it as a blending of competition and

Monopoly.,

Introduction

Thus as each Monopolist has a competitor which

produces a product not homogenous but differentiated

though closely related, it becomes a

Monopolistic Competition.

Overview of Competitive Environment

Perfect Competition

Monopoly Monopolistic Competition

Oligopoly

Market Power No Yes, subject to Govt regulation

Yes Yes

Mutual Interdependence among competing Firms

No No No Yes

Non- Price Competition No Optional Yes Yes

Easy Market entry or Exit Yes No Yes, relatively Easy

No, relatively Difficult

Features of Monopolistic Competition

1. A large number of Firms:Each firm having a small share of the market demandThere exist a stiff competitionSize of each firm is relatively small

2. Product Differentiation

3. Some influence over Price A firm has to choose a price and output which maximises profits

4. Non Price Competition Expenditure on Advertising and other selling cost

Non- Price Competition

The ability to differentiate their product in Imperfect competition with the

variable other than price.

Advertising Promotion Location and distribution channels Market segmentation Loyalty program Product extension / new product development Special customer service Product tie-ups

Shape of MR and AR curve

Sine close substitutes are available in the market, the demand curve

for the product of an individual firm under monopolistic competition

is fairly Elastic.

Both AR and MR curve are Downward sloping

MR curve lies below the AR curve.

Producer has to choose a price –quantity combination which yields him maximum possible profits.

Nature of MR and AR Curve

MR

AR

QO

MP

Short Run Equilibrium

1) Super Normal Profits

2) Losses

Long Run Equilibrium

If the firm earn supernormal or economic profits in the short run, it will lead to entry of new firms in the long run.

The cross elasticity of demand between the products of various firms will increase.

Which will cause a resultant shift in the demand curve to the left.

Equilibrium will be at a point where AR becomes tangent to the AC curve.

The firm would be making normal profits in the long run, but its price would be higher and output smaller than under Perfect

Competition.

Long Run Equilibrium

Equilibrium of the Firm and Industry under OLIGOPOLY

Introduction

It is refereed to as “Competition among few firms”.

Two kinds Pure Oligopoly : Oligopoly without Product Differentiation Differentiated Oligopoly: Oligopoly with Product Differentiation

Features / Characteristics

Few Sellers

Interdependence Competitors are few, any change in price, output, product will have a direct effect on competitors .

Importance of Advertising and selling costAggressive and defensive marketing strategies.

Group BehaviourDo the few firms cooperate with each other in promotion of common interest or do they fight to promote individual interest.

Constant shifting of the demand curve. Competitors keep on changing the price with the change in price of the

firm.

Causes for the Oligopolies A large amount of Fixed Cost

Barriers to Entry : Technological and Legal Barriers

Product differentiation creates Market Power

Takeovers / Mergers create oligopolies.

Economies of Scale

Few firms can fulfil the demand of the product by producing at large scale and thus lowering the average cost of production.

Economies of Scope Production of multi-products leads to lower average cost

Causes for the Oligopolies

Are oligopolies due to Economies of scale or Mergers / Take-over?

Both In some industries few firms dominate due to Economies of scale But in some its get dominated due to policy of mergers and

takeovers

Cooperative Vs Non Cooperative Behaviour

The behaviour of oligopolistic firm can be strategic in deciding about their price and output policies.

The strategic behaviour means that the oligopolistic firms must take into account the effect of their price- output decision on their firms and on the reaction they expect from other firms.

Two types of strategies: Compete with their rivals to promote their individual interests Cooperate with them to promote mutual interest ( maximise profits)

Collusive Oligopoly : Cooperative Model

To avoid uncertainty of interdependence, price wars, cut throat competition, firms enter into agreement regarding uniform price-output policy.

The agreement can be formal (open) or tacit (secret)

These agreements are called as Collusive agreements:

A) Cartels B) Price leadership

A) CARTELS

Firms jointly fix a price and output policy through agreements Now-a-days all types of formal or informal and tacit agreements are

made among oligopolisitic firms.

Cartel

Perfect CartelMarket Sharing

Cartel

Non- PriceCompetition

Output Quota

Perfect Cartels

When member firms agree to surrender completely their rights of price and output determination to Central Administrative agency, so

as to secure maximum joint profits.

The total profits is distributed among the member firm already agreed between them.

The output to be produced by each firm is decided by the centralagency in such a way that total cost of the total output is minimum.

The total cost will be minimum when firms in cartel produces suchoutput so that their marginal cost is equal.

Perfect Cartel is quite rare in the worldAs both Price and output get decided by the central Agency

Market Sharing Cartels

1) Non- Price Competition: A uniform price is fixed and members are free to produce and

sell

the amount of output which will maximise their individual profits. The firms agree not to sell at a price below the fixed price. But they are free to vary the style of their product and advertising

expenditure. If the members firms have identical cost then the price (monopoly

price) will ensure maximisation of joint profits But when the cost differs firms the cartel price will be fixed by

bargaining between the firms.

But with cost differences such loose cartels are unstable.

Market Sharing Cartels

2) Output Quota: Agreement between firms regarding quota of output and sold by

each of them at the agreed price. As the cost of firms are different , the quotas will be fixed and

market share differ Which are decided through bargaining between the firms. Which is based on

Past – period sales Productive capacity Division of market share region wise

B) Price Leadership

One firm sets the price and other follows it.

The follower firm adopts the price of the leader, even though they have to forgo from their profit maximising position.

Price leadership are illegal, so it is a result of informal and tacit understanding.

Types of Price Leadership Price set by low- cost firm Price by dominant firm Barometric price

Difficulties of Price Leadership

Success of Price leadership depends upon the correctness of his

estimates about the reactions of the followers. If its not correct then

it jeopardise his position in the market

If the leader fixes a higher price than the price preferred by followers,

the followers can make hidden price cuts in order to increase their share.

Tendency on part of the followers to indulge in non- price competition

to increase sales

Pricing in a Oligopolistic Market

In oligopoly there is a degree of price rigidity or stability.

Price rigidity is been explained by Kinked Demand Curve

As in oligopoly the products are differentiated, it is unlikely that when

the firm raises it price all customers would leave.

As a result the demand curve is not perfectly elastic or inelastic.

The kink is formed at the price because the segment of the demand curve above the price is highly elastic and the segment of the demand curve below the price is inelastic

Pricing in a Oligopolistic Market

Kinked Demand Curve:

Each oligopolist believes that if he lowers the price below the prevailing level, his competitor will follow him and will accordingly lower their prices. Whereas if he raises the price, competition will not follow his increase in the price.

Oligopolist will not gain a large share by

reducing its price, and will have reduction in sales

if it increase price. So there is Price Rigidity

dK of the demand curve is relatively elastic KD is relatively inelastic

P

M

d

K

D

Equilibrium in a Oligopolistic Market

Oligopoloist will be maximising his profits at the current price level. MR curve is a discontinuous curve The length of the MR discontinuity depends upon the relative

elasticities of the demand curve (dK and KD) Greater the difference in two elasticities, greater the length of the

discontinuity. MR curve is drawn with a gap of BC If the MC passes between this gap say point C it will be maximising

profit at the price of OP Even if there is change in cost and MC1 shifts to MC2, equilibrium

output will remain unchanged

Equilibrium in a Oligopolistic Market

Critical Appraisal of Kinked Demand Curve Theory

It does not explain how price has been determined.

It does not apply to the oligopoly cases of prices of Price leadership and price cartels which account for quite a large part of oligopolist markets.