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Market Structures

Concept of Competition

Whether a firm can be regarded as competitive depends on several factors, the most important of which are: The number of firms in the industry - As the number of firms increases, the effect of any one firm on the price and quantity in the market declines. The degree of rivalry - If firms are vigorously trying to claim market share at each others expense, each firm will be more constrained in its choices. The degree of homogeneity of the product - Differences in quality or other properties mean that the products of different firms are not perfect substitutes for each other, and that means customers will absorb some price differences among firms. The ease of entry and exit - If new producers can easily enter and exit the market, existing firms may behave as though there are more firms than there appear to be, because there are more potential competitors.

Barriers to entry
Entry into a market can be deterred by barriers to entry. Important barriers to entry include: High start-up costs - These may cause it to take a very long time for new firms to enter the market, during which time the market is less competitive than it otherwise would be Brand loyalty - If people are reluctant to consider new alternatives, the established firms in an industry face less of a threat from new competitors. Government restrictions - These restrict the ability of competitors to contest the market. Examples include licensing of electricians, plumbers, doctors, etc.; patents; protectionist tariffs and quotas; and absolute limits on the number of suppliers. We ask whether a market satisfies the above conditions, and to what degree, in order to decide what market structure best describes it.

Perfect Competition

Assumptions
Many suppliers each with an insignificant share of the market this means

that each firm is too small relative to the overall market to affect price via a change in its own supply each individual firm is assumed to be a price taker An identical output produced by each firm in other words, the market supplies homogeneous or standardised products that are perfect substitutes for each other. Consumers perceive the products to be identical Consumers have perfect information about the prices all sellers in the market charge so if some firms decide to charge a price higher than the ruling market price, there will be a large substitution effect away from this firm All firms (industry participants and new entrants) are assumed to have equal access to resources (technology, other factor inputs) and improvements in production technologies achieved by one firm can spill-over to all the other suppliers in the market There are assumed to be no barriers to entry & exit of firms in long run which means that the market is open to competition from new suppliers this affects the long run profits made by each firm in the industry. The long run equilibrium for a perfectly competitive market occurs when the marginal firm makes normal profit only in the long term No externalities in production and consumption so that there is no divergence between private and social costs and benefits
no affect on environment etc.....

Short-run Price & Output


In the short run the equilibrium market price is determined by the interaction between market demand and market supply.

supernormal profit

In the diagram Price P1 is the market-clearing price and this price is then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). A firm maximises profits when marginal revenue = marginal cost. In the diagram, the profitmaximising output is Q1. The firm sells Q1 at price P1. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost.

Not all firms make supernormal profits in the short run. Their profits

depend on the position of their short run cost curves. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i.e. they are at the break-even output). In this diagram, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximising level of output, the firm is making an economic loss (or sub-normal profits).

sub normal profit

Effect of change in demand


In the diagram there has been an increase in market demand (ceteris paribus). This causes an increase in market price and quantity traded. The firm's average revenue curve shifts up to AR2 (=MR2) and the profit maximising output expands to Q2. Notice that the MC curve is the firm's supply curve. Higher prices cause an expansion along the supply curve. Following the increase in demand, total profits have increased. An inward shift in market demand would have the opposite effect. Think also about the effect of a change in market supply - perhaps arising from a cost-reducing technological innovation available to all firms in a competitive market.

Long-run Price and Output


If most firms are making abnormal profits in the short run there will be an expansion of the output of existing firms and we expect to see the entry of new firms into the industry. Firms are responding to the profit motive and supernormal profits act as a signal for a reallocation of resources within the market. The addition of new suppliers causes an outward shift in the market supply curve. This is shown in the diagram below.

Making the assumption that the market demand curve remains unchanged, higher market supply will reduce the equilibrium market price until the price = long run average cost. The entry of new firms shifts the market supply curve to MS2 and drives down the market price to P2. At the profit-maximising output level Q2 only normal profits are being made. There is no incentive for firms to enter or leave the industry. Long-run equilibrium is established.

Does perfect competition lead to economic efficiency?


Perfect competition is used as a yardstick to compare with other market structures (such a monopoly and oligopoly) because it displays high levels of economic efficiency. In both the short and long run, price is equal to marginal cost (P=MC) and therefore allocative efficiency is achieved the price that consumers are paying in the market reflects the factor cost of resources used up in producing / providing the good or service.

Productive efficiency occurs when price is equal to average cost at its minimum point. This is not achieved in the short run firms can be operating at any point on their short run average total cost curve, but productive efficiency is attained in the long run because the profit maximising output is achieved at a level where average (and marginal) revenue is tangential to the average total cost curve. The long run of perfect competition, therefore, exhibits optimal levels of static economic efficiency. There is of course another form of economic efficiency dynamic efficiency which relates to aspects of market competition such as the rate of innovation in a market, the quality of output provided over time.

Thus, LR competitive equilibrium consists of two conditions: p* = MC p* = minimum ATC The first condition is caused purely by profit maximization, and its true in both the SR and the LR. The second condition, however, is caused by entry and exit in the LR. It wont necessarily be true in the SR. These two conditions have important efficiency implications. Marginal-cost pricing (p* = MC) means that consumers who buy the product face the true opportunity cost of their choices. They will only buy the good if the value to them is greater than the price, which represents the value of the resources that went into making the product. Minimum average-cost pricing (p* = minimum ATC) means that the product is being made at the lowest average cost possible, so that no resources are being wasted in its production.

Imperfect Competition
Monopolies & Oligopolies

Monopoly

A monopoly exists when a single large supplier can dictate the market price because buyers have no alternative suppliers. (Monopsony is the case of a single buyer). Firm influences market prices to their benefit. It results in increased costs for other market actors and inefficient use of market resources as a whole. Inefficient resource use results when monopolists receive greater returns than they "deserve" (i.e. greater than "normal" profits). Those resources cannot then be used elsewhere.

Monopoly
Origins of monopoly: Natural monopoly usually on a network or grid wasteful to duplicate! Geographical factors where a country or climate is the only source of supply of a raw materialquite rare. However, consider a single grocery store in a isolated village Government created monopolies now sold off! Through growth of the firm Through amalgamation, merger or takeover Through acquiring patent or license Through legal means Royal charter, nationalisation, wholly owned plc

Monopoly power

Need to know this

Monopoly power refers to cases where firms influence the market in some way through their behaviour determined by the degree of concentration in the industry

Influencing prices Influencing output Erecting barriers to entry Pricing strategies to prevent or stifle competition May not pursue profit maximisation encourages unwanted entrants to the market Sometimes seen as a case of market failure

Monopoly characteristics
Price could be deemed too high, may be set to destroy competition

(destroyer or predatory pricing), price discrimination possible. Efficiency could be inefficient due to lack of competition (Xinefficiency) or
could be higher due to availability of high profits

Innovation - could be high because of the promise of high profits,

Possibly encourages high investment in research and development (R&D). Could be low as there is no incentive to reduce costs. Collusion possible to maintain monopoly power of key firms in industry High levels of branding, advertising and non-price competition

How can a monopoly establish its position?


Known as barriers to entry. Economies of scale Patent protection Information advantage (not sharing its trade secrets!) Government protection Can you think of any Control of resources businesses that have
these characteristics that generates monopoly like power?

How can a monopoly establish its position? ...... Some answers!!


Economies of scale Microsoft! Patent protection drugs (anti aids) Information advantage (not sharing its trade secrets!) Coca cola,

Worcester sauce, Microsoft


Government protection (Kenya require new competitors to 1st get

a no objection letter from existing firms! E.g mobile phones Telkom until 2002 was the only mobile network in African continent)
Control of resources De beers diamonds in Africa 60% global

sales!

Revenue curves of a monopoly


The monopolist can influence

prices, so faces a downward facing Demand curve.


As the price maker, it can

choose the location of price along the Demand curve

Revenue curves of a monopoly


So why might the monopolist

choose to locate its price at unitary elastic point?


Look at the MR & TR position! Note the relationship between MR &

AR. MR has exactly twice the slope of the AR curve.


MR is ZERO at the maximum point of

Total revenue

Profit orientated Monopoly


A monopolist

wishing to maximise profits will produce at point where


MR = MC

The profit maximising level of output


So why is MC=MR profit maximising output?

Monopoly
Costs / Revenue

This is both the short run and long run equilibrium position for a monopoly Given the barriers to entry, the monopolist will be able to exploit abnormal profits in the long run as entry to the market is restricted.

MC
7.00

Monopoly Profit
3.00

AC

MR
Q1

AR

AR (D) curve for a monopolist likely to be relatively price inelastic. Output assumed to be at profit maximising output (note caution here not all monopolistsSales Output / may aim for profit maximisation!)

Revise some concepts

Consumer surplus consumers willingness to pay for a good minus the amount they actually pay for it. Producer surplus amount producers receive for a good minus their costs of producing it (profit). Total surplus = consumer surplus + producer surplus

Welfare implications of monopolies


Costs / Revenue

A look back at the diagram for perfect competition will reveal that in equilibrium, price will be equal to the MC of production. We can look therefore at a comparison of the differences between price and output in a competitive situation compared to a monopoly. The price in a competitive market would be 3 with output levels at Q1. The monopoly price would be 7 per unit with output levels lower at Q2. On the face of it, consumers face higher prices and less choice in monopoly conditions compared to more competitive environments.

MC
7

AC Loss of consumer surplus


3

AR
Q2 Q1

MR

Output / Sales

The higher price and lower output means that consumer surplus is reduced, indicated by the shaded area.

Monopoly
Costs / Revenue

Welfare implications of monopolies MC


The monopolist will be affected by a loss of producer surplus shown by the grey triangle but.. The monopolist will benefit from additional producer surplus equal to the shaded rectangle.

AC Gain in producer surplus


3

MR
Q2 Q1

AR
Output / Sales

Welfare implications of monopolies


Costs / Revenue

MC
7

AC

The value of the shaded triangle represents the total welfare loss to society sometimes referred to as the deadweight welfare loss.

MR
Q2 Q1

AR
Output / Sales

Problems of monopolies
Excessive prices (above market equilibrium) Supernormal profits Easy life no incentive to be innovative sole supplier

allocative inefficient Can delay innovation through barriers of entry Loss in consumer surplus and a gain in producer surplus (profits) Dead weight loss.. Product is under consumed.

The Case Against Monopoly - inefficiencies


There may be little pressure for a firm with monopoly power to

maximise their efficiency or minimise costs of production (i) Managerial slack or X-inefficiencies
(ii) Limited incentives to adopt cost-reducing innovations (iii) (John Hicks) The best of all monopoly profits is a quiet life The result may be a higher level of costs per unit (external

diseconomies of scale)

Benefits of a monopoly
EoS lower costs from size of business Innovation from retained profit have little threat of competition so

will invest profits into LT R&D New technology or product development many monopolies are patents protected.. Fewer wastes of resources most monopolies are network based co that any competition requires duplication of resources. To avoid govt investigation may choose NOT to set excessive prices but pass on low LRAC (EoS) / abnormal profit as lower prices Productively efficient (MR=MC) Creates stability for consumers monopolist knows its market well and can make LT plans with confidence

Monopoly
Problems with models a reminder:
Monopolies not always bad may be desirable in some cases

but may need strong regulation Monopolies do not have to be big could exist locally

Monopolistic Competition and Oligopoly

Checklist
1. Explain how price and quantity are determined in monopolistic competition. 2. Explain why selling costs are high in monopolistic competition. 3. Explain the dilemma faced by firms in oligopoly. 4. Use game theory to explain how price and quantity are determined in oligopoly.

Monopolistic competition
Monopolistic competition is a market structure in which: A large number of independent firms compete. Each firm produces a differentiated product. Firms compete on product quality, price, and marketing. Firms are free to enter an exit.

Features of MC
Large Number of Firms Like perfect competition, the market has a large number of firms. Three implications are:
Small market share No market dominance Collusion impossible

Product Differentiation Product differentiation is making a product that is slightly different from the products of competing firms. A differentiated product has close substitutes but it does not have perfect substitutes. When the price of one firms product rises, the quantity demanded of it decreases.

Features of MC
Competing on Quality, Price, and Marketing Quality
Design, reliability, service, ease of access to the product.

Price
A downward sloping demand curve.

Marketing
Advertising and packaging

Entry and Exit


No barriers to entry. A firm cannot make economic profit in the long run.

Competition with Differentiated Product


Short-run economic profits encourage new firms to enter the

market:
Increases the number of products offered Reduces demand faced by firms already in the market Incumbent firms demand curve shifts to the left Demand for incumbent firms products falls, and their profits decline.

Short-run economic losses encourage firms to exit the markets:


Decreases the number of products offered Increases demand faced by remaining firms Shifts the remaining firms demand curve to the right Increases the remaining firms profits

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. A ratio that exceeds 40 percent: indication of oligopoly. A ratio of less than 40 percent: indication of monopolistic competition.

The 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.

Output and Price in Monopolistic Competition

How, given its costs and the demand for jeans, does Tommy Hilfiger decide the quantity of jeans to produce and the price at which to sell them? The Firms Profit-Maximizing Decision The firm in monopolistic competition makes its output and price decision just like a monopoly firm does.

Profit-maximising Decision
Profit is maximized when MC = MR
1. The profit-maximizing

output is 150 pairs of Tommy jeans per day. 2. The profit-maximizing price is $70 per pair. 3. ATC is $20 per pair, so The firm makes an economic profit of $7,500 a day.

Long Run: Zero Economic Profit

Because there is no restriction on entry, economic profit induces entry, just as it does in perfect competition. The demand for the product of each firm decreases as more firms share the market. Eventually, economic profit is competed away and the firms earn normal profit.

Long-run Equilibrium

Initially, the firm earns an economic profit, which induces entry. Demand for the firms product decreases to D and marginal revenue decreases to MR'.

The output that maximizes profit is 50 pairs of Tommy jeans a day. The price is $30 per pair. Average total cost is also $30 per pair. Economic profit is zero.

Monopolistic vs Perfect Competition


Excess capacity
There is no excess capacity in perfect

competition in the long run Free entry results in competitive firms producing at the point where average total cost is minimised, which is the efficient scale of the firm There is an excess capacity in m.c. in the long run In m.c., output is less than the efficient scale of p.c.

Monopolistic vs Perfect Competition (cont.)


Mark up

For a competitive firm, price equals marginal cost For a monopolistically competitive firm, price exceeds marginal cost Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for m.c. firm.

M.C. and the Welfare of Society


M.C. does not have all the desirable properties of p.c. There is the normal deadweight loss of monopoly pricing in m.c. caused by the markup of the price over marginal cost However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming. Another way in which m.c. may be socially inefficient is that the no. of firms in the market may not be the idealone there may be too much or too little entry. Externalities to entry include:
Product-variety externalities consumer surplus accrues to the

consumers from the introduction of new product entry of a new firm conveys a positive externality on consumers. Business stealing externalities coz other firms lose customers and profits from the entry of new competitor, entry of a new firm imposes a negative externality on existing firms.

Oligopoly

Defining ..

An oligopoly is a market dominated by a few large firms producing either: A Homogeneous product (Homogeneous oligopoly) or A Heterogeneous product (Heterogeneous oligopoly)

KEY FEATURES OF OLIGOPOLY


A few firms selling similar product - degree of concentration is

very high (large %age of market is taken by leading firms) Each firm produces branded products (advertising and marketing is an important feature of competition within such markets) Likely to be significant entry barriers into the market in the long run which allows firms to make supernormal profits Interdependence between competing firms. Businesses have to take into account likely reactions of rivals to any change in price and output. This creates uncertainty in such markets - modeled through the use of game theory Examples of oligopoly are the sale of petrol, supermarkets, telecommunications, banks and building societies

Growth via Merger

Horizontal - across same stage of production/distribution network Vertical - Forward and/or backward along the production/distribution network. Vertical integration reduces transaction costs and this is why many firms do it.The internet reduces transaction costs and thus we should see less vertical integration and possibly the breakup of some large vertically integrated firms. Conglomerate - into unrelated areas

THEORIES ABOUT OLIGOPOLY PRICING


There are four major theories about oligopoly pricing: (1) Oligopoly firms collaborate to charge the monopoly price and get monopoly profits (2) Oligopoly firms compete on price so that price and profits will be the same as a competitive industry (3) Oligopoly price and profits will be between the monopoly and competitive ends of the scale (4) Oligopoly prices and profits are "indeterminate" because of the difficulties in modeling interdependent price and output decisions

THE IMPORTANCE OF PRICE AND NONPRICE COMPETITION


Price competition can involve discounting the price of a product (or

a range of products) to increase demand. Usually Price Rigidity (price tends to remain stable). Non-price competition focuses on other strategies for increasing market share. E.g. of a supermarket industry:

Mass media advertising and marketing Store Loyalty cards Banking and other Financial Services (including travel insurance) In-store chemists / post offices / creches Home delivery systems Discounted petrol at hyper-markets Extension of opening hours (24 hour shopping in many stores) Innovative use of technology for shoppers including self-scanning machines Financial incentives to shop at off-peak times Internet shopping for customers

Kinked Demand Curve


This was developed in the late 1930s by the

American Paul Sweezy. The theory aims to explain the price rigidity that is often found in oligopolistic markets. It assumes that if an oligopolist raises its price its rival will not follow suit, as keeping their prices constant will lead to an increase in market share. The firm that increased its price will find that revenue falls by a proportionately large amount, making this part of the demand curve relatively elastic (flatter). Conversely if an oligopolist lowers its price, its rivals will be forced to follow suit to prevent a loss of market share. Lowering price will lead to a very small change in revenue, making this part of the demand curve relatively inelastic (steeper).

elastic part (revenue decreses)

inelastic part (revenue not much change )

The firm then has no incentive to

change its price, as it will lead to a decrease in the firm's revenue. This causes the demand curve to kink around the present market price. Prices will further stabilize as the firm will absorb changes in its costs. The marginal revenue jumps (vertical discontinuity) at the quantity where the demand curve kinks, the marginal cost could change greatly - e.g., MC1 to MC2 (between prices a and b) - and the profit maximizing level of output remains the same.

MR jumps at kink

Drawback
Sweezy does not explain how original

price and output are determined. In perfect competition and monopoly models we know how price and output are determined. Sweezy just explains how or why they stay the same.

Game Theory An approach to modeling the strategic interaction of oligopolists in terms of moves and counter-moves.

Payoff Matrix A table showing the payoffs to each of two players for each pair of strategies they choose. Dominant strategy a strategy that is best for a firm no matter what strategy its competitor chooses.

Prisoners Dilemma
Nash Equilibrium
a situation in which economic participants choose best strategy for themselves given all others have choosen strategy

Cooperative behaviour in Oligopoly


There are no generally accepted Explicit collusion

models for price and output determination in oligopolistic market. Collusion is the solution implicit or explicit (cartels) attempts by firms to set prices. Cartels attempt to behave as if they were a monopoly tend not to last. Implicit follow the leader approach gentleman's agreement no formal negotiation

cooperation involving direct communication between competing firms about setting prices.
Cartels a group of producers

that select a common price that maximises total industry profits attempt to behave as if they are a monopoly.

Collusion Graphic View

Explicit => cartel members get together and agree on price Duopoly Same costs - monopoly solution Different costs once costs differ there are incentives to cheat.

Why cartels fail


As costs differ, incentives to cheat increase. As the number of firms increase, it gets harder to police. As product differentiation increases, it is harder to set price(s). Difficulty observing other firms prices. Unstable market demand.

The commonalities
No matter how you look at it certain constants will remain: MC=MR => Profit maximisation P to ATC => Profit / Loss P to AVC => Produce / Not Produce The key difference between price taker and price setter is how price is determined. Firms are not price takers / setters, markets are. Firms operate in many markets.