BUSINESS (MANAGERIAL) ECONOMICS

MODULE 3: Market Structure and Theory of Firm. 1. Markets and Market Structure: Markets: o Four components of a market: Buyers, sellers, a commodity and a price. o Personal contact between buyers and sellers: Not necessary. o Contact between buyers and sellers: May be through telephonic conversion or teleprinter or any such modern device. o Does not necessarily mean a place. Structure Conduct Performance Paradigm: Market Structure Business Conduct or Industry Behaviour Corporate Performance (Price Profit Output etc)

 Definition of Market Structure: Use market characteristics. o In terms of number and size of the buyers and sellers of the product. o In terms of type of product sold (standardized/homogeneous or differentiated products). o The degree of mobility of resources: Entry and exit of firms. o The degree of knowledge of economic agents (firms, suppliers of inputs and consumers): About prices and costs and demand and supply conditions. Two Broad Market Models: o Perfect Competition o Imperfect Competition Monopoly Monopolistic Competition Oligopoly.

Nature of industry where prevalent: P/C: Financial markets (to some extent) and some farm products Monopoly: Public utilities M/C: Manufacturing: Toothpaste, TV sets, Refrigerators etc Oligopoly: Aluminium, Cigarettes etc.

Different Market Models: Some Broad Characteristics

Market Model 1. Perfect Competition

No. of Sellers

Nature of Product

Entry Barriers to Sellers None

Degree of Control Over Price None

PED

CED Infini te Zero or Very Low Very High

Large, small, Homogeneous independent

Infinite

2. Monopoly

One

Homogeneous Insurmou , but no close ntable substitutes Differentiated, but very close substitutes Homogeneous or differentiated

Considerable

Very Small

3. Monopolistic Compn.

Many, small virtually independent Few, interdepend ent

None

Some

Large

4. Oligopoly

Substanti al

Some

Small

Low

Kinds of Revenue and Their Behaviour under P/C and I/C T R = P. Q A R = TR = P.Q = P Q Q M R = TR Q

Behaviour of AR (Price), TR and MR under P/C & I/C: A Test of Market Structure Quantity 1 2 3 4 5 6 7 8 9 10 Price P/C 16 16 16 16 16 16 16 16 16 16 I/C 16 15 14 13 12 11 10 9 8 7 P/C 16 32 48 64 80 96 112 128 144 160 TR I/C 16 30 42 52 60 66 70 72 72 70 P/C 16 16 16 16 16 16 16 16 16 16 MR I/C 16 14 12 10 8 6 4 2 0 -2

Assignment: Draw diagrams and interpret the Behaviour of Revenues.

 Algebraic Presentation of Behaviour of TR, AR and MR under P/C and I/C: TR = P.Q Let TR = 55Q MR = d(TR) = 55 dQ AR = TR = 55Q = 55 Q Q MR = AR under P/C Let TR = 55Q 2Q2 MR = d(TR) = 55 4Q dQ AR = TR = 55Q 2Q2 = 55 2Q Q Q AR = 55 2Q Falling AR (P) with an increase in Q MR = 55 4Q2 Falling MR at twice the rate of AR under I/C. Assignment: Consider the following TR and TC functions: 1) TR = 55Q. TC = 100 5Q + Q2 under P/C 2) TR = 55Q 2Q2. TC = 100 5Q + Q2 under I/C 3) Definition: = TR TC Max : MR = MC: Necessary Conditions 4) Calculate maximizing output (Q) and volume of under P/C and under I/C.

2.

Pricing Under Perfect Competition:

Characteristics of P/C:
A large number of sellers and buyers of the product. Small share of each buyer and seller in total demand and total supply. No individual buyer and seller can influence the price. A firm: price taker and not a price maker. Homogeneous Products: Product of each firm is a perfect substitute for the product of other firms. Perfect mobility of factors of production: No control of any firm on factors of production. Inputs can respond to incentives. Free entry and free exit of firms. No restriction on entry or exit. No patents or copy rights. Perfect knowledge among buyers and sellers about costs, prices, quality of products etc. Price differences, quickly eliminated Prevalence of a single price Resources sold to the highest bidder. Absence of collusion: No sellers union or buyers associations. Each buyer or seller acts independently. No government intervention: No licensing system, no control over inputs, no fixation of lower or higher prices etc.

 P/C: uncommon May be in stock market and agricultural commodities Even though uncommon, useful as a reference point for an ideal market situation. Can evaluate the efficiency of other market models with the characteristics of P/C as denominators. Price Determination under P/C: Price Determined by Market Demand and Market Supply: A Firm Price Taker Industry Price S P Firm E P* h MR=P=AR P O Q* Market Supply and Demand Q O Q Demand Curve facing an individual firm

 Price Determined by MS and MD: P = P* Q = Q*. A perfectly Competitive Firm: A price taker. Hence, a P/C firm has to determine quantity to sell at P* MR = P* = AR When P is constant, TR changes proportionately to change in Q MR is constant and equal to price. AR curve is the demand curve facing of a firm. A firm faces horizontal or infinitely elastic demand curve. Pricing in Market Period: Each firm has fixed stock of commodity to be sold. The stock with all the firms. Fixed Supply in the market vertical supply curve. Given fixed supply, price determined by demand. P S

P2
P1 D2

D1 Q*

 Examples: Pricing in Short Run and Equilibrium of a Firm: Case 1: Supernormal Profit Case 2: Belownormal Profit Case 3: Normal Profit.

Case 1
Price, Costs E P T
h

SMC

SAC

AR=MR

Q Output

Case 2 Price, Costs T P

h

SMC C hE

SAC AVC AR=MR

Q Output

Price, Costs

Case 3
P
h

SMC
E C

SAC
AR=MR

Q Output

 Observations: Case 1: ECTP = Supernormal , because P > SAC. Excess supply of output in the market P. Excess demand for inputs . An increase in input prices. The process of adjustment till normal profit is restored. Case 2: ECTP = Belownormal Exit of firms Excess supply of inputs, decreasing input prices Excess demand for products, increasing product price The process of adjustment, till normal profit is reached. Case 3: Normal profit situation P = SAC = SMC Normal profit is included in cost of production. Reproduce Case 3 by relabelling cost/revenue curves to create long run equilibrium conditions.

 Pricing in Long Run: Equilibrium Conditions LR : All inputs and costs of production variable. : Optimum plant size to produce least cost output i.e the best level of output. Condition for BLO: AR = P = MR = LMC = lowest LAC. : All supernormal profits and losses eliminated, only normal profit accrued. : Firm produces at the lowest point on its LAC. : The firm operates the scale of plant given by SATC at its lowest point SMC = LMC. Conditions of equilibrium of a firm in the LR: P = AR = MR = LMC = LAC Price LMC & Costs LAC P
h

AR=MR

Output

E = Point of equilibrium P = AR: By definition AR = MR: By the nature of market (P/C) MR = MC: By equilibrium condition MC = AC: By optimum output scale.

Normal Profit: Free entry and exit of firms critical to the operation of a highly competitive market. Supernormal profit and losses in the short run Normal profit in the LR, due to process of market adjustment. LR Equilibrium at the point E: P = AR = MR = LMC = LAC: Both the individual firms and industry are in Long run equilibrium.