Narsee Monjee Institute of Management Studies

NMIMS University

Market Structure Analysis:

Introduction

Dipankar De
Mumbai, September 2007

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 Market Structure

• Market structure is the pattern or form or manner in which its different

constituents, i.e. sellers and buyers, are linked together

• The following 4 main features of the market-structure:

• The degree of sellers concentration: This is the number and size distribution of
firms producing a particular commodity or types of commodities in the market.

• The degree of buyers concentration: This shows the number and size distribution
of buyers for the commodities in the market.

• The degree of product differentiation: This shows the difference in the products of
different firm in the market.

• The condition of entry to the market: This shows the relative ease with which new
firms can join the category of sellers (i.e. firms) in the market. 2
Market Conduct

• This is defined as the pattern of behaviour that firms follow in

adopting or adjusting to the market in which they operate to achieve
the well defined goal(s).

• Given the market conditions and goals, a firm will be acting alone or
jointly to decide about price levels for the products, the types of
products and their quantities, advertisement, etc.

• Also, the firm under such situation has to devise the ways for
interactions, cross-adaptation and coordination among competing
group of sellers in the market.
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 Market Performance

• This relates to economic efficiency.

• For the entire economic system of a community, economic efficiency means

efficient selection of goods to be produced, efficient allocation of resources in the
production of these goods and efficient choice of the methods of production, and
efficient allotment of the goods produced among the consumers.

• Allocative efficiency occurs when output is at that level where MC equals price in
each product for each firm.

• Among the factors affecting economic efficiency include the organisational or

structural conditions prevailing in the industry to which firm belongs, short-term
fluctuations in the market for both input and output, etc.

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THE STRUCTURE-CONDUCT-PERFORMANCE (S-C-P)
APPROACH
BASIC CONDITIONS

Social & Political choices;

Technol
ogy elasticities; tastes, etc.
Input prices

MARKET STRUCTURE

Concentration, distribution
Size , No. of firms,
Barriers to entry, Vertical integration, Cost
structure
, Product differentiation, etc.

MARKET CONDUCT

Price behaviour, Product behaviour,cial

Finan
policy, R&D
Innovation,
– Advertisement,
Collusion, etc.

MARKET PERFORMANCE

Profitability, Growth rate, Technological

advance, Equity content,
Efficiency
, Full-
employment, etc.
Narsee Monjee Institute of Management Studies
NMIMS University

Market Structure Analysis: I

Dipankar De
Mumbai, September 2007

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 Profit Maximization

• The assumption of profit maximization predicts business behavior reasonably

accurately and avoids unnecessary analytical complications

• But whether firms do maximize profit has been controversial

• For smaller firms managed by their owners, profit is likely to dominate almost all
the firm’s decisions

• In larger firms, however, managers who make day-to-day decisions usually have
little contact with the owners (shareholders). As a result, the owners of the firm
can not monitor the managers’ behavior on a regular basis.

• Managers may be more concerned with goals such as revenue maximization to

achieve growth or the payment to dividend holders rather than profit maximization

• Managers may be overly concerned with the firm’s short-run profit – perhaps to
earn a promotion or bonus – at the expense of LR profit.
(Principal-Agency 7Problem)
Cost, Revenue,
Profit Maximization
Profit

C(q)

A R(q)

Output
O q0 q*
π(q)

π(q) = R(q) – C(q)

Profit is maximized when the following condition is fulfilled

MR(q) = MC(q)
Perfect Competition

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 Perfect Competition

• A market is said to be under perfect competition when the following conditions

are met:

• Numerous small buyers and sellers: A large no. of sellers and buyers exist
in the market, each one of them individually have no noticeable influence upon
the market price and quantity of the product

• Homogeneity of product: The product of any one firm is identical to the

product of every other seller in the market. The buyers are, therefore,
indifferent to the sellers and can buy from any one

• Freedom of entry and exit: There are no barriers to entry or exit. Sellers and
buyers are free to join or leave whenever they want

• Perfect information: Each buyer and seller has complete information about
the market, i.e. about the prices, nature of product, costs, and demand, etc.
There is complete absence of advertisement and selling expenses
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 Perfect Competition

• In addition to the above,

– There are no artificial restraints in the market. The factors of
production are perfectly mobile. No middle-man, such as whole-sellers,
brokers, jobbers, retailers, etc. exists. The transactions are supposed to
be costless

– The sellers and buyers are independent in decision making. There is

no collusion of any kind among the buyers and sellers.

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 Perfect Competition

• In a perfectly competitive market, a firm is a price-taker

Demand Curve facing the Firm Market Demand Curve

Price Price

qi ∑ qi

Quantity Q= Quantity

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Perfect Competition

Price, MC
Cost

AC

AVC
Quantity

AR=MR=P

q* Quantity
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 Short-run Profitability: No-Shut
Down Condition
• A firm will find it profitable to shut-down (produce no output) when the price of its
product is less than the minimum AVC.
• In this situation, revenues from production will not cover variable costs, and
Price,
losses will increase Cost
AC

MC

B
AVC
C

D A
D

AR=MR=P
F
E

q* Quantity

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 Perfect Competition: The Long Run

• If in the short run, price is greater than min. AC, the firm would earn ‘super-
normal profit’ or ‘pure economic profit’, which is in excess of the ‘normal profit ’.

• This would attract new firms into the industry, and there would be increase in the
number of firms.

• The firms would compete among themselves for scarce resources, and hence
the level of competition in the industry would increase. The overall market supply
increases due to increased number of firms, and price would fall. A few firms
would make losses, and would exit the industry.

• The exodus of firms would continue, and industry supply would shift backwards
to the left. The interaction of industry supply and demand would lead to increase
in the price and it settles at the minimum of LRAC.

• At this point, there is no incentive for the firms to entry or exit the industry - the
long run equilibrium

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Perfect Competition: The Long Run

• A long run equilibrium occurs when three conditions

hold:
– All firms in the industry are maximizing profit
– No firm has an incentive either to enter or exit the industry because
all firms in the industry are earning zero economic profit
– The price of the product is such that the quantity supplied by the
industry is equal to the quantity demanded by the consumers.

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 Perfect Competition: Impact of Output Tax
on Firm
• Tax imposed on any particular firm will not affect the market price. However, as
the tax would raise the cost of producing each unit, MC cost curve shifts upward
to the left (by the amount of tax per unit). It also raises the AVC curve by the
amount of tax per unit.

• A tax might have 2 possible impact:

– If the tax is less than the profit margin, the firm will maximise its profit by
choosing an output at which MC+ t = P; as result output falls, firm’s SR supply
curve shifts to the left.
– If the tax> profit margin, the AVC curve will rise, and the min. AVC > P. The firm
may choose not to produce.

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 Perfect Competition: Impact of
Output Tax on Industry

• Tax imposed on all firms will have a cut in their output & production. Thus, at the
current market price, total output supplied falls, causing the price of the product to
increase.
• This increase in the price of the product diminishes some of the effects on the
individual firms output decision, as they would reduce their output less than they
would without a price increase
• Output taxes may also encourage some firms (those whose costs are somewhat
higher than the others) to exit the industry, as it would make production
unprofitable for those firms.
• Industry supply curve shifts to the left, and price rises and quantity sold in the
market falls
• LR equilibrium will have fewer firms and less output.

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 Monopoly

• Monopoly is characterised as: existence of only one firm supplying the

goods in the market, and it produces single or differentiated goods which
do not have any close substitutes in the market. There are substantial
barriers to entry existing in the market.

• A monopoly would recognise its influence over the market price and
chose that level of price and output that maximised its overall profits.

• However, it cannot choose price and output simultaneously.

• The monopolist chooses the output where MR = MC.

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 Equilibrium condition under
Monopoly
• If MR<MC, it would pay the firm to decrease output since the savings in cost would more
than make up for the loss in revenue. If MR>MC, it would pay for the firm to increase
output. The point where the firm has no incentive to change output is where MR = MC.
• A monopolist will never choose to operate where the demand curve is inelastic. For if
elasticity is less than unity, then MR is negative, so it can’t equal MC.

Price, cost
MC AC

Pm

MR=MC

D
MR

Qm Quantity 20
 Inefficiency of Monopoly

• A competitive industry
operates at a point where P =
Price MC. A monopolised industry
operates where P > MC.
MC

Pm • Thus, the price will be higher

and output lower if a firm
PC
behaves monopolistically
Deadweight loss
rather than competitively. For
this consumers will be worse
off under monopoly.
Demand
MR

Qm QC Quantity

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 Monopoly Power

• Monopoly power is defined as the ability of a firm to profitably charge a price

higher than marginal cost. A natural way to measure monopoly power is to
examine the extent to which the profit-maximising price exceeds marginal cost.

• Lerner’s degree of Monopoly Power is given as:

L = (P − MC ) P

• This Lerner’s Index always has a value between zero and one. For a perfectly
competitive firm, P = MC, so that L = 0. The larger L is, the greater the degree
of monopoly power.

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 Sources of Monopoly Power

• It implies from the Lerner’s index is that the less elastic its demand
curve, the more monopoly power it has.

• 3 factors determine a firm’s elasticity of demand:

– The elasticity of market demand

– The number of firms

– The interaction among the firms

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 Price Discrimination

• If a firm has some degree of monopoly power it has more options open
to it than a firm in a perfectly competitive industry. For example, it can
use more complicated pricing and marketing strategies.

• First degree price discrimination or Perfect price discrimination

• Second degree price discrimination
• Third degree price discrimination

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 Price Discrimination

• If a firm has some degree of monopoly power it has more options open
to it than a firm in a perfectly competitive industry. For example, it can
use more complicated pricing and marketing strategies.
• First degree price discrimination or Perfect price discrimination: The
monopolist sells different units of output for different prices and these
prices may differ from person to person.
• Second degree price discrimination: The monopolist sells different
units of output for different prices, but every individual who buys the
same amount of the good pays the same price. Thus prices differ
across the units sold, but not across people. An example of this is bulk
discounts
• Third degree price discrimination: The monopolist sells output to
different people for different prices, but every unit of output sold to a
given person sells for the same price. This is the most common form of
price discrimination, and examples include senior citizens’ discounts,
student discounts, etc. 25