Managerial Economics 1 1 Market Structure In economics, market structure (also known as market form)...

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• In economics, market structure (also known as market form) describes the state of a market with respect to competition.

• The major market forms are:• Perfect competition, in which the market consists of a very large

number of firms producing a homogeneous product. • Monopolistic competition, also called competitive market, where

there are a large number of independent firms which have a very small proportion of the market share.

• Oligopoly, in which a market is dominated by a small number of firms which own more than 40% of the market share.

• Oligopsony, a market dominated by many sellers and a few buyers. • Monopoly, where there is only one provider of a product or service. • Natural monopoly, a monopoly in which economies of scale cause

efficiency to increase continuously with the size of the firm. • Monopsony, when there is only one buyer in a market. • The imperfectly competitive structure is quite identical to the

realistic market conditions where some monopolistic competitors, monopolists, oligopolists, and duopolists exist and dominate the market conditions.

• These somewhat abstract concerns tend to determine some but not all details of a specific concrete market system where buyers and sellers actually meet and commit to trade.

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Market Structure/FormMarket Structure

Seller Entry Barriers

Seller Number

Buyer Entry Barriers

Buyer Number

Perfect Competition

No Many No Many

Monopolistic competition

No Many No Many

Oligopoly Yes Few No Many

Oligopsony No Many Yes Few

Monopoly Yes One No Many

Monopsony

Bilateral Dupoly

No

yes

Many

One

Yes

Yes

One

One

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Continued…• The correct sequence of the market

structure from most to least competitive is perfect competition, imperfect competition, oligopoly, and pure monopoly.

• The main criteria by which one can distinguish between different market structures are: the number and size of producers and consumers in the market, the type of goods and services being traded, and the degree to which information can flow freely.

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Perfect Competition

• Firms are price-takers• Each produces only a very small

portion of total market or industry output

• All firms produce a homogeneous product

• Entry into & exit from the market is unrestricted

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Demand for a Competitive Price-Taker

• Demand curve is horizontal at price determined by intersection of market demand & supply• Perfectly elastic

• Marginal revenue equals price• Demand curve is also marginal revenue

curve (D = MR)

• Can sell all they want at the market price• Each additional unit of sales adds to total

revenue an amount equal to price

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D

S

Quantity

Pri

ce (

dolla

rs)

Quantity

Pri

ce (

dolla

rs)

P0

Q0

Panel A – Market

Panel B – Demand curve facing a price-taker

Demand for a Competitive Price-Taking Firm

0 0

P0D = MR

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Profit-Maximization in the Short Run

• In the short run, managers must make two decisions:

1. Produce or shut down? If shut down, produce no output and hires

no variable inputs If shut down, firm loses amount equal to

TFC

2. If produce, what is the optimal output level?

If firm does produce, then how much? Produce amount that maximizes economic

profit TR TC Profit =

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Profit Margin (or Average Profit)

• Level of output that maximizes total profit occurs at a higher level than the output that maximizes profit margin (& average profit)• Managers should ignore profit margin

(average profit) when making optimal decisions

( P ATC )Q

Q Q

Average profit

P ATC Profit margin

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Short-Run Output Decision

• Firm’s manager will produce output where P = MC as long as:• TR TVC• or, equivalently, P AVC

• If price is less than average variable cost (P AVC), manager will shut down• Produce zero output• Lose only total fixed costs• Shutdown price is minimum AVC

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Total revenue =$36 x 600 = $21,600

Profit = $21,600 - $11,400

= $10,200

Total cost = $19 x 600 = $11,400

Profit Maximization: P = $36

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Profit Maximization: P = $36

Panel A: Total revenue & total cost

Panel B: Profit curve when P = $36

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Short-Run Loss Minimization: P = $10.50

Total cost = $17 x 300 = $5,100

Total revenue = $10.50 x 300 = $3,150

Profit = $3,150 - $5,100 = -$1,950

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Irrelevance of Fixed Costs

• Fixed costs are irrelevant in the production decision• Level of fixed cost has no effect on

marginal cost or minimum average variable cost

• Thus no effect on optimal level of output

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• AVC tells whether to produce• Shut down if price falls below

minimum AVC

• SMC tells how much to produce• If P minimum AVC, produce

output at which P = SMC

• ATC tells how much profit/loss if produce

Summary of Short-Run Output Decision

• ( P ATC )Q

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Short-Run Supply Curves

• For an individual price-taking firm• Portion of firms’ marginal cost

curve above minimum AVC• For prices below minimum AVC,

quantity supplied is zero

• For a competitive industry• Horizontal sum of supply curves of

all individual firms• Always upward sloping

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Derivation of Short-Run Supply Curves

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Long-Run Profit-Maximizing Equilibrium

Profit = ($17 - $12) x 240 = $1,200

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Long-Run Competitive Equilibrium

• All firms are in profit-maximizing equilibrium (P = LMC)

• Occurs because of entry/exit of firms in/out of industry• Market adjusts so P = LMC = LAC

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Long-Run Competitive Equilibrium

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Long-Run Industry Supply

• Long-run industry supply curve can be flat (perfectly elastic) or upward sloping• Depends on whether constant cost

industry or increasing cost industry

• Economic profit is zero for all points on the long-run industry supply curve for both types of industries

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Long-Run Industry Supply• Constant cost industry

• As industry output expands, input prices remain constant, & minimum LAC is unchanged

• P = minimum LAC, so curve is horizontal (perfectly elastic)

• Increasing cost industry• As industry output expands, input prices

rise, & minimum LAC rises• Long-run supply price rises & curve is

upward sloping

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Long-Run Industry Supply for a Constant Cost Industry

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Long-Run Industry Supply for an Increasing Cost Industry

Firm’s output

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Economic Rent

• Payment to the owner of a scarce, superior resource in excess of the resource’s opportunity cost

• In long-run competitive equilibrium firms that employ such resources earn only normal profit• Economic profit is zero• Potential economic profit is paid to

the resource as rent

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Economic Rent in Long-Run Competitive Equilibrium

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Profit-Maximizing Input Usage

• Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

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Profit-Maximizing Input Usage

• Marginal revenue product (MRP)• MRP of an additional unit of a variable input

is the additional revenue from hiring one more unit of the input

• If choose to produce:• If the MRP of an additional unit of input is

greater than the price of input, that unit should be hired

• Employ amount of input where MRP = input price

TRMRP P MP

L

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Profit-Maximizing Input Usage

• Average revenue product (ARP)• Average revenue per worker

• Shut down in short run if ARP < MRP• When ARP < MRP, TR < TVC

TRARP P AP

L

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Profit-Maximizing Labor Usage

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Implementing the Profit-Maximizing Output Decision

• Step 1: Forecast product price• Use statistical techniques

• Step 2: Estimate AVC & SMC

• SMC a bQ cQ22 3

• AVC a bQ cQ2

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Implementing the Profit-Maximizing Output Decision

• Step 3: Check shutdown rule• If P AVCmin, produce

• If P < AVCmin, shut down

• To find AVCmin, substitute Qmin into

AVC equation

min

bQ

c2

min min minAVC a bQ cQ2

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Implementing the Profit-Maximizing Output Decision

• Step 4: If P AVCmin, find output where P = SMC• Set forecasted price equal to

estimated marginal cost & solve for Q*

* *P a bQ cQ 22 3

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Implementing the Profit-Maximizing Output Decision

• Step 5: Compute profit or loss•Profit = TR - TC

• If P < AVCmin, firm shuts down &

profit is -TFC

* *P Q AVC Q TFC *( P AVC )Q TFC