CHAPTER 5

MARKET STRUCTURES

PERFECT COMPETITION, MONOPOLY

& IMPERFECT COMPETITION

Economics Lecture presentation

Market Structures

Market structure – identifies how a market is made up in terms of:

• Number of firms

• Nature of the product

• Entry

• Information

• Collusion

• Firm’s control over the price of the product

• Demand curve for the firm’s product

• Long-run economic profit

• Perfect competition

• Monopolistic competition

• Oligopoly

• Monopoly

Four different market structures

Key features of a market structure:

The equilibrium conditions

(for any firm)

Two decisions faced by firms:

1. Should we produce? – is it worth producing

under given conditions or shut down.

2. If yes, how much? – quantities where profits are maximised or losses minimised.

Shut Down Rule

• Fixed costs must be paid in the short-run.

• Variable-costs can be avoided by laying off workers

and shutting down.

• Firms shut down if price (Average Revenue) falls

below the Average Variable Cost.

• If Price is greater than average variable cost the

difference contributes towards Fixed Cost.

NB (TR>/= TVC)

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Profit Maximisation Rule• For any output level, the firm attempts to minimize

costs.

• Assume the firm aims to maximize economic

profits.

• Profits depend on both COSTS and REVENUE

• each of which varies with the level of output

• Profit maximisation can be explained in-terms of

TR and TC or MR and MC

Total Revenue & Total Cost Approach

• Profit = TR – TC.

• The short run profit

maximising output

is that output

corresponding to

where the vertical

distance between

TR & TC is

greatest.

Marginal Analysis Approach

• Profit maximising

output using MR and

MC curves.

• If MR > MC, an

increase in production

will increase profit

• If MR < MC, an

increase in production

will decrease profit

• Profit Maximising

Rule : MR = MC.

Marginal Analysis Approach Cnt.

• If MR > MC, output should be expanded

• If MR = MC, profits are maximised

• If MR < MC, output should be reduced

Perfect competition• This is when none of the individual market

participants (buyers & sellers) can influence the price

of the product

• Requirements

i. Large numbers of buyers and sellers = price takers

ii. No collusive behaviour between firms

iii. Products sold in the market are homogeneous

iv. No restrictions in relation to entry or exit of firms

(legal, technological, physical etc.)

Perfect competition (Contd)

• Requirements

v. Factors of production are perfectly mobile

i.e. from market to another.

vi. There is no government intervention in the

market.

vii. Buyers and sellers have perfect

information about market conditions.

Demand Curve for Individual Firm:

Firms Are Price Takers

• The firm`s demand curve is perfectly elastic.

• D = MR = AR = P.

• D, AR and MR curves are horizontal at the

market price.

The demand curve for the product of

the firm under perfect competition

The equilibrium of the firm under

perfect competition

• Profit is maximised (or losses minimised)

when a firm produces an output where

marginal revenue equals marginal cost,

provided marginal cost is rising and lies

above minimum average variable cost

i.e. P = MC………… (since P = MR)

Why Profit is maximised at MR = MC?

Revenue and Cost of a hypothetical

firm

Marginal Revenue and Marginal Cost of a firm

operating in a perfectly competitive market

The equilibrium of the firm under perfect

competition cntd.

• The firm’s actual profit position can be ascertained

by adding in the average cost (AC)curve to the

diagram

• Average profit is equal to AR - AC

Different possible short-run equilibrium positions of the

firm under perfect competition

• Economic profit – as long as AR is above AC

• Break even (normal profit) – when AR is equal to AC

• Economic loss – when AR less than AC

Different possible short-run equilibrium positions

of the firm under perfect competition

The supply curve of the firm and the market

supply curve

• Firm’s supply

curve – the rising

part of the firm’s

MC curve above

the minimum of

AVC

• Market supply

curve – add the

supply curves of

the individual firms

horizontally

Long-run equilibrium of the firm and the

industry under perfect competition

• The industry will be in equilibrium in the long run

only if all the firms are making normal profits

The firm and industry in equilibrium

(long run)

• If firms are making an economic profit – new

firms enter the market

The individual firm and the industry when the

firm initially earns an economic profit

• If firms are making an economic loss –

existing firms exit the market

The individual firm and the industry when the

firm initially makes an economic loss

Monopoly

• Is a market structure in which there is only one

producer/seller for a product.

Characteristics

The four characteristics of monopoly are:

• A single firm selling all output in a market

• A unique product

• Restrictions on entry into and exit out of the industry

• Specialized information about production techniques

unavailable to other potential producers

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Monopoly: But Why?

BARRIERS TO ENTRY

• Existence of large economies of scale (natural monopoly).One firm can provide

a lower price than 2 or more.

• Limited size of the market

• A patent; e.g. a new drug

• Sole ownership of a resource; e.g. diamonds (De Beers Consolidated mines)

• Licensing

• Import restrictions

• Formation of a cartel; e.g. OPEC

Monopoly: Assumptions

• Only one seller i.e. not a price-taker

–It is a price setter

• A unique product with no close substitutes

• Entry is restricted or blocked

Monopoly: Features• The monopolist’s demand curve is the

(downward sloping) market demand curve

–Demand curve is equal to market demand.

• The monopolist can alter the market price by

adjusting its output level.

• It has two choices:

– Charge a higher price

– Produces lower output level

Average, Total and Marginal revenue when the demand curve

for the product of the firm slopes downward

AR and MR under monopoly

TR under monopoly

Profit-maximising or equilibrium position in

the short-run• Monopolies follow the same profit maximizing

rule as competitive firm, MR=MC.

• The downward sloping demand curve indicates

that monopolist can increase its quantity when it

lowers the price of the product.

• The demand curve of a monopoly is also the AR

curve.

• The MR is always below the AR under monopoly.

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• In the Long Run, economic profits can be maintained!!

The short-run equilibrium of the firm under

monopoly

The short-run equilibrium of the firm

under monopoly

Economic Profit

The monopolist will produce at Q1 where MR=MC.

• The monopolist will charge price P1, which is determined

by the demand curve.

• Is the monopolist making an economic profit or loss?

• We compare the AR and AC to determine whether the

monopolist makes a profit or loss.

• AR(=P) > AC, therefore the monopolist is experiencing

economic profit.

• NB in the long-run due to barriers to entry of firms,

monopolist may also make economic profit or losses.

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Monopolistic competition

• Monopolistically competitive market – a large

number of firms produce similar but slightly

different products

• Differentiated (or heterogeneous) product –

different varieties of a product. The onus rests

with consumers. e.g. brands

• Price competition and non-price competition

Characteristics of monopolistic

competition

• Each firm produces a distinctive, differentiated

product

• Each firm faces a downward-sloping demand

curve for its particular product

• There are a large number of firms in the

industry

• There are no barriers to entry or exit

Short Run Equilibrium of Monopolistic Competition

Long Run Equilibrium of Monopolistic Competition

Oligopoly

• Oligopoly – a few large firms dominate the market

• Duopoly – there are only two firms in the market

The main features

• high degree of interdependence between the firms

• uncertainty

• barriers to entry

Two strategies:

• Collusion

• Competition

Conditions for successful collusion

• Small number of firms

• Similar production methods

• Homogeneous products

• Significant barriers to entry

• Stable market

• No government intervention e.g Competition Policy

• There is no general theory of oligopoly

• Importance of non-price competition

Popular misconceptions about a monopoly

• Can charge virtually any price it wants

• Can charge the highest price it can get

• Guaranteed an economic profit

• Has almost absolute economic power

The case against monopoly

• Output is lower and price is higher

• Little or no incentive for innovation

• Managerial inefficiency

• Questionable quality of products or service

• Unfair or socially unacceptable distribution of income and wealth

• Rent-seeking behaviour

• Economic power, politically powerful

Imperfect competition • Differences between perfect competitive

markets and imperfect competitive markets

Perfect

competition

Imperfect

competition

No. of sellers

and buyers

Many sellers and

buyers

Few seller and

buyers

Firm behavior Price-takers Price-setters

Demand curve Horizontal Negatively sloped

Collusion No collusion May have collusion

Products Homogeneous Heterogeneous

Entry and exit No restrictions Restriction

Information Perfect information Imperfect information

Competition policy in South Africa

• Monopolies or market dominance is

strongly discouraged by the South African

government.

• The South Africa Competition Act, No. 89 of

1998, as amended, was created to promote

and maintain competition in the country.