Market Structure

Aims & ObjectivesAfter studying this lesson, you will be able to

understand:

• Introduction to market models• Pure competition

▫ Short run▫ Long run

2

Four Market Models• Pure competition• Pure monopoly• Monopolistic competition• Oligopoly

LO1

Market Structure Continuum

Pure Competition

MonopolisticCompetition Oligopoly

PureMonopoly

8-3

3

Four Market Models

LO1

Characteristics of the Four Basic Market Models

Characteristic

Pure Competitio

nMonopolistic Competition Oligopoly Monopoly

Number of firms

A very large number

Many Few One

Type of product

Standardized Differentiated Standardized or differentiated

Unique; no close subs.

Control over price

None Some, but within rather narrow limits

Limited by mutual inter-dependence; considerable with collusion

Considerable

Conditions of entry

Very easy, no obstacles

Relatively easy Significant obstacles

Blocked

Nonprice Competition

None Considerable emphasis on advertising, brand names, trademarks

Typically a great deal, particularly with product differentiation

Mostly public relation advertising

Examples Agriculture Retail trade, dresses, shoes

Steel, auto, farm implements

Local utilities

8-4

4

Pure CompetitionShort run

Pure Competition: Characteristics• Very large numbers of sellers• Standardized product• “Price takers”• Easy entry and exit• Perfectly elastic demand• Firm produces as much or little as they want at the price• Demand graphs as horizontal line

• Examples of Competitive Markets• Agricultural commodities.• Prominent markets for intermediate goods and services.

LO2 8-6

6

Average, Total, and Marginal Revenue

• Total Revenue • TR = P X Q

• Average Revenue• Revenue per unit• AR = TR/Q

• Marginal Revenue • Extra revenue from 1 more unit of output sold• MR = dTR/dQ

LO3 8-7

7

Profit Maximization: TR-TC Approach• Three questions:• Should the firm produce?• If so, what amount?• What economic profit (loss) will be realized?

LO3 8-8

8

Profit function• It is given as • Profit = Total revenue- Total cost• Symbolically

λ = TR - TC

9

Concept of Normal profit, Super normal profit & Loss

• Normal profit ⇒ λ = 0 ⇒TR = TC• Super normal profit ⇒ λ > 0 ⇒TR > TC• Loss ⇒ λ < 0 ⇒TR < TC

10

Profit Maximization in Competitive Markets

• Profit Maximization is Imperative• Normal profit is necessary to attract and maintain

capital investment.• Efficient firms can earn normal profit.• Inefficient firms suffer losses.

• Role of Marginal Analysis• Set Mπ = MR – MC = 0 to maximize profits.• Conditions for profit maximization is• MR=MC• d/dQ (MR) < d/dQ (MC)

11

Average, Total, and Marginal Revenuein pure competition

• Total Revenue • TR = P X Q where P = P

• Average Revenue• Revenue per unit• AR = TR/Q = P

• Marginal Revenue • Extra revenue from 1 more unit of output sold• MR = dTR/dQ = d (PQ)/dQ = P

• Therefore, AR = MR = P

LO3 8-12

12

Average, Total, and Marginal Revenue in pure competition

LO3

Firm’sDemandSchedule(AverageRevenue)

Firm’sRevenue

Data

D = MR = AR

TR

QDP TR MR

$131131131131131131131131131131131

0123456789

10

$0131262393524655786917

104811791310

$131131131131131131131131131131

]]]]]]]]]]

8-13

13

Shape of MR, AR and Demand curve in perfect competition

The AR curve of a seller is the demand curve of the consumer

AR= MRP

Price, cost

Output

14

Equilibrium of a firm in perfect competition

• Equilibrium of a firm takes place when the individual firm maximizes profit

P=MR =AR

Firms are in equilibrium when profit is maximized⇒ MR= MC =P =AR

15

Break-even & Shut down point

Q’

Break-even point

Shut down point

Break even for a firm occursat that level of output at whichP = min ATCShut down for a firm occursat that level of output at which’P = min AVC

Firms shut down operations when prices come down to the level at which thePrice =min AVC. Hence no output is produced for prices below OP in figure. There is production only if price> OP.

16

Note: The derivation of shutdown and breakeven points is done in class

Marginal Cost and Firm Supply• Short-run Firm Supply• Firm’s marginal-cost curve shows the amount of

output the firm would be willing to supply at any market price.

• Marginal cost curve is the short-run supply curve so long as P > min AVC .

17

3 Production Questions

LO3

Output Determination in Pure Competition in the Short Run

Question Answer

Should this firm produce? Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost.

What quantity should this firm produce?

Produce where MR (=P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized.

Will production result in economic profit?

Yes, if price exceeds average cost (TR will exceed TC). No, if average total cost exceeds price (TC will exceed TR).

8-18

18

Pure CompetitionLong run

The Long Run in Pure Competition

• In the long run:• Firms can expand or contract capacity• Firms enter and exit the industry

LO1 9-20

20

Profit Maximization in the Long Run• Easy entry and exit• The only long run adjustment we consider

• Identical costs• All firms in the industry have identical costs

• Constant-cost industry• Entry and exit do not affect resource prices

LO2 9-21

21

Long-Run Equilibrium• Entry eliminates profits• Firms enter• Supply increases• Price falls

• Exit eliminates losses• Firms exit• Supply decreases• Price rises

LO3 9-22

22

Equilibrium of a perfectly competitive industry/long run equilibrium

E

E’

Let at the going price ‘P’ the representative firm in the industry earn supernormal profit as shown by the blue shaded area → new firms are attracted to the industry → pushing the supply curve to the right. Price starts coming down and the share of profit of each firm starts falling. This adjustment goes on till the time the entire supernormalprofit is removed and each firm earns only normal profit (TC= TR) at price P’. The reverse mechanism works if existing firms in industry earns losses. Adjustment Happens through exit of firms till normal profit point is arrived at. Thus, industry is in equilibrium at normal profit at the minimum point of AC where AR=MR=MC=AC=P

P

P’

S

S’

D

23

Long Run Supply• Constant cost industry - Long‑run supply will be perfectly

elastic; the curve will be horizontal. In other words, the level of output will not affect the price in the long run.• Entry/exit does not affect LR AC -• Constant resource price - expansion or contraction does not affect

resource prices or production costs.• Special case

• Increasing cost industry - Long‑run supply will be upward sloping as industry expands output.• Most industries• LR AC increases with expansion - Average‑cost curves shift upward as

the industry expands and downward as industry contracts, because resource prices are affected.

• Specialized resources

• Decreasing cost industry - Long‑run supply will be downward sloping as the industry expands output. • Average‑cost curves fall as the industry expands and firms will

enter until price is driven down to maintain only normal profits.

LO4 9-24

24

LR Supply: Constant-Cost Industry

LO4

P

0 Q90,000 100,000 110,000Q3 Q1 Q2

$50

P1

P2

P3

SZ1 Z2Z3

D3 D1 D2

9-25

25

LR Supply: Increasing-Cost Industry

LO4

P

0 Q90,000 100,000 110,000Q3 Q1 Q2

$50P1

S

Y1

Y2

Y3

D3

D1

D2

$40

$55P2

P3

9-26

26

LR Supply: Decreasing-Cost Industry

LO4

P

0 Q90,000 100,000 110,000Q3 Q1 Q2

$50P1

S

X1

X2

X3

D3

D1

D2

$40

$55P3

P2

9-27

27

Pure Competition and Efficiency

• In the long run, efficiency is achieved• Productive efficiency • Producing where P = min. AC

• Allocative efficiency• Producing where P = MC

LO5 9-28

28

Pure Competition and Efficiency

LO5

Single Firm Market

Pri

ce

Pri

ce

Quantity Quantity

0 0

P MR

D

S

QeQf

ATC

MCP=MC=MinimumATC (Normal Profit)

P

Consumer Surplus

Producer Surplus

9-29

29

Dynamic Adjustments• Purely competitive markets will automatically adjust to:• Changes in consumer tastes• Resource supplies• Technology

• Recall the “Invisible Hand”

LO6 9-30

30

Technological Advance: Competition

• Entrepreneurs would like to increase profits beyond just a normal profit• Decrease costs by innovating• New product development

LO6 9-31

31

32

Thank You