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Market Structure
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The Degree ofCompetition
• The four market structures– perfect competition
– monopoly
– monopolistic competition
– oligopoly
• Classifying markets– number of firms
– freedom of entry to industry
– nature of product
– nature of demand curve
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Market Structures
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Perfect Competition
• Assumptions
– firms are price takers
– freedom of entry
– identical products
– perfect knowledge
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The Revenue ofCompetitive Firm
• Total revenue (TR)– How much does the firm receive for the sale of the
total output?TR = P × Q
• Average revenue (AR)– How much does the firm receive for the sale of one
typical unit of output?AR = TR/Q
• Marginal revenue (MR)– How much does the firm receive for the sale of one
additional unit of output?MR = ΔTR/ΔQ
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Cost of Production
• Includes all the opportunity costs of making its output of goods and services.– Explicit costs: input costs that require a
direct outlay of money by the firm (e.g. opportunity cost of $100 electricity fee)
– Implicit costs: input costs that do not require an outlay of money by the firm (e.g. opportunity cost of renting out building)
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Profit
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Profit Maximization
• The firm will want to produce the quantity that maximizes the difference between total revenue and total cost.
• Occurs at the quantity where marginal revenue equals marginal cost (MR=MC).
• Why don’t the firm just produce the maximum quantity?
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Marginal Analysis
Q P=AR TC TR Profit MR MC Profit
0 6 3 -3
1 6 5 1 6 2 4
2 6 8 4 6 3 3
3 6 12 18 6 6 4 2
4 6 17 24 7 6 5 1
5 6 23 30 7 6 6 0
6 6 30 36 6 6 7 -1
7 6 38 42 4 6 8 -2
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Marginal Analysis
Q P=AR TC TR Profit MR MC Profit
0 6 3 0 -3
1 6 5 6 1 6 2 4
2 6 8 12 4 6 3 3
3 6 12 18 6 6 4 2
4 6 17 24 7 6 5 1
5 6 23 30 7 6 6 0
6 6 30 36 6 6 7 -1
7 6 38 42 4 6 8 -2
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O
£
(b) Firm
Q (thousands)
O
(a) Industry
P
Q (millions)
S
D
Pe
MC
ARD = AR
= MR
Qe
AC
AC
Short-run equilibrium of industry and firm under perfect competition
Firm is a price taker. Price is given by the market.
Firm is a price taker. Price is given by the market.
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Profit Maximization
• When MR > MC, increase Q
• When MR < MC, decrease Q
• When MR = MC, profit is maximized
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Profits returnto normal
O O
(a) Industry
P £
Q (millions)
S1
D
(b) Firm
LRAC
PL
P1
QL
Se
AR1 D1
ARL DL
Q (thousands)
New firms enter
Supernormal profits
Long-run equilibrium
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Produce or shut down – the short-run
• Shut down (short-run decision)
• Exit (long-run decision)
• Which costs are relevant?– If the firm shuts down, it only incurs fixed cost,
which is sunk and cannot be recovered.– Relevant cost in the short run is variable cost.
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Produce or shut down- the short-run
• The firm shuts down if the revenue it gets from producing is less than the variable cost of production.– Shut down if TR < VC– Shut down if TR/Q < VC/Q– Shut down if P < AVC
• As long as P ≥ AVC (or TR ≥ TVC), the firm should operate even if it is losing money (loss-minimizing)
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Enter or exit– the long run
• In the long run, the firm exits if the revenue it would get from producing is less than its total cost.– Exit if TR < TC– Exit if TR/Q < TC/Q– Exit if P < ATC
• A firm will enter the industry if such an action would be profitable.
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Monopoly
• A firm that is the sole seller of a product for which no close substitutes exist.
• The firm is protected from competitors by barriers that prevent entry from other firms
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Barriers to entry
• Monopoly resources
• Government-created monopolies
• Natural monopolies (economies of scale)
• Product differentiation and brand loyalty
• Aggressive tactics
• Lower costs for an established firm
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£
Q O
MC
AC
Qm
MR
AR
AC
Profit maximising under monopoly
AR
Total profit
Profit maximised at output of Qm
(where MC = MR)
Profit maximised at output of Qm
(where MC = MR)
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Profit Maximizationunder Monopoly
• MR = MC (true for all firms!)
• In a competitive firm, P = MR– Profit maximization leads to P = MC → P =
MC = MR
• For a monopoly, P > MR– Profit maximization leads to P > MC
• Why?
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£
Q O
MC ( = supply under perfect competition)
Q1
MR
P1
P2
Q2
AR = D
Comparison withPerfect competition
Equilibrium under PC &Monopoly – the same MC curve
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Monopolistic Competition
• A situation where there are a lot of firms competing with their own market segment
• Each firm has some discretion as to what price to charge for its products
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Monopolistic Competition
• Assumptions– Independence– Freedom of entry– Product differentiation
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£
Q O Qs
AR D
MC
AC
MR
Ps
ACs
Monopolistic Competition – Short run equilibrium
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ARL DL
MRL
£
Q O QL
PL
LRAC
LRMC
New firms entering the industry reduce demand for each
individual firm.
Price falls to PL
Monopolistic Competition – Long run equilibrium
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Oligopoly
• A few firms share a large proportion of the market
• Key features of oligopoly– barriers to entry– interdependence of firms
• Competition versus collusion
• Collusive oligopoly: cartels
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£
Q O
Industry D AR
Industry MC
Industry MR
Q1
P1
Industry profit maximised at
Q1 and P1.
Industry profit maximised at
Q1 and P1.
Members must agree to restrict
total output to Q1.
Members must agree to restrict
total output to Q1.
Profit-maximising cartel
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Factors favoring collusion
• Few firms• Open with each other• Similar production methods and average costs• Similar products• Dominant firm• Significant entry barriers• Stable market• No government measures to curb collusion
