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Four Market Structures

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Title: Four Market Structures


1
Four Market Structures
The focus of this lecture is the four market
structures. Students will learn the
characteristics of pure competition, pure
monopoly, monopolistic competition, and
oligopoly. Using the cost schedule from the
previous lecture, the idea of profit maximization
is explored. OBJECTIVES 1. Identify various
market structures and their characteristics. 2.
Be able to category firms into four market
structures. 3. Describe the effects of imperfect
competition upon the market and the firm. 4.
Understand the pricing structure of the four
structures. TOPICS Please read all the following
topics. PERFECT COMPETITION PERFECT COMPETITION
CONT. PERFECT COMPETITION EXAMPLE PURE
MONOPOLY MONOPOLY EXAMPLE PRICE
DISCRIMINATION MONOPOLISTIC COMPETITION OLIGOPOLY
TECHNOLOGICAL DEVELOPMENT ECONOMIC EFFICIENCY
2
Perfect Competition
Pure or perfect competition is rare in the real
world, but the model is important because it
helps analyze industries with characteristics
similar to pure competition. This model provides
a context in which to apply revenue and cost
concepts developed in the previous lecture.
Examples of this model are stock market and
agricultural industries. Characteristics 1. Many
sellers there are enough so that a single
sellers decision has no impact on market
price. 2. Homogenous or standardized products
each sellers product is identical to its
competitors. 3. Firms are price takers
individual firms must accept the market price and
can exert no influence on price. 4. Free entry
and exit no significant barriers prevent firms
from entering or leaving the industry. Demand The
individual firm will view its demand as
perfectly elastic. A perfectly elastic demand
curve is a horizontal line at the price. The
demand curve for the industry is not perfectly
elastic, it only appears that way to the
individual firms, since they must take the market
price no matter what quantity they produce.
Therefore, the firms demand curve is a
horizontal line at the market price. Marginal
revenue (MR) is the increase in total revenue
resulting from a one-unit increase in output.
Since the price is constant in the perfect
competition. The increase in total revenue from
producing 1 extra unit will equal to the price.
Therefore, P MR in perfect competition.
3
Profit-Maximizing Output
Short Run Analysis In the short run, the firm has
fixed resources and maximizes profit or minimizes
loss by adjusting output. Firms should produce if
the difference between total revenue and total
cost is profitable (EP gt0), or if the loss is
less than the fixed cost (EPgt- FC). The firm
should not produce, but should shut down in the
short run if its loss exceeds its fixed costs. By
shutting down, its loss will just equal those
fixed costs. Fixed cost in real life would be
rent of the office, business license fees,
equipment lease, etc. These cost would have to be
paid with or without any output. Therefore, fixed
cost would be the loss of shut down at any time.
If by producing one unit of output, this loss
could be lowered, then this unit should be
produced to minimize the loss. However, if by
producing one unit of output, this loss would be
higher , then this unit should not be produced.
The firm should shut down, just pay for the fixed
cost. If EPlt - FC  firm should shut down. Then
its lost will be the Fixed cost. EP - FC. In
order for EP lt - FC, market price, P, must be
lower than the minimum AVC. If EPgt - FC, firm
should produce. That is when market price is
greater than minimum AVC. Marginal revenue and
marginal cost (MC) are compared to decide the
profit-maximizing output. If MR gt MC, then the
firm should continue to produce. If MR MC, then
the firm should stop producing the additional
unit. As the additional units MC would be higher
according to law of diminishing returns, MR would
be less than MC that is, the firm would loss
profit by producing additional units. Therefore,
this is the profit maximizing output level. If MR
lt MC, then the firm should lower its output. In
conclusion The shutdown point is the level of
output and price at which the firm just covers
its total variable cost. If the MR of the product
is less than the minimum average variable cost
(min AVC), the firm will shut down because this
action minimizes the firms loss. In this case,
the firms economic loss equals its total fixed
costs. If MR lt min AVC, then each additional unit
produced would increase the loss. For pure
competition, MR is equal to price as the firm is
facing a perfectly elastic demand. Therefore, for
short run, if Price lt min AVC, then the firm
should shut down. If Price gt min AVC, then the
firm should produce. Price and MC are compared to
find the profit maximizing or loss minimizing
output level. The supply curve of the pure
competition firms would be the portion of the MC
curve above the min AVC. 1. If EP lt - FC or
Market P lt Min AVC, firm should shut down. Output
0 , and EP -FC 2. If EP gt - FC or Market P gt
Min AVC, firm should produce. Firm's output level
should be at where MRMC or PMC.  Use EP
TR - TC to get economic profit of the firm.
4
Perfect Competition Cont.
Following the rules discussed in the previous
section. Here is an example. Firms fixed cost is
100, its min AVC is 55. If market price is 50
which is less than min AVC, the firm would loss
5 more by producing each unit. If the firm
produces one unit, its total loss would be 5
plus 100 fixed cost. If the firm decides to shut
down, its loss would be only 100 as the firm
does not need to pay for the variable cost. Shut
down would be the loss minimization strategy. If
the market price is 60, the firm would lose 5
less by producing each unit. If the firm produces
one unit, its total cost would be fixed cost less
5, which is 95. The firm is better off by
producing, not shutting down. When the market
price is higher than the minimum AVC, MR and MC
should be compared to find out the optimal level
of output. Long Run Analysis Obviously, the
firm cannot be in loss for long. Three
assumptions are made for the long run
analysis 1. Entry and exit are the only long
run adjustments. 2. Firms in the industry have
identical cost curves. 3. The industry is in
constant return to scale. In long run, if
economic profits are earned, firms enter the
industry, which increases the market supply,
causing the product price to go down. Until zero
economic profits are earned, then the supply will
be steady. If losses are incurred in the short
run, firms will leave the industry which
decreases the market supply, causing the product
price to rise until losses disappear. This model
is one of zero economic profits in long run. The
long run equilibrium is achieved, the product
price will be exactly equal to, and production
will occur at, each firms point of minimum
average total cost.
5
Efficiency Analysis
  • Productive efficiency occurs where P min ATC.
    Perfect competitive firms will achieve productive
    efficiency as firms must use the least-cost
    technology or they won't survive.
  • 2. Allocative efficiency occurs where P MC.
    Price represent the benefit that society gets
    from additional units of a product, MC represents
    the cost to society of other goods given up to
    produce this product. Dynamic adjustments will
    occur in this market structure when changes in
    demand, supply or technology occurs. Perfect
    competitive firms will achieve this efficiency.
    Since no explicit orders are given to the
    industry, "the Invisible Hand" works in this
    system.
  • Even though both efficiencies are achieved in
    this system, the consumers are facing standard
    products, making shopping to be no fun at all. On
    the other hand, the consumers will receive the
    highest consumer surplus in this structure as the
    long run market price will be at the min ATC.
    Producers will receive the lowest producer
    surplus as consumers can easily find substitutes.

6
An Example
The following data represents a cost function of
a perfect competitive firm
TP or Q AFC AVC ATC MC
0
1 60 45 105 45
2 30 42.5 72.5 40
3 20 40 60 35
4 15 37.5 52.5 30
5 12 37 49 35
6 10 37.5 47.5 40
7 8.57 38.57 47.14 45
8 7.5 40.63 48.13 55
9 6.67 43.33 50 65
10 6 46.5 52.5 75
If the market price, P lt 37 this firm's output  Q 0 firm's economic profit, EP -60
 
If the market price, P gt 37, this firm's output  Q gt 0 firms' economic profit , EP TR - TC.
 
For example, when P 65, Q 9, EP 65 x 9 - 50 X 9 135
7
An Example Cont.
By given the market demand at various price
level, a market equilibrium price could be found.
TP or Q AFC AVC ATC MC
0
1 60 45 105 45
2 30 42.5 72.5 40
3 20 40 60 35
4 15 37.5 52.5 30
5 12 37 49 35
6 10 37.5 47.5 40
7 8.57 38.57 47.14 45
8 7.5 40.63 48.13 55
9 6.67 43.33 50 65
10 6 46.5 52.5 75
One firm's output level (column 2 in the above
table) is obtained by comparing  P and MC. Since
all firms are having the same cost function, the
market output level is the sum of individual
firms' output (column 4 in the above table). By
comparing the market supply and market demand, we
can find the market equilibrium at P 46 and  Q
10500 At this level, each firm is losing 8
dollars, indicating a contraction in this
industry. Some firms may leave in the long run,
causing the market supply to decrease and
equilibrium price will increase to the break-even
level.
PRICE Qs (1 firm's output) PROFIT Qs(1500 firms in the market)  / market supply Qd / market demand
26 0 -60 0 17000
32 0 -60 0 15000
38 5 -55 7500 13500
41 6 -39 9000 12000
46 7 -8 10500 10500
56 8 63 12000 9500
66 9 144 13500 8000
(assuming identical cost function for all firms)
8
Pure Monopoly
Pure monopoly exists when a single firm is the
sole producer of a product for which there are no
close substitutes. Examples are public utilities
and professional sports leagues. Characteristics
1. A single seller the firm and industry are
synonymous. 2. Unique product no close
substitutes for the firms product. 3. The firm
is the price maker the firm has considerable
control over the price because it can control the
quantity supplied. 4. Entry or exit is
blocked. Barriers to Entry Economies of scale is
the major barrier. This occurs where the lowest
unit cost and, therefore, low unit prices for
consumers depend on the existence of a small
number of large firms, or in the case of
monopoly, only one firm. Because a very large
firm with a large market share is most efficient,
new firms cannot afford to start up in industries
with economies of scale. Public utilities are
known as natural monopolies because they have
economies of scale in the extreme case. More than
one firm would be inefficient because the maze of
pipes or wires that would result if there were
competition among water companies or cable
companies. Legal barriers also exist in the form
of patents and licenses, such as radio and TV
stations. Ownership or control of essential
resources is another barrier to entry, such as
the professional sports leagues that control
player contracts and leases on major city
stadiums. It has to be noted that barrier is
rarely complete. Think about the telephone
companies a couple decades ago there was no
substitute for the telephone. Nowadays, cellular
phones are very popular. It creates a substitute
for your house phone, causing the traditional
telephone companies to lose their monopoly
position. Demand Curve Monopoly demand is the
industry or market demand and is therefore
downward sloping. Price will exceed marginal
revenue because the monopolist must lower price
to boost sales and cannot price discriminate in
most cases. The added revenue will be the price
of the last unit less the sum of the price cuts
which must be taken on all prior units of output.
The marginal revenue curve is below the demand
curve.
9
Profit Maximizing Output Efficiency
Profit Maximizing Output The MR MC rule will
still tell the monopolist the profit maximizing
output. The monopolist cannot charge the highest
price possible, it will maximize profit where TR
minus TC is the greatest. This depends on
quantity sold as well as on price. The
monopolist can charge the price that consumers
will pay for that output level. Therefore, the
price is on the demand curve. Losses can occur in
monopoly, although the monopolist will not
persistently operate at loss in the long run.
Monopolies will sell at a smaller output and
charge a higher price than would pure competitive
producers selling in the same market. Income
distribution is more unequal than it would be
under a more competitive situation, unless the
government regulates the monopoly and prevents
monopoly profits. If a monopoly creates
substantial economic inefficiency and appears to
be long-lasting, antitrust laws could be used to
break up the monopoly. Efficiency 1.
Productive efficiency occurs where P min ATC.
Monopoly firms will not achieve productive
efficiency as firms will produce at an output
which is less than the output of min ATC.
X-inefficiency may occur since there is no
competitive pressure to produce at the minimum
possible costs. 2. Allocative efficiency occurs
where P MC. This efficiency is not achieved
because price( what product is worth to
consumers) is above MC (opportunity cost of
product). It is possible that monopoly is more
efficient than many small firms. Economies of
scale (natural monopoly) may make monopoly the
most efficient market model in some industries.
However, X-inefficiency and rent-seeking cost
(lobbying, legal fees, etc.) can entail
substantial costs, causing inefficiency.
Producer surplus is significant due to lack of
competition, consumer surplus may be minimized.
This market structure will not contribute to a
fair income distribution of our society.
10
An Example
In this example, the cost function is the same as
the one used in  the perfect competition example.
You can see from the following analysis that the
output level and market price are different in
monopoly . The output level is lower than output
of the perfect competitive firm and price is
higher than the price of perfect competitive firm.
TP or Q AFC AVC ATC MC
0
1 60 45 105 45
2 30 42.5 72.5 40
3 20 40 60 35
4 15 37.5 52.5 30
5 12 37 49 35
6 10 37.5 47.5 40
7 8.57 38.57 47.14 45
8 7.5 40.63 48.13 55
9 6.67 43.33 50 65
10 6 46.5 52.5 75
Pd Qd TR MR EP
115 0 0 0
100 1 100 100 -5
83 2 166 66 21
71 3 213 47 33
63 4 252 39 42
55 5 275 23 30
48 6 288 13 3
42 7 294 6 -35.98
37 8 296 2 -89.04
33 9 297 1 -153
29 10 290 -7 -235
By comparing the MR and MC unit by unit, we can
find this firm's output at Q 4, and  P 63.
This is the profit maximization output level,
with EP 42. It is possible for this firm to
continue earning this profit in the long run as
there are no competition in the market.
11
Price Discrimination
  • Price discrimination is selling a good or service
    at a number of different prices, and the price
    differences is not justified by the cost
    differences. In order to price discriminate, a
    monopoly must be able to
  • be able to segregate the market
  • make sure that buyers cannot resell the original
    product or services.
  • Perfect price discrimination is a price
    discrimination that extracts the entire consumer
    surplus by charging the highest price that
    consumer are willing to pay for each unit.
  • As a result, the demand curve becomes the MR
    curve for a perfect price discriminator. Firms 
    capture the entire consumer surplus and maximize
    economic profit.

12
Monopolistic Competition
Monopolistic competition refers to a market
situation with a relatively large number of
sellers offering similar but not identical
products. Examples are fast food restaurants and
clothing stores. Characteristics 1. A lot of
firms each has a small percentage of the total
market. 2. Differentiated products variety of
the product makes this model different from pure
competition model. Product differentiated in
style, brand name, location, advertisement,
packaging, pricing strategies, etc. 3. Easy entry
or exit. Demand Curve The firms demand curve is
highly elastic, but not perfectly elastic. It is
more elastic than the monopolys demand curve
because the seller has many rivals producing
close substitutes it is less elastic than pure
competition, because the sellers product is
differentiated from its rivals.
13
Profit - Maximizing Output
The MR MC rule will give the firms the profit
maximizing output. The price they charge would be
on the demand curve. In the long run, the
situation will tend to be breaking even for
firms. Firms can enter the industry easily and
will if the existing firms are making an economic
profit. As firms enter the industry, the demand
curve facing by an individual firm shift down, as
buyers shift some demand to new firms until the
firm just breaks even. If the demand shifts below
the break-even point, some firms will leave the
industry in the long run. Therefore, most
monopolistic competitive firms should experience
break-even in the long run theoretically. In
reality, some firms experience profit as they
able to distinguish themselves from the others
and build a loyal customer base such as some
name brand apparel companies. Some firms
experience lost in long run but may continue the
business as they are still earning normal profit.
These firm owners usually like the flexible life
style and willing to earn a normal profit that is
lower than their opportunity cost.  Price
exceeds marginal cost in the long run, suggesting
that society values additional units which are
not being produced. Average costs may also be
higher than under pure competition, due to
advertising cost involved to attract customers
from competitors. The various types, styles,
brands and quality of products offers consumers
choices. However, economic inefficiency is the
result. The excess capacity (producing at the
quantity that a firm produces is less than the
quantity at which ATC is a minimum) exists in
this industry.
14
Oligopoly
Oligopoly exits where few large firms producing a
homogeneous or differentiated product dominate a
market. Examples are automobile and gasoline
industries. Characteristics 1. Few large firms
each must consider its rivals reactions in
response to its decisions about prices, output,
and advertising. 2. Standardized or
differentiated products. 3. Entry is hard
economies of scale, huge capital investment may
be the barriers to enter. Demand Curve Facing
competition or in tacit collusion, oligopolies
believe that rivals will match any price cuts and
not follow their price rise. Firms view their
demands as inelastic for price cuts, and elastic
for price rise. Firms face kinked demand curves.
This analysis explains the fact that prices tend
to be inflexible in some oligopolistic
industries.
15
Efficiency Advertisement
  • Productive efficiency occurs where P min ATC.
  • Monopolistic competitive firms will not achieve
    productive efficiency as firms will produce at an
    output which is less than the output of min ATC.
    Product differentiation is the major cause of
    excess capacity.
  • 2. Allocative efficiency occurs where P MC.
  • This efficiency is not achieved because price(
    what product is worth to consumers) is above MC
    (opportunity cost of product).
  • Advertisement is very crucial for each firm in
    this market structure as firms need exposure to
    get consumer's attention. However, too much
    spending will result in higher cost, and lower
    profit. Price, product attributes, and
    advertisement are three main factors that
    producers have to consider. The perfect
    combination cannot be forecasted easily.

16
Game Theory Cartel
Game theory suggests that collusion is beneficial
to the participating firms. Collusion reduces
uncertainty, increases profits, and may prohibit
entry of new rivals. Consider the following
payoff matrix in which the numbers indicate the
profit in millions of dollars for a duopoly (GM
and Ford) based on either a high-price or a
low-price strategy.  This example illustrated
that GM or Ford will earn the highest individual
profit when each adopts low price strategy while
other firm continues with the higher price
strategy (in B or C). But firms will earn the
highest total profit when both adopt the high
price strategy (A). When firms form a cartel,
they are acting as one entity (A). They will
perform as they are a large monopoly, earning the
highest total profit possible. However, members
do have an incentive to cheat as individuals can
increase their own profits by cheating in short
run (B or C). When other members are aware of the
cheating, they may carry out the same practice,
sometimes it may result in a price war and all
members loss (D).
Duopoly                             GM                             GM                             GM
 Ford   High-price         Low-price
 Ford High-price  A GM50M  Ford50M   B GM60M     Ford20M 
 Ford Low-price  C GM20M    Ford60M D GM30M  Ford30M   
Profit Analysis GM Profit Ford Profit Total profit in the industry
A Both firms adopt high price strategy Earns 50M Earns 50M 50 50 100M
B GM lowers price and Ford continues with high price strategy Increased to 60 M Dropped to 20M 60 20 80M
C Ford lowers price and GM continues with high price strategy Dropped to 20 M Increased to 60M 20 60 80M
D Both firms adopt low price strategy Earns 30M Earns 30M 30 30 60M
The Organization of Petroleum Exporting Countries
(OPEC) is a cartel. The eleven countries agreed
on the output amount and working together to
control the worlds crude oil supply. In US,
anti-trust law has set up guidelines for
corporations to follow to avoid collusion of
large firms in the same industry and protect
consumer rights.
17
Technological Development
Technological advance is a three-step process
that shifts the economys production
possibilities curve outward enabling more
production of goods and services. 1. Invention
is the discovery of a product or process and the
proof that it will work. 2. Innovation is the
first successful commercial introduction of a new
product, the first use of a new method, or the
creation of a new form of business enterprise. 3.
Diffusion is the spread of innovation through
imitation or copying. Expenditures on research
and development (RD) include direct efforts by
business toward invention, innovation, and
diffusion. Government also engages in RD,
particularly for national defense. Finding the
optimal amount of RD is an application of basic
economics marginal benefit and marginal cost
analysis. Optimal RD expenditures occur when the
interest rate cost of funds is equal to the
expected rate of return. Many projects may be
affordable but not worthwhile because the
marginal benefit is less than marginal cost.
Often the RD spending decision is complex
because the estimation of future benefits is
highly uncertain while costs are immediate and
more clear-cut.
18
The Role of Market Structure
1. Pure competition the small size of
competitive firms and the fact hat they earn zero
economic profit in the long run leads to serious
questions as to whether such producers can
finance substantial RD programs.  The firms in
this market structure would spend no significant
amount.  However, firms of the same industry may
gather their resources and develop RD
programs. 2. Monopolistic competition there is
a strong profit incentive to engage in product
development in this market structure as the firms
depend on product differentiation to stand out
from a large number of rivals. However, most
firms remain small which limits their ability to
secure inexpensive financing for RD and any
economic profits are usually temporary.
Therefore, spending on RD is limited in this
market structure. 3. Oligopoly many of the
characteristics of oligopoly are conducive to
technical advances including their large size,
ongoing economic profits, the existence of
barriers to entry and a large volume of sales.
Firms in oligopoly spent the highest amount on
RD among the four different market
structures. 4. Pure monopoly monopoly has
little incentive to engage in RD as the profit
is protected by absolute barriers to entry, the
only reason for RD would be defensive to
reduce the risk of a new product or process which
would destroy the monopoly.
19
Economic Efficiency
Economics is a science of efficiency in the use
of scarce resources. Efficiency requires full
employment of available resources and full
production. Full employment means all available
resources should be employed. Full production
means that employed resources are providing
maximum satisfaction for our material wants. Full
production implies two kinds of efficiency 1.
Allocative efficiency means that resources are
used for producing the combination of goods and
services most wanted by society. For example,
producing computers with word processors rather
than producing manual typewriters. 2. Productive
efficiency means that least costly production
techniques are used to produce wanted goods and
services. Full efficiency means producing the
"right" (Allocative efficiency) amount in the
"right "way (productive efficiency). Pure
competition Productive efficiency occurs where
price is equal to minimum average total cost (min
ATC) at this point firms must use the lease-cost
technology or they wont survive. Under pure
competition, this outcome will be achieved, as
the long run equilibrium price of pure
competitive firms would be at the min
ATC. Allocative efficiency occurs where price is
equal to marginal cost ( PMC), because price is
societys measure of relative worth of a product
at the margin or its marginal benefit. And the
marginal cost of producing product X measures the
relative worth of the other goods that the
resources used in producing an extra unit of X
could otherwise have produced. In short, price
measures the benefit that society gets from
additional units of good X, and the marginal cost
of this unit of X measures the sacrifice or cost
to society of other goods given up to produce
more of X. Under pure competition, this outcome
will be achieved. Dynamic adjustments will occur
automatically in pure competition when changes in
demand or in resources supply, or in technology
occur. Disequilibrium will cause expansion or
contraction of the industry until the new
equilibrium at PMC occurs.
20
Efficiency Cont.
Non-perfect competition Price of non-perfect
competitive firms will exceed marginal cost,
because price exceeds marginal revenue and the
firms produce where marginal revenue (MR) and
marginal cost are equal. Then the firms can
charge the price that consumers will pay for that
output level. Allocative efficiency is not
achieved because price (what product is worth to
consumers) is above marginal cost (opportunity
cost of product). Ideally, output should expand
to a level where PMC, but this will occur only
under pure competitive conditions where P MR.
Productive efficiency is not achieved because the
firms output is less than the output at which
average total cost is minimum. Economies of
scale (natural monopoly) may make monopoly the
most efficient market model in some industries.
X-inefficiency, the inefficiency that occurs in
the absence of fear of entry and rivalry, may
occur in monopoly since there is no competitive
pressure to produce at the minimum possible
costs. Rent-seeking behavior often occurs as
monopolies seek to acquire or maintain government
granted monopoly privileges. Such rent-seeking
may entail substantial cost (lobbying, legal
fees, public relations advertising etc.) which
are inefficient. There are several policy
options available when monopoly creates
substantial economic inefficiency 1. Antitrust
laws could be used to break up the monopoly if
the monopolys inefficiency appears to be
long-lasting. 2. Society may choose to regulate
its prices and operations if it is a natural
monopoly. 3. Society may simply ignore it if the
monopoly appears to be short-lived because of
changing conditions or technology. Efficiency Vs
technological advances Allocative efficiency is
improved when technological advance involves a
new product that increases the utility consumers
can obtain from their limited income. Process
innovation can lower production cost and improve
productive efficiency. Innovation can create
monopoly power through patents or the advantages
of being first, reducing the benefit to society
from the innovation. Innovation can also reduce
or even disintegrate existing monopoly power by
providing competition where there was none. In
this case economic efficiency is enhanced because
the competition drives prices down closer to
marginal cost and minimum average total cost.
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