Market Structures

Prof. Tarun Das, IILM, New Delhi

Contents
1. Different Market Structures
2. Perfect competition
3. Monopoly and Monopolistic competition
4. Structure-Conduct-Performance (SCP) approach
5. Review Questions

1 Different market structures

 A market is an arrangement through which buyers and sellers exchange their goods
and services, anything of value.
 Market structure is a set of characteristics that determine business environment
under which firms operate.
 Market structure is determined by:
(a) Number of sellers and buyers,
(b) Degree of product differentiation,
(c) Procedures for entry and exit of firms,
(d) Degree of contestability and rivalry of firms.

Markets Number Number Product Entry and Exit Contestability

of sellers of buyers and rivalry
Perfect Many Many Standardized Free Non-existent
competition
Monopoly Mono Poly Differentiated Blocked Nil
(single) (many)
Duopoly Duo Poly Both Restricted Exists
(two) (many)
Oligopoly Oligo Poly Both Impeded High
(a few) (many)
Monopolistic A few A few Differentiated Easy High
competition

2.1Perfect competition- basic characteristics

 Many sellers and many buyers.

 Perfectly competitive firms are price-takers.
 They sell homogeneous/standardized product
 Perfect knowledge of buyers and sellers about the market.
 No restrictions on entry and exit of firms
 Price is determined by free market forces of supply and demand.
 Despite the term “competitive”, firms do not contest others and donot act as rivals.
 Perfect competition is a utopia- real market is neither perfect nor competitive.

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2.2 Perfect competition- equilibrium conditions
1. Objective Function- Maximize Profits
P = Total Revenue – Total Cost = TR – TC= PQ – TC(Q) where P is constant.
2. First order condition, d P/dQ= 0 Þ P-MC=0 Þ P=AR=MR=MC
3.The second order and sufficient condition: 2nd derivative should be negative i.e.
d2 P/dQ2 < 0, -d(MC)/dQ <0 implying d(MC)/dQ >0,
i.e. MC must be rising, and MC>ATC
4. Break even point: P=MC=Min (ATC), There is no profit, no loss.
5. Shut down point: P=MC=Min (AVC), Loss equals total fixed cost.

Fig 2.3 Perfect Competition Equilibrium

200

150
COST (Rupees)

100

50

0
1

13

15

17
11

OUTPUT (Q)

AVC ATC MC

2.4 Review Questions- Perfect Competition

1. A firm with AVC = 10 - 0.03Q + 0.00005Q² and fixed cost of Rs.600 operates in a
perfectly competitive market.
(a) What is the marginal cost function?
(b) If the firm faces a market price of Rs.10 per unit, what would be the profit-
maximizing output and the level of profit?
(c) At what market price, will the firm shut down? What is the loss at this point?
Source: Ch-11, Q-11, p.465, Thomas and Morris.
Answer: pp.726-727, Thomas and Morris.

2.5 Answer to Q 2.4

1(a) MC = MVC = d(TVC)/dQ = d(AVC x Q)/dQ

= d(10 Q – 0.03 Q² + 0.00005 Q³ )/dQ
= 10 + 2 (- 0.03)Q + 3 (0.00005)Q²
= 10 – 0.06 Q + 0.00015 Q²

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 (b) Equilibrium condition MC=P=10
Þ 10 – 0.06 Q + 0.00015 Q² = 10
Þ 0.00015Q = 0.06 Þ Q =6/0.015=400
Profit = TR – TC = PQ- (TVC+TFC)
= 10 Q - [(10 Q – 0.03 Q² + 0.00005 Q³ )+ 600]
= 4000 – 2400- 600 = Rs.1000 (at Q=400)
(c) At shut down point MC = AVC
Þ 10 – 0.06 Q + 0.00015 Q² = 10 - 0.03Q + 0.00005Q²
Þ 0.0001 Q²= 0.03Q Þ Q=300
P = AVC (at Q=300) = Rs. 5.5, TVC=TR=5.5 x 300 =1650
Loss = TC – TR = TVC + TFC – TR = 1650+600-1650=600
3.1 Monopoly and Monopolistic Competition

1. Monopoly- Single Firm but many buyers. Unlike in the perfect competition, price is
variable and is determined by the monopolist. Entry is restricted.
Equilibrium condition MR = MC
2. Monopolistic Competition- existence of large number of small firms supplying
differentiated products to many consumers. Entry and exit of firms, as in the case of
perfect competition, is free- only difference is the product differentiation.
Equilibrium condition MR=MC for all

3.2 Peteraf’s Model on Cornerstones of Monopolistic Competition

1. Heterogeneity in factor endowments.

2. Ex-post limits to perfect competition – non-existence of perfect substitutes and perfect
imitable products and services
3. Imperfect mobility and tradability of resources and factors of production
4. Ex ante limits to competition- Advantage of locations and sites.

3.3 Review Question- Monopolistic Competition

1. A Monopoly Firm faces the following demand and average cost functions:
Q = 2600 – 100P + 0.2 Y –500 Pr
AVC = 20 – 0.07 Q + 0.0001Q²
Where Q=output, P=Price of the product,
Y=consumers income=Rs.20,000
Pr=Price of related good=Rs.2
AVC= Average variable cost.
(a) Derive MR function.
(b) Derive MC function.
(c) Find out optimal level of production and price.
Source:Ch-12, Q-15 and Q-18,pp.512-513, Thomas and Maurice. Answer: pp.729

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3.4 Answer to Q 3.3
1. (a) Q=2600–100P+0.2 Y–500Pr
=2600-100P+0.2x20000-500x2=5600-100P
Inverse Demand function P=56 – 0.01 Q
TR = P.Q=56Q- 0.01 Q²
MR = d(TR)/dQ = 56- 0.02 Q
(b) TVC = TVC.Q= (20 – 0.07 Q + 0.0001Q²)Q = 20Q-0.07Q²+0.0001Q³
MC=d(TVC)/dQ=20-0.14Q+0.0003Q²
(c ) At equilibrium MR = MC implying
Þ 56- 0.02 Q= 20-0.14Q+0.0003Q²
Þ 36+0.12Q-0.0003Q²=0
Solution gives Q=600, P=50

4.1 Structure- Conduct- Performance analysis (SCP) of Market Structures

The SCP approach argues that the behavior and therefore the performance of firms is
determined by the industrial structure in which firms operate. The following table
summarizes the basic characteristics of major market types regarding structures, strategy/
conduct, performance and equilibrium conditions.

Market type Market Structure/ Conditions on Conduct/ Strategy regarding

No. of Entry Product Price Product R&D and
firms strategy strategy advertising
(1) (2) (3) (4) (5) (6) (7)
Perfect Very large Free Standardized None Independent None
competition
Monopoly One Blocked Differentiated Independent Independent Light
Oligopoly Few Impeded Both Independent Independent Heavy
Monopolistic Large Easy Differentiated Independent Independent Heavy
competition Number
Market type Performance Equilibrium conditions
Profit Technical Progressive- Equity and
efficiency ness employment
(1) (8) (9) (10) (11) (12)
Perfect Normal Good Good Good MC=MR=P=AR
competition
Monopoly Excessive Poor Poor Poor MC=MR=P (1-1/Ep)
Oligopoly Excessive Poor Poor Poor MC=MR for all
Monopolistic Fair Good Fair Fair MC=MR=P (1-1/Ep)
competition

4.2 Critique of the SCP Approach

The structure-conduct-performance (SCP) approach argues that the industrial structure

determines the behaviour and performance of individual firms. Many economists have
challenged the SCP approach since there may well be reverse causal links.

(a) Complex Relations- The causality from structure to conduct to performance is

not uni-directional and is much more complex.

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(b) Contestable Markets- SCP emphasizes the role of price setting for making
profits. But Baumol argues that profits actually depend on the degree of
contestability i.e. the ease with which the firms can enter and exit.
(c) Chicago school (Milton Friedman)- There is no significant degree of monopoly
power. In the long run, markets will bring competition in the absence of
government intervention.
(d) The Austrian school - Like Chicago School, it criticizes government intervention
as it leads to non-optimal and inefficient allocation of resources. But it
concludes that monopoly power is a reality and not a bad thing as it encourages
cost-effectiveness and innovations and promotes growth. It says that SCP
analysis is too static.

4.3 Review Question- Market Power and SCP Approach

1. Provide a structure-conduct-performance (SCP) analysis, in a tabular
form, for perfect competition, monopoly, oligopoly and monopolistic
competition. What are the criticisms by Baumol, Chicago school and
Austrian school against the SCP analysis? Do you agree with their views?