Market Structure F

Market Structures
The Degree of Competition

Classifying markets
number of firms freedom of entry to industry nature of product nature of demand curve
The four market structures

perfect competition monopoly monopolistic competition oligopoly
Revenue Concepts
The demand for the product in the market reflects the revenue side of the firm. The concept of revenue is an important tool for price determination & the equilibrium of the firm. Revenue
Total Revenue Average Revenue & Marginal Revenue
Total & Average Revenue

Total income received by the seller from selling a given amount of the product is called Total Revenue. Total Revenue is calculated by multiplying the total output/total sales by the price at which the product is sold. [TR = Q x P]
Average Revenue is revenue earned per unit of output. Average Revenue is obtained by dividing the total revenue by the number of units sold. [AR = TR/n]
Marginal Revenue
Marginal revenue is the net revenue earned by selling an additional unit of the product. Marginal revenue is the addition made to total revenue by selling (n) units of a product instead of (n-1) where n is any given number, thus, MR = TRn TRn-1
Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price
Perfect competition onopolistic competition
Very many any / several
Unrestricted
Homogeneous (undifferentiated)
Cabbages, carrots (approximately) Builders, restaurants Cement cars, electrical appliances Local water company, train operators (over particular routes)
Unrestricted
Differentiated
Undifferentiated Oligopoly Few Restricted or differentiated
onopoly
One
Restricted or completely blocked
Unique

Unrestricted
Unrestricted
Differentiated
onopoly
One
Unique

Unrestricted
Unrestricted
Differentiated
onopoly
One
Unique

Unrestricted
Unrestricted
Differentiated
onopoly
One
Unique

Unrestricted
Unrestricted
Differentiated
onopoly
One
Unique

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Pure & Perfect Competition
Pure & Perfect Competition

PURE COMPETITION Large No of Buyers & Sellers Homogenous / Identical Products Free Entry & Exit In addition to the above, PERFECT COMPETITION has the following features
Perfect Competition
Perfect Knowledge of market Perfect Mobility of Factors of Production No Transport Cost Firms put together form an Industry under Perfect Competition
Assumptions
The firm operates in a perfectly competitive market and hence a price taker. The firm makes the distinction between the short and long run. The firms objective is to maximize profits in the short run, or to minimize loss. The firm includes its opportunity cost of operating as part of its total cost.
The consideration of opportunity cost in the coststructure of the firm is vital to the decision making model. The going market price should enables it to earn a revenue that covers not only its out-of-pocket costs, but also the opportunity cost.
Statement of projected cost for first year

Particulars
Cost of goods sold Gen. & Admin Exp Total Accounting Cost Foregone salary Foregone Returns on Investment Total Opportunity Cost Total Economic Cost
Amount ($)
300,000 150,000 450,000 45,000 5000 50,000 500,000
If revenue is $ 500,000 for the first year Accounting profit would be $ 50,000 (500,000 450,000) Economic profit would be zero because revenue = economic cost At break-even point revenue is just sufficient to cover out-of-pocket cost and opportunity cost
When a firm breaks-even in economic sense it is earning accounting profit equal to opportunity cost i.e. $ 50,000 This is normal profit If the revenue is $ 550,000 a profit of 50,000 is made (500,000 550,000) This is above normal profit or economic profit
If the revenue is $ 480,000, the economic loss is $ 20,000 (500,000 480,000) The accounting profit is $ 30,000 (480,000 450,000) The economic loss may coincide with firm earning an accounting profit.
Normal Profit, Economic Profit & Economic Loss

Normal Profit 500,000 - 450,000 - 50,000 0 Accounting profit for $ 50,000 equals opportunity cost of $ 50,000 Economic Profit 550,000 - 450,000 - 50,000 50,000 Accounting profit for $ 100,000 exceeds the opportunity cost of 50,000 Economic Loss 480,000 - 450,000 - 50,000 30,000 Accounting profit for $ 30,000 is less then the opportunity cost of $ 50,000
Revenue Accounting cost Opportunity cost Profit
Equilibrium Conditions
A Firm is said to be in equilibrium when it maximizes profits. Profits depend on the revenue & cost structures.
Equilibrium Position (Profits) =

TR = TC AR = AC MR = MC or or
Relation between AR & MR

Revenue Structure of a Firm Under Perfect Competition, AR curve is horizontal and MR curve coincides with it. Hence, P = AR = MR Under Monopoly, AR curve is a downward sloping curve and MR curve lies below AR curve.
Revenue Concepts
Perfect Competition P = AR = MR
Price 25 25 25 25 Qty 1 2 3 4 TR 25 50 75 100 AR 25 25 25 25 MR 25 25 25
Revenue Concepts
Monopoly P = AR > MR
Price 180 160 140 120 100 Qty 1 2 3 4 5 TR 180 320 420 480 500 AR 180 160 140 120 100 MR 140 100 60 20
Equilibrium Condition Perfect Competition - Monopoly

Price/Cost MC Price/Revenue/Cost MC P P=AR=MR E AR MR Q Quantity Q Quantity P=AR>MR
Short-run Conditions
Price is determined at industry level by supply and demand forces; Each firm has a horizontal demand curve at the market price; Demand, average revenue and marginal revenue curve are same; Equilibrium P = AR = MR = MC; Firms make supernormal profits.
Short-run equilibrium of industry and firm under perfect competition

P
S
MC
AC
Pe
AR AC
D = AR = MR
D O Q (millions) O Qe Q (thousands)
(a) I
ustr
( ) Firm
Loss under perfect competition

P
S
MC
AC
AC P1 AR1
D1 = AR1 = MR1
D O Q (millions) O Qe Q (thousands)
(a) I
ustr
( ) Firm
Long-run Conditions
Entry takes place, shifting supply curve to the right and price down; Super-normal profits are competed away, leading to P = AR = MR = MC = minimum LAC, OR LRAC = AC = MC = MR = AR
Long-run equilibrium under perfect competition

Profits return Supernormal profits New firms enter to normal
P
S1 Se LRAC P1 PL AR1 ARL D1 DL
D O Q (millions) O QL Q (thousands)
(a) I
ustr
( ) Firm
Perfect Competition: Short Run

The Firm in More Detail - Profits
Price/Cost
(SR)MC (SR)AC
P = AR =MR
PROFIT
Quantity
Revenue Cost
Perfect Competition: Short Run

The Firm in More Detail - Losses
Price/Cost
(SR)MC
P = AR =MR
Loss
Quantity
Revenue Cost
Long-run equilibrium of the firm under perfect competition

(LR)MC (SR)AC
LRAC
DL AR = MR
LRAC = (SR)AC = (LR)MC = MR = AR
Shut down conditions

If the firm is in a loss-making position:
It can continue the production process as long as it covers its variable cost. If it shuts down, it has to bear fixed cost. The firm should reduce costs so as to make normal profits. The concept of average cost, normal profit and average variable cost can help understand the shut-down position.
Should the firm shut down if it is making losses?

Shut-down conditions
Price/Cost SMC SAC
AC-NP
SAVC P P1 =A =M P=A =M
E
P2 P=A =M
At market price-P: the firm covers AVC but makes zero normal profit. (AC-NP) If market price falls down-P1:the firm covers only average variable cost in the short run. The firm can remain in the market as long as it is able to recover AVC. At price P1, output ON is the maximum bearable loss output in the short run. If market price falls down-P2: the firm should shut down. Shut- o oi t
N Q
Quantity
Shut down conditions

When Price/AR > AC, there are excess profits. When Price/AR = AC, there are only normal profits. When Price/AR < AC, there are losses incurred by the firm. The firms in the short-run is solely influenced by variable cost. The firm has to recover current business expenses.
Perfect Competition
Incompatibility of economies of scale with perfect competition Benefits of perfect competition
price equals marginal cost prices kept low firms must be efficient to survive
Monopoly
Monopoly
Pure Monopoly (total control) & Limited Monopoly (possibility of remote substitute/s)
Revive Starch
Single Seller producing / selling product without substitutes No Entry Monopolist can fix either price or quantity. Firm is the same as industry. Firms demand-curve is industrys demand curve
Monopoly
Downward sloping Demand curve, Demand is relatively inelastic Price = Average Revenue > Marginal Revenue Price > Marginal Cost :- economic inefficiency. The firm does not necessarily use the plant which gives lowest cost Supernormal-profits are made in the short as well as the long run.
Barriers to entry
Economies of scale Product differentiation and brand loyalty Lower costs for an established firm Ownership/control of key factors Ownership/control over outlets Legal protection Mergers and takeovers Aggressive tactics Intimidation
Monopoly
The monopolists demand curve
downward sloping MR below AR
Equilibrium price and output

Equilibrium output, where MC = MR
Price Determination
A monopoly firms ability to set its price is limited by
Demand curve for its product, and The price elasticity of demand for its product
The price elasticity of demand indicates how much more or less people are willing to buy in relation to price decrease or increase.
Price Determination
Assuming that a firms demand curve is linear, then As the price falls, the marginal revenue reaches zero, and then becomes negative. Assuming the firms marginal cost is constant in the short run. The downward sloping demand curve, the MR curve, and the constant MC curve can be plotted thus,
Profit maximising under monopoly
P = AR
P1
Forgone marginal profit
If the firm charges too high a price (i.e. P1) its MR will exceed its MC It will be foregoing some amount of marginal profit.
P* P2
If the firm sets its price MC = AVC too low, its MC will exceed its MR The firm will experience a marginal loss.
Marginal loss
MR
The firms ability to set price is further limited by the possibility of rising MC. This begins at Q Hence the monopoly firm should not set its price at the highest possible level.
MC
It should set it at the right level. The right level is MR = MC
MR
O
Using MR and MC to determine Optimal Price and Output

Q 0 1 2 3 4 5 6 7 8 9 10 11 12 P($) 180 170 160 150 140 130 120 110 100 90 80 70 60 TR 0 170 320 450 560 650 720 770 800 810 800 770 720 MR 170 150 130 110 90 70 50 30 10 -10 -30 -50 TC / Q AC 155.70 102.80 84.63 76.20 72.50 71.87 73.59 77.30 82.81 90.00 98.79 109.13 TC 100 155.70 205.60 253.90 304.80 362.50 431.20 515.10 618.40 745.30 900.00 1086.70 1309.60 MC 55.70 49.90 48.30 TR - TC T Pr -100 14.30 114.40 196.10
50.90 255.20 57.70 287.50 68.70 288.50 83.90 254.90 103.30 181.60 126.90 64.70 154.70 -100.00 186.70 -316.70 222.90 -589.60
Starting from zero output level, as the output increases, the MR associated with each unit exceeds the MC up to 6 units. Beyond this point the firm actually incurs marginal loss. However, beyond this point, total profit is still positive, but not maximum. Hence, by following MR=MC rule, a profit maximizing firm would produce 6 units per time period. To do so, it would have to set price of $120.
Monopoly

Equilibrium output, where MC = MR Equilibrium price, found from demand curve
Monopoly
Let us see how MR-MC rule underlies the monopoly pricing Here the firm would select P* because, this is the price at which customers would by Q*. Q* is the quantity the firm would want to produce because here the revenue received by selling the last unit is just equal to its cost, (MR=MC). The shaded area ABDC is total profit.
MC
P = AR
A P* = 120 C
AR MR
O
Q *= 6
Monopoly

Profit
Measuring profit
MC Total profit AC
AR
AC
AR MR
O
Qm
Monopoly

Profit
Measuring profit Supernormal profit can persist in long run
Long-run Equilibrium-Monopoly
LAC LMC
Price SMC p SAC
e
SMC P T R SAC S
S PERNORMA PROFI S [PRS ]
E
q Q
Demand/AR
MR
Quantity
Monopoly
Disadvantages of monopoly
high prices / low output: short run high prices / low output: long run lack of incentive to innovate inefficiency
Advantages of monopoly
economies of scale profits can be used for investment high profits encourage risk taking
Monopolistic Competition
Large number of Buyers & Sellers Differentiated Product, Differentiation either Real or Imaginary; Free entry & exit; Selling cost is an important feature Product differentiation make selling costs necessary. Not necessary for homogenous products under perfect competition Monopolist is notorious enough
Downward-sloping demand-curves. Demand is relatively elastic. Firms form Groups, Groups are part of Industry [Auto Industry Small car segment, Luxury car segment, SUVs, LCVs, etc. ] [Detergents Luxury soaps, detergent bars, detergent powders, liquid soaps, shampoos, etc.] Firms make supernormal profit in the short run
Short-run equilibrium of the firm under monopolistic competition
MC AC
Ps ACs
AR ! D MR
O
Qs
Long-run equilibrium of the firm under monopolistic competition
LRMC LRAC
PL
ARL ! DL MRL
O
QL
In the long-run, Price =Average Cost. Firms have plants which are too small to take full advantage of scale economies. when new firms enter, they take customers in equal proportions from all old firms all firms have same cost and demand curves, while producing different products will new firms not imitate successful old ones?
Price Discrimination
Discriminating Monopoly
The act of selling the same article produced under single control at different prices to different buyers. It is possible when the monopolist sells in different markets in such a way that it is not possible to transfer any unit of the commodity from the cheap to the dearer market.
Price discrimination means one of the following: Products with identical costs are sold in different markets at different prices The ratio of price to marginal cost differs from similar products.
Two conditions for price discrimination

Price discrimination is possible when, the two or more markets in which the product is sold must be capable of being separated, and Price discrimination is profitable when, The product in question has different elasticities in the two markets.
Types of Discrimination
Personal-based on income of the consumer
(e g doctors, lawyers, etc)
Nature of the product

(e.g branded and un-branded products, economy and premium, cinema halls, consumer notions, state v/s private universities,)
Age, sex and status of the customer

(e.g. insurance, Railway travel, air travel, cinemas & entertainment )
Types of Discrimination
Time of service (e.g. matinee shows, auto rickshaws, celcos, week days and week ends, prime time) Geographical factors (e.g. liquor, legal sanctions, prevention of reexchange) Use of the product (e.g. electricity, domestic and export market, )
Recent examples of PD
Advance reservation and advance purchase Rate differentiated on the basis of days in advance the reservation is made Flexibility to change arrangements Refundability Tie-up arrangements
Conditions for Discrimination

Market imperfections Agreement between rival sellers (direct services) Geographical / tariff barriers Differentiated products Ignorance of buyers Artificial difference between goods Elasticity of Demand
Price Discrimination
Meaning of price discrimination
First degree (rare / infrequent) Second degree (frequent) Third degree (the most common form)
First degree
Monopolist charges different prices to different buyers for each different unit of same product. It is possible only when buyers are few so that each buyer can be dealt with individually. The first degree discrimination is the most profitable for the seller, but it can be enforced only infrequently.
Second degree
A monopolist divides the whole market for his production into several sub-markets and each sub market is charged a different price. The price in each case is decided according to what the marginal buyers of the market are prepared to pay.
Second degree
The degree of the lowest price would be different in each class of market. Price discrimination is feasible when the total market is very wide with large no. of buyers having different taste, different incomes and different conditions. E.g. public utilities transport, telecos, etc.
Third degree
Most frequently encountered. The monopolist divides the total market into many sub-markets and sets different prices for its products in each market in a separate manner.
Third degree
In second degree price discrimination the price tends to be the minimum as per the marginal utility of the marginal buyer, whereas, in third degree price discrimination the price depends on the allocation of output and the demand conditions in each market. This is the most practical method.
Third-degree price discrimination

P
Revenue from a single price
P1
200
Third-degree price discrimination

P
P2 P1
Increased revenue from price discrimination A higher discriminatory price is now introduced
150
200
Profit-maximising output under third degree price discrimination
DX O MRX O O
(a) Market X
DY DX O MRX O MRY O
(a) Market X
(b) Market Y
DY DX O MRX O MRY O MRT
(a) Market X
(b) Market Y
(c) Total (markets X + Y)

MC
DY DX O MRX O MRY O MRT
(a) Market X
(b) Market Y

MC
DY DX O MRX O MRY O 3000 MRT
(a) Market X
(b) Market Y

MC
5 DY DX O MRX O MRY O 3000 MRT
(a) Market X
(b) Market Y

MC
5 DY DX O 1000 O MRX MRY O 3000 MRT
(a) Market X
(b) Market Y

MC
5 DY DX O 1000 O MRX 2000 MRY O 3000 MRT
(a) Market X
(b) Market Y

MC 9 5 DY DX O 1000 O MRX 2000 MRY O 3000 MRT
(a) Market X
(b) Market Y

MC 9 5 DY DX O 1000 O MRX 2000 MRY O 3000 MRT
(a) Market X
(b) Market Y
Oligopoly
Oligopoly
Competition amongst Few (4-5 Producers/Sellers) Key feature mutual interdependence with bulk production of the market output. Rivalry- one firm depends not only on the reaction of consumers but also the reaction of rival firms. Homogenous or Differentiated Products. Product Differentiation may vary Price Rigidity
Oligopoly
Decision-making is a complicated phenomenon. One firm cannot take any decision without taking into consideration the probable reaction of the rival firms. Difficulty for new firms to enter the market. Entry barriers are indirect in the forms of mergers, ownership & control of key factors, advantage of established firms, economies of scale, etc.
Oligopoly
Excessive expenditure on Advertisement Possible outcomes include: co-operation and collusion - the monopoly price price war - the perfectly competitive price
Classification of Oligopoly
On the basis of product differentiation Pure [OPEC] or Differentiated [Two-wheeler/4-wheeler market in India in the 80s] On the basis of entry of firms Open (free to enter) or Closed (barrier to entry)
On the basis of presence/absence of price leadership Partial (follow the leader) Ex. SBI as leader and Public Sector banks as followers pre-90 or Full (No leader-no follower)
On the basis of deliberate agreement Collusive (one common uniform price policy, a virtual monopoly) or Non-collusive (Each firm takes its own decision)
The Kinked Demand Curve under Oligopoly

D Price
P Relati el Elastic ema
Relati el I elastic ema
Q Qua tit
Oligopoly
Kinked Demand Curve
Price
D O Q
Qua tit
Point D-K shows relatively elastic demand, the firm raises the price of its product, rivals do not raise their prices; the demand for the firms product falls considerable. This is for demand curve DK above the original price OP. Point K-D shows relatively inelastic demand, the firm lowers the price of its product, rivals too will lower their prices; the demand for the firms product will not show any sizeable increase. This is for the demand curve KD below the original price OP.
Oligopoly
Kinked Demand Curve
Price
There is a sudden bend in the slope of the demand curve or the average revenue curve of the firm at point K. This sudden bend is called the
KINK. So, the oligopolist faces a kinked demand curve. Rivals immediately and quickly match price reductions but only
D
hesitantly and incompletely follow price increase, this leads to the kinked demand curve.
Qua tit
AR & MR curves under Oligopoly

AR curve is a kinked curve and MR curve is discontinuous Discontinuity depend on Number of rivals Size of rivals Differentiation of products Extent of collusion.
Kinked demand for a firm under oligopoly
Current price and quantity give one point on demand curve

P1
Q1
Kinked demand for a firm under oligopoly
D
P1
D
O Q1
Stable price under conditions of a kinked demand curve
MC2
P1
MC1
a b
O Q1
D !AR
Q
MR
Stable price under conditions of a kinked demand curve
MC2 MC1 K
P1
a b D !AR
Q1
MR
Price Determination at K
How the price is determined at point K involves the concept of an industry price leader. This is the firm that dares to break out of the pack without fearing the consequences. If the firm decides to raise its price, it assumes all other will follow. If the firm decides to lower its price, it assumes that other may follow, but will not go lower. That would trigger a price war hurting the entire industry.
Total and Per-Unit Short-Run Cost

Qt y
0 1 2 3 4 5 6 7 8 9 10 11 12
TFC TVC
100 100 100 100 100 100 100 100 100 100 100 100 100 0.00 55.7 106.6 153.9 204.8 262.5 331.2 415.1 518.4 645.3 800.0 986.7 1209.6
TC
100.0 155.7 206.6 253.9 304.8 362.5 431.2 515.1 618.4 745.3 900.0 1086.7 1309.6
TFC/Q
AFC AVC AC
TVC/Q
AFC+AV C
MC
100 50 33.33 25.0 20.0 16.67 14.29 12.50 11.11 10.00 9.09 8.33
55.7 52.8 51.3 51.2 52.5 55.2 59.3 64.8 71.7 80.0 89.7 100.8
155.70 102.80 84.63 76.20 72.50 71.87 73.59 77.30 82.81 90.00 98.79 109.13
55.70 49.90 48.30 50.90 57.70 68.70 83.90 103.30 126.90 154.70 186.70 222.90

Market Structure F

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Market Structure F

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Market Structures

The Degree of Competition

The four market structures

Total & Average Revenue

Features of the four market structures

Perfect competition onopolistic competition

Very many any / several

Undifferentiated Oligopoly Few Restricted or differentiated

Restricted or completely blocked

Features of the four market structures

Perfect competition onopolistic competition

Very many any / several

Undifferentiated Oligopoly Few Restricted or differentiated

Restricted or completely blocked

Features of the four market structures

Perfect competition onopolistic competition

Very many any / several

Undifferentiated Oligopoly Few Restricted or differentiated

Restricted or completely blocked

Features of the four market structures

Perfect competition onopolistic competition

Very many any / several

Undifferentiated Oligopoly Few Restricted or differentiated

Restricted or completely blocked

Features of the four market structures

Perfect competition onopolistic competition

Very many any / several

Undifferentiated Oligopoly Few Restricted or differentiated

Restricted or completely blocked

Features of the four market structures

erfect com et t o o o o st c com et t o

om e eous o u ffere t ate

ffere t ate oo Fe estr cte or ffere t ate

estr cte or com ete ocke

Pure & Perfect Competition

Pure & Perfect Competition

Statement of projected cost for first year

Normal Profit, Economic Profit & Economic Loss

Revenue Accounting cost Opportunity cost Profit

Equilibrium Position (Profits) =

Relation between AR & MR

Equilibrium Condition Perfect Competition - Monopoly

Short-run equilibrium of industry and firm under perfect competition

Loss under perfect competition

Long-run equilibrium under perfect competition

Perfect Competition: Short Run

Perfect Competition: Short Run

Long-run equilibrium of the firm under perfect competition

LRAC = (SR)AC = (LR)MC = MR = AR

Shut down conditions

Should the firm shut down if it is making losses?

Shut down conditions

Equilibrium price and output

Profit maximising under monopoly

Profit maximising under monopoly

It should set it at the right level. The right level is MR = MC

Using MR and MC to determine Optimal Price and Output

Equilibrium price and output

Profit maximising under monopoly

Equilibrium price and output

Profit maximising under monopoly

Equilibrium price and output

S PERNORMA PROFI S [PRS ]