MARKET STRUCTURE AND

PRICING

GROUP 6
MICHAEL DE GOMA
MICHAEL SANTOS
 PREVIEW
• meaning of markets.
• market structure and its significance.
• characteristics of the different types of market
• relationships between structure, conduct and performance.
• equilibrium conditions for different types of market in terms
• of price and output, both in graphical and algebraic terms.
• types and significance of entry and exit barriers
• different industries where different market conditions exist,
explaining their prevalence
• welfare implications regarding different forms of market.
• importance of oligopolistic markets, and examine the particular
problems relating to their analysis
 CHARACTERS OF
MARKET
 A market can be defined as a group of
economic agents, usually firms and
individuals, who interact with each other in a
buyer–seller relationship. This is fine as a
general definition but it lacks practical
applicability in defining a specific market.
 Relationships between Structure,
Conduct and Performance

 Structure: those set of variables that are relatively stable over time
and affect the behaviour of sellers and/or buyers. The way in which
markets fail to follow perfect competition conditions, depends
basically in the degree of: supply concentration, demand
concentration, product differentiation and market entrance
barriers. Also, the structure of the market will always be
determined by the nature of the product and the technology
available.
 Conduct: the way in which buyers and sellers behave, both
amongst themselves, and amongst each other. Firms choose their
own strategic behaviour, investment in research, in development,
advertising levels, collusions, etc.
 Performance: It is measured by comparing the results of firms
along the industry in efficiency terms, and different ratios are used
to assess different profitability levels. The variables considered at
this level are such as price quantity, product quality, resource
allocation, production efficiency, etc.
 Table 8.1. Characteristics of
Different Markets
MARKET NUMBER OF TYPE OF BARRIERS POWER TO NON-PRICE
STRUCTURE SELLERS PRODUCT OF ENTRY AFFECT COMPETITI
PRICE ON

Perfect Many Standardized None None None

competition

Monopolistic Many Differentiated Low Low Advertising

competition and product
differentiation

Oligopoly Few Standardization High Medium Heavy

or advertising and
Differentiated product
differentiation

Monopoly One Single product Very high High Advertising

 TYPES OF
MARKET
STRUCTURE
4 main types:
 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly
 PERFECT
COMPETITION
 Perfect Competition

 Pure or perfect competition is a theoretical market

structure in which the following criteria are met:
all firms sell an identical product (the product is a
"commodity" or "homogeneous"); all firms are
price takers (they cannot influence the market
price of their product); market share has no
influence on price; buyers have complete or
"perfect" information – in the past, present and
future – about the product being sold and the
prices charged by each firm; resources such a
labour are perfectly mobile; and firms can enter or
exit the market without cost.
 Conditions
There are five main conditions for perfect competition to exist:
1.) Many buyers and sellers - Each of these must buy or sell such a
small proportion of the total market output that none is able to have any
influence over the market price.
2.) Homogeneous product - Each firm must be producing an identical
product, for example premium unleaded petrol or skimmed milk.
3.) Free entry and exit from the market - This means that there are no
barriers to entry or exit that give incumbent firms an advantage over
potential competitors who are considering entering the industry.
4.) Perfect knowledge - Both firms and consumers must possess all
relevant market information regarding production and prices.
5.) Zero transportation costs - This means that it does not cost
anything for firms to bring products to the market or for consumers to go
to the market.
 Demand and Supply

 In order to perform either a graphical or

algebraic analysis we must consider the
determination of demand and supply
functions. It is important to distinguish
between the individual firm and the industry
as a whole.
a.) The firm’s demand function - We have just seen that under the
conditions of PC the firm will be a price-taker. This means that
each firm faces a perfectly elastic (horizontal) demand curve, at the
level of the prevailing market price.
b.) The firm’s supply function - This refers to the quantities of a
product that a firm is willing to put onto the market in a given time
period at different prices.
c.) The industry’s demand function - As explained in Chapter 3,
this can be viewed as the sum of all the individual consumers’
demand functions; graphically, these are summed horizontally.
d.) The industry’s supply function - This is obtained by summing
the supply functions of all the individual firms in the industry; this
is again a horizontal sum when represented graphically. However,
this is actually an oversimplification, since when the behaviour of
firms is aggregated this has an effect on input prices, bidding them
up.
 Graphical Analysis of
Equilibrium
 The equilibrium market price, P1, is determined
by the demand and supply functions in the
industry as a whole. The firms in the industry,
as price-takers, then have to determine what
output they will supply at that price.
 This output, q1, is where P1¼ MC, since this
will maximize profit. It is important to
distinguish between short-run and long-run
equilibrium, as will be explained.
 Short Run Equilibrium

 This price is taken by each firm

 The average revenue curve is their individual demand
curve
 Since the market price is constant for each unit sold,
the AR curve also becomes the marginal revenue
curve (MR) for a firm in perfect competition
 For the firm, the profit maximising output is at Q1
where MC=MR. This output generates a total revenue
(P1 x Q1)
 Since total revenue exceeds total cost, the firm in our
example is making abnormal (economic) profits.
Short Run Equilibrium with Perfect Competition
We can intuitively tell it makes profit because its average costs are lower than the average revenue.
To calculate the cost, see where the quantity hits the average cost line, and then draw a horizontal
line to the Y axis. Whatever area is above the cost is the profit or the loss.
Since we assume that all individual firms are profit maximizers, we take MC = MR for profit
maximization. If a company is loss-making, the rule still applies, so the loss is minimized. Similarly,
the least Total Cost is taken to maximize profit or minimize loss.
 Long Run Equilibrium

 The long run is a period of time which is sufficiently long to

allow the firms to make changes in all factors of production.
In the long run, all factors are variable and none fixed. The
firms, in the long run, can increase their output by changing
their capital equipment; they may expand their old plants or
replace the old lower-capacity plants by the new higher-
capacity plants or add new plants.
 Besides, in the long run, new firms can enter the industry to
compete the existing firms. On the contrary, in the long run,
the firms can contract their output level by reducing their
capital equipment; they may allow a part of the existing
capital equipment to wear out without replacement or sell
out a part of the capital equipment.
Long Run Equilibrium in Perfect Competition
If most firms are making abnormal profits in the short run, this encourages the entry of new
firms into the industry.
This will cause an outward shift in market supply forcing down the price.
The increase in supply will eventually reduce the price until price = long run average cost. At this
point, each firm in the industry is making normal profit.
Other things remaining the same, there is no further incentive for movement of firms in and out of
the industry and a long-run equilibrium has been established.
 Algebraic Analysis of
Equilibrium
 The graphical analysis above is useful
and illustrates many insights into the
nature of equilibrium. However,
algebraic analysis tends to be a more
powerful method when it comes to
modelling the situation and making
forecasts.
 Example; The demand equation for good X was P
= 10 - 2Q and the supply equation for good X
was P = ½Q
 To solve simultaneously, one first rewrites either
the demand or the supply equation as a function
of price. The supply curve may be rewritten as
follows: Q = 2P
 Substituting this expression into the demand
equation, one can solve for the equilibrium price:
 P = 10 -2(2P)
P = 10 – 4P
5P = 10
P=2
 The equilibrium price of good X is found to be
P2. Substituting the equilibrium price of 2 into
the rewritten supply equation for good X, one
has:
 Q = 2(2)
Q=4
Adjustment to Changes in Demand
CONSTANT-COST INDUSTRY
A perfectly competitive industry with a horizontal
long-run industry supply curve that results because
expansion of the industry causes no change in
production cost or resource prices.
INCREASING-COST INDUSTRY:
A perfectly competitive industry with a positively-
sloped long-run industry supply curve that results
because expansion of the industry causes higher
production cost and resource prices.
DECREASING-COST THEORY
A perfectly competitive industry with a negatively-
sloped long-run industry supply curve that results
because expansion of the industry causes lower
production cost and resource prices.
MONOPOLY
 Monopoly

 The term monopoly means a single seller

(mono = single and poly = seller). In
economics, a monopoly refers to a firm
which has a product without any substitute
in the market. Therefore, for all practical
purposes, it is a single-firm industry.
 However, it is preferable to define a
monopoly as being a firm that has the
power to earn supernormal profit in the
long run. This ability depends on two
conditions:
 1.) There must be a lack of substitutes for the
product. This means that any existing products are
not very close in terms of their perceived functions
and characteristics. Electricity is a good example.
 2.) There must be barriers to entry or exit. These
are important in the long run in order to prevent
firms entering the industry and competing away the
supernormal profit. We now need to examine them
in detail.
 Barriers to Entry and Exit
 These can be defined as factors that allow
incumbent firms to earn supernormal profits in the
long run by making it unprofitable for new firms to
enter the industry. It is useful to distinguish
between structural and strategic barriers.
 Structural barriers, often referred to as natural
barriers, occur because of factors outside the firm’s
control, mainly when an incumbent firm has natural
cost or marketing advantages, or is aided by
government regulations. Strategic barriers occur
when an incumbent firm deliberately deter sentry,
using various restrictive practices, some of which
may be illegal.
 Structural Barriers
 Control of essential resources - This often occurs for
geographical reasons, because of the concentration of such
resources in certain areas.
 Economies of scale and scope - If these are significant it means
that the minimum efficient scale (MES) will be large in the
industry.
 Marketing advantages of incumbents - Brand awareness and
image are very important in many industries, with consumers
being unwilling to buy unknown brands.
 Financial barriers - New firms without a track record find it more
difficult and more costly to raise money, because of the greater risk
they impose on the lender.
 Information costs - In order for a new firm to enter an industry, or
an existing firm to enter a new industry, much market research
needs to be carried out to investigate the potential profitability of
such entry. This again imposes a cost.
 Government regulations - Patent laws have already been
mentioned as a reason for blocking the entry of new firms.
 Strategic Barriers
 Limit pricing - This refers to the practice where an
incumbent tries to discourage entry by charging a low-price
before any new firm enters.
 Predatory pricing - This refers to the practice where an
incumbent tries to encourage exit, meaning drive firms out
of the industry, by charging a low price after any new firms
enter.
 Excess capacity - refers to a situation where a firm is
producing at a lower scale of output than it has been
designed for. Context: It exists when marginal cost is less
than average cost and it is still possible to decrease average
(unit) cost by producing more goods and services.
 Heavy advertising - This forces the potential entrant to
respond by itself spending more on advertising, which has
the effect of increasing its fixed costs, thus increasing the
minimum efficient scale in the industry.
 Graphical Analysis of
Equilibrium
 In the case of monopoly the firm and the industry are one
and the same thing, and therefore only one graph needs
to be drawn. The same will apply in the long run since
barriers to entry will prevent new firms from entering.
The only difference is that the relevant cost curves would
be long-run, as opposed to short-run, cost curves (LMC
and LAC instead of SMC and SAC).
 It should be noted that there is no supply curve in this
case. This is because a supply curve shows the quantities
that producers will put onto the market at different prices,
thus assuming that firms are price-takers. A monopoly on
the other hand is a price-maker
The conditions for Equilibrium in Monopoly are the same as those under
perfect competition. The marginal cost (MC) is equal to the marginal
revenue (MR) and the MC curve cuts the MR curve from below.
Algebraic Analysis of
Equilibrium
Pricing and Price Elasticity of
Demand
1 Monopolies always make large profits.
2 Monopolies have inelastic demand.
Comparison of Monopoly with
Perfect Competition
 a. Price. In monopoly the price is higher than in PC.
 b. Output. In monopoly the output is lower than in PC.
 c. Profit. There is an element of supernormal profit in
monopoly, given by the area of the rectangle BCED,
although as we have just seen this is not always the case in
monopoly. In perfect competition the price and long-run
average cost are equal, resulting in only normal profit being
made.
 The fourth factor listed was Efficiency.
 Two Types of Efficiency; Productive Efficiency and
Allocative Efficiency
 Productive efficiency - both the monopolist and the firm in PC
are achieving productive efficiency, since they both have a
constant level of LAC.
 Allocative efficiency - This refers to the optimal allocation of
resources in the economy as a whole. In order to consider this
aspect we need to introduce the concepts of consumer surplus
and producer surplus.
 a.) Consumer surplus represents the total amount of
money that consumers are prepared to pay for a certain output
over and above the amount that they have to pay for this
output.
 b.) Producer surplus, sometimes called economic rent,
represents the total amount of money that producers, meaning
all factors of production, receive for selling a certain output
over and above the amount that they need to receive to stay in
their existing use in the long run.
 Monopolistic Competition

The theory of monopolistic competition, as an intermediate

form of market structure between perfect competition and
monopoly, was originally developed by Chamberlin in 1933.
Its characteristics were summarized in the table above and
we can now examine the conditions for monopolistic
competition in more detail.
 Conditions
 There are five main conditions for monopolistic
competition to exist:
1. There are many buyers and sellers in the industry.
2. Each firm produces a slightly differentiated product.
3. There are minimal barriers to entry or exit.
4. All firms have identical cost and demand functions.
5. Firms do not take into account competitors’ behaviour in
determining price and output.
 As far as the first condition is concerned, there may be a few
large dominant firms with a large fringe of smaller firms, or
there may be no very large firms but just a large number of
small firms. Grocery retailing is an example of the first
situation, while the car repair industry is an example of the
second. In both cases there is product differentiation, and the
significance of this is that firms are not price-takers, but, rather,
have some control over market price. However, this control is
not as great as that of the monopolist for two reasons. First the
firms’ products have closer substitutes than the product of a
monopolist, making demand more elastic. The second reason is
related to the third condition above: the low barriers to entry
mean that any supernormal profit is competed away in the long
run. This also involves the fourth condition, that firms have
identical cost curves.
 Graphical analysis of equilibrium
 In the short run the equilibrium of the firm in
monopolistic competition is very similar to that
of the monopolist. Profit is again maximized by
producing the output where MC=MR.
Supernormal profit can be made, depending on
the position of the AC curve, because the
number of firms in the industry is fixed.
 The only real difference between the two situations is
that in Figure 8.9, relating to monopolistic competition,
the demand curve (and hence the MR curve) is flatter
than the demand curve in Figure 8.6 relating to
monopoly. This is because of the greater availability of
substitutes.
 In the long run, new firms will enter the industry, attracted by
the supernormal profit. This will have the effect of shifting the
demand curve downwards for existing firms. The downward
shift will continue until the demand curve becomes tangential
to the AC curve (LAC in this case), at which point all
supernormal profit will have been competed away.
Algebraic analysis of equilibrium
Comparison with perfect competition
and monopoly
 There are four areas where comparison can be made:
1. Price. This tends to be higher than in perfect competition (PC),
being above the minimum level of average cost, in both the short
run and the long run (similar to monopoly).
2. Output. This tends to be lower than in PC, since firms are using a
less than optimal scale, at less than optimal capacity (similar to
monopoly).
3. Productive efficiency. This is lower than in PC, for the reason
stated previously.
4. Allocative efficiency. There is still a net welfare loss, because
P>MC.
 It is to be noted that even though no supernormal profit is made
in the long run, neither productive nor allocative efficiency is
achieved. This has led a number of people to criticize the
marketing function of firms. This activity creates product
differentiation and is thus claimed to cause inefficiency. In
order to evaluate this argument one would also have to assess
the benefits of the marketing function in terms of increasing
customer awareness and knowledge, and reducing transaction
costs.
 Entry and exit barriers may be low rather than nonexistent, and
some firms may be more efficient than others. Thus the
relaxation of the third and fourth assumptions may result in
some firms being able to make supernormal profit in the long
run. Only the marginal firm, meaning the least efficient firm,
may in fact just be making normal profit, while all other firms
make some amount of supernormal profit, depending on their
efficiency and the level of entry and exit barriers
 Comparison with oligopoly
 It is the last assumption, regarding the independence of firms’
decision-making that has attracted the most attention from
economists. Many economists claim for example that
monopolistic competition is not really a distinct form of market
structure. This claim is based on the observation that firms are
typically faced with competition from a limited number of
neighbouring firms, with markets being segmented spatially.
Segmentation may also be in terms of product characteristics.
 Oligopoly
 An oligopolistic market structure describes the situation
where a few firms dominate the industry.
 The product may be standardized or differentiated
 Examples of the first type are steel, chemicals and paper,
while examples of the second type are cars, electronics
products and breakfast cereals. The most important
feature of such markets that distinguishes them from all
other types of market structure is that firms are
interdependent.
 Strategic decisions made by one firm affect other firms, who
react to them in ways that affect the original firm. Thus firms
have to consider these reactions in determining their own
strategies.
 Such markets are extremely common for both consumer and
industrial products, both in individual countries and on a global
basis. However, there is a considerable amount of
heterogeneity within such markets.
 Some feature one dominant firm, like Intel in computer chips;
some feature two dominant firms, like Coca-Cola and Pepsi in
soft drinks;
 Some feature half a dozen or so major firms, like airlines,
mobile phones or athletic footwear; and others feature a dozen
or more firms with no really dominant firm, like car
manufacturers, petroleum retailers, and investment banks. Of
course, in each case the number of major firms depends on
how the market is defined, spatially and in terms of product
characteristics.
 Conditions
 The main conditions for oligopoly to exist are therefore
as follows:
1. A relatively small number of firms account for the
majority of the market.
2. There are significant barriers to entry and exit.
3. There is an interdependence in decision-making.
 As far as the first condition is concerned there are a
number of measures that are used to indicate the degree
of market concentration in an industry. The easiest to
interpret are the four-firm or eight-firm concentration
ratios. These indicate the proportion of the total market
sales accounted for by the largest four or eight firms in
the industry
 A more detailed measure, though more difficult to interpret, is
the Herfindahl index. This index is computed by taking the
sum of the squares of the market shares of all the firms in
the industry
The kinked demand curve model
 This model was originally developed by Sweezy and has been
commonly used to explain price rigidities in oligopolistic
markets. A price rigidity refers to a situation where firms
tend to maintain their prices at the same level in spite of
changes in demand or cost conditions. The model assumes
that if an oligopolist cuts its prices, competitors will quickly
react to this by cutting their own prices in order to prevent
losing market share. On the other hand, if one firm raises its
price, it is assumed that competitors do not match the price
rise, in order to gain market share at the expense of the first
firm. In this case the demand curve facing a firm would be
much more elastic for price increases than for price reductions.
This results in the kinked demand curve shown below.
 This results in the kinked demand curve shown. It should be
noted that this is not a ‘true’ demand curve since it no longer
assumes that other things remain equal, apart from the price
charged by the firm. If the price charged falls below it is
assumed that other firms react to this and reduce their own
prices. We might call it an ‘effective’ demand curve.
 The model can be criticized on three main grounds
1. It takes the prevailing price as given; there is no attempt
to explain how this prevailing price is determined in the
first place.
2. It makes unrealistic assumptions regarding firms’
behaviour in terms of following price increases. It will be
seen in the next chapter that there may be good reasons
for following a price increase as well as following a
decrease
3. Empirical evidence does not generally support the
model.14 As mentioned above, in reality firms tend to
follow price increases just as much as they follow price
reductions.
 In spite of the above shortcomings the kinked demand curve
model remains a popular approach to analysing oligopolistic
behaviour. For one thing, it suggests that firms are likely to co-
operate on the monopoly price, and this fact is easily observed
in practice. We now need to turn our attention to such co-
operation.
 Collusion and cartels
 Collusion- is the term frequently used to refer to co-operative
behavior between firms in an oligopolistic market. Explicit
collusion often involves the firms forming a cartel.
 This is an agreement among firms, of a formal or informal
nature, to determine prices, total industry output, market shares
or the distribution of profits.
 The most important issues to discuss regarding cartels are first
the incentives to form them, and second the factors
determining their likely success.
1. Incentives
Firms in an oligopolistic market structure can increase profit by
forming a cartel. This is most easily explained by considering a
simple example. Let us take an industry producing a standardized
product, with just two firms; the market demand curve is P = 400 -
2Q, with each firm having a constant marginal cost of £40 and no
fixed costs.
 This situation is shown in Figure 8.12. Essentially the situation is
similar to comparing perfect competition and monopoly. If the two
firms compete in price, the price will be forced down to the level of
marginal cost.
 This is because each firm can grab 100 per cent of the market
share by undercutting the competitor, so this undercutting will
continue until supernormal profit is competed away. Obviously
the price will be £40 in this case, and the total market output
will be 180 units (from the demand equation). If the firms form
a cartel they can charge the monopoly price. In order to
determine this we have to determine the output where
MC=MR. This is done as follows:
 Thus, assuming that the profits are shared equally, each
firm can make a profit of £8,100. This is clearly
preferable to the competitive situation. At this stage we
are ignoring the more complicated situation where the
firms compete in terms of output by considering what
output the other firm will put on the market.
 Although both firms can make supernormal profit by
forming a cartel, this profit can only be sustained if the
firms agree to restrict total output. This usually involves
setting output quotas for each firm; in the above example
the quotas would be 45 units each. The enforcement of
output quotas creates a problem for cartels; each member
firm can usually profit at the expense of the others by
‘cheating’ and producing more than its output quota, thus
making the cartel unstable. We now need to consider the
factors that affect the likelihood of success of a cartel
2. Factors affecting success of a cartel
1. Number of sellers- As the number of sellers increases, individual firms
will ignore the effects of their pricing and output on other firms, since
these will be smaller. A big increase in one firm’s output will not have
as much effect on the industry price when there are a dozen firms in the
industry than when there are just two firms. Firms are more likely to
have disagreements regarding price and output strategies if there are
more firms and more likely to act independently.
2. Product differentiation- Co-operation is easier for firms if they are
producing a homogeneous or standardized product, because in this case
the firms can only compete in terms of price. With differentiated
products competition can occur over a whole array of product
characteristics.
3. Cost structures- As with differences in product, differences in cost
structures can make co-operation more difficult. Co-operation is also
more difficult in capital-intensive industries where fixed costs are a
high proportion of total costs. This is because if firms are operating at
less than full capacity it is possible to increase profits considerably by
increasing output and cutting prices.
4. Transparency- If the market is transparent it will not be
possible for a firm to undercut its competitors secretly. Cartels
may therefore take steps to publicize information regarding the
transactions of members in order to prevent them from
conducting secret negotiations. However, it may still be
possible to hide certain details of transactions, such as payment
terms, which in effect can amount to a price reduction.

 Because many of the above characteristics have not been

favorable, many cartels have proved to be unstable in practice,
and have been short-lived.
 Price leadership
 A commonly observed pattern of behaviour in oligopolistic
industries is the situation where one firm sets a price or
initiates price changes, and other firms follow the leader with a
short time lag, usually just a few days. There are various ways
in which such behaviour can occur, depending on two main
factors.
1. Product differentiation- For homogeneous products the
followers normally adjust their prices to the same level as the
leader. In the more common case of differentiated products the
price followers generally conform to some structure of
recognized price differentials in relation to the leader.
2. Type of leadership.
 There are two main possibilities:
 Dominant price leadership- refers to the situation where the
price leader is usually the largest firm in the industry. In this
case the leader is fairly certain of how other firms will react to
its price changes, in terms of their conforming to some general
price structure. This certainty may be increased by the implicit
threat of retaliation if a competitor does not follow the leader.
 Barometric- the price leader is not necessarily the largest firm,
and leaders may frequently change. There is more uncertainty
in this case regarding competitive reactions, but the leader is
normally reacting to changes in market demand or cost
conditions, and suggesting to other firms that it is in their
interests to follow the changes.
 A problem-solving approach
 The essential problem in the issue of market structure is the
determination of price and output, given the different market
conditions involved. Conclusions relating to profit and
efficiency follow from this. The starting point is always the
demand and cost functions. In some situations that the student
may face these will not be given in equation form
 The first step in that case is to derive the demand and cost
functions from the information given. Once this is done there is
a straightforward five-step procedure to solving the problem.
the following general steps are involved: