R16 The Firm and Market Structures PDF

CFA® Level I – Economics
The Firm and Market Structures
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Graphs, charts, tables, examples, and figures are copyright 2012, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
1
Contents and Introduction
1. Introduction
2. Analysis of Market Structures
3. Perfect Competition
4. Monopolistic Competition
5. Oligopoly
6. Monopoly
7. Identification of Market Structure
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2.1 Economists’ Four Types of Structures
Market: Group of buyers and sellers that are aware of each other and are able to
agree on a price for the exchange of goods and services
Four types of market structures:
3. Oligopoly
4. Monopoly
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2.2 Factors that Determine Market Structure
Five factors determine market structure:
1. The number and relative size of firms supplying the product

2. The degree of product differentiation
3. The power of seller over pricing decisions
4. The relative strength of the barriers to market entry and exit
5. The degree of non-price competition
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Characteristics of Market Structures
Perfect Monopolistic Oligopoly Monopoly
Competition Competition
Number of Sellers Many firms Many firms Few firms Single firm
Barriers to Entry Very low Low High Very high
Product Homogenous Substitutes but Close substitutes or Unique product

Differentiation differentiated differentiated
Non-price None Advertising and product Advertising and product Advertising

Competition differentiation differentiation
Price Power None Some Some to significant Considerable
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Characteristics of perfect competition:
1. There are large number of potential buyers and sellers
2. The products offered by the sellers are virtually identical
3. There are few or easily surmountable barriers to entry and exit
4. Sellers have no market-pricing power
5. Non-price competition is absent
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3.1 Demand Analysis in Perfectly Competitive Markets
• Market demand curve is downward sloping
• Q = 50 – 2P
• P= 25 – 0.5 Q
• TR = PQ = 25 Q – 0.5 Q2
• MR = 25 - QP
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Elasticity of Demand
• Price elasticity of demand depends on
 Substitutes
 Share of consumer’s budget spent on item
 Length of time within which demand schedule is being considered
• Elastic, inelastic and unitary elastic demand

 Perfectly elastic
 Perfectly inelastic
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Other Factors Affecting Demand and Consumer Surplus
• Other factors affecting demand

 Movement along the demand schedule versus shift in the demand curve
 Income elasticity of demand
 Cross-price elasticity of demand
• Consumer surplus: value minus expenditure

 Cut/paste from Demand and Supply Analysis: Introduction, Section 3.9
 Example 1
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3.2 Supply Analysis in Perfectly Competitive Markets
• When market prices increase firms supply greater quantities
• Market supply curve is the sum of the supply curves of the individual
firms
• Exhibit 5
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3.3 Optimal Price and Output in Perfectly Competitive Markets
Combine market supply and demand functions to solve for equilibrium price
and quantity
P = 25 – 0.5QD = - 2 + 0.2QS = P
Q = 38.57 and P = 5.71
Each firm is a price taker
Demand curve: P = 5.71
Example 2
Optimal Price and Output in Perfectly Competitive Markets (Cont…)
Generally cost curves are U-shaped

because of the law of diminishing
MC returns
Profit Maximized when: MR = MC
ATC Each firm will produce a quantity such

that MR = MC
P= MR = AR = D
What is the link between a firm’s
supply and the MC curve?
What is the economic profit?
3.4 Factors Affecting Long-Run Equilibrium in Perfectly Competitive Markets
If economic profit > 0 other firms will enter the

market
What will happen to the industry supply curve
What will happen to market price?
Show a typical firm’s demand curve, average total

cost curve and long-run marginal cost curve
See “Schumpeter on Innovation and Perfect

Competition”
Characteristics:
1. There are a large number of potential buyers and sellers
2. The products offered by each seller are close substitutes for the products offered
by other firms, and each firm tries to make its product look different
3. Entry into and exit from market are possible with fairly low costs
4. Firms have some pricing power
5. Suppliers differentiate their products through advertising and other non-price
strategies
4.1 Demand Analysis in Monopolistically Competitive Markets
• Downward sloping firm curve for each firm
• Profit maximizing quantity is where MR = MC
MC
ATC
MR D
4.2 Supply Analysis and 4.3 Optimal Price and Output
• Output is based on MR = MC
• Price is based on the demand curve
• Supply function is not well-defined (how is the different

from perfect competition?)
• Prices are higher and quantity is lower relative to perfect

competition
• See “The Benefits of Imperfect Competition”
4.4 Factors Affecting Long-Run Equilibrium in Monopolistically
Competitive Markets
• In the long-run economic profit will be 0
• Long-run price and quantity: Perfect competition versus monopolistic competition
MC
ATC
MR D
5. Oligopoly
Characteristics:
1. There are a small number of potential sellers
2. The products offered by each seller are close substitutes for the products offered
by the other firms and may be differentiated by brand or homogeneous and
unbranded
3. Entry into the market is difficult, with fairly high costs and significant barriers to
competition
4. Firms typically have substantial pricing power
5. Products are often highly differentiated through marketing, features and other
non-price strategies.
Temptation to collude
5.1 Demand Analysis and Pricing Strategies in Oligopoly Markets
• If firms collude  market demand is divided
• If firms do NOT collude  each firm faces an individual demand curve

and market demand curve will depend on pricing strategies
1. Pricing interdependence
2. Cournot assumption
3. Nash equilibrium
Pricing Interdependence – Kinked Demand Curve
Competitor will not follow a price increase BUT
Price will cut prices in response to a price decrease
Example: Coke and Pepsi

MC1
P = 100 Kink MC0
Model helps explain stable prices

A
Does not tell us what the price should be
MR
Q=5 Quantity
Cournot Assumption
Each firm determines profit-maximizing quantity assuming other firms’ output will not change
In the long-run, change in price or quantity will NOT increase profits
As the number of firms in an oligopoly increases, the

equilibrium point moves closer to perfect competition.
Monopoly
Cournot for Duopoly
Perfect Competition
Nash Equilibrium in a Duopoly Market
Nash equilibrium: firms arrive at an WesCo – Low Price WesCo – Low Price
equilibrium strategy after considering the 80
50
actions of other firms (interdependence); no 0
70
incentive for any firm to deviate from the
RifCo – Low Price RifCo – High Price
Nash equilibrium. Assume firms do not
cooperate (collude). WesCo – High Price WesCo – High Price
300 500
Example: WesCo and RifCo sell a similar 350 300
product. Each company can employ a high RifCo – Low Price RifCo – High Price
price strategy or a low price strategy. The
profit for each strategy is shown. What is
the Nash equilibrium? Factors that affect chances of successful collusion:
1) number and size of sellers 2) similarity of
Can both companies be better off if they products 3) cost structure 4) order size and
collude? frequency 5) retaliation and 6) degree of external
competition
5.2 Supply Analysis in Oligopoly Markets
No well defined supply function; can not determine
output and price without considering demand function
Profit maximized when MR = MC
Equilibrium price is based on the demand curve
Say we have an oligopoly market where one firm has

significantly lower cost of production than its competitors
and has 40% market share.
What quantity will be supplied by the market leader and

at what price? What quantity will be supplied by the Qty
other firms?
5.3 Optimal Price and Output and
5.4 Factors Affecting Long-Run Equilibrium
• No single optimum price and output model which works for all
oligopoly market situations
• Long-run economic profits are possible but empirical evidence suggests

that over time the market share of the dominant firm declines
6. Monopoly
Characteristics: How Monopolies are Created:
1. Single seller of a highly 1. Patent or copyright

differentiated product 2. Control over critical resources (De
2. No close substitute Beers)
3. Significant barriers to entry 3. Government authorization
4. Considerable pricing power 4. Strong brand loyalty which creates high
5. Product is differentiated through barriers to entry (Rolex)
non-price strategies such as 5. Network effect (Microsoft)
advertising
What is a natural monopoly?
6.1 Demand Analysis in Monopoly Markets
Demand curve is downward sloping
Q = 400 – 0.5P
P = 800 – 2Q
TR = 800Q – 2Q2
MR = ΔTR/ ΔQ = 800 – 4Q
AR = 800 – 2Q
6.2 Supply Analysis in Monopoly Markets
• Profit maximizing level of output is when MR = MC
• Price is based on the demand curve
• TC = 20,000 + 50Q + 3Q2
• MC = ΔTR/ΔQ = 50 + 6Q
6.3 Optimal Price and Output in Monopoly Markets
Optimal output is where MR = MC; this also the point where Δπ/ΔQ = 0
If π = -20,000 + 750Q – 5Q2, at what quantity is profit maximized?
MR = P [1 – 1/E]
Profit maximization condition: MR = MC
MC = P [1 – 1/E]
Profit maximizing price = MC / [1 – 1/E]
If MC = 75 and own price elasticity of demand = 1.5.

What is the profit maximizing price?
Natural Monopoly in a Regulated Pricing Environment
Natural monopoly: average cost of production

falls over the relevant range of consumer
demand
Left unregulated, monopoly will maximize profits

by producing the quantity for which MR = MC
Government regulation may attempt to improve

resource allocation by requiring average cost
pricing or marginal cost pricing
6.4 Price Discrimination and Consumer Surplus
• First Degree Price Discrimination: Consumer charged
maximum he is willing to pay; no consumer surplus
• Second Degree Price Discrimination: Consumer

charged differently based on how much he values
product. Example: A TI BAII Plus Professional.
• Third Degree Price Discrimination: Consumers

segregated based on demographic or other traits.
Example: Airline tickets
Example
My monthly demand for visits to the local gym is given by: Q = 25 – 5P where Q is the number of visits
per month and P is the price per visit. The gym’s marginal cost is 1 per visit.
1. Draw my demand curve
2. If the gym charged a price per visit equal to its marginal cost, how many visits would I make per
month
3. What is my surplus at this price?
4. How much could the gym charge per month for a membership fee?
Example 3
Example
Monopolists have considerable pricing power and may charge consumers in different ways. Exporters
charging higher prices for denim jeans in the international market compared to local markets is an
example of:
A. First-degree price discrimination
B. Second-degree price discrimination
C. Third-degree price discrimination
Answer: C
Third degree price discrimination occurs when customers are segregated by demographics. Dividing the customers into two groups,
local and international; and charging two different prices is an example of third degree price discrimination.
First degree of price discrimination allows a monopolist to charge each customer the highest price the customer is willing to pay.
Second degree of price discrimination is when the monopolist charges different people different prices using the quantity purchased
as an indicator of how highly the customer values the product.
6.5 Factors Affecting Long-Run Equilibrium in Monopoly Markets
• Unregulated monopolies can earn economic profits in the long-run
• For regulated monopolies there are several possible solutions

 Price = Marginal Cost
 National ownership
 Government entity which regulated authorized monopoly
 Franchise monopolistic firm through bidding war
• Example 4
7. Identification of Market Structure
• Analysts and regulators are concerned with degree of market competition
• When there is a possible merger you should consider the impact of competition
law (anti-trust law)
• Econometric approaches can be used for measuring market concentration or

market power
 Use regression to estimate elasticity of demand and supply
 What will a very inelastic demand curve indicate?
 Theoretically appealing but data is not easily available
• Simpler approaches include the N-firm concentration ratio and Herfindahl-

Hirshman Index (HHI)
N-Firm Concentration Ratio and HHI
N-Firm Concentration Ratio
• Sum of the market shares of the N largest firms
• Simple to use and understand
• Unaffected by merges among top incumbents
• Does not quantify market power
• Does not consider barriers to entry
• Does not consider elasticity of demand
Herfindahl-Hirschman Index (HHI)

• Sum of squared market shares of N largest firms in a
market (ranges from 0 to 1)
• Simple and commonly used by regulators
• Does not consider barriers to entry
• Does not consider elasticity of demand
Example 5
Summary
Perfect Monopolistic Oligopoly Monopoly
Competition Competition
Major
Characteristic
Demand Analysis
Supply Analysis
Optimal Quantity
and Price
Long-run
Other
Conclusion
• Read summary
• Review learning objectives
• Examples
• Practice problems
• Practice questions from other sources

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CFA® Level I – Economics

The Firm and Market Structures

Four types of market structures:

1. The number and relative size of firms supplying the product

Barriers to Entry Very low Low High Very high

Product Homogenous Substitutes but Close substitutes or Unique product

Non-price None Advertising and product Advertising and product Advertising

Price Power None Some Some to significant Considerable

• Elastic, inelastic and unitary elastic demand

• Other factors affecting demand

• Consumer surplus: value minus expenditure

Each firm is a price taker

Demand curve: P = 5.71

Generally cost curves are U-shaped

Profit Maximized when: MR = MC

ATC Each firm will produce a quantity such

What is the economic profit?

If economic profit > 0 other firms will enter the

What will happen to the industry supply curve

What will happen to market price?

Show a typical firm’s demand curve, average total

See “Schumpeter on Innovation and Perfect

• Profit maximizing quantity is where MR = MC

• Price is based on the demand curve

• Supply function is not well-defined (how is the different

• Prices are higher and quantity is lower relative to perfect

• See “The Benefits of Imperfect Competition”

• Long-run price and quantity: Perfect competition versus monopolistic competition

• If firms collude  market demand is divided

• If firms do NOT collude  each firm faces an individual demand curve

Example: Coke and Pepsi

P = 100 Kink MC0

Model helps explain stable prices

Does not tell us what the price should be

In the long-run, change in price or quantity will NOT increase profits

As the number of firms in an oligopoly increases, the

Profit maximized when MR = MC

Equilibrium price is based on the demand curve

Say we have an oligopoly market where one firm has

What quantity will be supplied by the market leader and

• Long-run economic profits are possible but empirical evidence suggests

1. Single seller of a highly 1. Patent or copyright

What is a natural monopoly?

Demand curve is downward sloping

• Price is based on the demand curve

• TC = 20,000 + 50Q + 3Q2

If MC = 75 and own price elasticity of demand = 1.5.

Natural monopoly: average cost of production

Left unregulated, monopoly will maximize profits

Government regulation may attempt to improve

• Second Degree Price Discrimination: Consumer

• Third Degree Price Discrimination: Consumers

• For regulated monopolies there are several possible solutions

• Econometric approaches can be used for measuring market concentration or

• Simpler approaches include the N-firm concentration ratio and Herfindahl-

Herfindahl-Hirschman Index (HHI)

• Review learning objectives

• Practice questions from other sources

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