Different Forms of Market

• Perfect Competition
• Monopoly
• Oligopoly
• Monopolistic Competition

5-1
 Characteristics of Perfect Competition

• a large number of competitors, such that no

one firm can influence the price.
• the good a firm sells is indistinguishable from
the ones its competitors sell.
• firms have good sales and cost forecasts
• there is no legal or economic barrier to its entry
into or exit from the market.

5-2
 Monopoly

• The sole seller of a good or service.

• Some monopolies are generated because of
legal rights (patents and copyrights).
• Some monopolies are utilities (gas, water,
electricity etc.) that result from high fixed
costs. These are Natural monopolies.

5-3
 Monopolistic Competition

• Monopolistic Competition: a situation in a

market where there are many firms producing
similar but not identical goods.
• Example : the fast-food industry. McDonald’s has
a monopoly on the “Happy Meal” but has much
competition in the market to feed kids burgers
and fries.
• Toothpaste firms: colgate, pepsodent etc.

5-4
 Oligopoly
• Oligopoly: a situation in a market where there are very few
discernible competitors-less concentrated than monopoly,
but more concentrated than-competitive system.
• There is still competition within an oligopoly, as in the case of
airlines. Airlines match competitor’s air fares when sharing
the same routes.
automobile companies compete as the new models come
out. One will reduce financing rates and the others will follow
suit.
• → high amount of interdependence which encourages
competition in non price-related areas, like advertising and
packaging.
• Example: Tobacco companies, soft drink companies, and
airlines are examples of an oligopoly.

5-5
 Comparison
• Prices in an oligopoly are usually lower than in
a monopoly, but higher than it would be in a
competitive market.
• Prices tend to remain stable because if one
company lowers the price too much, then the
others will do the same. This lowers the profit
margin for all the companies, but is great for
the consumer.
• Output in oligopoly would be less than in a competitive
market and more than in a monopoly.
• Most competition in oligopoly is by means of R&D(
innovation), packaging etc.
• Major barriers keep companies from joining
oligopolies: Economies of scale, access to technology,
patents, and actions of the businesses in the oligopoly.
• Oligopolies develop in industries that require a large
sum of money to start. Existing companies in
oligopolies discourage new companies because of
exclusive access to resources or patented processes,
cost advantages as the result of mass production.
 Which Model Fits Reality?
• Perfect competition is rare outside
agriculture though it fits some labor
markets.
• Monopolies are common in utilities (Gas,
Electricity, Telephone services etc.)
• Major branded companies are typically
either in oligopolistic or monopolistically
competitive industries.

5-8
 Distinguishing Characteristics :
Market Forms
Perfect Monopolistic Oligopoly Monopoly
Competition Competition

Number Many-often Several* Few* One

thousands or
of Firms
even millions

Barriers None Few Substantial yes, at least in the

short run
to Entry

Product Identical Similar but not Similar or N/A

identical Identical
Similarity

* The line between “several” and “few” is not definite

5-9
Economic Profit vs Accounting Profit
• Objective of a Firm: To maximise Profit
• However, firms tries to maximise economic profit.
• Accounting Profit: Total Revenue- Explicit Cost
• Economic Profit: Accounting Profit– Implicit Costs.
• =Accounting Profit - Implicit Costs (Opportunity costs of
resources)
• =Accounting Profit- Normal Profit
• Normal Profit : the level of profit that firms could get in
their next best alternative investment→ i.e.resources
used could have been used elsewhere and earned in
such alternative uses.

5-10
• If the firm is to stay in the industry, it would
make a profit at least sufficient to cover the
returns from alternative uses→ (normal
profit).
• If economic profit > 0→ supernormal profit
(stay in the industry)
• If economic profit < 0→ (Exit from the
industry)
 Market Forms and Economic Profits

• Under perfect competition or monopolistic

competition, economic profits become zero
because of the entry of new firms increases
market supply and lowers prices.
• Economic profits are under no pressure to shrink
under oligopoly or monopoly because entry
doesn’t occur so prices do not fall.

5-12
 How is the market price Determined?

• Market Demand:
The (horizontal) sum of individual demand curves

• Market Supply:
The (horizontal) sum of individual supply curves
 Market Supply & Demand as well as SS and DD for an individual
firm
P P
Smo
Sm1
S

po Do
p1 D1

Dm
Q Q
0 0
q1 qo
Market A typical firm
Perfect Competition:Profit Maximization in the Short Run
• An individual firm takes the market price as given; the demand each
individual firm faces is horizontal.
• MR = P: Demand
• ∏ =p.q – C(q)= TR-TC, q is the output of any firm, TR denotes Total Revenue.
• Setting FOC→ d∏/ dq =0, …………(1)

• i.e. p* - MC = 0, ………………………….(2)
• i. e. p* = MC ……………………This is FOC of profit max

• SOC:
Take differentiation of (2):
i.e. d2∏/ dq2 < 0,………………………(2)

→ -d2C/dq2 < 0, i.e d(MC)/dq > 0,

i.e MC must be rising at equilibrium.

Proposition: In the short- run, firm could have an economic profit.

 Profit Maximization in the SMC
Short Run : fig A
$
SATC

AVC
c
Pm Df , MR

b
a
Here pm <SATC,
Firm earns ∏ =cb

Q
0 Qe

Blue portion defines profit of a firm in the SR

 Profit Maximization of a firm in the SMC
Short Run: Fig B
$
SAC
P≥Min AVC

AC c
Pm D’f , MR
d

SAVC
a Demand fun faced by Here pm <SAC,
A firm
e
Greater loss in case stop
Production:ce > cd
P’m
Q
0 Qe
Vertical difference between SAC and SAVC is the SFC = ce in fig. Here the firms
incurs a loss = cd. If id stops production for this loss, it still has to incur fixed
cost=ce>cd
 Adjustments in the Long Run
• If economic profits are present new firms
will come into the industry
• The Market price will fall
• The profit shrinks
• Input prices may go up
• Firms try to stay profitable by taking
advantage of economies of scale
• Firms adopt an optimal size
• Economic profits tend toward zero
 A competitive firm’s
long-run equilibrium:
Firm varies plant size and reaches optimal size at E LATC
SAC1

SAC2
SAC4
SAC3

Pm E D

Optimal plant size, breakeven point=,

Optimal plant size is one Here p= MR =LMC=LAVC
In which SAVC is tangent to LAVC
At best level of oiutput
Q
o Qe
At point E, a firm earns zero economic profit, i.e. firm receives only a normal return
on invt or an amount equal to what it would earn by investing in alternative uses of
similar risk.
Long-Run Equilibrium under Perfect Competition
• Many “optimal-size” firms, each producing at
the minimum long run average cost and charging
the market price where:

P = MR= MC = SATC = LATC

• Allocative efficiency: MC = P
• Productive efficiency: MC= SATC = LATC
• Zero economic profit (normal profit) : P = ATC
 Pure Monopoly
• A single firm producing a homogenous or
differentiated (unique) good and facing the
market demand.
• No substitutes
• No new entries allowed
• The monopoly is a price maker
• P>MR
• Possibility of a sustained economic profit
 What circumstances lead to the
formation of a monopoly?
• Extensive economies of scale: natural monopolies
• Exclusive patent rights
• Copy rights to intellectual properties
• Government franchises
• Exclusive access to a essential resource (input)
• Cartels

A monopoly is a profit maximizer too!

 $ Demand Curve Faced by A Monopolist
a
-2b

-b

MR Dm Q
0
 Monopoly: Market Behaviour
The aim is to maximise profits MC = MR

p
MR  p  y  p
y
<0

MR lies inside/below the demand curve

Note: Contrast with perfect competition (MR = P)
 Monopoly: Equilibrium

Demand
MR y=Q
 Monopoly: Equilibrium
MC

MR Demand y
 Monopoly: Equilibrium
MC

P
AC

MR Demand y
 Monopoly: Equilibrium
MC Output Decision
MC = MR
P
AC

ym
MR Demand y
 Monopoly: Equilibrium
MC Pm = the price

P
AC

Pm

ym
MR Demand y
 Monopoly: Equilibrium
• Firm = Market
• Short run equilibrium diagram = long run
equilibrium diagram (apart from shape of cost
curves)
• At qm: pm > AC therefore you have excess
(abnormal, supernormal) profits
• Short run losses are also possible
 Monopoly: Equilibrium
MC The shaded area
is the excess
profit
P
AC

Pm

ym
MR Demand y
 Monopoly: Elasticity

TR  py  yp

WHY? Increasing output by y will have two effects on profits

1) When the monopoly sells more output, its revenue increase by py
2) The monopolist receives a lower price for all of its output
 Monopoly: Elasticity
TR  py  yp
Rearranging we get the change in revenue when output changes i.e. MR

TR p
MR   p y
y y

TR  yp 
MR   p
1 

y  py 
 Monopoly: Elasticity
TR  yp 
MR   p
1 

y  py 

1
  = elasticity of demand


TR  1
MR   p1  
y  
 Monopoly: Elasticity
Recall MR = MC, therefore,

R  1
MR   p1    MC  0
y  
Therefore, in the case of monopoly,  < -1, i.e. ||  1. The
monopolist produces on the elastic part of the demand
curve.
P> 0, e<0, hence (1-1/e) >0
Hence e >1
 The Dynamics of a Monopolistic Market
• As a profit maximizer, a monopoly may try
to take advantage of economies of scale
• A monopoly tends to try to protect its
monopolistic position
• A monopoly may take advantage of
technological advances
• A monopoly may face changes in demand
• A monopoly may try to promote its product
to maintain demand
 $
ATC>MC, P>MR, P>MC, P>ATC

SMC

P k LATC

SATC

m
n

Q
o
Qe
L-R Positive Economic Profit MR