NORTHERN CARIBBEAN UNIVERSITY COLLEGE OF BUSINESS AND HOSPITALITY MANAGEMENT DEPARTMENT OF BUSINESS AND MANAGEMENT STUDIES ECON216: MICROECONOMICS

Handout Market Structures

A market exists where buyers and sellers negotiate the exchange of a product. An industry is made up of firms producing similar products. Market structure refers to the number and type of firms in a particular industry. Concentration ratios measure the proportion of an industrys output or employment accounted for by, say, the five largest firms.

Revenue The money received from the sale of output is called revenue.

Term Total revenue Average revenue Marginal revenue

Symbol Definition TR The income received from the sale of a given output. AR The amount received from the sale of each unit. MR The amount received from selling one extra unit.

Equation TR = AR Q AR = TR Q MR = TR Q

Profit Accountancy and economic definitions of profit are different. Economists regard normal profits as a cost of production. Revenue minus production costs equals abnormal profit : = TR TC = (AR AC) Q New classical theory assumes that firms aim to maximise profits. However, where ownership and control of a company are in separate hands, managers may have a different aim, such as sales maximisation.

Term Normal profit

Abnormal profit

Abnormal loss

Symbol Definition = 0 The minimum amount of profit the firm must receive to carry on producing (i.e. transfer income). Profits exceed the amount the firm must receive to carry on producing (i.e. economic rent, super normal profit). - Profits are below the amount the firm must receive to carry on producing (i.e. subnormal profit).

TR TC is Zero

Positive

Negative

Perfect Competition
A perfectly competitive industry is made up of a large number of small firms, each selling homogenous (identical) products to a large number of buyers. No individual customer receives preferential treatment. There are no barriers to entry of exit. Consumers and producers have perfect market knowledge. There is perfect mobility of factors of production. Each firm is a price taker, therefore MR = P(AR) and both are constant. The profit-maximising level of output occurs where marginal cost (MC) rises to equal marginal revenue (MR) i.e. when MR = MC.
Price Industry S Price Firm MC

P P D

D = AR = MR =P

0 0

Q (thousands)

0 0

Q (tens)

In the above diagram, the representative firm has to decide whether or not to produce extra units. The firm compares the cost of the marginal unit (i.e. MC) with the revenue received from its sale
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(i.e. MR). An extra unit is only worth producing if MR exceeds MC. Since MC includes an amount of normal profit, the firm maximises its profits by increasing production up to and including Q.

Supply Curves in Perfect Competition

Industry Price S D LS MC AC Price Firm

0 0

Q (thousands)

0 0

Q (tens)

In the diagram above, an increase in demand raises the market price to firm earns an abnormal profit of ( )

. In the short run the

. In the long run the entry of new firms increases

supply and the supply curve shifts to the right. Assuming constant scale economies, the price falls back to P and normal profits are restored. The MC curve shows combinations of price and quantity supplied by a firm. Therefore the MC curve is the supply curve of the firm. The addition of each firms MC curve gives the industrys short-run supply curve. The long-run supply curve (LS) shows the amount of a good supplied by the industry at different prices, allowing the number of firms and size of plant to vary.

Abnormal Losses in Perfect Competition A loss-making firm carries on production in the short run, provided that: a. It believes the situation will improve in the future. b. It can cover its variable cost.
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 In the long run, some firms making abnormal losses leave the industry, supply decreases and price rises.

In the diagrams below, the total revenue curves will shift upwards until normal profits are restored.

$ TC VC A B C TR

TC VC

J TR K L

Monopolistic Competition
Monopolistic competition is a market structure with a large number of firms producing differentiated products. There is spare capacity in the industry. Each firm is a price maker, so AR > MR and both fall the more the firms sell. There are no barriers to entry and exit. The firms are assumed to be profit maximisers and will produce where MC = MR. There will be non-price competition and possibly some price competition. The absence of barriers to entry and exit is likely to mean that profits will be earned in the long run as shown in the diagram below.

Cost/ Revenue
MC AC P/C

AR 0 Q MR Output

Oligopoly
An oligopolistic market is one that is dominated by a few firms so there is a high concentration of sales. The firms may produce identical products (perfect oligopoly) or differentiated products (imperfect oligopoly). Each firm is a price maker, so AR > MR and both fall with output. There are no barriers to entry and exit. Firms are interdependent. The behaviour of one firm will be influenced by the behaviour of its rivals. Firms may seek to maximise profits or adopt other pricing strategies. Supernormal profits are likely to be earned in the long run. Prices are likely to be stable because: a. Firms may believe that changing price will gain them no advantage this is explained by the kinked demand curve, as shown in the diagram below. b. Firms may engage in collusion.

Price

D 0 Q Quantity

Firms wishing to increase sales are likely to use non-price competition such as: a. Advertising, where firms promote information about the company or a product. Advertising aims to: i. ii. increase demand for a product. improve brand image and encourage consumer loyalty, thereby making demand more price-inelastic. iii. create separate markets for the same product so that price discrimination can take place e.g. soap powders. b. Organising promotion campaigns (e.g. free offers). c. Providing improved after-sales service.

Monopoly
A pure monopoly is a sole supplier. In this case the firm is the industry. The definition used in government policy is a firm that has at least a 25% share of the market. There are significant barriers to entry and exit. Monopolists are price makers and can set price or output for their own product. Monopolists are usually assumed to be profit makers and can set price or output for their own product. Monopolists are likely to earn supernormal profits in the long run. In the diagram below, supernormal profit equals the area (P C) Q.
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Cost/ Revenue MC

P C

AC

AR 0 Q MR Output

Comparison of Market Structures

In assessing how firms will behave in different market structures it is important to note the following: 1. Structure, including: a. the number of the firms in the industry; b. the size of the firms; c. how easy of difficult it is for firms to enter or leave the market. 2. Conduct, including: a. the influence individual firms have over the price of their products; b. the type of products produced; c. how the firms compete. 3. Performance, including: a. the type of profits firms earn in the long run; b. how efficient the firms are.

Market Structure Perfect competition Monopolistic competition Oligopoly Pure monopoly

No. of firms Nature of products Many small Many small Dominated by few large One large Homogenous Differentiated Differentiated Unique

Substitutes

Price taker/maker Taker Maker Maker Maker

Barriers to entry None None Some Complete

Many perfect Many close Few None

Above normal profits Only in the short run Only in the short run Possible in the long run Possible in the long run

Degrees of Competition The most competitive market structure is perfect competition. Imperfect competition covers market structures between perfect competition and monopoly, i.e. monopolistic competition and oligopoly. The least competitive market structure is pure monopoly. Elasticity of Demand The greater a firms market share the more price inelastic demand will be for its product. The diagram below shows the MR, AR and TR curves of an imperfectly competitive firm.

$ PED > 1

PED = 1 A PED < 1

MR $

TR

 The MR curve bisects the origin and the AR curve. To sell more output, the firm has to reduce price on the extra unit and all preceding units. Therefore, MR is always less than price. Up to Q, MR is positive, TR is rising and PED is elastic. Beyond Q, MR is negative, TR is falling and PED is inelastic. At A, PED is unitary. Total revenue is maximised at Q. Oligopolies have relatively inelastic demand and monopolies even more inelastic demand. Firms producing under conditions of monopolistic competition have relatively elastic demand. A perfectly competitive firm has perfectly elastic demand and hence a total revenue curve that increases at a constant rate.

Profit Levels The level of profit a firm earns depends on market conditions, market structure, and the firms objectives. Monopolists and oligopolists do not automatically earn supernormal profits. Given favourable market conditions, monopolists and oligopolists can earn supernormal profits in the long run due to barriers to entry. The absence of barriers to entry and exit means that firms producing under conditions of monopolistic competition and perfect competition earn normal profits in the long run. A state-run monopoly may seek to achieve allocative efficiency rather than profit maximisation.

Efficiency Allocative efficiency is achieved when a firm produces where MC = AR (marginal cost pricing). Productive efficiency exists when a firm produces at the lowest unit cost, i.e. where MC = AC. Technical efficiency is achieved when a firm produces a given quantity of output with the minimum number of inputs. X-inefficiency arises when a firm fails to produce on the lowest possible average and marginal cost curves. Perfectly competitive firms are always allocatively efficient and achieve productive and technical efficiency in the long run. Imperfectly competitive firms and monopolies are usually allocatively, productively and technically efficient. Monopolies often experience organisation slack and so are X-inefficient.

Pricing Strategies 1. Profit maximisation pricing that is, producing where MC = MR and charging the corresponding price. 2. Price discrimination this occurs when the same product is sold in different markets for different prices. A discriminating monopoly is only able to practise price discrimination if it: a. has some monopoly power and so can set price and exclude competitors. b. is able to prevent the resale of the product. c. has markets with different price elasticity of demand for the product. The monopolist adds together for both markets ( + from market A and from market B to find the MR curve and combined

). Output is fixed at the point where the

curve intersects the MC curve at Q. Q is then divided between the two markets by setting output at MC = MR in each market. Note that QA + QB = Q. Price is Price is higher in the market where demand is less elastic. 3. Cost-plus pricing this occurs when a firm adds a given percentage mark-up to average cost. A loss can be made if sales fall short of estimates. 4. Market penetration pricing this occurs when a firm reduces price to increases market share (the percentage of an industrys sales accounted for by one firm). 5. Limit pricing this occurs when a firm sets price just low enough to discourage possible new entrants. 6. Predatory pricing this occurs when a firm reduces price in the short run so as to force competitors out of the industry. 7. Skimming pricing this occurs when a firm charges a high initial price if some consumers are prepared to pay more for a new product. Eventually price is lowered to extend demand. Contestable Markets The theory of contestable markets argues that what is important is not actual but potential competition. A market is perfectly contestable when the costs of entry and exit are zero. A contestable market is one where any entry costs can be recovered on exit, i.e. there are no sunk costs. In a perfectly contestable market the threat of entry by potential rivals will ensure that the firm or firms in the industry will: a. earn normal profits. b. achieve allocative, productive and technical efficiency.
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in market A and

in market B.