CHAPTER 4

THE FIRM AND MARKET

STRUCTURES
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1. INTRODUCTION

Market
Structure

Degree of
Competition

Profitability

The market structure and the degree of competitiveness in the

industry affect a firms pricing and output strategy and, eventually, its
long-run profitability.

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2. ANALYSIS OF MARKET STRUCTURES

Perfect
Competition
Large number of
firms
Homogeneous
product
Single producer
unable to
influence market
prices

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Monopolistic
Competition
Large number of
firms
Product
differentiation

Oligopoly
Small number of
firms
High barriers to
entry
Nonprice
competition
Interdependence
of firms (e.g.,
retaliation)

Monopoly
Single firm
Exercises power
in pricing and
output
Restricted entry

DETERMINANTS OF MARKET STRUCTURES

Number and relative size of firms
Degree of product differentiation
Power of the seller over pricing decisions
Relative strength of barriers to market entry and exit
Degree of nonprice competition

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CHARACTERISTICS OF MARKET STRUCTURE

Barriers to
Entry

Pricing
Power of
Firm

Nonprice
Competition

Homogeneous/
Standardized

Very Low

None

None

Many

Differentiated

Low

Some

Advertising
and Product
Differentiation

Oligopoly

Few

Homogeneous/
Standardized

High

Some or
Considerable

Advertising
and Product
Differentiation

Monopoly

One

Unique Product

Very High

Considerable

Advertising

Market
Structure

Number
of Sellers

Perfect
competition

Many

Monopolistic
competition

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Degree of
Product
Differentiation

DEMAND, REVENUES, COSTS, AND PROFIT

Perfectly competitive market:
- The price is the lowest for all market structures.
- Price = Marginal revenue = Marginal cost.
- Economic profit is zero in the long run.
- Elasticity is infinite because of the abundance of substitute products and
competitors.
Monopolistic competition:
- The price is higher relative to that in a perfectly competitive market.
- Marginal revenue = Marginal cost, where the marginal cost includes the cost
of product differentiation.
- Economic profit is possible in the short run with differentiation but zero in the
long run.
- Elasticity increases as firms enter the industry, which drives the price down.

Copyright 2014 CFA Institute

DEMAND, REVENUES, COSTS, AND PROFIT

Oligopoly
- Marginal revenue = Marginal cost, where cost includes product differentiation.
- The price depends on the pricing of competitors and the assumptions made
regarding competitors reactions to price changes.
- Barriers to entry allow firms in an oligopolistic market to earn economic profits.
- Price elasticity depends on whether the price is increased (relatively inelastic)
or decreased (relatively elastic).
- Kinked demand curve
Price
MR

MC3

MC2
MC1
MR

Q
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Quantity
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DEMAND, REVENUES, COSTS, AND PROFIT

Monopoly
- Marginal revenue = Marginal cost, where marginal cost includes the cost of
differentiation.
- Monopolists sell at higher prices than other market structures.
- Barriers to entry allow the monopolist to earn economic profits.
- As long as marginal revenue is positive, demand is elastic.

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SUPPLY FUNCTIONS
Perfect
Competition
Supply curve for
the market is the
sum of individual
supply curves of
individual firms.
Long-run
marginal cost
schedule is
firms supply
curve.

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Monopolistic
Competition
No well-defined
supply function
that determines
output.

Oligopoly
No well-defined
supply function
that determines
output.

Monopoly
No well-defined
supply function.

PROFIT-MAXIMIZING PRICE AND OUTPUT

Perfect
Competition

Monopolistic
Competition

Price and output

at point at which
Marginal
revenue =
Marginal cost
Economic profit
possible in the
short run, but
zero in the long
run

Price and output

at point at which
Marginal
revenue =
Marginal cost
Economic profit
possible in the
short run, but
zero in the long
run

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Oligopoly
Cannot
determine price
and output
without
considering
pricing strategy
Consider
retaliation in
pricing and
output decision
making
Kinked demand
curve

Monopoly
Marginal
revenues =
Long-run
marginal cost

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FACTORS AFFECTING LONG-RUN EQUILIBRIUM

Perfect
Competition

Monopolistic
Competition

Economic profits
attract entrants
into the market.
Economic profit
is zero in the
long run.
Demand =
Marginal
revenue and
Average
revenue

Economic profits
attract entrants
into the market.
Economic profit
is zero in the
long run.

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Oligopoly
Long-run profits
are possible.
Profits attract
entrants.

Monopoly
The demand
curve is
negatively
sloped.
There are
sufficient
barriers to entry,
so there are no
new entrants.
The unregulated
monopoly
produces profits
in the long run.

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IDENTIFYING MARKET STRUCTURES

Methods of identifying market structures
1. Econometric approaches
- Goal is to estimate the elasticity of supply and demand.
- Issue is that only equilibrium price and quantity can be observed, not the
entire demand and supply (problem of endogeneity).
- Time-series regression analysis requires a large number of observations,
which may not be practical because the market structure may have
changed over time.
- Cross-sectional regression analysis requires a large amount of data and is
affected by specific proxies for demand.
2. Measures of concentration
- Concentration ratio
- HerfindahlHirschman Index (HHI)

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CONCENTRATION MEASURES
The concentration ratio is the ratio of
the sales of the 10 largest firms in the
industry divided by the total sales of
the industry.
- Ranges from 0 (perfect
competition) to 100 (monopoly)
- Advantages
- Easy to compute
- Disadvantages
- Does not quantify market power
- Does not consider the ease of
entry into the market
- Unaffected by mergers of the
larger competitors
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The HerfindahlHirschman Index

(HHI) is the sum of the squared
market shares of the top N
companies.
- The higher the HHI, the more
concentrated
- Advantages
- Easy to compute
- Affected by mergers of the larger
competitors
- Disadvantages
- Does not quantify market power
- Does not consider the ease of
entry into the market

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CONCLUSIONS AND SUMMARY

There are four categories of market structures: perfect competition, monopolistic
competition, oligopoly, and monopoly.
The categories differ because of the following characteristics:
- Number of producers
- Degree of product differentiation
- Pricing power of the producer
- Barriers to entry of new producers
- Level of nonprice competition

A financial analyst must understand the characteristics of market structures in order

to better forecast a firms future profit stream.
The optimal level of production in all market structures is the quantity at which
marginal revenue equals marginal cost.
Only in perfect competition does the marginal revenue equal price. In the remaining
structures, price generally exceeds marginal revenue because a firm can sell more
units only by reducing the per-unit price.
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CONCLUSIONS AND SUMMARY

The quantity and price in equilibrium differs among market structures.
- The quantity sold is highest in perfect competition, and the price in perfect
competition is usually lowest (but this depends on such factors as demand
elasticity and increasing returns to scale).
- Monopolists, oligopolists, and producers in monopolistic competition attempt
to differentiate their products so that they can charge higher prices.
- Monopolists typically sell a smaller quantity at a higher price.
Competitive firms do not earn economic profit. There will be a market
compensation for the rental of capital and of management services, but the lack
of pricing power implies that there will be no extra margins.
Although in the short run, firms in any market structure can have economic
profits, the more competitive a market is and the lower the barriers to entry, the
faster the extra profits will fade.
- In the long run, new entrants shrink margins and push the least efficient firms
out of the market.
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CONCLUSIONS AND SUMMARY

An oligopoly is characterized by the importance of strategic behavior.
- Firms can change the price, quantity, quality, and advertisement of the
product to gain an advantage over their competitors.
- Several types of equilibrium (e.g., Nash, Cournot, kinked demand curve) may
occur that affect the likelihood of each of the incumbents (and potential
entrants in the long run) having economic profits. Price wars may be started
to force weaker competitors to abandon the market.
Measuring market power is complicated, but two approaches are typically used:
- Estimating the elasticity of demand and supply econometrically.
- Using a measure based on company revenues relative to the industry
revenues with either the concentration ratio or the HerfindaHerschman
Index (HHI).

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