Market Structures

Market Structures

Module Outline

• Introduction to Economics
• Supply, Demand, and Market Equilibrium
• Elasticity
• Theory of the Firm
• Market Structures
• Factor Markets

Market Structure Types

• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly

Introduction to Markets

• Market Definition: Any arrangement that facilitates the buying or selling of a good or service.
• The market is a concept or model, not necessarily a specific place.
• Markets can be broadly or narrowly defined (e.g., food market vs. fast food market in Dublin).
• Examples of market definitions:
  • Fast food market
  • Fast food market in Ireland
  • Fast food market in Dublin (Blanchardstown)
  • Gourmet fast food (e.g., Gourmet Burger)
  • Restaurants – Vegan restaurants
  • Restaurants in Dublin vs. restaurants in Blanchardstown
  • Indian take away – McDonalds – Burger King…local chip shop…
• The type of market impacts a firm's success.
• Key factor: Degree of competition.

Market Power, Categories, and Characteristics

• Markets are divided based on the level of competition and market power of individual firms.
• Market power is the degree of control a firm has over the market price.
• Four broad categories:
  • Perfect competition
  • Monopolistic competition
  • Oligopoly
  • Monopoly
• Characteristics to consider:
  • Number of firms in the market
  • Product differentiation (homogeneous vs. heterogeneous)
  • Information available to market participants
  • Freedom of entry and exit (barriers to entry)

Market Structure Spectrum

• Perfect Competition ---------------------- Monopolistic Competition ---------------------- Oligopoly ---------------------- Monopoly
• Perfect competition is at one end, monopoly at the other.
• Both are extreme examples.

Perfect Competition

• Useful starting point, but difficult to find real-world examples.
• Some close examples are markets for raw materials and agricultural products.
• Used as a benchmark to describe other market structures and efficiency.

Perfect Competition Characteristics

• Large number of firms, each with a negligible output compared to the market.
• Firms are price takers and cannot influence the price.
• Homogeneous product: Product is identical across all firms and recognized as such by consumers.
• Perfect information: Consumers know market prices, and firms know competitors' actions.
• Complete freedom of entry and exit from the market.

Perfect Competition: Supply and Demand

• Equilibrium is achieved where supply and demand intersect.
• Example: Market for apples reaches equilibrium at a price of €10 per ton, with 29 million tons demanded and supplied.
• $D<em>0$ and $S</em>0$ represent the initial demand and supply curves.

Perfect Competition: Individual Firm

• Individual street traders in a small farmers market.
• All traders sell apples at 25c (price that provides profit, buying apples at €10 per ton).
• In a perfectly competitive market, all apple sellers charge 25c.
• Demand curve for the perfectly competitive firm is horizontal.
• Demand is perfectly elastic at a price level of 25c per apple.
• If a trader increases the price to 27c, demand will drop to zero.
• If a trader reduces the price to 23c, they will sell all the apples, but other traders will match that price until there is no profit.

Perfect Competition Example: Kenyan Tea Market

• 29 million kg of tea produced per month.

• Kenyan tea market = predominately small tea producers (farms) whose product is then sold at auction where growers are price takers.

• Average farm produces 35kg of tea per month.

• Price of tea is set by the market at $3.31.

• Diagram 1: Market demand and supply for Kenyan tea.

• Diagram 2: Individual demand curve for a Kenyan farmer who maximizes profit by producing 35 kg per month (where marginal cost = marginal revenue).

• $MC$ = Marginal Cost

• $MR$ = Marginal Revenue (same as price in this case)

• $AR$ = Average Revenue

Perfect Competition: Marginal and Average Revenue

• Marginal Revenue: Change in revenue from producing and selling one more unit.
• $MR = \frac{\Delta TR}{\Delta Q}$
• Average Revenue: Total revenue divided by the quantity sold.
• $AR = \frac{TR}{Q}$
• Key point: In a perfectly competitive market, Marginal revenue = Price = Average revenue.
• $TR = P \cdot Q$

Kenyan Tea Market Example: Increase in Demand

• Increase in world demand shifts market demand curve to the right (market demand is now 31 million Kg).
• Market price increases to $3.49 per Kg.
• To maximize profits, individual tea suppliers will increase production to the point where marginal cost equals marginal revenue - the output per farmer increases to 37 Kg per month - in the short run.
• $D<em>0$ and $S</em>0$ represent the initial demand and supply curves.
• In the long-run the increase in supply will cause a reduction in market price.

Perfect Competition: Revenue Example

• Firm is a price taker.


• AR = TR/Q


• TR = P*Q


• MR = ΔTR/ΔQ


• Table:
  

• First condition: MR = SMC (Short-run marginal cost)
• Second condition: P >= SAVC (Short-run average variable cost) - Firm must cover its short-run variable costs.
• Output decision in short-run
• First condition: MR = LMC (Long-run marginal cost)
• Second condition: P >= LAC (Long-run average cost) - Firm must cover all costs.
• Output decision in long run

Perfect Competition: Four Scenarios

• Four scenarios a firm faces in relation to its output decision:
  • Producing at a Supernormal profit
  • Producing at a normal profit
  • Producing at a loss
  • Shutdown

Perfect Competition: Supernormal Profit

• Price is above the SATC (Short-run average total cost).
• First condition for production met at Q* where MR = SMC.
• AR curve is above the SATC curve – the firm is making a supernormal profit.
• Supernormal profit per unit = distance between the SATC curve and the AR curve at Q* = line segment XY
• Shaded area = area of supernormal profits

Perfect Competition: Normal Profit

• Profit maximizing output is Q*, where MR = SMC.
• The AR curve is tangent to the SATC curve.
• At this point, the firm is making a normal profit.

Perfect Competition: Loss

• Price is below SATC curve but above the SAVC curve.
• At Q* the firm is covering its variable costs.
• Loss = difference between Average total cost and Price = shaded rectangle, CYXP

Perfect Competition: Shutdown

• Market price is below the SAVC curve.
• Market price received does not cover the variable costs of the firm = shutdown to minimize losses

Perfect Competition: Summary of Profit Conditions

• Price intersects marginal cost above the average cost curve: supernormal profit.
• Price intersects marginal cost at the minimum point of the average cost curve: normal profit.
• Price intersects marginal cost below the average cost curve: loss.

Industry vs. Single Firm

• Industry: Price maker.
• Single Firm: Price taker.
• Short run: Firms can make supernormal profits.
• Long run: New firms enter, shifting the supply curve, and profits normalize.
• If firms are earning positive economic profits then new companies will want to enter the Industry.
• New firms = shift in industry supply to the right = reduced market price.
• Firms will continue to enter the industry until the price is equal to average cost (Just below P’) = no incentive to enter the industry.

Monopoly

• Monopoly is another form of market structure, which is identified by the following characteristics:
  • There is only one firm (seller) in the market. In effect, the firm is the market.
  • A unique product is sold. There are no close substitutes.
  • There are barriers to entry which preclude the possibility of new firms entering, even if the monopolist is making supernormal profits.
• Examples of monopolies in Ireland ….. Many monopolies are the result of historical decisions…
• Previously protected markets have been opened up to at least some competition.
• Some have been privatised and some have become take-over targets or have entered into joint ventures with foreign firms.

Monopoly: Barriers to Entry

• Barriers to entry are the main source of monopoly power.
• Economies of scale: Minimum viable scale (MVS) is the amount of output required to produce at a cost close to competitors.
• Government regulations: Licensing agreements, patents (restrict copying for 17 years), and regulations for product quality/safety.
• Learning curve effects: Incumbents have knowledge for lower-cost production.
• Cost of exit: Factors that keep firms competing, such as labor agreements, government intervention, and emotional attachment.
• Natural monopoly: Control of a scarce physical resource.
• Legal monopoly: Laws prohibit competition (patent, trademark, copyright).

Monopoly: Examples

Monopoly: Profit Maximization

• Maximise profits where MR = MC
• Downward sloping: to sell more the monopoly must lower price.
• Output Q* sold at price P*.
• Profit per unit = XY.
• Total Profit = XYPC.
• Barriers to entry mean SNP continue unless overcome or removed, e.g. change in government regulations = no more monopoly.

Monopoly: Profit Maximization Explained

• Profit-maximizing monopoly produces output where MR = MC (same rule in perfect competition).
• Because P > ATC, the monopoly firm earns economic profit = shaded rectangle.
• Barriers to entry prevent new companies from entering, so a monopoly’s economic profit can last indefinitely.

Monopoly: Long Run Profits

• Profit-maximizing monopolist produces output level Q1, i.e. where marginal cost (MC) = marginal revenue (MR).
• Even in the long run, the monopolist makes supernormal (sometimes called Monopoly profits).
• In the perfectly competitive market supernormal profits means more firms enter = shift in supply curve and fall in price.
• Monopoly has no fear of firms entering the industry = no chance of supernormal profits disappearing.
• Then it checks that price covers average cost.
• Q1 can be sold at price P1 = excess of average costs (AC1).
• Monopoly profits = shaded areas $(P<em>1 – AC</em>1) \cdot (Q_1)$

Monopoly: Steps to Maximize Profit

• Step 1: Identify the quantity (Q₁) where MR=MC.
• Step 2: Look at demand curve to see what price to charge for Q1.
• Step 3: Identify profit.
• Step 1: Profit-Maximizing Level of Output
• Use the points on the demand curve D to calculate total revenue, and then, based on total revenue, calculate its marginal revenue curve.
• The profit-maximizing quantity will occur where MR = MC—or at the last possible point before marginal costs start exceeding marginal revenue.
• Here, MR = MC occurs at an output of 5.
• Step 2: Price to Charge
• Charge what the market is willing to pay = dotted line drawn straight up from the profit- maximizing quantity to the demand curve = profit-maximizing price. Here, P =$800.
• Note: This price is above the average cost curve, which shows that the firm is earning profits.
• Step 3: Calculate Total Revenue, Total Cost, and Profit
• Total revenue = overall shaded box = the quantity sold*price = 5 * $800 = $4000
• Bottom part of the shaded box = total costs = quantityaverage cost = 5$330 = $1650
• Larger box (total revenue) minus smaller box (total cost) = profits = $4000 - $1650 = $2350.
• Remember…. If this was a perfectly competitive market firms would (could) enter the industry (attracted by profits) = erode/reduce this profit in the long run…But…monopolist protected by barriers to entry (legal/natural)

Monopoly: Price Discrimination

• Conditions necessary for price discrimination:
  • Seller must be able to classify consumers into separate groups (remember elasticity?)
  • Markets must be separated so that the products cannot be resold (i.e. no arbitrage).
• A monopolist attempting to charge as close as possible to the maximum a consumer is willing to pay (this is called customer surplus).
• A monopolist who can practise price discrimination can increase profits, beyond what is earned by a single-price monopolist.
• Price discriminating monopolist - charges different prices to different customers for the same product for reasons other than differences in costs.
• Single price monopolist – charges the same price for the product to all customers.

Monopoly: Types of Price Discrimination

• Two types of price discrimination:
  • First degree price discrimination
    • When every consumer is charged the maximum that he or she is willing to pay, e.g. customised services.
    • The customer must believe that the product or service is unique in some way.
    • Results in higher profits as it allows the monopolist to capture all or part of the customer surplus.
  • Third degree price discrimination
    • Firm separates consumers into a small number of classes and establishes a different price for each class, e.g. business rates, student fares, night-time rates, etc.
    • Possible? Legal services?

Monopolistic Competition

• Incorporates features of both perfect competition and monopoly.
• It differs from perfect competition … Products produced are heterogeneous or differentiated = product differentiation.
• It is similar to perfect competition … Large number of firms in the market and freedom to enter and exit.

Monopolistic Competition: Product Differentiation

• Product differentiation means:
  • That the product produced by one firm is different from the products produced by the firm's competitors.
  • That in the short run, firms have some degree of market power (with respect to their own particular products/brands) = the possibility of supernormal profits.
  • But, close but not perfect substitute products or brands are always available.
• Differentiation achieved through:
  • Product design
  • Customer service
  • Packaging
  • Advertising

Monopolistic Competition: Demand Curves

• Demand curve of perfectly competitive firm is perfectly elastic = it can sell all the output it wishes at the prevailing market price.
• Demand curve of monopoly firm = market demand - can sell more output only by decreasing the price it charges.
• Demand curve of monopolistically competitive firm falls in between…

Monopolistic Competition: Short-Run Profits

• Starts like Monopoly….
• Total Revenue = ${P^<em>} \cdot {Q^</em>}$
• Total Cost = ${C^<em>} \cdot {Q^</em>}$

Monopolistic Competition: Long-Run Adjustment

• New firms = more competitors = shift in Demand curve (left) [D=AR] = firm now selling less output.
• These SNP attract new firms to the industry…
• New firms keep entering as long as SNP exists…
• SNP exist if AR > AC
• New firms keep entering as long as SNP exists…
• Super normal profit = XYPC.
• AR>AC
• The new firms shift the demand curve until AR = AC

Monopolistic Competition: Profit Maximization

• Short-run
  • Profit maximization: MC = MR
  • Output = Q
  • Price = P
  • Price (AR) > ATC = supernormal profits (area PABC)
• Long-run
  • Super-normal profits = new entrants
  • Shifts the demand curve for existing firms to the left
  • More new entrants until only normal profit is available = long run equilibrium

Oligopoly

• Oligopolistic market = small number of firms (sellers), each with some ability to affect the market price

  • Most important feature = recognition of interdependence between firms
  • Firms are said to be mutually dependent

• With few sellers, each oligopolist is likely to be aware of the actions of the others

• So, the decisions of one firm influence and are influenced by the decisions of other firms

• Strategic planning by oligopolist needs to take into account the likely responses of the other market participants.

• Products are either homogeneous or differentiated

  • Oligopolistic market products can be identical, e.g. the oil market, tin, copper, etc.
  • Or products might be differentiated, e.g. the automobile and newspaper markets

Oligopoly: Models

• No single theory of economic behaviour for oligopolist
• But, can look at two important models which differ due to assumptions made about an individual firms behaviour and its reactions to rival firm strategies
  • Collusion (Cartel)
  • Price leadership

Oligopoly: Price Leadership

• Price leadership model demonstrates a tacit (or implicit) form of collusion compared to explicit collusion of the cartel
• Based on the existence of a generally recognised dominant firm
• This firm sets price and the other firms follow
• Other firms in the market are technically free to choose whether or not to 'follow the leader‘
• BUT, their freedom is limited by the ability of the dominant firm to retaliate
• Examples of dominant firms arguably include Kellogs (breakfast cereals), Goodyear (tyres), Intel (semiconductors) and Coca Cola (soft drinks)
• Others ???

Oligopoly: Cartels

• Cartel = group of firms in a particular market who collude on price and output decisions in an effort to earn monopoly profits.
• Organisation of Petroleum Exporting Countries (OPEC)
• Results in higher prices, higher profits and lower output than would otherwise be the case
• But, cartels will often face competition from non-members who are not bound by any formal agreement
• Cartels are outlawed in most countries - to protect consumers and society
• Illegal actions of cartels difficult to investigate and successfully prosecute
• More importantly, once a cartel is formed, there is an incentive for each individual participant to cheat!

Oligopoly: Game Theory

• It is hard to predict how firms colluding will actually act
• Game theory can help understand oligopolistic behaviour.
• Game = rules, players (decision makers), strategies (actions) and payoffs (scores).
• Players try to maximise his/her own payoff

Oligopoly: Prisoner's Dilemma

• Two suspected thieves are arrested by the Gardaí
• Sergeant places the two suspects into different/ separate rooms
• Told:
  • if both confess – joint sentence = 4 years
  • If neither confess – joint sentence = 1 year
  • If one confesses and the other does not –confessors sentence quashed, while accomplice will receive 8 years
• Neither suspect knows what the others decision will be.

Oligopoly: Prisoner's Dilemma Matrix

• One-time prisoners’ dilemma game = each confesses = not the best equilibrium outcome for the prisoners!

Oligopoly: Duopoly

• Firms have a collusive agreement = decide to form a cartel
• = restrict output, raise price, and increase profits!
• Price-fixing game: Each firm can comply with the agreement or cheat by lowering its price and increasing its output (profit)
• Each firm knows that if and if it alone cheats, its profit is higher than if it complies with the agreement
• One-time game = prisoners’ dilemma. Nash equilibrium = each firm’s strategy is to cheat
• But, in a repeated game, other strategies can create a cooperative equilibrium = equilibrium in which the players cooperate = make and share the monopoly profit

Oligopoly: Duopoly Examples

• Firms must decide if they plan to advertise or not, the numbers on the following matrix represent profit in thousands.

• Firms must decide what price they plan to charge with each firm making a different amount depending on what the other firm charges, in millions of Euros.

• Two firms GM and Ford must decide between setting a High-price or Low-price strategy.

• Firms must decide if they will collude to maintain a high price or undercut.

Consequences: R&D

• Perfect competition
  • Small size of competitive firm + lack of supernormal profits in the long run = limited ability to finance substantial R&D programmes
• Monopolistic competition:
  • Strong profit incentive to engage in product development as the firm depends on product differentiation to stand out from rivals
  • But, supernormal profits are temporary and may limit spending on R&D
• Oligopoly:
  • Typically larger size of firm, potential for profits and barriers to entry may support R&D
• Pure monopoly:
  • No/little incentive to engage in R&D - profits protected by barriers to entry
  • Might see R&D as a defensive strategy to reduce the risk of a new product destroying existing monopoly

Consequences: Efficiency

• Remember, economics is a science of efficiency in the use of scarce resources!

  • 1. Allocative efficiency means that resources are used for producing the combination of goods and services most wanted by society
  • 2. Productive efficiency means that least costly production techniques are used to produce wanted goods and services.

• Full efficiency = producing the