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2015, Study Session # 4, Reading # 16

THE FIRM AND MARKET STRUCTURE


1. INTRODUCTION
 In a highly competitive market, long-run profits are decreased by the forces of competition.
 In less competitive markets, large profits can persist in the long-run.
 In the short-run, any outcome is possible

2. ANALYSIS OF MARKET STRUCTURE

2.1 Economists Four Types of Structure

Perfect
Competition

Monopolistic
Competition

Oligopoly

2.2 Factors that determine Market Structure

Monopoly

Number &
relative size
of firms

Degree of
product
differentiation

Barriers to
entry & exit

Power of
sellers over
pricing
decisions

Degree of
non-price
competition

Market
Structure

Number of
Sellers

Degree of Product
Differentiation

Barriers to
Entry

Pricing Power
of Firm

Non-Price
Competition

Firms
Demand

Non-price
competition

Allocative/
productive
efficiency

Long-run
profits

Perfect
Competition

Many

Homogeneous/Stand
ardized

Very Low

None

None

Perfectly
elastic

None

Highly efficient

Elastic over
Advertising and some price
Product
ranges and
Differentiation inelastic over
others

Considerable

Less efficient than


perfect
competition.

Monopolistic
Competition

Many

Differentiated

Low

Some

Few

Homogeneous/Stand
ardized

High

Some or
Considerable

Advertising and
Product
Differentiation

Kinked
demand

Considerable
for a
differentiated
oligopoly.

Oligopoly

Less efficient than


perfect
competition.

Positive

Monopoly

One

Unique Product

Very High

Considerable

Advertising

Inelastic

Somewhat

Inefficient

High

Porter Five Forces and Market Structure

Threat of
substitute

Threat of entry

Intensity of
competition
among
incumbents

Bargaining
power of
customers

Bargaining
power of
suppliers

3.3 Optimal Price and Output in Perfectly


Competitive Markets

3. PERFECT COMPETITION

Characteristics:
i) Free entry & exit to industry
ii) Homogenous Product
iii) Large number of buyers & sellers
iv) Sellers are price takers
v) No Price competition

Advantages:
i) High degree of competition helps in efficient
allocation of resources
ii) In the long run, firm can make only normal
profit
iii) Firms operate at maximum efficiency.
iv) Larger quantity of goods at the lowest price

 An individual firm represents a small seller among a


large number of firms in the industry.
 Firm faces infinitely elastic demand curve
 Price is determined by the market supply & demand,
which implies that shift in supply curve of a single
firm doesnt affect the market price
 Total revenue increases by a constant amount
 In perfect competition, Marginal Revenue = Avg.
Revenue = Price = Demand i.e. MR = AR = P = D

 Short-run: In the short run, firms make economic profit/loss


 Long-run: New firms enter into the industry supply increases
P Firms make normal prot

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2015, Study Session # 4, Reading # 16


3.1 Demand Analysis in a perfectly competitive Market

Impact of Elasticity on Total Revenue

3.1.1 Elasticity of Demand


When Demand is elastic
(%Qd>%P):
 P TR
 P TR

 Its the responsiveness


of quantity demanded
to change in price (all
else constant)

When Demand is inelastic:


(%  Qd < %  P)
 P TR
 P TR

 Total Revenue is Max. at point where |Ed| = 1


 Total Revenue is Max. at point where MR = 0
 Relationship b/w MR & Price elasticity

3.1.1 Elasticity of Demand

MR = P (1

 


Elastic Demand
|ED|>1

Unit Elastic
|ED| = 1

 Effect of steepness/flatness of demand & supply curve on the price elasticity


o Steeper the curve at a given point, less elastic supply or demand will be
o When curves are flat, demand & supply is referred as perfectly elastic i.e., Demand is
affected by  P. (EP = infinity)
o When curves are vertical, supply & demand curves are referred as perfectly inelastic.
(EP = 0). Demand is not affected by P.

Inelastic
Demand
|ED|<1

Determinants of Elasticity

Time Period
Longer the period
greater the
elasticity

Number & closeness


of substitutes:
Greater the number
of substitutes, more
elastic the demand

Proportion of
income taken up by
the product
Larger the
proportion, more
elastic the demand

Luxury or necessity:
E   E 

3.1.2 Other Factors Affecting Demand

Income Elasticity of
Demand:
% 

 
%  

Normal Good:
IQ d
IQ d
EY > 0

Cross Elasticity:

% 
  

%    

Inferior Goods:
IQ d
IQ d
EY < 0

Complements:
ED < 0
PY Q X
PY Q X

Substitutes:
ED > 0
PY Q X
PY Q X

3.1.3 Consumer Surplus


CS = Value Consumer places on units consumed Price paid to buy those units

3.2 Supply Analysis in Perfectly Competitive Markets

PQS

 Market Supply: Its the horizontal sum of all


individual supplies (quantity only) at each possible
price

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2015, Study Session # 4, Reading # 16


4. MONOPOLISTIC COMPETITION
4.1 Demand Analysis in Monopolistically
Competitive Markets
 Monopolistic Competition firm has a
downward sloping demand curve due to
product differentiation
 Price > MC
 Price = ATC Long-run
 MR < Price

Characteristics:
i) Many Buyers & sellers
ii) Differentiated Products
iii) Low cost Entry & Exit
iv) Firm has some control over price
v) Use of advertising & other non-price strategies
Monopolistically Competitive Firm in the Short Run:
 Profit is maximized where MR = MC
 No well defined supply schedule
 Output level is determined at a point
where MR = MC

SR-Economic Profit encourages new firm to enter the market resulting


in:
 number of products offered.
 Reduction in demand faced by firms already in the market
 Incumbent firms demand curve shift to the left.
 Demand for incumbent firms products fall, & the price declines

SR-Economics losses encourage firms to exit the market:


i) Decrease in number of products offered
ii) Increase in demand faced by remaining products.
iii) Shift the remaining firms demand curve to the right
iv) Increase the remaining firms profit

Differences between Monopolistic Competition & Perfect Competition

 In perfect competition, there is no excess capacity in


the long-run, firms produce at their efficient scale.
 In monopolistic competition, output is at less than
efficient scale of perfect competition

5.1 Demand Analysis and Pricing Strategies

 Demand depends on degree of pricing inter


dependence
 In case of price collusion, aggregate market
demand curve is composed of individual
production participants
 In case of non-collusion, each firm faces an
individual demand curve

 Duopoly: Its an oligopoly with only two


producers in the market.

 For competitive firm P = MC


 For monopolistically competitive
firm P > MC

 Unlike perfect competition, in


monopolistic competition explicit
cost include advertising or
marketing cost

5. OLIGOPOLY
Characteristics:
i) Few sellers
ii) Industry dominated by small number of large firms
iii) Product offered by each seller is close substitutes for the products offered by
other firms
iv) Independent firms
v) Barrier to entry & exit are high
vi) Firms have substantial control over price
vii) Products are differentiated through advertising & other non-price strategies.
 Price Collusion: An agreement among firms
on the quantity produced and price to
charge.
 Profit increases.
 Uncertainty of cash flows reduces.
 Provide opportunities to create barriers to
entry

 Cartel: A collusive agreement that are made


openly & formally
Factors necessary for a collusion to be successful
Small number of firms in the industry
Products produced by firms is identical/same
Similar cost structure
Orders received by firms are small in size & frequent
Severe threat of retaliation by other firms in the
market
vi) Degree of external competition.
i)
ii)
iii)
iv)
v)

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2015, Study Session # 4, Reading # 16

Pricing Strategies

Price interdependence:
 Firm pricing decisions depend on each other
 Firms face two demand curves i.e. kinked
demand curve

Cournot Assumption:
Profit maximizing output by each firm is
determined by assuming no change in other
firms output.

Nash Equilibrium:
 Game theory: Study of how people behave in strategic situations
 Nash equilibrium occurs in a non-game situation when a participant is unwilling to deviate from its
strategy having considered their opponents strategies.
5.2 Supply Analysis in Oligopoly Market

5.3 Optimal Price & Output in Oligopoly market

 No well defined supply schedule


 Output level is determined at point where
MR = MC

 There is no single optimum price & output


analysis that is appropriate for all oligopoly
market situations.
 In the long run, firms either generate
positive profits or breakeven
 Reducing prices lead to decline in total
revenue for all the firms

Dominant firm: A firm is referred to as


dominant when firms market share 40%.

Greater Capacity

Lower cost structure

First market
advantage

Greater customer
loyalty

6. MONOPOLY
Characteristics:
i) Single seller & product is highly differentiated
ii) Product offered by a firm has no close substitutes
iii) High barrier to entry
iv) Significant control over pricing (or output/supply)
v) Product is differentiated by the seller by using non-price strategies
Factors that allow Monopoly to exist:
i) Barrier to entry in the market in the form of patent or copyright
ii) Significant control over critical resources
iii) Natural monopolies exist in industries where the production is based on significant economies of scale & dealing with cost structures in the market
iv) Strong brand loyalty
v) Firm has greater market power due to increasing returns associated with network effects
6.1 Demand Analysis in Monopoly Markets

 Monopolist has downward sloping


demand curve
 Average Revenue Curve = Market
Demand Curve
 Monopolist profit is maximized at
quantity of output where MR = MC
 P = MC Perfectly competitive firms
profit-maximizing quantity of output.
 P > MR = MC at the monopolist profit
maximizing quantity of output.

6.2 Supply Analysis in Monopoly Markets

i) Price is determined by the demand curve


ii) Optimal level of quantity is determined
by the intersection of MC and MR i.e. at
QM
iii) Profit maximizing price & output exist at
the elastic portion of demand curve

 Relationship between MR & Price


elasticity in Monopoly:
MR = P [1 -

Relative to competitive industry, a


monopolist:
i) Produces a smaller quantity (QM < QC)
ii) Charges a higher price (PM > PC)
iii) Earns economic profit.




] = 

6.4 Price Discrimination and Consumer Surplus


 It refers to charging consumer different
prices for the same good

First-degree Price
Discrimination:
Each consumer is
charged highest
price that he/she
is willing to pay.

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Second-degree
Price
Discrimination:
Monopolist offers
a menu of
quantity-based
pricing options
and consumers
can select based
on high highly
they value the
product.

Third degree Price


Discrimination:
Consumers are
segregated by
demographic or
other traits.

2015, Study Session # 4, Reading # 16

7. IDENTIFICATION OF MARKET STRUCTURE

7.1 Econometric Approaches

a) Market power can be measured by estimating the elasticity of demand


& supply in a market
 Highly elastic close to perfect competition
 Inelastic Firms have market power
b) Using cross-sectional regression analysis instead of time series analysis
 Complex method
 Different specifications of explanatory variables

7.2 Simpler Measures

i) Concentration Ratio
CR = Sum of sales value of the largest x firms/ Total market sales.
 0 CR < 100%
 CR = 100% for monopoly
 CR = 0% for perfectly competitive industry
ii) Herfindahl-Hirschman Index (HHI):
 HHI = squared market share of the ith firm
 HHI = 1 Perfectly competitive industry
 For M firms in the market with equal market share:
HHI = (1/M)
 Not direct measure of market power
 less appropriate as a profitability measure as it ignores elasticity of
demand

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