Managerial

Economics
Market Structures
May-June 2019
Market Morphology

➢ Nature of Competition – number,

● Defined as the institutional relationship
between buyers and sellers.
● Market refers to the interaction
between buyers and sellers of a good
(or service) at a mutually agreed upon
price.
● Such interaction may be at a particular
place, or may be over telephone, or
even through the Internet!
● Sellers and buyers may meet each other
personally, or may not ever see each
other, as in E-commerce.
size and distribution of sellers.
➢ Nature of Product – homogeneous
or differentiated
➢ Number and size of Buyers-
numbers, size and distribution of
buyers
➢ Freedom to exit or enter the
market – technological, legal and
financial constraints to enter or exit
the market

Thus market may be defined as a place, a

function, a process.
Market Morphology- contd

Type of market Number Nature of Number Freedom of Examples

of firms product of entry and
buyers exit
Perfect V e r y Homogeneous V e r y Unrestricted Agricultural
competition Large (undifferentiated) Large commodities,
unskilled labour

Monopolistic Many Differentiated Many Unrestricted Retail stores,

competition FMCG
Oligopoly Few Undifferentiated Few Restricted C a r s ,
or differentiated Computers,
universities
Monopoly Single Unique Many Restricted I n d i a n
Railways,

Monopsony Many Undifferentiated Single N o t Indian defence

or differentiated applicable industry
Different Market Structures

In terms of market power, monopolistic competition and oligopoly are somewhere

between the two extremes of perfect competition and monopoly.

From a pedagogical standpoint, it is easier to understand and appreciate the

particulars of monopolistic competition and oligopoly if there is first a thorough
understanding of perfect competition and monopoly
Perfect Competition

Perfect Competition
The Markets for agricultural products (e.g., corn, wheat, coffee, pork bellies),
financial instruments (e.g., stocks, bonds, foreign exchange), and precious metals
(e.g., gold, silver, platinum).

In each market, the products are standardized commodities, and supply and demand
are clearly the primary determinants of their market price.
Demand and Revenue in a Perfect Competition

● Following the assumption of rationality, all firms aim at maximisation of

profits.
● In perfect competition, since firms are price takers, all they can change is
quantity.
● So, to arrive at what quantity a firm will be ready to supply, we will need to
use the concepts of costs.
Profit, Revenue and Cost Curves of a FIrm

TC
● Profit (Π) = TR - TC.
Revenue, TR
Cost, B ● Profit curve (Π) begins from the
Profit negative axis, implying that the
firm incurs losses at an output less
Profit than OQ1.
Loss ● At point A, i.e. output Q1 firm
A
earns no profit no loss.
● Firm earns maximum profit at
Q* Q2 Output
output OQ*.
Q1
O
● At point B, TR=TC again; profit is
Maximum equal to zero, at output OQ2.
Profit
● Rational firm would try to
O
maximise profit.
Q1 Q* Q2 Output
Π
Profit is maximised when MR=MC
Market Demand Curve and Firms Demand Curve

● Market equilibrium is at the point of intersection (E) of the market demand and
market supply curves, where equilibrium output for the industry is given at Q*
and price at P*.
● Each perfectly competitive firm, being a price taker, takes the equilibrium
price from the market as given at P*.

INDUSTRY FIRM
Market
Demand Market
Price S Price
Supply
D

E P=AR=MR
P*

S
D
O Q* O
Output Output
Long Run Price and Output for the Industry and the Firm

● In the long run perfectly competitive firms earn only normal profits.
AR=MR=MC=AC
● The reason is the unrestricted entry into and exit of firms from the industry
in the long run.
● When existing firms enjoy supernormal profits in the short run new firms
are attracted to the industry to gain profits.
● The supply of the commodity in the market increases. Assuming no
change in the demand side, this lowers the price level.
● When firms are making losses in the short run, some may be forced to leave
the industry in the long run.
● Their exit from the industry causes a reduction in the supply of the
product and as a result the equilibrium price rises.
● This process of adjustment continues up to the point where the price line
becomes tangential to the AC curve.
Monopoly

Monopoly
Examples of a pure monopoly are not easy to find. Some years ago, good examples
could be found among government-sanctioned and regulated monopolies in the
telecommunications and gas and electric industries.

Patent laws sometimes provide companies with temporary monopolies. The

pharmaceutical industry can definitely be said to earn economic profit during the
time in which its products are protected by patents.
Monopoly

▪ A monopoly (from the Greek word “mono” meaning single and “polo” meaning
to sell) is that form of market in which a single seller sells a product (good or
service) which has no substitute.
▪ Monopoly exists when there is no close substitute to the product and also
when there is a single producer and seller of the product
▪ E.g. Indian Railway is a monopoly, since there is no other agency in the
country that provides railway service.
▪ Pure monopoly is that market situation in which there is absolutely no
substitute of the product, and the entire market is under control of a single
firm.
Demand and MR Curves

Revenue,
Cost • The demand curve of the monopolist
is highly price inelastic because there
is no close substitute and consumers
have no or very little choice.
• It is not perfectly inelastic
because pure monopoly does not
exist in real life.
• Hence it faces a normal
AR
MR downward sloping demand (AR)
O
Quantity curve.
Downward Sloping Demand Curve for Monopoly

A steeper AR: Relatively higher monopoly power.

A horizontal AR: Relatively lower monopoly power.

The downward slope of the demand of monopoly represents that the monopolist
will have to decrease the price for generating higher demand.
Price and Output Decisions in the Short Run

AR>AC
Price,
Revenue, MC
• The monopolist cannot set both Cost
price and quantity at its own will. B AC
PE
• In order to maximize profit a
monopoly firm follows the rule of A
MR=MC when MC is rising. E AR
• A monopoly firm may earn MR
supernormal profit or normal profit O QE Quantity
or even subnormal profit in the
short run.
• The negative slope of the demand Firm maximizes profit where
(i) MR=MC (ii) MC cuts MR from below, at
curve is instrumental for chances of
point E.
monopoly profits in the short run.
Equilibrium price=OPE, Output= OQE
• In the short run, the firm would reap
Total revenue =OPEBQE
the benefits of supplying a product
which not only is unique, but also Total cost = OAEQE
has negligible cross elasticity. Supernormal profit= AEBPE,
since price (AR) > AC
Price and Output Decisions in the Long Run

• A monopolist is in full control of the market price

• It would not continue to incur loss in the long run.
• It would try to reduce cost of production
• Otherwise it would close down in the long run.
• Monopolist would try to earn at least normal profit in the long run and may
earn supernormal profit due to entry restrictions in the market.
• If in the long run a monopoly firm earns supernormal profit
• This would attract competition and high price would make it possible for a
new entrant to survive.
• To retain its monopoly power, the firm may have to resort to a low price and
earn only normal profit even in the long run to create an economic barrier to
new entrants.
Supply Curve of a Monopoly Firm

• A monopolist is a price maker

• The firm itself sets the price of the product it sells, instead of taking
the price as given.
• It equates MC with MR for profit maximization, but unlike perfect
competition, it does not equate its price to MR.
• Supply of the good by the monopolist at a given price would be determined
by both the market demand and the MC curve.
• As such, there is no defined supply curve for a monopolist.
 Comparison of four market types

In order of the competition found in the following market structures

Perfect Competition > Monopolistically Competitive > Oligopoly > Monopoly

There is no competition in the case of a monopoly market structure and the

competition is extreme in case of a perfectly competitive market structure.
Market entry and exit most directly affects the ability of a firm to earn economic
profit in the long run. In perfect competition, entry into the market is easy.
Therefore, if firms are observed to be earning economic profit, over time the
entry of new firms eager to partake in these profits quickly reduces the ability of
both incumbents and new entrants to earn economic profit
Examples of Market Types

Monopolistic Competition
Small businesses, particularly retail and service establishments, provide the best
examples of this kind of market.
Among them are boutiques, luggage stores, shoe stores, stationery shops,
restaurants, repair shops, laundries, and beauty parlors. There are many of them
in any given city or area of the city.
The start-up capital is relatively low, so it is fairly easy to start these types of
businesses. Each one tries its best to stand out among its many competitors by
differentiating its product.

● It is a market situation in which a relatively large number of producers offer

similar but not identical products.
● A combination of perfect competition and monopoly.
● Imperfect competition because a large number of sellers sell heterogeneous or
differentiated products and buyers have preferences for specific sellers.
● Monopolistic, because each of these sellers makes the product unique by some
differentiation and has control over the small section of market, just like a
monopolist.
Features of Monopolistic Competition

Chamberlin:
“Monopolistic competition is a challenge to the traditional viewpoint of
economics that competition and monopoly are alternatives…By contrast it is
held that most economic situations are composites of both competition and
monopoly.”

Features:
● Large number of buyers and sellers:..
● Heterogeneous products.
● A differentiated product enjoys some degree of uniqueness in the mind-
set of customers, be it real, or imaginary.
● Selling costs exist
● Independent decision making.
● Imperfect knowledge.
● Unrestricted entry and exit.
Price and Output Decisions in the short run.

● Firms have limited discretion over price, due to the existence of consumer
loyalty for specific brands.
● Negative slope of the demand curve that is instrumental for chances of
monopoly profits in the short run.
● The reason for supernormal profit in short run, is supplying a product which is
differentiated, or at least perceived to be different by the consumer.
Price and Output decision in the long run

● Just like perfect competition, in monopolistic competition too all the firms
would earn normal profits in the long run.
● In the long run supernormal profit would attract new firms to the industry
till all the firms earn only normal profits.
● Losses, will force firms to exit the industry till remaining firms in the
market earn only normal profits.
● If all the firms only normal profit there will be no tendency to enter or exit the
market.
Role of Advertising in Monopolistic Competition

● The key difference between perfect competition and monopolistic competition is

the assumption that firms produce differentiated products.
● The Firms have some control over their prices solely based on the fact that the
product is differentiated.
● For this reason most Firms try to convince the customers about superiority of their
products
● Toothpaste, mouthwash, fast-food restaurants, cooking oil
● Firms employ two strategies
● Advertising
● Frequently introducing “new improved products”.
● The question of how much to spend on advertising is dependant upon the nature
of the industry but generally a manager should advertise to the point where the
incremental revenue equals the incremental cost.
Comparison with Monopoly and Perfect Competition

Firms are in equilibrium and earning normal

profit Perfect competition: horizontal
demand curve (DC); output QC;
AR=AC
price PC
Price, Monopolistic competition:
Revenue, LAC
Cost downward sloping highly elastic
demand curve (DMC); output QMC (<
QC), at price PMC (> PC).
PM EM
EMC Monopoly: downward sloping less
PMC EC
PC DC elastic curve D M; output Q M (< QC
and QMC), at price PM (> PC and PMC).
DMC Monopoly and monopolistically
DM
O competitive firm operate at less
QM QMC QC Quantity than optimum output and charge a
higher price.
Excess Capacity Excess capacity due to market
imperfections= QC> Q MC >QM
Examples of Market Types

Oligopoly

The oligopoly market is generally considered to be the playing field of big

businesses.
In the United States, a large segment of the manufacturing sector competes in
oligopoly markets.

For example, in the manufacturing sector, oil refining, certain types of computer
hardware and software, chemicals and plastics, processed foods, tobacco, steel,
automobile, copper, and soft drinks can all be considered oligopoly markets.
Oligopoly

● Derived from Greek word: “oligo” (few) “polo” (to sell)

● A few dominant sellers sell differentiated or homogenous products under
continuous consciousness of rivals’ actions.
● Oligopoly looks similar to other market forms; as there can be many sellers
(like in monopolistic competition), but a few very large sellers dominate the
market.
● Products sold may be homogenous (like in perfect competition), or
differentiated (like in monopolistic competition).
● Entry is not restricted but difficult due to requirement of investments.
● One aspect which differentiates oligopoly from all other market forms, is the
interdependence of various firms: no player can take a decision without
considering the action (or reaction) of rivals.
Features of Oligopoly

• Few Sellers: small number of large firms compete

• Product: Some industries may consist of firms selling identical products, while
in some other industries firms may be selling differentiated products.
• Entry Barriers: No legal barriers; only economic in nature
• Huge investment requirements
• Strong consumer loyalty for existing brands
• Economies of scale
Features of Oligopoly

Non Price Competition: Firms are continuously watching their rivals, each of
them avoids the incidence of a price war.

• Two firms A & B sell a homogenous

P1 product and sell at P1.
• Firm A lowers the price to gain market
A B share.
P2 • B fears loss of its customers and retorts by
lowering the price below that of A.
• A further reduces the price and this
Market share O Market process continues.
of A share of B • The two firms reach P2.
• Both realize that this price war is not
helping either of them and decide to end
the war.
• Price again stabilises at P2.
Features of Oligopoly

Indeterminate Demand Curve

Price D1 • Price and output determination is very
complex as each firm faces two demand
D curves.
• Demand is not only affected by its own
price or advertisement or quality, but is
also affected by the price of rival
products, their quality, packaging,
D promotion and placement.
D1
• When the firm increases the price it
O faces less elastic demand (D1D1)
Quantity • When it reduces the price it faces highly
elastic demand (DD)
Duopoly

● Duopoly is that type of oligopoly in which only two players operate (or
dominate) in the market.
● Used by many economists like Cournot, Stackelberg, Sweezy, to explain the
equilibrium of oligopoly firm, as it simplifies the analysis.

Price and Output Decisions

● No single model can explain the determination of equilibrium price and output
● Difficult to determine the demand curve and hence the revenue curve of the
firm
● Tendency of the firm to influence market conditions by various activities like
advertisement, and fear of price war resulting in price rigidity.
Kinked Demand Curve

● Paul Sweezy (1939) introduced concept of kinked demand curve to explain ‘price
stickiness’.
● Assumptions
● If a firm decreases price, others will also do the same. So, the firm initially
faces a highly elastic demand curve.
● A price reduction will give some gains to the firm initially, but due to similar
reaction by rivals, this increase in demand will not be sustained.
● If a firm increases its price, others will not follow. Firm will lose large
number of its customers to rivals due to substitution effect.
● Thus an oligopoly firm faces a highly elastic demand in case of price fall and
highly inelastic demand in case of price rise.
● A firm has no option but to stick to its current price.
● At current price a kink is developed in the demand curve
● The demand curve is more elastic above the kink and less elastic below the kink.
Kinked Demand Curve

Price, D
Revenue, 1
Cost
K MC1 • Discontinuity in AR (D1KD2) creates
P discontinuity in the MR curve.
MC2
A • At the kink (K), MR is constant
S between point A and B.
• Producer will produce OQ, whether it
T B D2
is operating on MC1 or MC2, since the
O profit maximizing conditions are
Q Quantity
being fulfilled at points S as well as
MR
T.
• D1K = highly elastic portion of the • If MC fluctuates between A and B,
demand curve (AR) when rival firms do the firm will neither change its
not react to price rise output nor its price.
• KD2 = less elastic portion, when rival • It will change its output and price
firms react with a price reduction. only if MC moves above A or below B.
• Kink is at point K.
Collusive Oligopoly

● Rival firms enter into an agreement in mutual interest on various accounts such
as price, market share, etc.
● Explicit collusion: When a number of producers (or sellers) enter into a formal
agreement.
● Tacit collusion: A collusion which is not formally declared.
● Cartel
• A formal (explicit) agreement among firms on price and output.
• Occurs where there are a small number of sellers with homogeneous
product.
• Normally involves agreement on price fixation, total industry output,
market share, allocation of customers, allocation of territories,
establishment of common sales agencies, division of profits, or any
combination of these.
• Immidiate impact is a hike in price and a reduction in supply.
• Two types:
● centralized cartels

● market sharing cartels.

Factors Influencing Cartels

● Number of firms in the industry: Lower the number of firms in the industry, the
easier to monitor the behaviour of other members.
● Nature of product: Formed in markets with homogenous goods rather than
differentiated goods, to arrive at common price. But if goods are homogeneous,
an individual firm may gain larger market share by cheating, i.e. by lowering the
price.
● Cost structure: Similar cost structures make it easier to coordinate.
● Characteristics of sales: Low frequency of sales coupled with huge amounts of
output in each of these sales make cartels less sustainable, because in such cases
firms would like to undercut the price in order to gain greater market share.
● with large number of firms and small size of the market some firms may
deviate from the cartel price and thus cheat other members.
Informal and Tacit Collusion

● Formed when firms do not declare a cartel, but informally agree to charge
the same price and compete on non price aspects.
● Sometimes this agreement involves division of the market among the players
in such a way that they may charge a price that would maximize their profit
without fear of retaliation.
● Also seen in case of highly skilled human resource.
● It is as damaging to consumers as formal cartels, because it makes an
oligopoly act like a monopoly (in a limited sense) and deprives consumers of
the benefits of competition.