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uk Market Structure Copyright 2006 Biz/ed

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Market Structure Market structure identifies how a market is made up in terms of: The number of firms in the industry The nature of the product produced The degr e of monopoly power each firm has The degree to which the firm can influence pri ce Profit levels Firms behaviour pricing strategies, non-price competition, outpu t levels The extent of barriers to entry The impact on efficiency Copyright 2006 Biz/ed

http://www.bized.co.uk Market Structure Perfect Competition Pure Monopoly More competitive (fewer imperfections) Copyright 2006 Biz/ed

http://www.bized.co.uk Market Structure Perfect Competition Pure Monopoly Less competitive (greater degree of imperfection) Copyright 2006 Biz/ed

http://www.bized.co.uk Market Structure Perfect Competition Pure Monopoly Monopolistic Competition Oligopoly Duopoly Monopoly The further right on the scale, the greater the degree of monopoly power exercis ed by the firm. Copyright 2006 Biz/ed

http://www.bized.co.uk Market Structure Importance: Degree of competition affects the consumer will it benefit the consu mer or not? Impacts on the performance and behaviour of the company/companies in volved Copyright 2006 Biz/ed

http://www.bized.co.uk Market Structure Models a word of warning! Market structure deals with a number of economic models These models are a represe ntation of reality to help us to understand what may be happening in real life T here are extremes to the model that are unlikely to occur in reality They still have value as they enable us to draw comparisons and contrasts with what is obse rved in reality Models help therefore in analysing and evaluating they offer a b enchmark Copyright 2006 Biz/ed

http://www.bized.co.uk Market Structure Characteristics of each model: Number and size of firms that make up the industry Control over price or output Freedom of entry and exit from the industry Nature of the product degree of homo geneity (similarity) of the products in the industry (extent to which products c an be regarded as substitutes for each other) Diagrammatic representation the sh ape of the demand curve, etc. Copyright 2006 Biz/ed

http://www.bized.co.uk Market Structure Characteristics: Look at these everyday products what type of market structure a re the producers of these products operating in? Electric Guitar Jazz Body Vodka Remember to think about the nature of the product, entry and exit, behaviour of the firms, number and size of the firms in the industry. You might even have to ask what the industry is?? Mercedes CLK Coupe Canon SLR Camera Bananas Copyright 2006 Biz/ed

http://www.bized.co.uk Perfect Competition One extreme of the market structure spectrum Characteristics: Large number of firms Products are homogenous (identical) consumer has no reason to express a preference for any firm Freedom of entry and exit into and out of the industry Firms are price takers have no control over the price they charge f or their product Each producer supplies a very small proportion of total industr y output Consumers and producers have perfect knowledge about the market Copyright 2006 Biz/ed

http://www.bized.co.uk Perfect Competition Diagrammatic representation Cost/Revenue MC AC Givenaverage the cost ofis the Thethis industry price firm The MC is cost curve is the output the At The assumption of profit maximisation, shapedproduces standa rd U additional curve. producing theby the demand determined firm is(marginal) AC of MC industry making units of output. It at an cuts supply curve =profit. MC ou tput where the atMR and the normal its This point long to thethe falls a output The of (Q1). asis first (due run alaw of lowest at whole. levelfirm is a This a because is diminishing relationship fraction of small supplier within mathematic altotal industry rises very the position. equilibriumreturns) then asthe output rises. supply. industry and has no between marginal and average values. control over price. They will sell each extra unit for the same price. Price therefore = MR and AR P = MR = AR Q1 Output/Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Perfect Competition Diagrammatic representation Cost/Revenue MC MC1 AC AC1 Because the model assumes perfect knowledge, makes Average and and MC firm The a ssume a firm thewould Nowlower ACMarginal costs gains that advantage nowlower co uld form of firm to be imply be the modification to some theexpected is for only a short timein the short run, form but price, or gains some its product before others copy earning abnormal profit the idea the same. remains or are attracted the (AR>AC) represented a new of cost advantage (saybyto the industry by grey ar ea. method). What production the existence of abnormal profit. would happen? If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again. AC1 Abnormal profit P = MR = AR P1 = MR1 = AR1 Q1 Q2 Output/Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Monopolistic or Imperfect Competition Where the conditions of perfect competition do not hold, imperfect competition wil l exist Varying degrees of imperfection give rise to varying market structures M onopolistic competition is one of these not to be confused with monopoly! Copyright 2006 Biz/ed

http://www.bized.co.uk Monopolistic or Imperfect Competition Characteristics: Large number of firms in the industry May have some element of control over pric e due to the fact that they are able to differentiate their product in some way from their rivals products are therefore close, but not perfect, substitutes Ent ry and exit from the industry is relatively easy few barriers to entry and exit Consumer and producer knowledge imperfect Copyright 2006 Biz/ed

http://www.bized.co.uk Monopolistic or Imperfect Competition Implications for the diagram: Cost/Revenue MC AC 1.00 Abnormal Profit 0.60 We assume that theQ1 and Marginal Cost equilibrium This is demandrunandfacing If The firm produces firm Since the additional the a short curve produces where wil labeMC Average Cost in position forreceived1.00the sells firm willfirmdownward th e each a be MR = on revenue unit for from (profit maximising output). same shape . falls, the the monopolistic market (on average with represents sloping and the cost each unit sold However, At because the products this output average) lies under the AR earned each unit being MR curve level, AR>AC structure. for from sa les. and the firm makes in 40p x are differentiated 60p, curve. will make AR the firm abnormal profit (the grey some way, the firm Q1 in abnormal profit.will sh adedbe able to sell extra only area). output by lowering price. MR Q1 D (AR) Output / Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Monopolistic or Imperfect Competition Implications for the diagram: Cost/Revenue MC AC Because there is relative freedom of entry and exit into the market, new firms w ill enter encouraged by the existence of abnormal profits. New entrants will inc rease supply causing price to fall. As price falls, the AR and MR curves shift i nwards as revenue from each sale is now less. MR1 Q1 MR AR1 D (AR) Output / Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Monopolistic or Imperfect Competition Implications for the diagram: Cost/Revenue MC AC AR = AC Notice that the existence of more substitutes makes the new AR (D) curve more pr ice elastic. The firm reduces output to a point where MC = MR (Q2). At this outp ut AR = AC and the firm will make normal profit. MR1 Q2 Q1 MR AR1 D (AR) Output / Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Monopolistic or Imperfect Competition Implications for the diagram: Cost/Revenue MC AC This is the long run equilibrium position of a firm in monopolistic competition. AR = AC MR1 Q2 AR1 Output / Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Monopolistic or Imperfect Competition Some important points about monopolistic competition: May reflect a wide range o f markets Not just one point on a scale reflects many degrees of imperfection Exam ples? Copyright 2006 Biz/ed

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Monopolistic or Imperfect Competition Restaurants Plumbers/electricians/local builders Solicitors Private s t hire firms Insurance brokers Health clubs Hairdressers Funeral directors Estat e agents Damp proofing control firms Copyright 2006 Biz/ed

http://www.bized.co.uk Monopolistic or Imperfect Competition In each case there are many firms in the industry Each can try to differentiate its product in some way Entry and exit to the industry is relatively free Consum ers and producers do not have perfect knowledge of the market the market may ind eed be relatively localised. Can you imagine trying to search out the details, p rices, reliability, quality of service, etc for every plumber in the UK in the e vent of an emergency?? Copyright 2006 Biz/ed

http://www.bized.co.uk Oligopoly Competition between the few May be a large number of firms in the industry but the industry is dominated by a small number of very large producers Concentration Ratio the proportion of total market sales (share) held by the top 3,4,5, etc firms: A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of all the sales in the industry Copyright 2006 Biz/ed

http://www.bized.co.uk Oligopoly Example: Music sales The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this i ndependents group. An oligopolistic market structure therefore may have many firm s in the industry but it is dominated by a few large sellers. Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-c ontent/press/20030909.html Copyright 2006 Biz/ed

http://www.bized.co.uk Oligopoly Features of an oligopolistic market structure: Price may be relatively stable across the industry kinked demand curve? Potentia l for collusion Behaviour of firms affected by what they believe their rivals mi ght do interdependence of firms Goods could be homogenous or highly differentiat ed Branding and brand loyalty may be a potent source of competitive advantage No n-price competition may be prevalent Game theory can be used to explain some beh aviour AC curve may be saucer shaped minimum efficient scale could occur over la rge range of output High barriers to entry Copyright 2006 Biz/ed

http://www.bized.co.uk Oligopoly Price The kinked demand curve - an explanation for price stability? The firm therefore , charging demand IfThe principle of is effectively faces Assume the firm to low er its price to of the firm seeks the kinked a price a kinked demand on the princ iple rivals 5 andcompetitivean output of its to gain a curve rests curve forcing i t producing advantage, 100. maintain asuit. Any gains pricing will will follow s table or rigid it makes that: If it chose to raise price above 5, its structure. Oligopolistic firms may in quickly be lost and the % change rivals would not fol low suit andits firm a. If a firm raises its price, the overcome this by engagin g in nondemand will be smaller than the % effectively facesnot follow suit rival s will an elastic demand price competition. total revenue reduction in price cur ve for its product (consumers would would If a firm lowers its price, its again fall as the firm now faces b. buy from the cheaper rivals). The % a relatively i nelastic demand curve. rivals will all do the same change in demand would be gre ater than the % change in price and TR would fall. 5 Total Revenue B Total Revenue A Total Revenue B 100 Kinked D Curve D = Inelastic D = elastic Quantity Copyright 2006 Biz/ed

http://www.bized.co.uk Duopoly Market structure where the industry is dominated by two large producers Collusion may be a possible feature Price leadership by the larger of the two fi rms may exist the smaller firm follows the price lead of the larger one Highly i nterdependent High barriers to entry Cournot Model French economist analysed duo poly suggested long run equilibrium would see equal market share and normal prof it made In reality, local duopolies may exist Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Pure monopoly where only one producer exists in the industry In reality, rarely exists always some form of substitute available! Monopoly exists, therefore, whe re one firm dominates the market Firms may be investigated for examples of monop oly power when market share exceeds 25% Use term monopoly power with care! Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Monopoly power refers to cases where firms influence the market in some way thro ugh their behaviour determined by the degree of concentration in the industry Influencing prices Influencing output Erecting barriers to entry Pricing strateg ies to prevent or stifle competition May not pursue profit maximisation encourag es unwanted entrants to the market Sometimes seen as a case of market failure Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Origins of monopoly: Through growth of the firm Through amalgamation, merger or takeover Through acqu iring patent or license Through legal means Royal charter, nationalisation, whol ly owned plc Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Summary of characteristics of firms exercising monopoly power: Price could be deemed too high, may be set to destroy competition (destroyer or predatory pricing), price discrimination possible. Efficiency could be inefficie nt due to lack of competition (X- inefficiency) or could be higher due to availability of high profits Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Innovation - could be high because of the promise of high profits, Possibly enco urages high investment in research and development (R&D) Collusion possible to m aintain monopoly power of key firms in industry High levels of branding, adverti sing and non-price competition Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Problems with models a reminder: Often difficult to distinguish between a monopoly and an oligopoly both may exhi bit behaviour that reflects monopoly power Monopolies and oligopolies do not nec essarily aim for traditional assumption of profit maximisation Degree of contest ability of the market may influence behaviour Monopolies not always bad may be des irable in some cases but may need strong regulation Monopolies do not have to be big could exist locally Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Costs / Revenue MC 7.00 Monopoly Profit 3.00 AC This is curve for a monopolist Given both the short run and AR (D)the barriers t o entry, likelyrunbe relativelyposition the monopolist will be able to long to e quilibrium price inelastic. Output assumed the exploit abnormal profits in to fo r a monopoly be at profit entry to the long run as maximising output (note cauti on here market is restricted. not all monopolists may aim for profit maximisatio n!) MR Q1 AR Output / Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Costs / Revenue Welfare implications of monopolies A look back a the diagram for The higher in at competitive be The price pricepri ce lower monopoly and would perfectunit with output levels output means that 3wil l reveal 7 per competition with market would be consumer that in equilibrium, pri ce will be surplusat Q2. at Q1. output is reduced, indicated by lower levels equ al to the MC of production. the grey shaded area. On the face of it, consumers W e higher prices and less facecan look therefore at a comparison of the differenc es choice in monopoly conditions between price and competitive compared to more output in a competitive situation compared environments. to a monopoly. MC 7 AC Loss of consumer surplus 3 MR Q2 Q1 AR Output / Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Costs / Revenue Welfare implications of monopolies The monopolist will be benefit from additional producer affected by a loss of pr oducer surplus shownto the grey equal by the grey shaded but.. triangle rectangle. MC 7 AC Gain in producer surplus 3 MR Q2 Q1 AR Output / Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Monopoly Costs / Revenue Welfare implications of monopolies The value of the grey shaded triangle represents the total welfare loss to socie ty sometimes referred to as the deadweight welfare loss. MC 7 AC 3 MR Q2 Q1 AR Output / Sales Copyright 2006 Biz/ed

http://www.bized.co.uk Contestable Markets Theory developed by William J. Baumol, John Panzar and Robert Willig (1982) Help ed to fill important gaps in market structure theory Perfectly contestable marke t the pure form not common in reality but a benchmark to explain firms behaviours Copyright 2006 Biz/ed

http://www.bized.co.uk Contestable Markets Key characteristics: Firms behaviour influenced by the threat of new entrants to the industry No barri ers to entry or exit No sunk costs Firms may deliberately limit profits made to discourage new entrants entry limit pricing Firms may attempt to erect artificia l barriers to entry e.g Copyright 2006 Biz/ed

http://www.bized.co.uk Contestable Markets Over capacity provides the opportunity to flood the market and drive down price in the event of a threat of entry Aggressive marketing and branding strategies t o tighten up the market Potential for predatory or destroyer pricing Find ways of reducing costs and increasing efficiency to gain competitive advantage Copyright 2006 Biz/ed

http://www.bized.co.uk Contestable Markets Hit and Run tactics enter the industry, take the profit and get out quickly (possi ble because of the freedom of entry and exit) Cream-skimming identifying parts o f the market that are high in value added and exploiting those markets Copyright 2006 Biz/ed

http://www.bized.co.uk Contestable Markets Examples of markets exhibiting contestability characteristics: Financial services Airlines especially flights on domestic routes Computer indus try ISPs, software, web development Energy supplies The postal service? Copyright 2006 Biz/ed

http://www.bized.co.uk Market Structures Final reminders: Models can be used as a comparison they are not necessarily meant to BE reality! When looking at real world examples, focus on the behaviour of the firm in rela tion to what the model predicts would happen that gives the basis for analysis a nd evaluation of the real world situation. Regulation or the threat of regulatio n may well affect the way a firm behaves. Remember that these models are based o n certain assumptions in the real world some of these assumptions may not be val id, this allows us to draw comparisons and contrasts. The way that governments d eal with firms may be based on a general assumption that more competition is bet ter than less! Copyright 2006 Biz/ed