Chapter Four

Market structures
&
Business Decisions
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 Market and market structure
• A market can be defined as a group of economic
agents, usually firms and individuals, who interact
with each other in a buyer–seller relationship.
• Market structures are classified into four based on
number of sellers, type of product, barriers to
entry, and power to affect. These are:
– Perfect competition,
– Monopoly,
– Monopolistic competition and
– Oligopoly.
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 Perfect competition
• Perfect competition represents a
situation where competition is at a
maximum.
• It is sometimes referred to as pure
competition or atomistic competition,
• Usually, it is considered as an ideal
market.

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 Perfect competition
• It has the following characteristics:
– There many buyers and sellers
– Products are standardized, there is no non-price
discrimination
– Firms are price-takers and they do not have the
power to affect price
• Each produces only a very small portion of total market
or industry output
– All firms produce a homogeneous product
– Entry into & exit from the market is unrestricted
– Perfect information
– Zero transaction cost
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 Perfect competition
• Demand curve is horizontal
– Perfectly elastic
• Marginal revenue equals price
– Demand curve is also equal to marginal
revenue curve (D = MR)
• Can sell all they want at the market price
– Each additional unit of sales adds to total
revenue an amount equal to price

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 Perfect competition
• Competitive firms attempt to maximize
profits.
• Competitive firms cannot charge more
than the market price of others, since
their product is identical to all others.
– Hence, competitive firms are price takers.
• Total revenue, TR, is P·Q, where price
is given.
• Therefore, marginal revenue, MR, is
price, P.
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 Perfect competition
• Profit maximization implies that each firm
produces an output where Price = Marginal
Cost (P = MC).
• To produce more than this quantity implies
that P < MC, which is not the most
profitable decision.
• To produce less than where P=MC, implies
that P > MC, and the firm could increase
profits by expanding output.
• In short-run, a competitive firm may earn
economic profits.
• In long-run, entry pushes price down to the
minimum point of the average cost curve, so
that economic profits become zero.
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 Demand for a Competitive Price-Taking Firm

Price (dollars)
Price (dollars)

P0 P0
D = MR

0 Q0 0

Quantity Quantity

Panel A – Panel B – Demand curve

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Market facing a price-taker
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 Short-Run Output Decision
• Firm will produce output where
P = SMC as long as:
–Total revenue ≥ total avoidable
cost or total variable cost (TR 
TVC)
• Equivalently, the firm should
produce if P  AVC
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 Short-Run Output Decision
• The firm will shut down if:
–Total revenue cannot cover total
avoidable cost (TR < TVC) or,
equivalently, P  AVC
–Produce zero output
–Lose only total fixed costs
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 Profit Maximization: P = $36

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 Long-Run Competitive Equilibrium

• All firms are in profit-maximizing equilibrium (P

= LMC)
• Occurs because of entry/exit of firms in/out of
industry is free
• Long run equilibrium: P = MC = MR = ATC =
LRAC. No reason for new firms to enter the
market or for existing firms to leave.
• As long as the market demand and supply curves
remain unchanged, the industry will continue to
produce a total of Q units of output at price p.
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 Long-Run Equilibrium for a Firm and the Industry

(a) Firm (b) Industry or market

MC S
Dollars per unit

Price per unit

ATC
LRAC
e
p d p

Quantity Quantity
0 q per period 0 Q
per period

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 Example
• If a firm has a demand structure: P = 950 - Q and
cost structure represented by MC =50. Then,
determine the output and price for the firm, in a
competitive market structure.
• Answer
• In a competitive market structure
P = MR = MC
P = mc = 50.
Then, 50 = 950-q
Thus, p = 50 and q = 900
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 Example
For an industry:
QS = 3000 + 200 P and
QD = 13500 - 500 P

For a firm:
FC = 50
MC = 3 Q

FIND OPTIMAL price and output for this

firm.
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 Answer: First find the equilibrium price.
Set D = S, where:
3,000 + 200 P = 13,500 - 500 P.
This implies:
700 P = 10,500 or:
10,500 / 700 = P = $15.

At this price, the firm produces where P = MC,

and because MC = 3Q

P = 15 = 3 Q Q=5
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 Exercises
• Find profit maximizing quantity and revenue if
the market price is 20 and the marginal cost is
0.5q.
• Find profit maximizing quantity and revenue if
the marginal revenue is 15 and the marginal
cost is q.
• A firm has 12q revenue structure and 2 +
0.125q2 cost structure. Find profit maximizing
price, output, revenue and cost, and maximum
profit

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 Monopoly
• Single firm produces & sells a good or
service for which there are no good
substitutes. It is characterized by:
– High barrier to entry and exit
– Profit maximizer
– Price maker
– Single seller
– Price discrimination

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 Barriers to Entry
• Economies of scale
• Capital requirements
• Technological superiority
• No substitute goods
• Control of natural resources
• Network externalities
• Legal barriers
• Deliberate actions
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 The Monopolist’s Supply Decision
• Unlike competitive firms, monopoly does not
take market P as given. It can select (P,Q) pair
on industry D curve that maximize profit.
• Monopolist’s Demand curve is downward
sloping, not horizontal.
• Profits are not competed away by entry of new
firms.
• To maximize profit, monopolist compares MR
and MC.

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 Demand & Marginal Revenue for a Monopolist

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Short-Run Profit Maximization for Monopoly

• Monopolist will produce where MR = SMC as

long as TR at least covers the firm’s total
avoidable cost (TR ≥ TVC)
– Price for this output is given by the demand curve
• If TR < TVC (or, equivalently, P < AVC) the firm
shuts down & loses only fixed costs
• If P > ATC, firm makes economic profit
• If ATC > P > AVC, firm incurs a loss, but
continues to produce in short run

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 Short-Run Profit Maximization for Monopoly

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 Long-Run Profit Maximization for Monopoly

• Monopolist maximizes profit by

choosing to produce output
where MR = LMC, as long as P
 LAC
• Will exit industry if P < LAC
• Monopolist will adjust plant size
to the optimal level
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 Example
• Suppose that the firm has a demand structure:
P = 950 - Q and MC =50
• Find the quantity and price of the
monopolist.
• Solution
– A frim produces at MR = MC to maximize profit.
So, 950 -2Q = 50
– QM = 450 so
– PM = 950 - 450 = $500

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 Monopolistic Competition
• Large number of firms sell a
differentiated product
–Products are close (not perfect)
substitutes
• Market is monopolistic
–Product differentiation creates a degree of
market power
• Market is competitive
–Large number of firms, easy entry
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 Monopolistic Competition
• Short-run equilibrium is identical to
monopoly
• Unrestricted entry/exit leads to long-
run equilibrium
–Attained when demand curve for each
producer is tangent to LAC
–At equilibrium output, P = LAC and
MR = LMC
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 Short-Run Profit Maximization

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 Short-Run Equilibrium with Monopolistic
Competition (with profits)
Panel (a)

MC
ATC

P1 d
Dollars per Unit

ATC • Price (P1) > ATC

A • Economic profit
Profits
MR

q
Panel (a)
Quantity
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 Short-Run Equilibrium with Monopolistic
Competition (with losses)

Panel (b)
MC ATC

ATC
Dollars per Unit

P1
d
Losses
A -Price (P1) < ATC
-Economic loss

MR

q
Panel (b)
Quantity

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30 Economics/MBA
 Oligopoly Markets
• An oligopoly market structure describes the
situation where a few firms dominate the
industry.
• The most important feature of oligopoly markets
that distinguishes them from all other types of
market structure is that firms are interdependent.
– Strategic decisions made by one firm affect other
firms, who react to them in ways that affect the
original firm.

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 Key Characteristics of Oligopoly
• Interdependency
• Strategy
• High Barrier to Entry and Exit
• Collusion
• Price stickness

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 Interdependence
• Firms operating under conditions of oligopoly
are said to be interdependent .
• A firm operating in a market with just a few
competitors must take the potential reaction of
its closest rivals into account when making its
own decisions.
• An understanding of game theory and
prisoner’s dilemma helps appreciate the
concept of interdependence.
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 Strategy
• Strategy is extremely important to firms that are
interdependent, because they must anticipate the
likely response of a rival to any given change in
their price, or their non-price activity.
• They need to plan, and work out a range of
possible options critical strategic decisions, such
as:
– Whether to compete with rivals, or collude with them.
– Whether to raise or lower price, or keep price constant.
– Whether to be the first firm to implement a new
strategy, or whether to wait and see what rivals do.
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 Barriers to entry
• Oligopolies frequently maintain their position of dominance in a market
might because it is too costly or difficult for potential rivals to enter the
market.
• These hurdles are called barriers to entry and the incumbent can erect them
deliberately, or they can exploit natural barriers that exist.
 Natural entry barriers include:
• Economies of large scale production.
• Ownership or control of a key scarce resource
• High set-up costs
• High R&D costs
 Artificial barriers include:
• Predatory pricing
• Limit pricing
• Superior knowledge
• Predatory acquisition
• Advertising
• A strong brand
• Loyalty schemes
• Exclusive contracts, patents and licences
• Vertical integration

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 Collusion
• If colluding, participants act like a
monopoly and can enjoy the benefits
of higher profits over the long term.
There are three major types of
collusion:
Overt
Covert
Tacit
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 Price stickiness and Kinked DD curve
• Once a price has been determined, will stick it at this
price because of interdependence
• The demand curve will be kinked, at the current price.

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 Example
• Suppose that the firm has a demand structure:
P = 950 - Q and MC =50
• Find the quantity and price of the
oligopolist.
Solution
• Let us start from two firms (DUOPOLY)
market. The total market supply is the
summation of the oligopolies(Duopoly)
Thus, Q = q1 + q2
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 Cournot Solution:
Case of 2 Firms (Duopoly)
• Assume each firm maximizes profit
• Assume each firm believes the other will
NOT change output as they change
output.
– The so-called: Cournot Assumption

• Find where each firm sets MR = MC

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 Let Q = q1 + q2
P = 950 - Q = 950 - q1- q2 and MC = 50

 TR1 = Pq1= (950- q1-q2)q1 =950q1 - q12 - q1q2

and
 TR2 = Pq2= (950- q1-q2)q2 =950q2 - q2q1 - q22

 Set MR1= MC & MR2= MC

950 -2q1 - q2 = 50 2 equations &
2 unknowns
950 - q1 - 2q2 = 50
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With 2 Equations & 2 Unknowns: Solve for
Output
950 -2q1 - q2 = 950 - q1 - 2q2
So, q2 = q1 Then plug this into the demand
equation we find:
950 - 2q1 - q1 = 950 - 3q1 = 50.
Therefore q1 = 300 and Q = 600
The price is: P = 950 - 600 = $350
 Comparison

Suppose that: P = 950 - Q and MC =50

• IN COMPETITION
– P = MC, so 950 - Q = 50
$500 – PC = $50 and QM = 900
PM
Pcournot $350 • IN MONOPOLY
PC – MR = MC, so 950 -2Q = 50
$50
– QM = 450 so
– PM = 950 - 450 = $500
D • IN Cournot
QM QCournot QC DUOPOLY
450 600 900 – Let Q = q1 + q2
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 N-Firm Cournot Model
• For 3 firms with linear demand and
cost functions:
QC
–Q = q 1 + q 2+ q 3
– In linear demand and cost
models, the solution is higher
output and lower price
N
QCournot = { N / (N+1) }QCompetition

THEREFORE, Increasing the Number of

Firms increases competition. This is the
PC
historical basis for Anti-trust Policies
N
Example: Cournot as N the number of firms, increases, the
price gets closer to competition.

N=3 N=5

• If N = 3 Triopoly • If N = 5
• P = 950 - Q & • P = 950 - Q and MC
MC=50 = 50
• Then, Q = (3/4)(900) • Then Q = (5/6)(900)
• Q = 675 • Q = 750
• P =$275 • P = $200

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 Comparison
Market Price Quantity
Structure
Perfectly 50 900
competitive market
Oligopoly 350 600
market(duopoly)
Oligopoly 275 675
market(Triopoly)
Oligopoly 200 750
market(Pentapoly)
Monopoly 500 450
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 Text and References Books
• Luke M. Froeb and Brian T. McCann, Managerial
Economics: A Problem Solving Approach, Thomson
South-Western, 2008.
• Nick Wilkinson 2005: Managerial Economics: A
problem Solving approach. Cambridge University Press
• E. Mansfield, Managerial Economics, Sixth Edition,
2006
• Any other text in Managerial Economics

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