Friday 20th

January 2023

Unit 4: Describing the Main Market Structures:

A key decision for a firm is how much to produce and this will
be dependent on the firm’s revenues and costs. However, the
firm’s revenues will be dependent on the structure and nature
of the market in which it operates. In order to understand the
immediate environment within which a business operates, we
need to be aware of the different market structures in which it
might be operating. We will therefore, be considering output
decisions by firms which operate in the forms of market
structures characterised as Perfect Competition, Monopoly and
Monopolistic Competition. The behavioural relationship
between the firms in an industry can also influence price and
output decisions and these will be examined using the theory
Oligopoly.

State ownership and competition policy can be used to ensure

that industries are operating in the national and public interest.
Policies are used to influence competition including subsidies,
tariffs, quotas and monopsonistic purchasing.

Structure, Conduct and Performance Analysis:

Structure:

The structure of an industry refers to the number of

producers / players (firms or suppliers) in the industry.
Economists start by examining two extreme forms of structure,
Perfect Competition which has many suppliers and
Monopoly which has only a single supplier.

Conduct:

The conduct of the individual firms refers to how they act to

gain revenues and profits. Economics analysis states that a
firm under perfect competition will be a price taker which
will produce as much as it is profitable at the prevailing
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market price and will not influence price by increasing or
reducing its own output. By contrast, a monopoly is a price-
maker because it will seek to use its control over supply to
drive up sales in order to maximise its profits.

Performance:

The performance of the industry refers to its effectiveness in

solving the economic problem. This includes productive
efficiency, how well it uses its resources, its exchange
efficiency, that is whether the prices it charges represent a
good deal for customers and its market stability, that is
whether it exhibits stable prices and supply or not.

Perfect Competition:

This market structure derives its name from the underlying

assumptions of the model. These combine to make
competition as effective as possible. Economists conclude that
perfect competition is the most efficient industrial structure due
to its tendency to produce at minimum average cost and for
each firm to sell at a price equal to its marginal cost. Perfect
competition is therefore a “theoretical market structure in
which no supplier (or buyer) has an advantage over
another and therefore prices are set by open
competition”.

Characteristics of Perfect Competition: the assumptions

underlying the model of perfect competition are as follows –

(i) There are a large number of buyers and sellers in the

market
(ii) Firms are price takers, unable to influence the market
price individually. Buyers and sellers can trade as much as
they want at the prevailing market price, as determined
by the interaction of supply and demand.
(iii) Producers and consumers have the same, perfect
information about the product and the market.

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(iv) The product is homogeneous – one unit of the product is
the same as any other unit.
(v) There is free entry of firms into and free exit of firms out
of the market – there are no barriers to entry. There are
also no restrictions on the mobility of factors of
production.
(vi) There are no transport costs or information gathering
costs.
Equilibrium in the Short-Run:
How are price and output determined in the case of the profit-
maximising firm operating under conditions of perfect
competition in the short-run?
We assume that in the short-run the number of firms in the
market is temporarily fixed. In these circumstances, it is
possible for firms to make supernormal profits or losses.
Diagrammatic Explanation:
Figure 1 shows the cost and demand curves of a firm in the
short-run making supernormal profits. The demand curve is the
horizontal line D1 at price P1. The curve is a horizontal line
indicating that the firm has to accept the price that the
market as a whole fixes for it. If the firm were to charge a
higher price it would lose all its sales because customers,
acting rationally and with perfect information, would buy the
identical product from another supplier at a lower price. There
is no point charging a higher price than the market price
because the firm can sell all its output at the given price. Thus
the demand curve for the firm is perfectly elastic at price P1.
Because the demand curve is perfectly elastic, it is also the
marginal revenue curve; every new unit sold at price P1
increases total revenue by the same amount, P1.
Figure 1 also shows the average total cost curve (ATC) and the
marginal cost curve (MC), with the MC cutting the ATC at the
lowest point of the ATC. Given these cost curves and the
demand curve D1, the firm will produce the output Q1, where
the MC curves cuts the MR horizontal curve at the point C. This
is the profit maximising level of output (MC = MR).
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Note, however, that the profit maximising level of output is not
the same as the level of technical efficiency. This would
occur at output E, where Average Total Cost (ATC) is at its
minimum. By definition, technical efficiency is achieved when a
firm is producing the level of output at which its average total
costs are minimised.
At Q1, on figure 1, average revenue is greater than average
total cost, so the firm is making supernormal profits
indicated by the rectangle ABCD. These supernormal profits will
attract new firms into the industry and the price will be
competed downwards. This new position is illustrated in figure
2, where the new price is P2. Here, instead of making a profit,
the firm makes a loss shown by the rectangle WXYZ. Once
again the firm produces where MC = MR giving an output of Q2.
A firm could choose to continue producing for a short period so
long as revenues covered its variable costs; in this case MC
= MR is the loss minimising position rather than the profit
maximising position.
In the long-run, whenever supernormal profits are being made,
new firms will enter the industry increasing supply and
causing the price to fall. Similarly, when losses are made, firms
will leave the industry and the price will rise. If profits are not
“normal”, they act as a signal to producers to transfer
resources into or out of, an industry.
Efficiency of a perfect market:
The price acts as a signalling mechanism that enables firms to
respond to fluctuations in demand, supplying society at the
minimum possible price, given existing technology and
resource availability. There is technical efficiency, since firms
operate at the minimum point of ATC. There is no wastage and
resources are used as efficiently as possible.
There is also allocative efficiency as resources are allocated to
production to meet demand at as low a price as possible.
Equilibrium in the Long-Run:
In a perfectly competitive market in the long-run, the firm
takes the given market price and its average revenue curve is
horizontal. The firm’s average total cost curve is “U” shaped.
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We saw that in the short-run, firms would enter the industry to
secure a share of supernormal profits and leave the industry in
times of loss. However, in the long-run, these movements are
eradicated and a long-run equilibrium will be established where
there is just enough profit (normal profit) to keep the existing
firms in the industry. There is no incentive for the firms to enter
or leave the industry. This long term position is illustrated in
diagram 3. Note the following points about this diagram:
(i) The market price, P, is the price which all individual firms
in the market must take.
(ii) If the firm must accept a given MR, as it must in conditions
of perfect competition, and it sets MC=MR, then the MC
curve is in effect the individual firm’s supply curve,
diagram 3(b). The market supply curve in diagram 3(a)
is derived by aggregating the individual supply curves of
every firm in the industry.
(iii) Consumer supply is represented by the area to the left of
the demand curve above P.
(iv) The firm is operating at its most cost-effective point at the
lowest point on the ATC curve.
Diagram 3(b) also shows us that the individual firm’s
equilibrium position occurs where price equals marginal
cost... Since price is a measure of value of the product to the
customer and marginal cost measures the cost to the producer
of attracting resources from alternative uses, then the price of
the last unit of output is equal to the opportunity cost of its
production. This signifies that allocative efficiency is being
achieved.
The long-run equilibrium position under perfect competition is
unique because it is the only market condition which achieves
allocative efficiency.
In the long-run, all firms in the industry will have
MC=MR=AC=AR=Price, as at output Q1 in diagram 3(b).
Because this position earns the entrepreneur the desired return
on their capital (normal profit), ensures allocative efficiency and
means that firms operate at their most cost-effective point,

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long-run equilibrium under perfect competition is held to be a
desirable model for an economy.
Monopoly:
In this market structure there is only one firm, the sole
producer of a product which has no closely competing
substitute. The following are the assumptions underlying the
model of monopoly:
(i) The market has a single supplier and many consumers.
The single supplier controls market supply and can
control price.
(ii) The monopolist can be a price maker through the
amount of products that it produces for sale. If it reduces
output the scarcity it causes will drive up prices.
(iii) The product it produces has no close substitutes.
Therefore, the customer cannot satisfy their needs by
switching to different producers ‘products.
(iv) The industry has barriers to entry which prevent new
firms setting up and competing for the high prices and
profits being enjoyed by the monopolist.

Profit Maximising Equilibrium of a Monopoly:

Because a monopoly is the sole supplier to the market, it faces
the market demand curve (AR=D=P). This will be downward
sloping reflecting the law of demand that price must be
reduced in order to increase unit sales.
Diagram 4 shows the position of the monopolist earning
supernormal profits in the short-run. The monopolist’s profit
is maximised at output Q1 where marginal cost (MC) equals
marginal revenue (MR) and the price charged is the average
revenue P1. The monopolist is earning supernormal profits
because the price P1 charged on the products is way above the
ATC and MC curves represented by the rectangle area of
P1ZYX.
The monopolist will charge a higher price than a perfectly
competitive firm and produce less output. The output of the
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monopolist will be at a level where ATC is not at a minimum.
Monopoly is therefore less efficient in using the scarce
economic resources compared to perfect competition firm.
Technical Inefficient and X – inefficiency:
Technical inefficiency – arises because unlike perfectly
competitive firms, monopolies do not produce at an output
level which minimises average costs. The resources they
consume could be better used elsewhere.
X-inefficiency – arises because monopolies are wasteful and
spend more than they need to spend in their production
process. Lack of competition often makes monopolies
complacent.

The difference between technical inefficiency and x-inefficiency

is illustrated in diagram 5:

(i) Diagram 5(a) – if a monopolist maximises profit at output

level Q2, there is technical inefficiency because the firm
could minimise its average costs (ATC) at Q1.

(ii) Diagrame 5(b) – if a monopolist has an average cost curve

ATC1, where it ought to use resources more efficiently
and have an average cost curve ATC2, there is x-
inefficiency.

Monopolistic Competition and Non-price Competition:

Monopolistic competition is a market structure in which a firm’s

products are comparable rather than homogeneous. Product
differentiation gives the products some market power by
acting as a barrier to entry. Monopolistic competition is a
market structure which combines features of perfect
competition and monopoly.

A firm operating in conditions of monopolistic competition has a

downward sloping curve like a monopoly, meaning, the
quantity of output customer’s demand responds to the price at
which the firm is prepared to sell. The downward sloping

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demand curve is possible because of product differentiation
created by the firm. However, unlike a monopoly firm, a firm
operating under monopolistic competition is unable to utilise
barriers to entry against other firms. Indeed, the firm already
competes with rivals which can take retaliatory competitive
action if the firm makes big profits.

Firms in monopolistic competition will try to avoid

competition on price in order to preserve their position as
price maker. They will often resort to non-price competition
instead, perhaps through advertising and sales promotion or
through product differentiation. With product differentiation,
suppliers try to create differences between their products and
other similar products. These differences might be real or
largely imaginary and created mainly by advertising and
brand image.

However, one of the key features of monopolistic competition is

that there are no significant barriers to entry.

Profit Maximising Equilibrium:

A firm which operates in conditions of monopolistic competition

will have a short-run equilibrium in which it can make
supernormal profits and a long-run equilibrium in which it
cannot make supernormal profits. In the long-run, the
monopolistic competitor cannot earn supernormal profits
since there are no entry barriers in the industry. Its short-run
supernormal profits will be competed away by the new
entrants in the industry. As a result of competition, the
demand curve will move to the left and the firm will eventually
be able to achieve normal profits only.

The short-run equilibrium for a firm in monopolistic competition

is shown in diagram 6. This is the same as the equilibrium of a
monopoly firm earning supernormal profits. The firm makes
supernormal profits of (P – A) Q units shown by the area of the
rectangle PQBA.

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Note that although the short-run equilibrium of a firm in
monopolistic competition resembles that of a monopolist’s, the
demand curve (the average revenue curve) for the firm in
monopolistic completion is likely to be more elastic. This is
because the customer in the market has a choice between
products and can be tempted to move between products by
advertising campaigns which are a feature of this market
structure.

The long-run equilibrium of a firm in a monopolistic

competition is illustrated in diagram 7. This is the same as the
equilibrium of a monopoly firm which earns no supernormal
profits but normal profits only. The supernormal profits
earned in the short-run have attracted new entrants and so
have been competed away.

The competitive rivalry resulting from the new entrants into the
market causes the firm to lose some of its customers but not
all of them. This is an important point because the firm has
established a brand loyalty which will make it possible for it to
retain some of its customers despite the entry of the new
competitors into the market.

However, although monopolistic competition creates normal

profits in the long-run just like perfect competition, but unlike
perfect competition, it does not achieve allocative or
technical efficiency.

Allocative efficiency occurs where price equals marginal

cost. However, as the diagram indicates, the price, P1, is
higher than marginal cost at output level Q1where MC=MR.
This means that output could be increased so some people
could be better off without others suffering. Allocative
efficiency would be achieved at quantity QA and price A.

Technical efficiency is not achieved because the average cost

of the equilibrium output is not at the lowest point on the
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average cost curve (T). This would be achieved where output
quantity is equal to QT. The diagram also indicates that the
firm has excess capacity because the output at the level of
technical efficiency (QT) is greater than the current output
level of Q1.

As a result of the allocative and technical inefficiency,

monopolistic competition still gives rise to higher prices and
lower outputs than perfect competition.

Oligopoly:

This is a market structure where a few large suppliers

dominate the market and there is a behavioural relationship
between them i.e. they take each others’ responses into
account when setting price and output decisions.

Oligopoly differs from monopoly in that there is more than

one firm in the market and from monopolistic competition
because in oligopoly the number of rival firms is small. Real
world examples of oligopolies serving a country’s markets are
very numerous and include some of the following:

(i) Cigarette production

(ii) Mobile telephone network provision

(iii) Banking services

(iv) Automobile production and

(v) Airlines

The size of the existing firms in an oligopoly is likely to act as a

barrier to entry to potential new entrants and can allow
oligopolists to sustain supernormal or abnormal profits in
the long-run. Oligopolists may produce a homogeneous
product (oil) or there may be product differentiation
(cigarettes and cars). An oligopoly will exhibit both price and
non-price competition between firms.

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Another key feature of oligopoly is that firms’ production
decisions are interdependent. One firm cannot set price
and output without considering how its rivals’responses will
affect its own profits. An oligopolist’s pricing and output
decisions will usually depend on what assumptions they make
about their competitors’ behaviour or reaction.

One strategy which an oligopolist might adopt is to cooperate

with other firms and such a strategy will give rise to a cartel.

Price Cartels by Oligopolist Producers:

A price cartel or price ring, is created when a group of

oligopoly firms combine to agree on a price at which they will
sell their product to the market. The market might be willing to
demand more of the product at a lower price while the cartel
attempts to impose a higher price (for higher unit profits) by
restricting supply to the market.

Each oligopoly firm could increase its profits if all of the firms
together control prices and output as if the market were a
monopoly and split the output between them. This is known as
collusion which can either be tacit or openly admitted.
Collusion usually leads to higher prices and lower outputs
than the free market equilibrium and so reduces consumer
surplus and consumer sovereignty.

Cartels are illegal but difficult to prevent. There might still be

price leadership. This occurs when all firms realise that one of
them is initiating a price change that will be of benefit to them
all and so follow the leader and change their own price in the
same way.

Diagram 8 shows that in a competitive market with a market

supply curve S1 and demand curve D, the price would be P1
and output Q1. A cartel of producers might agree to fix the
market price at P2 which is higher than P1. But to do so, the
cartel must also agree to cut down market supply from Q1 to
Q2 and so fix the market supply curve at S2.
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Game Theory and Oligopoly:

Economists sometimes model the strategies of oligopolists and

market participants in other types of market structure using
game theory which involves examining participants’ strategies
according to what they stand to gain or lose from each
strategy.

Game theory is an attempt to explain the decisions of firms by

developing simulations that examine participants ‘strategies
according to what they stand to gain or lose from each
strategy. There are four strategies about pricing which an
oligopoly might adopt:

(i) Co-operate with the other large firms to agree on a

common policy on pricing and market sharing. This is
collusive oligopoly.

(ii) Make their own decisions and ignore rivals i.e. to become
a price leader. The effect of this will depend on how rivals
react.

(iii) Become a price follower i.e. price taker and respond to the
actions of a price leader.

(iv) Do nothing. The firm may feel it would be

disadvantageous to change its price.

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