PRINCIPLES OF ECONOMICS
Module-D: Market Structure
Module-D: Market Structure
There are several models of market structure, these include a. Perfect Competition (atomized
competition, price taker, freedom of entry & exit, no nonprice competition, standardized
product);
b. Monopoly (one seller, price giver, entry & exit blocked, unique product, nonprice competition);
c. Monopolistic competition (large number of independent sellers, pricing policies, entry
difficulty, nonprice competition, product differentiation); d. oligopoly (very few sellers, often
collude, often price leadership, entry difficult, nonprice competition, product differentiation).
Market structures are categorized based on their key features.
Key Features of the Market Structure
Number of Nature of Control Over Entry/Exit
Sellers/Firms product/Services Price
Perfect Numerous Homogenous No Control Free
Competition
Monopolistic Large Differentiated Some Control Not Free
Oligopoly Few Homogenous/ May have May or May not
Differentiated Significant
Control
Monopoly One Unique Significant Entry
Control Restricted
Perfect Competition
For the perfectly competitive market, a firm is a price taker and market is the price maker. The
market graph is a standard supply and demand graph with an equilibrium price and quantity.
Since the firm is a price taker (no ability to affect price), the firm‟s demand curve is horizontal
(perfectly elastic) at the market price. This demand curve is also the firm‟s average revenue
(AR), marginal revenue (MR), and price (P). Together the 4 curves in one form what is often
labeled MRDARP (Marginal Revenue, Demand, Average Revenue, Price). The firm produces
the quantity where MR=MC. The cost curves for perfect competition are the same as a
monopoly and monopolistically competitive firm. The AVC and AFC are rarely needed in this
graph. When a firm earns zero economic profit, it has no incentive to exit the industry.
Likewise, other firms have no special incentive to enter. A long-run competitive equilibrium
occurs when three conditions hold: all firms in the industry are maximizing profit; no firm has
an incentive either to enter or exit the industry because all firms are earning zero economic
profit; and the price of the product is such that the quantity supplied by the industry is equal to
the quantity demanded by consumers (Figure D1).
In a perfectly competitive market, a barrier to entry is anything that makes it difficult for
entrepreneurs to enter the market and compete. Barriers to entry can be high startup costs,
customer loyalty, government regulation, etc. In perfectly competitive markets, barriers to
entry are low. That means, when firms are earning economic profits, competing firms seek
that profit and enter the market in the long run. When firms enter the market, prices fall and
economic profit goes to zero. When firms are earning economic losses, firms exit the market
(as resources will be more profitable elsewhere) in the long run, causing prices to rise until
economic losses are zero. In the end, low barriers to entry (and exit) mean competitive
markets earn zero economic profit in the long run. On the graph, when firms enter the
market it shifts the market supply curve to the right, decreasing the market price and
MR=D=AR=P until firms break even. When there are economic losses in the short run,
firms exit the market in the long run which shifts the market supply curve to the left,
increasing price and MR=D=AR=P until the firm breaks even.
Short Term Profit and Loss Situation in a Perfectly Competitive Market
Long term profit for a perfectly competitive firm is zero (Figure D1). In this market,
allocative efficiency is attained because price equals marginal cost in both the short-run and
long- run. Productive efficiency occurs when the firm is producing at the minimum of the
average total cost (ATC) curve (where it intersects the MC). In the short run, perfectly
competitive firms are not productively efficient, but in the long run they are (may earn profit
or loss as shown in Figure D2).
The minimum point on the AVC correlates to the lowest price a firm would be willing to
accept. If the market price is above the AVC, the firm will produce the quantity where
MR=MC. As the price falls, profit will fall but the firm will continue to produce where
MR=MC. If the price continues to fall, the firm will produce lower quantities as long as the
price stays above the AVC. If the price falls below the AVC, the firm shuts down
(temporarily) as the firm will only lose its fixed costs if it shuts down. Producing at a price
below the AVC would cause the firm to lose more than their fixed costs. If the price equals
the minimum of the AVC, the firm will produce that quantity; it is the lowest quantity the
firm would produce. As a result, the firm‟s supply curve is the MC curve above the AVC.
Generally perfectly competitive firms are considered as part of constant cost industries.
Those are industries where the firm‟s cost curves do not shift based on the equilibrium
output in the market. However, there could also be an increasing cost industry. That would
be a product where an increase in the market equilibrium quantity would cause an increase
in costs for the individual firm. Increasing cost industries occur because the long run average
total cost curve for the industry as a whole is upward sloping. Precious metals are an example
increasing cost industry because as more gold and silver is produced (through mining) the
cost of producing more constantly increases; as gold and silver become more and more
difficult and costly to mine. A decreasing cost industry is just the opposite. Cost curves will
shift downward as industry output increases. This is as a result of the industry‟s long-run
average total cost curve sloping downward. These industries capture economies of scale.
Microchips are an example of a product in a decreasing cost industry. The more that are
produced, the cheaper production typically gets.
Monopolistic Competition
Monopolistic practically is the market structure that combines monopoly and competition. In
monopolistic competition firms face downward-sloping demand curves. Therefore, they
have some monopoly power. But this does not mean that monopolistically competitive firms
are likely to earn large profits. Monopolistic competition is also similar to perfect competition:
Because there is free entry, the potential to earn profits will attract new firms with
competing brands, driving economic profits down to zero. To make this clear, let‟s examine
the equilibrium price and output level for a monopolistically competitive firm in the short and
long run. The following graph (Figure D4) shows the short-run equilibrium. Because the
firm‟s product differs from its competitors, its demand curve DSR is downward sloping.
(This is the firm‟s demand curve, not the market demand curve, which is more steeply
sloped.) The profit maximizing quantity QSR is found at the intersection of the marginal
revenue and marginal cost curves. Because the corresponding price PSR exceeds average
cost, the firm earns a profit, as shown by the shaded rectangle in the figure (Figure D4).
Super Normal Profit by the Monopolistic Firm in the Short Run
In the long run (Figure D5), this profit will induce entry by other firms. As they introduce
competing brands, our firm will lose market share and sales; its demand curve will shift
down. (In the long run, the average and marginal cost curves may also shift. We have
assumed for simplicity that costs do not change.) The long-run demand curve DLR will be
just tangent to the firm‟s average cost curve. Here, profit maximization implies the quantity
QLR and the price PLR. It also implies zero profit because price is equal to average cost.
The firm still has monopoly power. Its long-run demand curve is downward sloping because
its particular brand is still unique. But the entry and competition of other firms have driven its
profit to zero. More generally, firms may have different costs, and some brands will be more
distinctive than others. In this case, firms may charge slightly different prices, and some will
earn small profits.
A comparison of perfectly completive (Figure D4) and monopolistic (Figure D5) long run
equilibrium indicates comparative market efficiency and optimum use of resources. Under
perfect competition, as in (Figure D4), price equals marginal cost, but under monopolistic
competition, price exceeds marginal cost. Thus there is a deadweight loss, as shown by the
yellow-shaded area in (Figure D5). In both types of markets, entry occurs until profits are
driven to zero. Under perfect competition, the demand curve facing the firm is horizontal, so
the zero-profit point occurs at the point of minimum average cost. Under monopolistic
competition the demand curve is downward- sloping, so the zero-profit point is to the left of
the point of minimum average cost. In evaluating monopolistic competition, these
inefficiencies must be balanced against the gains to consumers from product diversity.
Long Run Equilibrium in the Monopolistic Market
Oligopoly
Oligopoly market may take different model structure, and with the passage of time it make take
different shape. It is much more difficult for an oligopoly to determine at what output it can
maximize its profit. There are two major reasons for this: the interdependence of the oligopolistic
firms and their diversity, especially in terms of concentration ratios. Some oligopolies have a very
high concentration ratio, allowing them to act more like a monopoly, while other industries have
a much lower concentration ratio, thus, making it more difficult to determine the best pricing
strategy, since the number of possible responses by competitors is increased.
In a stable economy, oligopolies' prices change much less frequently than under any other market
model, such as pure competition, monopolistic competition, and even monopoly. When prices do
change, the firms generally move in the same direction and by the same magnitude in their price
changes, which may be the result of collusion. There are several basic theories about oligopolistic
pricing: kinked-demand model, or non-collusive oligopoly, the cartel or collusion model, the price
leadership model, and contestable market model.
Kinked-Demand Model Consider a firm in an oligopoly that wants to change its price. How will
the other firms react? There are 2 possibilities: they can either match the price changes or ignore
them. But what the other firms will actually do will probably depend on the direction of the price
change. If one firm raises its price, the others probably will not follow, since that will allow them
to take market share from the price changer. This makes the demand curve more elastic, since as
the firm raises its price, then many of its customers will buy from the other firms, lowering the
revenue of the higher-priced firm.
If the firm lowers its price, then the other firms would surely follow, to prevent any loss of market
share. This part of the demand curve is much more inelastic, since all the firms are acting in
concert. This creates a kink in the demand curve, where the change in demand goes from very
elastic at higher prices to inelastic at lower prices. Since the marginal revenue curve depends on
prices, the marginal revenue curve is also kinked. At lower prices, the marginal revenue curve
drops downward creating a gap. The marginal cost curves of both scenarios will intersect the same
quantity being produced by the oligopoly, represented by the vertical line in the graph; therefore,
there is no change in quantity produced as prices are lowered, as long as the change in marginal
cost is within the marginal revenue gap. In the graph below (Figure D6), if a firm raises its price
(elastic), the others do not match the increase, then revenue will decline in spite of the price
increase. If the firm lowers its price (inelastic), then the other firms will match the decrease to
avoid losing market share. Because there is a kink in the demand curve, there is a gap in the
marginal revenue curve (MR1 - MR2). Since firms maximize profit by producing that quantity
where marginal cost = marginal revenue, the firms will not change the price of their product as
long as the marginal cost is between MC1 and MC2, which explains why oligopolistic firms
change prices less frequently than firms operating under other market models.
Figure D6: Kinked Demand Curve in the Oligopoly Market
The kinked-demand curve explains why firms in an oligopoly resist changes to price. If one of
them raises the price, then it will lose market share to the others. If it lowers its price, then the
other firms will match the lower price, causing all the firms to earn less profit.
Critics of the kinked-demand model point out that while the model explains why oligopolies
maintain pricing, it doesn't explain how its products were initially priced. Also not explained is
that when the economy changes significantly, especially with high inflation, then the firms of an
oligopoly do change prices often. Oligopolistic firms may even engage in a price war, where
each firm charges a successfully lower price to gain market share.
Cartel or Collusion Sometimes firms in an oligopoly try to form a cartel by agreeing to fix prices
or to divide the market among themselves, or to restrict competition some other way. The
primary characteristic of the Cartel Model is collusion among the oligopolistic firms to fix prices
or restrict competition so that they can earn monopoly profits.
If the dominant firms in an oligopoly can successfully collude to fix prices, then they can be
certain of each other's output, which will allow to maximize their profits by producing that
quantity of output where marginal revenue = marginal cost, just as it would be for a monopoly.
However, if any of the firms cheat, then a price war may ensue, lowering the profits of all firms,
and maybe even causing them to operate at a loss. In most modern economies, collusion is
generally against the law, however there are certain countries that engage in collusion to
maximize their profits from their natural resources. Each participating firm is then allocated with
a quota.
Cartel in the Oligopoly Market Structure
The best example of a cartel today is the Organization of Petroleum Exporting Countries, otherwise
known as OPEC, which comprises 12 oil-producing nations that supply 60% of all oil traded
internationally. Prices are maintained by restricting each country of the OPEC cartel to a specific
production allocation. The OPEC cartel is largely responsible for the large fluctuations in gasoline
prices that occurred in the United States since 1973, although recently, speculation in the
commodity markets has also increased volatility.
Collusion is often difficult to detect, because it is often based on tacit or covert agreements that are
made during social interactions between the executives of oligopolistic firms. Nonetheless, there are
several obstacles to collusion.
One common obstacle is differences in demand and cost. Firms that serve different geographic
markets will have varying levels of demand, and they may also have different efficiencies, resulting
in different production costs. If economies of scale are steep for an industry, then smaller firms will
aggressively compete on price to increase their market share, so that they can earn reasonable profits.
In such cases, it will be difficult for the firms to agree on the price, because they will have different
marginal cost curves. A good example is Saudi Arabia and Venezuela in the production of oil. Saudi
Arabia is efficient in producing soil, whereas Venezuela, governed by an inept communist
government, is highly inefficient, so it would be very difficult for Venezuela to accept a price that
would be suitable for Saudi Arabia. Consequently, there is a great temptation for inefficient producers
to cheat, and if they cheat, then price competition ensues.
Another factor that increases cheating is recessions. During recessions, demand declines, which
shifts the firm's marginal cost and demand curve to the left. Firms often respond by reducing prices so
that they can better utilize their production capacity and to try to gain market share from the other
firms.
A larger number of firms in the oligopoly make it difficult both to create and maintain collusion.
If there are only 2 or 3 firms in the oligopoly, then it is fairly easy to collude to set prices or to
limit competition. However, if there are 6 or more firms with a smaller share of the market, then
collusion becomes increasingly difficult. Indeed, the likelihood of successful collusion decreases
as the number of firms increases.
Another possible barrier to collusion is that if prices are maintained too high, then it may allow new
entrants into the industry that will provide more competition, or, smaller firms that did not have
much market power can cut prices and increase production to grab market share.
The other major barrier to collusion is antitrust law. Most modern economies prohibit collusion,
since it is against the public interest, although there are some exceptions. A very common exception
is the pricing of insurance products, since many insurance companies depend on rating companies
that gather information on insurance risks and how to price them.
Price Leadership Model In many industries, there is a dominant firm in an oligopoly, and the other
firms often follow the dominant firm in price changes, which can be viewed as a type of
implicit price collusion. Hence, the dominant firm also becomes the price leader. Since most firms
have been in the business for a number of years, they can observe how their competitors react to
changes in the industry, allowing them to reach an understanding of how their competitors will react
to any price changes. Firms in an oligopoly do not often change prices, certainly not for minor
changes in costs, but they will change prices if cost changes are substantial. Indeed, if there is a
general price increase in the inputs of an industry, then all firms will surely increase their prices.
Increasing price of inputs, of course, helps to protect the industries from antitrust prosecutions since
they have a reasonable basis for increasing the price of their products that is not related to restricting
competition.
Oftentimes, the price leader will communicate the need to raise prices through press releases, trade
publications, and speeches by major executives, especially when announcing quarterly earnings.
There are many times when a price leader will limit price increases to discourage the entrance of
new competitors — a practice called limit pricing. This will be particularly true if the economies of
scale are not that steep, since high prices can allow the entrance of new competitors who will be
able to survive on a small market share.
Sometimes price leadership breaks down and price wars result. However, price wars are self-
limiting, since they will often lead to losses. Eventually, the firms will capitulate and return to the
practice of following the price leader.
Contestable Market Model The contestable market model is an oligopolistic model based on
barriers to entry and barriers to exit that determine the firm's price and output. If the barriers are
high, then the oligopolist will set higher prices. On the other hand, if the barriers are low, then the
oligopolist will set low prices to prevent new firms from entering the industry or to promote the
exit of its competitors.
Productive Inefficiency Pure competition achieves productive efficiency by producing products at
the minimum average total cost. They also achieve allocative efficiency because they produce until
their marginal cost = price. However, because oligopolies produce only until marginal cost =
marginal revenue, they lack both the productive and allocative efficiency of pure competition.
Because oligopolies can successfully thwart competition, they restrict output to maximize profits,
producing only until marginal cost = marginal revenue. Hence, oligopolies exhibit the
same inefficiencies as a monopoly. Because the marginal cost curve intersects the marginal
revenue curve before it intersects the average total cost curve, oligopolies never reach an efficient
scale of production efficiency, since they never operate at their minimum average total cost.
Similarly, the marginal cost curve never intersects the market demand curve; therefore, oligopolies
produce less product than what the market desires, so oligopolies lack allocative efficiency.
Monopoly
There are no close substitutes and no competitors, and the product is unique. High barriers prevent
any competitors from entering. Monopolies may engage in rent seeking behavior (working to pass
voter initiatives, lobbying politicians, etc), to maintain a monopoly. These actions will increase
the firm‟s ATC and erode some economic profits. Due to the high barriers to entry, super normal
economic profit is possible in the long run. Monopoly power gives firms the ability to charge
higher prices than would be charged in a competitive market. High barriers to entry are the driving
force behind giving firms monopoly power. Monopolies price above marginal cost and do not
produce at the lowest average cost so they are not allocative or productively efficient and they
have deadweight loss. Monopolies usually capture economies of scale because the profit
maximizing quantity is on the downward sloping portion of their long-run average total cost curve.
Since there is only one firm, the market is firm. As a result, the firm's demand curve is downward
sloping. The average revenue, and price will also be the demand curve (DARP). If the firm is a
single price monopoly, the marginal revenue curve is below demand. The cost curves for a
monopoly are the same as a perfectly competitive firm and monopolistically competitive firm. The
AVC and AFC are rarely needed in this graph.
Economic Profit in a Monopoly Market Structure
Single price monopolies have both consumer and producer surplus. But since they do not
produce the allocative efficient quantity (where P=MC), they create deadweight loss and are
inefficient.
Allocative Inefficiency in the Monopoly Market
A natural monopoly is an industry which captures economies of scale at the allocative efficient
quantity resulting in much lower average costs when there is a large single provider. These
businesses usually have extremely high start-up costs but have a very low marginal cost of
production. Electricity providers are a prime example of natural monopolies. The most expensive
part of providing homes in a city with electricity is putting up wires and cables all over town to
carry the electricity. If electric service was not a monopoly and consumers had multiple choices
regarding who to purchase electricity from, the costs of production would be dramatically higher (as
multiple sets of cables and wires would need to be strung) and price would likely be higher as a
result. So, the natural monopoly may actually benefit consumers.
Governments will often regulate natural monopolies by imposing price ceilings which may be more
efficient than the unregulated price. The socially optimal price is efficient and creates no
Perfect Price Discrimination and Allocative Efficiency
deadweight loss where price equals marginal cost, but the firm may suffer economic losses at this
price. If forced to earn economic losses, the firm will eventually exit the market so the government
must provide the firm with a lump sum subsidy (equal to its loss) to eliminate deadweight loss.
Some monopolies are able to price discriminate and charge different prices for different units of
output. Price discrimination occurs when a firm is able to charge different customers different
prices for the same product. Like letting kids eat free or giving senior citizens discounts at
restaurants. Firms charge lower prices to people with a lower willingness to pay and higher prices
to people with a higher willingness to pay. If the firm is able to figure out the maximum price each
customer is willing to pay and charge them that price, the firm would be a perfect price
discriminator. That would cause the MR curve to be the same curve as the Demand, Average
Revenue, and Price (MRDARP). Perfect price discriminators are allocative efficient. The last unit
produced will be priced at the marginal cost.
Banking Industry- Monopolistic or Oligopoly Market Structure
In several published literature, banking industry has been terms as close to the monopolistic market structure
considering the number of firms or banks with high density branch networks in a country; the nature of
differentiated financial products or services; involvement of sunk costs; entry restrictions etc. And, it was
expected that the industry would continue to be monopolistic competition to allow more players into the
market. However, in several recent publications, there are opinions that banking industry is no longer
monopolistic competition. The allowance of more players into the market would mean that the customers
would get more choice and due to increased competition, interest rates and other banking services would
reduce. The ideal economic situation that was projected was an industry full of many players that offer
differentiated products.3
However, there are claims that banking industry is changing its market structure due to maturation, and
currently, the industry operates like an oligopoly. The oligopoly condition was made possible through
consolidation and mergers to make „few bigger‟ banks that influence the market since they have a huge
customer base. There are existence of dominant firms despite high number of banks in global economies.
In USA, some banks have huge customer bases such as Citibank, JP Morgan & Chase, and Bank of
America. Therefore, these banks control almost three-quarters of the customer base and their decisions is
accepted. Unlike, to popular belief that in the long run, the banking industry should be more like „Perfect
Competition‟ or normal profit, the new phenomena are marking the customers lose even more. 4
Australia‟s banking system has become so concentrated its major banks can pass on costs and set prices to
boost profits without fear of losing market share, through every stage of the economic cycle, the
Productivity Commission has found. The “four pillars” policy, which has underpinned Australia‟s banking
system since the 1990s, and which was designed to prevent mergers between the four biggest banks to
maintain competition. The reality of Australia‟s „oligopolistic banking system‟ means the biggest banks
are now regularly exploiting the inertia of existing customers, maintaining their market position with
persistently opaque pricing, conflicted advice and remuneration arrangements, and a lack of easily
accessible information that induces their customers to maintain loyalty to unsuitable products.5
Indicative Questions and Exercises
1. Identify and compare features of the four major market structures.
2. „The conditions for profit maximization by a firm is when MC = MR and MC cuts MR
from‟- Explain your answer.
3. „A perfectly competitive firm earns zero or normal profit in the long run‟- Why and How?
4. Show how Allocative efficiency is attained in a perfectly competitive market.
5. „Average Revenue is the lowest in the perfectly competitive market as compared to that
of the other forms of market structure‟- Explain.
6. What are differentiated products? „Market price of oligopolistic firms are higher than
the perfectly competitive firms in the long run‟-Show using graphs.
7. Compare the shape of the demand curve for perfectly competitive and monopolistic
competition in the long and short run.
8. „Advertisement cost is an integral part of a monopolistic market structure‟-Why? Explain
9. Explain allocative inefficiency in case of monopolistic completion as compared to that of
the perfectly competitive market.
10. Explain short run and long run equilibrium situations in a monopolistic market situation.
11. When demand curve might be kinked? Explain the shape of marginal revenue curve in a
kinked demand curve model.
12. What is the collusion? Why is it very difficult to maintain an oligopoly cartel?
13. Examine the key features of monopolistic and oligopoly market structure and make
distinction between them.
14. How a dominant firm may become market leader and create price leadership model
in an oligopoly market structure?
15. Compare Oligopoly and Monopoly market structure based on their key features.
16. Explain short run and long run market equilibrium for a monopoly market structure.
17. Why Monopoly is considered as inefficient as compared to that of perfect competition
and monopolistic market structure?
18. Identify dead weight loss in a monopolistic market structure.
19. What is price discrimination? „Perfect Price Discrimination may create allocative
efficiency‟- How? Explain.
20. Assess the banking industry of Bangladesh based on the features of the market structure,
and comment on the market structure of t banking in Bangladesh.