Chapter 35 - Different Market Structure

 Industry: a group of productive enterprises or organisations that produce or

supply goods, services, or sources of income.
 MNC: A multinational corporation (MNC) has business operations in two or more
countries.
 Market Structure: the way in which a market is organised in terms of the
number of firms and barriers to the entry of new firms.
 Barriers to Entry: any restriction that prevents new firms from entering an
industry.

Market Structure Number of Barrier to Control Over

Spectrum Firms Entry Price Change

Perfect Competition Large None None

(Large number of firms)

← Monopolistic Many Low Limited

Competition

← Oligopoly Few High Significant

Monopoly (Small number Small High Full

of firms – often just one)

It shows the transition:

 Left side → Many firms, no barriers, no price control.
 Right side → Few or one firm, high barriers, full price control.

 Perfect Competition: an ideal market structure with many buyers and sellers,
identical or homogeneous products and no barriers to entry. It is on the furthest
left end of the spectrum.
 Imperfect Competition: any market structure except for perfect competition.

 Monopolistic Competition: a market structure where there are many firms,

differentiated products and few barriers to entry. This falls after perfect
competition in the middle of the spectrum structure.
  Oligopoly: is a market structure with few firms and high barriers to entry. Falls
after monopolistic competition in the middle of spectrum structure.
 Monopoly: a pure monopoly is Just 1 firm in an industry with very high barriers
to entry. It falls at the furthest right end of the spectrum
Stages to help identify the market structure in the spectrum:

 Count firms, larger numbers, closer to perfect competition.

 Concentration ratio to see the combined market structure of the biggest firms as
a percentage of the industry total. The bigger percentage is closer to oligopoly
and monopoly.

 Considering barriers to entry

 Considering the importance of economies of scale to a firm, the more it is, the
closer to oligopoly.
Barriers to Entry:
 Access to Capital: The market could have high fixed costs/set-up costs, such as
research and development, which might require a high salary over a long period
to be profitable.
 Sunk costs act as a barrier to exit, and the high risk of entry and failure
prevent potential firms from entering.
 Advertising and brand names with high consumer loyalty are hard to achieve,
so they deter firms as they are also regarded as a form of investment.
 Start-ups have less advantage of economies of scale, and large firms can
take advantage of their economies of scale and use predatory pricing.
 Patents restrict the use of production processes/products.

 Some existing firms may have monopoly access to raw materials,

components and retail outlets.

Concentration Ratio

 Concentration Ratio: the collective market share of the largest firms in the
industry.
 It is found by taking the ‘n’ number of top firms and adding up their market
share. Then, put them in a ratio.

 Company A's market share is 10%, company B's market share is 15%, company
C's market share is 20%, and company D's market share is 25%.
  the ratio would be n=4, total market share of the top firms=70, thus 4:70.
 Important note: Only add the big dominators, not all the firms in the market.

 A higher concentration ratio suggests a more monopolistic or oligopolistic market,

while a lower concentration ratio indicates a more competitive market.
Perfect Competition

 Theoretical Extreme, the only applicable example is the produce

market, which has the following characteristics:

o Perfect knowledge about market conditions and prices by all buyers and
sellers.
o Individual firms have no influence on market price, which is determined
by market demand and quantity-supplied forces. Firms are price takers.

o All products are identical (same quality and identical to every consumer)

o Freedom of entry into and exit from the market.

 Demand = Average revenue = Marginal revenue.

o This is because firms cannot influence price; they just take it. This leaves
the marginal revenue constant, which makes equal average revenue
(Additional units will give the same revenue every time).

o The price is equal to AR and MR.

 The chosen output will be where MC = MR (price), the profit maximisation point.

 Abnormal profit results in the short run, but since it creates incentives for new
firms to enter, supply rises, causing prices to fall and profits to return to normal.
 Long-run equilibrium leaves only productive and allocative efficient firms due
to normal profit.

 The Shutdown price is when P=AR=AVC.

o If the firm’s price (average revenue) falls below its average variable cost, it
is making an operating loss since that would mean the total revenue
would be less than the variable costs. This is short-term since firms
may return from this loss by cutting costs, loans, economic growth, etc.
o The long-term shutdown price is when the price is less than the
minimum ATC; the firm will have to exit the market permanently since it
cannot cover all its costs.
Contestable Market

 Contestable Market: Any market structure with a threat that potential entrants
are free and able to enter this market.
 No cost for entry, and it exists in the perfect contestable market. The government
does this to deregulate the market and make it more competitive.
 Features of Contestable Market

o Free entry

o The number and size of firms are irrelevant.

o Only normal profit can be earned in the long run.

o The threat of potential entrants into the market is overriding

o All firms are subject to the same regulations and government control.

o Mechanisms must be in place to prevent unfair pricing designed by

established firms to stop new firms from entering.

o Cross subsidisation is eliminated.

Imperfect Competition

 any market structure except for perfect competition

Monopolistic Competition

 Characteristic:

o Numerous buyers and sellers

o Few barriers to entry

o Wide choice of differentiated products

o Firms have some influence on market price

 Similar to perfect competition, except for product differentiation. This requires

brand image, so advertising and promotion play a big role in this market
structure.
 Firms can charge prices above marginal cost, which means as the firm makes
more of the product, the price is lowered, and that’s why marginal revenue is
below the demand curve.

 In the short-run, as firms aim to maximise/minimise profit, they will aim to

produce where MC=MR; this has them making an abnormal profit. Like perfect
 competition, this creates incentives for new firms to enter due to low barriers
to entry. But unlike perfect competition, firms can set their prices; this
creates competition and shifts prices from where it meets demand to where
it meets ATC and MC. This leads to losses, but as firms are free to exist,
these losses are turned into normal profits.

 In the long run, firms will still produce where MC=MR; however, the demand
curve would have shifted to the left due to competition and firms entering the
market. This causes normal profit and excess capacity, as firms won’t produce
at minimum ATC in the long run.
Oligopoly

 Characteristics:

o Dominated market by a few firms

o Decisions are interdependent on rival strategies/reactions.

o High or substantial barriers to entry

o Products may be differentiated or not.

o The uncertainty and risk associated with price competition may lead to
price rigidity.
 Oligopoly behaviour can follow 2 routes, aggressive competition in the form of
price wars and another less risky approach through non-price competition to
increase revenue and horizontal integration.

 Non-Price Competition

o physical characteristics
o location

o service level

o advertising
 The second route is cooperation and collusion.

o Cooperation like research and development, where firms pool their

knowledge and perhaps participate in joint ventures.
o Collusion is different; it is anticompetitive action by producers;

 Price Leadership: a situation in a market whereby a particular firm has the

power to change prices, the result of which is that competitors follow the lead.
  Cartel: a formal agreement between firms to limit competition by limiting output
or fixing prices.
Main Theories to Attempt to Explain Oligopolistic Behaviour
The Kinked Demand Curve

 is a means of analysing firms' behaviour in an oligopoly without collusion.

 The kinked demand curve shows how oligopoly firms won’t be able to have price
competition, and that will lead to the temptation to collude.

Impact of Price Rise

 In the graph above, p is the equilibrium price; if the price rises above that, there
will be a Reverse movement along the demand curve, causing a reduction in
Q (quantity) and a reduction in MR (marginal revenue).

 If a firm increases the price, it becomes more expensive than its rivals,
so consumers will switch to its rivals.

 Therefore, for a price rise, there is likely to be a significant fall in demand.

Demand is, therefore, price elastic.

 In this case, by increasing price, firms will lose revenue because the percentage
fall in demand is greater than the percentage rise in price.
Impact of Price Cut
  In the graph above, p is the equilibrium price; if the price reduces below that,
there will be Forward movement along the demand curve, causing a slight
increase in Q (quantity), a reduction in MR (marginal revenue) and
a significant increase in MC (marginal cost).

 If a firm cut its price, it will likely lead to a different effect. In the short term, if a
firm cuts price, it would cause a big increase in demand, leading to a rise in
revenue. The firm would gain market share.

 However, other firms will not want to see this rise in market share, so they
will respond by also cutting prices to follow the first firm. The net effect is
that if all firms cut-price – the individual firm will only see a small increase in
demand.

 Because there is a ‘price war’, demand for a firm is price inelastic – there is a
smaller percentage rise in demand.

 If demand is inelastic and price falls, then revenue will fall.

Game Theory

 Showcases interdependences that a kinked demand curve cannot showcase.

 This diagram showcases the different options a firm can decide based on
competition and price.
 Prisoners’ dilemma is showcased here, with a Nash
equilibrium and dominant strategy.

 The Nash Equilibrium: a decision-making theorem within game theory that

states a player can achieve the desired outcome by not deviating from their initial
strategy. In this case, the Nash equilibrium is either selling for 1 dollar for
companies A and B, where each gets 3 million in return.
  Dominant Strategy:

 Prisoners’ Dilemma: when both parties are under the guise of guilty, where if
both fess up, punishment is shared if one is proven guilty, full punishment, This
causes both parties to be in a dilemma. Related to pricing strategy.
 Principal Agent Problem: a principal hires an agent to own the business, but
there is a case of info. Failure, since the principal, cannot ensure that the
appointed agent makes the necessary decisions to run the firm in the best
interests of shareholders. For ex. the agent is following the objective of satisfying,
whereas the principal believes he or she is implementing a policy of profit
maximisation.

 Price rigidity (non-price competition) like the Nash equilibrium is not the best
outcome, therefore pushes firms to collude and use tactic collusion.

 It also provides an incentive to cheat on collusive agreements, which could put

firms at risk of being caught, which could reflect negatively.
Monopoly

 A pure monopoly is a single firm, but in real life, a monopoly can be a firm with a
large percentage of market share and a mass dominant position.
 In theory characteristic:

o Single seller

o No close substitutes

o High barriers to entry

o The monopolist is the price maker

 Local monopolies can exist because it could be too costly for the others to set
up, even tho it could be a small firm.

 No distinction between short-run and long-run due to barriers of entry and no

economic incentive for the monopolist to move away.

 Monopoly sets prices higher than market equilibrium (where MC=ATC), causing
them to make supernormal (abnormal) profits. This would normally attract new
firms, but due to the higher barriers of entry, no effect on the profit occurs.
 Natural Monopoly:

o Where a single supplier has a substantial cost advantage such that

competing producers would raise costs and where duplication will produce
 an inefficient use of resources. This can also be done by the government,
for example, utilities, because private firms may exploit the customers.
o It could be making an abnormal profit, but if it behaved like a competitor
firm, equilibrium is where price = long-run marginal cost. This leads to
price and added quantity loss, causing a loss without government
subsidies. That is why being in the public sector is more logical.
 Positives of Monopoly

o a monopolist cannot always make abnormal profit

o the competitive market has an uncertainty of profits - monopolists can

invest in this and provide better quality products and job security.

o Investment may take the form of process innovation.

o Profit would be used to finance product innovation.

o If the benefits of economies of scale were passed on to consumers, they

would have gained from it.
Comparing Monopoly and Perfect Competition

 Monopoly price higher than perfect

 Monopoly output lower

 Monopolists making long and short-run abnormal profits

 Productive efficiency and producing optimum output in perfect competition and

also allocative efficiency, price = MC.

 Monopolists take consumer surplus and make abnormal profits.

 X inefficiency - where the typical costs exceed those experienced in a more
competitive market. This happens when the firm lacks the incentives to lower the
costs.

 The monopoly firm is productively inefficient, producing less than the optimum
output in the search for extra profit. The price change is well above marginal cost
and is not allocative efficiency.
 If a perfectly competitive industry were turned into a monopoly, there would be
a welfare loss of area x and greater allocative inefficiency.