MARKET STRUCTURES

Market structures are the various market conditions under which firms operate in order to
determine prices and output to be produced.
There are 4 types of market structures which are:
- Perfect competition
- Monopoly/monopolist
- Monopolistic competition
- Oligopoly

PERFECT MARKET/COMPETITION
Perfect competition occurs in a market structure with a large number of participants who
have access to all required information about the marketplace and are all price-takers. Prices
are determined by demand and supply Examples of market structures demonstrating most
conditions of a perfect competition include the stock exchange, the foreign exchange market,
the central grain exchange, and agricultural produce markets.
A perfect market is a market where no single buyer or seller has a noticeable influence on
the price of a good. This gives a true reflection of the scarcity value of goods and services.

Characteristics / Conditions of a Perfect Market

a) Products must be Homogenous (i.e. identical).

 Products must be identical. There should be no differences in style, design and
quality.
 In this way products compete solely on the basis of price and can be purchased
anywhere.
 If products differ, sellers can persuade buyers to buy their more expensive products
by grading them e.g. The markets for maize and coal consist of homogenous
products which are graded; Grade A fetches a higher price than other grades.

b) There should be a large number of buyers and sellers.

 It should not be possible for one buyer or seller to influence the price.
 When there are many sellers the share of each seller to the market is so small that
the seller cannot influence the price.
 Sellers are price takers; they accept the prevailing market price. If they increase
prices above the market price, they will lose customers.
.
c) No Preferential Treatment/ Discrimination
 Collusion occurs when buyers and sellers make an agreement to limit competition. In
a perfect market no collusion takes place.
 Buyers and sellers base their actions solely on price, homogenous product fetch the
same price and therefore no preference is shown for buying from or selling to any
particular person.

d) Free competition
 Buyers must be free to buy whatever they want from any firm and in any quantity.

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  Sellers must be free to sell what, how much and where they wish.
 They should be no State interference and no price control.
 Buyers should not form groups to obtain lower prices nor should sellers combine to
enforce higher prices.

e) Efficient transport and communication

 Efficient transport ensures that products are made available everywhere.
 In this way changes in demand and supply in one part of the market will influence the
price in the entire market.
 Efficient communication keeps buyers and sellers informed about market conditions.

f) The factors of production are completely mobile:

 Producers may enter and leave a market with little interference.
 Entering and leaving a perfect market is easy as less capital is required as well as
fewer legal restrictions
 They can move freely / transfer between markets if they make economic loss in any
market.

g) All participants must have perfect knowledge of market conditions

 All buyers and sellers must be fully aware of what is happening in any part of the
market
 Technology has increased competition as information is easily obtained via the
internet.

In reality there are few perfect markets, however there are

some sectors such as mining (e.g. gold) and agriculture (e.g. maize)
where many of the conditions are met. These sectors illustrate the
way in which the market mechanism works.

The individual business (firm) and the industry

 The firm is one of many sellers that make up the market. The market (industry) is
therefore a summation of all firms that exist in the market.
 The firm under perfect competition is a “price taker”
 The individual business is very restricted by the conditions in the market.
 It has no influence on others firms or the buyers in the market because it has a very small
share in the market.
 All goods and services are classified according to industry/market. e.g Wheat industry,
clothing industry etc.
 The industry has thousands of buyers sellers, and the prices is determined by the forces
of demand and supply.

Demand curve for an Individual Producer and industry under Perfect Competition

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 The Market / Industry The individual producer / business

D S

P2

P1 P1 D

P3

S D
0 Q 0 Q

 Under perfect competition, the market’s demand and supply curve determines the market
price. The market price is established at P1.
 The individual producer is a price taker and sells goods at this market price of P1
 At this price, demand remains the constant.
 A higher price such as P2 cannot be charged as customers will be lost to other producers.
 A lower price such as P3 cannot be charged as a small profit will be made.
 The demand curve for the product of the single firm must be a horizontal line at the ruling
price, in other words a perfectly elastic demand curve. No matter how many units the firm
sells, it can’t change the price. It can sell its entire output at the ruling price. If it tries to
sell at a higher price, its demand will drop to zero and obviously there will be no incentive
to sell at lower prices.
 The market industry diagram shows the determination of the market price OP* by market
forces of demand and supply.
 DD is the demand curve facing the industry and supply SS is the total market supply
provided by all firms in that industry – equilibrium market price is OP* and quantity OQ*.
 The market price OP* is externally determined and the firm sees the demand curve for its
product as being perfectly elastic. The firm can now supply any quantity it wishes at the
ruling price OP*. If it rises to reduce or increase price, demand for its product falls to zero.

DEMAND, MR and AR for an individual producer in a perfect market

Quantity Price (P) Total Marginal Average

Revenue Revenue Revenue
MR = ΔTR AR = TR
ΔQ Q
1 5 5 5 5
2 5 10 5 5
3 5 15 5 5
4 5 20 5 5
5 5 25 5 5
6 5 30 5 5
The demand curve for the individual producer

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 OUTPUT
It’s also known as production, it refers to the quantity or number of units produced. In a
perfectly competitive market, the firm is a price taker thus in its pursuit of profit - it would only
take the given price and its own cost structure into account when determining its output.
Therefore the business needs to decide on a level of output where it realises the lowest cost
and the highest revenue.
It needs to consider its average cost (AC) and total cost (TC).
AC – is the total cost of production divided by the number of units produced.
TC - total fixed cost + total variable cost.

Cost from an economist point of view is also known as opportunity cost which includes
explicit and implicit costs.
Economists cost of production = opportunity cost = explicit cost + implicit cost.
 Explicit cost is the actual expenditure of a business on the purchase or hire of the
inputs required for production e.g. wages, interest on capital, raw materials, etc.
 Implicit cost is the value of inputs that are owned by the entrepreneur and used in the
production process. The value of these inputs must be calculated based on the
returns they could have earned if put to the next best alternative e.g. owner occupied
property used for business.

OUTPUT DETERMINATION IN THE SHORTRUN

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Interaction between demand & supply Output of business
MC
P D S P h AC

P1 e P1 f e i AR=MR

0 Q1 Q 0 Q1 Q2 Q3 Q

The business maximises profit where short-run MC intersect MR i.e. point e.

Reason!
1. To the left of Q2 i.e. at output Q1 profit is not maximised because each unit to the left of
Q2 gives a revenue for the business that is greater than the MC i.e. MR lies above MC
(points f & g).
It therefore costs less to produce a unit of this kind than the amount for which the unit is
sold; therefore the business can raise its profit by producing more units.
2. To the right of point e, e.g. at Q3, the output cost of each additional unit (MC) is higher
than the revenue it earns when sold i.e. MC lies above MR (points h & i).
It means that a loss is being made on such units and total profits are being reduced.
The business does not benefit by producing more than Q2.
3. At point e (Q2), the MC are exactly equal to a point where output costs of the last unit
are equal to revenue it earns.
This is the profit maximising position, which is also the equilibrium position of the
business.

LONGRUN
In the long run all factors of production are variable (mobile).
A business may adapt its production plant or by reducing the present one. The market can
expand or shrink as new business enters the market or existing ones leave the market.
If a business decides to start small and expand operations, the costs would initially fall as
large scale production makes lower unit costs possible, due to factors such as specialisation
and use of improved technology. This is called economies of scale.
If a firm grows too large where further expansion would lead to higher unit costs, this
becomes diseconomies of scale.

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 LONGRUN AVERAGE COST CURVE
AC5

Costs
LRAC
AC4

AC1
AC2 AC3

Qty
The above diagram illustrates five different plant sizes.
 AC1 represent the smallest short-run AC curve and AC5 the largest.
 The building of AC1 would result in lower unit costs i.e. lower short-run AC and this
applies until AC3.
 Once point e is passed, a larger plant size means an increase in unit costs as the
minimum points of AC4 and AC5 lie above AC3 and disadvantages would come into
play.
 The LRAC indicates total unit costs in the long term
 The LRAC indicates the lowest cost per unit at which any particular output can be
produced.
THE INDUSTRY

 The industry is in equilibrium at the price at which the quantity demanded is exactly equal
to the quantity supplied.
 Business making economic profit will expand their plants in the long run.
 New businesses will be attracted to the industry by economic profits that prevail; those
that are making economic losses will close in the long run.
 The entry and exit of firms will result in the remaining businesses making a normal profit in
the long run.

PROFITS
A profit is the difference total costs (TC) and total revenue (TR). Profits can be expressed as
either TR – TC or AR – AC.
Normal and Economic Profits

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If a firm is producing at a profit maximising output level where AR = AC then it is making a
normal profit.
At this level the business makes profits enough to cover its costs but not excessive.
This is the long-run position (AC = AR) of a perfectly competitive firm.
Normal Profit

P MC
C, MC, MR AC

P1 e AR=MR=P

0 Q1 Qty
Normal profit is the minimum earnings required to prevent the entrepreneur from leaving with
his factors of production.
TR for the firm is therefore represented by the area 0,P1,e,Q1 .
In this instance the business is maximising profit at point e where MC = MR.
Economic / Supernormal profit
When a business is able to generate profits which exceed those needed to cover the costs
then its making economic profit.

P MC
AC, MC,MR AC
P2 e2 AR=MR=P

S R

0 Q2 Qty
The minimum point of the short-run AC is lower than the market price P2.
The business is in equilibrium (Its maximising profits) at point e 2 where MC=MR hence it will
produce quantity Q2 at price P2.
 TR = 0P x 0Q2
 TC = 0S x 0Q2

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TR therefore exceeds TC thus the business is making a profit that’s represented by the area
P2,e2,R,S.
Assumption
The business is having the following;
 P2 – $10
 AC – $8
 Q2 – 100units
a. It means the business is selling 100 units at a profit maximising output level, they charge
$10.
b. The AC of producing 100 units is $8, thus the firm is making a profit of $2 (10 – 8) per
unit on average.
 Total profit = $2 x 100 = $200

Economic Loss
An economic loss occurs when average costs for the firm are higher than the average
revenue, this means that TC are higher than TR.
Under perfect conditions a firm can make a loss in the short run and not in the long-run as it
will exit the industry.
Loss making business
AC, MC, MR MC
AC
M L
P3 e3 AR=MR=P

0 Q3 Qty
In the diagram above the minimum point of the short-run AC curve is higher than the market
price P3.
The business is in equilibrium or the loss is minimised at e3 where MC=MR.
At the market price P3, the business will produce quantity Q 3. At this point, the total cost
exceeds TR.
TC is represented by OM x 0Q3 and TR = OP x OQ 3 hence the business is making a loss at
e3 (P3,M,L,e3).
The losses of some businesses cancel out the economic profits of others, therefore only a
normal profit is possible in a perfectly competitive firm.

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 Supply: Individual Businesses
Businesses under perfect condition maximise profits where MC = MR, this can be used to
derive the business supply curve.
This curve is determined by taking different market prices and determining how much the
business should produce at each price.
Output of the business determines its supply.
a. Increase in market price b. Supply curve of the business

P D3 S MC AC
D2 P3 e3
P3
AVC

P2 D1 P2 e2

P1 P1 e1

0 Qty Q1 Q2 Q3 Q
The AVC curve has been introduced as it represents part of the TC, it consists of such costs
as fuel, labour, material, etc.
Explanation
Suppose the market price is rising gradually from P 1 – P3 as a result of an increase in
demand as shown in diagram a. by the shift in demand curve from D1 to D2 and then D3, this
increase will cause the market price to shift from P1 to P2 then P3.
This shift causes the horizontal demand curve to shift upwards implying that each higher
demand curve will intersect MC curve at a point that lies to the right of the previous
intersection as shown by e1, e2, and e3.
At these points MC=MR and the business is maximising profit and it will produce at these
points.
This will cause the quantity produced to increase as price increases.
Points e1, e2, and e3 will therefore plot the business supply curve. If the price is below e 1, the
business would not be able to cover its variable cost and it’s therefore better to close shop.
This is known as the shutdown point.
nb. Shutdown point is the point where AR is equal to average variable cost (AVC), any lower
point results in a firm earning less per unit than the AVC of producing it.
Loss minimising point is when AR is between shutdown point and breakeven point.

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 The Industry
The short-run supply curve of the industry can be obtained by adding up the horizontal
supply curves of all individual businesses in the industry.
The quantity offered in the market at a particular price is the sum of all quantities that the
individual businesses in that industry offer at that price.
The exact shape and location of this supply curve are determined by the technology and the
prices of factors of production as well as by the size of the business in the industry.
The long-run equilibrium output level
The long-run is a period of time where all factors of production are variable and can be
increased.
New firms are attracted into the industry by firms making supernormal profits.
This is because there are no barriers to entry and there is perfect knowledge.
This will cause the industry supply curve to shift to the right.
It reduces average revenue of each firm until AR = AC thereby competing away supernormal
profits.
If AR fall below AC, firms will start making loss hence in the long run they will exit the
industry leaving the remaining ones making a normal profit.
The equilibrium output level for a firm under perfect competition in the long run is one of
normal profit.
Long run equilibrium position of a perfect firm
In the diagram below the long-run marginal cost (LRMC) intersects the AR curve at Q1.
At the price of P1, the AR is equal to the long-run AC.
At this level no supernormal profit is made.

P LRMC
AC, MC, MR LRAC
P1 e D=AR=MR=P

0 Q1 Qty
SHUTDOWN POSITION OF A FIRM
If a firm shut down operation in the short-run, it will incur a loss equal to its total fixed cost
(TFC) because no variable costs will be incurred. Therefore, the perfectly competitive firm
will shut down and produce nothing at any price below which the firm’s loss will exceed its
total variable cost (TVC) to include a fraction of or all the TFC

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 Cost/Rev MC AC
P1 e
AVC
P2 d

P3 c AR = MR

P4 b

P5 a

0 Q1 Q2 Q3 Q4 Quantity
 Point a: a firm will not produce here because AR < AVC
 Point b: it is the lowest price that the firm will charge (shut-down point). It represents
the beginning of the supply curve.
 Point c: the firm is making an economic loss because AR < AC. The loss is
minimised because the firm produces where MR = MC.
 Point d: the firm is making normal profit (breaking even) because AR = AC.
 Point e: the firm is making economic (supernormal) profits because AR > AC.

Perfect competition and resource allocation

Firms that are perfectly competitive allocate scarce resources efficiently between uses. This
is because of the triple equality condition found in the long run, that is, P (=MR) = AC = MC.
Efficiency is achieved when two conditions are satisfied.

(a) P = Minimum AC (Productive Efficiency). In the long rung competition forces forms to
produce at the point of minimum AC of productions and charge that price which is
just consistent with these costs.
(b) P = MC (Allocative Efficiency). Again, the price charged in the long run is equal to
marginal cost, a condition that is known as allocative efficiency.
(c) X Efficient: Competition between firms will act as a spur to increase efficiency.
(d) Resources will not be wasted through advertising because products are
homogenous.
(e) Normal profit means consumers are getting the lowest price. This also leads to
greater equality in society.

Advantages of Perfect Competition

(i) Goods are sold at the lowest possible price: The absence of barriers to entry makes it
possible for new firms to emerge when positive economic profits are being recorded in

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 the industry. As industry supply increases the price falls, to the extent that it may be
possible for the consumers to pay prices equal to marginal cost of production.
(ii) Efficient Utilization of resources: Every firm being a price-taker strives to minimize
costs thereby making most efficient utilization of resources.
(iii) Sales promotion is less expensive: In perfect competition, products are homogenous in
the eyes of the consumers, therefore, expensive advertisement or sales promotional
strategy is avoided.
(iv) Consumers enjoy and are better off in terms of consumer surplus

Disadvantages of Perfect Competition theory

(i) Perfect competition assumes perfect information and knowledge. As a result, a firm
can not expect to gain much competitive advantage over other firms by developing
new technology. There is little incentive to develop new technologies since other firms
can adopt the new technique. Since technological innovation is considered essential
for economic growth, a perfectly competitive world, while promoting allocative
efficiency, may well retard growth.
(ii) Perfect competition assumes perfect information about technology. The absence of
barriers to entry promotes technological theft which in turn, discourages inventions and
innovations. Therefore, there is no guarantee that resources are most efficiently
utilized.
(iii) Competitive markets values are based on the private costs and benefits associate with
the actions of individual consumers and producers. External costs and benefits of
production and consumption are not captured. This is referred to as market failure.
(iv) The problem of income inequality is worsened: In the long-run, some entrepreneurs
who have access to bigger financial capital will adopt costsaving technology, lower
price and drive the smaller firms out of business.

MONOPOLY

Monopoly is a greek word monos – single and polein to sell. A monopoly exist when the
market is dominated by a single supplier of a product for which there are no close substitute
and in which it is very difficult or impossible for another firm to exist.
Thus, for monopoly to exist the following conditions must be fulfilled.
(i) The firm must be the only supplier
(ii) No close substitute for the firm's products must be in existence
(iii) There must be restrictions or barriers to entry which make the survival of potential
rivals extremely unlikely

Reasons for monopoly

Why do monopolies arise? There are many reasons which often are discussed as barriers to
entry. Barriers to entry are obstacles to entry that protect the firm within a market from the
threat of competition by potential entrants

(a) A Single firm may control the entire supply of a basic input that is required to
manufacture a given product. in this case the firm becomes a natural monopoly for example
DeBeers in South Africa which control almost every piece of land on which diamonds are
mined.

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(b) A firm may acquire a monopoly over the production of a good by having patents on the
product or on certain basic processes that are used in the production. The patent laws to
make a certain product as a way to encourage invention

(c) A firm may become a monopolist because it is protected by an Act of the Parliament for
example government corporations such as ZBH.

(d) When a firm is enjoying economies of scale, it may supply the market effectively at
lowest possible cost making the entry of other firms extremely difficult.

(e) If production requires an initial large capital requirement for example laying of rail tracks,
a firm that will be able to source the capital may become a monopoly e.g. NRZ.

(f) Merger and acquisition: Large firms may merge to control the entire market supply or a
large firm may acquire (buy) smaller firms that can no longer operate profitably to gain total
control of the market supply.

(g) Locational factor: Due to the size of an area, there might not be incentive for investors to
establish firms in the areas until one investor takes the risk and remains the sole firm in the
community enjoying the monopoly power. This is the case for rural banking scheme in most
developing economies.

The demand curve for the monopolist

Since the monopolist is the only firm in the industry, it faces the industry market demand
curve which is downward slopping. Thus, to sell an additional unit of output, the firm has to
reduce its price.

They decide on their production levels – once the monopolist decide on a price, the quantity
sold is determined by market demand thus by reducing price they can sell more and vice
versa

Monopoly firm’s demand curve

An individual business in perfect competition is confronted with a perfectly elastic (horizontal)
demand curve at a price determined by market forces but a monopolist is faced with a
normal demand curve which slopes downwards from left to right D = AR as shown below:

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 a. AR and MR curves

P1 D=AR

P2

MR
0 Q1 Q2 Qty
b. TR Curve
TR

0 Q1 Q2 Qty
Any point on the demand curve D is an indication of the quantity of the product that can be
sold and the price at which it will trade e.g. the monopolist can sell Q1 at price P 1.
Since each of the individual units i.e. Q 1 can be sold at P1, it implies P1 is also the price or
revenue that the monopolist will obtain per unit on the relevant point on the demand curve.
This implies to any price quantity combination on the demand curve, meaning that the
monopolist demand curve is also its AR curve.

The MR curve is also downward sloping because the addition to total revenue from the sale
of additional units becomes progressively smaller and smaller with price being reduced in
order to sell one extra unit. Another point to note is that the MR is less than AR at every level
of output except for the first unit. This can be illustrated by the following example.

Assume a monopolist sells 100 units at a price of $2.50 each. In order to raise sales to 101
units, the price should be reduced $2.48. Thus average revenue falls to $2.48 but marginal
revenue which is the difference in total revenue resulting from the increase in sales from 100
to 101 units can be calculated as:

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TR1 = 100 @ 2.50 = $250.00

TR2 = 101 @ 2.48 = $250.48

Therefore the increase in TR = 48c (250.00 – 250.48). Thus MR = $0.48 is less than AR =
$2.48

The monopolist demand curve, contrary to the perfect competitors demand curve, is its AR
curve and not its MR curve.

Monopoly output and price determination

A profit maximizing monopolist will employ the same rationale as a perfectly competitive firm,
that is, it will produce an output level where MR = MC. In the short run, a monopolist can
earn abnormal profits due to the fact that it will be charging very high prices since it faces no
competition.
A monopoly is a subject to the same technology constraints as any other business therefore
the cost structure will not differ much from that of a competitive business.
P MC
P,MR,MC & AC AC

P1 C
D B

A
MR D = AR

0 Q1 Qty
1. It’s necessary to determine the point at which MC = MR, because this means that the
business has expanded production to the point where production costs of the last unit are
equal to the revenue it earns; it happens at point A, where MC = MR which is also the profit
maximising quantity Q1.
2. The price at which Q1 can be sold is obtained by moving upwards to point C on the
demand curve, at price P1.
The monopolist TR is P1 x Q1 = O, P1, C, Q1. The TC = AC x Qty produced or area O,D,B,Q 1,
the difference between the two is total profit which is area D,P1,C,B.
The profitability of a monopolist depends on the demand of the product and cost of
production.

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 Short term loss for the monopolist
The AC curve lies above the demand curve, equilibrium is achieved where MR = MC
although in this instance it is a loss minimising position (as opposed to profit maximising).

P MC AC

A B AVC
P1 D
C E

MR D = AR

0 Q1 Qty
In an equilibrium position the monopolist will produce quantity Q 1 and sell P1. This price P1 is
lower than the short term AC as shown by B, D.
The monopolist therefore makes a loss represented by A, B, D, P1.

LONGTERM EQUILIBRIUM
If the monopoly makes a short term loss, it will endeavour to build a plant that will yield a
profit.
If the business makes a short term profit, in the long run the plant size will be changed to
make more economic profit.
In the long-run profit is maximised by equating marginal revenue with long-run marginal
costs i.e. MR = LMC, this is shown in the diagram below where MR curve and the LMC
curve intersect at point A; which determines the long-run profit maximising output Q1 at price
P1.

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 P LMC
P,MR,MC & AC
P1 C LAC

D B D = AR

MR
0 Q1 Qty

1) Allocatively Inefficient.

Monopolies are allocatively inefficient because they earn super-normal profit by restricting
output to raise price as they do not produce what consumers want or the desired quantities.

2) Productively Inefficient.

Monopolies are productively inefficient because they do not produce at the lowest point on
their AC curve.

3) Pareto Inefficient.

Monopolies are Pareto inefficient because they cause a welfare loss. Market failure happens
because the price mechanism breaks down and resources are allocated by the monopoly
and not free markets. The monopoly restricts output to raise price and maximize profit.
Because the monopoly only produces Q* and not Q 1 there is lost consumer surplus and lost
producer surplus, a welfare loss, and society loses out

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4) X-Inefficient.

Monopolies could be X-inefficient. A monopoly in an uncompetitive and incontestable market

has no current or potential threat to its market power and super-normal profit. Workers and
managers will put in less effort at work because they know the monopoly will not go bankrupt
if they do not minimize costs since profits are high. So the monopoly may be dis-incentivised
to minimize costs, will use its technology inefficiently, squander resources, let costs spiral
upwards and become X-inefficient.

5) Dynamic Efficiency

Monopolies may be dynamically efficient, that is, invest in Research and Development
(R&D), innovate and produce new and better products/technologies for consumers. A
monopoly does this to stay ahead of any potential competition. Consumers and society
benefit because new and better quality goods are invented. Microsoft devotes a lot of
resources to R&D to produce new and better quality products/technologies for example,
Windows 10. Similarly, Apple innovated to develop the iPod, etc.

Natural Monopoly

A natural monopoly exists if an industry can only support one firm. An example of a natural
monopoly is NRZ. Only one set of railway lines can be laid so only one firm can operate
them.

Natural monopolies usually exist in the rail and utility industries. A large start-up investment
in the infrastructure is required before a firm can operate for example, railway tracks, gas
lines, water pipe networks and the electricity grid. This initial investment is very costly so
fixed costs are very high. AC and MC begin high then continue to fall. AC remains above
MC. A natural monopoly will produce at MR = MC and make super-normal profit.

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A large level of output is required for a firm to exploit economies of scale. More competition
is a wasteful duplication of resources and too inefficient, competition is not possible in the
long-run. If a 2nd firm enters the market then each firm produces Q2 and average costs are
so high that both firms make a loss.

If the government wants the natural monopoly to be allocatively efficient by producing at P1

= MC then the firm must be subsidised because it makes a loss

Price Discrimination by the Monopolist

Price discrimination refers to a situation where the firm charges different prices for reasons
not justified by differences in cost of production, for example charging different rates to low
density suburbs and high density suburbs by most municipalities

Conditions necessary for price discrimination

For price discrimination to be successful, certain conditions must be met.

1) It only works when it is not possible to buy a good from one market and resale it in
another market. Thus there should be heterogeneous markets.
2) The markets should have different elasticities of demand. There should thus, be two
markets. One whose demand for the good is elastic and the second one whose demand
is inelastic.
3) Transport costs should be prohibitively high. This is meant to prevent seepage or
arbitrage, a situation where one buys a product in one market at a lower price and resale
it a higher price in another market.

Given the foregoing, profit maximisation requires that the monopolist equals marginal
revenue in these two markets whose demand curves are shown below:

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If two markets are separate and have different demand curves, AR 1 and AR2, a monopolist
maximise profits by selling at different prices in the two markets. The profit maximising
output of the firm in the long run occurs where long run marginal cost (MC) equals marginal
revenue (MR). MR = MR1 + MR2 shown in C above. Total output is divided between the two
markets. In market 1, Q1 is sold at P1 , and in market 2, Q2 is sold at P2 . Marginal revenue in
both markets is the same. The steeper the (inelastic) demand curve in a market, the higher
the price.

NB: If the elasticities in the two markets are the same, there is no advantage from applying
price discrimination.

CONSUMER SURPLUS

A perfectly discriminating monopolist is able to charge a separate price to each consumer.

This means that each consumer can be charged the maximum amount he is willing to pay
for each unit of the good, and it is able to sell to the highest ‘bidder’ first. It can in this way
obtain the maximum revenue from the sale of any given quantity.

Consumer surplus under monopoly

20
From the above diagram, if all units are sold at the same price A, then an amount D is sold
and total revenue is equal to OACD. If the same amount is sold by a perfectly discriminating
monopolist, then a different price is charged for each unit, and the total revenue is OBCD.
The difference ABC, measures the consumers’ surplus. If the price is raised from E to A, the
total loss of consumers’ surplus is EACH of which EACG is transferred to producers, and
GCH represents the deadweight loss of consumers’ surplus. In a perfectly competitive
market consumer surplus is the difference between the market price and the highest price
the consumer is prepared to pay as illustrated below:

Given market price of Pe, the consumer is prepared to pay as much as price a. Thus P eab
represents consumer surplus

ADVANTAGES AND DISADVANTAGES OF MONOPOLY

The Advantages of Monopoly

(i) If the monopoly is in a perfectly contestable market then the threat of potential
competition makes the monopoly act as if there were actual competition so it sets P =
MC and the monopoly is allocatively efficient
(ii) The monopoly may be a natural monopoly. Having more than one firm in the industry
means a wasteful duplication of resources
(iii) Monopolies earn super-normal profit so they have the potential to be dynamically
efficient by investing in R&D to produce new and better products for consumers.
(iv) Monopolies may be regulated by competition authorities. Maybe a regulator is
imposing a price cap of RPI-X on the monopoly, this forces the monopoly to act as if
there were competition in the industry
(v) No risk of over – production: As a sole producer, the firm knows the quantity that
consumers of its product will demand and therefore will not produce in excess of
demand.
(vi) Efficient and full use of resources: The monopoly firm can use its equipments and
machines to their full capacity to producing a large quantity of its product based on the
known market. The perfectly competitive firm is not sure of its market share and
therefore its resources may be underutilized.

21
(vii) Monopoly helps to reduce price: Monopoly is associated with large scale production
and low average cost; therefore, the firm can afford to sell at a lower price than the
perfectly competitive firm.
(viii) Inventions and innovations: The monopolist is encouraged to invest in research and
development (R and D) efforts because of the barriers to entry. There is a tendency for
the firm to introduce a cheaper technique, sell at a lower price or improve the quality of
its products for the benefit of the consumers.

The Disadvantages of Monopoly

(i) Allocatively inefficient. Monopolies restrict output to raise prices. As the monopoly
does not produce what consumers want or the desired quantities
(ii) Productively inefficient. Monopolies do not produce at the lowest point on their AC
curve.
(iii) Pareto inefficient. Monopolies lead to market failure and a welfare loss. Monopolies
restrict output to raise prices, this causes a loss of both consumer surplus and
producer surplus
(iv) X-inefficient. A monopoly that faces no current or potential competition may suffer
Xinefficiency because its workers put in less effort and the monopoly’s costs
consequently rise
(v) Exploitation of the consumers: Consumers pay higher prices than what they would
have paid under perfect competition because there is no other place they can access
the product.
(vi) Consumer choice is restricted: The firm is the only producer in the market; therefore
buyers cannot choose from a wide range of identical goods as it is the case under
perfect competition.
(vii) Creation of Artificial Scarcity: Most often the typical monopolist tries to reduce output in
order to sell at higher prices and enhance its profit.
(viii) Inefficiency: The monopolist faces no challenge as a result of absence of competition.
In other words, there is no urge for the firm to adopt cost-saving production technique
for efficient use of its resources

COMPARISON BETWEEN MONOPOLY AND PERFECT COMPETITION

In the perfect competition and monopoly, maximum profit is the primary objectives of the firm
and, the objective is attained at the output at the output level where MC = MR. Despite some
similarities, there are a number of important difference between the perfect competition and
monopoly models.

(i) Number of firms in the Industry: There is a very large number of small firms (sellers)
and buyers in perfect competition. Price is determined for the entire industry by the
forces of demand and supply, and each firm is a price – taker. On the other hand, a
pure monopoly is an industry with only one firm, and the firm fixes the price for its
production. It is therefore called a price setter.
(ii) Output and price: The perfectly competitive price is lower than the level of output
greater than the monopoly price and output, respectively.
(iii) Equilibrium conditions: Under perfectly competitive equilibrium MC = MR = Price (AR)
because MR and AR coincide and is a straight line parallel to the quantity axis. Under

22
 monopoly, the AR curve slopes down to the left with MR curve below it. They are at
equilibrium when MC = MR < Price (AR).
(iv) Profit maximization positions in the long-run: In the long-run, the firm in perfect
competition will earn normal profit because the short-run supernormal profits are
competed away by the new firms that will enter the industry. On the contrary, the
monopoly firm will always earn supernormal profits in the long-run because there are
barriers preventing entry of new firms and competition.

Long-run equilibrium business in Perfect competition vs Monopoly

a. Perfect competition b. Monopoly
P LMC LMC LAC

LAC Pm C
P1 e
E B G
F D=AR
MR

0 Q1 Qty 0 Qm Q

MONOPOLISTIC COMPETITION
Monopolistic Competition is an intermediary market structure which has features of perfect
competition and monopoly respectively. It tries to strike a balance between the two-market
structures. Monopolistic competition derives its monopoly from the fact that each firm has a
monopoly on the price or output of its products.

In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores
the impact of its own prices on the prices of other firms.

Unlike perfect competition, the firm maintains spare capacity. Examples of industries with
market structures similar to monopolistic competition include restaurants, cereal,
clothing, shoes, and service industries in large cities

Assumptions:

1. Many Buyers and Sellers.

Many sellers means that each firm has a small market share. Many buyers means no buyer
has any monopsony power to affect prices. The fact that there are "many firms" gives each
firm the freedom to set prices without engaging in strategic decision making regarding the
prices of other firms and each firm's actions have a negligible impact on the market. For

23
example, a firm could cut prices and increase sales without fear that its actions will prompt
retaliatory responses from competitors.

How many firms will an MC market structure support at market equilibrium? The answer
depends on factors such as fixed costs, economies of scale and the degree of product
differentiation. For example, the higher the fixed costs, the fewer firms the market will support

2. Imperfect Information.

Information is imperfect but near perfect. Almost all information is available at zero cost. Most
information including that of firms’ prices and products are known.

3. Heterogeneous / Differentiated Goods.

Firms produce heterogeneous goods, goods slightly different from each other, so goods are
close substitutes. Goods may be different because of some physical differences like look,
taste or feel. Advertising could also be used to create a perception of differentiation even if
goods share basically the same physical characteristics. Advertising creates a brand image
and brand loyalty, it makes demand more inelastic because consumers become attached to
buying a good from a certain firm, they become less sensitive to price changes for that
particular firm’s good.

4. Firms are Price-Makers.

Because firms produce heterogeneous goods, each firm has some degree of monopoly
power, so firms are price-makers. A firm can raise its price without losing all of its
consumers. So each firm faces downward sloping AR and MR curves, although these curves
are very elastic because goods are close substitutes.
A firm’s demand curve depends on the number of rival firms in the market. As the number of
firms in the market rises, each firm’s demand curve shifts left because consumers become
more spread out over each firm (buy less from each particular firm).

24
 Price maker
P AR = MR = 0

MR = 0
0 Qty
5. Inefficiency

There are two sources of inefficiency in the MC market structure.

a) Allocatively inefficient - First, at its optimum output the firm charges a price that exceeds
marginal costs (P > MC), The MC firm maximizes profits where marginal revenue =
marginal cost. Since the MC firm's demand curve is downward sloping this means that
the firm will be charging a price that exceeds marginal costs. The monopoly power
possessed by a MC firm means that at its profit maximizing level of production there will
be a net loss of consumer (and producer) surplus, they do not produce what consumers
want or the quantities demanded.
b) Productively inefficient - The second source of inefficiency is the fact that MC firms
operate with excess capacity. That is, the MC firm's profit maximizing output is less than
the output associated with minimum average cost, they never produce at the bottom of
their AC curve both in the short run and long-run.

6. Low Entry or Exit Barriers.

New firms can easily enter the industry at any time and incumbent firms can easily leave the
industry at any time. In the long run there are no entry and exit costs. There are numerous
firms waiting to enter the market, each with their own "unique" product or in pursuit of positive
profits. Any firm unable to cover its costs can leave the market without incurring liquidation
costs. This assumption implies that there are low start-up costs, no sunk costs and no exit
costs.

Short-run equilibrium for a firm under monopolist competition

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The firm maximizes its profits and produces a quantity where the firm's marginal
revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price
based on the average revenue (AR) curve. The difference between the firm's
average revenue and average cost, multiplied by the quantity sold (Qs), gives the
total profit.

Long-run equilibrium of the firm under monopolistic competition

The firm still produces where marginal cost and marginal revenue are equal;
however, the demand curve (and AR) has shifted as other firms entered the market
and increased competition. The firm no longer sells its goods above average cost
and can no longer claim an economic profit.
A firm making profits in the short run will nonetheless only break even in the long run
because demand will decrease and average total cost will increase. This means in
the long run, a monopolistically competitive firm will make zero economic profit. This
illustrates the amount of influence the firm has over the market; because of brand
loyalty, it can raise its prices without losing all of its customers. This means that an
individual firm's demand curve is downward sloping, in contrast to perfect
competition, which has a perfectly elastic demand schedule
Long-run equilibrium for a firm under monopolist competition

26
A MC firm’s demand curve is not flat but is downward sloping. Thus in the long run the
demand curve will be tangential to the long run average cost curve at a point to the left of its
minimum. The result is excess capacity.

COMPARISON OF PERFECT COMPETITOR WITH MONOPOLISTIC COMPETITOR

The long-run characteristics of a monopolistically competitive market are almost the same as
a perfectly competitive market. Two differences between the two are that monopolistic
competition produces heterogeneous products and that monopolistic competition involves a
great deal of non-price competition, which is based on subtle product differentiation.

Both a perfect competitor and monopolistic competitor firm will operate at a point where
demand or price equals average cost. For a perfect competitor firm this equilibrium condition
occurs where the perfectly elastic demand curve equals minimum average cost.

Socially undesirable aspects compared to perfect competition

 Selling costs: Products under monopolistic competition are spending huge amounts on
advertising and publicity. Much of this expenditure is wasteful from the social point of
view. The producer can reduce the price of the product instead of spending on publicity.
 Excess Capacity: Under Imperfect competition, the installed capacity of every firm is
large, but not fully utilized. Total output is, therefore, less than the output which is
socially desirable. Since production capacity is not fully utilized, the resources lie idle.
Therefore, the production under monopolistic competition is below the full capacity level.
 Unemployment: Idle capacity under monopolistic competition expenditure leads to
unemployment. In particular, unemployment of workers leads to poverty and misery in
the society. If idle capacity is fully used, the problem of unemployment can be solved to
some extent.

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 Cross Transport: Under monopolistic competition expenditure is incurred on cross
transportation. If the goods are sold locally, wasteful expenditure on cross transport
could be avoided.
 Lack of Specialization: Under monopolistic competition, there is little scope for
specialization or standardization. Product differentiation practiced under this competition
leads to wasteful expenditure. It is argued that instead of producing too many similar
products, only a few standardized products may be produced. This would ensure better
allocation of resources and would promote economic welfare of the society.
 Inefficiency: Under perfect competition, an inefficient firm is thrown out of the industry.
But under monopolistic competition inefficient firms continue to survive.

Problems

 Monopolistically competitive firms are in-efficient, it is usually the case that the costs of
regulating prices for products sold in monopolistic competition exceed the benefits of
such regulation.
 A monopolistically competitive firm might be said to be marginally inefficient because
the firm produces at an output where average total cost is not a minimum. A
monopolistically competitive market is productively inefficient market structure because
marginal cost is less than price in the long run.
 Monopolistically competitive markets are also allocatively inefficient, as the price given
is higher than Marginal cost. Product differentiation increases total utility by better
meeting people's wants than homogenous products in a perfectly competitive market.
 Another concern is that monopolistic competition fosters advertising and the creation
of brand names. Advertising induces customers into spending more on products
because of the name associated with them rather than because of rational factors.
 Defenders of advertising dispute this, arguing that brand names can represent a
guarantee of quality and that advertising helps reduce the cost to consumers of
weighing the trade-offs of numerous competing brands. There are unique information
and information processing costs associated with selecting a brand in a
monopolistically competitive environment.
 In a monopoly market, the consumer is faced with a single brand, making information
gathering relatively inexpensive. In a perfectly competitive industry, the consumer is
faced with many brands, but because the brands are virtually identical information
gathering is also relatively inexpensive.
 In a monopolistically competitive market, the consumer must collect and process
information on a large number of different brands to be able to select the best of them.

28
 In many cases, the cost of gathering information necessary to selecting the best brand
can exceed the benefit of consuming the best brand instead of a randomly selected
brand. The result is that the consumer is confused. Some brands gain prestige value
and can extract an additional price for that.

Examples
In many markets, such as toothpastes, smartphones and toilet paper, producers practice
product differentiation by altering the physical composition of products, using special
packaging, or simply claiming to have superior products based on brand
images or advertising

OLIGOPOLIES

An oligopoly (from Ancient Greek (olígos), meaning 'few', and (polein), meaning 'to sell') is
a market form in which a market or industry is dominated by a small number of sellers
(oligopolists).

There is no precise upper limit to the number of firms in an oligopoly, but the number must be
low enough that the actions of one firm significantly impact and influence the others.

Characteristics

a. Product may be homogenous or differentiated

Oligopolies may produce homogenous e.g. steel, glass or differentiated e.g. automobiles,
etc. If the firms produce a homogenous producer, the industry is called a perfect or pure
oligopoly. If the firms produce a differentiated product the industry is called an imperfect or
differentiated oligopoly. It is easier to deal with the case of perfect or pure oligopoly. When
two firms dominate the market as what used to exist when Circle Cement used to serve the
northern part of the country while Portland Cement was serving the southern part, this is
known as duopoly.
b. Ability to set price

Oligopolies are price setters rather than price takers, although they prefer to compete on
non-price factors such as advertising, promotions, etc to avoid price wars.

c. Entry and exit

Barriers to entry are high. The most important barriers are government licenses, economies
of scale, patents, access to expensive and complex technology, and strategic actions by
incumbent firms designed to discourage or destroy nascent (emerging) firms. Additional

29
sources of barriers to entry often result from government regulation favouring existing firms
making it difficult for new firms to enter the market.
d. Number of firms
"Few" – a "handful" of sellers. There are so few firms that the actions of one firm can
influence the actions of the other firms.
e. Long run profits
Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms
from entering market to capture excess profits.
f. Perfect knowledge
Assumptions about perfect knowledge vary but the knowledge of various economic factors
can be generally described as selective. Oligopolies have perfect knowledge of their own
cost and demand functions but their inter-firm information may be incomplete. Buyers have
only imperfect knowledge as to price, cost and product quality.
g. Interdependence
The distinctive feature of an oligopoly is interdependence. Oligopolies are typically
composed of a few large firms. Each firm is so large that its actions affect market conditions.
Therefore, the competing firms will be aware of a firm's market actions and will respond
appropriately. This means that in contemplating a market action, a firm must take into
consideration the possible reactions of all competing firms and the firm's countermoves.
It is very much like a game of chess, in which a player must anticipate a whole sequence of
moves and countermoves in order to determine how to achieve his or her objectives; this is
known as game theory.
For example, an oligopoly considering a price reduction may wish to estimate the likelihood
that competing firms would also lower their prices and possibly trigger a ruinous price war.
Or if the firm is considering a price increase, it may want to know whether other firms will
also increase prices or hold existing prices constant. This anticipation leads to price rigidity
as firms will be only be willing to adjust their prices and quantity of output in accordance with
a "price leader" in the market.
This high degree of interdependence and need to be aware of what other firms are doing or
might do is to be contrasted with lack of interdependence in other market structures. In
a perfectly competitive (PC) market there is zero interdependence because no firm is large
enough to affect market price.
All firms in a perfect market are price takers, as current market selling price can be followed
predictably to maximize short-term profits. In a monopoly, there are no competitors to be
concerned about. In a monopolistically-competitive market, each firm's effects on market
conditions is so negligible as to be safely ignored by competitors.

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The interdependence of firms in oligopoly markets lead to a range of behaviour patterns
bordering on one extreme, firms being engaging in fierce competition and on another, firms
explicitly co-operating. As a result there is no single model of oligopoly behaviour
h. Non-Price Competition
Oligopolies tend to compete on terms other than price. Loyalty schemes, advertisement, and
product differentiation are all examples of non-price competition

Forms of Oligopolies
1. Oligopoly with price leadership

This model of oligopoly behaviour is based on the assumption that one of the firms in the
industry is the price leader. The price leader will set the price and the rest follow its lead, that
is, the followers will adopt this price. Thus the followers behave like firms in perfect
competition while the price leader behaves like a monopolist in the sense that it has freedom
to set price.
Two forms of price leadership can be discussed: the dominant firm and the barometric - firm.
i. The dominant firm leadership applies to industries in which there is a single large dominant
firm in the industry and a number of minor firms. The dominant firm sets the price for the
industry probably using the marginalist rule for profit maximization (MR = MC), but the
assumption is that it lets the minor firms sell all they want at that price. Whatever amount the
minor firms do not supply at that price is supplied by the dominant firm.
ii. The barometric firm leadership applies to the industry in which one firm usually is the first
to make changes in price that are generally accepted by other firms in the industry. The
barometric firm may not be the largest or most powerful firm but a reasonable accurate
interpreter of changes in basic cost and demand conditions in the industry. According to
Kaplan, Dirlan and Lanilotti, a firm may emerge as a barometric firm through experienced
stability during a period of violent price fluctuations and cutthroat competition in the industry
during which many other firms suffer.

2. The kinked demand curve model

This well-known model designed to explain the rigidity of prices in oligopoly markets was
advanced by Paul Sweezy (1939) "Demand under Conditions of Oligopoly", Journal of
Political Economy, August 1939.

The conjectural (hypothetical) assumptions of the model are; if the firm raises its
price above the current existing price, competitors will not follow and the acting firm
will lose market share and second if a firm lowers prices below the existing price

31
then their competitors will follow to retain their market share and the firm's output will
increase only marginally.

If the assumptions hold then:

 The firm's marginal revenue curve is discontinuous (or rather, not
differentiable), and has a gap at the kink
 For prices above the prevailing price the curve is relatively elastic
 For prices below the point the curve is relatively inelastic
 The gap in the marginal revenue curve means that marginal costs can fluctuate
without changing equilibrium price and quantity. Thus prices tend to be rigid.

The kinked demand curve

The kinked demand curve is a combination of two types of demand curves with different
elasticities. Because of the 'kink' in the demand curve, the marginal revenue curve is not
continuous. Given that the firm's marginal cost curve is MC0 marginal cost does not equal
marginal revenue at any level of output. However output OQ 0 remains the most profitable
output and OP0 the most profitable price even if the marginal cost curve shifts to MC1.
Thus under these circumstances, one might expect price to be quite rigid at the level of the
kink. Although this model may be useful under some circumstances in explaining why price
tends to remain at a certain level (OP 0), it is of no use in explaining why this level, rather than
another currently prevails. In other words, the theory does not explain how the going price
gets to be at OP0 in the first place.
 Above the kink, demand is relatively elastic because all other firms' prices remain
unchanged.
 Below the kink, demand is relatively inelastic because all other firms will introduce a
similar price cut, eventually leading to a price war.

32
  Therefore, the best option for the oligopolist is to produce at point K which is the
equilibrium point and the kink point.

3. Collusion and cartels

Collusion occurs when the few firms composing an oligopolistic industry reach an explicit or
unspoken agreement to fix prices, divide a market, or otherwise restrict competition among
themselves.
The advantages to the firms of collusion seem obvious: increased profits, decreased
uncertainty, and a better opportunity to prevent entry. Conversely, collusive arrangements
are often hard to maintain, since once a collusive agreement is made, any of the firms can
increase its profit by cheating on the agreement. As a result, cartels are very unstable.
When a collusive arrangement is made openly and formally, it is called a cartel. A cartel is a
group of sellers of a product who have joined together to control its production, sale and
price in hope of obtaining the advantages of monopoly. Thus when a cartel is successful it
may end up more of a monopoly, but because they do not combine to produce together, they
do not enjoy economies of scale. An example of a cartel is the Organisation of Petroleum
Exporting Countries (OPEC). OPEC was formed in 1960 with the objective of controlling
crude oil production.

In 1973, members restricted output and prices of crude oil tripled. However, the cartel failed
to keep prices high by the mid 1980s because the OPEC never established barriers to entry.
As a result, when prices rose, non-cartel members increased output and putting a downward
pressure on prices. On the other hand, close substitutes for oil and energy efficient
technologies were developed. Thus demand for oil became more elastic. Members of the
cartel have been in disagreement over quotas. By 1989, cheating among members became
rampant, and production exceeded the total quota, putting pressure downward on prices.
This destroyed the cartel’s ability to maintain high prices.

SUMMARY OF MARKET STRUCTURES

Market Perfect Monopolistic Oligopoly Monopoly

33
characteristic competition competition
Number of firms Many small firms Many small firms A few large A single firm, or
dominant firms the most
dominant firm
with at least 25%
market share
Nature of Homogenous Heterogeneous Homogenous Unique with no
product (identical) (different, some (eg glass or steel close substitutes
branding) or
Heterogeneous
(slightly different)
Ability to set Price taker Price maker Price maker Price maker
prices
Price Very low Low High Very high
Entry barriers None Low High Very high
Long-run profits Normal profits Normal profits Super-normal Super-normal
profits profits
Allocative Yes, short run No No No
efficiency and long run
Productive Long run only No No No
efficiency
Pareto efficient Yes No No No
X-Inefficient No No Maybe Maybe
Objective Profit Profit Profit max, Profit
maximisation maximisation Revenue max or maximisation
sales max.
Collusion No No Maybe No
R&D No No Maybe Maybe
Example Agriculture Newsagents, Motor cars, oil, Microsoft, NRZ
market, stock fast food, banking,
market, gold restaurants, insurance
market tissues

Contestability

34
A contestable market is one in which there are little (or no) barriers to entry or exit, entry/exit
costs are low (or zero) so the threat of potential competition is high. Also, firms do not collude
and there is perfect information (so all incumbent and potential firms know all the prices,
profits and products of each firm).

Any market could be contestable. An incumbent firm in a contestable market must set a low
price and earn low super-normal profit (maybe even normal profit) in the long-run and short-
run. Assume there is a monopoly in a contestable market earning low super-normal profit. If
this incumbent firm sets a high price to try and earn high super-normal profit it will suffer ‘hit
and run’ competition. ‘Hit and run’ firms are firms that quickly enter and exit the industry to
earn supernormal profit. ‘Hit and run’ firms can do this because there are little entry/exit
barriers. Because more and more firms enter the market, prices are competed down and
high super-normal profit is competed away until low super-normal profit is earned again.

After super-normal profit is competed away, most ‘hit and run’ firms then leave the industry
because they earned the super-normal profit they came in for. Any firm that stays in the
industry takes away some of the market share of the original incumbent firm. So the
incumbent firm must act as if the market is competitive, set a low price and earn low
supernormal profit. It is the ‘threat’ of potential entrants that brings about a competitive
outcome, not current competition. A market may be perfectly contestable so that and only
normal profit is earned.

Contestability is a matter of degree. The more contestable the market, the lower the
incumbent firm’s prices and profits must be to deter potential entrants. A market may be
contestable, it may not be.

Summary to evaluate whether a market is contestable or not:

Contestable Not Contestable (Evaluation)
Barriers to entry may be low. For example, Maybe other entry barriers exist. For
there may be little advertising costs. example, patents.
Another entry barrier may be low. For Again, maybe other entry barriers exist. For
example, there may be little machinery and example, predatory pricing.
start-up costs.
Sunk costs may be low. The market may be highly concentrated with
many brand names.
Low profits are being made, implying there Maybe a large firm is limit pricing to create
are many small firms and no dominant large such low profits.
firm.
New firms may be entering the market, Maybe only large firms are entering the
maybe ‘hit and run firms’, implying low entry market
barriers.

35
A growing market means more demand from
consumers and the potential for new firms to
enter

A merger / takeover may increase contestability, but it may not

Mergers Decrease Contestability. Mergers Increase Contestability
A larger firm has more market power, a more Maybe the merger results in a monopoly and
recognizable brand and the power to higher prices. Higher prices means smaller
outcompete rivals. firms may now be able to compete as they
can cover their costs whilst they are not
benefiting from economies of scale
A larger firm may benefit from economies of A larger firm could suffer from diseconomies
scale and have a lower AC than rivals. This of scale and thus a high AC. Rivals could
large firm could then outcompete rivals then compete with the large firm.
through predatory or limit pricing.
Entry barriers may be higher. A larger firm The market may already have such high
means rivals must spend more on advertising entry barriers or sunk costs that a merger
to build a brand to compete with the big firm. does not have any significant effect on
contestability and new firms entering.
A larger firm could cross-subsidize. Maybe Maybe the government becomes weary of
the large firm could make a profit in one the large firm and punishes it as the large
market and use those profits to fund a loss by firm may act against the public’s interests
charging lower prices in another market.
Rivals in that low price market will then be
outcompeted.

Essay questions

1. Analyse the differences and similarities between the main features of a perfectly
competitive firm and a monopoly firm. [25]
2. Discuss whether monopoly is always a disadvantage to society. [25]
3. All firms in business seek to maximise profit. Discuss. [25]
4. (a) What are the conditions necessary for price discrimination? [12]
(b) Assess the benefits of price discrimination to the society. [13]

36