2ECO0903 Chap5

Chapter 5
Market Structure
Market Structure Theory of a Firm
What is a Firm?
It is an institution that buys or hires factors of production and initiate the process
production to transform these factors of production to goods and services for sale.
What is the objective of a firm?
Is to minimize costs and maximize profits i.e. profit maximization
=
Accounting Profit vs. Economic Profit
Accounting profit only takes into consideration of explicit costs
Economic profit takes into consideration of total costs i.e explicit and implicit costs
Market Structure Equilibrium of A Firm
Equilibrium of a Firm
When profit is maximized and losses minimized
No tendency to increase or decrease output. Output level already gives the maximum
profit
Assumptions of Equilibrium of a Firm
1. A rational firm
Always have the intention to maximize profits
2. Production of one product
Only produce one type of goods
3. Least cost combination
Minimal production costs possible
Two methods to determine the equilibrium of a firm i.e. Total Approach and Marginal Approach
Total Approach
Total Approach use Total Revenue and Total Cost to determine the equilibrium
of a firm
A Firms Equilibrium is achieved when Total Revenue Total Cost is at the
maximum
Perfect Competition Market Imperfect Competition Market
a
a
a refers to the output where
profit is maximized
Marginal Approach use Marginal Revenue, MR and Marginal Cost, MC to
determine the equilibrium of a firm
A firms equilibrium is reached, when:
=
Marginal Approach
a
Perfect Competition Market
Imperfect Competition Market
Relationship between Price, AR and MR
Marginal Approach
Quantity Price
Total
Revenue
Average
Revenue
Marginal
Revenue
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
Quantity Price
Total
Revenue
Average
Revenue
Marginal
Revenue
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
Price = Average Revenue = Marginal Revenue = Demand
Price = Average Revenue = Marginal Revenue = Demand
Relationship between MR and MC is as follows:
1. MR > MC : A firm can increase its profits by increasing output
2. MR < MC : A firm can reduce its loses by decreasing output
3. MR = MC : Profits are at a maximum
Marginal Approach
Definition of a Market
It is an arrangement that facilitates the buying and selling of a product,
service, factor of production or future commitment.
Definition of a Market Structure
It refers to the number and distribution size of buyers and sellers in the market
for particular goods and services.
Characteristics of market structure include:
Number of buyers and sellers
Market shares
The degree of product standardization
Ease of market entry and exit
Market Structure
Market Structure Classifications
Market Form
Characteristics
Perfect Competition Monopolistic
Competition
Oligopoly Monopoly
Number of firms Large Number Large Few One
Type of Product Homogenous Differentiated Homogenous or
Differentiated
Unique, no close
substitute
Conditions for Entry Very easy Relatively Easy Significant obstacles Blocked
Control over price None Some Some Considerate
Price elasticity of demand Infinite (Perfectly
Elastic)
Large (Elastic) Small (Inelastic) Very Small (Perfectly
Inelastic)
Examples Wheat, corn Food, clothing Automobiles,
cigarettes
Local phone service
Characteristics of Perfect Competition
1. Large number of buyers and sellers
2. Homogenous / Identical products
3. Free entry / exit
4. Role of non-price competition
5. Perfect knowledge of the market
6. Perfect mobility of factors of production
7. Absence of transport costs
Market Structure Perfect Competition
Price Determination in Perfect Competition
1. Firms in perfect competition are price takers.
2. They take the price determined by the market and supply quantity of their choice
Price
Quantity
SS
DD
Price
Quantity
P
P
AR = MR
Market Demand
Individual Demand
Firms Equilibrium
Total Approach
Marginal Approach
Equilibrium Quantity
Profit for Perfect Competition
Supernormal Profit
Also known as Economic Profit
Price > ATC
Price
Qtty
SS
DD
Normal Profit
Also known as breakeven
Price equals to ATC
Total revenue equals to Total costs
SS
DD
Price
Quantity
Subnormal Profit
Also known as Economic Loss
Price is lower than average total cost
Total revenue is less than total cost
SS
DD
Price
Quantity
Shutdown point for firms in perfect competition market
Golden rule : Firms should continue to produce as long as the price is higher than the average
variable cost.
As long as total revenue can cover the firms total variable cost, the firm should
continue its operation
This is because variable cost is the cost component that varies with output. Fixed
costs is a cost that already incurred even prior to the start of production
Loss due to Total
Fixed Cost i.e.
ABCP
A
B
Long run Effect : Entry into Industry
B
Increase of supply drives down the
price from P to P1
Price equals to Average Revenue
and equals to Marginal Revenue
Producing at profit maximization
point i.e. MR = MC, Price, P1 is same
with ATC i.e. competitive firms just
breakeven in the long-run (normal
profit)
The supernormal / economic profit
ABPP1 earlier noted at Price P is
eliminated
Long run Effect : Exit from the Industry
Firms exiting from the industry will
decrease of supply drives up the
price from P to P1
Price equals to Average Revenue
and equals to Marginal Revenue
Producing at profit maximization
point i.e. MR = MC, Price, P1 is same
with AC i.e. competitive firms just
breakeven in the long-run (normal
profit)
The initial losses is eliminated with
the decrease of supply, therefore
increasing the price
Market Structure Monopoly
Monopoly
A single seller in the market
producing product which has to
substitute
One Seller but a large
number of buyers
Product has no close
substitutes
The firm is a price
maker
High barrier of entry
The role of non-price
competition is low
Barriers of Entry
Natural barriers
1. Required economies of scale
2. Huge investment costs
Legal barriers
1. Patent and Copyright
Deliberate barriers
1. Control of raw material
2. Deliberate underpricing to
deter new entries
Short run Producer Equilibrium
Aim to produce at quantity with maximum profit
Total Approach
Producing at 6. Firm has the maximum profit i.e. TR TC
*Note : Why total revenue curve is non-linear?
As quantity increases, moving
down the demand curve,
elasticity reduces.
Therefore, when at the top of
the demand curve, elasticity is
high, drop in prices will increase
quantity demand, therefore TR
increases
However, at lower spectrum of
the demand curve, elasticity is
low, decrease of price, reduces
TR
Marginal Approach and Long run equilibrium
In the long run because of :
1. High barrier of entry
2. Substantial market power due to single seller
Firm can choose to produce at profit maximization point where MR = MC
and charges a price higher than the competitive level and average cost,
therefore earning a supernormal profit
Market Structure Monopolistic Competition
Monopolistic
Competition
Large number of
sellers, therefore low
market power
Differentiated product
therefore non- price takers
but set its own price
The firm is a price
maker
Low barrier of entry
and exit
The role of non-price
competition is high,
therefore may substantially
increase selling cost
Short-run Equilibrium
1. Profit maximization point
MC firms can differentiate their product, therefore
has certain control over their prices. Thus, unlike
perfect competition, which are price takers, MC firms
set their own price
Therefore each firm has their individual demand
curve and is downward sloping
However, MC firms demand curve is more elastic
than monopoly but less elastic than perfect
competition
2. Profit taking
To maximize profit, firms produce at MR = MC
Depending on cost structure, firms may incur
supernormal, normal or subnormal profit in the short
run
Market Structure Monopolistic Competition, MC
Supernormal Profit
Normal Profit
Subnormal Profit
In the Long Run
In the long-run, firms in monopolistic competition market will only earn Normal Profit because:
1. If firms earn supernormal profit, in the short-run, more firms will enter the market and lower down the price
2. If firms earn subnormal profit, in the short-run, then firms will exit the market, slowing down the demand
and increases the price, therefore existing firms will earn Normal Profit
Market Structure Monopolistic Competition, MC
Note !!!
Explore to explain graphically how item 1 and 2 can occur
Market Structure Oligopoly
Oligopoly
Few sellers with
medium to large size
Can be differentiated or
homogeneous product
The firm is a price
maker
High barrier of entry
and exit
Oligopolistic firms are mutual
interdependence. Therefore
firms always consider the
reaction of their rival firms
before setting prices, quantity
of output, advertising and etc
Short-run / Long-run Equilibrium
1. Demand Curve
Oligopoly firms have kinked individual demand curve
Assuming after taking into consideration of rival firms reaction, firmsets price at P1
If firm decreases the price lower than P1, rival firms will react through price war, therefore firm will
hardly increase any quantity demanded. Thus, elasticity below the kink is inelastic
If firm increase the price, rival firms will not react, but firm will lose a lot of quantity demanded to
competitors, therefore elasticity is elastic above the kinked
In conclusion, there is no incentive for firm either increase or decrease its price, therefore price is rigid
and stable at P1
Price
Quantity
P1
Q1
Dd = AR
Short-run / Long-run Equilibrium
2. Profit Maximization
Just like firms from other market structure, oligopolies seek to produce at profit maximization point i.e.
MR = MC
Due to the kinked demand curve,
there is a gap in the MR curve i.e. ab
Therefore any shift of MC curve within
this gap will not change the profit
maximization output i.e. Q1
However, if MC were to shift to MC3,
profit maximization output will reduce
substantially vs. a smaller increase in
price, therefore revenue reduces
Therefore cost efficiency is essential in
oligopoly
a
b
Setting Prices and Output
We have determined that an oligopoly individual firms demand curve is kinked and producing at Q1 with
price P1 as below:
Quantity
P1
Q1
Dd = AR
Price
How then is P1 and Q1 set? As explained, an oligopoly firm when setting prices
and quantity of output must first consult the possible reaction of its rival firm.
Thus, the prices and quantity can be set through the below:
1. Cartel Formation (Explicit Collusion)
A group of firms collude with the objective to stifle the competitiveness
in the market
It eliminates uncertainty and improve profits by stabilizing the price
Under a Cartel, firms reach a collective agreement on the price to set
and quantity to produce.
Therefore collectively they can restrict supply and push up the prices
2. Price Leadership (Tacit Collusion)
Occurs when the market leader (with substantial market share) sets the
price and every other firms collectively follow without any formal or
explicit agreement
If product is homogenous or closely homogenous, smaller firms may
have to adjust their output to manage their marginal cost accordingly
Tutorial
Tutorial
Tutorial
9) A purely competitive seller is:
A. both a price maker and a price taker.
B. neither a price maker nor a price taker.
C. a price taker.
D. a price maker.
1. Draw the Total Revenue and Total Cost curves and identify the profit
maximizing quantity and profit maximizing price for :
2. Draw the Marginal Revenue, Average Revenue and Marginal Cost to
identify the profit maximizing quantity and profit maximizing price
for:
Tutorial
Causes of Market Failure
Market Failure and Government Policy
Market Failure
Market is where buyers and sellers meet
and transact. Market failure occurs
when the market fail to allocate
resources efficiently, therefore goods
and services are not distributed
optimally
Public Goods
Monopoly
Externality Inequality
Monopoly
Monopoly occurs when one seller has absolute market power, therefore manage to hold the prices higher than competitive
level but cutting down its supply.
Consumer surplus is the positive difference of between the price that he is willing to
pay and the actual price that he actually paid
Producer surplus is the positive difference between the price that producer is
willing to produce and supply and the actual price that he gets for supplying
Diagram 1
Diagram 2
Diagram 2 shows that monopoly choose to
produce at profit maximization point MC =
MR, instead of producing at the competitive
level of Qc, monopoly produce at Qm,
therefore:
1. Causes a deadweight loss of ABE
2. A transfer of surplus of AFGB from
consumer to producer
Deadweight loss is a resource allocation
inefficiency that occurs in the market when
the resources are not optimally used for
welfare
As such government has stringent policy that
against cartel formation or any type of
monopolistic practice
A
B
C
E
F
G
Price Discrimination
1. The deadweight loss created by monopoly can be compensated if the monopoly practice Price Discrimination.
2. Price Discrimination refers to the selling or the charging of different prices to different buyers for the same good.
3. Price discrimination can only happen if:
1. Existence of different market for the same good
2. The cost of differentiating the market must be low
3. Existence of different degree of elasticity of demand
4. No resale is permitted i.e. product purchased from market with low price, cannot resell in a higher price market
4. There are different degrees of price differentiation:
1. First degree differentiation
Price charged based on the maximum amount that each consumer is willing and capable to pay
2. Second degree differentiation
Price charged based on blocks of product. Example, photocopy single page is 10 cents but photocopy 100 pages
is RM8.00
3. Third degree differentiation
Price charges based on different segment / group of consumers. Example, privilege pricing for golden citizens or
free coverage for ladies night
Public Goods
Public good has two main characteristics :
Non-excludability where it is not possible to provide a good or service to one person without it thereby being available for
others to enjoy
Non-rivalry where the consumption of a good or service by one person will not prevent others from enjoying it
Therefore commercial firms are not interested to produce public goods as they are not able to charge a price and therefore
profit from it.
To solve the problem, government will step in to produce such goods and services, funded by tax revenue that collected
fromeconomic agents. Subsequently the government may seek to privatize strategically the supply of the goods and services
to a commercial firm as such charges will be applied and certain consumers will be excluded from the consumption of the
goods and services.
Example are : Healthcare (public hospitals are moving into semi private e.g. Hospital University), roads, security (police force)
and etc
Externalities
Externalities are spill-over effects due to production or
consumption of certain product, which are not appropriately
compensated or accounted for in the pricing mechanism.
Externalities are divided to :
1. Positive externalities
Positive spillover effect which will bring benefits to the
society
2. Negative externalities
Negative spillover effect which will be damaging to the
society
In a perfect environment, the positive externalities have to be
appropriately rewarded and negative externalities have to be
penalized accordingly. However, the market or pricing mechanism
fail to account this.
As such government need to step in to provide subsidy for
positive externalities such as Research and Development carry out
by firms and impose tax on negative externalities such as waste
products that are damaging to the environment
With the subsidy provided, quantity can be
increased, therefore increasing the trade and
prices lower, therefore increasing the consumer
surplus
When subsidy is provided
With the subsidy provided, quantity can be
increased, therefore increasing the trade and
prices lower, therefore increasing the consumer
surplus
When tax is imposed
When tax is imposed on top of the price, price increases and
quantity demanded will reduce, therefore causing a deadweight
loss. Nevertheless, the tax received can negate the negative
externality therefore compensate the deadweight loss.
Supply1
Society Inequality
Market failure can be caused by inequality, which commonly happens in market economy, due to inefficient distribution of
wealth, which is attributable to:
1. Uneven growth due to geographical area i.e. urban vs suburban
2. Unequal distribution of opportunities
Inequality causes market failure due to huge disparity of living standard, which will affect demand of certain products.
Government can intervene to regulate the income disparity by using certain policy such as :
1. Price Ceiling
2. Price Floor
Society Inequality
Price Ceiling
Government can impose a price ceiling to certain necessity market
such as flour, sugar and etc.
Price ceiling imposed is Pc
Price ceiling imposed will increase consumer surplus and reduce the
producer surplus, thus increasing the consumers welfare
Nevertheless, deadweight loss will be created
Government can choose to provide subsidy so that output can be
increased to meet the shortage
Society Inequality
Price Floor
Price floor is aptly applicable in labour market i.e. minimum wage
1. Price floor will increase the seller (labour surplus) and reduce the buyer (firm) surplus
2. A deadweight loss will also be created

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