Unit 3: Market Structures

1. Overview of Market Structures

Market Structure refers to the organizational and other characteristics of a market that affect the nature of competition and pricing. The behavior of a firm is heavily influenced by the market structure in which it operates.

Key Determinants:

• Number of Buyers and Sellers: Determines the influence of individual agents.
• Nature of the Product: Homogeneous (identical) vs. Differentiated.
• Barriers to Entry and Exit: Legal, technical, or economic hurdles.
• Control over Price: Price taker vs. Price maker.
• Information: Perfect vs. Imperfect knowledge.

2. Perfect Competition

Definition

Perfect competition is a theoretical market structure characterized by a complete absence of rivalry among the individual firms. It serves as a benchmark for efficiency.

Key Characteristics

1. Large Number of Buyers and Sellers: No single buyer or seller can influence the market price; they are price takers.
2. Homogeneous Products: Products are identical substitutes (e.g., agricultural commodities like wheat).
3. Free Entry and Exit: No barriers prevent firms from entering or leaving the industry.
4. Perfect Information: All participants have full knowledge of price and product quality.
5. Perfect Mobility of Factors of Production: Labor and capital can move freely.
6. No Transaction Costs.

Revenue Curves

• Price (P) is constant.
• The firm's demand curve is perfectly elastic (horizontal).
• Average Revenue (AR) = Marginal Revenue (MR) = Price (P).

Equilibrium Analysis

Profit Maximization Rule: Produce where (and MC is rising).

A. Short-Run Equilibrium

In the short run, a firm can make:

• Supernormal Profit: Price > Average Total Cost (ATC).
• Normal Profit: Price = ATC (Break-even point).
• Loss: Price < ATC.
  • Shut-down point: If Price < Average Variable Cost (AVC), the firm stops production immediately.

B. Long-Run Equilibrium

• Due to free entry/exit, supernormal profits attract new firms, increasing supply and driving prices down.
• Losses cause firms to exit, decreasing supply and driving prices up.
• Result: In the long run, firms earn only Normal Profits ().
• Equation: .

Efficiency

• Allocative Efficiency: Achieved (). Resources are allocated exactly according to consumer desire.
• Productive Efficiency: Achieved (). Production occurs at the lowest possible cost.

3. Monopoly

Definition

A market structure in which a single seller dominates the entire market for a good or service that has no close substitutes.

Sources of Monopoly Power (Barriers to Entry)

• Natural Monopoly: High fixed costs/economies of scale make it efficient for only one firm to exist (e.g., utilities).
• Legal Barriers: Patents, copyrights, and government licenses.
• Resource Control: Exclusive ownership of essential raw materials.

Key Characteristics

1. Single Seller: The firm is the industry.
2. Price Maker: The firm controls the price by adjusting output.
3. No Close Substitutes: Cross-elasticity of demand is near zero.
4. Downward Sloping Demand: To sell more, the monopolist must lower the price.

Revenue Curves

• AR Curve: Downward sloping (same as Market Demand).
• MR Curve: Downward sloping and lies below the AR curve (because to sell an extra unit, price must be lowered on all units).

Equilibrium Analysis

Profit Maximization Rule: Produce where .

• Short Run & Long Run: A monopolist can earn Supernormal Profits in the long run because barriers to entry prevent competition.
• Pricing: Price is set on the Demand curve corresponding to the quantity where .
• Condition: .

Economic Costs of Monopoly

• Deadweight Loss: Monopolies produce less and charge more than competitive markets (). This results in a loss of total social welfare.
• X-Inefficiency: Lack of competition may lead to lax cost controls and higher production costs.

4. Monopolistic Competition

Definition

A market structure blending elements of monopoly and perfect competition. It involves many firms selling products that are similar but not identical.

Key Characteristics

1. Many Sellers: High degree of competition.
2. Product Differentiation: Real or perceived differences (brand, packaging, features). This gives firms some control over price.
3. Free Entry and Exit: Low barriers.
4. Non-Price Competition: Heavy reliance on advertising and marketing.

Revenue Curves

• Demand Curve: Downward sloping but highly elastic (flatter) due to the presence of many close substitutes.

Equilibrium Analysis

A. Short-Run Equilibrium

• Firms behave like monopolies.
• Can earn supernormal profits, normal profits, or incur losses depending on demand relative to cost.
• Output where .

B. Long-Run Equilibrium (The Tangency Solution)

• If firms earn supernormal profits, new firms enter with similar products.
• Demand for the incumbent firm’s product falls (shifts left).
• Result: Firms earn only Normal Profits.
• Graphical Point: The Demand curve is tangent to the ATC curve. , but .

Excess Capacity Theorem

Unlike perfect competition, firms in monopolistic competition do not produce at the minimum of the ATC curve. They operate with excess capacity (they could produce more at a lower average cost but choose not to).

5. Oligopoly

Definition

A market structure dominated by a small number of large firms (e.g., Automobile, Telecom, Airline industries).

Key Characteristics

1. Few Large Firms: High concentration ratio.
2. Interdependence: The decision of one firm (price/output) directly affects rivals. Firms must anticipate competitors' reactions.
3. Barriers to Entry: High capital costs, brand loyalty.
4. Price Rigidity: Prices tend to stay stable to avoid price wars.

Models of Oligopoly Behavior

A. Kinked Demand Curve (Paul Sweezy)

• Explains price rigidity.
• Assumption: Rivals will match price cuts (to maintain market share) but will ignore price increases (to steal customers).
• Result: The demand curve is kinked at the current price. The MR curve has a vertical gap. MC can fluctuate within this gap without changing the profit-maximizing price.

B. Collusive Oligopoly (Cartels)

• Firms cooperate to restrict output and raise prices (acting like a collective monopoly).
• Example: OPEC.
• Instability: There is always an incentive for individual members to "cheat" by producing more than their quota.

C. Price Leadership

• One dominant firm sets the price, and smaller firms follow suit.

D. Game Theory (Nash Equilibrium)

• Used to analyze strategic interaction.
• Prisoner's Dilemma: Demonstrates why two firms might not cooperate even if it is in their best interest to do so. Often results in both firms choosing a low price (Nash Equilibrium) rather than a high price (Collusion).

6. Pricing Strategies

Firms use various strategies to determine the optimal price depending on their market structure and objectives.

A. Price Discrimination

Charging different prices to different consumers for the same good, not based on cost differences. Requires monopoly power and the ability to prevent resale (arbitrage).

• First-Degree (Perfect): Charging every consumer the maximum they are willing to pay (captures all consumer surplus).
• Second-Degree: Charging different prices based on quantity (e.g., bulk discounts, block pricing).
• Third-Degree: Charging different prices to different consumer groups based on elasticity (e.g., student discounts, peak vs. off-peak travel).

B. Cost-Plus (Mark-up) Pricing

• Adding a standard percentage profit margin to the average cost of production.
• Formula: .
• Common in: Retail and oligopolies (to avoid price wars).

C. Penetration Pricing vs. Price Skimming (New Products)

• Penetration Pricing: Setting a low initial price to gain market share quickly. (Used in Monopolistic Competition/Oligopoly).
• Price Skimming: Setting a high initial price to capture surplus from early adopters, then lowering it over time. (Used when a firm has a temporary monopoly/patent).

D. Predatory Pricing

• Setting prices below cost (AVC) specifically to drive competitors out of the market.
• Illegal in many jurisdictions (antitrust laws).

E. Peak-Load Pricing

• Charging higher prices during periods of high demand and lower prices during off-peak times.
• Used when capacity is fixed (e.g., Electricity, Transport).

F. Limit Pricing

• Setting a price low enough to deter new entrants from entering the market. The price is below the profit-maximizing level but above the competitive level.

Summary Comparison Table