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Market Structure www.lrjj.cn The Degree of Competition • The four market structures – perfect competition – monopoly – monopolistic competition – oligopoly • Classifying markets – number of firms – freedom of entry to industry – nature of product – nature of demand curve www.lrjj.cn Market Structures Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Perfect competition Very many Unrestricted Homogeneous (undifferentiated) Cabbages, carrots (approximately) Horizontal: firm is a price taker Monopolistic competition Many / several Unrestricted Differentiated Builders, restaurants Downward sloping, but relatively elastic Undifferentiated Cement or differentiated cars, electrical appliances Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Oligopoly Monopoly Few One Restricted Restricted or completely blocked Unique Local water company, train operators (over particular routes) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price www.lrjj.cn Perfect Competition • Assumptions – firms are price takers – freedom of entry – identical products – perfect knowledge www.lrjj.cn The Revenue of Competitive Firm • Total revenue (TR) – How much does the firm receive for the sale of the total output? TR = P × Q • Average revenue (AR) – How much does the firm receive for the sale of one typical unit of output? AR = TR/Q • Marginal revenue (MR) – How much does the firm receive for the sale of one additional unit of output? MR = ΔTR/ΔQ www.lrjj.cn Cost of Production • Includes all the opportunity costs of making its output of goods and services. – Explicit costs: input costs that require a direct outlay of money by the firm (e.g. opportunity cost of $100 electricity fee) – Implicit costs: input costs that do not require an outlay of money by the firm (e.g. opportunity cost of renting out building) www.lrjj.cn Profit www.lrjj.cn Profit Maximization • The firm will want to produce the quantity that maximizes the difference between total revenue and total cost. • Occurs at the quantity where marginal revenue equals marginal cost (MR=MC). • Why don’t the firm just produce the maximum quantity? www.lrjj.cn Marginal Analysis Q 0 1 2 3 4 5 6 7 P=AR 6 6 6 6 6 6 6 6 TC 3 5 8 12 17 23 30 38 TR 18 24 30 36 42 Profit MR -3 1 6 4 6 6 6 7 6 7 6 6 6 4 6 MC Profit 2 3 4 5 6 7 8 4 3 2 1 0 -1 -2 www.lrjj.cn Marginal Analysis Q 0 1 2 3 4 5 6 7 P=AR 6 6 6 6 6 6 6 6 TC 3 5 8 12 17 23 30 38 TR 0 6 12 18 24 30 36 42 Profit MR -3 1 6 4 6 6 6 7 6 7 6 6 6 4 6 MC Profit 2 3 4 5 6 7 8 4 3 2 1 0 -1 -2 www.lrjj.cn Short-run equilibrium of industry and firm under perfect competition Firm is a price taker. Price is given by the market. P £ MC S Pe AC D = AR = MR AR AC D O O Q (millions) (a) Industry Qe Q (thousands) (b) Firmwww.lrjj.cn Profit Maximization • When MR > MC, increase Q • When MR < MC, decrease Q • When MR = MC, profit is maximized www.lrjj.cn Long-run equilibrium Profits return to normal New firms enter P £ Supernormal profits S1 Se LRAC P1 AR1 D1 PL ARL DL D O O Q (millions) (a) Industry QL Q (thousands) (b) Firm www.lrjj.cn Produce or shut down – the short-run • Shut down (short-run decision) • Exit (long-run decision) • Which costs are relevant? – If the firm shuts down, it only incurs fixed cost, which is sunk and cannot be recovered. – Relevant cost in the short run is variable cost. www.lrjj.cn Produce or shut down - the short-run • The firm shuts down if the revenue it gets from producing is less than the variable cost of production. – Shut down if TR < VC – Shut down if TR/Q < VC/Q – Shut down if P < AVC • As long as P ≥ AVC (or TR ≥ TVC), the firm should operate even if it is losing money (loss-minimizing) www.lrjj.cn Enter or exit – the long run • In the long run, the firm exits if the revenue it would get from producing is less than its total cost. – Exit if TR < TC – Exit if TR/Q < TC/Q – Exit if P < ATC • A firm will enter the industry if such an action would be profitable. www.lrjj.cn Monopoly • A firm that is the sole seller of a product for which no close substitutes exist. • The firm is protected from competitors by barriers that prevent entry from other firms www.lrjj.cn Barriers to entry • • • • • • Monopoly resources Government-created monopolies Natural monopolies (economies of scale) Product differentiation and brand loyalty Aggressive tactics Lower costs for an established firm www.lrjj.cn Profit maximising under monopoly £ MC Total profit AC AR Profit maximised at output of Qm (where MC = MR) AC AR MR O Qm Q www.lrjj.cn Profit Maximization under Monopoly • MR = MC (true for all firms!) • In a competitive firm, P = MR – Profit maximization leads to P = MC → P = MC = MR • For a monopoly, P > MR – Profit maximization leads to P > MC • Why? www.lrjj.cn Equilibrium under PC & Monopoly – the same MC curve £ MC ( = supply under perfect competition) Comparison with Perfect competition P1 P2 AR = D MR O Q1 Q2 Q www.lrjj.cn Monopolistic Competition • A situation where there are a lot of firms competing with their own market segment • Each firm has some discretion as to what price to charge for its products www.lrjj.cn Monopolistic Competition • Assumptions – Independence – Freedom of entry – Product differentiation www.lrjj.cn £ Monopolistic Competition – Short run equilibrium MC AC Ps ACs AR = D MR O Qs www.lrjj.cn Q £ Monopolistic Competition – Long run equilibrium New firms entering the industry reduce demand for each individual firm. LRMC Price falls to PL LRAC PL ARL = DL MRL O QL Q www.lrjj.cn Oligopoly • A few firms share a large proportion of the market • Key features of oligopoly – barriers to entry – interdependence of firms • Competition versus collusion • Collusive oligopoly: cartels www.lrjj.cn Profit-maximising cartel £ Industry profit maximised at Q1 and P1. Industry MC P1 Members must agree to restrict total output to Q1. Industry D = AR Industry MR O Q1 Q www.lrjj.cn Factors favoring collusion • • • • • • • • Few firms Open with each other Similar production methods and average costs Similar products Dominant firm Significant entry barriers Stable market No government measures to curb collusion www.lrjj.cn