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Market Structures
Perfect Competition
Perfectly competitive market
many buyers and sellers,
identical (also known as
homogeneous) products,
no barriers to either entry or exit, and
buyers and sellers have perfect
information.
Price Takers – take the market price
Perfect Competition
Demand for the firm:
because firm’s output is such a small
share of total market supply, the demand for
each firm’s output is perfectly elastic
there is no effect on market price,
they simply produce as much as they can at
the going price
This means there will be a horizontal
demand curve for their product
This does NOT mean that the market
demand curve is horizontal
Demand curve facing a single firm
no individual firm can affect the market
price
demand curve facing each firm is perfectly
elastic
Profit maximization
produce where MR = MC
Marginal revenue = change in Total Revenue/change in Quantity
Marginal Cost = Change in Total Cost/ Change in Quantity
Method of Totals
Ex: green pepper farmer operates in perfectly
competitive market.
*Going price for a peck of green peppers (144
peppers) is $11
*The Table on the next slide will summarize
how TR, TC and profit differ at the various
levels of output
*Short Run – has $16 of fixed costs (ability to
change only one variable)
*All costs reflect both explicit and implicit costs
of hiring resources
Table 1
Method of Totals
Daily
Bushels
of green
peppers
Price (P) Total
0
Profit
Revenue
(TR)
Total
Cost
(TC)
$11
$0
$16
-$16
1
$11
$11
$22
-$11
2
$11
$22
$27.50
-$5.50
3
$11
$33
$34
-$1
4
$11
$44
$42
$2
5
$11
$55
$53
$2
6
$11
$66
$65
$1
(economic)
The Method of “Marginals”
Decision making implies:
If MB>MC, do more of it
If MB<MC, do less of it
If MB=MC, stop here
Since the only decision for Perfectly Competitive firm is to choose
the optimal level of output, the firm’s rule is:
MB=MC=MR
Table 2 Method of Marginals
Daily
Bushels
(Pecks) of
green
peppers
Price
(P)
Total
Revenu
e
(TR)
Total
Cost
(TC)
Profit
0
$11
$0
$16
-$16
1
$11
$11
$22
2
$11
$22
3
$11
4
Marginal
Revenue
(MR)
Marginal
Cost
(MC)
-$11
$11
$6
$27.50
-$5.50
$11
$5.50
$33
$34
-$1
$11
$6.50
$11
$44
$42
$2
$11
$8
5
$11
$55
$53
$2
$11
$11
6
$11
$66
$65
$1
$11
$12
(economic)
In perfect competition, Price is equal to MR (producers can
produce as much as they want at market price
Method of Marginals
•MR = ∆TR/ ∆Q = P* ∆Q/ ∆Q = P
•AR = TR/Q = P*Q/Q = P
•P = MR = AR = demand for firm’s product
One Green Pepper Farmer
D=P=MR=AR
MC
P
11
Qe=5
Q
Short Run Profit and Loss
P-ATC describes the per unit difference between what the
firm receives from the sale of each unit and the average
cost of producing it, or profit per unit.
When you multiply the per unit profit by the number of units
produced, it yields total profit.
Daily
Pecks of
Peppers
Price
(P)
Total
Cost
(TC)
Average
Total Cost
(ATC)
0
$11
$16
1
$11
$22
$22
-$11
-$11
2
$11
$27.50
$13.75
-$2.75
-$5.50
3
$11
$34
$11.33
-$.33
-$1
4
$11
$42
$10.50
$.50
$2
5
$11
$53
$10.60
$.40
$2
6
$11
$65
$10.83
$.17
$1
(P-ATC)
Profit =
q*(PATC)
-$16
Graph 4
Short Run Profit or Loss
One Green Pepper Farmer
Profit = 5*($11 - $10.60) = $2
P
11
1o.60
MC
ATC
D=P=MR=AR
Qe=5
Q
P = MR
Profit-maximizing level of output
Economic Profits > 0
Economic profit
Loss minimization and the shutdown rule
Suppose that P < ATC. Since the firm is
experiencing a loss, should it shut down?
Loss if shut down = fixed costs
Shut down in the short run only if the loss
that occurs where MR = MC exceeds the
loss that would occur if the firm shuts down
(= fixed cost)
Stay in business if TR > VC. This implies
that P > AVC. Shut down if P < AVC.
Economic loss (AVC<P< ATC)
Loss if shut down
Break-even price
If price =
minimum point on
ATC curve,
economic profit =
0.
Owners receive
normal profit.
No incentive for
firms to either
enter or leave the
market.
P < AVC
Short-run supply curve
A perfectly
competitive
firm will
produce at
the level of
output at
which P =
MC, as long
as P > AVC.
Short Run Positive Profits
Summary of long run adjustment to short run
positive profits:
1. Entry of new firms attracted by
economic Profit >0
2. increase in market supply
3. decrease in market price to PLR
4. Profits fall to the break even point,
PLR=MR=MC=ATC and econ. Profit = 0
5. Market quantity increases
6. Individual producer output falls
Long run
Firms enter if economic profits > 0
market supply increases
price declines
profit declines until economic profit equals zero
(and entry stops)
Firms exit if economic losses occur
market supply decreases
price rises
losses decline until economic profit equals zero
Long-run equilibrium
Long-run equilibrium and
economic efficiency
Two desirable efficiency properties
(assuming no market failure)
P = MC (Social marginal benefit = social
marginal cost)
P = minimum ATC
Long Run adjustment to short run losses
1. Exit of existing firms prompted by economic profit<0
2. Decrease in market supply
3. An increase in the market price to PLR.
4. Profits increase to the break even point,
PLR=MR=MC=ATC and economic profit =0
5. Market quantity decreases.
6. Individual producer output rises
Consumer and producer surplus
Consumer surplus = net gain from
trade received by consumers (MB > P
for consumers up to the last unit
consumed)
Producer surplus = net gain received
by producers (P > MC up to the last
unit sold)
Consumer and producer surplus
Consumer surplus
Gains from
trade =
consumer
surplus +
producer Producer surplus
surplus
Market Structures Continued
Monopoly
Monopolistic Competition
Oligarchy
Monopoly
Demand Curve Slopes Downward
Demand equals price
If MR<Priced, then lower price to sell more
MR=addition to TR by selling one more unit
As Price Decreases, Quantity sold
increases – law of demand
No Supply Curve
Differences between Monopolies
and Competitive Industries
Lump Sum Tax will not affect price for
monopoly – may cause some in perfect
competition to leave the market
An increase in demand does not mean a
monopoly will supply more
Competitive firm in long run will produce at
its minimum ATC – monopolies only by
chance
Price Ceilings – monopolies – increase
quantity supplied; perfect competition –
supply will decrease
The Basics
Monopoly – one firm producing a
good with no close substitutes
MR=P-(Change in Price)x previous
quantity
Produced where MR=MC if P>AVC in
short run and P>ATC in long run
Shut down in short run: Demand
curve is below the AVC curve at all
points
Basics continued
Shut down in the long run: Demand curve is below
ATC curve at all points
Price Discrimination – different prices for same
good
Charge more to those with inelastic demands
Charge less to those with more elastic demands
If several separate markets, set P so same MR in each
market
Conditions for price discriminations:
Buyers cannot resell the goods
Monopoly knows which customers have more inelastic
demand
Monopolistic Competition and
Oligopoly
Monopolistic
Competition
Many firms and
No long run
barriers to entry
Firms sell similar
but not identical
products
Oligopoly
There are a few
firms and
High barriers to
entry such that
there is no long run
entry into the
industry and
Each produces
identical products
Basics
More competition is Price is close to
MC
More Collusion is Price close to
Monopoly Price
Kinked demand curve oligopoly: if one
firm raises P, others keep old P and
firm loses businesses. If lower Pr,
price war: Result: same P for wide
range of MC
Basics continued
Dominant Firm Oligopoly: one big firm
with many small competitors – small
competitors follow big firm P. Big
Firm sets Price knowing this
Cartel – few firms, barriers to entry,
firms collude to set Price. Price set at
monopoly Price. Each firm has an
incentive to cheat at P>ATC
More basics
Game theory: analyzes situations
where firms or individuals interact
while attempting to achieve their own
goals
Dominant strategy: do what is best for
you – collusion is best for both
Basics continued
Event
Monopoly
Lump Sum
Tax<profits
Supply curve
Change in
Price=0
No
Price Ceiling
Competitive
Firm
P up in the
long run
Yes
Q up for some Q down (or
P
unaffected)
Practice Price Yes if possible No
Discrimination
Chapter 11: Monopoly
Monopoly market
single seller for a product with no
close substitutes
barriers to entry
Barriers to entry
economies of scale
actions by firms
actions by government
Economies of scale – natural
monopolies
Natural
monopolies
are often
regulated
monopolies
Actions by firms to create and
protect monopoly power
patents and copyrights,
high advertising expenditures result in
high sunk costs (costs that are not
recoverable on exit), and
illegal actions designed to restrict
competition
Monopolies created by
government action
patents and copyrights,
government created franchises, and
licensing.
Local monopoly
Local monopoly – a monopoly that
exists in a local geographical area
(e.g., local newspapers)
Price elasticity and MR
As noted earlier, since the demand
curve facing a monopoly firms is
downward sloping, MR < P
MR > 0 when demand is elastic
MR = 0 when demand is unit elastic
MR < 0 when demand is inelastic
Average revenue
As in all other market structures,
AR=P (note that AR = TR/Q = (PxQ) /
Q = P)
The price given by the demand curve
is the average revenue that the firm
receives at each level of output.
Monopolist receiving positive
profits
Zero-profit monopolist
Monopolist receiving economic
loss
Monopolist that shuts down in
the short run
Monopoly price setting
There is a unique profit-maximizing price
and output level for a monopoly firm.
It is optimal to produce at the level of
output at which MR = MC and to charge
the price given by the demand curve at this
output level.
Charging a higher (or lower) price results in
lower profits.
Price discrimination
In imperfectly competitive markets, firms
may increase their profits by engaging in
price discrimination (charging higher
prices to those customers with the most
inelastic demand for the product).
Necessary conditions for price
discrimination:
the firm must not be a price-taker
firms must be able to sort customers by their
elasticity of demand
resale must not be feasible
Example: air travel
Dumping
If firms practice price discrimination by
charging different prices in different
countries, they are often accused of
dumping in the low-price country.
Predatory dumping occurs if a country
charges a low price initially in an attempt to
drive out domestic competitors and then
raises prices once the domestic industry is
destroyed.
There is little evidence of the existence of
predatory dumping.
Deadweight loss due to
monopoly
Other costs associated with
monopoly
X-inefficiency – occurs if firms do not have
an incentive to engage in least-cost
production (since they are not faced with
competitive pressure).
Rent-seeking behavior – the cost of using
resources (such as lawyers, lobbyists, etc.)
in an attempt to acquire monopoly power.
This behavior does not benefit society and
diverts resources away from productive
activities.
Regulation of natural monopoly
monopoly
outcome:
P(m), Q(m)
marginal-cost
pricing:
P(mc), Q(mc)
“fair-rate of
return” pricing
system: P(f),
Q(f)
Chapter 12: Oligopoly and
Monopolistic Competition
Characteristics of a monopolistically
competitive market
Many buyers and sellers
Differentiated products
Easy entry and exit
Relationship to other market
models
Monopolistic competition is similar to
perfect competition in that:
There are many buyers and sellers
There are no barriers to entry or exit
Monopolistic competition is similar to
monopoly in that:
Each firm is the sole producer of a particular
product (although there are close substitutes)
The firm faces a downward sloping demand
curve for its product
Demand curve facing a
monopolistically competitive firm
The firm’s demand curve and
entry and exit
As firms enter a
monopolistically
competitive
market, the
demand facing a
typical firm
declines and
becomes more
elastic.
Short-run equilibrium in a monopolistically
competitive industry
Economic profits
lead to entry and
a reduction in the
demand facing a
typical firm.
Long-run equilibrium in a
monopolistically competitive industry
Entry
continues until
economic
profit equals
zero for a
typical firm.
This
equilibrium is
often referred
to as a
“tangency
equilibrium.”
Short-run equilibrium with
economic losses
Long-run equilibrium
Monopolistic competition vs.
perfect competition


A monopolistically
competitive firm,
in the long run,
has “excess
capacity” – (i.e.,
it produces a
level of output
that is below the
least-cost level).
This is a cost of
product variety.
Monopolistic competition and
efficiency
As the number of firms rises, a
monopolistically competitive firm’s demand
curve becomes more elastic.
As the number of firms in a market
expands, the market approaches a
perfectly competitive market.
Thus, economic inefficiency may be
smaller when there is a large number of
firms in a monopolistically competitive
market.
Product differentiation and
advertising
Monopolistically competitive firms
may receive short-run economic profit
from successful product differentiation
and advertising.
These profits are, however, expected
to disappear in the long run as other
firms copy successful innovations.
Location decisions
Monopolistically competitive firms
often locate near each other to appeal
to the “median” customer in a
geographical region. (e.g., fast food
restaurants and car dealerships)
Oligopoly
a small number of firms produce most
output
a standardized or differentiated
product
recognized mutual interdependence,
and
difficult entry.
Strategic behavior
Strategic behavior occurs when the
best outcome for one party depends
upon the actions and reactions of
other parties.
Kinked demand curve model
Other firms are assumed to match
price decreases, but not price
increases.
There is little evidence suggesting
that this model describes the behavior
of oligopoly firms.
Game theory models are more
commonly used.
Game theory
Examines the payoffs associated with
alternative choices of each participant
in the “game.”
Game theory examples
Prisoners’ dilemma
Duopoly pricing game
Dominant strategy
A dominant strategy is one that provides
the highest payoff for an individual for each
and every possible action by rivals.
Confession is the dominant strategy in the
prisoners’ dilemma game. A low price is
the dominant strategy in the duopoly
pricing game
It is more difficult to predict the outcome
when no dominant strategy exists or when
the game is repeated with the same
players.
Shared monopoly
Joint profits are higher when firms
behave as a shared monopoly
Such a cartel arrangement is illegal in
the U.S.
Price leadership
Facilitating practices (e.g., cost-plus
pricing, recommended retail prices,
etc.)
Cartels
Cartels are legal in some countries
A cartel arrangement can maximize
industry profits
Each firm can increase its profits by
violating the agreement
Cartel agreements have generally
been unstable.
Imperfect information
Brand name identification – serves as
a signal of product quality. Customers
are willing to pay a higher price for
products produced by firms that they
recognize.
Product guarantees also serve as a
signal of product quality
Different Types of Market Structures
Visual 3.1
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