INDUSTRY ECONOMICS

MARKET MODELS

The market environment of any firm will be influenced by two factors, firstly demand for the product at
each possible price level and secondly, the type of competition it encounters from its rivals in the market. In
the form of four simplified market structures which can serve as models are:

 Perfect competition
 Monopoly
 Oligopoly
 Monopolistic competition

These four market models can be placed in a continuum:

Four Market Models

Perfect Competition Monopolistic Competition Oligopoly Monopoly

Infinite number of Many Sellers Just a few Only one

sellers sellers Seller

Perfect Imperfect Competition

(Pure Competition)

PERFECT COMPETITION
Perfect Competition – a market structure of a large number of individual firms each selling a standardized
product and each having so small a share of the total market that none can influence market price.

Characteristics of Perfect Competition

For perfect competition to exist, an ideal world containing the following six market conditions apply.

 There are a large number of buyers, all so small that no single buyer can influence the price ruling
in the market or the demand.
 There are a large numbers of sellers, all so small that no single seller can influence price or quantity
demanded. All firms are Price takers.
 There are no barriers to entry in Long Run; there is total freedom to enter or exit the market
therefore normal profit is earned in long run.
 There are Homogenous/Identical products. This guarantees that prices of all firms remain same and
if one firm decides to raise the price it would lose its market share.
 Perfect knowledge exists between buyers and sellers.
 Cost of production for all firms is identical.
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  Resources are employed in accordance with consumer sovereignty.
 Perfect competition keeps the prices at lowest possible level for a given output.
 Homogenous products provide little consumer choice.

Profit situation under Perfect Competition

Perfect Competition in short Run

In the short run a firm in the perfectly competitive market can add to its fixed factors and new firms cannot
enter into the industry. Three possible profits are therefore possible:

Super Normal profit – occurs when firm’s total revenue exceeds its total costs, both implicit and explicit.
It is also known as super profit or economic profit.

Example

Price & Cost MC

Supernormal Profit

AC AC
D = AR = MR
P

C
AVC

0 Q Output

Normal Profit - occurs when a firm’s total revenue is exactly equal to its total cost. It is the profit just
enough to keep the producer in operation.

Price & Cost MC

Normal Profit AC

AVC
P&C D = AR = MR

0 Q Output

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Subnormal Profit – occurs when the firms total cost exceeds total revenue. It is a loss in the firm.

Price & Cost

Subnormal Profit AC
MC

C AVC

P D = AR = MR

0 Q Output

Prefect Competition in Long Run

In long run, all productive factors are variable. New firms can enter the market and existing firms can leave
it. If supernormal profit is being earned by perfect competition firms, then new firms will be attracted until
just normal profits are being earned. However, if firms are experiencing losses in the long run, some will
exit the market. This will reduce supply and cause an upward movement in price until normal profits are
being earned again.

Breakeven and Shutdown Point

Breakeven point is a point where the firm is earning a normal profit, i.e. the firm’s total revenue (TR) is
just enough to cover its total cost (TC).

Shutdown point is a point where the firm is able to cover only its variable cost. If the firm continues to face
this situation then eventually it may decide to shut down.

Example

Price & Cost MC

Breakeven Point AC

AVC
P1 D = AR = MR (1)

P2 D = AR = MR (2)

Shutdown point

0 Output
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IMPERFECT COMPETITIONN

Market Structures lie between two extremes – Perfect and Imperfect competition. The imperfect
competitions are:
 Monopoly
 Oligopoly
 Monopolistic Competition

1. Monopoly – is a market situation where there is a single seller of product sometimes referred to as single
firm market. In other words monopoly is entire industry.

How does monopoly come into being?

Monopolies emerge because of barriers preventing entry of other firms in the industry. Such barriers are:
1. Legal Barriers – are the law and order that has to be observed before monopoly can emerge. These
include:
Government Regulation – laws passed to commence the monopoly e.g. govt. license.
Government Franchise – is an exclusive right given to a firm to supply good or service e.g. Telecom has
been given exclusive right to deal with all post & telecom services.
Patent Right – is an exclusive right given to the inventor or producer to produce the particular good or
services?
2. Regional barriers – If products cross national boundaries this leads to very high transport and tariff
costs.
3. Technological barriers – very high capital investments required to achieve the economies of scale.
4. Unique Supply Of resources - e.g. Gold are only found in Vatukoala and Hydro system of Monosavu.

Characteristics of Monopoly
 Single seller of goods and services.
 Monopolies are price makers. Since they are the sole suppliers of goods and services, they are able
to set the price and quantity combination.
 Monopolies face a downward sloping demand curve i.e. demand usually contracts following a price
rise and expands following a price reduction.
 Monopolies maximize profit by charging higher prices and restricting output since they are profit oriented
(have profit motive).
 They have strong barriers to entry hence are mostly able to earn supernormal profit.
 They involve themselves in price discrimination.
 They are able to undertake research and development.

Types of Profit Situation in Monopoly

Short – Run Situation

Monopoly makes three possible profits in the short run:

a. Supernormal Profit
Supernormal profit is made when the monopoly’s Total Revenue (TR) is greater than Total Cost (TC).

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 Example

Price & Cost

Supernormal Profit MC

P AC

D = AR

0 Q MR Output

b. Normal Profit
Normal profit is made when the monopoly’s Total Revenue (TR) just covers the Total Cost (TC)
Example

Price & Cost

Normal Profit MC

P=C AC

D = AR

0 Q MR Output

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 c. Subnormal Profit
Subnormal profit is made when the monopoly’s Total Revenue (TR) is less than the Total Cost (TC).

Example

Price & MC
Subnormal Profit

AC
C

D = AR

0 Q MR Output

Long Run Equilibrium

* In the Short run, any of the three profits could be made.
* In the Long Run, most likely profit to prevail is supernormal profit. This profit attracts the new firms but barriers to
entry restrict their entry. Monopoly profits are protected. Firms operating at a loss may leave. Normal profit firms
continue in the long run. Therefore in long run only normal and supernormal profits prevails.

Performance of Monopolies
1. Due to the fact that monopoly firm is the industry itself, it has a significant market power and can earn
supernormal profit in the long run.
2. Since it is a single producer it has freedom to produce with a plan size which is less than optimal therefore loss of
Economic Efficiency.
3. If we compare a monopolist to a perfectly competitive firm we can see that the monopolists restrict output to drive
up the price and earn supernormal profit. Consumers have to pay higher price which is not of their best interest, thus
monopolies fail to operate efficiently or respond to consumers demand (loss of allocative and productive efficiency,
creating dead weight loss). (include a graph to illustrate deadweight loss)
4. They lack incentive to innovate since there is no competitive urgency to improve their product.

Good Side of Monopoly

1. Since monopolies earn supernormal profit and have strong barriers to entry, they have greatest ability to undertake
research and development and innovation.

2. Monopolies are able to achieve economies of scale which thereby can lower prices.

Economic Effect
 Under Utilization of resources due to profit motive.
 Unequal distribution of income because consumers have to pay higher prices.
 Technological progress through economies of scale
 Heavy market concentration in the long run
 Long run advantage to consumers, i.e. in terms of research and development and innovation.

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Natural Monopoly – occurs when a single firm can supply the entire industry output more efficiently than several
sellers.

Oligopoly
- is a market structure consisting of a few, relatively large firms selling products which are close substitutes. There is
rivalry between firms e.g. biscuits and confectionary manufactures, hardware shops, mobile phone companies, etc.

Characteristics
1. Few sellers few large firms dominate the supply to an entire market.
2. Each firm produces similar products.
3. Entry into the industry is very difficult because it involves very high start up cost (sunk costs) -Strong barriers.
4. High degree of real and imaginary product differentiation.
5. Consumers knowledge about product differentiation is limited.
6. Rivalry between firms since there are so few firms in the Oligopoly market that each firm must consider the prices
and quantity reactions of its rivals therefore leading to mutual interdependence ( actions of one producer will affect
the actions of others.
7. Each firm keeps a close eye on what the other firms are doing, especially in terms of prices i.e. if one firm
decreases price, it will be followed by others because of fear of loss of market share resulting in kinked demand
curve.
8. Loss of allocative efficiency
9. Formation of cartels a group of firms get together to enjoy monopoly power.
10. Involves a product differentiation in form of (non-price competition):
* quality improvement in the product itself
* Use of different packaging
* Bonus offered or discount
* Longer warranty period
11. Competition is very fierce and often known as ‘cut throat competition.
12. Heavy advertising throughout the years therefore it turns to be a fixed cost (FC)
13. Involve a research and development and due to large size, revenue and profit potential is greater and have funds
to undertake research and development.
14. Price leadership may also develop where one large firm will dominate the industry.
15. Predatory competition occurs when a dominate firm in the market takes over smaller rivals in the same market.
Formation of cartels
Firms under oligopoly market situation form an open collusion or a group of firms form an agreement to set the price
and the quantity in the industry and enjoy monopoly power and act as price makers. This open collusion works for
the interest of member firms example OPEC.

Obstacles to Collusion
 Demand and cost differences
 Number of firms - large number of firms would lead to difficulty to manage.
 Cheating
 Recession in the economy.

Price & Output decisions under Oligopoly

Kinked Demand Curve theory

This theory is based on the idea that if one firm increases its price, then it will lose its market share to the other firms,
hence an oligopoly firm has a relatively elastic demand curve above equilibrium. On the other hand, if a firm
decreases its price, then the other firms will follow suit, hence there will be very little change in the market share of
each of the firms, and hence an oligopoly firm has a relatively inelastic demand curve below the equilibrium,
forming a kink at the equilibrium, hence a kinked demand curve as illustrated below.

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Price,
Cost &
Revenue
$

D MC1

Pe
MC2

D
0
Qe Output

Marginal Revenue Curve for an Oligopoly.

For an Oligopoly, the D=AR curve is made up of two demand curves, hence two MR curves, resulting in the
marginal revenue curve as a line of discontinuity as seen in the figure above.

Note:
Because the AR is made up of two demand curves, there is a discontinuous portion in the MR curve and that is why
MC varies between MC1 and MC2. The profit maximizing output remains the same at Qe.

Non – Pricing Marketing Strategies

*Also called product differentiation or non price competition.
*Sellers persuade buyers that their products are different (through advertising and packaging)
* makes minor changes to products or make it attractive product variation.
*Promotion of brand names
* Sponsorship of big sports events
*Advertising adds to overall cost of production
*Horizontal product differentiation – when a firm differentiates a product to set it apart from other products, i.e.
through minor changes and through advertising and packaging
*Vertical product differentiation – When one firm offers its own product differentiation e.g. new car producers put a
basic model in the market and then offer a range of improved models or high prices.

Performance of Oligopolies
* No guarantee of efficiency
*Small customer market
*Unlikely to achieve economies of scale
*P > MC i.e. mark up pricing leads to misallocation of resources or exploitation of consuming public.
*research and development undertaken by firms. Each has sufficiently high profits to fund such development and
innovation. It is advantageous to consumers because of better product quality.

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MONOPOLISTIC COMPETITION
is a market structure that lies between two extremes of prefect competition and monopoly. It is referred to as
monopolistic competition because through its behavior in advertising, product differentiation and pricing aims to
increase sales. E.H. Chamberlain coined the term monopolistic competition.

Characteristic of Monopolistic Competition

 There are a large number of buyers and sellers therefore price fixing is impossible and price and output
behavior of one firm has minimum impact on others.
 Long run barriers are nonexistent; because of their small scale i.e. small capital cost to start or operate so any
one can start up monopolistic competition (unlike monopoly).
 Similar production cost for each firm.
 Similar but not identical product. This is called product differentiation. It is also known as non- price
competition. Forms of product differentiation are packaging and quality improvement (It is most effective
competitive instrument - attracts most consumers therefore sale as and profitability in the long run).
 They have some control over price due to successful competition.

Examples of Monopolistic Competition are:

Solicitors; restaurants; hairdressers; takeaway food stores; coffee shops; dry cleaners, etc.
Types of profits in the short run:
In short run it is possible for monopolistic competitive firms to earn supernormal, subnormal and normal profit.

a. Supernormal Profit
Supernormal profit is made when the firm’s Total Revenue (TR) is greater than Total Cost (TC).

Example

Price & Cost

Supernormal Profit MC

AC

D = AR
C

MR

0 Q Output

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 b. Normal Profit
Normal profit is made when the firm’s Total Revenue (TR) just covers the Total Cost (TC)
Example

Price & Cost Normal Profit MC

AC

P=C

D = AR

MR

1 Q Output

c. Subnormal Profit
Subnormal profit is made when the firm’s Total Revenue (TR) is less than the Total Cost (TC).

Example

Price & MC
Subnormal Profit

AC
C

D = AR

MR

0 Q Output

Long run Equilibrium:

In the long run, the supernormal profit will be competed away because of larger number of firms, either through
entry of new firms or changes in the product quality. Those firms making economic losses in short run will leave the
industry. Those earning normal profit will remain in the industry.

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