Chapter Five Analysis of Market Structure

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Introduction to Economics Chapter five Market structure

Chapter Five
ANALYSIS OF MARKET STRUCTURE
5.1 Introduction
We have learnt the analysis of cost in the earlier chapter. Now let us try to introduce the concept
of market and different types of market structures. We will first deal with the characteristics of
perfect competition and equilibrium of the firm and industry in perfect competition in short and
long run. This will be flowed by discussion on meaning and assumptions under monopoly,
monopolistic competition and Oligopoly markets.

On the basis of nature of competition, markets are classified into two as those with perfect and
imperfect competition. We shall discuss them briefly here. They will be dealt with in detail later.
a) Perfect competition:: there are huge numbers of buyers and sellers in the market. Buyers
and sellers are aware of the prices at which transactions take place. For a commodity the
same price prevails uniformly throughout the market. No individual seller or buyer can
influence the price in the market. In other words a perfect market is a market in which a
firm is a “price taker”. The same price of a commodity rules throughout the market.

b) Imperfect competition:: A market is said to be imperfect when the buyer or seller or both
are not aware of the offers being made by others. Naturally, therefore, different prices
come to prevail for the same commodity at the same time in an imperfect market.
Imperfect market is a market in which a firm is a”price maker”. In the real world,
however, we cannot find a perfect market. Especially, in this dynamic world imperfect
market is widely practiced.
5.2. Perfectly Competitive Market
Definitions: As explained above, perfect market (or perfectly competitive market) is one type of
market classified on the basis of nature of competition. It is a market structure characterized by a
complete absence of rivalry among the individual firms. Thus, perfect competition in economic
theory has a meaning diametrically opposite to the everyday use of this term. In practice
businessmen use the word competition as synonymous to rivalry. In theory, perfect competition
implies no rivalry among firms.

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5.2.1. Conditions (Assumptions) for the existence of perfect market


The followings are the conditions (assumptions) for the existence of perfect market. A market is
said to be perfectly competitive when the following assumptions are fulfilled.

a) Large number of sellers and buyers.


The number of buyers and sellers under perfect market are very large. When there are large
number of sellers and buyers, each contributing only an insignificant portion to the total volume
of goods sold and bought, it is difficult for any one seller or buyer or even a group of sellers or
buyers to affect the price. In other words, the price of the product in the market is the result of
the combined influence of all the firms in the industry and once a price is determined, each one
of the firms takes it for granted and adjusts its own output to that price. Thus each seller is a
“price taker”.

Thus, the large number of buyers and sellers assumed to exist in a perfectly competitive market
explains the lack of control by individual buyers over price. In a perfectly competitive market the
demand for output of each seller is perfectly elastic, indicating that the firm can sell any amount
of output at the prevailing market price. The demand curve of the individual firm is also its
average revenue (AR) and its marginal revenue (MR) curve. (Look fig 6.1)

Price (P)
Where P: market price
P P= AR=MR AR: Average revenue
MR: Marginal revenue
0 Output
Fig 6.1: Individual demand curve in perfect competition
b) Product homogeneity:
The product offered for sale by all sellers must be homogenous. The goods offered for sale are
perfect substitutes for one another from buyers’ point of view. Thus, there is no need of
advertising to differentiate between the products of various sellers. From this condition of
homogeneity of the product, it follows that if a seller raises his price slightly above the current
level, he will lose all his customers to the other sellers. Nor will be lower his price from the

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ruling price, since he can sell all his output at the prevailing price. This condition also points out
to the same conclusion that every seller under perfect competition will be content to accept the
prevailing price in the market.

c) Free entry and exit of firms


There should be absolute freedom for firms to get in (enter) or get out (exit) of the industry. Each
firm is small in size, and produces only a small portion of the total output. New firms will be
attracted to the industry if high profits are earned, and some of the existing firms might leave the
industry if they continue to incur losses.

d) Profit Maximization: Each seller is aimed at maximizing profits. The ultimate goal is
possible profit. No other goals are pursued.

e) No government regulation: This means that there is no government intervention in the


market. The government cannot manage the activities (operations) of the firm.

f) No collusion among buyers and sellers: Buyers do not gang up on sellers to force them to
sell at a lower price. And sellers do not gang up on buyer to force them to buy at highest price.

g) Perfect mobility or free movement of resources: The factors of production are free to move
from one firm to another throughout the economy. There is no restriction of employment and
investment. Resources are free to move geographically from one job to another, from low-to high
paying industry, which implies that skills can be learned easily.

h) Perfect knowledge
Finally, it is assumed that all sellers and buyers have complete knowledge of the conditions of
the market. Buyers and sellers possess complete information (knowledge) about the prices at
which goods are being bought and sold.

NB. The first six conditions (a-f) are the conditions necessary for pure competition, while the last
two (g-h), in addition to the first six conditions will bring about perfect competition.

5.2.2. Short rum Equilibrium of the Competitive Firm

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The firm is in equilibrium when it maximizes its profits, defined as the difference between total
cost (TC) and total revenue (TR). That is total profit = TR-TC. The equilibrium of the firm may
be shown graphically in two ways. Either by using the TR and TC curves (called total approach),
or the marginal revenue (MR) and marginal cost (MC) curves (called marginal approach). Here
MR is the change in TR for a one-unit change in the quality sold.

1) Total Approach
According to this approach, total profits are maximized when the positive difference between TR
and TC is greatest. The equilibrium output of the firm is the output at which total profits are
maximized. This can be explained with the help of the following table.

Table 6.1: Equilibrium output using TR-TC approach

1 2 3 4 5

Output Price Total revenue Total cost Total Profits


(Q) (In Birr) (In Birr) (In birrr) (In Birr)

0 8 0 800 -800

100 8 800 2000 -1200

200 8 1600 2300 -700

300 8 2400 2400 0

400 8 3200 2524 +676

500 8 4000 2775 +1225

600 8 4800 3200 +1600

650 8 5200 3510 1690

700 8 5600 4000 1600

800 8 6400 6400 0

In the above table 6.1 output (column 1) times price (column2) gives us TR (column3). TR
minus TC (column 4) gives us total profits (column 5). So the table reveals to us the fact that
total profit are maximized (at birr 1690) when the firm produces and sells 650 units of the
commodity per time period.

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Introduction to Economics Chapter five Market structure

The profit maximizing level of output for this firm can also be viewed from the figure 6.2 below
(obtained by plotting the values of columns 1, 3, 4, and 5 of the above table). In this figure, the
TR curve is a positively sloped straight line through the origin because price remains constant at
birr 8. At 100 units of output, this firm maximizes total losses or negative profits (point A).At
300 units of output, TR equals TC (point B and D) and the firms breaks even. The firm
maximizes its total profits (point C) when it produces and sells 650 units of output. At this output
level, the TR curve and the TC curve have the same slope and so the vertical distance between
them is greatest. TC

TR/TC TR

A B

0 300 650 800 Output

Fig 6.2: Graphical Approach of the short-run Equilibrium

2) Marginal Approach
In general, it is more useful to analyze the short run equilibrium of the firm with the marginal
revenue – marginal cost approach. Marginal revenue (MR) is the change in TR for a one unit
change in the quantity sold. Thus, MR equals the slope of the TR curve. Since in perfect
competition, P is constant for the firm, MR equals P. The marginal approach tells us that the
perfectly competitive firm maximizes its short-run totals profits at the output level, when MR or
P equals marginal cost (MC) and MC is rising. The firm is in short run equilibrium at this best or
optimum, level of output.

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The profit maximizing or best level of output for this firm can also be viewed from figure 6.3
below. As long as MR exceeds MC (from A’ to D’), it pays for the firm to expand output. The
firm would be adding more to its TR than to its TC and so its total profits would rise. It does not
pay for the firm to produce past points D’ since MC exceeds MR. The firm would be adding
more to its TC than to its TR and so its total profits would fall. Thus, the firm maximizes its total
profits at the output level of Q ¿ units (given by point D’, where P or MR equals MC and MC is
rising). The total profit is given by the area of rectangle PDACA.

AC

MC

P D P=MR=TR=DD

AC A

0 Q¿ Output

Fig 6.3: Marginal Approach

5.2.3. Short Run Profit or Loss of Competitive Firm

If, at the best, or optimum, level of output, (1) price (P) exceeds average cost (AC) the firm is
maximizing total profits; (2) if P is equal to AC, the firm is at breakeven; (3) if P is less than AC
but greater that AVC, the firm is minimizing total losses; (4) if P is equal to AVC, the is at shut
down point; (5) if P is less that AVC, the firm minimizes its total losses by shutting down (Please
use appropriate graph to explain each case).

5.3. Imperfect competition

In real life, neither pure competition nor perfect competition exists. Rather there are different
varieties of imperfect competition. An imperfectly competitive firm is one that can exercise some
control over the price it receives for its product. There are two main reasons a firm might have

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some control over the price it charge (1) each firm produces a sizable share of the market and (2)
each firm sells a product that is distinguishable from competitors’ products. These two reasons
are the opposite for a perfectly competitive firm. It is sufficient for a firm to fulfill either of these
requirements to be imperfectly competitive. The imperfectly competitive markets include
Monopoly Market, Monopolistic Competition and Oligopoly Markets.

5.3.1 Monopoly Market

Definition: Monopoly is one example of imperfect market. Monopoly is a market structure in


which there is a single seller, there are no close substitutes for the commodity it produces and
there are barriers to entry.

Sources of Monopoly

The rise and existence of monopoly is related to the factors, which prevents the entry of new
firms. The different barriers to entry that are the causes of monopoly are described below.

1) Ownership of strategic raw materials: - some firms may get monopoly power if they
posses certain scarce & key raw materials that are essential for the production of certain
goods or if the supply of a commodity is localized in a single place. For example, India
possesses manganese mines; the extraction of diamonds is controlled by South Africa.
This type monopoly is known as raw material monopoly.
2) Government Licensing: A monopoly, which are created for the interest of the public.
For example, the public utility sectors such as water supply, postal, telegraph and
telephone services, radio and TV services, generation and distribution of electricity. Such
monopolies are known as public monopolies.
3) Limit-pricing policy: The existing firm adopts a limit pricing policy, that is, a pricing
policy aiming at the prevention of new entry. Such a pricing policy may be combined
with other polices such as heavy advertising or continuous product differentiation, which
render entry unattractive. This is the case of monopoly established by creating barriers to
new competition.

Assumptions (Characteristics) of Pure Monopoly

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1. Single Seller: There is only one seller of the goods and services in monopoly market. It
is a market structure in which the entire supply is controlled by one firm, which implies
that the firm and industry are same.
2. Unique product: The goods produced and supplied by monopolist have no close
substitute. Barrier to entry: Entry is blocked in such market structure. The barriers may
be legal, financial, and natural.
3. Barrier to entry: There is barrier for new firms to enter into the market. Entry is blocked
in monopoly market due to above reason.
4. No Collusion and Competition: Because there is only one firm there is no competition
exists and no collusion among firms also.
5. The monopolist is the price maker: It does not take a price which is determined by the
interaction of market demand and market supply. In order to expand its sale, it decreases
the price of the commodity.
6. Profit Maximization: Like firms in perfectly competitive market, the core goal of the
monopolist is also profit maximization.

As we can see from the above assumptions of monopoly, there is only one seller having some
kind of control over the supply of a commodity and, therefore, is in a position to influence the
price. There are no close substitutes for the products produced by the monopolist. Thus, the firm
is the industry and faces the negatively sloped industry demand curve for the commodity. As a
result, if the monopolist wants to sell more of the commodity, he or she must lower its price.
Moreover, for a monopolist, MR<P and the MR curve lies below the demand (D) curve. Look at
following Fig.

MR/P

MR D

0 Quantities

Fig 6.4: Revenue and demand curve of monopolist

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Introduction to Economics Chapter five Market structure

5.3.2. Monopolistic Competition

Definition: Monopolistic competition is a market structure with many buyers and sellers in
which product differentiation exists and in which there are elements of both monopoly and
perfect competition. A monopolistically competitive market combines the characteristics of
competitive and monopoly markets.

Basic Assumptions: The following are some of the basic assumptions of a monopolistic
competition market:

1. Large number of buyers and Sellers: There are relatively large number of sellers and
buyers in market. But, the number of buyers and sellers in this market is not as large as
perfectly competitive market.
2. Differentiated Products: - Product differentiation is the major characteristic of
monopolistically competitive market structure. The products of the sellers are
differentiated, but they are close substitute. In other word, many firms sell slightly
differentiated (heterogeneous) products so that any firm in a monopolistic competition
market has some degree of freedom in the determination of price for its product. That is,
the firm is not price taker for it has some degree of monopoly power over its product.
3. Freedom of entry and exit: Entry to and exit from the market relatively to monopoly is
easy. This is because, firms can enter in to the market by having patent rights for their
products, copy rights on their brand names and trademarks, enhancing the difficulty and
cost of being successfully imitating their products (innovation). This in turn gives them
the right to become price marker depending on the quality of their products. The best
examples for monopolistic competition are the market for toothpastes, automobiles, TV,
PCs, soaps, breweries etc.
4. Non-price competition: - Due to product differentiation, in addition to price
competition, there is also non-price competition. That is, competition for potential
consumers through advertising and sales promotion (by/through arranging exhibitions,
trade fair, acquiring certificate for quality assurance, sponsorship etc).

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5. Profit maximization: The goal of each firm in monopolistic competition is profit


maximization both in the short run and long run.

5.3.3. Oligopoly

Definition: An oligopoly is a market structure in which there are few firms that produce
identical or closely substituted products (identical or differentiated). Oligopoly is said to exist
when there are more than one seller in the market, but their number is not so large so as to make
the contribution of each firm negligible. Firms thus, are situated mutually interdependence. That
is they behave as if any one firm’s action directly affect other rivals and is affected by the action
of others.

Characteristics of Oligopoly Market

The basic characteristics of oligopolistic market structure are the following:

1) Very Few Numbers of Sellers: There are a few sellers of a homogeneous or


differentiated product.
2) Produce Homogeneous or differentiated (identical or closely substituted)
products. If the oligopolistic firms produce homogeneous product, the industry is
called pure oligopoly. If firms produce closely substituted products, it is called
differentiated oligopoly.
3) Barrier to entry: In oligopoly market firms are small enough in number implies
there is barrier for new firms to enter into the market. In oligopoly market barrier to
entry is difficult or impossible for new firms to enter the market.
4) Keen (or intense) competition between firms: The number of firms is small enough
that each seller takes into account the actions of other firms in its pricing and output
decisions. In other words, each firm keeps a close watch on the activities of the rival
firms and prepares itself with a number of aggressive and defensive marketing
strategies.
5) Interdependence: the nature and degree of competition makes firms interdependent
in respect of decision making. If one firm reduces its price it will attract consumers
and increases its sells, leading to a substantial loss of sales by other firms in the
industry. The other firms may or may not reduce their price, but the firm that reduces

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price can no longer assume other firms do not notice his/her action. The outcome of
his/her decision depends on the reaction of other firms.

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