MARKET STRUCTURE AND MARKET FAILURE

MARKET STRUCTURE

Definition
Market structure refers to the types of competition that exists among firms/ organizations in a particular
industry.

Main Characteristics or Features of Market Structures

1) The number of sellers

There may be many, one or a few.

2) The type of product sold

Some firms sell identical (homogenous) products while others sell different (heterogenous) brands.

3) Barriers to entry into and/ or exit out of the market

These include factors such as high cost of production, specialized technology, licenses and control over
natural resources.

4) The level of knowledge

In some markets, firms may have perfect knowledge about other competitors in terms of profitability
and production techniques while in other markets, firms may have imperfect knowledge.

5) Control over price

In some markets, firms are price setters which mean that they have total control over the price set in the
market. In other markets, firms are price takers and cannot set their own price but depend on the price
set by the market.

Types of Market Structure

1) Perfect Competition
2) Monopoly
3) Monopolistic Competition
4) Oligopoly

Market Structure in the Short run and the Long run

The distinction between the short run and the long run is also important in analyzing market structure.
 In the short run, the number of firms in an industry is fixed, as new firms cannot enter the market, nor
can existing firms exit.
 In the long run, usually18 months, new firms would be able to enter the industry and existing firms
would be able to leave.
Activity

Research and complete the table below to distinguish the features of each type of market Structure.

Features Monopoly Oligopoly Monopolistic Perfect

Competition Competition
Number of
Sellers Few Many

Number of
Buyers Many

Homogeneous/
Product Unique Differentiated

Knowledge of
Market Imperfect Perfect

Price-maker with
Price Price maker price rigidity

Entry conditions No free entry Freedom of entry

MARKET STRUCTURE AND MARKET FAILURE

MARKET STRUCTURE - Perfect Competition

Definition
Perfect competition is a market structure in which there are many sellers, many buyers all with perfect
knowledge of information and providing and consuming a homogeneous/ similar product.

Price Elasticity of Demand in the Perfect Competitive Market

It will be expected that price elasticity of demand will be very high (perfectly elastic demand) in this type of
market structure.
In this case, price increases will lead to decreases in total revenues and profit because buyers will go to other
sellers as a result of the now increased price.
For the seller to be profitable in this market structure, price must be decreased so that customers will return
from the competitor.

Features of Perfect Competition

1) The market is large, meaning that there is a large or infinite number of consumers.
2) There is a large or infinite number of suppliers that supply the market.
3) The output supplied by each firm in the market is identical. This is referred to product homogeneity.
4) Firms are price takers, meaning that every firm takes the market equilibrium price as the price it sells its
output for.
5) Buyers and sellers have perfect knowledge about the market situation, meaning that the consumers and
producers are both aware of the prices in the market.
6) There is freedom of entry to and exit from the industry.

 When firms earn abnormal profit in an industry, new firms will enter the industry as there are no entry
barriers. This causes supply to rise and market price to fall, and therefore causes profits to decline. Firms
will continue to enter until only normal profits are being earned.
(Abnormal profit is any profit earned in excess of normal profit. If the total revenue earned by the
firm is higher than total cost then abnormal profit is earned. It also implies that average revenue is
greater than average cost. Abnormal profit is also called supernormal profit, surplus profit or economic
profit.

(Normal profit is the minimum amount of profit that is necessary to encourage a firm to continue
production. When average revenue is equal to average cost, normal profit is earned)

 In the reverse scenario, when an industry is incurring losses, firms will leave and supply will fall. This
will cause price to rise and profits will rise to the normal level, that is, in the long run the firms in the
industry would earn just normal profits.
Short Run and Long Run Equilibrium under Perfect Competition

(1) In the short run, if the market price or average revenue (AR) is greater than the average cost
(AC), then a firm under perfect competition could earn abnormal profit.

MC AC
Price ($)

P MR=AR (Demand curve)

AR>AC

MR=MC

Quantity

The figure above shows abnormal profits earned in the short run when AR (average revenue)
is greater than AC (average cost).
Abnormal profits would encourage new firms to enter the industry. However, this can only
happen in the long run. As new firms enter, the supply of good increases and this causes the
market price to fall.

(2) If, in the short run, at market price, average revenue (AR) is less than average cost (AC), then the
firm under perfect competition would incur a loss.

Price ($)

AC

MC

AR<AC

P MR=AR (Demand curve)

MR=MC

Quantity

The figure above shows a loss incurred in the short run when AR (average revenue) is greater
than AC (average cost).
In this scenario, where losses are incurred under perfect competition, firms are inclined to exit
the industry. This can only happen in the long run, which causes supply to decrease and,
therefore, the market price to fall.

(3) If, in the short run, the market price was at a level where average revenue (AR) was equal to
average cost (AC), then the firm would earn normal profit.

MC AC

Price ($)
 P MR=AR (Demand curve)

P=AR=MR=MC=AC

Q0 Quantity

The figure above shows normal profit earned in the short run when AR (average revenue)
equal to AC (average cost).

In this situation, no new firm would be motivated to enter the industry, nor would any existing
firm choose to leave. This represents long run equilibrium under perfect competition. Therefore,
under perfect competition, only normal profit would be earned due to freedom of entry and exit.

The Firm’s Supply Curve under Perfect Competition

Cost ($)
MC

P2

P1
0 Q1 Q2 Quantity

The figure above shows the marginal cost of producing a good or providing a service

The marginal cost curve gives the price the producer would be willing to accept for different
quantities of the good or service he produces. In other words, the marginal cost curve is the
supply curve of the firm that operates under perfect competition. The profit in this case would be
normal.

Advantages of Perfect Competition

(1) Efficient production

An efficient allocation of resources, the firm produces at the productive optimum (AC=MC).
Average cost of production is minimized at this point. This implies that resources are being
used efficiently.

(2) The price is low

 The price charged is low compared to other types of market structure, which means that
consumer welfare is maximized.

(3) No advertising
Producers do not have to spend money or time on advertising or other forms of sales
promotion. This is because all firms produce identical products and sell them at the market
price. These costs are therefore saved.

(4) Consumer sovereignty

Consumer demand or willingness to pay for various products sends a signal to firms to
produce certain goods. This means consumers determine what goods and services are to be
produced. This referred to as consumer sovereignty.

Disadvantages of Perfect Competition

(1) No Scope for economies of scale because of the high number of firms in the
industry.
(2) Undifferentiated products- all homogeneous. Important in industries like
clothes and cars
(3) Lack of supernormal profits may mean the investment of Research and Development
(R&D) is unlikely.
(4) With perfect knowledge there is no incentive to develop new technology because of the
ability to share information.

Activity
Answer the following multiple choice questions by circling your choice from the given options

(1) In perfect competition there is/ are:

A product differentiation
B a few firms
C freedom of entry and exit
D lack of perfect knowledge

(2) A perfectly competitive market is one where:

A there are few buyers and sellers.
B there are few buyers but many sellers.
C there are many buyers and many sellers.
D there is only one seller.
(3) A perfectly competitive firm has a:
A downward sloping demand curve.
B an upward sloping demand curve.
C a vertical demand curve.
D a horizontal demand curve.

(4) The perfectly competitive firm makes:

A normal profits in the short run and normal profits in the long run.
B abnormal profits in both the short and long run.
C abnormal profits in short run and normal profits in the long run.
D normal profit in the short run and losses in the long run.

(5) The perfectly competitive firm sets price where:

A price is equal to average variable cost.
B price is equal to average fixed cost.
C price is equal to average total cost.
D price is equal to marginal cost.

(6) The shutdown point for the perfectly competitive firm is where:
A price equal to marginal cost.
B price equals to average total cost.
C price is equal to average total cost.
D price is equal to average variable costs.

(7) A perfectly competitive firm maximizes profit at the level of production at which
A AC=MC
B AR=AC
C AR<MC
D AR=MC

(8) Which of the following is an essential feature of perfect competition?

A Buyers and sellers are price takers.
B Firms face barriers to entry and exit.
C Producers have more market information than consumers.
D Product differentiation.

(9) If under perfect competition firms are earning abnormal profits in the short run,
then
A new firms would enter and price would rise.
B new firms would enter and prices would fall.
C no new firms would enter but prices would fall.
D no new firms would enter but prices would rise.

(10) In the long run, the equilibrium of the firm that operates under perfect competition
occurs where
 A P=MC
B P=MR=AR
C P=MR=AR=MC
D P=MR=AR=MC=AC

MARKET STRUCTURE AND MARKET FAILURE

MARKET STRUCTURE - Monopoly, Oligopoly and Monopolistic Competition

In reality, perfect competition does not exist, as all the conditions necessary for this type of market structure do
not occur together. Markets in reality, are oligopolies or monopolistic or monopolies. One common feature of
these forms of market structure is that individual firms are price setters, that is, there is no longer any market
price, as each firm has the power to set its own price. In this case, if the individual firm wants it consumers to
buy more of its products, it will have price them lower. As such, firms which are price setters have a downward-
sloping demand curve.

Price ($)
 MR AR= Demand
0 100 200 Quantity

The figure above shows the demand curve by individual Price Setting Firm.

Comparing the Average Revenue (AR) and the Marginal Revenue (MR) it can be seen the MR curve declines
twice as fast as AR. Thus, if the MR curve cuts the horizontal axis at 100, the AR curve would cut the axis at
200, two times this level. Given this type of demand, the firm’s equilibrium would now be examined for price
setting firms: monopoly, oligopoly and monopolistic competition.

MARKET STRUCTURE AND MARKET FAILURE

MARKET STRUCTURE - Monopoly

Monopoly refers to the market structure with no competition. This occurs whenever there is only one producer
or provider of a particular good or service.

The main reason that there is only one firm in an industry is that there are barriers preventing new firms from
entering that industry. As such, monopoly firms are usually large-scale producers, as the supply the entire
market. Example, GTT monopolizes the telecommunication industry as it pertains to landline telephone
services.
 MC
Price ($)

AC

10

AC=MC

MR=MC MR AR
0 QE Q0 Quantity

The figure above shows the monopoly profit maximizing equilibrium where marginal revenue is equal to
marginal cost (MR=MC). This corresponds to a level of output shown by QE. Given the demand curve (AR),
the price which the monopoly firm is able to set for this output is $10.
Clearly, at this output level the monopoly earns abnormal profit as average revenue is greater than average cost
(AR>AC).
The abnormal profit is shown by the rectangular shape in the diagram.

Since there are barriers that prevent additional firms from entering the market, the firm is able to enjoy
abnormal profit in the long run.

Advantages of Monopoly

(1) Economies of scale

Being the sole producer, the firm is usually a large one and the firm can therefore enjoy economies of
scale with lower cost.

(2) New Technology

A monopoly can also afford to purchase the latest and most sophisticated technology. With the latest
machinery, the monopoly firm is able to use production inputs more efficiently.

(3) Research and development

The firm can undertake research and development to stimulate innovation and invention. The monopoly
may find it worthwhile to spend money on research and development to develop better products.

Disadvantages of Monopoly
(1) Higher Price
A monopoly firm usually charges a higher price. As the monopoly firm is the only producer of the good,
he charges a higher price than it would be if it were determined by demand and supply. The monopolist
could also limit the supply of the good so that consumers would be willing to pay a higher price to get
the good.

(2) The firm does not produce at the productive optimum point

(3) There is absence of consumer sovereignty

The consumers have to buy whatever goods and services are produced by the monopoly firm as they
have no other options to choose from.

(4) There is greater inequality of income

A monopoly can earn excessive profits by charging a high price for its goods and services. This could
cause a greater inequality of income within the economy.

Ways to Control Monopoly

The government can control the power of the monopolies in several ways. These are:

(1) Nationalization
Sometimes, when a private firm gets too large or too powerful, the government takes over, nationalizes
it and turns it into a state-owned entity that does not aim to maximize profits.

(2) Setting up a maximum price (price ceiling)

The government can fix a suitable maximum price for products to prevent the monopoly from selling it
at too high a price.

(3) Imposing taxes

The government can impose taxes on the monopoly to prevent it from becoming too profitable.
Activity

You are required to answer the following questions by circling the letter of your choice from the given options.

(1) For a monopoly firm, average revenue is

A greater than price.

B equal to marginal revenue
C less than marginal revenue
D greater than marginal revenue.

(2) In general, a monopoly is likely to

A earn lower profits than a perfectly competitive firm.
B earn about the same profits as a perfectly competitive firm.
C sell less output than a perfectly competitive firm.
D charge a lower price than a perfectly competitive firm.
(3) In a monopoly:
A there are many firms.
B The product has no close substitutes.
C There are low barriers to entry.
D The firm follows the price in the market.

MARKET STRUCTURE AND MARKET FAILURE

MARKET STRUCTURE - Oligopoly

An oligopoly exists when there are a few large producers that supply a particular market.
The commercial banking sector in Guyana is often described as an oligopoly, as there are about five (5) banks
in the industry.

Features or characteristics of an oligopoly

1) Oligopolistic firms are similar to monopolistic firms, because an oligopolistic firm faces a downward
sloping demand curve.
2) Entry barriers prevent new firms from entering its industry.

3) Oligopolies earn abnormal profits in the long run.

Advantages of Oligopolies

1) The large size of oligopoly firms may result in significant reductions in unit cost of production through
economies of scale and consumers potentially may benefit from lower price.

2) Oligopolies can also reinvest profits in research and development projects, which results in the
development of more sophisticated goods and services and, hence, improved consumer welfare.

3) Consumers prefer larger firms because such firms often offer superior customer services, such as
warranties, guarantees, after-sale services and customer support.

Disadvantage of Oligopolies

In terms of production efficiency, oligopolies, like monopolies, are also criticized, as output does not
correspond to the productive optimum.

MARKET STRUCTURE AND MARKET FAILURE

MARKET STRUCTURE - Monopolistic Competition

Monopolistic competition is defined as a market structure with a large number of sellers or suppliers whose
products can be differentiated where there are low barriers to entry.

Features of Monopolistic Competition

(1) Firms in this market structure tend to engage in some product differentiation through branding,
advertising and a range of other marketing devices.
(2) Firms can earn abnormal profits in the short run if Average Revenue is greater than Average Cost as in a
perfectly competitive market.

Price ($) AC
MC

PE

MR=MC

MR AR

0 QE Quantity
The above figure shows abnormal profit earned by firms under Monopolistic Competition.

(3) When such abnormal profits are earned by existing firms encourage new firms to enter the industry. As
much more firms enter the industry, the market share of each firm is diluted and this has the effect of
reducing the abnormal profits earned by each firm.
This will cause a leftward shift of the demand curve of each existing firm in the industry. It should be
noted that as the Average Revenue (AR) curve shifts to the left, the Marginal Revenue (MR) curve also
shifts to the left.

Price($)

MR2 MR1 AR2 AR1

 0 Quantity

The figure above shows the left shift of the Demand Curve of Existing Firms as New Firms Enter the
Monopolistically Competitive Industry.

(4) The entry of new firms in the monopolistically competitive industry will continue until all abnormal
profit is eliminated as a result of the increased competition, where the Average Revenue curve shifts
until it becomes tangential to the Average Cost (AC) curve.

Price ($) AC

MC

AC=MC

MR=MC MR AR
0 QE Q0 Quantity

The figure above shows Normal Profit under Monopolistic Competition

In the diagram, the productive optimum is shown by QO. The firm under monopolistic competition
produces at QE. This implies that in the type of market structure, the firm does not produce at the most
efficient output level.

Barriers to Entry

These are restrictions that prevent other firms from entering an industry in the long run.

(1) Patents, licences and copyrights (legal barriers to entry)

A patent is a right granted by the government that allows only the inventor of a product to
produce and sell the invention. For example, if a firm invented a new type of computer, it would
apply to the government for a patent that would prevent other firms from replicating the product
and selling it.
A licence is a legislative arrangement granted by the government which allows only approved
licence holders to enter a certain industry. For example, only a licenced dentist can provide
dental services to the public. Since licences are issued and enforced by governments, this gives
the state control over the number of firms that can enter the industry.
 A copyright is a legal right that gives the publisher of a book or the producer of an audio CD or a
DVD movie the exclusive right to copy and sell these products. For examples, only the publisher
of this book has the right to copy and market it. If anyone copies it he or she can face legal
proceedings.

(2) Production secrets

If the production of a good involves a secret ingredient or a secret recipe, then this would
effectively prevent other firms from producing this good. For examples, the fast food chicken
restaurants such as Chicken and Burgers have their secret recipe.

(3) Predatory pricing

This refers to aggressive price cutting by existing firms so that no new firm will be able to
compete with such low prices. A firm that achieves economies of scale can easily cut prices to
prevent new firms from entering the industry.

(4) Control over raw materials

The exclusive ownership or control of a substantial amount of an essential raw material would
considerably limit attempts by other firms to enter an industry. Without the availability of these
raw materials, rival firms would not be able to enter the industry.

Activity
Answer the following questions by circling the letter next to your choice from the given options.

1 What are the features of monopolistic competition?

A Many firms, homogeneous product, and barriers to entry.
B Many firms, differentiated products, and barriers to entry.
C Many firms, differentiated products, and no barriers to entry.
D Few firms, differentiated products, and no barriers to entry.

2 Under monopolistic competition, the market price in the long run will be
A equal to marginal revenue.
B equal to average cost.
C equal to marginal cost.
 D equal to minimum average cost.

3 Which of the following features is common to both monopolistic competition and monopoly?
A The firm has a downward sloping demand curve.
B Easy entry into the industry.
C Only normal profit is earned.
D Lack of close substitutes.

4 Which of the following features is common to both monopolistic competition and perfect
competition?
A The firm has a downward sloping demand curve.
B Only normal profit is earned.
C There are barriers to entry into the industry.
D There is a product differentiation.

5 An oligopoly:
A is an industry in which there is price rigidity.
B produces only homogenous outputs.
C is an industry into which entry is relatively easy.
D is a situation in which there is no collusion.

6 A market of few sellers and many buyers is:

A a monopoly.
B perfect competition.
C monopolistic competition.
D an oligopoly

7 All of the following are barriers to entry except:

A government regulations.
B patents.
C the ‘know-how’ of a firm.
D interdependence.

8 Which is a feature of monopolistic competition?

A a small number of firms.
B the firms producing homogenous output.
C high barriers to entry.
D product differentiation.

9 The two most extreme market structures in terms of performance and number of firms are:
A perfect competition and monopolistic competition.
 B monopolistic competition and pure monopoly.
C monopolistic competition and oligopoly.
D perfect competition and pure monopoly.

10 The market structure of monopolistic competition is best described as:

A many firms with some control over price, and some product differentiation.
B many firms with no control over price, producing identical products with no differentiation.
C a few firms with some control over price, producing highly differentiated products.
D a few firms with no control over price, producing highly differentiated products.

11 Firms in monopolistic competition and perfect competition typically:

A are price takers.
B produce identical products.
C have many buyers and sellers.
D face a downward-sloping demand curve.