UNIT 6 ANALYSIS OF MARKET STRUCTURE

Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Meaning of the Market
6.3 Elements of Market
6.4 Classification of Market
6.4.1 On the Basis of Area
6.4.2 On the Basis of Time
6.4.3 On the Basis of Nature of competition
6.5 Conditions for the Existence of Perfect Market
6.6 Short Run Equilibrium of the Firm
6.6.1 Total Approach
6.6.2 Marginal Approach
6.7 Short Run Profit or Loss?
6.8 Short run Supply Curve
6.9 Long Run Equilibrium of the Firm
6.10 Imperfect Competition
6.10.1 Monopoly Defined
6.10.2 Price and Output Determination Under Monopoly
6.11 Key terms
6.12 Answer to Check Your Progress Exercise
6.13 Model Examination Questions
6.14 References

6.0 AIMS AND OBJECTIVES

The purpose of the unit is to explain the meaning, elements and different forms of markets
and the determination of price of a product under different periods, such as short run and long
run.

After reading this unit, you will be able to;

 define the market

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  list the elements of the markets
 classify the market on the basis of, area, time and nature of competition,
 determine the pice under different time periods, namely short run and long run,
and
 distinguish perfect competition from imperfect competition.

6.1 INTRODUCTION

We have learnt the analysis of cost in the earlier unit. Now let us try to introduce the concept
of market and different types of market structure. This chapter concentrates on two major
market structure, namely perfect competition and Imperfect competition. We will first deal
with the characteristics of perfect competition and equilibrium of the firm and industry in
perfect competition is short and long run. This will be flowed by discussion on price and
output determination under monopoly, an example of imperfect competition.

6.2 MEANING OF THE MARKET

The term ‘market’ is and elusive concept. The word is generally used to describe the process
of exchange. The process of exchange always involves certain elements such as goods or
service, buyers, place and time.

6.3 ELEMENT OF MARKET

Some element of markets are (1) there must be a commodity which is to be dealt with (2)
there must be buyer and sellers, (3) there must be a place, be it a certain province, a country or
the entire world, where the process of exchange takes place (4) there must be intercourse
between buyers and sellers.

6.4 CLASSIFICATION OF MARKET

We may classify markets into three categories according to factors such as area, time and
nature of competition

6.4.1 On the Basis of Area

Markets may be categorized on the basis of area they may be further classified into:

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(a) Local markets:
markets: certain commodities, which are perishable and which are cheap have local
markets. For example, milk, fish and vegetables usually have local markets.
(b) National markets:
markets: there are some goods which have national market. For example certain
varieties of cloth, say “ Yager Lebes” (i,e, locally made national cloth), have national market.
There may not be a market for “Yager Lebes” in other nations for their mode of dress is
different. They may not wear “Yager lebes”.Similarly “Tella “ and “Tej”, a national drink of
Ethiopia, has national market.

(c ) International markets:
markets: there are certain commodities the transactions of which are
carried on through the world. For example, gold, steel, wool and tea etc..

6.4.2 On the Basis of Time

Markets may be classified on the basis to time. We further classify these markets into:
(a) Very short period market
(b) Short period market
(c) Long period of secular markets which cover a generation

6.4.3 On the Basis of Nature of Competition

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:
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:
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

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 world, however, we cannot find a perfect market. Especially, in this dynamic world
imperfect market is widely practiced.

Check your progress Exercise - 1

1. What is market in economics?
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2. What are the elements of market?

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3. Classify the markets on the basis of area

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4. Classify the markets on the basis of nature of competition.

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6.5 CONDITIONS FOR THE EXISTENCE OF PERFECT MARKET

Explained in section 6.4 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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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.

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 out put 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
AR: Average revenue
MR: Marginal revenue

p p= AR=MR
0 out put
Fig 6.1
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, no 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

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lose all his customers to the other sellers. Nor will be lower his price from the 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

The third requirement of perfect competition, implied in the first condition itself, is that 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 out put. 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
Fourthly, each seller is aimed at maximizing profits. The ultimate goal is possible profit. No
other goals are pursued.

e) No government regulation
The fifth requirement of perfect competition is that there is no government intervention in the
market. The government can not manage the activities (operations ) of the firm.

f) No collusion among buyers and sellers

The sixth condition of perfect competition is that 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 through out 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.

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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) we have enumerated above, are the conditions necessary for
pure competition, while the last two (g-h), in addition to the first seven conditions will bring
about perfect competition.

Check Your Progress Exercise - 2

1. What is the shape of the demand curve facing a perfectly competitive firm? What is
implied by such a demand curve?
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2. What is perfect competition?

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6.6 SHORT RUM EQUILIBRIUM OF THE FIRM

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.

6.6.1 Total Approach

Total profits equal total revenue (TR) minus total cost (TC). Thus, total profits are maximized
when the positive difference between TR and TC is greatest. The equilibrium out put of the
firm is the output at which total profits are maximized. This can be explained with the help of
the following table.

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Table 6.1
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 out put (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 60 units of the commodity per time period.

The profit maximizing level of out put 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 taste). In this
figure the arrows indicate parallels lines and 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 the firms breaks even. The firm maximizes its total profits (point D) 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.

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 Fig 6.2 Graph
6.6.2 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 out put 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. look at the table 6.2 below.
Table 6.2
(1) (2) (3) (4) (5) (6)
Output (Q) Price=MR marginal Average cost Profit/Unit Total Profits
(in Birr) cost (in Birr) (in Birr) (in Birr) (in Birr)
100 8 12.00 20.00 -12.00 -1200
200 8 3.00 11.50 -3.50 -700
300 8 1.00 8.00 0 0
400 8 1.25 6.31 +1.69 +676
500 8 2.50 5.55 +2.45 +1225
600 8 4.25 5.33 +2.67 +1602
650 8 (8.00) 5.40 +2.60 +1690
700 8 8.00 5.71 +2.29 +1603
800 8 24.00 8.00 0 0

In the above table 6.2 above, column (1) and (2) are the same as in Table 6.1. Column (3) and
(4) of table 6.2 are calculated directly from column (4) and column (1) of table 6.1 (since the

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MC values refer to the mid points between successive levels of output, the MC at 650 units of
out put is birr 8 and is the same as the MC recorded along side 700 units of out put) . The
values in column (5) are obtained by subtracting each value of column (4) from the
corresponding value in column (2). The values of column (6) are then obtained by multiplying
each value of column (5) by the values in column (1). Note that the values of total profits are
the same as those in table 6.1 (except for two very small rounding errors). The firm
maximizes total profits when it produces 650 units of output. At that level of out put, MR=
MC and MC is rising.

The profit maximizing, or best level of out put for this firm can also be viewed from figure
6.3 below (obtained by plotting the values of the first four columns of table 6.2). 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 650 units ( given by point D’, where P or MR equals MC and MC is
rising ). The profit per unit at this level of output is given by D’D” or birr 2.60, while total
profit is given by the area of rectangle D’D”FG, which equals birr 1690.

Fig 6.3 Graph

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Check Your Progress Exercise - 3

1. What is marginal revenue and why is price always equal to marginal revenue under
perfect competition?
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2. What are the two conditions that should be fulfilled by the firm to maximize its total
profits using marginal approach?
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6.7 SHORT RUN PROFIT OR LOSS?

If, at the best, or optimum, level of output, price (p) exceeds average cost (AC) the firm is
maximizing total profits; if p is less than AC but greater that AVC, the firm is minimizing
total losses; if p is less that AVC, the firm minimizes its total losses by shutting down.

Fig. 6.4 shows hypothetical MC, AC and AVC curves for a “Representative” firm; d 1 to d4
(and MR1 to MR4) are alternative demand (and marginal revenue) curves that might face the
perfectly competitive firm. The results with each alternative demand curve are summarized in
table6.3.

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 Fig 6.4.
Table 6.3
Equilibrium Output Price (P) AC Profit/ Total Result
point (q) ( in Birr) (intirr) unit (in Profits
Birrr) (in birr)
Total
With d4 A 600 19 15.00 4.00 2,400 profits
maximized
Break
With d3 B 500 14 14.00 0 0 even point
Total
With d2 C 400 10 15.00 -5.00 -2,000 losses
minimized
Shut down
With d1 F 300 7 16.33 -9.33 -2,800 point

With d2, if the firm stopped producing, it would incur a total loss equal to its total fixed cost
(TFC) of birr 2800 ( obtained from the average fixed cost (AFC) of DE, or birr 7 per unit,
times 400). With d1 , P= average variable cost(AVC) and so TR = TVC (Total variale cost).
Therefore, the firm is indifferent to whether it produces or not ( in either case it would incur
total losses equal to its TFC). At prices below birr 7 per unit, AVC exceeds P and so TVC
exceeds TR. Therefore, the firm minimizes its total losses ( at the level of its TFC of birr
2800) by shutting down altogether.

6.8 SHORT RUN SUPPLY CURVE

Since, in perfectly competitive market we can read from the MC curve how much the firm
will produce and sell at various prices, the firm’s short-run supply curve is given by the rising
portion of its MC curve (over and above its AVC curve). If factor prices remain constant, the
competitive industry short run supply curve is obtained by summing horizontally the short run
MC SMC curves (over and above their respective AVC curves) of all the firms in the
industry.
Panel A of the figure 6.5 below gives the short run supply curve derived from that portion of
the MC curve that lies above the minimum point of AVC ( please see fig6.4 above).

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 Fig 6.5

The industry or market short run supply curve shown in panel B above is obtained on the
assumption that there are 100 identical firms in the industry and factor prices remain constant
to this industry regardless of the amounts of inputs it uses (The “ “ sign refers to the “
summation of “.) Note that no output of the commodity is produced at prices below birr 7 per
unit.

Check Your Progress Exercise 4

1. What does shut down point refers to?
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2. The short run supply curve for a firm operating under conditions of perfect competition is
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6.9 LONG RUN EQUILIBRIUM OF THE FIRM

In the long run, all factors of production and all costs are variable. Therefore, a firm will
remain in business in the long run only if (by constructing the most appropriate plant to
produce the best level of out put) its TR equals or is greater than its TC. The best, or
optimum, level of out put for a perfectly competitive firm in the long run is given by the point

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where P or MR equals long run MC (LMC) and LMC is rising . If, at this level of out put, the
firm is making a profit, more firms will enter the perfectly competitive industry until all
profits are squeezed out.

In the figure 6.6 below, at the market price of birr 16, the perfectly competitive firm is in long
run equilibrium at point A, where P or MR = SMC=LMC = SAC=LAC. The firm produces
and sells 700 units of out put per time period, utilizing the most appropriate scale of plant
(represented by SAC 2) at point B. The firm makes a profit of birr 5 per unit (AB) and a total
profit of birr 3500.

Fig 6.6

Since the firm in fig. 6.6 is making profits, in the long run more firms will enter the industry,
attracted by those profits. The market supply of the commodity will increase, causing the
market equilibrium price to fall. This will continue until all firms just break even. In figure 6.6
this occurs at point E, where P=MR=SMC=LMC=SAC=LAC=8 birr. The firm will operate
the optimum scale of plant (represented by SAC 1,) at the optimum rate of output (400units)
and will make zero profits. All firms in the industry find themselves in the same situation (if
all firms have identical cost curves) and so there is no incentive for any of them to leave the
industry or for new firms to enter it.

Check Your Progress Exercise - 5

1 Examine the equilibrium of firm under perfect competition in the long run.
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2. Explain the adjustment process through which long-run equilibrium of a firm is achieved
under perfect competition.
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6.10 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 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 fro 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.

6.10.1 Monopoly Defined

Monopoly is one example of imperfect market. It refers to a market structure where 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. Thus for a monopolist, MR<P and the MR curve
lies below the demand (D) curve. Look at Fig. 6.7 below.

MR,P
(in birr)

0 MR Quantity
Fig. 6.7

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 6.10.2 Price and Output Determination Under Monopoly
As in the case of perfect competition, it is more useful to analyze the short run equilibrium of
the pure monopolist with the marginal approach. This tells us that the short run equilibrium
level of output for the monopolist is the output at which MR= SMC and the slope of the MR
P AVC).
curve is smaller than the slope of the SMC curve (provided that at this output P

Table6.4 below indicates that the monopolist maximizes total profits (at birr 3.75) when
producing and selling 2.5 units of output at the price of birr 5.50. At this level of output, MR
= SMC (= 3 birr); MR is falling and SMC is rising (so that the negative slope of the MR curve
is smaller than the positive slope of the SMC curve). As long as MR  SMC, it pays for the
monoplist to expand output and sales since doing so would add more to TR than to STC (so
profits rise). The opposite is true when MR  SMC. Thus total profits are maximized where
MR = SMC.
Table 6.4
(1) (2) (3) (4) (5) (6) (7) (8) (9)
P Q TR MR STC SMC SAC profits/ Total
(in birr) (output) (in birr) (in birr) (in birr) (in birr) (in birr) unit profit
(in birr) (in birr)
8.00 0 0 --- 6 --- --- --- - 6.00
7.00 1 7.00 7 8 2 8 -1.00 -1.00
6.00 2 12.00 5 9 1 4.50 +1.50 +3.00
5.50 2.5 13.75 (3) 10 (3) 4.00 +1.50 +3.75
5.00 3 15.00 3 12 3 4.00 +1.00 +3.00
4.00 4 16.00 1 20 8 5.00 -1.00 -4.00
3.00 5 15.00 -1 35 15 7.00 -4.00 -20.00

The profit maximizing or best level of output for this monopolist can also be viewed in fig 6.8
(obtained by plotting the values of columns 1,2,4,6 and 7 of table 6.4 above).

In fig 6.8, the best, or optimum, level of output for monopolist is given by the point where the
SMC curve intersects the MR curve from below (so that at the intersection point, the slope of
the MR curve which is always negative, is smaller than the slope of the SMC curve, which is

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usually positive). At this best output level of 2.5 units, the monopolist makes a profit of 1.50
birr per unit (the vertical distance between D and SAC at 2.5 units of output) and birr 3.75 in
total (2.5 units of output times birr 1.50 profit per unit). Note that the best level of output is
smaller than that associated with minimum SAC and smaller than the output level at which
P= SMC.

Fig 6.8

Check Your Progress Exercise - 6

1. Define an imperfect market.
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2. Describe the process of price and output determination under monopoly and compare it
with under perfect competition.
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6.11 KEY TERMS

 Marginal cost
 Characteristics of perfect competition
 P = MC as maximum profit conditions
 Firm’s supply curve and its MC curve

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  P = MC = AC, break even point
 Shut down point where P = MC = AVC
6.12 ANSWERS TO CKECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise 1

1. A market refers to the process of exchange, which involves certain elements such as
goods or services, buyers, sellers, place and time.

2.
a. there must be a commodity
b. there must be buyer and sellers
c. there must be a place
d. there must be competition among buyers and sellers

Check Your Progress Exercise 2

1. It is horizontal or parallel to the quantity axis and it implies that price is
constant or doesn’t vary.

Check Your Progress Exercise 3

1. Marginal revenue is the additional revenue obtained from the sale of one extra unit of
output. It is equal to price under perfect market because every good is sold at constant
price in this market.

Check Your Progress Exercise 4

1. It is a point where the profit of the firm is zero or a point at which the firm’s total
revenue and total cost are equal.

Check Your Progress Exercise 5

1. The long run equilibrium condition for the firm operating under perfect competition
occurs when P=MR=SMC=LMC=SAC=LAC.

Check Your Progress Exercise 5

1. It is markets where firms can exercise some control overthe price it receive for its
product.

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6.13 MODEL EXAMINATION QUESTIONS

I. Multiple choice
1. Total profits are maximized where
a. TR equals TC
b. The TR and the TC curve are parallel
c. The TR curve and TC curve are parallel and TC exceeds TR.
d. The TR curve and the TC curve are parallel and TR exceeds TC.
2. The best, or optimum, level of output for a perfectly competitive firm is given by the
point where.
a. MR equals AC
b. MR equals MC
c. MR exeeds MC by the greatest amount
d. MR equals MC and MC is rising
3. At the best, or optimum, short run level of output, the firm will be
a. Maximizing total profits
b. Minimizing total losses
c. Either maximizing total profits or minimizing total losses
d. Maximizing profits per unit
4. The short run supply curve of the perfectly competitive firm is given by
a. The rising portion of its MC curve over and above the shut down point
b. The rising portion of its MC curve over and above the break-even point
c. The rising portion of its MC curve over and above the AC curve
d. The rising portion of its MC curve.
5. At the best, or optimum, level of output for the monopolist
a. MR = SMC
b. P = SMC
c. P = lowest SAC
d. P is highest
6. In a perfectly competitive market economy.
a. Producers are price makers, while consumers are price takers

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 b. Producers are price takers, while consumers are price makers
c. Neither producers and nor consumers are price makers
d. Neither producers nor consumers are price-takers
e. Both producers and consumers are price makers
7. The total revenue of a perfectly competitive firm depends on
a. Profit of a firm
b. The quantity of output
c. The price of its product
d. All of the above
e. None of the above
8. Which of the following statements is correct?
a. If MC is less than AC, AC will rise with a rise in use of inputs
b. If marginal product is greater than average product (AP), then AP will decrease
with increased use of an input
c. When MR us greater than MC, a profit maximizing firm would expand output
d. All of the above
e. None of the above
9. One of the following is true about MR in perfectly competitive market
a. MR is the product of price of a commodity and MP
b. MR is the ratio of change in total revenue and change in quantity of output
c. MR equals price of output
d. All of the above
e. None of the above
10. The monopoly firm faces
a. Vertical demand curve
b. Horizontal demand curve
c. Diagonal demand curve that goes through the origin
d. Upward slopping demand curve
e. Down ward slopping demand curve.

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6.14 REFERENCES

1. A Koutsoyiannis , Modern Micro Economics

2. Stonier and hague , A text Book of Economic Theory.
3. H.S. Agrawal , Micro Economics / Priciples of Economics

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