Market Structure

PROF:- MAZAHIR SAIFEE

Market Structure
 Market structure – identifies how a market
is made up in terms of:
 The number of firms in the industry
 The nature of the product produced
 The degree of monopoly power each firm has
 The degree to which the firm can influence price
 Profit levels
 Firms’ behaviour – pricing strategies, non-price competition,
output levels
 The extent of barriers to entry
 The impact on efficiency
 Market Structure
Perfect Pure
Competition Monopoly

More competitive (fewer imperfections)

 Market Structure
Perfect Pure
Competition Monopoly

Less competitive (greater degree

of imperfection)
 Market Structure
Pure
Perfect
Monopoly
Competition

Monopolistic Competition Oligopoly Duopoly Monopoly

The further right on the scale, the greater the degree

of monopoly power exercised by the firm.
Market Structure
 Importance:
 Degree of competition affects
the consumer – will it benefit
the consumer or not?
 Impacts on the performance
and behaviour of the company/companies
involved
Market Structure
 Models – a word of warning!
 Market structure deals with a number of economic ‘models’
 These models are a representation of reality to help us to
understand what may be happening in real life
 There are extremes to the model that are unlikely
to occur in reality
 They still have value as they enable us to draw comparisons and
contrasts with what is observed
in reality
 Models help therefore in analysing and evaluating – they offer a
benchmark
Market Structure
 Characteristics of each model:
 Number and size of firms that make up
the industry
 Control over price or output
 Freedom of entry and exit from the industry
 Nature of the product – degree of homogeneity
(similarity) of the products in the industry (extent to
which products can be regarded as substitutes for
each other)
 Diagrammatic representation – the shape
of the demand curve, etc.
 Market Structure
Characteristics: Look at these everyday products – what type of
market structure are the producers of these products operating
in?

Electric Remember to
think about the
Guitar – nature of the
Jazz
VodkaBody product, entry and
exit, behaviour of
the firms, number
and size of the
firms in the
Mercedes CLK Coupe industry.
You might even
have to ask what
Canon SLR Camera
Bananas the industry is??
Perfect Competition
 One extreme of the market structure spectrum
 Characteristics:
 Large number of firms
 Products are homogenous (identical) – consumer
has no reason to express a preference for any firm
 Freedom of entry and exit into and out
of the industry
 Firms are price takers – have no control
over the price they charge for their product
 Each producer supplies a very small proportion
of total industry output
 Consumers and producers have perfect knowledge about the market
 Absence of selling cost and transport cost.
 No government regulation.
 Perfect Competition
Diagrammatic representation Given
AtThe
The The
the
MC
average
this industry
assumption
is the
output costcost
price
theof
curve ofisprofit
is the
firm
maximisation,
standard
producing
determined
‘U’ –additional
theshaped
by
firm theproduces
curve.
demand
Cost/Revenue atis making normal =atprofit.
MC MCan
(Q1).
(marginal)
This
lowest
cuts
and
output
falls
as is
Thisat
the
supply
a
point
where
a first
AC
units
long
whole.
output
of
curve
because
(due
MC
of
theoutput.
run
level
The
industry
to firm
the
is
MR
its It
of athe
law
is a of
fraction
equilibrium position. rises
diminishing
veryof
mathematical small
the total
returns)
supplier
industry
relationship then
within
supply.
between
asthe
output
industry
marginal
[Link] andhas average
no
AC values.
control over price. They will
sell each extra unit for the
same price. Price therefore
= MR and AR

P = MR = AR

Q1 Output/Sales
 Perfect Competition
Diagrammatic representation Because the model assumes
perfect
Average
Nowlower
The knowledge,
assume
and
ACMarginal
aand
firmMC the firm
makes
costs
would
Cost/Revenue
MC gains
could
short
lower
earning
the
some that
imply be
form
time
its product
advantage
expected
the
of modification
butabnormal
price,
for
firm istonow
before inothers
or gains
be only
profit
the
some
to a
copy
short
MC1 the
run, idea
formremains
(AR>AC) or
of cost are attracted
represented
advantage
the [Link] tothe
(say the
a
industry by
new production
grey area. the existence
method). of
AC abnormal
What would profit.
happen?If new firms
enter the industry, supply will
increase, price will fall and the
AC1 firm will be left making normal
profit once again.

P = MR = AR
Abnormal profit
AC1
P1 = MR1 = AR1

Q1 Q2 Output/Sales
Monopolistic or Imperfect
Competition
 Where the conditions of perfect competition
do not hold, ‘imperfect competition’ will exist
 Varying degrees of imperfection give rise to
varying market structures
 Monopolistic competition is one of these –
not to be confused with monopoly!
 Monopolistic or Imperfect
Competition
 Characteristics:
 Large number of firms in the industry
 May have some element of control over price due to
the fact that they are able to differentiate their product
in some way from their rivals – products are therefore
close, but not perfect, substitutes
 Entry and exit from the industry is relatively easy –
few barriers to entry and exit
 Consumer and producer knowledge imperfect
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC We Marginal
assume Cost
that and
the firmand
Cost/Revenue This
IfThe
the
is
Since demand
firm
a the
short
produces
run
curve
additional equilibrium
Q1
facing
produces
Average
position
sells
the
revenue
firm
each where
Cost
forwill
received
a
unit
firm
beforwill
MR abe
= MC
downward
in£1.00
from the
on
(profit
same
each maximising
monopolistic
average
sloping shape.
unit
with
andsold
marketHowever,
output).
represents
thefalls,
costthe(on
AtMRbecause
this
structure.
average)
the AR output
curve the
earned
forlies level,
eachproducts
under
from AR>AC
unit sales.
the
being
AC and
60p,
arethedifferentiated
firm makes
the firm will make 40p x
AR curve.
in
£1.00 abnormal
some way, profitthe(the
firmgrey
will
Q1 in abnormal profit.
shaded
only be area).
able to sell
extra output by lowering
Abnormal Profit price.

£0.60

MR D (AR)
Q1
Output / Sales
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC Because there is relative
Cost/Revenue
freedom of entry and exit
into the market, new
firms will enter
AC encouraged by the
existence of abnormal
profits. New entrants will
increase supply causing
price to fall. As price
falls, the AR and MR
curves shift inwards as
revenue from each sale
is now less.

MR1 AR1 D (AR)

MR
Q1 Output / Sales
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC Notice that the existence
Cost/Revenue
of more substitutes makes
the new AR (D) curve
more price elastic. The
AC firm reduces output to a
point where MC = MR
(Q2). At this output AR =
AC and the firm will make
AR = AC
normal profit.

MR1 AR1 D (AR)

MR
Q2 Q1 Output / Sales
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC This is the long run
Cost/Revenue
equilibrium position
of a firm in monopolistic
competition.
AC

AR = AC

MR1 AR1
Q2 Output / Sales
 Monopolistic or Imperfect
Competition
 Some important points about monopolistic
competition:
 May reflect a wide range of markets
 Not just one point on a scale – reflects many
degrees
of ‘imperfection’
 Examples?
 Monopolistic or Imperfect
Competition
 Restaurants
 Plumbers/electricians/local builders
 Solicitors
 Private schools
 Plant hire firms
 Insurance brokers
 Health clubs
 Hairdressers
 Funeral directors
 Estate agents
 Damp proofing control firms
 Monopolistic or Imperfect
Competition
 In each case there are many firms
in the industry
 Each can try to differentiate its product
in some way
 Entry and exit to the industry is relatively free
 Consumers and producers do not have perfect
knowledge of the market – the market may indeed be
relatively localised. Can you imagine trying to search out
the details, prices, reliability, quality of service, etc for
every plumber in the UK in the event of an emergency??
Oligopoly
 Competition between the few
 May be a large number of firms in the industry but the
industry is dominated
by a small number of very large producers
 Concentration Ratio – the proportion of total
market sales (share) held by the top 3,4,5, etc
firms:
A 4 firm concentration ratio of 75% means the top 4
firms account for 75% of all
the sales in the industry
Oligopoly
 Example: The music industry has
a 5-firm concentration
ratio of 75%.
 Music sales – Independents make up
25% of the market but
there could be many
thousands of firms that
make up this
‘independents’ group.
An oligopolistic market
structure therefore
may have many firms
in the industry but it is
dominated by a few
large sellers.
Market Share of the Music Industry 2002. Source IFPI: [Link]
Oligopoly
 Features of an oligopolistic market structure:
 Price may be relatively stable across the industry –
kinked demand curve?
 Potential for collusion
 Behaviour of firms affected by what they believe their rivals
might do – interdependence of firms
 Goods could be homogenous or highly differentiated
 Branding and brand loyalty may be a potent source of competitive
advantage
 Non-price competition may be prevalent
 Game theory can be used to explain some behaviour
 AC curve may be saucer shaped – minimum efficient scale
could occur over large range of output
 High barriers to entry
 Oligopoly
Price The kinked demand curve - an explanation for price stability?

The
Assume
IfThe
thefirm
principle
firmthe
therefore,
seeks
firmofto
is
thelower
charging
effectively
kinked
its price
demand
a faces
priceto of
£5‘kinked
gain
a and
acurve
competitive
producing
demand
rests on an
curve’
advantage,
output
the forcing
of its
principle100.
itrivals
to
will follow
maintain that:
asuit.
stableAnyorgains
rigid pricing
it makes will
If it chose to raise price above £5, its
quickly beOligopolistic
structure. lost and the firms % changemay in
rivals
a. would
If a firmnotraises
followitssuit
price,
anditsthe firm
demand will
overcome this
beby smaller
engagingthaninthenon-%
effectively
rivalsfaces an follow
will not elasticsuit
demand
reduction
price competition.
in price – total revenue
curve for its product (consumers would
would
b. Ifagaina firmfall as theitsfirm
lowers nowitsfaces
price,
buy from the cheaper rivals). The %
£5 a relatively
rivalsinelastic
will all dodemand
change in demand would be greater
the same curve.
than the % change in price and TR
Total would fall.

Revenue B
Total Revenue A
D = elastic
Total Revenue B Kinked D Curve
D = Inelastic

100 Quantity
Duopoly
 Market structure where the industry is
dominated by two large producers
 Collusion may be a possible feature
 Price leadership by the larger of the two firms may exist –
the smaller firm follows the price lead
of the larger one
 Highly interdependent
 High barriers to entry
 Cournot Model – French economist – analysed duopoly –
suggested long run equilibrium would see equal market
share and normal profit made
 In reality, local duopolies may exist
Monopoly
 Pure monopoly – where only
one producer exists in the industry
 In reality, rarely exists – always
some form of substitute available!
 Monopoly exists, therefore,
where one firm dominates the market
 Firms may be investigated for examples of
monopoly power when market share exceeds
25%
 Use term ‘monopoly power’ with care!
Monopoly
 Monopoly power – refers to cases where
firms influence the market in some way
through their behaviour – determined by the
degree
of concentration in the industry
 Influencing prices (price maker)
 Influencing output (no close substitutes)
 Erecting barriers to entry
 Pricing strategies to prevent or stifle competition
 Price discrimination
 Nominal selling cost
Monopoly
 Origins of monopoly:
 Through growth of the firm
 Through amalgamation, merger
or takeover
 Through acquiring patent or license
 Through legal means – Royal charter,
nationalisation, wholly owned plc
Monopoly
 Innovation - could be high because
of the promise of high profits, Possibly
encourages high investment in research and
development (R&D)
 Collusion – possible to maintain monopoly
power of key firms
in industry
 Monopoly
Costs / Revenue
This(D)
AR
Given isthe
both
curve
barriers
the
forshort
a to
monopolist
entry,
run and
MC likely
the
long monopolist
run
to be
equilibrium
relatively
will be
position
price
able to
inelastic.
exploit
for a monopoly
abnormal
Output assumed
profits in the
to
£7.00
be atrun
long profit
as maximising
entry to the output
(note caution
market is restricted.
here – not all
AC monopolists may aim
Monopoly for profit maximisation!)

Profit
£3.00

MR AR
Output / Sales
Q1
 Monopoly Welfare
Costs / Revenue implications of
monopolies
MC The value of the grey shaded
£7 triangle represents the total
welfare loss to society –
AC sometimes referred to as
the ‘deadweight welfare loss’.

£3

AR
MR
Output / Sales
Q2 Q1
Contestable Markets
 Theory developed by William J. Baumol, John
Panzar and Robert Willig (1982)
 Helped to fill important gaps in market
structure theory
 Perfectly contestable market – the pure
form – not common in reality but a benchmark
to explain firms’ behaviours
Contestable Markets
 Key characteristics:
 Firms’ behaviour influenced by the threat
of new entrants to the industry
 No barriers to entry or exit
 No sunk costs
 Firms may deliberately limit profits made
to discourage new entrants – entry limit pricing
 Firms may attempt to erect artificial barriers to
entry – e.g…
Contestable Markets
 Over capacity – provides the opportunity to
flood the market
and drive down price in the event
of a threat of entry
 Aggressive marketing and branding strategies
to ‘tighten’ up the market
 Potential for predatory
or destroyer pricing
 Find ways of reducing costs and increasing
efficiency to gain competitive advantage
Contestable Markets
 ‘Hit and Run’ tactics – enter the
industry, take the profit and get out
quickly (possible because of the
freedom of entry and exit)
 Cream-skimming – identifying parts of
the market that are high in value added
and exploiting those markets
Contestable Markets
 Examples of markets exhibiting
contestability characteristics:
 Financial services
 Airlines – especially flights
on domestic routes
 Computer industry – ISPs, software, web
development
 Energy supplies
 The postal service?
Market Structures
 Final reminders:
 Models can be used as a comparison – they are not necessarily meant to
BE reality!
 When looking at real world examples, focus on the behaviour of the firm in
relation to what the model predicts would happen – that gives the basis for
analysis and evaluation of the real world situation.
 Regulation – or the threat of regulation may well affect
the way a firm behaves.
 Remember that these models are based on certain assumptions – in the
real world some of these assumptions may not be valid, this allows us to
draw comparisons and contrasts.
 The way that governments deal with firms may be based on a general
assumption that more competition is better than less!