CHAPTER six

MARKET STRUCTURE AND THE

DECISION OF A FIRM
6.1. INTRODUCTION
• market refers to a physical place where
commodities are bought and sold.
• In economics, the term market
• does not necessarily refer to a particular place, but
• to the mechanism or arrangement by which buyers
and sellers of a commodity are able to contact
each other for having economic exchange and
• by which they are able to strike deals about price
and the quantity to be bought and sold.
• In short, market is a structure in which the buyers
and sellers of a commodity remain in contact.
• Markets are classified into different types on the basis
of factors such as:
• the degree of competition among firms in a market,
• the number of buyers and sellers,
• the nature of the commodity,
• the mobility of goods and factors of production, and
the knowledge of buyers and sellers about prices in
the market.
• The types of market structure are:
• Perfectly competitive market
• Pure monopoly market
• Monopolistically competitive market
• Oligopoly market
6.2. PERFECTLY COMPETITIVE MARKET
• A perfectly competitive market or perfect
competition is a market structure in which
there are a large number of producers (firms)
producing a homogeneous product so that no
individual firm can influence the price of the
commodity.
• In this type of market, the price is determined
through the forces of demand and supply.
We discuss below the main features which a
market must have in order to be perfectly
competitive.
Assumptions of Perfectly Competitive Markets
• Very large number of buyers and sellers
• homogeneous product: they are identical in
all respects, including quality, color, size,
weight, design, etc. They are perfect
substitutes for one another, no seller can
charge a higher price.
• Free entry and exit of firms: firms with high
profit enters and firms with loss leave the
market
• Perfect knowledge:
• Perfect mobility: There is perfect mobility of
goods and factors of production without any
hindrance or obstruction.
• Absence of transport cost: In perfect
competition, it is assumed that there is no
transport cost for consumers who may buy
from any firm. This ensures the existence of a
single uniform price of the product.
• Example: most agricultural product‘s market.
• Distinction between Perfect Competition and
Pure Competition
• the difference is only a matter of degree.
• Competition is said to be pure when the first
three conditions explained above are satisfied.
• In contrast, competition is said to be perfect
when all six of the conditions explained above
are satisfied.
• Revenue of a Perfectly Competitive Market
• some of the basic relevant concepts.
• i Revenue: The revenues of a firm are the
receipts that it obtains from selling its
products.
• Similar to costs, revenues have three main
categories: Total Revenue (TR), Average
Revenue (AR), and Marginal Revenue (MR).
• ii Total, Average and Marginal Revenue:
• a) Total Revenue (TR): total amount of money
that the firm receives from the sale of a given
amount of its output.
• Total revenue can be estimated by multiplying
the quantity sold by its selling price,
• TR = P × Q
• Where; P is the price per unit, and Q is the
quantity of output sold.
 b) Average Revenue (AR): Average Revenue is
the total revenue (TR) divided by the quantity
sold (Q), or it is the per-unit revenue

• average revenue (AR) and price of the product

(P) have the same meaning.
• Average revenue means per unit revenue
received by the seller from the sale of the
commodity.
 c) Marginal Revenue (MR): Marginal revenue is
the change in total revenue resulting from one
unit increase in the sales.
• MR = TRn – TRn – 1
Quantity Price TR AR MR
1 50 50 50 50
2 50 100 50 50
3 50 150 50 50
• TR, AR and MR under Perfect Competition
• In perfect competition, a firm‘s additional
revenue (MR) from the sale of every
additional unit of the commodity is just equal
to the market price (P) or (AR).
• Hence, average revenue and marginal revenue
become equal and constant in the given
situation.
• Consequently, the AR and MR curves are the
same and would be horizontal or parallel to
the X-axis. This is also called the price line.
• Assuming that price per unit of a commodity is Birr 5, the
behavior of and relationship between TR, MR and AR of a
firm under perfect competition, are shown in the following
schedule.
• Profit Maximization or Producer’s Equilibrium in the
Short Run
• Economic theory assumes that the goal of a
competitive firm is profit maximization.
• the most important question for a firm is to
determine its level of output in such a way as to
obtain maximum profit or to have no tendency either
to expand or contract its output.
• This level is known as the state of equilibrium.
• There are two approaches to finding out the level of
output at which a competitive firm maximizes its
profit. They are:
• Total Approach (TR and TC approach)
• Marginal Approach (MR and MC approach)
• Total Approach with Graphical Analysis
• i. Total Revenue and Total Cost Approach: A
firm is in equilibrium at that level of its output
where the difference between TR and TC is
maximum.
• Mathematically, profit is maximum when TR –
TC maximum.
• Also, TR > TC → Profit
• TR = TC → Neither profit nor loss
• TR < TC → Loss
Quantity TR TC Profit
1 200 50 150
2 300 60 240
3 400 100 300
4 500 260 240
5 600 370 230
6 700 500 200
7 800 700 100
• ii Marginal Revenue and Marginal Cost
Approach: In general a firm‘s profit
maximizing condition is MR = MC and MC is
rising. But for a competitive firm, this
condition is expressed as:
• P = MC (because in perfect competition, price
= AR = MR)
• Profit Maximization in the Long Run
• Normal Economic Profit: covers the
opportunity cost of all the resources used in
production, it is said to earn normal profit (or
zero profit).
• A firm under perfect competition will be in
equilibrium (state of profit maximization) in
the long run when it earns only normal profits.
• The key to long-run equilibrium is free entry
and free exit of firms in the industry.
• If the existing firms are making abnormal profits in the
short run, new firms will be entering the industry to
earn these abnormal profits. The total supply of the
industry will increase -> the equilibrium price will fall ->
so will abnormal profits -> entry of new firms will
continue until increased supply has driven down the
market price sufficiently to eliminate all abnormal profits
and so that all the firms in the industry earn only normal
profits, i.e., just covering their total costs.
• On the other hand, if the existing firms are incurring
losses in the short run -> some of the firms will exist
from the industry in the long run -> the supply of the
industry decreases and the market price rises -> Firms
will continue to withdraw -> price will continue to rise
until the remaining firms in the industry are covering all
their costs, i.e., earning only normal profits.
• So, in the long run, a firm under perfect
competition can neither have abnormal profits
nor losses — it earns only normal profits.
• P = (AR) = LAC (i.e., normal profits)
• MC = MR (profit-maximization rule), and also
that the LMC curve cuts the MR curve.
• Since, under perfect competition, AR = MR,
we can write the equilibrium condition (by
equating, 1 and 2) as: in the following:
• MC = MR = AR = LAC or P = LMC = LAC
• Practical Work
• 1. For a perfectly competitive firm, the following
information is given:
• TFC = Birr 10,000; AVC = Birr 40; AR = Birr 60
• Find the quantity produced by the firm at the break-
even point.
• Solution:
• Given: TFC = 10,000, AVC = 40, and AR = 60 at break-
even point,
• P = AR = ATC = AFC + AVC
• ⇒ 60 = AFC + 40
• or 60 = TFC/Q + 40 , TFC/Q = 60 - 40 = 20
• 10,000/Q = 20 , Q =10000/20 = 500 units
• 2. Suppose, for a perfectly competitive firm, marginal
cost function is given by: MC = Q2– 2Q + 20
• Find the quantity produced (Q) at the equilibrium level
of output, if price per unit of good produced is Birr 44.
• Solution:
• At equilibrium level of output, P = MC = MR
• ⇒ 44 = Q2 – 2Q + 20
• ⇒ Q2 – 2Q – 24 = 0
• ⇒ (Q – 6) (Q + 4) = 0
• ⇒ Q = 6 or Q = –4
• Neglecting the negative value of the quantity produced,
we get Q = 6, which is the output at equilibrium level.
(Here you must be able to apply calculus).
B) Monopoly

• Monopoly exists where one firm dominates the market

(There are no close substitutes for the products
produced by the monopolist)
– (market structure in which there is only one producer/seller
for a product)
• Pure monopoly – where only one producer exists in
the industry (Ex: EELPA in Ethiopia)
• In reality, rarely exists – always some form of substitute
available!

• Firms may be investigated for exercising monopoly

power when market share exceeds 25%
Monopoly...

• Monopoly originates
• 1. economies of scale i.e. one firm grows large, costs
less than others, so sells more, and grows to become
sole firm.
– This is so-called NATURAL MONOPOLY
• 2. law - govt may restrict to one nationalized firm
– Ex: Hydro Electric Power production in Ethiopia

• 3. agreement between firms, so that all act together as

one monopolist - often illegal but happens.
Monopoly...

• 4. exclusive ownership of unique resource : e.g. one

source of supply of raw material
– e.g. in Saudi Arabia the government has sole control over the
oil industry.

• 5. copyrights, patents and licenses are

particular forms of this.
 Graphical representation of Monopoly
AR (D)the
Given curve for a to
barriers
Costs / Revenue monopolist
entry, the likely to
be relativelywill
monopolist price
be
MC This is both the short
inelastic.
able Output
to exploit
run and long run
$7.00 assumed
abnormal to be at in
profits
equilibrium position
profit
the maximising
AC for along run as entry
monopoly
Monopoly output (note caution
to the market is
here – not all
restricted.
Profit monopolists may
aim
$3.00
for profit
maximisation!)

MR AR
Output / Sales
Q1
C) 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
 C) Monopolistic or Imperfect Competition

• Characteristics:
– Many buyers and sellers of that type of good (=
competition)
– Free entry and exit (= competition)
– But each with own brand of the good
• Product differentiation is possible & thus products are close
but not perfect, substitutes
– So each firm faces a downward sloping demand curve
for its branded product

– Consumer and producers do not have perfect

knowledge about the market
• Can you imagine trying to search out the details, prices,
 Monopolistic or Imperfect Competition
This is a short run
Short run Equilibrium: equilibrium position
MC for a firm in a
Cost/Revenue Marginal
Since
If the the Cost
monopolistic
The demand
firm market
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curve
We assume that the
and
Q1 Average
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MR D (AR)
Q1 Output / Sales
Real World Examples

• May reflect a wide range of markets

– Bars & Restaurants
– Hairdressers and Barbers
– Private clinics
– Private schools
– Bakeries
– Plumbers/electricians/local builders
– Cereal, clothing, shoes, and service industries in
large cities.
– etc
D) Oligopoly
• An oligopoly is a market dominated by a small
number of strategically interdependent firms
– How few?
• At some point, number of firms is large enough—and
interdependence weak enough—that oligopoly
becomes a poor description
– Monopolistic competition would fit better
– No absolute number at which oligopoly ends and
monopolistic competition begins
• Strategic interdependence requires that a few
firms dominate the market
– Their share of market is large
Oligopoly...
• As combined market share shrinks, strategic
interdependence becomes weaker
• Oligopoly is a matter of degree
– Not an absolute classification
• 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
• Example:
– Coffee exporters in Ethiopia- 6 major constitute >70%
– Gas stations in Ethiopia -
 Oligopoly vs. Other Market Structures

• Oligopoly presents the greatest challenge to

economists
– essence of oligopoly is strategic interdependence
– economists have had to modify the tools used to
analyze other market structures and to develop
entirely new tools as well
• One approach—game theory—has yielded rich
insights into oligopoly behavior
3
4
 The Game Theory Approach
• Mainly developed by John Von Neumann (1903-
1957), John F. Nash, Jr.(1928- )
• Game theory approach
– An approach to modeling strategic interaction of
oligopolists in terms of moves and countermoves
– The classic example of game theory is the prisoner’s
dilemma
– Pay off matrix

3
5
 Game Theory Approach
• Some situations to which game theory can
be applied:
– firms competing for business
– political candidates competing for votes
– animals fighting over prey
– bidders competing in an auction
– legislators' voting behavior under pressure
from interest groups
– Tragedy of the commons 3
6
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
– High barriers to entry
 Graphical representation of an Oligopolic Competition

The kinked demand curve - an

explanation for price stability? The principle of the kinked
Price demand curve rests on
the principle that:
a. If a firm raises its price,
its rivals will not follow
suit
b. If a firm lowers its price,
$5 its rivals will all do the
same
Total
Revenue B
Total Revenue A
D = elastic
Total Revenue B Kinked D Curve
D = Inelastic

100 Quantity
E) 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
– In reality, local duopolies may exist
• Example: Boieng Vs Airbus in commercial large jet aircraft
market
Summary on four types of market
Market Structure
Perfect Monopolistic
Competition Competition Oligopoly Monopoly
# of Firms Many Many Few One
Product Identical Differentiated Either No close substitute
Differentiation
Barriers to None None Big Insurmountable
Entry
Control over None Some Considerable Considerable or
Price Regulated
Concentration 0 Low High 100
Ratio
Long Run 0 0  0  0
Economic
Profit
Examples Wheat Processed Automobiles Local 4
Food, Brand Electricity, Water 0
Clothing
 Some terminologies on MS
• Monopoly
• Monpsony
• Duopoly
• Duopsony
• Oligopoly
• Oligopsony
• Perfect competitive market
 Matching
• -----[Link] A. Many
• ___2.Duopoly B. Two Producers
• ___3.P=AC C. Cooperation
• ___4.Monopolistic D. Interdependence
• ___5.Free entry E. Perfect competition
• ___6.Price maker F. Monopoly
• ___7.Cartels G. Shut down
• ___8.P=AVC H. Breakeven