Marketstructure (1)

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Copyright 2006 – Biz/ed
Market Structure

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
More competitive (fewer imperfections)
Perfect
Competition
Pure
Monopoly

Market Structure
Less competitive (greater degree
of imperfection)
Perfect
Competition
Pure
Monopoly

Market Structure
Perfect
Competition
Pure
Monopoly
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?
Remember to
think about the
nature of the
product, entry and
exit, behaviour of
the firms, number
and size of the
firms in the
industry.
You might even
have to ask what
the industry is??Canon SLR CameraBananas
Mercedes CLK Coupe
Vodka
Electric
Guitar –
Jazz Body

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

Perfect Competition
Diagrammatic representation
Cost/Revenue
Output/Sales
The industry price is
determined by the demand
and supply of the industry
as a whole. The firm is a
very small supplier within
the industry and has no
control over price. They will
sell each extra unit for the
same price. Price therefore
= MR and AR
P = MR = AR
MC
The MC is the cost of
producing additional
(marginal) units of output. It
falls at first (due to the law of
diminishing returns) then rises
as output rises.
AC
The average cost curve is the
standard ‘U’ – shaped curve.
MC cuts the AC curve at its
lowest point because of the
mathematical relationship
between marginal and average
values.
Q1
Given the assumption of profit
maximisation, the firm produces
at an output where MC = MR
(Q1). This output level is a
fraction of the total industry
supply.
At this output the firm
is making normal profit.
This is a long run
equilibrium position.

Perfect Competition
Diagrammatic representation
Cost/Revenue
Output/Sales
P = MR = AR
MC
AC
Q1
Now assume a firm makes
some form of modification to
its product or gains some
form of cost advantage (say a
new production method).
What would happen?
AC1
MC1
AC1
Abnormal profit
Q2
Because the model assumes
perfect knowledge, the firm
gains the advantage for only a
short time before others copy
the idea or are attracted to the
industry by the existence of
abnormal profit. If new firms
enter the industry, supply will
increase, price will fall and the
firm will be left making normal
profit once again.
P1 = MR1 = AR1
The lower AC and MC would
imply that the firm is now
earning abnormal profit
(AR>AC) represented by the
grey area.
Average and Marginal costs
could be expected to be
lower but price, in the short
run, remains the same.

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!

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

Competition
Implications for the diagram:
Cost/Revenue
Output / Sales
MC
AC
Marginal Cost and
Average Cost will be the
same shape. However,
because the products
are differentiated in
some way, the firm will
only be able to sell extra
output by lowering
price.
D (AR)
The demand curve facing
the firm will be downward
sloping and represents
the AR earned from sales.
MR
Since the additional
revenue received from
each unit sold falls, the
MR curve lies under the
AR curve.
We assume that the firm
produces where MR = MC
(profit maximising output).
At this output level, AR>AC
and the firm makes
abnormal profit (the grey
shaded area).
Q1
£1.00
£0.60
Abnormal Profit
If the firm produces Q1 and
sells each unit for £1.00 on
average with the cost (on
average) for each unit being
60p, the firm will make 40p x
Q1 in abnormal profit.
This is a short run equilibrium
position for a firm in a
monopolistic market
structure.

Competition
Cost/Revenue
Output / Sales
MC
AC
D (AR)MR
Q1
Because there is relative
freedom of entry and exit
into the market, new
firms will enter
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.
AR1
MR1

Competition
Cost/Revenue
Output / Sales
MC
AC
D (AR)MR
Q1
AR1
MR1
Notice that the existence
of more substitutes makes
the new AR (D) curve
more price elastic. The
firm reduces output to a
point where MC = MR
(Q2). At this output AR =
AC and the firm will make
normal profit.
Q2
AR = AC

Competition
Cost/Revenue
Output / Sales
MC
AC
AR1
MR1
This is the long run
equilibrium position
of a firm in monopolistic
competition.
Q2
AR = AC

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?

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

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:
• Music sales –
The music industry has
a 5-firm concentration
ratio of 75%.
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: http://www.ifpi.org/site-content/press/20030909.html

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
The kinked demand curve - an explanation for price stability?Price
Quantity
D = elastic
D = Inelastic
£5
100
Kinked D Curve
The principle of the kinked 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, its
rivals will all do the same
Assume the firm is charging a price of
£5 and producing an output of 100.
If it chose to raise price above £5, its
rivals would not follow suit and the firm
effectively faces an elastic demand
curve for its product (consumers would
buy from the cheaper rivals). The %
change in demand would be greater
than the % change in price and TR
would fall.
Total Revenue A
Total
Revenue B
If the firm seeks to lower its price to
gain a competitive advantage, its rivals
will follow suit. Any gains it makes will
quickly be lost and the % change in
demand will be smaller than the %
reduction in price – total revenue
would again fall as the firm now faces
a relatively inelastic demand curve.
Total Revenue B
Total Revenue A
The firm therefore, effectively faces
a ‘kinked demand curve’ forcing it to
maintain a stable or rigid pricing
structure. Oligopolistic firms may
overcome this by engaging in non-
price competition.

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
– Influencing output
– Erecting barriers to entry
– Pricing strategies to prevent or stifle competition
– May not pursue profit maximisation – encourages
unwanted entrants to the market
– Sometimes seen as a case of market failure

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
• Summary of characteristics of firms
exercising monopoly power:
– Price – could be deemed too high, may be
set to destroy competition (destroyer or
predatory pricing), price discrimination
possible.
– Efficiency – could be inefficient due to lack
of competition (X- inefficiency) or…
• could be higher due to availability of high profits

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
• High levels of branding, advertising
and non-price competition

Monopoly
• Problems with models – a reminder:
– Often difficult to distinguish between a monopoly
and an oligopoly – both may exhibit behaviour
that reflects monopoly power
– Monopolies and oligopolies do not necessarily aim
for traditional assumption of profit maximisation
– Degree of contestability of the market may influence
behaviour
– Monopolies not always ‘bad’ – may be desirable
in some cases but may need strong regulation
– Monopolies do not have to be big – could exist locally

Monopoly
Costs / Revenue
Output / Sales
AC
MC
ARMR
AR (D) curve for a monopolist
likely to be relatively price
inelastic. Output assumed to
be at profit maximising output
(note caution here – not all
monopolists may aim
for profit maximisation!)
Q1
£7.00
£3.00
Monopoly
Profit
Given the barriers to entry,
the monopolist will be able to
exploit abnormal profits in the
long run as entry to the
market is restricted.
This is both the short run and
long run equilibrium position
for a monopoly

Monopoly
Costs / Revenue
Output / Sales
AC
MC
AR
MR
Welfare
implications of
monopolies
A look back at the diagram for
perfect competition will reveal
that in equilibrium, price will be
equal to the MC of production.
We can look therefore at a
comparison of the differences
between price and output in a
competitive situation
compared to a monopoly.
Q1
£3
The price in a competitive
market would be £3 with
output levels at Q1.
Q2
£7
The monopoly price would be
£7 per unit with output levels
lower at Q2.
On the face of it, consumers
face higher prices and less
choice in monopoly conditions
compared to more competitive
environments.
Loss of consumer
surplus
The higher price and lower
output means that consumer
surplus is reduced, indicated by
the grey shaded area.

Monopoly
Costs / Revenue
Output / Sales
AC
MC
AR
MR
Welfare
implications of
monopolies
Q1
£3
Q2
£7
The monopolist will be
affected by a loss of producer
surplus shown by the grey
triangle but……..
The monopolist will benefit
from additional producer
surplus equal to the grey
shaded rectangle.
Gain in producer
surplus

Monopoly
Costs / Revenue
Output / Sales
AC
MC
AR
MR
Welfare
implications of
monopolies
Q1
£3
Q2
£7
The value of the grey shaded
triangle represents the total
welfare loss to society –
sometimes referred to as
the ‘deadweight welfare loss’.

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!

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