Chapter 8-market-structure

Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved. Page 1

CHAPTER 8

MARKET STRUCTURE

LECTURE OUTLINE

1 INTRODUCTION

2 PERFECT COMPETITION

2.1 Characteristics of perfect competition

2.2 Revenue curves and schedules under perfect competition

2.3 Profit-maximising rule

2.4 Short-run equilibrium of a perfectly competitive market

2.5 Long-run equilibrium of a perfectly competitive market

2.6 Short-run shut-down rule

2.7 Long-run shut-down rule

2.8 Derivation of the short-run supply curve of a firm under perfect competition

2.9 Perfect competition and the public interest

3 MONOPOLY

3.1 Characteristics of monopoly

3.2 Barriers to entry

3.3 Revenue curves of a monopoly

3.4 Short-run equilibrium of a monopolistic market

3.5 Long-run equilibrium of a monopolistic market



3.8 A monopoly does not have a supply curve

3.9 Monopoly and the public interest

3.10 Natural monopoly

4 MONOPOLISTIC COMPETITION

4.1 Characteristics of monopolistic competition

4.2 Revenue curves of a monopolistically competitive firm

4.3 Short-run equilibrium of a monopolistically competitive market

4.4 Long-run equilibrium of a monopolistically competitive market

4.5 Monopolistic competition and the public interest



5 OLIGOPOLY

5.1 Characteristics of oligopoly

5.2 Collusive versus competitive (non-collusive) behaviour

5.3 Non-price competition

5.4 Oligopoly and the public interest

References

John Sloman, Economics

William A. McEachern, Economics

Richard G. Lipsey and K. Alec Chrystal, Positive Economics

G. F. Stanlake and Susan Grant, Introductory Economics

Michael Parkin, Economics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics



1 INTRODUCTION

Economists are interested to study the behaviour of firms such as whether they will charge

a high or low price, whether they will make a large or small amount of profit, whether they

will produce efficiently, etc. The answers to these questions will depend on the number of

firms in the market, the nature of their products, the availability of knowledge and the

presence or absence of barriers to entry. For instance, a firm in a highly competitive

environment will behave quite differently from a firm facing little or no competition. In

particular, a firm that faces competition from many firms is likely to charge a low price,

make a small amount of profit and produce efficiently. The converse is also true.

The structure of a market is the characteristics of the market such as the number of firms in

the market, the nature of their product, the availability of knowledge and the presence or

absence of barriers to entry that affect the behaviour and profitability of the firms in the

market. This chapter gives an exposition of the four types of market structure: perfect

competition, monopoly, monopolistic competition and oligopoly.

2 PERFECT COMPETITION (PC)

2.1 Characteristics of perfect competition

A very large number of small firms (small market share)

In a PC market, there are a very large number of small firms. Therefore, each firm in a PC

market has a small market share.

Homogeneous products

In a PC market, the firms sell homogenous products that are perfect substitutes for one

another. Homogenous products are identical products.

Perfect knowledge

In a PC market, firms and consumers are fully aware of the production technology, price,

quality and availability of the product.

PC firms are price-takers

Due to its small market share, product homogeneity and perfect knowledge, a PC firm is a

price-taker in the sense that it is unable to influence the market price by changing its output

level. Therefore, a PC firm can only sell its output at the market price that is determined by

the market forces of demand and supply. In other words, a PC firm faces a perfectly elastic

demand curve at the market price. At the market price, the quantity demanded of the good

produced by a PC firm is infinite. Therefore, in principle, a PC firm can sell all the output

that it produces at the market price.



No barriers to entry

There are no barriers to entry in a PC market. The absence of barriers to entry in a PC

market allows a PC firm to make only normal profit (TR TC) in the long run.

Note: Perfect competition does not exist. It is only a benchmark. The word 'perfect' in

“perfect competition” does not mean 'the best' or 'the most desirable'. Rather, when it

is used with the word 'competition', perfect means “of the highest degree”.

2.2 Revenue curves and schedules under perfect competition

The market demand curve is downward-sloping (refer to the notes on “Demand and

Supply”).

A PC firm's demand curve is horizontal (perfectly elastic) at the market price (refer to

section 2.1).

The revenue schedules of a perfectly competitive firm

Price Quantity TR AR MR

3 10 30 3 ---

3 11 33 3 3

3 12 36 3 3

3 13 39 3 3

Total revenue (TR) Price (P) × Quantity (Q)

Average revenue (AR) TR/Q P

Marginal revenue (MR) ΔTR/ΔQ

Market Representative firm



In the above left-hand diagram, the market price (P0) is determined by the market demand

(D) and the market supply (S). In the above right-hand diagram, the PC firm faces a

perfectly elastic demand curve at P0. At P0, the quantity demanded of the good produced by

the PC firm is infinite. Therefore, in principle, a PC firm can sell all the output that it

produces at the market price.

TR curve of a PC firm

The representative firm's demand curve is horizontal at the market price of $3.

The representative firm's demand curve is also its AR and MR curves.

Since the demand curve is perfectly elastic, the TR curve is an upward-sloping straight line

drawn from the origin.

2.3 Profit-maximising rule

Profit is the excess of TR over TC. Profit is maximised at the output level where MR is

equal to MC.



In the above diagram, profit is maximised at Q0 where MR is equal to MC. If output

increases from Q0, both TR and TC will rise. However, at an output level higher than Q0,

such as Q1, MC is higher than MR. Therefore, the increase in TC will be greater than the

increase in TR and hence the increase in output will lead to a decrease in profit. If output

decreases from Q0, both TR and TC will fall. However, at an output level lower than Q0,

such as Q2, MR is higher than MC. Therefore, the decrease in TR will be greater than the

decrease in TC and hence the decrease in output will lead to a decrease in profit. Since

profit cannot be increased by changing output from Q0, it must be maximised at Q0.

Further, MR is equal to MC at two output levels, Q0’ and Q0. At Q0’, where MC is falling,

profit is NOT maximised. Between Q0’ and Q0, MR is higher than MC. If output increases

from Q0’ to Q0, a profit will be made on each unit of output and this means that the profit at

Q0 is higher than the profit at Q0’. Therefore, the profit of a PC firm is maximised at the

output level where MR is equal to MC, assuming MC is rising.



In the above diagram, the vertical distance between the TR and the TC curves is the largest

at Q0. The slope of the TR curve at this output level (MR) is equal to the slope of the TC

curve (MC). Therefore, Q0 in the TR/TC diagram is the same as Q0 in the MR/MC

diagram.

The profit-maximising rule can also be proven mathematically.

Profit Total Revenue – Total Cost

(Q) TR(Q) – TC(Q)

By the first-order condition,

d/dQ 0

dTR/dQ – dTC/dQ 0

MR – MC 0

MR MC

2.4 Short-run equilibrium of a perfectly competitive market

A PC firm is in short-run equilibrium when it is producing the profit-maximising output

level. A PC market is in short-run equilibrium when all the firms in the market are in

short-run equilibrium. However, this does not necessarily mean that the firms in the market

are making positive economic profit. Indeed, the firms in a PC market in short-run

equilibrium can make one of three types of profit: supernormal profit (positive economic

profit), subnormal profit (negative economic profit or economic loss) and normal profit

(zero economic profit).

Supernormal profit (TR TC or AR AC)

In the above diagram, at Q0 where MR is equal to MC, AR is greater than AC. Therefore,

the firm is making supernormal profit represented by the shaded area.



Subnormal profit (TR TC or AR AC)

In the above diagram, at Q0 where MR is equal to MC, AR is less than AC. Therefore, the

firm is making subnormal profit represented by the shaded area.

Normal profit (TR TC or AR AC)

In the above diagram, at Q0 where MR is equal to MC, AR is equal to AC. Therefore, the

firm is making normal profit.



2.5 Long-run equilibrium of a perfectly competitive market

A PC market is in long-run equilibrium when the firms that wish to leave the market and

the potential firms that wish to enter the market have done so. In other words, a PC market

is in long-run equilibrium when the number of firms in the market is constant. In PC

market, this occurs when all the firms make normal profit.

If the firms in a PC market are making supernormal profit, potential firms will enter the

market in the long run due to the absence of barriers to entry. The market supply will

increase which will lead to a fall in the market price. Potential firms will stop entering the

market when the firms in the market make only normal profit.


In the above diagram, supernormal profit represented by the shaded area attracts potential

firms into the market in the long run, resulting in the market supply curve (S) shifting to the

right from S0 to S1. With the entry firms, the market price (P) falls from P0 to P1. At P1,

since the firms in the market make only normal profit, the incentive for potential firms to

enter the market disappears.

If the firms in a PC market are making subnormal profit, they will leave the market when

their fixed factor inputs need replacing. Those that cannot cover their total variable cost

will leave the market immediately. The market supply will decrease which will lead to a

rise in the market price. The exit of firms will stop when the firms in the market start

making normal profit.




In the above diagram, subnormal profit represented by the shaded area induces the firms to

leave the market, resulting in the market supply curve (S) shifting to the left from S0 to S1.

With the exit of firms, the market price (P) rises from P0 to P1. At P1, since the firms in the

market make normal profit, the incentive for the firms to leave the market disappears.


If a firm is making supernormal profit (TR TC), it should continue production. If it is

making subnormal profit (TR TC), at first thought, it may seem that it should shut down

production. However, this is not true in the short run. In the short run, a firm should

continue production so long as its TR can at least cover its TVC (TR ≥ TVC). This is

because fixed costs will be incurred whether the firm continues or shuts down production

in the short run. Consider the following cases.

Case 1: TR TVC or AR AVC

If TR is less than TVC, the firm will make a loss equal to its TFC if it shuts down

production. However, if it continues production, the excess of its TVC over its TR will add

to its loss, in which case, it will make a loss greater than its TFC. Therefore, the firm should

shut down production. However, it will still stay in the market.


If TR is greater than TVC, the firm will make a loss equal to its TFC if it shuts down

production. However, if it continues production, the excess of its TR over its TVC will

offset a portion of its TFC, in which case, it will make a loss less than its TFC. Therefore,

the firm should continue production. However, it will still stay in the market.




If TR is equal to TVC, the firm will make the same amount of loss whether it continues or

shuts down production. However, in this instance, the firm should continue production

because in doing so, it may be able to make supernormal profit in the future if market

conditions improve. In the event that market conditions deteriorate, the firm can shut down

production without being worse off than if it shuts down production now.


In the long run, all costs are variable. Therefore, if a firm is making subnormal profit (TR

TC), it should shut down production and leave the market. In other words, in the long run,

a firm should continue production only if its TR is greater than or equal to its TC (TR ≥

TC).

2.8 Derivation of the short-run supply curve of a firm under perfect competition

The supply curve shows the quantity supplied at each price. In other words, given the price

of a good, the quantity supplied is determined entirely by the supply curve. The portion of

the MC curve above the AVC curve of a PC firm is the supply curve.

In the above diagram, given the market price of the good (P0) that is determined by the

market forces of demand and supply, the quantity supplied (Q0) is determined entirely by

the MC. Intuitively, given the price of a good, the quantity supplied is determined by the

marginal revenue and the marginal cost. However, in the case of a PC firm, price is equal to

marginal revenue. Therefore, given the price of the good produced by a PC firm, the

quantity supplied is determined entirely by the MC curve. Further, at a price lower than its

AVC, the firm will shut down production to avoid making a loss greater than its TFC.

Therefore, the supply curve of a PC firm is the portion of the MC curve above the AVC

curve.



2.9 Perfect competition and the public interest

Advantages

Due to intense competition in the market, PC firms are not lax in cost control. In other

words, they are not overstaffed, they do not lack the incentive to use the most efficient

production technology, etc. Therefore, PC firms are x-efficient and hence productively

efficient.

A firm is allocatively efficient when it cannot change its output level and hence the

allocation of resources in the economy in a way that will increase the total benefit for

consumers and this occurs when it charges a price equal to its marginal cost, assuming no

externalities. PC firms are allocatively efficient because they charge a price equal to their

marginal cost, assuming no externalities. When the price of a good is equal to the marginal

cost, the marginal benefit that consumers place on the last unit of the good is equal to the

forgone marginal benefit that they place on the amount of other goods that could have been

produced using the same resources. Therefore, PC firms cannot change their output level to

increase the total benefit for consumers and hence are allocatively efficient.

The price charged by the firms in a PC market is lower than the price that would be charged

by the firm in the same market operating under monopoly, assuming the cost structure of a

monopoly is the same as that of a PC industry.

In the above diagram, the PC price (PPC) is lower than the monopoly price (PM) and the PC

output level (QPC) is higher than the monopoly output level (QM).

The distribution of income in an economy that abounds with PC markets will be more

equal than one that abounds with monopolistic markets because although PC firms can

make only normal profit in the long run, a monopoly can make supernormal profit in the

long run.



Since PC firms produce the output levels which correspond to the lowest points on their

AC curves, we say that they are producing at optimum capacity.

Disadvantages

A monopoly reaps more economies of scale than a PC industry and if this results in its MC

curve being substantially lower than the horizontal summation of the MC curves of the

firms in the same market operating under PC, it will produce a higher output level and

charge a lower price.

In the above diagram, due to substantial economies of scale, the monopoly price (PMC) is

lower than the PC price (PPC).

Due to lack of ability and willingness, PC firms do not engage in research and development.

Due to perfect knowledge, any innovation, whether process or product, can easily and

quickly be copied by other firms. Further, research and development very often requires

huge expenditure outlays which PC firms are unable to finance and this is because they are

small and they make only normal profit in the long run.

PC firms produce homogeneous products which offer consumers no variety of choices.

3 MONOPOLY

3.1 Characteristics of monopoly

A single large firm

In a monopolistic market, there is a single large firm (known as the monopoly or the

monopolist). Therefore, the output level of a monopoly is the market output level.

Unique product

A monopoly sells a unique product that has no close substitutes.



A monopoly is a price-setter

Due to lack of competition in the market, a monopoly is a price-setter in the sense that it is

able to set its price by setting its output level. In other words, a monopoly faces a

downward-sloping demand curve.

Barriers to entry

There are barriers to entry in a monopolistic market. The presence of barriers to entry in a

monopolistic market allows a monopoly to make supernormal profit (TR TC) in the long

run.

Note: In reality, a monopoly is not defined as a single large firm in a market that sells a

unique product that has no close substitutes. For instance, in the UK, a monopoly is

defined as a firm that has 25% or more of the share of the market.

3.2 Barriers to entry

Definition

A barrier to entry is an obstacle that is faced by potential firms which restricts them from

entering and competing with the firm or firms in a market. Barriers to entry are the sources

of monopoly power.

Very substantial economies of scale

A monopoly may emerge naturally because it can reap very substantial economies of scale

and this occurs when the economies of scale are so substantial that the market can

accommodate only one firm. In other words, a single firm can meet the market demand at

an average cost which allows it to make supernormal profit. However, with two or more

firms, all will make subnormal profit. With each firm catering to less than the market

demand, there is simply no price that would allow the firms to cover cost.



In the above diagram, the monopoly which faces the demand curve (D1) can make at least

normal profit by producing anywhere within the output range from QMIN to QMAX. With

two firms in the market, each firm faces the demand curve (D2), which lies entirely below

the LRAC curve. Neither firm can make at least normal profit regardless of the output level.

A monopoly that occurs due to this reason is known as a natural monopoly (which will be

discussed in greater detail later).

Financial barriers

Some businesses require high start-up costs which not many firms are able to finance.

Legal barriers

A firm may have obtained its monopoly position through the acquisition of a patent or

copyright. A patent is granted to an inventor to allow him the exclusive right to produce the

product or use the production process that is patented. In the latter, potential firms cannot

enter the market as they do not have access to the technology. The aim of awarding patents

is to promote research and development. A copyright, similar to a patent, is granted on

plays, textbooks, novels, songs, computer software, and the like. Today, patents and

copyrights are commonly referred to as intellectual properties.

Control of key factor inputs

If a firm controls the supply of some key factor inputs, it can deny access to these factor

inputs to potential rivals.

Control of wholesale and retail outlets

If a firm controls the outlets through which the product can be sold, it can prevent potential

rivals from gaining access to consumers.



3.3 Revenue curves of a monopoly

AR, MR and TR curves of a monopoly

3.4 Short-run equilibrium of a monopolistic market

A monopoly is in short-run equilibrium when it is producing the profit-maximising output

level. A monopolistic market is in short-run equilibrium when the monopoly is in short-run

equilibrium, since it is the only firm in the market. However, this does not necessarily

mean that the monopoly is making positive economic profit. Indeed, a monopoly in

short-run equilibrium can make one of three types of profit: supernormal profit (positive

economic profit), subnormal profit (negative economic profit or economic loss) and

normal profit (zero economic profit).



Supernormal profit (TR TC or AR AC)

In the above diagram, at Q0 where MR is equal to MC, AR is greater than AC. Therefore,

the firm is making supernormal profit represented by the shaded area.

Subnormal profit (TR TC or AR AC)

In the above diagram, at Q0 where MR is greater than MC, AR is less than AC. Therefore,

the firm is making subnormal profit represented by the shaded area.



Normal profit (TR TC or AR AC)

In the above diagram, at Q0 where MR is equal to MC, AR is equal to AC. Therefore, the

firm is making normal profit.

3.5 Long-run equilibrium of a monopolistic market

Provided that a monopoly can sustain the barriers to entry, the short-run equilibrium will

also be the long-run equilibrium. If a monopoly cannot reverse a subnormal-profit

equilibrium in the long run, it will cease production and leave the market. In other words,

in the long run, a monopoly can make supernormal or normal profit. Note that the former is

impossible for the firms in PC market in the long run.


Refer to section 2.6.



3.8 A monopoly does not have a supply curve

Although the portion of the MC curve above the AVC curve of a PC firm is the supply

curve, this is not true of a monopoly.



In the above diagram, given the profit-maximising price of the good (P0) that corresponds

to the output level where marginal revenue (MR) is equal to marginal cost (MC), the

quantity supplied will be Q0’ if the MR curve is MR’. However, given the same price of the

good (P0), the quantity supplied will be Q0” if the MR curve is MR”. Therefore, given the

price of the good produced by a monopoly, not only is the quantity supplied determined by

the MC curve, but it is also affected by the MR curve. Since the quantity of the good

supplied by a monopoly is not determined entirely by the MC curve, the MC curve of a

monopoly is not the supply curve. Indeed, given the price of the good produced by a

monopoly, there is no single curve that entirely determines the quantity supplied.

Therefore, a monopoly does not have a supply curve.

3.9 Monopoly and the public interest

Advantages

A monopoly reaps more economies of scale than a PC and MC industry and if this results

in its MC curve being substantially lower than the horizontal summation of the MC curves

of the firms in the same market operating under PC or MC, it will produce a higher output

level and charge a lower price.

Since a monopoly is large and it can make supernormal profit in the long run, it has the

ability to engage in research and development. Successful product innovations will lead to

greater product variety and successful process innovations will lead to a lower average cost

of production and hence a lower price.

The ability of a monopoly to practise price discrimination may be beneficial to consumers.

Price discrimination may allow a firm to reach a market that otherwise would not be

reached or to produce a good that otherwise would not be produced. Further, if the increase

in profit from price discrimination is ploughed back into research and development, more

benefits to consumers will be created.



Disadvantages

Due to lack of competition in the market, a monopoly may be lax in cost control. In other

words, it may be overstaffed, it may lack the incentive to use the most efficient production

technology, etc. Therefore, a monopoly may be x-inefficient and hence productively

inefficient. However, if a monopoly faces potential competition, it may be x-efficient and

hence productively efficient to prevent potential firms from entering the market. Even in

the absence of potential competition, the sheer aim of making more profit may drive a

monopoly to be x-efficient and hence productively efficient.

A monopoly is allocatively inefficient because it charges a price higher than its marginal

cost. When the price of a good is higher than the marginal cost, the marginal benefit that

consumers place on the last unit of the good is greater than the forgone marginal benefit

that they place on the amount of other goods that could have been produced using the same

resources. Therefore, if a monopoly increases its output level, the total benefit for

consumers will increase and hence is allocatively inefficient.

In the above diagram, the deadweight loss, which is the loss of surplus due to market

failure or government intervention, is represented by the shaded area.

The price charged by the firm in a monopolistic market is higher than the price that would

be charged by the firms in the same market operating under perfect competition or

monopolistic competition, assuming the cost structure of a monopoly is the same as that of

a PC industry and a MC industry.

The distribution of income in an economy that abounds with monopolistic markets will be

less equal than one that abounds with PC markets because although PC firms can make

only normal profit in the long run, a monopoly can make supernormal profit in the long

run.



A monopoly does not produce the output level which corresponds to the lowest point on its

AC curve, unless by chance. In other words, a monopoly is not producing at optimum

capacity.

Due to its big size, a monopoly may be able to exert pressure on the government to pass

laws that may hurt other sectors of the economy.

The ability of a monopoly to practise price discrimination may lead to a fall in the

consumer surplus, which will be a welfare loss for consumers.

3.10 Natural monopoly

A natural monopoly is a monopoly that emerges when the market can accommodate only

one firm. An example is a public utility firm. A natural monopoly has two distinctive

characteristics. First, it can reap very substantial economies of scale and hence its LRAC

curve is falling over the entire range of market demand. In other words, its minimum

efficient scale is high relative to the market demand. Second, it incurs very high start-up

costs and hence its AC curve is falling over the entire range of the market demand.

In the above diagram, the monopoly which faces the demand curve (D1) can make at least

normal profit by producing anywhere within the output range from QMIN to QMAX. With

two firms in the market, each firm faces the demand curve (D2), which lies entirely below

the LRAC curve. Neither firm can make at least normal profit regardless of the output level.

A monopoly that occurs due to this reason is known as a natural monopoly.



In the above diagram, the profit-maximising output level (QM) where marginal revenue

(MR) is equal to marginal cost (MC) is much lower than the allocatively efficient output

level (QA) where price (P) is equal to marginal cost (MC). Therefore, if a natural monopoly

increases its output level, the total benefit for consumers will increase significantly and

hence is very allocatively inefficient.

The government can pass a regulation that requires the monopoly to charge a price equal to

its marginal cost to achieve allocative efficiency, assuming no externalities and the

monopoly, and this is commonly known as marginal cost pricing.

In the above diagram, the output level under marginal cost pricing (QMC) is equal to QA.

However, in an attempt to make more supernormal profit, the monopoly may provide false

information about its revenue and cost structures to the government. If this happens, the



use of marginal cost pricing in a monopolistic market will not achieve allocative efficiency.

Further, under such a pricing regulation, the monopoly will make a loss represented by the

shaded area, because PMC is lower than AC at QMC. Therefore, the government has to give

the monopoly a lump-sum subsidy to allow it to cover its loss. However, if the government

is unwilling or unable to give the monopoly a lump-sum subsidy, marginal cost pricing will

not be feasible.

In the event that marginal cost pricing is unfeasible since it may cause the monopoly to

make a loss, the government can pass a regulation that requires the monopoly to charge a

price equal to its average cost to reduce allocative inefficiency and this is commonly

known as average cost pricing. In the above diagram, the output level under average cost

pricing (QAC) is closer to QA than QM is. However, the use of average cost pricing in a

monopolistic market will not achieve allocative efficiency.

The government can give a subsidy to the monopoly to induce it to increase output to

achieve allocative efficiency.

In the above diagram, a per-unit subsidy leads to a fall in the AC and the MC curves. If the

new AC and the new MC curves are AC’ and MC’, the new profit-maximising output level

(QM’) will be equal to QA. However, in an attempt to make more supernormal profit, the

monopoly may provide false information about its revenue and cost structures to the

government. If this happens, the use of subsidy in a monopolistic market will not achieve

allocative efficiency. Further, since the subsidy will be financed by taxpayers and will

increase the profit of the monopoly, the government is likely to refrain from using it to

avoid hurting its popularity rating.



The government can nationalize the market to produce the good itself to achieve allocative

efficiency. If it seeks to maximise welfare, allocative efficiency will be achieved. However,

advocates of privatisation argue that since a state-owned monopoly does not need to

consider factors such as profitability and survival and does not face potential competition,

it is more likely to be x-inefficient and hence productively inefficient than a private

monopoly.

4 Monopolistic competition (MC)

4.1 Characteristics of monopolistic competition

A large number of small firms

In a MC market, there are a large number of small firms.

Differentiated products

In a MC market, the firms sell differentiated products that are close substitutes for one

another. Differentiated products are products that are sufficiently similar to be

distinguished as a group from other products. An example is restaurant foods.

MC firms are price-setters

Due to product differentiation, a MC firm is a price-setter in the sense that it is able to set its

price by setting its output level. In other words, a MC firm faces a downward-sloping

demand curve. However, due to the large number of substitutes in the market, the demand

for the good produced by a MC firm is more price elastic than the demand for the good

produced by a monopoly.

No barriers to entry

There are no barriers to entry in a MC market. The absence of barriers to entry in a MC

market allows a MC firm to make only normal profit (TR TC) in the long run.

Note: Since MC firms sell differentiated products, there is no market demand and market

supply in a MC market.

4.2 Revenue curves of a monopolistically competitive firm


4.3 Short-run equilibrium of a monopolistically competitive market




4.4 Long-run equilibrium of a monopolistically competitive market

A MC market is in long-run equilibrium when the firms that wish to leave the market and

the potential firms that wish to enter the market have done so. In other words, a MC market

is in long-run equilibrium when the number of firms in the market is constant. In a MC

market, this occurs when all the firms make normal profit.

If the firms in a MC market are making supernormal profit, potential firms will enter the

market in the long run due to the absence of barriers to entry. As the number of firms in the

market increases, each firm will have a smaller market share. In other words, the demand

curve that each firm faces will shift to the left which will lead to a fall in its profit. Potential

firms will stop entering the market when the firms in the market make only normal profit.

If the firms in a MC market are making subnormal profit, they will leave the market when

their fixed factor inputs need replacing. Those that cannot cover their total variable cost

will leave the market immediately. As the number of firms in the market decreases, each

firm will have a larger market share. In other words, the demand curve that each firm faces

will shift to the right which will lead to a fall in its loss. The exit of firms will stop when the

firms in the market start making normal profit.

4.5 Monopolistic competition and the public interest

Advantages

Due to intense competition in the market, MC firms are not lax in cost control. In other

words, they are not overstaffed, they do not lack the incentive to use the most efficient

production technology, etc. Therefore, MC firms are x-efficient and hence productively

efficient.

Due to intense competition and the absence of barriers to entry in a MC market, the price

charged by the firms in a MC market is lower than the price that would be charged by the

firm in the same market operating under monopoly, assuming the cost structure of a

monopoly is the same as that of a MC industry.

The distribution of income in an economy that abounds with MC markets will be more

equal than one that abounds with monopolistic markets because although MC firms can

make only normal profit in the long run, a monopoly can make supernormal profit in the

long run.

MC firms produce differentiated products which offer consumers a great variety of

choices.

Disadvantages

MC firms are allocatively inefficient because they charge a price higher than their marginal

cost. When the price of a good is higher than the marginal cost, the marginal benefit that

consumers place on the last unit of the good is greater than the marginal benefit that they



place on the amount of other goods that could have been produced using the same

resources. Therefore, if MC firms increase their output level, the total benefit for

consumers will increase and hence are allocatively inefficient. However, the problem of

allocative inefficiency in a MC market is less severe than that in a monopolistic market

because the price elasticity of demand for the good produced by a MC firm is higher than

that for the good produced by a monopoly.

A monopoly reaps more economies of scale than a MC industry and if this results in its MC

curve being substantially lower than the horizontal summation of the MC curves of the

firms in the same market operating under MC, it will produce a higher output level and

charge a lower price.

The price charged by the firms in a MC market is higher than the price that would be

charged by the firms in the same market operating under PC.

In the above diagram, the PC price (PPC) is lower than the MC price (PMC).

Due to lack of ability and willingness, MC firms do not engage in research and

development. Due to the absence of barriers to entry, any innovation, whether process or

product, can easily and quickly be copied by other firms. Further, research and

development very often requires huge expenditure outlays which MC firms are unable to

finance and this is partly because they small and partly because they make only normal

profit in the long run.

Since MC firms do not produce the output levels which correspond to the lowest points on

their AC curves, we say that they are producing with excess capacity (or producing under

capacity).

Due to intense price and non-price competition, MC firms may spend excessively on

advertising.



5 Oligopoly

5.1 Characteristics of oligopoly

A small number of large firms

In an oligopolistic market, there are a small number of large firms. Hence, the output level

of each firm in an oligopolistic market is large relative to the market output level.

Homogeneous or differentiated products

Although the firms in some oligopolistic markets sell homogeneous products (e.g. cement

and steel), the firms in most oligopolistic markets sell differentiated products (e.g. cars and

electrical appliances).

Oligopolists are price-setters

Due to its large market share, an oligopolist is a price-setter in the sense that it is able to set

its price by setting its output level. In other words, an oligopolist faces a downward-sloping

demand curve.

Barriers to entry

There are barriers to entry in an oligopolistic market, although they are often lower than the

barriers to entry in a monopolistic market. The presence of barriers to entry in an

oligopolistic market allows an oligopolist to make supernormal profit (TR TC) in the

long run.

Strategic interdependence (also known as mutual interdependence)

Due to the small number of large firms in an oligopolistic market, the actions of one firm

affect, and are affected by the actions of its rivals. Therefore, if a firm in an oligopolistic

market changes the price or the specification of its product, the sales of its rivals will be

affected. The rivals will then respond by changing the price and the specifications of their

product, which will affect the sales of the first firm. Therefore, no firm in an oligopolistic

market can ignore the actions and the reactions of the other firms in the market.

Note: Oligopoly is the dominant market structure for the production of goods. However,

for the provision of services, monopolistic competition is more prevalent.

5.2 Collusive versus competitive (non-collusive) behaviour

On the one hand, the interdependence of oligopolists gives them the incentive to collude

because they will be better off if they to jointly maximise profit. On the other hand, they are

tempted to compete with each other to gain a bigger market share. Therefore, oligopolists

may either collude or compete.

Collusive behaviour



If oligopolists collude, there will be price stability. Oligopolists can collude by banding

together to agree on a common price higher than the price that they currently charge and

this is commonly known as cartelisation. To avoid a surplus of the goods, they must also

agree on a set of output quotas and the most likely method is for them to divide the market

among themselves according to their current market shares.

There are certain factors that favour cartelisation. Cartelisation is more likely in a market

where there are only a few firms, the firms produce homogeneous products, the firms have

the same cost structure and there are high barriers to entry and therefore there is little fear

of disruption by potential firms.

In reality, cartelisation is illegal in many parts of the world due to competition policy

(known as anti-trust laws in the US), where any attempt to distort competition is prohibited.

Despite that, oligopolists can collude covertly and this is commonly known as tacit

collusion. Tacit collusion usually takes the form of price leadership where the followers

keep to the price set by the leader. The price leader may be the firm with the largest market

share (known as the dominant firm price leadership) or the firm which is believed to have

the most information about market conditions (known as the barometric firm price

leadership).

Competitive (Non-collusive) behaviour

At first thought, if oligopolists do not collude, price war will be inevitable. However, price

stability has been found to be an empirical regularity in most oligopolistic markets, even in

those where the firms do not collude. This phenomenon can be explained by the theory of

the kinked demand curve which is based on two asymmetrical assumptions.

First, if a firm in an oligopolistic market increases its price, its rivals will not follow suit

because by keeping their price the same, they can attract customers from the firm.

Accordingly, if a firm in an oligopolistic market increases its price, its quantity demanded

will decrease by a larger percentage as customers will switch from the firm to the rivals

which will lead to a fall in revenue for the firm.

Second, if a firm in an oligopolistic market reduces its price, its rivals will follow suit to

prevent losing customers to the firm. Accordingly, if a firm in an oligopolistic market

reduces its price, its quantity demanded will increase by a smaller percentage as customers

will not switch from the rivals to the firm, which will lead to a fall in revenue for the firm.

Therefore, oligopolists do not have the incentive to change their price, assuming no

substantial changes in the cost of production.

The theory of the kinked demand curve can be illustrated with a diagram. A firm in an

oligopolistic market faces a demand curve that is kinked at the current equilibrium, and the

kink on the demand curve leads to the gap on the MR curve.



Kinked demand curve

In the above diagram, since the current price and the current output level are P0 and Q0, the

MC curve must be cutting the MR curve at the gap. A small change in the cost of

production will lead to a shift in the MC curve but so long as the new MC curve lies

between MC’ and MC”, the price will remain unchanged and this explains price stability in

oligopolistic markets where the firms do not collude.

However, if there is a large change in the cost of production, the new MC curve will shift

out of the range between MC’ and MC” which will lead to a change in the price and the

output level. In this case, the firms may plunge into a price war before they reach a new

equilibrium. The new demand curve will be kinked at the new equilibrium.

One limitation of the theory is that it does not explain how the price is set in the first place.

Further, price stability could be due to other factors. For example, oligopolists may not

want to change price too frequently to prevent upsetting customers.

5.3 Non-price competition

Firms engage in non-price competition through product development and product

promotion. Product development will improve the quality and the features of the good and

product promotion will increase the awareness and the appeal. Successful product

development and product promotion will not only lead to an increase in the demand for the

good, but they will also make the demand less price elastic as consumers will perceive the

good to be more different from its substitutes. In other words, successful product

development and product promotion will shift the demand curve of the good to the right

and make it steeper.



5.4 Oligopoly and the public interest

If oligopolists collude, they will effectively be acting like a monopoly. In this instance, the

advantages and disadvantages to society experienced under monopoly will also be

experienced under oligopoly. However, oligopoly may be more disadvantageous than

monopoly in two respects.

First, an oligopolist is likely to be smaller than a monopoly. Therefore, it may reap less

economies and hence charge a higher price.

Second, an oligopolist is more likely to engage in excessive advertising than a monopoly.

Therefore, it is likely to produce at a higher average cost and hence charge a higher price.

If oligopolists compete, oligopoly may be more advantageous than a monopoly in two

respects.

First, unlike a monopoly may not be x-efficient and hence productively efficient due to

competition in the market, an oligopolist is x-efficient and hence productively efficient.

Second, unlike a monopoly which may not have the incentive to engage in research and

development due to lack of competition in the market, an oligopolist has the incentive to

engage in research and development due to competition in the market. Successful product

innovations will lead to greater product variety and successful process innovations will

lead to a lower average cost of production and hence a lower price.

Chapter 8-market-structure

Technology

market price

pc market

competitive market short

monopolistic market

pc firms

market forces of demand

competitive firm price

types of market structure