Economics - Market Structures

Market Structures Page | 1 Objectives of Firms

Marginal Revenue (MR)

Traditional theory

1.

MR = AR

Profit maximisation 1.

MC = MR

Alternative theories Managerial theories 1. 2. 3.

Managerial utility maximisation Sales revenue maximisation Growth maximisation

Behaviourial theories 1. 2.

A variety of goals, eg. production, sales, market share, profit Aim to achieve a satisfactory performance for each goal

Total Revenue (TR) 1.

Straight line from origin

Perfect markets 1. 2.

Firms are price takers No market power for firms

Imperfect markets 1. 2.

Firms are price setters Varying extent of market power of firms

Market structures differ in terms of 1. 2. 3. 4.

Nature of product Ease of entry Concentration of firms Competition between firms

Equilibrium Output Marginal approach

Equilibrium output for all market structures at MC = MR Profits Normal profit 1. 2. 3.

TR = TC Zero economic profit No incentive for firms to leave or new ones to enter

Supernormal profits 1. 2. 3.

TR > TC Firms earns more than opportunity costs Entry of firms will depend on ease of entry a. If barriers exist, profit level remains high b. If no entry barriers, profit level goes down to normal profit

1. 2.

MC = MR Since P = MR, P = MC. Firm is allocative efficient.

Total approach 1.

Point where vertical difference between TR and TC is the greatest

Subnormal profits 4. 5. 6.

TR < TC Firms makes less than opportunity cost Firms will cease production when a. Revenue < Variable Cost, firm leaves in short run b. Revenue > Variable Cost, firm continues in short run but leaves in long run

Perfect Competition Characteristics 1. 2. 3.

Homogeneous products No barriers to entry, hence a large number of small firms Firms have no market power, price takers

Short Run Profits Supernormal Profits

Revenue Curves Average Revenue (AR) 1. 2.

Same as demand curve of product Perfectly elastic http://education.helixated.com An Open Source Education Project

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New firms will enter → Industry’s supply increases → Price falls until normal profit Normal Profits

Evaluation of Perfection Competition Pros 1.

Allocative efficient, sum of consumer surplus and producer surplus is maximum

2. 3. 4.

Production at least cost output, minimum efficient scale Normal profit Ease of movement of resources

Subnormal Profits

Cons 1. 2. 3.

Social efficiency is not attainable without government intervention when externalities are present Little incentive to innovate Absence of product variety

Monopoly Firm’s objective shifts to loss minimisation. Long Run Profits 1. 2.

Normal profit Price = Minimum of AC (minimum efficient scale)

Characteristics 1. 2. 3. 4.

No close substitutes Strong barriers to entry Only firm Strong market power

Barriers to Entry 1.

2. 3.

Cost condition a. Highly capital-intensive b. Minimum efficient scale occurs at high output Legal barriers Contrived barriers a. Control of input supplies b. Brand loyalty

Revenue Curves

From supernormal profits to long run equilibrium, AR/MR moves down

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Different types of consumers (with different price elasticity of demand) charged differently Less elastic market charged higher

Two effects:

Equilibrium Supernormal profits due to: 1.

P > MC

2.

Price discrimination

3. 4.

Lower costs from economies of scale Incentive to innovate

1.

Absorption of consumer surplus by firm

2.

Allocatively efficient as in 1st degree

Pros 1. 2. 3.

Higher consumption level made possible Extra revenue is reinvested Enables firms to supply otherwise unprofitable goods

Evaluation of Monopoly Pros 1.

Cost advantage a. Economies of scale and R&D will lead to lower MC b. Price can be lower and output (MC = MR) can be higher than allocative efficient level of PC (P = MC)

2. 3.

Research and development Lower cost despite not producing at minimum efficient scale as MC is lower

c. Shaded area = Supernormal profits

Lower MC → Larger consumer surplus

Price Discrimination

Cons

A practice of firms charging different prices for the same products, unsupported by cost reasons

1. 2.

Allocatively inefficient Higher price, lower output a. Production at MC = MR and not P = MC b. Loss of consumer surplus

3.

Income inequality

Conditions Necessary 1. 2. 3.

Markets are separable Differing price elasticities of demand between markets Resale of product not possible

1st Degree Price Discrimination 1. 2. 3.

Different price for every customer No consumer surplus left Allocatively efficient (P = MC)

2nd Degree Price Discrimination 1.

Charging differently according to blocks of consumption

Theory of Contestable Markets 1. 2. 3.

Price, output and behaviour in an industry is determined by the threat of competition Monopolies forced to be more efficient and lower price to prevent new entrants Factors favouring contestability: a. Free trade policy b. Deregulation trend

Controlling Monopolies 3rd Degree Price Discrimination

1.

Regulation on pricing and output

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Transferring monopoly to government (nationalisation) Taxes Legislations and anti-trust policies

Monopolistic Competition Characteristics 1. 2. 3. 4.

Slightly differentiated products Entry of firms is relatively easy Many small firms Mild market power due to slight product differentiation

Revenue Curve 1.

Same as monopoly, with lower price elasticity

Short Run Profit 1.

Supernormal profits Monopolistic Competition leads to: 1. 2. 3.

Higher price Lower output Higher AC

Comparison Monopoly 1. 2.

2.

between

Monopolistic

Competition

and

Lack of R&D due to normal profits Monopolistic competition’s smaller scale leads to higher costs

Oligopoly

Normal profits

Characteristics 1. 2. 3. 4.

Differentiated products Restricted entry of new firms Few large firms a. Two firms - Duopoly Interdependence among firms

Alternative Theories of Oligopoly’s Price-Output Non-collusive 1. 3.

Price rigidity with kinked demand

a.

Subnormal profits a. AC above AR

b.

Long Run Profit

1.

Decrease in demand for firms → MR and AR shifts to the left and become more elastic Normal profits Output falls short of MES

Evaluation of Monopolistic Competition

1. 2. 3. 4.

Cartel Dominant firm price leadership Barometric firm price leadership ‘Rule of thumb’ pricing

➢

Collusion best when: I. Few firms II. Identical products III. Awareness of methods and common costs IV. No new competition

Pros 1.

Small margin of P > MC

2.

Economies of scale → lower LRAC, lower MC, higher output

3.

Product varieties

Evaluation of Oligopoly Pros

Cons 1. 2. 3.

Rise in price → others do not follow → revenue falls → demand is elastic

Collusive

Supernormal profits → entry of new firms

a.

2. 3.

Drop in price → others follow → revenue falls → demand is inelastic

1. 2.

Allocative inefficient (P > MC) Excess capacity between LR output ant MES output Lack of R&D

Comparison between Perfect Competition

Monopolistic

Competition

R&D Product differentiation

Cons and

1. 2. 3. 4.

Allocatively inefficient (P > MC) Wastage of resources Smaller scale of production compared to monopoly Firms may collude and behave as a monopoly

Non-Price Competition

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Product development and innovation Marketing