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ECONOMICS
MICROECONOMICS PART 1
TOPIC:MARKET STRUCTURE

&
DIFFERENT OBJECTIVES
OF FIRM

A-LEVEL

MARKET STRUCTURE
The term market structure describes the way in which goods and services are
supplied by firms in a particular market or industry
...

There are different types of market structure and the criteria used for the
classification are:
•
•
•
•

Number of firms
Concentration ratio
Number of customers
Importance of economies of scale

The different market structures are:
1
...

3
...


Perfect competition
Monopolistic competition
Oligopoly market
Monopoly market

DEGREE OF COMPETITION
100%
PERFECT
COMPETITION

0%
MONOPOLISTIC
COMPETITION

OLIGOPOLY

DUOPOLY

MONOPOLY

PERFECT COMPETITION
It is a model that has been constructed in order to show the best allocation of
resources
...
on the other hand,there is
large numbers of buyers which gives information about total qty
demanded
...
An individual firm is a price taker and will sell any
quantity at the decided price
...
While producers are aware
about the techniques of production
• Homogeneous goods
• There is no barriers to entry and exit
...
The condition necessary for equilibrium is MC=MR,and MC must
be rising

SHORT RUN EQUILIBRIUM:In the short run,the firm can have abnormal
profit or abnormal loss
...
The firm is a price taker, and it accepts the industry price of P
...
The Blue shaded rectangle shows
the area of supernormal profits earned in the short run
...
The firm is a price taker, and it accepts the industry price of P
...
The Blue shaded rectangle shows
the area of abnormal loss made in the short run
...


The diagram below shows the long run equilibrium for a perfectly competitive
market
...
Since there are no barriers to entry in a
perfectly competitive market, new firms are able to enter the industry
...
The price level in the market falls as a consequence
...
In the long run,
competitive pressure ensures equilibrium is established
...
The new equilibrium at P=MC means firms produce at the new
output of Q2 in the long run

The diagram below shows the long run equilibrium for a perfectly competitive
market
...
Since there are no barriers to exit in a perfectly
competitive market, firms are able to leave the industry
...
The price level in the market rises as a consequence
...
In the long run, competitive
pressure ensures equilibrium is established
...
The new
equilibrium at P=MC means firms produce at the new output of Q1 in the long
run

In the long run a firm in a perfectly competitive market will be make normal pr

The firms produce at q which is the profit maximising level of output
...

P =MC, so there is allocative
efficiency
...

Since firms are small, there are few
or no economies of scale

The supernormal profits produced in
the short run might increase
dynamic efficiency through
investment
...
In reality, branding,
product differentiation, adverts and
positive and negative externalities,
mean that competition is imperfect

THE SHUTDOWN CONDITION:

When a firm is making abnormal loss, the decision to closedown depends on
the time period in the short run, the average variable cost(avc) is significant
...
Thus the firm has to obtain a price
which is at least equal to AVC in order to stay in the business in the short run
...


The firm must close down in the short run if AVC>price

IN the long run, all the cost are variable and the must be covered if the firm
stays in the business
...


The above diagram shows the short run decision to close down as AVC>PRICE

In the above diagram, Here output is OQ*, where MC = MR
...
The fixed costs are given by the area
ABCD
...
It will therefore be worth remaining in the business at least in
the short run
...


MONOPOLY(IMPERFECT MRKT)
It exists when there is only one seller or one supplier in the industry
...
It is at the
complete opposite end of the spectrum to perfect competition
...
For example, Google dominates the
search engine market, with 90% share
...
If two large
firms in an oligopoly (several large sellers) have greater than 25% market
share, they are said to have monopoly power
...

There are very few examples of pure monopolies, but several firms have
monopoly power
...


CHARACTERISTICS OF MONOPOLY:
• Sole seller in a market (a pure monopoly)
• There is imperfect knowledge in the market
...

• Goods are not homogeneous and they do not have close substitutes
...
The main forms of
barriers to entry are:
1
...
this is referred as a legal monopoly created in order to
achieve social and political objectives
2
...
Advertising and brand names with a high degree of consumer loyalty
may be a difficult obstacle for new firms to overcome
...
In industries where huge amount of sunk cost is involved, new firms will
not be interested to join
...

5
...
Entry limit pricing; It means setting low price deliberately in order to
discourage new firms
7
...
in other words
demand curve is downward sloping
...
This is at the point MC = MR, so the monopolist
produces an output of Q at a price of P
...


• Since the firm is the sole supplier in the market, the firm’s cost and
revenue curve is the same as the industry’s cost and revenue curve
...
P>MC in the diagram, due to
profit maximisation which occurs at MC = MR, so there is allocative
inefficiency in a monopoly
...


Monopolies can earn significant
supernormal profits, so they might
invest more in research and
development
...
There
could be more invention and
innovation as a result
...
This is
more likely to happen in a market
where there are high barriers to
entry, such as in a monopoly
Monopolies could exploit the consumer If there is a natural monopoly, it
by charging them higher prices
...
This loss of allocative efficiency is a the same infrastructure might be
form of market failure
...
For example, it might be
considered inefficient and wasteful
to have two lots of water suppliers
...
For example, Microsoft
have few or no competitors, so
generates a lot of export revenue
production costs are high
...


There is a loss of consumer surplus and
a gain of producer surplus
...

This leads to gains in producer surplus
...
The long run average
cost curve can be used to show this:

Consumers do not get as much choice
in a monopoly as they do in a
competitive market
...
MC is the combined
marginal cost curve of all the firms in the perfectly competitive
industry
...
Equilibrium occurs where
demand equals supply, and therefore in perfect competition
OPc would be the equilibrium price and OQc the equilibrium
output of the industry
...

However, if monopolisation of a perfectly competitive industry
leads to the reaping of economies of scale, as may well be
the case when several small producers are replaced by one
large producer, then lower prices and a greater output might
result - the opposite of what we originally predicted
...

In the diagram, the gaining of economies of scale is indicated
by a downward shift of the marginal cost curve from MC to
MC1, and where MC1 intersects with the marginal revenue
curve a new and greater equilibrium output is obtained at OQ1,
with a price of OP1, which is lower than the perfectly
competitive price of OPc
...
producer
will also benefit from higher sales(abnormal profit)
...


NATURAL MONOPOLY:
Natural monopoly (or a decreasing cost monopoly) occurs when a single firm
can supply a good or service to an entire market at lower cost than could two
or more firms
...
As natural monopoly exhibits decreasing long run average cost (LRAC),
the long run marginal cost (LRMC) curve is always below the LRAC
...
Monopolies have the market power to set the price of a good
higher (P>MC) than in the competitive markets (P=MC)
...
Excess pricing results in
allocative inefficiency and a decline in consumer welfare
...
This will help reduce the deadweight loss and increase
consumer welfare
...


The above diagram shows the LRAC and LRMC curves of a natural monopoly
...
profits will be given by rectangle PAABC
...
However, at the regulated price PG, the
monopoly firm is incurring a loss of DFEPG
...


Instead of forcing the monopolist to follow marginal cost pricing, the regulating
authority must try and implement multi price system
...
By following such
a system, the customers who pay the high price are subsidizing the losses that
the monopoly firm incurs by selling its commodity at a low price
...
The profit from the sale of
a good too high price customers will be P1ACB
...
At P2, the quantity
demanded is Q2
...
Under this system, the profit from high price customers
balances the losses incurred from low price customers
...
Govt may require some nationalized
businesses to set a price which is equal to AC
...


MONOPOLY SHUTDOWN CONDITION:

A monopoly is presumed to produce the quantity of output that minimizes
economic loss, if price is greater than average variable cost but less than
average total cost
...
The other two are profit maximization (if price exceeds average total
cost) and loss minimization (if price is greater than average variable cost but
less than average total cost)
...
The key to this shutdown
production decision is a comparison of the loss incurred from producing with
the loss incurred from not producing
...

One of Three Alternatives
Shutting down is one of three short-run production alternatives facing a
monopoly
...
The other two are
profit maximization and loss minimization
...
In this case,
the firm generates an economic profit
...
In this case, the firm incurs a smaller loss by
producing some output than by not producing any output

PRICE DISCRIMINATION UNDER
MONOPOLY:
Price discrimination refers to the practice whereby the same commodity is
held at different prices to different customers for reasons not associated to
differences in the cost of production
...
it is the practice whereby different people are made
to pay different prices for the same good
...
G; bus fare, stadium ticket
and doctor fee
• Time discrimination; It is a practice whereby the same good is provided
to different people as different prices at different time periods :e
...
e
...

• Place discrimination; here the same product is given to different people
at different prices in different regions
...
g dumping i
...
selling at a lower
price in a foreign market and at a higher price in the local market

Monopolies can be classified into several degrees depending upon the degree
on that they practice
...
In other words, the price to
be charged to the customers is based upon his purchasing
power
...
the diagram below shows 1st degree price discrimination;
PRICE

P1

P2

D

P3

QTY
Q1

Q2

Q3

In the diagram,each person is charged a different price
...
In this way, the monopolist being a
profit maximizer will max his gains and their consumer will get the good they
want at the price that they can afford to pay
...
G travelling by train is charged at different prices
...
Here
we categorize the group of people based on the purchasing power

PRICE

P1

P2
P3

D
QTY
Q1

Q2

Q3

ACCORDING to the diagram ,each consumer consumes as per his purchasing
power
...


3RD DEGREE PRICE DISCRIMINATION;
Here, Different markets are involved for E
...
the good is held at a
higher price in the local than in the foreign market

CONDITIONS FOR PRICE DISCRIMINATION:
MARKET IMPERFECTION: price discrimination cannot exist in the perfect
market for price discrimination to prevail, the market must be imperfect so
that different prices can be charged
...
Thus to practice the several
degree price discrimination ,consumer surplus should exist
CUSTOMER CLASSIFICATION: In order to charge different groups different
prices, the monopolist should be able to identify and classify his customers
MARKET SEGREGATION: for price discrimination to exist ,markets should be
separated by strong barriers
...
Segregation
can be through physical barriers ,transportation etc
...
It should be noted that
a discriminating monopolist operates in more than one market
...

Let us assume that there are two markets A and B
...
The MC curve
of the producer for both markets will thus be equal to

MC=ΣMR
=MRA + MRB
This determines how much to produce
...
The market having an inelastic demand will bear an increased in
price whereas that having elastic demand will know a fall in price
...


Costs
Consumers

Usually, price
discrimination results in
a loss of consumer
surplus
...


Benefits

Consumers could
benefit from a net
welfare gain as a result
of cross subsidisation, if
they receive a lower
price
...
For example,
consumers
...

This can yield positive
externalities

Producers

If it is used as a
predatory pricing
method, the firm could
face investigation by the
Competition and
Markets Authority
...

The higher supernormal
profits, which result
from price
discrimination, could
help stimulate
investment
...

This will limit or prevent
job losses, which might
result from the closure
of the loss-making
market
...
It describes on industry which
each firm can influence market share to some extent by changing its price

relative to its competitors
...


Characteristics of monopolistically competitive markets:
• There are no barriers to entry to and exit from the market

• Firms sell non-homogeneous products due to branding (there is product
differentiation)
...

This makes the XED of the goods and services sold high
...

Each seller has the same degree of market power as other sellers, but
their market power is relatively weak
• Since firms have a downward sloping demand curve, they can raise their
price without losing all of their customers
...
Firms
are short run profit maximisers
...

• Therefore, it can be seen that as p>MC, there is absence of allocative
efficiency in the monopolistic market
...
the diagrams below shows the equilibrium
situation of a firm making supernormal profit and sub normal loss
...
Firms
usually enter the market when AR>AC ,In doing this ,the supernormal profit of
the market gets vanished
...
similarly, when firms make losses, they
will leave the market
...
Thus the loss will also fade in the long run
...
Only normal profit
should exist at the equilibrium point in a monopolistic competition
...


POINT T AND S represents unused capacity/excess/wastage
...
this also
indicates that there is no productive efficiency

ADVANTAGES
Firms are allocatively inefficient in
the short and long run (P > MC)

DISADVANTAGES
In the long run, dynamic efficiency
might be limited due to the lack of
supernormal profits
...
This makes firms
productively inefficient (also note:
the firm does not operate at the
bottom of the AC curve)
...
In a
monopolistically competitive market,
firms have x-inefficiency, since they
have little incentive to minimise their
costs
...

The model of monopolistic
competition is more realistic than
perfect competition
...


OLIGOPOLY MARKET:
It refers to a situation where there are few large suppliers of homogenous or
differentiated product
...
G in Mauritius, soft drinks industry, gas industry,
petroleum industry
...
Collusive oligopoly: This is formed when producers group
together to charge a common price
...
g
...

2
...


OPEN OLIGOPOLY: Here there exist no barriers to entry
CLOSE OLIGOPOLY: In this case, govt decides whether or not to
allow a firm to enter a market
...


PURE OLIGOPOLY: Here, goods are perfect substitutes (no
product differentiation)FOR e
...
; petroleum industry

5
...


Characteristics of an oligopoly:
•

High barriers to entry and exit There are high barriers of entry to and
exit from an oligopoly
...
High concentration ratio

•

In an oligopoly, only a few firms supply the majority of the market
...
The high
concentration ratio makes the market less competitive
...

This means that the actions of one firm affect another firm’s behaviour
...
The degree of product differentiation can change
how far the market is an oligopoly

• Price rigidity: Oligopolist prefer to use non-price competition, rather
than compete by changing prices

EQUILIBRIUM OF OLIGOPOLY:
Firms can follow different pricing policies:
1
...
COLLUSIVE PRICING STRATEGY MODEL
3
...
However, when firm decreases its price, other firms will do the
same(interdependence) and demand will be inelastic
...
The oligopolist firm will charge price where MC=MR in
order to maximise profit
...


PT BC:DISCONTINUITY GAP
ELASTIC: If price rises more than p other firms will not follow suit
INELASTIC: If price decreases lower than p, other firms will follow suit QTY will
not change
NOTE: Wherever the MC is between the discontinuity gap(BC), Price will
remain at P
...
G OPEC

• Collusion leads to a lower consumer surplus, higher prices and greater
profits for the firms colluding
...


• Firms in an oligopoly have a strong incentive to collude
...
This deters new entrants
and is anti-competitive
...
Moreover, there
should be consumer inertia
...


• Collusion can be overt or tacit
...
It works best when there are only a
few dominant firms, so one does not refuse
...
For example, it is often suspected that fuel
companies partake in overt collusion
...


• Tacit collusion occurs when there is no formal agreement, but collusion
is implied
...
Price wars are harmful to supermarkets and
their suppliers
...
Collusion is usually with
poor intentions, whilst cooperation will be beneficial
...
Cooperation might refer to how a firm is
organised and how production is managed
...
The profit maximising condition is MC=MR
and q1 is the total amount that industry will sell at price p
...
Here is a diagram below
...

A formal agreement for price/output is a CARTEL
...
e
...
The criteria for collusion of any kind to
work successfully are:
•
•
•
•
•
•
•

Small number of firms
No govt intervention
Similar cost structure
A leader
Stable market conditions
Barriers to entry
Possible to store good

It is however beneficial for members to cheat on the agreement and make
bigger profit
...


ABNORMAL PROFIT: pdef
GAIN: adeg
LOSS: fgbc
NET GAIN: adeg-pdef
The CARTEL tends to break down as there is an incentive to cheat
...


PRICE LEADERSHIP
Price leadership is a common feature of oligopolistic markets
...
They then alter their own
prices in line with those of leader
...
A good example in many countries is
petroleum retailing where the market leader is a well known MNC
...
It is the same when a price fall is
announced; smaller rivals are forced to follow the fall in price to retain market
share
...

FIGURE 1;shows a simple representation of price leadership
...
DD is their demand curve
...
It maximises profits at point A where
MC=MR
...
It is
therefore compelled to lower its price to PA with lower profits due to its higher
costs of production
...
It is used to predict the outcome of a decision
made by one firm, when it has incomplete information about the other firm
...

The consequences of the choice depend on what the other prisoner choose

Prisoner A

Confess
Deny

Confess
5 years, 5 years
10 years, 1 year

Prisoner B
Deny
1 year, 10 years
2 years, 2 years

• The two prisoners are not allowed to communicate, but they can
consider what the other prisoner is likely to choose
...


•

The dominant strategy is the option which is best, regardless of what
the other person chooses
...
It
is the most likely outcome
...
If collusion is allowed in this dilemma, then both
prisoners would deny
...


•

A Nash equilibrium is a concept in game theory which describes the
optimal strategy for all players, whilst taking into account what
opponents have chosen
...


• However, even if both prisoners agree to deny, each one has an
incentive to cheat and therefore confess, since this could reduce their
potential sentence from 2 years to 1 year
...


• It essentially sums up the interdependence between firms when making
decisions in an oligopoly
...


If firms collude, there is a loss of
consumer welfare, since prices are
raised and output is reduced
...
The absence of competition
means efficiency falls
...


Advantages
Oligopolies can earn significant
supernormal profits, so they might
invest more in research and
development
...
There could be more invention
and innovation as a result
...
This is
more likely to happen in a market
where there are high barriers to entry
Higher profits could be a source of
government revenue
...

This is especially true in the
pharmaceutical industry and for car
safety technology
...
It saves on duplicate
research and development
...
The long run average cost
curve can be used to show this:

Contestable markets and their implication Characteristics of
contestable markets:
• Contestable markets face actual and potential competition
...


• There are no significant entry or exit barriers to the industry
...


•

There is low consumer loyalty
...


Implications of contestable markets for the behaviour of firms:

•

If markets are contestable, firms are more likely to be allocatively
efficient
...
This makes them productively efficient
...
Due to the low barriers to entry which provide easy access
to the market, firms are wary of new entrants entering the market,
taking supernormal profits, and then leaving
...


•

Markets which are highly contestable are akin to a perfectly competitive
market
...


• There could be supernormal profits in the short run and only normal
profits in the long run
...
However, in practice, firms can
only earn normal profits in the short run
...
Without supernormal profits,
there is no incentive for new firms to enter, even if barriers to entry and
exit are low
...
Models that consider the
traditional theory of the firm are based upon the assumption that firms
aim to maximise profits
...

• Profit is the difference between total revenue and total cost
...


• Firms break even when TR = TC
...
A firm profit maximises when
they are operating at the price and output which derives the greatest
profit
...
In other words, each extra unit produced gives no extra
loss or no extra revenue
...


• Profits decrease when MC > MR
...


•

Some firms might profit maximise in the long run since consumers do
not like rapid price changes in the short run, so this will provide a stable
price and output
...
They are more
likely to have short run profit maximisation as an objective, because they
need to keep their shareholders happy
...
It covers the opportunity cost
of investing funds into the firm and not elsewhere
...
Normal profit is considered to be a cost,
so it is included in the costs of production
...
This exceeds the value
of opportunity cost of investing funds into the firm
...


• PED and total revenue:
• Total revenue is equal to average price times quantity sold
...
This will increase total revenue
...
This will reduce total revenue
...
This is a short term
view
...
Firms might aim to
sell as much as possible to keep their market position, even if it is at a
loss in the short run
...
This
could be to take advantage of economies of scale, such as risk-bearing or
technological
...
Firms might grow by expanding their
product range or by merging or taking over existing firms
...


•

Increasing their market share: This helps increase the chance of
surviving in the market, and it can be achieved by maximising sales
...
They did this at a
loss in the short run, but they gained customer loyalty and now they are
a leading e-reader producer
...
Firms might consider improving their customer service or
the quality of the good they produce
...
If firms can gain a reputation for high quality goods, they
could potentially charge higher prices, since consumers might be willing
to pay more for them
...
In other words, each extra unit sold generates no extra revenue
...
Not-for-profit organisations
might work at this output and price
...

An example of sales maximising is Amazon’s Kindle launch
...
It helps keep out and deter competitors
...


The satisficing principle:
• Another objective a firm might have is satisficing
...


• Shareholders want profits since they earn dividends from them
...
Therefore, managers
might choose to earn enough profits to keep shareholders happy, whist
still meeting their other objectives
...


The reasons for and the consequences of a divorce of ownership
from control:
• The principal-agent problem can be linked to the theory of asymmetric
information
...
For example, shareholders and managers have different
objectives which might conflict
...
Principle agent problem usually occurs in oligopoly
and monopoly markets
...
This could result in conflicting objectives between
different stakeholders in the firm
...
However,
they also need to keep shareholders happy, since they are an important
source of investment
...


• When a manager sells their shares, shareholders gain more control over
the decisions of the firm
...

This could be to put pressure on the management of the firm or to try
and get higher dividends
...
3 billion bonus in 2004
...
In the short run, it leads to them making losses
...
They price their goods and services below their average
costs
...


•

Limit pricing discourages the entry of other firms
...
Potential firms are therefore unable to compete with
existing firms
...
Their
competitors then lower their prices to match
...


•

Non-price competition aims to increase the loyalty to a brand, which
makes demand for a good more price inelastic
...
They might keep their shops open for longer, so
consumers can visit when it is convenient
...




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