Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

MARKET STRUCTURES
The term market structure refers to all the features that may
affect the behaviour and performance of the firms in a market
(for example, the number of firms in the market or the type of
product they sell
...


Perfect Competition
 It provides an important benchmark for comparison with other
market structures
...
e
...

 Customers and sellers have perfect knowledge of the market
e
...
buyers know the nature of the product being sold and the
prices being charged by each firm
...


 There are many buyers and sellers such that each firm is a
prize taker
...

 There is freedom of entry and exit into the industry i
...
any new
firm is free to enter the industry and start producing while any
existing firm is free to cease production and leave production
...

 It is assumed that land, labour and capital can switch and
immediately from one line of production to another
...

 The means that the firm can sell all that it produces at the ruling
market price
...
If Q units are sold at a unit
price P, then TR = P
...

 Average Revenue (AR): This is the amount of revenue per unit
of output sold
...
It
is obtained by dividing total revenue by units sold i
...
AR =
TR/q
...

 This is the change in a firms’ total revenue resulting from a
change in its rate of sales by one unit
 Given by ∆TR =

∆q
 Revenue concepts for a Price Taking Firm:

Q
P
TR(Q
...

 N/B: For a firm operating under perfect competition price equals
marginal revenue
...

 In this case it will have an operating loss equal to its total fixed
cost
...

 Therefore it will be worthwhile for the firm to produce as long as
it can find some level of output for which revenue exceeds
variable cost
...

 How much should the firm produce?
 If a firm decides to produce, then it has to decide how much to
produce
...
e
...
e
...


 On the other hand, if any unit adds more to cost than it does to
revenue (i
...
MC>MR) then producing and selling that unit will
decrease profits i
...
the firm should contract production
...

 Thus assuming that it is worthwhile for the firm to produce, it
should produce output for which marginal revenue (MR) equals
marginal cost (MC) i
...
where MR = MC
...

 Both total revenue and total cost are functions of quantity
produced Q given as
...

 Thus = - = 0------ (2)
 But = MR and = MC --- (3)
 Thus profit maximization requires that MC = MR
...

 Under perfect competition, MR will be constant and equal to
price of the product (P)
...


 Sufficient condition (for profit maximization) to ensure that the
value for the profit function is a maximum (rather than
minimum), we require that the second derivative be negative
written as
 - i
...
the slope of MC curve should be greater than the N
...

that is the slope of the MR curve while is the slope of MC
curve (that is to say that MC should cut MR from below)
...

 The firm is a price taker and has to accept the ruling price as
given and thus faces a perfectly elastic demand curve
...

 The profit maximizing level of output is oq1
...

 The average cost (ATC) at output level Q1 is Q1 B
...

 At the equilibrium level of output, the total revenue is
represented by the area oP1AQ
...
e
...

 The same equilibrium of the firm can be shown using total cost
curve and revenue curves
...

 At each output, the vertical distance between the TR and TC
curves shows by how much total revenue exceeds or falls short
of total cost
...

 The output is the same as the previous one Q1
...

 The diagram below shows, the firm making losses
...

 Because price is below average total cost, the firm is suffering
losses (i
...
the firm will not replace its capital as it wears out)
shown by the shaded area
...


A Firm making Normal Profits

 In the above diagram, price is P2 and at this price, the firm is
just covering its total cost
...

 The firm is breaking even
...

 In the short-run there are three possibilities: firms may be
making profits, suffering, losses or just breaking even
...

 Thus there will be no incentive for such firms to leave the
industry
...

 The effect of new entrants on the supply curve is to shift the
supply curve to the right and lower the equilibrium price
...

 The effect of firms exiting the industry will shift the supply curve
to the left and raise the equilibrium price for the remaining firms
...


 In the above diagram, the equilibrium price is P1 and output
Q1
...

 Price equals both marginal cost and average costs
...

 At each output, the vertical distance between the TR and TC
curves shows by how much total revenue exceeds or falls short
of total cost
...

 The output is the same as the previous one Q1
...

 Normal profit
 Normal profit is earned when total revenues equal the total
opportunity costs of all input resources
...


 If actual economic profit were below normal profit (i
...
a loss in
economic terms) the firm would the industry and move
elsewhere
...
e
...

 These excess profits are called supernormal profit or monopoly
profits
...

 In competitive industry supernormal profits therefore tend to be
temporary, because they will be eroded by competition
...

 Monopolists can make supernormal profit by constructing entry
barriers, which prevent or deter rival firms from entering the
market as competitors
...

 By adjusting the quantity it produces, in response to the current
market price, the firm determines the market supply
...

 The above diagram shows a firm’s marginal cost curve and
alternative prices
...

 The marginal cost curve gives the marginal cost corresponding
to each level of output
...

 For prices below average variable cost, the firm will supply zero
units
...


 Thus in perfect competition, the firm’s supply curve is its
marginal cost curve for those levels of output for which marginal
cost is above average variable cost
...

 The Industry Supply Curve
 In perfect competition, the industry supply curve is the
horizontal sum of the marginal cost curves (above the level of
average variable cost) of all firms’ in the industry
...

 Together they would supply (Q1 + Q2) units
...


Monopoly
 A monopoly occurs when the output of an entire industry is
produced and sold by a single firm called a monopolist
...

 Because a monopoly firm is the sole producer of the product
that it sells, its demand curve is identical with the market
demand curve for the product
...

 This means that it faces a trade off between the price it
charges and the quantity it sells
...


 Average and Marginal Revenue
 When the monopolist charges the same price for all the units
sold the average revenue per unit is identical with price
...

 Marginal Revenue Curve
 Because the monopolist demand curve is negatively sloped it
must lower the price that it charges on all units in order to sell
an extra unit
...


Short Run Equilibrium of the Monopolist
 The monopolist maximizes its profits by producing where
marginal cost equals marginal revenue
...

 At this output, the price of Po is charged
...

 The total profits are profits per unit of Po – Co multiplied by the
output of Qo
...

 If AR is less than AC at any output, the monopolist can
minimize cost in the short-run
...

 TR = OP x Q while TC = Oc x Q
...

 Suppose the AR function shifts downward such that the firm’s
AR < AVC, so that at all output levels, its TR will be less than its
TVC
...


 Sources of Monopoly Power
 The following are some sources of monopoly power:
 Exclusive ownership and control of factor inputs e
...
raw
materials
...

 Unless new supplies of the resource are discovered, there will
be no possibility of new forms entering the industry
...
A monopoly may result from the holding of a
patent on an invention or innovation
...

 A copyright restricts the reproduction of printed or recorded
material in a similar way
...
In some cases the state creates a monopoly
by law e
...
Kenya Railways Corporation
...


 High Entry Costs
...

 This may mean that a new competitor probably producing a low
volume of output would be faced with higher per unit cost
production and so would be unable to compete effectively in the
market
...


Discriminating Monopoly
Price discrimination is a situation in which a supplier charges different
prices to different consumers for the same or similar product
...


There are different degrees of price discrimination namely 1st, 2nd and
3rd degree of price discrimination
...


Where the markets are not effectively separated, consumers in the
lower price market will be reselling the commodity in the higher price
market
...


Separation need not necessarily be geographical but any device that
makes arbitrage impossible separation could be by time, or by nature
of the product
...
e
...

 Supply must be in the hands of a monopolist
...

The amount of output to sell in each of the markets
...

Summary
Monopolist has a downward sloping demand curve;
MR is below AR
Equilibrium output is where MR = MC;
Equilibrium price is found from the demand curve,
Supernormal profits can persist in the long run















Monopolistic Competition
Characteristics
This is a combination of monopoly and perfect competition
...
There are
so many firms that each one ignores the possible reactions
of its many competitors when it makes its own price and
output decisions
...
g
...
g
...

There is free entry into and exit out of the industry
...

Each firm aims at maximizing profits both in the short run
and in the long run
...

 But the curve is rather elastic because similar products sold by
other firms provide many close substitutes
...

 The Firm making Losses
 Losses arise when costs rise or when demand falls
...

 In this case the firm’s ATC curve lies above the demand curve
...

 For as long as price = AR is above its AVC, the firm minimizes
its losses
...

 Total revenue is OP x OQ, while total cost is OC x OQ
...


 By producing OQ and charging OP, the firm is at least able to
cover all the variable costs and part of its fixed costs
...

 If existing firms in the industry are earning profits, new firms will
enter
...

 If existing firms are making losses in the industry in the short
run, they will quit the industry in the long run
...

 The long run equilibrium position of a firm in monopolistic
competition is achieved when the demand curve facing the firm
is tangential to the long run average cost curve
...

 Since AR equals AC the firm earns only normal profit in the
long run
...

 Non-price competition refers to strategies adopted by
producers to give their products a competitive advantage other
than a price cut
...

 Altering the physical make up of the product (design)
...
g
...


Oligopoly
 Oligopoly is a market in which there are only few sellers
...

 Considerable barriers to entry;
 Prices are normally very sticky or slow to change;
 Firms are prone to collusion
...

 The market is dominated by few large firms
...
g
...

 ii) Differentiated oligopolies produce differentiated products
...


 The Kinked Demand Model
 Each firm in an oligopoly must speculate on the reactions of its
competitors;
 How any particular firm in the industry will respond to changing
market conditions is never known precisely in advance
...

 The kinked demand model is shown below:
 At the prevailing market price Po the firm is producing OQo
units of output
...

 Since the firm sells differentiated product it can raise its price
above Po without losing all its sales, but if the other firms in the
industry hold their prices at Po, its sales will decline rapidly
...

 But if the firm reduces its price, its competitors would probably
follow suit and match the price reduction hence all the firms will

 The firm’s perceived demand curve after a price reduction will
therefore be relatively price inelastic
...

 The line BC gives the marginal revenue (MR) curve that
corresponds to the portion BA of the demand curve
...

 A profit maximizing oligopoly firm will produce at the level of
output where MC = MR
...

 Even if the MC curve shifts up or down between points C and E
on the MR, the firm will have no incentive to change its price or
output
...

 Non-price competition refers to strategies adopted by firms to
give their products a competitive advantage other than a price
cut
...

 They do so in an attempt both to shift the demand curves for
the industry’s products and to attract customers from competing
firms
...

 Firm can also undertake other kinds of sales promotion activity
such as free gifts, special features to the products, free delivery
and after sales services etc
...

 The most common is the third degree discrimination
...

 Consider the profit maximizing outputs and prices of a
discriminating monopolist
...

 This is then allocated to the two markets such that MRA =
MRB
...

 Thus OQA is sold in market A at price OPA and OQB is sold in
market B at a price of OPB
...


Monopolistic Competition
•
•
•

•
–
–
–
–
•
•
•

Characteristics
This is a combination of monopoly and perfect competition
...
There are
so many firms that each one ignores the possible reactions
of its many competitors when it makes its own price and
output decisions
...
g
...
g
...

There is free entry into and exit out of the industry
...

Each firm aims at maximizing profits both in the short run
and in the long run
...

But the curve is rather elastic because similar products sold by
other firms provide many close substitutes
...

• The Firm making Losses
• Losses arise when costs rise or when demand falls
...
In this case
the firm’s ATC curve lies above the demand curve
...

• For as long as price = AR is above its AVC, the firm minimizes
its losses
...
Total revenue is OP x OQ, while total cost is
OC x OQ
...
But
although price is less than AVC the firm will continue producing
because if it stops producing it will incur greater losses (the
whole of fixed costs)
...


Long Run Equilibrium

• Freedom of entry and exit forces profits to zero in the long run
...
Their entry will mean that the demand for the product mus
be shared among firms and hence each firm’s demand curve will
shift to the left until zero profits are earned
...
As they quit the market
share of the remaining firms will increase and they will continue
to quit until all the losses are eliminated
...
Equating
MR with MC, the firm produces quantity OQ1 and sells at price
OP1
...


• Non Price Competition
• Under monopolistic competition firms may try to retain or
increase its above normal profits by engaging in some
form of non-price competition
...

• This might include advertising further expenditure on
packaging to make the good appear more attractive to
customers
...

In an oligopoly, there is mutual interdependence
between all firms in the industry
...
g
...


The Kinked Demand Model
• 42In an oligopoly each firm must speculate on the reactions of
its competitors, hence how any particular firm in the industry will
respond to changing market conditions is never known
precisely in advance
...

• The kinked demand model facing the oligopolies is shown
below:
• At the prevailing market price Po the firm is producing OQo
units of output
...

• The kink in the demand curve represents the assumed reaction
of competing firms to a change in the firm’s price
...


• Above Po, the firms perceived demand curve would be
relatively price elastic
...

• The firm’s perceived demand curve after a price reduction will
therefore be relatively price inelastic
...

• The line BC gives the marginal revenue (MR) curve that
corresponds to the portion BA of the demand curve
...
e
...

• A profit maximizing oligopoly firm will produce at the level of
output where MC = MR
...
Even if the MC curve shifts up or down between
points C and E on the MR, the firm will have no incentive to
change its price or output
...

• Non-price competition refers to strategies adopted by firms to
give their products a competitive advantage other than a price
cut
...

They do so in an attempt both to shift the demand curves for
the industry’s products and to attract customers from competing
firms
...

• Firm can also undertake other kinds of sales promotion activity
such as free gifts, special features to the products, free delivery
and after sales services etc
...
of firms

Freedom of
entry

Nature of
product

Examples

Perfect
competition

Very many

Unrestricted

Homogeneous Approx

---