Types of market structure

The lecture provides answers for the following questions: 1. What is meant by a competitive firm? 2. Draw the cost curves for a typical firm. For a given price, explain how the firm chooses the level of output that maximizes profit. 3. Under what conditions will a firm shut down temporarily? Explain. 4. Under what conditions will a firm exit a market? Explain. 5. Does a firm’s price equal marginal cost in the short run, in the long run, or both? Explain. 6. Does a firm’s price equal the minimum of average total cost in the short run, in the long run, or both? Explain.

TYPES OF MARKET STRUCTURE

Economists who study industrial organization divide markets into four types:

 Monopoly

 Oligopoly

 Monopolistic competition

 Perfect competition

1 PERFECT COMPETITION

1.1 Characteristics

A competitive market, sometimes called a perfectly competitive market, has two

characteristics:

 There are many buyers and many sellers in the market

 The goods offered by the various sellers are largely the same

 Firms can freely enter or exit the market

Buyers and sellers in competitive markets must accept the price the market

determines and, therefore, are said to be pricetakers.

1.2 Revenues of a competitive firm

Average revenue: total revenue divided by the quantity sold  For all firms, average revenue equals the price of the good

Marginal revenue: the change in total revenue from an additional unit sold  For

competitive firms, marginal revenue equals the price of the good

<???> When a competitive firm doubles the amount it sells, what happens to the price of

its output and its total revenue?

1.3 Profit maximization

The goal of a competitive firm is to maximize profit, which equals total revenue minus total cost We are now ready to examine how the firm maximizes profit and how that decision leads to its supply curve

- Example:

- Marginal cost curve and firm’s supply decision

The marginal-cost curve (MC) is upward sloping.

The average-total-cost curve (ATC) is U-shaped

The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost

At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal.

This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and

the average variable-cost curve (AVC) It also shows the market price (P), which equals marginal revenue (MR) and average revenue (AR)

At the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising

production increases profit At the quantity Q2, marginal cost MC2 is above marginal revenue MR2, so reducing production increases profit The profit-maximizing quantity

QMAX is found where the horizontal price line intersects the marginal-cost curve.

1.4 Supply curve

An increase in the price from P1 to P2 leads to an increase in the firm’s profit-maximizing quantity from Q1 to Q2 Because the marginal-cost curve shows the quantity supplied by the firm at any given price, it is the firm’s supply curve

1.5 The firm’s short-run decision to shut down

A shutdown refers to a short-run decision not to produce anything during a specific period

of time because of current market conditions  The firm shuts down if the revenue that

it would get from producing is less than its variable costs of production

Shut down if TR < VC or TR/Q < VC/Q or P < AVC.

Exit refers to a long-run decision to leave the market The short-run and long-run

decisions differ because most firms cannot avoid their fixed costs in the short run but can

do so in the long run  The firm exits the market if the revenue it would get from

producing is less than its total costs

Exit if TR < TC or TR/Q < TC/Q or P < ATC.

Enter if P > ATC

1.6 Profit and loss

Profit = TR – TC = (TR/Q - TC/Q) x Q = (P - ATC) x Q

2 MONOPOLY

2.1 Characteristics

- Only one firm in the market

- The firm is a price maker

2.2 Barrier to entry

- A key resource is owned by a single firm

- The government gives a single firm the exclusive right to produce some good or service

- The costs of production make a single producer more efficient than a large number of producers

Natural monopoly: a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms Natural

monopoly >< Govt created monopoly

<???> What are the three reasons that a market might have a monopoly? Give two

examples of monopolies, and explain the reason for each

2.3. How monopoly makes poduction

A competitive firm is small relative to the market in which it operates and, therefore, takes the price of its output as given by market conditions By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market

2.4 Revenue

A monopolist’s marginal revenue is always less than the price of its good  To increase

the amount sold, a monopoly firm must lower the price of its good

Marginal revenue is very different for monopolies from what it is for competitive firms

When a monopoly increases the amount it sells, it has two effects on total revenue (PxQ):

- The output effect: More output is sold, so Q is higher.

- The price effect: The price falls, so P is lower.

2.5 Profit maximization

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A) It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B)

2.6 Monopolist’s profit

Profit = TR – TC = (TR/Q - TC/Q) x Q = (P - ATC) x Q

The area of the box BCDE equals the profit of the monopoly firm The height of the box (BC) is price minus average total cost, which equals profit per unit sold The width of the box (DC) is the number of units sold

2.7 Inefficiency of monopoly

Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it Thus, the quantity produced and sold by a monopoly is below the socially efficient level The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer)

3 OLIGOPOLY

3.1 Characteristics

- Few sellers in the market

- Each seller offers a product similar or identical to the others

3.2. Pricing strategy and oligopolist’s profit

When firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost)

Like monopolists, oligopolists are aware that increases in the amount they produce reduce the price of their product Therefore, they stop short of following the competitive firm’s rule of producing up to the point where price equals marginal cost

In making this decision, the well owner weighs two effects:

- The output effect: Because price is above marginal cost, selling 1 more product at the going price will raise profit

- The price effect: Raising production will increase the total amount sold, which will lower the price of product and the lower profit on all the other products sold

As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market The price approaches marginal cost, and the quantity produced approaches the socially efficient level

3.3 Game theory and the economics of co-operation

- Oligopolists would be better off cooperating and reaching the monopoly outcome Yet because they pursue their own self-interest, they do not end up reaching the monopoly outcome and maximizing their joint profit Each oligopolist is tempted to raise production and capture a larger share of the market As each of them tries to do this, total production rises, and the price falls

- Game theory is the study of how people behave in strategic situations

- A particularly important “game” is called the prisoners’ dilemma This game provides insight into the difficulty of maintaining cooperation Many times in life, people fail to cooperate with one another even when cooperation would make them all better off An oligopoly is just one example

- Prisoners’ dilemma is a particular “game” between two captured prisoners that

illustrates why cooperation is difficult to maintain even when it is mutually beneficial

- Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen 3.4.

4 MONOPOLISTIC COMPETITION

4.1 Characteristics

- Many sellers in the market

- Each seller offers a product that is similar but not identical to the others

- Free entry

4.2 Monololistically competitive firm in the short run

4.3 Monololistically competitive firm in the short run

Two characteristics describe the long-run equilibrium in a monopolistically competitive market:

- As in a monopoly market, price exceeds marginal cost This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downward sloping demand curve makes marginal revenue less than the price

- As in a competitive market, price equals average total cost This conclusion arises because free entry and exit drive economic profit to zero

In a monopolistically competitive market, if firms are making profit, new firms enter, and the demand curves for the incumbent firms shift to the left Similarly, if firms are making losses, old firms exit, and the demand curves of the remaining firms shift to the right Because of these shifts in demand, a monopolistically competitive firm eventually finds itself in the long-run equilibrium shown here In this long-run equilibrium, price equals average total cost, and the firm earns zero profit

4.4 Monopolistic versus perfect competition

- Excess capacity

- Markup over marginal cost

A second difference between perfect competition and monopolistic competition is the relationship between price and marginal cost For a competitive firm, such as that shown

in panel (b), price equals marginal cost For a monopolistically competitive firm, such as that shown in panel (a), price exceeds marginal cost, because the firm always has some market power

Because a competitive firm is a price taker, its revenue is proportional to the amount of output

it produces The price of the good equals both the firm’s average revenue and its marginal revenue

To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost Thus, the firm’s marginal cost curve

is its supply curve

In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost

In a market with free entry and exit, profits are driven to zero in the long run In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price

Changes in demand have different effects over different time horizons In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses But if firms can freely enter and exit the market, then in the long run the number of firms adjusts to drive the market back to the zero-profit equilibrium

Amonopoly is a firm that is the sole seller in its market Amonopoly arises when a single firm owns a key resource, when the government gives a firm the exclusive right to produce a good,

or when a single firm can supply the entire market at a smaller cost than many firms could Because a monopoly is the sole producer in its market, it faces a downward-sloping demand curve for its product When a monopoly increases production by 1 unit, it causes the price of its good to fall, which reduces the amount of revenue earned on all units produced As a result, a monopoly’s marginal revenue is always below the price of its good

Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost The monopoly then chooses the price at which that quantity is demanded Unlike a competitive firm, a monopoly firm’s price exceeds its marginal revenue, so its price exceeds marginal cost

Amonopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus That is, when the monopoly charges a price above marginal cost, some consumers who value the good more than its cost of production do not buy it As a result, monopoly causes deadweight losses similar to the deadweight losses caused by taxes Policymakers can respond to the inefficiency of monopoly behavior in four ways They can use the antitrust laws to try to make the industry more competitive They can regulate the

prices that the monopoly charges They can turn the monopolist into a government-run enterprise Or, if the market failure is deemed small compared to the inevitable imperfections

of policies, they can do nothing at all

Oligopolists maximize their total profits by forming a cartel and acting like a monopolist Yet,

if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome The larger the number of firms

in the oligopoly, the closer the quantity and price will be to the levels that would prevail under competition

The prisoners’ dilemma shows that self-interest can prevent people from maintaining

cooperation, even when cooperation is in their mutual interest The logic of the prisoners’ dilemma applies in many situations, including arms races, advertising, common-resource problems, and oligopolies

Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition The application of these laws can be controversial, because some

behavior that may seem to reduce competition may in fact have legitimate business purposes

A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry

The equilibrium in a monopolistically competitive market differs from that in a perfectly competitive market in two related ways First, each firm has excess capacity That is, it operates on the downward-sloping portion of the average-total-cost curve Second, each firm charges a price above marginal cost

Monopolistic competition does not have all the desirable properties of perfect competition There is the standard deadweight loss of monopoly caused by the markup of price over marginal cost In addition, the number of firms (and thus the variety of products) can be too large or too small In practice, the ability of policymakers to correct these inefficiencies is limited

The product differentiation inherent in monopolistic competition leads to the use of

advertising and brand names Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition Defenders of advertising and brand names argue that firms use them to inform consumers and to compete more vigorously on price and product quality