Chapter 8_market Structure

7/28/2019 Chapter 8_market Structure

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Written by: Edmund Quek

2011 Economics CafeAll rights reserved. Page 1

CHAPTER 8

MARKET STRUCTURE

LECTURE OUTLINE

1 INTRODUCTION

2 PERFECT COMPETITION

2.1 Characteristics of perfect competition2.2 Revenue curves and schedules under perfect competition2.3 Profit-maximising rule2.4 Short-run equilibrium of a perfectly competitive market2.5 Long-run equilibrium of a perfectly competitive market

2.6 Short-run shut-down rule2.7 Long-run shut-down rule2.8 Derivation of the short-run supply curve of a firm under perfect competition2.9 Perfect competition and the public interest

3 MONOPOLY

3.1 Characteristics of monopoly3.2 Barriers to entry3.3 Revenue curves of a monopoly3.4 Short-run equilibrium of a monopolistic market3.5 Long-run equilibrium of a monopolistic market3.6 Short-run shut-down rule3.7 Long-run shut-down rule3.8 A monopoly does not have a supply curve3.9 Monopoly and the public interest3.10 Natural monopoly

4 MONOPOLISTIC COMPETITION

4.1 Characteristics of monopolistic competition4.2 Revenue curves of a monopolistically competitive firm4.3 Short-run equilibrium of a monopolistically competitive market4.4 Long-run equilibrium of a monopolistically competitive market4.5 Monopolistic competition and the public interest


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5 OLIGOPOLY

5.1 Characteristics of oligopoly5.2 Collusive versus competitive (non-collusive) behaviour5.3 Non-price competition

5.4 Oligopoly and the public interest

ReferencesJohn Sloman, EconomicsWilliam A. McEachern, EconomicsRichard G. Lipsey and K. Alec Chrystal, Positive EconomicsG. F. Stanlake and Susan Grant, Introductory EconomicsMichael Parkin, EconomicsDavid Begg, Stanley Fischer and Rudiger Dornbusch, Economics


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1 INTRODUCTION

Economists are interested to study the behaviour of firms such as whether they will chargea high or low price, whether they will make a large or small amount of profit, whether theywill 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 thepresence or absence of barriers to entry. For instance, a firm in a highly competitiveenvironment will behave quite differently from a firm facing little or no competition. Inparticular, 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 inthe market, the nature of their product, the availability of knowledge and the presence orabsence of barriers to entry that affect the behaviour and profitability of the firms in themarket. This chapter gives an exposition of the four types of market structures: perfectcompetition, monopoly, monopolistic competition and oligopoly.

2 PERFECT COMPETITION (PC)

2.1 Characteristics of perfect competition

A very large number of small firmsIn a PC market, there are a very large number of small firms. Therefore, each firm in a PCmarket has a small market share.

Homogeneous productsIn a PC market, the firms sell homogenous products that are perfect substitutes for oneanother. Homogenous products are identical products.

Perfect knowledgeIn a PC market, firms and consumers are fully aware of the production technology, price,quality and availability of the product.

PC firms are price-takersDue to its small market share, product homogeneity and perfect knowledge, a PC firm is aprice-taker in the sense that it is unable to influence the market price by changing its outputlevel. Therefore, a PC firm can only sell its output at the market price that is determined bythe market forces of demand and supply. In other words, a PC firm faces a perfectly elasticdemand curve at the market price. At the market price, a PC firm can sell an infiniteamount of output and hence it does not have the incentive to charge a lower price. Further,a PC firm does not have the incentive to charge a price higher than the market price as thequantity demanded of the good produced by the firm will be zero.


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No barriers to entryThere 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 itis 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 andSupply).

A PC firm's demand curve is horizontal (perfectly elastic) at the market price (refer tosection 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) TR/Q

Market Representative firm


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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 aperfectly elastic demand curve at P0. At P0, the quantity demanded of the good produced bythe PC firm is infinite. Therefore, in principle, a PC firm can sell all the output that itproduces 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 linedrawn 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 isequal to MC.


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In the above diagram, profit is maximised at Q0 where MR is equal to MC. If outputincreases 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 theincrease in TR and hence the increase in output will lead to a decrease in profit. If outputdecreases 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 thedecrease in TC and hence the decrease in output will lead to a decrease in profit. Sinceprofit 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 increasesfrom Q

0 to Q

0, 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 theoutput level where MR is equal to MC, assuming MC is rising.


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In the above diagram, the vertical distance between the TR and the TC curves is the largestat Q0. The slope of the TR curve at this output level (MR) is equal to the slope of the TCcurve (MC). Therefore, Q0 in the TR/TC diagram is the same as Q0 in the MR/MCdiagram.

The profit-maximising rule can also be proven mathematically.Profit Total RevenueTotal Cost

(Q) TR(Q)TC(Q)By the first-order condition,

d/dQ 0

dTR/dQdTC/dQ 0

MRMC 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 outputlevel. A PC market is in short-run equilibrium when all the firms in the market are inshort-run equilibrium. However, this does not necessarily mean that the firms in the marketare making positive economic profit. Indeed, the firms in a PC market in short-runequilibrium can make three types of profit: supernormal profit (positive economic profit),subnormal profit (negative economic profit or economic loss) and normal profit (zeroeconomic 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.


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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, thefirm 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, thefirm is making normal profit.


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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 andthe potential firms that wish to enter the market have done so. In other words, a PC marketis 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 themarket in the long run due to the absence of barriers to entry. As the number of firms in themarket increases, the market supply will increase which will lead to a fall in the marketprice resulting in a fall in the profits of the firms. Potential firms will stop entering themarket when the firms in the market make only normal profit.


In the above diagram, supernormal profit represented by the shaded area attracts potentialfirms into the market in the long run, resulting in the market supply curve (S) shifting to theright 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 toenter the market disappears.

If the firms in a PC market are making subnormal profit, they will leave the market whentheir fixed factor inputs need replacing. Those that cannot cover their total variable costwill leave the market immediately. As the number of firms in the market decreases, themarket supply will decrease which will lead to a rise in the market price resulting in a fall inthe losses of the firms. The exit of firms will stop when the firms in the market start makingnormal profit.


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In the above diagram, subnormal profit represented by the shaded area induces the firms toleave 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 themarket make normal profit, the incentive for the firms to leave the market disappears.

2.6 Short-run shut-down rule

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 downproduction. However, this is not true in the short run. In the short run, a firm shouldcontinue production so long as its TR can at least cover its TVC (TR TVC). This isbecause fixed costs will be incurred whether the firm continues or shuts down productionin the short run. Consider the following cases.

Case 1: TR TVC or AR AVCIf TR is less than TVC, the firm will make a loss equal to its TFC if it shuts downproduction. However, if it continues production, the excess of its TVC over its TR will addto its loss, in which case, it will make a loss greater than its TFC. Therefore, the firm shouldshut down production. However, it will still stay in the market.

Case 2: TR TVC or AR AVCIf TR is greater than TVC, the firm will make a loss equal to its TFC if it shuts downproduction. However, if it continues production, the excess of its TR over its TVC willoffset 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.


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Case 3: TR TVC or AR AVCIf TR is equal to TVC, the firm will make the same amount of loss whether it continues orshuts down production. However, in this instance, the firm should continue productionbecause in doing so, it may be able to make supernormal profit in the future if marketconditions 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.

2.7 Long-run shut-down rule

In the long run, all costs are variable. Therefore, if a firm is making subnormal profit (TRTC), 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 priceof a good, the quantity supplied is determined entirely by the supply curve. The portion ofthe 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 bythe MC. Intuitively, given the price of a good, the quantity supplied is determined by themarginal revenue and the marginal cost. However, in the case of a PC firm, price is equal tomarginal revenue. Therefore, given the price of the good produced by a PC firm, thequantity supplied is determined entirely by the MC curve. Further, at a price lower than itsAVC, 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 AVCcurve.


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2.9 Perfect competition and the public interest

AdvantagesDue to intense competition in the market, PC firms are not lax in cost control. In otherwords, 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 productivelyefficient.

A firm is allocatively efficient when it cannot change its output level and hence theallocation of resources in the economy in a way that will increase the total benefit forconsumers and this occurs when it charges a price equal to its marginal cost, assuming noexternalities. PC firms are allocatively efficient because they charge a price equal to theirmarginal cost, assuming no externalities. When the price of a good is equal to the marginalcost, the marginal benefit that consumers place on the last unit of the good is equal to theforgone marginal benefit that they place on the amount of other goods that could have beenproduced using the same resources. Therefore, PC firms cannot change their output level to

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

Due to the absence of market power, the price charged by the firms in a PC market is lowerthan the price that would be charged by the firm in the same market operating undermonopoly, 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 PCoutput level (QPC) is higher than the monopoly output level (QM).

The distribution of income in an economy that abounds with PC markets will be moreequal than one that abounds with monopolistic markets because although PC firms canmake only normal profit in the long run, a monopoly can make supernormal profit in thelong run.


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DisadvantagesA monopoly reaps more economies of scale than a PC industry and if this results in its MCcurve being substantially lower than the horizontal summation of the MC curves of thefirms in the same market operating under PC, it will charge a lower price.

In the above diagram, due to substantial economies of scale, the monopoly price (P MC) islower than the PC price (PPC).

Due to lack of ability and incentive, PC firms do not engage in research and development.Due to perfect knowledge, any innovation, whether process or product, can easily andquickly be copied by other firms. Further, research and development very often requireshuge expenditure outlays which PC firms are unable to finance and this is because they aresmall 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 firmIn a monopolistic market, there is a single large firm (known as the monopoly or themonopolist). Therefore, the output level of a monopoly is the market output level.

Unique productA monopoly sells a unique product that has no close substitutes.


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A monopoly is a price-setterDue to lack of competition in the market, a monopoly is a price-setter in the sense that it isable to set its price by setting its output level. In other words, a monopoly faces adownward-sloping demand curve.

Barriers to entryThere 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 longrun.

Note: In reality, a monopoly is not defined as a single large firm in a market that sells aunique product that has no close substitutes. For instance, in the UK, a monopoly isdefined 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 which restricts potential firms from entering a market tocompete with the incumbent firm or firms.

Economies of scaleA monopoly may emerge naturally because it can reap very substantial economies of scaleand this occurs when the economies of scale are so substantial that the market canaccommodate only one firm. In other words, a single firm can meet the market demand atan average cost which allows it to make supernormal profit. However, with two or morefirms, 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.


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In the above diagram, the monopoly which faces the demand curve (D1) can make at leastnormal profit by producing anywhere within the output range from QMIN to QMAX. Withtwo firms in the market, each firm faces the demand curve (D2), which lies entirely belowthe 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 barriersSome businesses require very high start-up costs which not many firms are able to finance.

Legal barriersA firm may have obtained its monopoly position through the acquisition of a patent orcopyright. A patent is granted to an inventor to allow him the exclusive right to produce theproduct or use the production process that is patented. In the latter, potential firms cannotenter the market as they do not have access to the technology. The aim of awarding patentsis 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 andcopyrights are commonly referred to as intellectual properties.

Control of key factor inputsIf a firm controls the supply of some key factor inputs, it can deny access to these factorinputs to potential rivals.

Control of wholesale and retail outletsIf a firm controls the outlets through which the product can be sold, it can prevent potentialrivals from gaining access to consumers.


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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 outputlevel. A monopolistic market is in short-run equilibrium when the monopoly is in short-runequilibrium, since it is the only firm in the market. However, this does not necessarilymean that the monopoly is making positive economic profit. Indeed, a monopoly inshort-run equilibrium can make three types of profit: supernormal profit (positiveeconomic profit), subnormal profit (negative economic profit or economic loss) andnormal profit (zero economic profit).


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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.


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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, thefirm 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 willalso be the long-run equilibrium. If a monopoly cannot reverse a subnormal-profitequilibrium 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 isimpossible for the firms in PC market in the long run.

3.6 Short-run shut-down rule

Refer to section 2.6.

3.7 Long-run shut-down rule


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 supplycurve, this is not true of a monopoly.


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In the above diagram, given the profit-maximising price of the good (P0) that correspondsto the output level where marginal revenue (MR) is equal to marginal cost (MC), thequantity supplied will be Q0 if the MRcurve is MR. However, given the same price of thegood (P0), the quantity supplied will be Q0 if the MR curve is MR. Therefore, given theprice of the good produced by a monopoly, not only is the quantity supplied determined bythe MC curve, but it is also affected by the MR curve. Since the quantity of the goodsupplied by a monopoly is not determined entirely by the MC curve, the MC curve of amonopoly is not the supply curve. Indeed, given the price of the good produced by amonopoly, 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

AdvantagesA monopoly reaps more economies of scale than a PC industry and if this results in its MCcurve being substantially lower than the horizontal summation of the MC curves of thefirms in the same market operating under PC, it will charge a lower price.

Since a monopoly is large and it can make supernormal profit in the long run, it has theability to engage in research and development. Product innovations will lead to greaterproduct variety or higher product quality and process innovations will lead to a lower costof production which may be passed on to consumers in the form of 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 bereached or to produce a good that otherwise would not be produced. Further, if the increasein profit from price discrimination is ploughed back into research and development, morebenefits to consumers will be created.


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DisadvantagesDue to lack of competition in the market, a monopoly may be lax in cost control. In otherwords, it may be overstaffed, it may lack the incentive to use the most efficient productiontechnology, etc. Therefore, a monopoly may be x-inefficient and hence productivelyinefficient. 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 inthe absence of potential competition, the sheer aim of making more profit may drive amonopoly to be x-efficient and hence productively efficient.

A monopoly is allocatively inefficient because it charges a price higher than its marginalcost. When the price of a good is higher than the marginal cost, the marginal benefit thatconsumers place on the last unit of the good is greater than the forgone marginal benefitthat they place on the amount of other goods that could have been produced using the sameresources. Therefore, if a monopoly increases its output level, the total benefit forconsumers will increase and hence is allocatively inefficient.

In the above diagram, the deadweight loss, which is the loss of surplus due to marketfailure or government intervention, is represented by the shaded area.

Due to greater market power, the price charged by the firm in a monopolistic market ishigher than the price that would be charged by the firms in the same market operatingunder perfect competition, assuming the cost structure of a monopoly is the same as that ofa PC industry.

The distribution of income in an economy that abounds with monopolistic markets will beless equal than one that abounds with PC markets because although PC firms can makeonly normal profit in the long run, a monopoly can make supernormal profit in the longrun.


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The ability of a monopoly to practise price discrimination may lead to a fall in theconsumer 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 onlyone firm. An example is a public utility firm. A natural monopoly has two distinctivecharacteristics. First, it can reap very substantial economies of scale and hence its LRACcurve is falling over the entire range of market demand. In other words, its minimumefficient scale is high relative to the market demand. Second, it incurs very high start-upcosts 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 leastnormal profit by producing anywhere within the output range from QMIN to QMAX. Withtwo firms in the market, each firm faces the demand curve (D2), which lies entirely belowthe 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.


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In the above diagram, the profit-maximisingoutput level (QM) where marginal revenue(MR) is equal to marginal cost (MC) is much lower than the allocatively efficient outputlevel (QA) where price (P) is equal to marginal cost (MC). Therefore, if a natural monopolyincreases its output level, the total benefit for consumers will increase significantly andhence is very allocatively inefficient.

The government can pass a regulation that requires the monopoly to charge a price equal toits marginal cost to achieve allocative efficiency, assuming no externalities and themonopoly, 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 falseinformation about its revenue and cost structures to the government. If this happens, the


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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 theshaded area, because PMC is lower than AC at QMC. Therefore, the government has to givethe monopoly a lump-sum subsidy to allow it to cover its loss. However, if the governmentis 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 tomake a loss, the government can pass a regulation that requires the monopoly to charge aprice equal to its average cost to reduce allocative inefficiency and this is commonlyknown as average cost pricing. In the above diagram, the output level under average costpricing (QAC) is closer to QA than QM is. However, the use of average cost pricing in amonopolistic market will not achieve allocative efficiency.

The government can give a subsidy to the monopoly to induce it to increase output toachieve allocative efficiency.

In the above diagram, a per-unit subsidy leads to a fall in the AC and the MC curves. If thenew 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, themonopoly may provide false information about its revenue and cost structures to thegovernment. If this happens, the use of subsidy in a monopolistic market will not achieveallocative efficiency. Further, since the subsidy will be financed by taxpayers and willincrease the profit of the monopoly which is already making supernormal profit, thegovernment may be reluctant to use it for fear of hurting its popularity rating.


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The government can nationalise the market to produce the good itself to achieve allocativeefficiency. 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 toconsider 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 firmsIn a MC market, there are a large number of small firms. Therefore, each firm in a MCmarket has a small market share.

Differentiated productsIn a MC market, the firms sell differentiated products that are close substitutes for oneanother. Differentiated products are products that are sufficiently similar to bedistinguished as a group from other products. An example is hawker foods.

MC firms are price-settersDue to product differentiation, a MC firm is a price-setter in the sense that it is able to set itsprice by setting its output level. In other words, a MC firm faces a downward-slopingdemand curve. However, due to the large number of substitutes in the market, the demandfor the good produced by a MC firm is more price elastic than the demand for the goodproduced by a monopoly.

No barriers to entryThere 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 marketsupply in a MC market.

4.2 Revenue curves of a monopolistically competitive firm


4.3 Short-run equilibrium of a monopolistically competitive market



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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 andthe potential firms that wish to enter the market have done so. In other words, a MC marketis 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 themarket in the long run due to the absence of barriers to entry. As the number of firms in themarket increases, the demand for the good produced by each firm will fall which will leadto a fall in its profit. Potential firms will stop entering the market when the firms in themarket make only normal profit.

If the firms in a MC market are making subnormal profit, they will leave the market whentheir fixed factor inputs need replacing. Those that cannot cover their total variable costwill leave the market immediately. As the number of firms in the market decreases, the

demand for the good produced by each firm will rise which will lead to a fall in its loss. Theexit of firms will stop when the firms in the market start making normal profit.

4.5 Monopolistic competition and the public interest

AdvantagesDue to intense competition in the market, MC firms are not lax in cost control. In otherwords, they are not overstaffed, they do not lack the incentive to use the most efficientproduction technology, etc. Therefore, MC firms are x-efficient and hence productivelyefficient.

Due to less market power and the absence of barriers to entry, the price charged by a firm ina MC market is lower than the price that would be charged by the firm in the same marketoperating under monopoly, assuming the cost structure of a monopoly is the same as that ofa MC firm.

The distribution of income in an economy that abounds with MC markets will be moreequal than one that abounds with monopolistic markets because although MC firms canmake only normal profit in the long run, a monopoly can make supernormal profit in thelong run.

MC firms produce differentiated products which offer consumers a great variety ofchoices.

DisadvantagesMC firms are allocatively inefficient because they charge a price higher than their marginalcost. When the price of a good is higher than the marginal cost, the marginal benefit thatconsumers place on the last unit of the good is greater than the marginal benefit that theyplace on the amount of other goods that could have been produced using the same


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resources. Therefore, if MC firms increase their output level, the total benefit forconsumers will increase and hence are allocatively inefficient. However, the problem ofallocative inefficiency in a MC market is less severe than that in a monopolistic marketbecause the price elasticity of demand for the good produced by a MC firm is higher thanthat for the good produced by a monopoly.

A monopoly reaps more economies of scale than a MC industry and if this results in its MCcurve being substantially lower than the horizontal summation of the MC curves of thefirms in the same market operating under MC, it will charge a lower price.

Due to greater market power, the price charged by a firm in a MC market is higher than theprice that would be charged by a firm in the same market operating under PC, assuming thecost structure of a PC firm is the same as that of a MC firm.

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

Due to lack of ability and incentive, MC firms do not engage in research and development.Due to the absence of barriers to entry, any innovation, whether process or product, caneasily and quickly be copied by other firms. Further, research and development very oftenrequires huge expenditure outlays which MC firms are unable to finance and this is partlybecause 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 ontheir AC curves, we say that they are producing with excess capacity (or producing undercapacity).

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


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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. Therefore, each firm inan oligopolistic market has a large market share.

Homogeneous or differentiated productsAlthough the firms in some oligopolistic markets sell homogeneous products (e.g. cementand steel), the firms in most oligopolistic markets sell differentiated products (e.g. cars andelectrical appliances).

Oligopolists are price-settersDue to its large market share, an oligopolist is a price-setter in the sense that it is able to setits price by setting its output level. In other words, an oligopolist faces a downward-sloping

demand curve.

Barriers to entryThere are barriers to entry in an oligopolistic market, although they are often lower than thebarriers 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 thelong run.

Strategic interdependence (also known as mutual interdependence)Due to the small number of large firms in an oligopolistic market and hence the largemarket share of each firm, the actions of one firm affect, and are affected by the actions of

the other firms in the market. Therefore, if a firm in an oligopolistic market changes itsprice, the sales of its rivals will be affected. The rivals will then react by changing theirprices which will affect the sales of the first firm. Therefore, no firm in an oligopolisticmarket 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 colludebecause they will be better off if they to jointly maximise profit. On the other hand, they aretempted to compete with each other to gain a bigger market share. Therefore, oligopolistsmay either collude or compete.

Collusive behaviourIf oligopolists collude, there will be price stability. Oligopolists can collude by bandingtogether to agree on a common price higher than the price that they currently charge and


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this is commonly known as cartelisation. To avoid a surplus of the goods, they must alsoagree on a set of output quotas and the most likely method is for them to divide the marketamong 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 havethe same cost structure and there are high barriers to entry and therefore there is little fearof 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 tacitcollusion. Tacit collusion usually takes the form of price leadership where the followerskeep to the price set by the leader. The price leader may be the firm with the largest marketshare (known as the dominant firm price leadership) or the firm which is believed to havethe most information about market conditions (known as the barometric firm price

leadership).

Competitive behaviourAt first thought, if oligopolists do not collude, price war will be inevitable. However, pricestability has been found to be an empirical regularity in most oligopolistic markets, even inthose where the firms do not collude. This phenomenon can be explained by the theory ofthe 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 suitbecause by keeping their prices the same, they can attract customers from the firm.Accordingly, if a firm in an oligopolistic market increases its price, its quantity demandedwill decrease by a larger percentage as customers will switch from the firm to the rivalswhich will lead to a fall in revenue for the firm. Second, if a firm in an oligopolistic marketreduces 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 demandedwill increase by a smaller percentage as customers will not switch from the rivals to thefirm, which will lead to a fall in revenue for the firm. Therefore, oligopolists do not havethe incentive to change their prices, assuming no substantial changes in the cost ofproduction.

The theory of the kinked demand curve can be illustrated with a diagram. A firm in anoligopolistic market faces a demand curve that is kinked at the current equilibrium, and thekink on the demand curve leads to the gap on the MR curve.


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Kinked demand curve

In the above diagram, since the current price and the current output level are P0 and Q0, theMC curve must be cutting the MR curve at the gap. A small change in the cost ofproduction will lead to a shift in the MC curve but so long as the new MC curve liesbetween MC and MC, theprice will remain unchanged and this explains price stability inoligopolistic markets where the firms do not collude.

However, if there is a large change in the cost of production, the new MC curve will shiftout of the range between MC and MC which will lead to a change in the price and theoutput level. In this case, the firms may plunge into a price war before they reach a newequilibrium. 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 notwant to change price too frequently to prevent upsetting customers.

5.3 Non-price competition

Firms engage in non-price competition through product development and productpromotion. Product development will improve the quality and the features of the good andproduct promotion will increase the awareness and the appeal. Successful productdevelopment and product promotion will not only lead to an increase in the demand for thegood, but they will also make the demand less price elastic as consumers will perceive thegood to be more different from its substitutes. In other words, successful productdevelopment and product promotion will shift the demand curve of the good to the rightand make it steeper. Product development will lead to real product differentiation as it willresult in physical changes of the good. Product promotion will lead to imaginary productdifferentiation as it will only affect the perception of consumers.


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5.4 Oligopoly and the public interest

If oligopolists collude, they will effectively be acting like a monopoly. In this instance, theadvantages and disadvantages to society experienced under monopoly will also beexperienced 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 lesseconomies 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 tworespects.

First, unlike a monopoly may not be x-efficient and hence productively efficient due tocompetition 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 anddevelopment due to lack of competition in the market, an oligopolist has the incentive toengage in research and development due to competition in the market.

Documents

Chapter 8_market Structure