Market
Structures
Perfect Competition (Ch 20)
Monopolistic Competition (Ch 22)
Oligopoly (Ch 22)
Monopoly (Ch 21 and 23)
Commonalities among Firms
n
Every firm must
answer:
n
What price to
charge.
n
How many to
produce.
n
What resource mix
to use.
n
Every firm must
operate within its market structure.
n
This will govern
how the above questions can be answered.
Perfect
Competition
Chapter 20
Perfect Competition
n
Many buyers and
many sellers, all small.
n
Homogeneous
product.
n
Easy entry into
and easy exit out of the industry.
n
No market power:
seller must take the price determined by the market.
Price Takers
n
Each firm makes a
tiny portion of the total market supply.
n
Each has no
significant effect on the total Q or P in the market.
n
If seller’s P
> market P, customers leave and seller sells none
n
Seller’s P is
never < market P, since he can sell all he has at the market P
Market Demand Curve vs. Firm Demand Curve
n
Perception is
important.
n
The market has a
downward sloping demand curve.
n
However, each
firm acts as if its demand curve is horizontal.
Market Demand Curve vs. Firm Demand Curve
(chart)
Marginal Revenue = Price
n
Marginal revenue
(MR) is the increase in total revenue when one more unit of output is sold.
n
In perfect
competition, MR = P.
Demand Curve and MR Curve (chart)
Review: Marginal Analysis
n
If MB > MC, do
it! and your betterment (profit) increases.
n
If MB < MC,
don’t do it! because your betterment (profit) would decrease.
n
Maximize your
betterment (profit) where MB=MC.
n
For a firm, the
MB is marginal revenue (MR).
Profit-Maximizing Rule
n
If MR>MC,
increase Q and profits rise.
n
If MR<MC,
decrease Q and profits rise.
n
If MR=MC, this is
the Q where profits are maximized.
n
In perfect
competition, MR=P=MC.
Answering the “How Much to Produce?”
Question
n
Overlay the
firm’s MC curve onto its demand (MR) curve.
n
To maximize
profit, the firm produces the Q where MR=MC.
Using the Profit-Maximization Rules: A
Summary
MR > MC increase output and increase profit
MR = MC maximize
profit
MR < MC decrease output and increase profit
A Little Bit of Math
n
Profit = TR – TC
n
Profit = P x Q –
ATC x Q
n
Profit = (P –
ATC) x Q
n
(P – ATC) is
profit per unit
n
If P > ATC,
profit per unit > 0
n
If P < ATC,
profit per unit < 0
n
If P = ATC,
profit per unit = 0
In a loss situation, should the firm shut
down?
n
Case 1: If
P>ATC, economic profits exist.
n
TR>TC.
n
Firm continues to
operate.
n
May expand in the
long run.
In a loss situation, should the firm shut
down?
n
Cases 2 and 3: If
P<ATC, economic losses exist.
n
TR<TC.
n
To minimize
losses, reduce Q until MR=MC again.
n
Further analysis
is required.
In a loss situation, should the firm shut
down?
n
Can the firm pay
its variable costs?
n
Case 2: Compare P
to AVC:
n
If P<AVC, all
TVC can’t be paid.
n
Firm shuts down:
n
Q=0, so TVC=0.
Only TFC remain.
n
Losses are less
than if operating.
In a loss situation, should the firm shut
down?
n
Can the firm pay
its variable costs?
n
Case 3: Compare P
to AVC:
n
If P>AVC, firm
can pay all TVC and some TFC.
n
Firm continues to
operate.
n
Firm must cut
costs to regain profitability.
In a loss situation, should the firm shut
down? (chart)
MC is the Firm’s Supply Curve
n
Since the firm
sets MR=MC always, it operates on its MC curve.
n
It closes down if
it falls below AVC.
Lowest-cost producer
n
As market P
falls, high-cost firms reach P<ATC before low-cost firms.
n
They make the
“shut down” decision first.
n
The firm with the
lowest cost production will be the last to face this decision
n
The lowest-cost
firm is the most likely survivor of an industry “shake out”
Entry and Exit
n
The long-run
investment decision is driven by the profit motive and shifts the market supply
curve.
n
Economic Profits
> 0? Expand.
n
Supply curve
shifts right.
n
Economic Profits
< 0? Shrink or shut down.
n
Supply curve
shifts left.
Ultimate Outcome is Zero Economic Profits:
Case 1
n
Consumer demand
is high.
n
P > ATC;
Economic profits exist.
n
Industry expands
n
Market supply
shifts right; P falls
n
Economic profits
fall to zero.
n
Expansion ceases;
P stabilizes
n
This is the
relentless profit squeeze.
Ultimate Outcome is Zero Economic Profits:
Case 2
n
Consumer demand
decreases.
n
P < ATC;
Economic losses exist.
n
Industry shrinks
n
Market supply
shifts left; P rises
n
Economic losses
fall to zero.
n
Shrinking ceases;
P stabilizes
n
Industry shrinks
in response to declining consumer demand.
Monopoly
Ch 21 and 23
Monopoly
n
A market
controlled by a single producer/seller.
n
No close
substitutes.
n
A significant
barrier to entry is keeping all competition out of this market.
Barriers to Entry
n
Patents
n
Monopoly
Franchises
n
Control of Key
Inputs
n
Economies of
Scale
n
Brand loyalty
Market Power and the Demand Curve
n
A firm with
market power can influence the market price of its product.
n
This firm faces a
downward-sloping demand curve:
n
To sell more, it
must lower the price.
n
To increase the
price, it must expect to sell less.
Price and Marginal Revenue
n
Monopoly’s
profit-maximizing rule:
n
Produce at an
output where MR = MC.
n
Unlike
competitive firms, marginal revenue is always less than price for a monopolist,
i.e., MR < P
n
The MR curve lies
below the demand curve at every point but the first.
Price and Marginal Revenue (chart)
Demand Curve and MR Curve
n
The MR curve is
always under the demand curve and slopes downward twice as fast.
Find the Profit-Maximizing Price and
Quantity
n
1. Locate where
MR = MC.
n
2. Go down to the
horizontal axis. Identify profit-maximizing Q.
n
3. Go up to the
demand curve, then left to the vertical axis. Identify profit-maximizing P.
Not Complete Market Power
n
A monopolist will
produce an output, Q, that maximizes its profits, where MR = MC.
n
The demand curve
shows the profit-maximizing P consumers are willing to pay for the output.
n
Charging a higher
P will decrease profit, not increase it.
n
Producing more
will decrease profit, not increase it.
Profits in a Monopoly
n
Demand is high
for this product.
n
P > ATC at the
profit-maximizing Q, so economic profits exist.
Losses in a Monopoly
n
Here, demand is
low for the product.
n
P<ATC at the
profit-maximizing (loss-minimizing) Q, so economic losses exist.
Monopoly vs. Perfect Competition
n
A monopoly will
earn larger profits than a comparable competitive industry because it will:
n
restrict quantity
it supplies to its profit-maximizing Q
n
… and therefore
push up the price.
Monopoly vs. Perfect Competition
n
Monopolists
provide all the supply. Market P and Q are set by the monopolist’s MR = MC.
n
If they get some
competition, the supply curve shifts right, P falls and Q rises.
n
Thus, monopolists
provide less Q and sell at higher P than competition.
Monopoly vs. Competition
n
There will be
different outcomes in the market, depending on whether it is a monopoly or
competitive.
What happens in a Competitive Industry?
n
High prices and
economic profits signal the consumers’ increased demand.
n
High profits
attract new suppliers and output expands. Supply shifts right.
n
Prices fall to
minimum ATC (and = MC) and economic profit reaches zero.
n
Profit squeeze
signals suppliers to reduce costs or improve product quality.
What happens in a Monopoly Industry?
n
High prices and
economic profits signal the consumers’ increased demand.
n
Barriers to
entry, so no new competition.
n
No expansion.
Profits are already maximized, so no Q increase. P does not fall.
n
P > MC at all
times.
n
No profit
squeeze, so no pressure to reduce costs or improve product quality.
Are there monopolies today?
n
Today’s
monopolies are established by government
n
Usually, when a
market is of a size that only one distributor can achieve economies of scale.
n
A monopolist can
deliver the product at a much lower cost than, say, four competitors, each ¼
the size
Natural Monopoly
n
An industry where
only one firm can achieve economies of scale over the range of market demand.
n
Achieving
economies of scale is a “natural” barrier to entry.
n
Examples: local
telephone, local cable, and other local utilities.
Natural Monopoly
n
Government
establishes a natural monopoly
n
It defines the
area and quality of service
n
It regulates the
price:
n
P = ATC
n
Zero economic
profit.
Antitrust
Laws
n
The Justice Department watches for monopolistic abuse in markets.
n
Antitrust laws forbid:
n
restraint of
trade.
n
collusion between
firms to limit markets or raise prices.
n
anti-competitive
practices.
Antitrust Problems
n
How is a market
defined?
n
Narrowly or
broadly?
n
How should the
benefits of innovation be considered?
Mergers
n
The Justice
Department reviews proposed mergers for antitrust violations:
n
Horizontal
mergers: between two competitors.
n
Vertical mergers:
between a supplier and its customer.
n
Conglomerate
mergers: between two firms in different industries.
n
They will not
approve a merger if competition is weakened.
Monopolistic Competition
Oligopoly
Chapter 22
Real World Competition
n
Most firms and
industries fall into these two categories:
n
Monopolistic
competition
n
The industry has
many small, innovating, product differentiating firms
n
Oligopoly
n
The industry is
dominated by a few large firms
Monopolistic Competition
n
Many small firms,
locally competing.
n
Very limited
market power.
n
Easy to enter and
exit.
n
P – ATC is small,
so they use non-price competition.
n
Innovate to
become “unique”.
n
Become, for a
short time, a monopolist.
Monopolistic Competition
n
Downward sloping
demand curve
n
P>MR
n
Profit maximize
by producing the Q where MR=MC.
n
Demand curve
establishes P.
The Product Differentiation Cycle
n
The firm makes
its product to be more desirable than competing products in the same market.
n
The firm become
“unique” – the only one with a new feature.
n
Customers want
this feature, so demand increases for the firm’s product.
The Product Differentiation Cycle
n
As demand
increases, the firm can charge a higher price.
n
Its economic
profits grow.
n
For awhile, it
has a monopoly on the unique product, service, or feature.
n
Customers shun
the competitors’ substitute goods even when they have a lower price.
The Product Differentiation Cycle
n
Low barriers to
entry allow competitors to “clone” the innovation and compete.
n
Loyalty to the
firm’s product disappears. Market supply shifts right, and prices fall.
n
Economic profits
move toward zero.
n
It is time for
another firm to “break out” with a new innovation to start the cycle all over
again.
The Product Differentiation Cycle
n
Results:
n
Constant catering
to the customer
n
Constant product
improvement
n
Constant adding
of new features
n
Those who fail to
keep up get left behind and, ultimately, will leave this business
Oligopoly Behavior
n
A few large rival
firms remain as an industry matures.
n
Barriers to entry
are high, so new entrants are rare.
n
The firms are
constantly monitoring the actions of their rivals.
n
Decision-making
becomes interdependent.
Oligopoly Behavior
n
Market share: the
fraction of the total market that buys its product instead of from the
competition.
n
Each firm has a
market share.
n
Each firm is
highly protective of its market share. It does not want to lose market share to
its rivals.
The Battle
for Market Share
n
Increased sales
by firm A will be noticed immediately by firm B and C.
n
A’s market share
increases while B’s and C’s market share decreases.
n
B and C will
react.
The Battle
for Market Share
n
If A increases
sales by lowering prices, B and C will retaliate by lowering their prices, too.
n
Result: no changes in market share; profits
fall for all.
n
If A wants to
raise prices, it will not do so unless A expects B and C will raise prices,
too.
n
Result: no
changes in market share; profits may rise for all.
Interdependence
n
Nobody makes a
decision without considering what the others will do in retaliation.
n
To preserve and
protect their market share, they react to other firms’ moves.
n
Sometimes at the
expense of profit maximization.
n
Thus, there is
little up or down movement in price.
Brand Loyalty
n
An oligopolist
aggressively markets its products to gain sales and market share.
n
One way is to
attract more customers by making your product different – more unique – more
exciting.
n
Real or imagined … as long as the
customer is convinced your product is better than the competition.
n
This creates brand loyalty, the basis for repeat
sales to the same customer.
Collusion
n
Firms could
coordinate their behavior to maximize industry-wide profits.
n
Since falling
prices rapidly reduce oligopoly profits, rivals may join together to stop
falling prices.
n
Or, conspire to
raise prices in unison.
n
Or, restrict
competition by setting up exclusive marketing areas.
n
These actions are
illegal in the US under
antitrust laws.
Cartels
n
An oligopoly
could formally organize into a cartel (a shared monopoly).
n
Collectively,
they choose an industry output that maximizes total industry profit.
n
Each firm then
produces an assigned quota, which will add up to the industry output.
n
Market demand
then indicates the market price for that output.
Cartels
n
This is effective
if:
n
all producers are
part of the cartel.
n
each producer
sticks to its production quota.
Cartels
n
Problems:
n
If a firm’s quota
does not profit-maximize for the firm, it might cheat on production.
n
Outside producers
do not have to obey a quota.
n
Increased
production will push down market prices and lower industry profits.
Cartels
n
Cartels are
illegal in the US.
n
The Organization
of Petroleum Exporting Countries (OPEC) is a cartel.
n
OPEC restricts
output of its members to maintain a high price for oil.
n
Member cheat on
production.
n
Non-member oil
countries do not have quotas.
Competition increases prosperity
n
Forces producers
to operate efficiently
n
Requires producers
to cater to customers’ preferences
n
Generates
incentive to improve products, find lower cost processes, reach economies of
scale
n
Puts personal
self-interest (betterment) to work to satisfy consumers’ needs, thereby
elevating our standard of living
Industry Life Cycle
n
Innovation Phase
n
Growth Phase
n
Mature Phase
n
Decline Phase
Industry Life Cycle
n
1. In the
“innovation” phase, an entrepreneur begins to offer a more attractive, more
useful, or less costly, substitute for an old technology
n
2. Increased
consumer demand for the new product leads to industry expansion as “clones” of
the new product appear.
Industry Life Cycle
n
3. Decreasing
demand for the old technology leads to that industry’s decline as firms cease
production and leave the industry.
n
4. Resources
shift from the old, declining industry to the new, expanding industry. This is
what Joseph Schumpeter called the “process of creative destruction”.
Industry Life Cycle
n
5. The expansion,
or “growth”, phase is intensely competitive due to easy entry. As supply shifts
right, prices fall and the less efficient, higher cost firms must make the
“shut down” decision.
n
6. Efficient,
low-cost firms buy up the assets and hire the workers of the shut down firms,
creating an oligopoly.
Industry Life Cycle
n
7. A few
low-cost, efficient firms grow to large size and capture large market share.
This is industry “shake-out”.
n
8. The industry
moves from “growth” to “mature” phase as the product is no longer “new” for
buyers but becomes a replacement commodity.
n
9. Mature
industries continue until its consumers find a new innovative substitute for
its product. Then it goes into its “decline” phase.
Industry expansion
n
Product is
popular with customers and economic profits occur (P>ATC)
n
Existing firms
expand; new firms enter to pursue economic profits
n
Supply curve
shifts right, so P falls toward ATC and economic profits fall to zero
n
Industry
expansion is complete when