Chap 7 - Market Structure.pdf

7/24/2019 Chap 7 - Market Structure.pdf

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FOUNDATION IN ECONOMICS

ECONOMICS 1

MARKET STRUCTURE

A market is an economic situation where sellers and buyers trade goods or services.

There are 4 types of market structure corresponding to the number of sellers available in

the market, as well as their characteristics.

PERFECT COMPETITION

A perfect competitionis a market structure where there are infinite sellers and buyers,

trading a homogenous product in the market. A homogenous product is an identicalproduct, where it id difficult to differentiate the product between competitors, for

example - rice, black oil etc.

Assumptions:

1. There are infinite sellers and

buyers.2. The product is homogenous.

3. There is freedom of entry and

exit.

4. The producers are rational.

5. The firms are price-takers.6. Information is complete.

The freedom of entry and exit here means that any potential firm is able to join the

industry, or any existing firm is free to leave the industry, without any difficulties. An

industry refers to a group of firms that produce the same item. For example, the music

industry, the education industry etc.

As the firms are price-takers, the price each firm is charging is the same, no matter how

many output are produced and sold. The price is set by the industry demand and supply.

Assuming that the market price is RM5,

Market Structure

Perfect

Competition

Im erfect Com etition

Monopolistic

Competition

OligopolyMonopoly


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P (RM) Q TR (RM) AR (RM) MR (RM)

5 1

5 2

5 35 4

5 5

5 6

5 7

5 8

5 9

5 10

Marginal Revenueis the additional revenue due to the last unit of output produced. MR

=dQ

dTR.

From the table, it is shown that P = AR = MR.

TYPES OF PROFIT

For any firm, in the short run, there are three types of profit. They are normal profit,

abnormal (supernormal) profitand subnormal profit (loss).

A normal profit is defined as a profit level that enables a firm to remain in the industry in

the long run. In economics, a normal profit is also known as a zero profit. This means

that TR = TC. An abnormal profit is an excess of normal profit. Here, TR > TC.

A rational producer wants to maximise profit. The approach to be followed is MR =MC. When MR = MC, the firm maximises its position either getting the highest profit

possible, or breaking even instead of suffering losses, or that it minimises the loss.

Q TR TC Profit MR MC

10 1000 500 500 100 -

11 1100 560 540 100 60

12 1200 630 570 100 70

13 1300 710 590 100 80

14 1400 800 600 100 90

15 1500 900 600 100 100

16 1600 1010 590 100 110

17 1700 1130 570 100 120

18 1800 1260 540 100 130

P, R

Q

P = AR = MR


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Normal Profit

Abnormal Profit

Subnormal Profit

MR = MC at e. So, the quantity thatmaximises the firms position is 0Q1.At the price of 0P1, the total revenue(TR), which is P x Q, is 0P1eQ1.

At 0Q1, the unit cost is eQ1. As such,the total cost (TC) = 0P1eQ1.

Profit = 0, as TR = TC.

MR = MC at e. The TR is 0P1eQ1. TheTC is 0cbQ1.

The profit earned is cP1eb. This is theabnormal profit.

MR = MC at e. The TR is 0P1eQ1.The TC is 0cbQ1.

The loss is P1cbeb. This is the

subnormal profit.


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Normal Profit in the long run.

The Shutdown Point

If a perfect competitive firm suffers loss in the short run, it does not mean that the firm shouldleave the industry. It depends on the Pand AVC.

If P > AVC, then the firm should continue to operate. If a firm shuts down, it bears fixed cost. If itcontinues, it bears the loss. When P > AVC, the FC > loss. This means that the firm shouldcontinue its operation.

If P < AVC, then the firm should cease its operation. This is because its FC < loss.

In the long run, there is only normalprofit. This is because the abnormalprofit attracts new entrants, causingprofit of each firm to shrink. As long asabnormal profit still exists, newentrants will continue to join theindustry, until profit in the long run isjust zero profit. If the firms sufferlosses, then those that are not able tosustain, will leave the industry, until thesubnormal profit shrinks to zero.

The size of loss is P1cbe, if thefirm continues. If the firm

shuts down, the fixed cost isdcba.

As FC > loss, then, it is betterto bear the loss.


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When P = AVC, the firm depends on other factors to decide on its continuity. FC = loss. So,whether the firm continues or not, the burden is the same. If the future demand is expected to behigher, or if the future cost is expected to be less, then, the firm should continue, as the P will bebigger than AVC.

The Short Run Supply Curve of A Perfect Competitive Firm

As the firm produces according to MR = MC, the diagrams below show the quantities that aperfect competitive firm will produce at each price level, to optimise the firms position. At 0P1, onthe right-hand side (r-h-s) diagram, MR1 = MC at a1. In the left-hand side (l-h-s) diagram, itshows that the firm supplies 0Q1at the price of 0P1(a1). When the price falls to 0P2, MR2= MCat b. This means that 0Q2is the quantity that maximises profit, and hence, will be produced. On

In this diagram, the fixed cost

is only dcba, while the loss isbigger P1cae.

The loss and the FC shown inthe diagram are the same size,P1cbe.

The e point in this diagram isknown as the shutdown point.


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the l-h-s diagram, it shows that 0Q2 is supplied at the price of 0P2. As the price decreases, thequantity that maximises profit changes too.

The firm does not produce any quantity once the price is lower than AVC. The lowest price that afirm is willing to accept is indicated by point e, the shutdown point.

When a until e are joined, it forms the locus that shows the quantity supplied at each price level,

in a given time period. This is the firms supply curve.

The firms supply curve is positively sloped, because it reflects the law of diminishing returns.The supply curve is the MC curve, above AVC. As MC reflects the law of diminishing returns, sodoes the supply curve.

Monopoly

A monopolyrefers to a market structure where there is only one seller, selling a unique productto many buyers.

Assumptions:1. There is only one seller.2. The producer is rational.3. There are barriers to entry.4. The firm is able to set the price or the quantity only, but not both.5. The information is prefect.

In this case, the firm is the industry. The firm faces a negatively sloped demand curve.

P (RM) Q TR (RM) AR (RM) MR (RM)

10 1

9 2

8 3

7 4


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6 5

5 6

4 7

3 82 9

1 10

As seen from the table, P is the AR. But P > MR.

Types of Profit

Just like a perfect competitive firm, a monopolist faces 3 types of profit.

In the short run, a monopolist may earn abnormal profit.

It may also earn only normal profit.

MR = MC at e. Quantity that maximisesprofit is 0Q1. At the quantity of 0Q1, theprice is 0P1. So, the TR is 0P1aQ1.

The unit cost is bQ1. The TC is 0cbQ1.

The profit earned is cP1ab. This is theabnormal profit.


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In the short run, a monopolist may suffer loss too.

In the long run, a monopolist is most likely to earn abnormal profit, where its TR > TC. In rarecases, it may earn only normal profit.

Barriers to Entry

The TC = TR in this diagram. Both arethe size of 0P1aQ1. Profit is zero. This is

known as the normal profit.

MR = MC at e. Quantity that minimisesloss is 0Q1. At the quantity of 0Q1, theprice is 0P1. So, the TR is 0P1aQ1.

The unit cost is bQ1. The TC is 0cbQ1.

The loss is P1cba. This is the subbnormalprofit.


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A monopolist is able to maintain its abnormal profit in the long run as it is able to block other firmsfrom joining its industry. There are several barriers to entry

a. Law and regulationb. Finance and technologyc. Ownership of natural resourcesd. Economies of Scale

Disadvantages of the Existence of a Monopoly

1. Quantity supplied may be limited.2. As such, the price increases.3. The monopolist earns abnormal profit, causing the income gap to increase.4. Consumer surplus decreases.5. There is less initiative for the monopolist to improve production, or quality.

Controlling Monopoly

The government may be forced to control a monopoly, in order to protect the interest of theeconomy, especially to protect the interest of the poor income group. As such, the governmentmay impose price control (where P = MC), impose direct or indirect tax, provide subsidy or takeover the firm.


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Monopolistic Competition

A monopolistic competitive market is a market structure where there are many sellers, selling

differentiated products to many sellers.

Assumptions:1. There are many sellers, although it is not as many as in the perfect competition.2. There is freedom to entry and exit, although it is not as high as in the perfect competitive

market.3. The producers are rational.4. The product is differentiated.5. The information is perfect.

Types of Profit

Just like in the other market structures, a monopolistic competitive firm faces any of the 3 types ofprofit. It may earn abnormal or normal profit, or it could be facing loss.

* The diagrams look like the ones in the monopolistic market, except that the demand curve for amonopolistic competitive firm is elastic, as there are substitutes.

In the long run, due to the freedom of entry and exit, the firms are able to earn only normal profit.

Product Differentiation

A product differentiation is a method by the producer to attract consumers to buy his product,instead of from his rivals. Product differentiation is a non-price differentiation. For examples,think of the difference between a Honda car and a Proton car. Or Pepsi and Coca-cola. Or aDell computer and an Acer computer.

1. Branding2. Features3. Advertising4. Service5. Size, weight, colour etc.

Chap 7 - Market Structure.pdf

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