Chapter 8-market-structure (1)
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Transcript of Chapter 8-market-structure (1)
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 1
CHAPTER 8
MARKET STRUCTURE
LECTURE OUTLINE
1 INTRODUCTION
2 PERFECT COMPETITION
2.1 Characteristics of perfect competition
2.2 Revenue curves and schedules under perfect competition
2.3 Profit-maximising rule
2.4 Short-run equilibrium of a perfectly competitive market
2.5 Long-run equilibrium of a perfectly competitive market
2.6 Short-run shut-down rule
2.7 Long-run shut-down rule
2.8 Derivation of the short-run supply curve of a firm under perfect competition
2.9 Perfect competition and the public interest
3 MONOPOLY
3.1 Characteristics of monopoly
3.2 Barriers to entry
3.3 Revenue curves of a monopoly
3.4 Short-run equilibrium of a monopolistic market
3.5 Long-run equilibrium of a monopolistic market
3.6 Short-run shut-down rule
3.7 Long-run shut-down rule
3.8 A monopoly does not have a supply curve
3.9 Monopoly and the public interest
3.10 Natural monopoly
4 MONOPOLISTIC COMPETITION
4.1 Characteristics of monopolistic competition
4.2 Revenue curves of a monopolistically competitive firm
4.3 Short-run equilibrium of a monopolistically competitive market
4.4 Long-run equilibrium of a monopolistically competitive market
4.5 Monopolistic competition and the public interest
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© 2011 Economics Cafe All rights reserved. Page 2
5 OLIGOPOLY
5.1 Characteristics of oligopoly
5.2 Collusive versus competitive (non-collusive) behaviour
5.3 Non-price competition
5.4 Oligopoly and the public interest
References
John Sloman, Economics
William A. McEachern, Economics
Richard G. Lipsey and K. Alec Chrystal, Positive Economics
G. F. Stanlake and Susan Grant, Introductory Economics
Michael Parkin, Economics
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics
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© 2011 Economics Cafe All rights reserved. Page 3
1 INTRODUCTION
Economists are interested to study the behaviour of firms such as whether they will charge
a high or low price, whether they will make a large or small amount of profit, whether they
will 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 the
presence or absence of barriers to entry. For instance, a firm in a highly competitive
environment will behave quite differently from a firm facing little or no competition. In
particular, 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 in
the market, the nature of their product, the availability of knowledge and the presence or
absence of barriers to entry that affect the behaviour and profitability of the firms in the
market. This chapter gives an exposition of the four types of market structure: perfect
competition, monopoly, monopolistic competition and oligopoly.
2 PERFECT COMPETITION (PC)
2.1 Characteristics of perfect competition
A very large number of small firms (small market share)
In a PC market, there are a very large number of small firms. Therefore, each firm in a PC
market has a small market share.
Homogeneous products
In a PC market, the firms sell homogenous products that are perfect substitutes for one
another. Homogenous products are identical products.
Perfect knowledge
In a PC market, firms and consumers are fully aware of the production technology, price,
quality and availability of the product.
PC firms are price-takers
Due to its small market share, product homogeneity and perfect knowledge, a PC firm is a
price-taker in the sense that it is unable to influence the market price by changing its output
level. Therefore, a PC firm can only sell its output at the market price that is determined by
the market forces of demand and supply. In other words, a PC firm faces a perfectly elastic
demand curve at the market price. At the market price, the quantity demanded of the good
produced by a PC firm is infinite. Therefore, in principle, a PC firm can sell all the output
that it produces at the market price.
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No barriers to entry
There 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 it
is 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 and
Supply”).
A PC firm's demand curve is horizontal (perfectly elastic) at the market price (refer to
section 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) ΔTR/ΔQ
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 a
perfectly elastic demand curve at P0. At P0, the quantity demanded of the good produced by
the PC firm is infinite. Therefore, in principle, a PC firm can sell all the output that it
produces 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 line
drawn 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 is
equal to MC.
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In the above diagram, profit is maximised at Q0 where MR is equal to MC. If output
increases 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 the
increase in TR and hence the increase in output will lead to a decrease in profit. If output
decreases 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 the
decrease in TC and hence the decrease in output will lead to a decrease in profit. Since
profit 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 increases
from Q0’ to Q0, 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 the
output 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 largest
at Q0. The slope of the TR curve at this output level (MR) is equal to the slope of the TC
curve (MC). Therefore, Q0 in the TR/TC diagram is the same as Q0 in the MR/MC
diagram.
The profit-maximising rule can also be proven mathematically.
Profit Total Revenue – Total Cost
(Q) TR(Q) – TC(Q)
By the first-order condition,
d/dQ 0
dTR/dQ – dTC/dQ 0
MR – MC 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 output
level. A PC market is in short-run equilibrium when all the firms in the market are in
short-run equilibrium. However, this does not necessarily mean that the firms in the market
are making positive economic profit. Indeed, the firms in a PC market in short-run
equilibrium can make one of three types of profit: supernormal profit (positive economic
profit), subnormal profit (negative economic profit or economic loss) and normal profit
(zero economic 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, the
firm 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, the
firm 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 and
the potential firms that wish to enter the market have done so. In other words, a PC market
is 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 the
market in the long run due to the absence of barriers to entry. The market supply will
increase which will lead to a fall in the market price. Potential firms will stop entering the
market when the firms in the market make only normal profit.
Market Representative firm
In the above diagram, supernormal profit represented by the shaded area attracts potential
firms into the market in the long run, resulting in the market supply curve (S) shifting to the
right 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 to
enter the market disappears.
If the firms in a PC market are making subnormal profit, they will leave the market when
their fixed factor inputs need replacing. Those that cannot cover their total variable cost
will leave the market immediately. The market supply will decrease which will lead to a
rise in the market price. The exit of firms will stop when the firms in the market start
making normal profit.
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Market Representative firm
In the above diagram, subnormal profit represented by the shaded area induces the firms to
leave 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 the
market 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 down
production. However, this is not true in the short run. In the short run, a firm should
continue production so long as its TR can at least cover its TVC (TR ≥ TVC). This is
because fixed costs will be incurred whether the firm continues or shuts down production
in the short run. Consider the following cases.
Case 1: TR TVC or AR AVC
If TR is less than TVC, the firm will make a loss equal to its TFC if it shuts down
production. However, if it continues production, the excess of its TVC over its TR will add
to its loss, in which case, it will make a loss greater than its TFC. Therefore, the firm should
shut down production. However, it will still stay in the market.
Case 2: TR TVC or AR AVC
If TR is greater than TVC, the firm will make a loss equal to its TFC if it shuts down
production. However, if it continues production, the excess of its TR over its TVC will
offset 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 AVC
If TR is equal to TVC, the firm will make the same amount of loss whether it continues or
shuts down production. However, in this instance, the firm should continue production
because in doing so, it may be able to make supernormal profit in the future if market
conditions 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 (TR
TC), 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 price
of a good, the quantity supplied is determined entirely by the supply curve. The portion of
the 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 by
the MC. Intuitively, given the price of a good, the quantity supplied is determined by the
marginal revenue and the marginal cost. However, in the case of a PC firm, price is equal to
marginal revenue. Therefore, given the price of the good produced by a PC firm, the
quantity supplied is determined entirely by the MC curve. Further, at a price lower than its
AVC, 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 AVC
curve.
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2.9 Perfect competition and the public interest
Advantages
Due to intense competition in the market, PC firms are not lax in cost control. In other
words, 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 productively
efficient.
A firm is allocatively efficient when it cannot change its output level and hence the
allocation of resources in the economy in a way that will increase the total benefit for
consumers and this occurs when it charges a price equal to its marginal cost, assuming no
externalities. PC firms are allocatively efficient because they charge a price equal to their
marginal cost, assuming no externalities. When the price of a good is equal to the marginal
cost, the marginal benefit that consumers place on the last unit of the good is equal to the
forgone marginal benefit that they place on the amount of other goods that could have been
produced using the same resources. Therefore, PC firms cannot change their output level to
increase the total benefit for consumers and hence are allocatively efficient.
The price charged by the firms in a PC market is lower than the price that would be charged
by the firm in the same market operating under monopoly, 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 PC
output level (QPC) is higher than the monopoly output level (QM).
The distribution of income in an economy that abounds with PC markets will be more
equal than one that abounds with monopolistic markets because although PC firms can
make only normal profit in the long run, a monopoly can make supernormal profit in the
long run.
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Since PC firms produce the output levels which correspond to the lowest points on their
AC curves, we say that they are producing at optimum capacity.
Disadvantages
A monopoly reaps more economies of scale than a PC industry and if this results in its MC
curve being substantially lower than the horizontal summation of the MC curves of the
firms in the same market operating under PC, it will produce a higher output level and
charge a lower price.
In the above diagram, due to substantial economies of scale, the monopoly price (PMC) is
lower than the PC price (PPC).
Due to lack of ability and willingness, PC firms do not engage in research and development.
Due to perfect knowledge, any innovation, whether process or product, can easily and
quickly be copied by other firms. Further, research and development very often requires
huge expenditure outlays which PC firms are unable to finance and this is because they are
small 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 firm
In a monopolistic market, there is a single large firm (known as the monopoly or the
monopolist). Therefore, the output level of a monopoly is the market output level.
Unique product
A monopoly sells a unique product that has no close substitutes.
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A monopoly is a price-setter
Due to lack of competition in the market, a monopoly is a price-setter in the sense that it is
able to set its price by setting its output level. In other words, a monopoly faces a
downward-sloping demand curve.
Barriers to entry
There 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 long
run.
Note: In reality, a monopoly is not defined as a single large firm in a market that sells a
unique product that has no close substitutes. For instance, in the UK, a monopoly is
defined 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 that is faced by potential firms which restricts them from
entering and competing with the firm or firms in a market. Barriers to entry are the sources
of monopoly power.
Very substantial economies of scale
A monopoly may emerge naturally because it can reap very substantial economies of scale
and this occurs when the economies of scale are so substantial that the market can
accommodate only one firm. In other words, a single firm can meet the market demand at
an average cost which allows it to make supernormal profit. However, with two or more
firms, 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 least
normal profit by producing anywhere within the output range from QMIN to QMAX. With
two firms in the market, each firm faces the demand curve (D2), which lies entirely below
the 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 barriers
Some businesses require high start-up costs which not many firms are able to finance.
Legal barriers
A firm may have obtained its monopoly position through the acquisition of a patent or
copyright. A patent is granted to an inventor to allow him the exclusive right to produce the
product or use the production process that is patented. In the latter, potential firms cannot
enter the market as they do not have access to the technology. The aim of awarding patents
is 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 and
copyrights are commonly referred to as intellectual properties.
Control of key factor inputs
If a firm controls the supply of some key factor inputs, it can deny access to these factor
inputs to potential rivals.
Control of wholesale and retail outlets
If a firm controls the outlets through which the product can be sold, it can prevent potential
rivals 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 output
level. A monopolistic market is in short-run equilibrium when the monopoly is in short-run
equilibrium, since it is the only firm in the market. However, this does not necessarily
mean that the monopoly is making positive economic profit. Indeed, a monopoly in
short-run equilibrium can make one of three types of profit: supernormal profit (positive
economic profit), subnormal profit (negative economic profit or economic loss) and
normal 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, the
firm 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 will
also be the long-run equilibrium. If a monopoly cannot reverse a subnormal-profit
equilibrium 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 is
impossible 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
Refer to section 2.7.
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 supply
curve, 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 corresponds
to the output level where marginal revenue (MR) is equal to marginal cost (MC), the
quantity supplied will be Q0’ if the MR curve is MR’. However, given the same price of the
good (P0), the quantity supplied will be Q0” if the MR curve is MR”. Therefore, given the
price of the good produced by a monopoly, not only is the quantity supplied determined by
the MC curve, but it is also affected by the MR curve. Since the quantity of the good
supplied by a monopoly is not determined entirely by the MC curve, the MC curve of a
monopoly is not the supply curve. Indeed, given the price of the good produced by a
monopoly, 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
Advantages
A monopoly reaps more economies of scale than a PC and MC industry and if this results
in its MC curve being substantially lower than the horizontal summation of the MC curves
of the firms in the same market operating under PC or MC, it will produce a higher output
level and charge a lower price.
Since a monopoly is large and it can make supernormal profit in the long run, it has the
ability to engage in research and development. Successful product innovations will lead to
greater product variety and successful process innovations will lead to a lower average cost
of production and hence 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 be
reached or to produce a good that otherwise would not be produced. Further, if the increase
in profit from price discrimination is ploughed back into research and development, more
benefits to consumers will be created.
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Disadvantages
Due to lack of competition in the market, a monopoly may be lax in cost control. In other
words, it may be overstaffed, it may lack the incentive to use the most efficient production
technology, etc. Therefore, a monopoly may be x-inefficient and hence productively
inefficient. 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 in
the absence of potential competition, the sheer aim of making more profit may drive a
monopoly to be x-efficient and hence productively efficient.
A monopoly is allocatively inefficient because it charges a price higher than its marginal
cost. When the price of a good is higher than the marginal cost, the marginal benefit that
consumers place on the last unit of the good is greater than the forgone marginal benefit
that they place on the amount of other goods that could have been produced using the same
resources. Therefore, if a monopoly increases its output level, the total benefit for
consumers will increase and hence is allocatively inefficient.
In the above diagram, the deadweight loss, which is the loss of surplus due to market
failure or government intervention, is represented by the shaded area.
The price charged by the firm in a monopolistic market is higher than the price that would
be charged by the firms in the same market operating under perfect competition or
monopolistic competition, assuming the cost structure of a monopoly is the same as that of
a PC industry and a MC industry.
The distribution of income in an economy that abounds with monopolistic markets will be
less equal than one that abounds with PC markets because although PC firms can make
only normal profit in the long run, a monopoly can make supernormal profit in the long
run.
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A monopoly does not produce the output level which corresponds to the lowest point on its
AC curve, unless by chance. In other words, a monopoly is not producing at optimum
capacity.
Due to its big size, a monopoly may be able to exert pressure on the government to pass
laws that may hurt other sectors of the economy.
The ability of a monopoly to practise price discrimination may lead to a fall in the
consumer 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 only
one firm. An example is a public utility firm. A natural monopoly has two distinctive
characteristics. First, it can reap very substantial economies of scale and hence its LRAC
curve is falling over the entire range of market demand. In other words, its minimum
efficient scale is high relative to the market demand. Second, it incurs very high start-up
costs 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 least
normal profit by producing anywhere within the output range from QMIN to QMAX. With
two firms in the market, each firm faces the demand curve (D2), which lies entirely below
the 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-maximising output level (QM) where marginal revenue
(MR) is equal to marginal cost (MC) is much lower than the allocatively efficient output
level (QA) where price (P) is equal to marginal cost (MC). Therefore, if a natural monopoly
increases its output level, the total benefit for consumers will increase significantly and
hence is very allocatively inefficient.
The government can pass a regulation that requires the monopoly to charge a price equal to
its marginal cost to achieve allocative efficiency, assuming no externalities and the
monopoly, 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 false
information 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 the
shaded area, because PMC is lower than AC at QMC. Therefore, the government has to give
the monopoly a lump-sum subsidy to allow it to cover its loss. However, if the government
is 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 to
make a loss, the government can pass a regulation that requires the monopoly to charge a
price equal to its average cost to reduce allocative inefficiency and this is commonly
known as average cost pricing. In the above diagram, the output level under average cost
pricing (QAC) is closer to QA than QM is. However, the use of average cost pricing in a
monopolistic market will not achieve allocative efficiency.
The government can give a subsidy to the monopoly to induce it to increase output to
achieve allocative efficiency.
In the above diagram, a per-unit subsidy leads to a fall in the AC and the MC curves. If the
new 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, the
monopoly may provide false information about its revenue and cost structures to the
government. If this happens, the use of subsidy in a monopolistic market will not achieve
allocative efficiency. Further, since the subsidy will be financed by taxpayers and will
increase the profit of the monopoly, the government is likely to refrain from using it to
avoid hurting its popularity rating.
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The government can nationalize the market to produce the good itself to achieve allocative
efficiency. 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 to
consider 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 firms
In a MC market, there are a large number of small firms.
Differentiated products
In a MC market, the firms sell differentiated products that are close substitutes for one
another. Differentiated products are products that are sufficiently similar to be
distinguished as a group from other products. An example is restaurant foods.
MC firms are price-setters
Due to product differentiation, a MC firm is a price-setter in the sense that it is able to set its
price by setting its output level. In other words, a MC firm faces a downward-sloping
demand curve. However, due to the large number of substitutes in the market, the demand
for the good produced by a MC firm is more price elastic than the demand for the good
produced by a monopoly.
No barriers to entry
There 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 market
supply in a MC market.
4.2 Revenue curves of a monopolistically competitive firm
Refer to section 3.3.
4.3 Short-run equilibrium of a monopolistically competitive market
Refer to section 3.4.
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© 2011 Economics Cafe All rights reserved. Page 25
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 and
the potential firms that wish to enter the market have done so. In other words, a MC market
is 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 the
market in the long run due to the absence of barriers to entry. As the number of firms in the
market increases, each firm will have a smaller market share. In other words, the demand
curve that each firm faces will shift to the left which will lead to a fall in its profit. Potential
firms will stop entering the market when the firms in the market make only normal profit.
If the firms in a MC market are making subnormal profit, they will leave the market when
their fixed factor inputs need replacing. Those that cannot cover their total variable cost
will leave the market immediately. As the number of firms in the market decreases, each
firm will have a larger market share. In other words, the demand curve that each firm faces
will shift to the right which will lead to a fall in its loss. The exit of firms will stop when the
firms in the market start making normal profit.
4.5 Monopolistic competition and the public interest
Advantages
Due to intense competition in the market, MC firms are not lax in cost control. In other
words, they are not overstaffed, they do not lack the incentive to use the most efficient
production technology, etc. Therefore, MC firms are x-efficient and hence productively
efficient.
Due to intense competition and the absence of barriers to entry in a MC market, the price
charged by the firms in a MC market is lower than the price that would be charged by the
firm in the same market operating under monopoly, assuming the cost structure of a
monopoly is the same as that of a MC industry.
The distribution of income in an economy that abounds with MC markets will be more
equal than one that abounds with monopolistic markets because although MC firms can
make only normal profit in the long run, a monopoly can make supernormal profit in the
long run.
MC firms produce differentiated products which offer consumers a great variety of
choices.
Disadvantages
MC firms are allocatively inefficient because they charge a price higher than their marginal
cost. When the price of a good is higher than the marginal cost, the marginal benefit that
consumers place on the last unit of the good is greater than the marginal benefit that they
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© 2011 Economics Cafe All rights reserved. Page 26
place on the amount of other goods that could have been produced using the same
resources. Therefore, if MC firms increase their output level, the total benefit for
consumers will increase and hence are allocatively inefficient. However, the problem of
allocative inefficiency in a MC market is less severe than that in a monopolistic market
because the price elasticity of demand for the good produced by a MC firm is higher than
that for the good produced by a monopoly.
A monopoly reaps more economies of scale than a MC industry and if this results in its MC
curve being substantially lower than the horizontal summation of the MC curves of the
firms in the same market operating under MC, it will produce a higher output level and
charge a lower price.
The price charged by the firms in a MC market is higher than the price that would be
charged by the firms in the same market operating under PC.
In the above diagram, the PC price (PPC) is lower than the MC price (PMC).
Due to lack of ability and willingness, MC firms do not engage in research and
development. Due to the absence of barriers to entry, any innovation, whether process or
product, can easily and quickly be copied by other firms. Further, research and
development very often requires huge expenditure outlays which MC firms are unable to
finance and this is partly because 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 on
their AC curves, we say that they are producing with excess capacity (or producing under
capacity).
Due to intense price and non-price competition, MC firms may spend excessively on
advertising.
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© 2011 Economics Cafe All rights reserved. Page 27
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. Hence, the output level
of each firm in an oligopolistic market is large relative to the market output level.
Homogeneous or differentiated products
Although the firms in some oligopolistic markets sell homogeneous products (e.g. cement
and steel), the firms in most oligopolistic markets sell differentiated products (e.g. cars and
electrical appliances).
Oligopolists are price-setters
Due to its large market share, an oligopolist is a price-setter in the sense that it is able to set
its price by setting its output level. In other words, an oligopolist faces a downward-sloping
demand curve.
Barriers to entry
There are barriers to entry in an oligopolistic market, although they are often lower than the
barriers 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 the
long run.
Strategic interdependence (also known as mutual interdependence)
Due to the small number of large firms in an oligopolistic market, the actions of one firm
affect, and are affected by the actions of its rivals. Therefore, if a firm in an oligopolistic
market changes the price or the specification of its product, the sales of its rivals will be
affected. The rivals will then respond by changing the price and the specifications of their
product, which will affect the sales of the first firm. Therefore, no firm in an oligopolistic
market 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 collude
because they will be better off if they to jointly maximise profit. On the other hand, they are
tempted to compete with each other to gain a bigger market share. Therefore, oligopolists
may either collude or compete.
Collusive behaviour
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If oligopolists collude, there will be price stability. Oligopolists can collude by banding
together to agree on a common price higher than the price that they currently charge and
this is commonly known as cartelisation. To avoid a surplus of the goods, they must also
agree on a set of output quotas and the most likely method is for them to divide the market
among 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 have
the same cost structure and there are high barriers to entry and therefore there is little fear
of 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 tacit
collusion. Tacit collusion usually takes the form of price leadership where the followers
keep to the price set by the leader. The price leader may be the firm with the largest market
share (known as the dominant firm price leadership) or the firm which is believed to have
the most information about market conditions (known as the barometric firm price
leadership).
Competitive (Non-collusive) behaviour
At first thought, if oligopolists do not collude, price war will be inevitable. However, price
stability has been found to be an empirical regularity in most oligopolistic markets, even in
those where the firms do not collude. This phenomenon can be explained by the theory of
the 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 suit
because by keeping their price the same, they can attract customers from the firm.
Accordingly, if a firm in an oligopolistic market increases its price, its quantity demanded
will decrease by a larger percentage as customers will switch from the firm to the rivals
which will lead to a fall in revenue for the firm.
Second, if a firm in an oligopolistic market reduces 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 demanded will increase by a smaller percentage as customers
will not switch from the rivals to the firm, which will lead to a fall in revenue for the firm.
Therefore, oligopolists do not have the incentive to change their price, assuming no
substantial changes in the cost of production.
The theory of the kinked demand curve can be illustrated with a diagram. A firm in an
oligopolistic market faces a demand curve that is kinked at the current equilibrium, and the
kink on the demand curve leads to the gap on the MR curve.
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© 2011 Economics Cafe All rights reserved. Page 29
Kinked demand curve
In the above diagram, since the current price and the current output level are P0 and Q0, the
MC curve must be cutting the MR curve at the gap. A small change in the cost of
production will lead to a shift in the MC curve but so long as the new MC curve lies
between MC’ and MC”, the price will remain unchanged and this explains price stability in
oligopolistic markets where the firms do not collude.
However, if there is a large change in the cost of production, the new MC curve will shift
out of the range between MC’ and MC” which will lead to a change in the price and the
output level. In this case, the firms may plunge into a price war before they reach a new
equilibrium. 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 not
want to change price too frequently to prevent upsetting customers.
5.3 Non-price competition
Firms engage in non-price competition through product development and product
promotion. Product development will improve the quality and the features of the good and
product promotion will increase the awareness and the appeal. Successful product
development and product promotion will not only lead to an increase in the demand for the
good, but they will also make the demand less price elastic as consumers will perceive the
good to be more different from its substitutes. In other words, successful product
development and product promotion will shift the demand curve of the good to the right
and make it steeper.
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© 2011 Economics Cafe All rights reserved. Page 30
5.4 Oligopoly and the public interest
If oligopolists collude, they will effectively be acting like a monopoly. In this instance, the
advantages and disadvantages to society experienced under monopoly will also be
experienced 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 less
economies 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 two
respects.
First, unlike a monopoly may not be x-efficient and hence productively efficient due to
competition 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 and
development due to lack of competition in the market, an oligopolist has the incentive to
engage in research and development due to competition in the market. Successful product
innovations will lead to greater product variety and successful process innovations will
lead to a lower average cost of production and hence a lower price.