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Market Structure Analysis: Introduction

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Market Structure• Market structure is the pattern or form or manner in which its different constituents, i.e. sellers and buyers, are

linked together

• The following 4 main features of the market-structure:

• The degree of sellers concentration: This is the number and size distribution of firms producing a particular commodity or types of commodities in the market.

• The degree of buyers concentration: This shows the number and size distribution of buyers for the commodities in the market.

• The degree of product differentiation: This shows the difference in the products of different firm in the market.

• The condition of entry to the market: This shows the relative ease with which new firms can join the category of sellers (i.e. firms) in the market.

• Market structure is a multidimensional concept.

• Each of these 4 dimensions of the market structure is important in determining the behaviour of the firms which in turn affects their

performance as well as the performance of the industry as a whole.

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Market Conduct

• This is defined as the pattern of behaviour that firms follow in

adopting or adjusting to the market in which they operate to achieve

the well defined goal(s).

• Given the market conditions and goals, a firm will be acting alone or

jointly to decide about price levels for the products, the types of

products and their quantities, advertisement, etc.

• Also, the firm under such situation has to devise the ways for

interactions, cross-adaptation and coordination among competing

group of sellers in the market.

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Market Performance

• This relates to economic efficiency.

• For the entire economic system of a community, economic efficiency means

efficient selection of goods to be produced, efficient allocation of resources in the

production of these goods and efficient choice of the methods of production, and

efficient allotment of the goods produced among the consumers.

• Allocative efficiency occurs when output is at that level where MC equals price in

each product for each firm.

• Among the factors affecting economic efficiency include the organisational or

structural conditions prevailing in the industry to which firm belongs, short-term

fluctuations in the market for both input and output, etc.

BASIC CONDITIONS

Social & Political choices; Technology elasticities; tastes, etc.

Input prices

MARKET STRUCTURE

Concentration, Size distribution, No. of firms, Barriers to entry, Vertical integration, Cost

structure, Product differentiation, etc.

MARKET CONDUCT

Price behaviour, Product behaviour, Financial policy, R&D – Innovation, Advertisement,

Collusion, etc.

MARKET PERFORMANCE

Profitability, Growth rate, Technological advance, Equity content, Efficiency, Full-

employment, etc.

THE STRUCTURE-CONDUCT-PERFORMANCE (S-C-P) THE STRUCTURE-CONDUCT-PERFORMANCE (S-C-P) APPROACHAPPROACH

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Dipankar DeMumbai, September 2007

Narsee Monjee Institute of Management StudiesNMIMS University

Market Structure Analysis: I

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Profit Maximization

• The assumption of profit maximization predicts business behavior reasonably accurately

and avoids unnecessary analytical complications

• But whether firms do maximize profit has been controversial

• For smaller firms managed by their owners, profit is likely to dominate almost all the firm’s

decisions

• In larger firms, however, managers who make day-to-day decisions usually have little

contact with the owners (shareholders). As a result, the owners of the firm can not

monitor the managers’ behavior on a regular basis.

• Managers may be more concerned with goals such as revenue maximization to achieve

growth or the payment to dividend holders rather than profit maximization

• Managers may be overly concerned with the firm’s short-run profit – perhaps to earn a

promotion or bonus – at the expense of LR profit.

(Principal-Agency Problem)

Profit MaximizationCost, Revenue, Profit

O q0 q*Output

C(q)

R(q)

π(q)

A

B

π(q) = R(q) – C(q)

Profit is maximized when the following condition is fulfilled

MR(q) = MC(q)

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Perfect Competition

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Perfect Competition

• A market is said to be under perfect competition when the following conditions

are met:

• Numerous small buyers and sellers: A large no. of sellers and buyers exist

in the market, each one of them individually have no noticeable influence upon

the market price and quantity of the product

• Homogeneity of product: The product of any one firm is identical to the

product of every other seller in the market. The buyers are, therefore,

indifferent to the sellers and can buy from any one

• Freedom of entry and exit: There are no barriers to entry or exit. Sellers and

buyers are free to join or leave whenever they want

• Perfect information: Each buyer and seller has complete information about

the market, i.e. about the prices, nature of product, costs, and demand, etc.

There is complete absence of advertisement and selling expenses

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Perfect Competition

• In addition to the above,

– There are no artificial restraints in the market. The factors of

production are perfectly mobile. No middle-man, such as whole-sellers,

brokers, jobbers, retailers, etc. exists. The transactions are supposed to

be costless

– The sellers and buyers are independent in decision making. There is

no collusion of any kind among the buyers and sellers.

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Market Demand Curve

D

Quantity

Price

Q=

Demand Curve facing the Firm

Quantity

Price

d

Perfect Competition

iqiq

• In a perfectly competitive market, a firm is a price-taker

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Perfect Competition

Quantity

D

S

MC

q* Quantity

AC

Price, Cost

AVC

AR=MR=P

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Short-run Profitability: No-Shut Down Condition

Price, Cost

C

D

F

q*

E

A

MC

Quantity

AC

AVC

AR=MR=P

B

D

• A firm will find it profitable to shut-down (produce no output) when the price of its

product is less than the minimum AVC.

• In this situation, revenues from production will not cover variable costs, and

losses will increase

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Perfect Competition: The Long Run

• If in the short run, price is greater than min. AC, the firm would earn ‘super-

normal profit’ or ‘pure economic profit’, which is in excess of the ‘normal profit ’.

• This would attract new firms into the industry, and there would be increase in the

number of firms.

• The firms would compete among themselves for scarce resources, and hence

the level of competition in the industry would increase. The overall market supply

increases due to increased number of firms, and price would fall. A few firms

would make losses, and would exit the industry.

• The exodus of firms would continue, and industry supply would shift backwards

to the left. The interaction of industry supply and demand would lead to increase

in the price and it settles at the minimum of LRAC.

• At this point, there is no incentive for the firms to entry or exit the industry - the

long run equilibrium

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Perfect Competition: The Long Run

• A long run equilibrium occurs when three conditions

hold:

– All firms in the industry are maximizing profit

– No firm has an incentive either to enter or exit the industry because

all firms in the industry are earning zero economic profit

– The price of the product is such that the quantity supplied by the

industry is equal to the quantity demanded by the consumers.

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Perfect Competition: Impact of Output Tax on Firm

• Tax imposed on any particular firm will not affect the market price. However, as

the tax would raise the cost of producing each unit, MC cost curve shifts upward

to the left (by the amount of tax per unit). It also raises the AVC curve by the

amount of tax per unit.

• A tax might have 2 possible impact:

– If the tax is less than the profit margin, the firm will maximise its profit by

choosing an output at which MC+ t = P; as result output falls, firm’s SR supply

curve shifts to the left.

– If the tax> profit margin, the AVC curve will rise, and the min. AVC > P. The firm

may choose not to produce.

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Perfect Competition: Impact of Output Tax on Industry

• Tax imposed on all firms will have a cut in their output & production. Thus, at the current market price, total output supplied falls, causing the price of the product to increase.

• This increase in the price of the product diminishes some of the effects on the individual firms output decision, as they would reduce their output less than they would without a price increase

• Output taxes may also encourage some firms (those whose costs are somewhat higher than the others) to exit the industry, as it would make production unprofitable for those firms.

• Industry supply curve shifts to the left, and price rises and quantity sold in the market falls

• LR equilibrium will have fewer firms and less output.

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Monopoly

• Monopoly is characterised as: existence of only one firm supplying the

goods in the market, and it produces single or differentiated goods which

do not have any close substitutes in the market. There are substantial

barriers to entry existing in the market.

• A monopoly would recognise its influence over the market price and

chose that level of price and output that maximised its overall profits.

• However, it cannot choose price and output simultaneously.

• The monopolist chooses the output where MR = MC.

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Equilibrium condition under Monopoly

• If MR<MC, it would pay the firm to decrease output since the savings in cost would more than make up for the loss in revenue. If MR>MC, it would pay for the firm to increase output. The point where the firm has no incentive to change output is where MR = MC.

• A monopolist will never choose to operate where the demand curve is inelastic. For if elasticity is less than unity, then MR is negative, so it can’t equal MC.

D

Pm

Qm

MC

MR=MC

Quantity

Price, cost

MR

AC

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Inefficiency of Monopoly

• A competitive industry

operates at a point where P =

MC. A monopolised industry

operates where P > MC.

• Thus, the price will be higher

and output lower if a firm

behaves monopolistically

rather than competitively. For

this consumers will be worse

off under monopoly.

Deadweight loss

Demand

Quantity

Price

MC

Pm

PC

Qm QC

MR

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Monopoly Power

• Monopoly power is defined as the ability of a firm to profitably charge a price

higher than marginal cost. A natural way to measure monopoly power is to

examine the extent to which the profit-maximising price exceeds marginal cost.

• Lerner’s degree of Monopoly Power is given as:

• This Lerner’s Index always has a value between zero and one. For a perfectly

competitive firm, P = MC, so that L = 0. The larger L is, the greater the degree

of monopoly power.

PMCPL )(

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Sources of Monopoly Power

• It implies from the Lerner’s index is that the less elastic its demand curve, the more monopoly power it has.

• 3 factors determine a firm’s elasticity of demand:

– The elasticity of market demand

– The number of firms

– The interaction among the firms

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Price Discrimination

• If a firm has some degree of monopoly power it has more options open to it than a firm in a perfectly competitive industry. For example, it can use more complicated pricing and marketing strategies.

• First degree price discrimination or Perfect price discrimination

• Second degree price discrimination

• Third degree price discrimination

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Price Discrimination

• If a firm has some degree of monopoly power it has more options open to it than a firm in a perfectly competitive industry. For example, it can use more complicated pricing and marketing strategies.

• First degree price discrimination or Perfect price discrimination: The monopolist sells different units of output for different prices and these prices may differ from person to person.

• Second degree price discrimination: The monopolist sells different units of output for different prices, but every individual who buys the same amount of the good pays the same price. Thus prices differ across the units sold, but not across people. An example of this is bulk discounts

• Third degree price discrimination: The monopolist sells output to different people for different prices, but every unit of output sold to a given person sells for the same price. This is the most common form of price discrimination, and examples include senior citizens’ discounts, student discounts, etc.