Microeconomics Lecture

8/20/2019 Microeconomics Lecture

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Four Market StructuresThe focus of this lecture is the four market structures. Students will learn the characteristics of pure

competition, pure monopoly, monopolistic competition, and oligopoly. Using the cost schedule from the

previous lecture, the idea of profit maximization is explored.

OBJECTIVES

1. Identify

various

market

structures

and

their

characteristics.

2. Be able to category firms into four market structures.

3. Describe the effects of imperfect competition upon the market and the firm.

4. Understand the pricing structure of the four structures.

TOPICS

Please read

all

the

following

topics.

PERFECT COMPETITION

PERFECT COMPETITION CONT.

PERFECT COMPETITION EXAMPLE

PURE MONOPOLY

MONOPOLY

EXAMPLEPRICE DISCRIMINATION

MONOPOLISTIC COMPETITION

OLIGOPOLY

TECHNOLOGICAL DEVELOPMENT

ECONOMIC EFFICIENCY



Perfect CompetitionPure or perfect competition is rare in the real world, but the model is important because it helps

analyze industries with characteristics similar to pure competition. This model provides a context in

which to apply revenue and cost concepts developed in the previous lecture. Examples of this model

are stock market and agricultural industries.

Characteristics1. Many sellers: there are enough so that a single seller’s decision has no impact on market price.

2. Homogenous or standardized products: each seller’s product is identical to its competitors’.

3. Firms are price takers: individual firms must accept the market price and can exert no influence on

price.

4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry.

Demand

The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a

horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears

that way to the individual firms, since they must take the market price no matter what quantity they

produce. Therefore,

the

firm’s

demand

curve

is

a horizontal

line

at

the

market

price.

Marginal revenue (MR) is the increase in total revenue resulting from a one‐unit increase in output.

Since the price is constant in the perfect competition. The increase in total revenue from producing 1

extra unit will equal to the price. Therefore, P= MR in perfect competition.



Perfect Competition Cont.Following the rules discussed in the previous section. Here is an example.

Firms fixed cost is $100, its min AVC is $55.

If market price is 50 which is less than min AVC, the firm would loss $5 more by producing each unit. If the firm produces

one unit, its total loss would be $5 plus $100 fixed cost. If the firm decides to shut down, its loss would be only $100 as the

firm does

not

need

to

pay

for

the

variable

cost.

Shut

down

would

be

the

loss

minimization

strategy.

If the market price is 60, the firm would lose $5 less by producing each unit. If the firm produces one unit, its total cost

would be fixed cost less $5, which is $95. The firm is better off by producing, not shutting down. When the market price is

higher than the minimum AVC, MR and MC should be compared to find out the optimal level of output.

Long

Run

Analysis

Obviously, the firm cannot be in loss for long. Three assumptions are made for the long run analysis:

1. Entry and exit are the only long run adjustments.

2. Firms in the industry have identical cost curves.

3. The industry is in constant return to scale.

In long run, if economic profits are earned, firms enter the industry, which increases the market supply, causing the product

price to go down. Until zero economic profits are earned, then the supply will be steady. If losses are incurred in the short

run, firms will leave the industry which decreases the market supply, causing the product price to rise until losses disappear.

This model is one of zero economic profits in long run. The long run equilibrium is achieved, the product price will be exactly

equal to, and production will occur at, each firm’s point of minimum average total cost.



Efficiency Analysis

1. Productive efficiency: occurs where P= min ATC. Perfect competitive firms will

achieve productive efficiency as firms must use the least‐cost technology or they

won't

survive.

2. Allocative efficiency: occurs where P = MC. Price represent the benefit that society

gets from additional units of a product, MC represents the cost to society of other

goods given up to produce this product. Dynamic adjustments will occur in this

market

structure

when

changes

in

demand,

supply

or

technology

occurs.

Perfect

competitive firms will achieve this efficiency. Since no explicit orders are given to

the industry, "the Invisible Hand" works in this system.

Even though both efficiencies are achieved in this system, the consumers are facing

standard

products,

making

shopping

to

be

no

fun

at

all.

On

the

other

hand,

the

consumers will receive the highest consumer surplus in this structure as the long run

market price will be at the min ATC. Producers will receive the lowest producer surplus

as consumers can easily find substitutes.



An ExampleThe

following

data

represents

a cost

function

of

a perfect

competitive firm:

TP or Q AFC AVC ATC MC

0

1 60 45 105 45

2 30 42.5 72.5 40

3 20 40 60 35

4 15 37.5 52.5 30

5 12 37 49 35

6 10 37.5 47.5 40

7 8.57 38.57 47.14 45

8 7.5 40.63 48.13 55

9 6.67 43.33 50 6510 6 46.5 52.5 75

If the market price, P < 37; this firm's output Q = 0; firm's

economic profit, EP = ‐60

If the market price, P > 37, this firm's output Q > 0; firms'

economic profit

, EP=

TR

‐ TC.

For example, when P = 65, Q = 9, EP = $65 x 9 ‐ 50 X 9 = 135



An Example Cont.By given the market demand at various price level, a market equilibrium price could be found.

PRICE Qs (1 firm's output) PROFIT Qs(1500 firms in the market) / market supply Qd / market demand

26 0 -60 0 17000

32 0 -60 0 1500038 5 -55 7500 13500

41 6 -39 9000 12000

46 7 -8 10500 10500

56 8 63 12000 9500

66 9 144 13500 8000

(assuming identical cost function for all firms)


0

1 60 45 105 45

2 30 42.5 72.5 40

3 20 40 60 35

4 15 37.5 52.5 30

5 12 37 49 35

6 10 37.5 47.5 40

7 8.57 38.57 47.14 45

8 7.5 40.63 48.13 55

9 6.67 43.33 50 65

10 6 46.5 52.5 75

One firm's output level (column 2 in the above table) is

obtained by comparing P and MC. Since all firms are having

the same cost function, the market output level is the sum of

individual firms' output (column 4 in the above table).

By comparing the market supply and market demand, we can

find the

market

equilibrium

at:

P= 46 and Q = 10500

At this level, each firm is losing 8 dollars, indicating a

contraction in

this

industry.

Some

firms

may

leave

in

the

long

run, causing the market supply to decrease and equilibrium

price will increase to the break‐even level.



Pure MonopolyPure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. Examples

are public

utilities

and

professional

sports

leagues.

Characteristics

1. A single seller: the firm and industry are synonymous.

2. Unique product: no close substitutes for the firm’s product.

3. The firm is the price maker: the firm has considerable control over the price because it can control the quantity supplied.

4. Entry

or

exit

is

blocked.

Barriers to Entry

Economies of scale is the major barrier. This occurs where the lowest unit cost and, therefore, low unit prices for consumers

depend on the existence of a small number of large firms, or in the case of monopoly, only one firm. Because a very large

firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale.

Public utilities are known as natural monopolies because they have economies of scale in the extreme case. More than one

firm would

be

inefficient

because

the

maze

of

pipes

or

wires

that

would

result

if there

were

competition

among

water

companies or cable companies. Legal barriers also exist in the form of patents and licenses, such as radio and TV stations.

Ownership or control of essential resources is another barrier to entry, such as the professional sports leagues that control

player contracts and leases on major city stadiums. It has to be noted that barrier is rarely complete. Think about the

telephone companies a couple decades ago; there was no substitute for the telephone. Nowadays, cellular phones are very

popular. It creates a substitute for your house phone, causing the traditional telephone companies to lose their monopoly

position.

Demand Curve

Monopoly demand is the industry or market demand and is therefore downward sloping. Price will exceed marginal

revenue because the monopolist must lower price to boost sales and cannot price discriminate in most cases. The added

revenue will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output. The

marginal

revenue

curve

is

below

the

demand

curve.



Profit –Maximizing Output & EfficiencyProfit –Maximizing Output:

The MR

= MC

rule

will

still

tell

the

monopolist

the

profit

– maximizing

output.

The

monopolist

cannot

charge

the

highest

price possible, it will maximize profit where TR minus TC is the greatest. This depends on quantity sold as well as on price.

The monopolist can charge the price that consumers will pay for that output level. Therefore, the price is on the demand

curve. Losses can occur in monopoly, although the monopolist will not persistently operate at loss in the long run.

Monopolies will sell at a smaller output and charge a higher price than would pure competitive producers selling in the

same market.

Income distribution is more unequal than it would be under a more competitive situation, unless the government regulates

the monopoly and prevents monopoly profits. If a monopoly creates substantial economic inefficiency and appears to be

long‐lasting, antitrust laws could be used to break up the monopoly.

Efficiency:

1. Productive efficiency: occurs where P= min ATC. Monopoly firms will not achieve productive efficiency as firms will

produce at an output which is less than the output of min ATC. X‐inefficiency may occur since there is no competitive

pressure to produce at the minimum possible costs.

2. Allocative efficiency: occurs where P = MC. This efficiency is not achieved because price( what product is worth to

consumers) is above MC (opportunity cost of product).

It is possible that monopoly is more efficient than many small firms. Economies of scale (natural monopoly) may make

monopoly the most efficient market model in some industries. However, X‐inefficiency and rent‐seeking cost (lobbying, legal

fees, etc.) can entail substantial costs, causing inefficiency.

Producer surplus is significant due to lack of competition, consumer surplus may be minimized. This market structure will

not

contribute

to

a

fair

income

distribution

of

our

society.



An ExampleIn this example, the cost function is the same as the one used in the

perfect competition example. You can see from the following analysis

that the output level and market price are different in monopoly . The output level is lower than output of the perfect competitive

firm; and price is higher than the price of perfect competitive firm.

Pd Qd TR MR EP

115 0 0 0

100 1 100 100 -5

83 2 166 66 21

71 3 213 47 33

63 4 252 39 42

55 5 275 23 30

48 6 288 13 3

42 7 294 6 -35.98

37 8 296 2 -89.04

33 9 297 1 -153

29 10 290 -7 -235


0

1 60 45 105 45

2 30 42.5 72.5 40

3 20 40 60 35

4 15 37.5 52.5 30

5 12 37 49 35

6 10 37.5 47.5 40

7 8.57 38.57 47.14 45

8 7.5 40.63 48.13 55

9 6.67 43.33 50 65

10 6 46.5 52.5 75

By comparing the MR and MC unit by unit, we can find this firm's

output at:

Q = 4, and P= 63. This is the profit maximization output level, with

EP = 42.

It is

possible

for

this

firm

to

continue

earning

this

profit

in

the

long

run as there are no competition in the market.



Price

DiscriminationPrice discrimination is selling a good or service at a number of different prices, and the

price differences is not justified by the cost differences. In order to price discriminate,

a monopoly must be able to

1. be able to segregate the market

2. make sure

that

buyers

cannot

resell

the

original

product

or

services.

Perfect price discrimination is a price discrimination that extracts the entire consumer

surplus by charging the highest price that consumer are willing to pay for each unit.

As a result, the demand curve becomes the MR curve for a perfect price discriminator. Firms capture the entire consumer surplus and maximize economic profit.



Monopolistic Competition

Monopolistic competition refers to a market situation with a relatively large number of

sellers offering similar but not identical products. Examples are fast food restaurants

and clothing stores.

Characteristics

1. A lot of firms: each has a small percentage of the total market.

2. Differentiated products: variety of the product makes this model different from

pure competition model. Product differentiated in style, brand name, location,

advertisement, packaging,

pricing

strategies,

etc.

3. Easy entry or exit.

Demand Curve

The firm’s demand curve is highly elastic, but not perfectly elastic. It is more elastic

than the

monopoly’s

demand

curve

because

the

seller

has

many

rivals

producing

close

substitutes; it is less elastic than pure competition, because the seller’s product is

differentiated from its rivals.



Profit ‐ Maximizing OutputThe MR = MC rule will give the firms the profit – maximizing output. The price they charge would be on

the demand curve.

In the long run, the situation will tend to be breaking even for firms. Firms can enter the industry easily

and will if the existing firms are making an economic profit. As firms enter the industry, the demand curve

facing by

an

individual

firm

shift

down,

as

buyers

shift

some

demand

to

new

firms

until

the

firm

just

breaks even. If the demand shifts below the break‐even point, some firms will leave the industry in the

long run.

Therefore, most monopolistic competitive firms should experience break‐even in the long run

theoretically. In reality, some firms experience profit as they able to distinguish themselves from the

others and

build

a loyal

customer

base;

such

as

some

name

brand

apparel

companies.

Some

firms

experience lost in long run but may continue the business as they are still earning normal profit. These

firm owners usually like the flexible life style and willing to earn a normal profit that is lower than their

opportunity cost.

Price exceeds

marginal

cost

in

the

long

run,

suggesting

that

society

values

additional

units

which

are

not

being produced. Average costs may also be higher than under pure competition, due to advertising cost

involved to attract customers from competitors. The various types, styles, brands and quality of products

offers consumers choices. However, economic inefficiency is the result. The excess capacity (producing at

the quantity that a firm produces is less than the quantity at which ATC is a minimum) exists in this

industry.



OligopolyOligopoly exits where few large firms producing a homogeneous or differentiated

product dominate a market. Examples are automobile and gasoline industries.

Characteristics

1. Few large firms: each must consider its rivals’ reactions in response to its decisions

about prices, output, and advertising.

2. Standardized or differentiated products.

3. Entry is hard: economies of scale, huge capital investment may be the barriers to

enter.

Demand Curve

Facing competition or in tacit collusion, oligopolies believe that rivals will match any

price cuts and not follow their price rise. Firms view their demands as inelastic for

price cuts,

and

elastic

for

price

rise.

Firms

face

kinked

demand

curves.

This

analysis

explains the fact that prices tend to be inflexible in some oligopolistic industries.



Efficiency & Advertisement

1. Productive efficiency: occurs where P= min ATC.

Monopolistic competitive firms will not achieve productive efficiency as firms will

produce

at

an

output

which

is

less

than

the

output

of

min

ATC.

Product

differentiation

is

the major cause of excess capacity.

2. Allocative efficiency: occurs where P = MC.

This

efficiency

is

not

achieved

because

price(

what

product

is

worth

to

consumers)

is

above MC (opportunity cost of product).

Advertisement is very crucial for each firm in this market structure as firms need

exposure

to

get

consumer's

attention.

However,

too

much

spending

will

result

in

higher

cost, and lower profit. Price, product attributes, and advertisement are three main

factors that producers have to consider. The perfect combination cannot be forecasted

easily.



Game Theory & CartelGame theory suggests that collusion is beneficial to the participating firms. Collusion reduces uncertainty, increases profits,

and may

prohibit

entry

of

new

rivals.

Consider the following payoff matrix in which the numbers indicate the profit in millions of dollars for a duopoly (GM and

Ford) based on either a high‐price or a low‐price strategy. This example illustrated that GM or Ford will earn the highest

individual profit when each adopts low price strategy while other firm continues with the higher price strategy (in B or C).

But firms will earn the highest total profit when both adopt the high price strategy (A). When firms form a cartel, they are

acting as one entity (A). They will perform as they are a large monopoly, earning the highest total profit possible. However,

members do

have

an

incentive

to

cheat

as

individuals

can

increase

their

own

profits

by

cheating

in

short

run

(B

or

C).

When

other members are aware of the cheating, they may carry out the same practice, sometimes it may result in a price war and

all members loss (D). Duopoly GM

Ford High-price Low-price

High-price A: GM=$50M Ford=$50M B: GM=$60M Ford=$20M

Low-price C: GM=$20M Ford=$60M D: GM=$30M Ford=$30M

Profit Analysis GM Profit Ford Profit Total profit in the industry

A: Both firms adopt high price strategy Earns $50M Earns $50M $50 + $50 =$100M

B: GM lowers price and Ford continues with

high price strategy

Increased to $60 M Dropped to $20M $60 + $20 =$80M

C: Ford lowers price and GM continues with

high price strategy

Dropped to $20 M Increased to $60M $20 + $60 =$80M

D: Both firms adopt low price strategy Earns $30M Earns $30M $30 + $30 =$60M

The Organization of Petroleum Exporting Countries (OPEC) is a cartel. The eleven countries agreed on the output amount

and working

together

to

control

the

world’s

crude

oil

supply.

In

US,

anti

‐trust

law

has

set

up

guidelines

for

corporations

to

follow to avoid collusion of large firms in the same industry and protect consumer rights.



Technological DevelopmentTechnological advance is a three‐step process that shifts the economy‘s production possibilities curve

outward enabling more production of goods and services.

1. Invention: is the discovery of a product or process and the proof that it will work.

2. Innovation: is the first successful commercial introduction of a new product, the first use of a new

method, or

the

creation

of

a new

form

of

business

enterprise.

3. Diffusion: is the spread of innovation through imitation or copying.

Expenditures on research and development (R&D) include direct efforts by business toward invention,

innovation, and diffusion. Government also engages in R&D, particularly for national defense. Finding

the optimal amount of R&D is an application of basic economics: marginal benefit and marginal cost

analysis. Optimal

R&D

expenditures

occur

when

the

interest

rate

cost

of

funds

is

equal

to

the

expected

rate of return.

Many projects may be affordable but not worthwhile because the marginal benefit is less than marginal

cost. Often the R&D spending decision is complex because the estimation of future benefits is highly

uncertain

while

costs

are

immediate

and

more

clear‐

cut.



The

Role

of

Market

Structure1. Pure competition: the small size of competitive firms and the fact hat they earn zero

economic profit in the long run leads to serious questions as to whether such producers can

finance substantial R&D programs. The firms in this market structure would spend no

significant

amount. However,

firms

of

the

same

industry

may

gather

their

resources

and

develop R&D programs.

2. Monopolistic competition: there is a strong profit incentive to engage in product

development in this market structure as the firms depend on product differentiation to stand

out

from

a

large

number

of

rivals.

However,

most

firms

remain

small

which

limits

their

ability

to secure inexpensive financing for R&D and any economic profits are usually temporary.

Therefore, spending on R&D is limited in this market structure.

3. Oligopoly: many of the characteristics of oligopoly are conducive to technical advances

including:

their

large

size,

ongoing

economic

profits,

the

existence

of

barriers

to

entry

and

a

large volume of sales. Firms in oligopoly spent the highest amount on R&D among the four

different market structures.

4. Pure monopoly: monopoly has little incentive to engage in R&D as the profit is protected by

absolute

barriers

to

entry,

the

only

reason

for

R&D

would

be

defensive

– to

reduce

the

risk

of

a

new product or process which would destroy the monopoly.



Economic EfficiencyEconomics is a science of efficiency in the use of scarce resources. Efficiency requires full employment of available

resources and

full

production.

Full

employment

means

all

available

resources

should

be

employed.

Full

production

means that employed resources are providing maximum satisfaction for our material wants. Full production implies two

kinds of efficiency:

1. Allocative efficiency means that resources are used for producing the combination of goods and services most wanted

by society. For example, producing computers with word processors rather than producing manual typewriters.

2. Productive

efficiency

means

that

least

costly

production

techniques

are

used

to

produce

wanted

goods

and

services.

Full efficiency means producing the "right" (Allocative efficiency) amount in the "right "way (productive efficiency).

Pure competition:

Productive efficiency occurs where price is equal to minimum average total cost (min ATC); at this point firms must use

the

lease‐

cost

technology

or

they

won’t

survive.

Under pure competition, this outcome will be achieved, as the long run equilibrium price of pure competitive firms

would be at the min ATC.

Allocative efficiency occurs where price is equal to marginal cost ( P=MC), because price is society’s measure of relative

worth of a product at the margin or its marginal benefit. And the marginal cost of producing product X measures the

relative worth

of

the

other

goods

that

the

resources

used

in

producing

an

extra

unit

of

X could

otherwise

have

produced.

In short, price measures the benefit that society gets from additional units of good X, and the marginal cost of this unit

of X measures the sacrifice or cost to society of other goods given up to produce more of X.

Under pure competition, this outcome will be achieved. Dynamic adjustments will occur automatically in pure

competition when changes in demand or in resources supply, or in technology occur. Disequilibrium will cause expansion

or contraction

of

the

industry

until

the

new

equilibrium

at

P=MC

occurs.



Efficiency Cont.Non‐perfect competition:

Price of

non

‐perfect

competitive

firms

will

exceed

marginal

cost,

because

price

exceeds

marginal

revenue

and

the

firms

produce where marginal revenue (MR) and marginal cost are equal. Then the firms can charge the price that consumers will

pay for that output level. Allocative efficiency is not achieved because price (what product is worth to consumers) is above

marginal cost (opportunity cost of product). Ideally, output should expand to a level where P=MC, but this will occur only

under pure competitive conditions where P = MR. Productive efficiency is not achieved because the firms’ output is less

than the output at which average total cost is minimum.

Economies of scale (natural monopoly) may make monopoly the most efficient market model in some industries. X‐

inefficiency, the inefficiency that occurs in the absence of fear of entry and rivalry, may occur in monopoly since there is no

competitive pressure to produce at the minimum possible costs. Rent‐seeking behavior often occurs as monopolies seek to

acquire or maintain government –granted monopoly privileges. Such rent‐seeking may entail substantial cost (lobbying,

legal fees, public relations advertising etc.) which are inefficient.

There are

several

policy

options

available

when

monopoly

creates

substantial

economic

inefficiency:

1. Antitrust laws could be used to break up the monopoly if the monopoly’s inefficiency appears to be long‐lasting.

2. Society may choose to regulate its prices and operations if it is a natural monopoly.

3. Society may simply ignore it if the monopoly appears to be short‐lived because of changing conditions or technology.

Efficiency Vs technological advances:

Allocative efficiency

is

improved

when

technological

advance

involves

a new

product

that

increases

the

utility

consumers

can obtain from their limited income. Process innovation can lower production cost and improve productive efficiency.

Innovation can create monopoly power through patents or the advantages of being first, reducing the benefit to society

from the innovation. Innovation can also reduce or even disintegrate existing monopoly power by providing competition

where there was none. In this case economic efficiency is enhanced because the competition drives prices down closer to

marginal cost and minimum average total cost.

Microeconomics Lecture

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