Market Structures

(Mankiw, chapter 14,15,16,17)

 Market structures
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly
 Learning Outcomes
L.O.5 Identify, interpret, analyze and evaluate the results of
different market structures
L.O.5.1 Differentiate between normal rate of return (normal
profit) and economic profit.
L.O.5.2 Describe how a firm would use marginal analysis to
determine a profit-maximizing level of production output
in different market structures.
L.O.5.3 Compare and contrast the market structures. Give an
example of each.
L.O.5.4 Demonstrate and differentiate the market structures via
diagrams.
 Market structures
Seller Buyer
Market Seller Buyer
Product Entry Entry
Structure Number Number
Barriers Barriers
Perfect
Homogenous No Many No Many
Competition
Monopolistic
Different No Many No Many
competition
Oligopoly Similar Yes Few No Many
No close
Monopoly Yes One No Many
substitute
Cost curves for a typical firm
Costs
$3.00
2.50 MC
2.00
1.50 ATC

1.00 AVC

0.50 AFC
0 2 4 6 8 10 12 14
Quantity of Output
5
 Competitive Firm - market
• A perfectly competitive firm is one without market power.
• It is not able to alter the market price of the good it produces.
• A corn farmer is an example of a perfectly competitive firm.
• A competitive market is one in which no buyer or seller has
market power.
• High tech electronics and agricultural goods are sold in competitive
markets.
 Market Power - monopoly firm
• Market power is the ability to alter the market price of a good
or service.
• Your campus book store has market power.
• A monopoly firm is one that produces the entire market supply
of a particular good or service.
• Your local cable TV company is an example of a monopoly firm.
 Imperfect Competition
• Imperfect competition is between the extremes of monopoly
and perfect competition.
• In duopoly only two firms supply a particular product.
• In oligopoly a few large firms supply all or most of a particular
product.
• In monopolistic competition many firms supply essentially the
same product but each has brand loyalty.
 Profit maximization
• Total revenue: TR = P x Q
• Average revenue: Total revenue divided by the quantity sold
• Marginal revenue: Change in total revenue from an additional
unit sold
• Profit () = Total revenue (TR) – Total cost (TC)
• Maximize profit
• Produce quantity where total revenue minus total cost is greatest
• Compare marginal revenue with marginal cost
• If MR > MC – increase production
• If MR < MC – decrease production
 Perfect Competition
• Free entry and exit to industry
• Homogenous product – identical so no consumer
preference
• Large number of buyers and sellers – no individual seller
can influence price
• Sellers are price takers – have to accept the market price
• Perfect information available to buyers and sellers
 Perfect Competition
• Perfectly competitive firms are pretty much faceless, no brand
image, no real market recognition.
• A perfectly competitive firm is one . . .
• whose output is so small in relation to market volume,
• that its output decisions have no perceptible impact on price.
• Price taker.
• Individual firms output decisions do not affect the market price.
• Individual firms must take the market price and do the best they can
within these constraints
Market vs. Firm Demand
The Catfish Market Demand for Individual
Farmer's Catfish
PRICE (per fish)
Market
supply

pe Equilibrium price pe Demand facing

single farmer

Market
demand

QUANTITY (thousand fish per day) QUANTITY (fish per day)

Profit maximization for a competitive firm
The firm maximizes profit
Costs by producing the quantity at
and which marginal cost equals
Revenue marginal revenue. MC
MC2 ATC
P=MR1=MR2 P=AR=MR
AVC

MC1

0 Q1 QMAX Q2 Quantity
 The Lure of Profits
Market entry pushes price down and . . . Reduces profits of competitive firm

S1
S2 MC ATC
E1 S3
p1 p1
p2 p2
p3 p3
Market demand

QUANTITY (thousands of pounds per day) QUANTITY (pounds per day)

 Demand D = P= MR
Profit maximization Profit maximization: MC = MR = P
Profit:  =TR–TC=PQ–ATC*Q =Q(P-ATC)

P MC

ATC
P=AR=MR f
P
g AVC
l
k
h

O
Q1 Q
Profit as the area between price and average total cost

(a) A firm with profits (b) A firm with losses

Price Price
MC MC

Profit ATC Loss ATC

P
ATC AVC
ATC P=AR=MR
AVC P
P=AR=MR

0 Q Quantity 0 Q Quantity
(profit-maximizing quantity) (loss-minimizing quantity)

17
Marginal cost as the competitive firm’s supply
curve Price
MC

P2
ATC

P1 AVC

0 Q1 Q2 Quantity

An increase in the price from P1 to P2 leads to an increase in the firm’s profit-maximizing

quantity from Q1 to Q2. Because the marginal-cost curve shows the quantity supplied by the
firm at any given price, it is the firm’s supply curve.
The competitive firm’s short-run supply curve
Costs
1. In the short run, the MC
firm produces on the
MC curve if P>AVC,...
ATC

AVC

2. ...but
shuts down
if P<AVC.

0 Quantity

In the short run, the competitive firm’s supply curve is its marginal-cost curve
(MC) above average variable cost (AVC). If the price falls below average
variable cost, the firm is better off shutting down.
Profit Maximization& Competitive Firm’s Supply Curve

• Shutdown
• Short-run decision not to produce anything
• During a specific period of time
• Because of current market conditions
• Firm still has to pay fixed costs
• Exit
• Long-run decision to leave the market
• Firm doesn’t have to pay any costs
Profit Maximization& Competitive Firm’s Supply Curves

• Firm’s long-run decision to exit/enter a market

• Exit the market if
• Total revenue < total costs; TR < TC
• Same as: P < ATC
• Enter the market if
• Total revenue > total costs; TR > TC
• Same as: P > ATC
• Competitive firm’s long-run supply curve
• The portion of its marginal-cost curve
• That lies above average total cost
21
The competitive firm’s long-run supply curve

Costs
1. In the long run, the MC
firm produces on the
MC curve if P>ATC,...
ATC

2. ...but
exits if
P<ATC

0 Quantity

In the long run, the competitive firm’s supply curve is its marginal-cost
curve (MC) above average total cost (ATC). If the price falls below average total cost, the
firm is better off exiting the market.
22
 Supply Curve in a Competitive Market
• Long run: market supply with entry and exit
• Long run – firms can enter and exit the market
• If P > ATC – firms make positive profit
• New firms enter the market
• If P < ATC – firms make negative profit
• Firms exit the market
• Process of entry and exit ends when
• Firms still in market: zero economic profit (P = ATC)
• Because MC = ATC: Efficient scale
• Long run supply curve – perfectly elastic
• Horizontal at minimum ATC

23
 Monopoly
• Firm that is the sole seller of a product without close
substitutes
• Price maker
• Barriers to entry
• Monopoly resources
• Government regulation: Government gives a single firm the exclusive
right to produce some good or service
• Government-created monopolies: Patent and copyright laws
• The production process: Natural Monopoly

27
How Monopolies Make Production& Pricing Decisions

• Monopoly versus competition

• Monopoly
• Price maker
• Sole producer
• Downward sloping demand
• Market demand curve
• Competitive firm
• Price taker
• One producer of many
• Demand – horizontal line (Price)
28
 Monopoly profit maximization
• Demand: P = 120 - Q Q P TR MR TC MC ATC Profit
• Total revenue: TR = PxQ = 120Q – Q2 0 120 0 120 1200 0 -1200
10 110 1100 100 1250 10 125 -150
• Marginal Revenue: MR = 120 – 2Q 20 100 2000 80 1400 20 70 600
• Total Cost: TC = 1200 + 0.5Q2 30 90 2700 60 1650 30 55 1050
• ATC = 1200/Q + 0.5Q 40 80 3200 40 2000 40 50 1200
• MC = Q 50 70 3500 20 2450 50 49 1050
60 60 3600 0 3000 60 50 600
• AVC = 0.5Q
70 50 3500 -20 3650 70 52 -150
• AFC = 1200/Q 80 40 3200 -40 4400 80 55 -1200
90 30 2700 -60 5250 90 58 -2550
100 20 2000 -80 6200 100 62 -4200
 • Demand P = 120 –Q
Monopoly demand • Total revenue: TR = PQ = 120Q – Q2
Q P MR TR
0 120 120
• Marginal revenue: MR = 120 – 2Q
0
10 110 100 1100 130 4000
20 100 80 2000 120
110 3500
30 90 60 2700
40 80 40 3200 100 3000
90
50 70 20 3500 80 2500
60 60 0 3600 70
2000
70 50 -20 3500 60
80 40 -40 50 1500
3200
40
90 30 -60 2700 30 1000
100 20 -80 2000 20 500
110 10 -100 1100 10
0 0
120 0 -120 0
0 10 20 30 40 50 60 70 80 90 100 110 120 130
 Monopoly revenue, cost, profit
TR TC Profit
3800
Q P TR TC Profit 3600
0 120 0 1200 -1200 3400
3200
10 110 1100 1250 -150 3000
2800
20 100 2000 1400 600 2600
2400
30 90 2700 1650 1050 2200
2000
40 80 3200 2000 1200 1800
50 70 3500 2450 1050 1600
1400
60 60 3600 3000 600 1200
1000
70 50 3500 3650 -150 800
600
80 40 3200 4400 -1200 400
200
90 30 2700 5250 -2550 0
100 20 2000 6200 -4200 0 10 20 30 40 50 60 70 80 90 100 110 120 130
 Monopoly revenue, cost, profit
Q P MR MC ATC AVC AFC 140 MC ATC AVC AFC P MR
130
0 120 120 0 0 120
10 110 100 10 125 5 120 110
100
20 100 80 20 70 10 60
90
30 90 60 30 55 15 40 80
40 80 40 40 50 20 30 70
60
50 70 20 50 49 25 24 50
60 60 0 60 50 30 20 40
70 50 70 52 35 17 30
20
80 40 80 55 40 15 10
90 30 90 58 45 13 0
100 20 100 62 50 12 0 10 20 30 40 50 60 70 80 90 100 110
 Monopoly profit maximization
130
120 Q P MR MC ATC Profit
110 0 120 120 0 -1200
100 10 110 100 10 125 -150
90 MR 20 100 80 20 70 600
80
MC 30 90 60 30 55 1050
70 PROFIT 40 80 40 40 50 1200
60
50
ATC 50 70 20 50 49 1050
40 60 60 0 60 50 600
30 70 50 -20 70 52 -150
20
10 80 40 -40 80 55 -1200
0 90 30 -60 90 58 -2550
0 10 20 30 40 50 60 70 80 90 100 110 120 130 100 20 -80 100 62 -4200
 Monopoly profit maximization
130 Q P MR MC ATC Profit
120 MR MC ATC 0 120 120 0 -3000
110
100 10 110 100 10 -1950
90 LOSS 20 100 80 20 -1200
80 30 90 60 30 115 -750
70 40 80 40 40 95 -600
60
50 50 70 20 50 85 -750
40 60 60 0 60 80 -1200
30 70 50 -20 70 78 -1950
20 80 40 -40 80 78 -3000
10
0 90 30 -60 90 78 -4350
100 20 -80 100 80 -6000
0 10 20 30 40 50 60 70 80 90100110120130
The inefficiency of monopoly
Costs
and
Revenue
Marginal cost
Deadweight
loss
Monopoly
price

Demand

Marginal revenue

0 Monopoly Efficient Quantity

quantity quantity
Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than
its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The
deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value
of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer). 38
The market for drugs
Costs
and
Revenue

Price
during
patent life

Price after Marginal cost

patent
expires

Demand
Marginal revenue

0 Monopoly Competitive Quantity

quantity quantity

When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price,
which is well above the marginal cost of making the drug. When the patent on a drug runs out, new
firms enter the market, making it more competitive. As a result, the price falls from the monopoly price
to marginal cost. 39
 Price Discrimination
• Price discrimination
• Sell the same good at different prices to different customers
• Charges each customer a price closer to his or her willingness to pay
• Sell more than is possible with a single price
• Requires the ability to separate customers according to their willingness to pay.
• Examples of price discrimination
• Movie tickets
• Airline prices
• Discount coupons
• Financial aid
• Quantity discounts

41
Welfare with and without Price Discrimination

42
 Public Policy Toward Monopolies
• Increasing competition with antitrust laws
• Prevent companies from coordinating their activities to make markets
less competitive
• Regulation: Regulate the behavior of monopolists
• Public ownership
• How the ownership of the firm affects the costs of production
• Private owners
• Incentive to minimize costs
• Public owners (government)
• If it does a bad job: Losers are the customers and taxpayers
• Do nothing
43
 Monopolistic competition

• Monopolistic competition
• Many sellers
• Product differentiation
• Product differentiation
• Not price takers
• Downward sloping demand curve
• Free entry and exit
• Zero economic profit in the long run

45
 Monopolistic competitors in the short run

(a) Firm makes profit (b) Firm makes losses

Price Price
MC MC ATC

ATC ATC
Price

ATC Price

Profit Demand Losses

Demand
MR
MR
0 Profit- Quantity 0 Loss- Quantity
maximizing minimizing
quantity quantity
Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which
marginal revenue equals marginal cost. The firm in panel (a) makes a profit because, at this
quantity, price is above average total cost. The firm in panel (b) makes losses because, at this
quantity, price is less than average total cost. 46
 Competition with Differentiated Products

• If firms are making profit in short run

• New firms - incentive to enter the market
• Increase number of products
• Reduces demand faced by each firm: Demand curve shifts left
• Each firm’s profit – declines until: zero economic profit
• If firms are making losses in short run
• Firms - incentive to exit the market
• Decrease number of products
• Increases demand faced by each firm: Demand curve shifts right
• Each firm’s loss – declines until: zero economic profit

47
Monopolistic versus perfect
competition (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price Price
MC MC
ATC

Price ATC
P=MC
P=MR
Markup (demand curve)
MC

Demand

MR

0 Quantity Efficient Quantity 0 Quantity produced Quantity

produced scale = Efficient scale
Excess capacity

Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the long-
run equilibrium in a perfectly competitive market. Two differences are notable. (1) The perfectly competitive firm
produces at the efficient scale, where average total cost is minimized. By contrast, the monopolistically
competitive firm produces at less than the efficient scale. (2) Price equals marginal cost under perfect competition,
but price is above marginal cost under monopolistic competition. 48
 Monopolistic competition & society’s welfare

• Sources of inefficiency
• Markup of price over marginal cost
• Deadweight loss
• Too much or too little entry
• Product-variety externality
• Positive externality on consumers
• Business-stealing externality
• Negative externality on producers

• Advertisement: to sell differentiated products at price above

marginal cost => incentive to advertise to attract more buyers

49
 Competition with Differentiated Products
• The critique of advertising
• Firms advertise to manipulate people’s tastes
• Impedes competition
• Increase perception of product differentiation, Foster brand loyalty
• Makes buyers less concerned with price differences among similar goods
• The defense of advertising
• Provide information to customers: Customers - make better choices, Enhances the
ability of markets to allocate resources efficiently
• Fosters competition: Customers - take advantage of price differences
• Allows new firms to enter more easily
• Advertising as a signal of quality?
• Advertising – little apparent information
• Real information offered – a signal: Willingness to spend large amount of money =
signal about quality of the product
 Competition with Differentiated Products
• Firm – brand name
• Spend more on advertising
• Charge higher prices than generic substitutes
• Critics of brand names
• Products – not differentiated
• Irrationality: consumers are willing to pay more for brand names
• Defenders of brand names
• Useful: high quality
• Consumers – information about quality
• Firms – incentive to maintain high quality
A Monopolistically Competitive Firm in the Short and Long Run

$/Q Short Run $/Q Long Run

MC MC

AC AC

PSR

PLR

DSR
DLR

MRSR
MRLR

QSR Quantity QLR Quantity

Comparison of Monopolistically Competitive
Equilibrium and Perfectly Competitive Equilibrium
Perfect Competition Monopolistic Competition
$/Q $/Q
Deadweight
MC AC loss MC AC

P
PC
D = MR

DLR
MRLR

QC Quantity QMC Quantity

 Monopolistic competition: between perfect
competition& monopoly
Market structure
Perfect Monopolistic
competition competition Monopoly
Features that all three market structures share
Goal of firms Maximize profits Maximize profits Maximize profits
Rule for maximizing MR = MC MR = MC MR = MC
Can earn economic profits in the short run? Yes Yes Yes
Features that monopolistic competition shares with
monopoly
Price taker? Yes No No
Price P = MC P > MC P > MC
Produces welfare-maximizing level of output? Yes No No
Features that monopolistic competition shares with
competition
Number of firms Many Many One
Entry in long run? Yes Yes No
Can earn economic profits in long run? No No Yes
54
 Oligopoly – Competition amongst the few
• Industry dominated by small number of large firms
• Many firms may make up the industry
• High barriers to entry
• Products could be highly differentiated – branding or homogenous
• Non–price competition
• Price stability within the market - kinked demand curve?
• Potential for collusion?
• Abnormal profits
• High degree of interdependence between firms

5-57
 Oligopoly

Price
Kinked Demand Curve

£5

D = elastic
Kinked D Curve
D = Inelastic

100 Quantity

58
 Oligopoly

• Oligopoly
• Only a few sellers
• Offer similar or identical products
• Interdependent
• Game theory
• How people behave in strategic situations
• Choose among alternative courses of action
• Must consider how others might respond to the action he takes

59
 Markets with Only a Few Sellers
• A small group of sellers
• Tension between cooperation and self-interest
• Is best off cooperating: Acting like a monopolist, Produce a small
quantity of output
• Each - cares only about its own profit
• Duopoly
• Collude and form a cartel: Act as a monopoly
• Don’t collude – self-interest
• Difficult to agree; Antitrust laws
• Higher quantity; lower price; lower profits
• Nash equilibrium

60
 EXAMPLE: Cell Phone Duopoly in Smalltown

P Q ▪ Smalltown has 140 residents

$0 140
▪ The “good”:
5 130
cell phone service with unlimited anytime minutes and
10 120 free phone
15 110
20 100
▪ Smalltown’s demand schedule
25 90 ▪ Two firms: T-Mobile, Verizon
30 80 (duopoly: an oligopoly with two firms)
35 70 ▪ Each firm’s costs: FC = $0, MC = $10
40 60
45 50
 EXAMPLE: Cell Phone Duopoly in Smalltown

P Q Revenue Cost Profit Competitive

$0 140 $0 $1,400 –1,400 outcome:
P = MC = $10
5 130 650 1,300 –650
Q = 120
10 120 1,200 1,200 0
Profit = $0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350 Monopoly
30 80 2,400 800 1,600 outcome:
35 70 2,450 700 1,750 P = $40
40 60 2,400 600 1,800 Q = 60
45 50 2,250 500 1,750 Profit = $1,800
 EXAMPLE: Cell Phone Duopoly in Smalltown
• One possible duopoly outcome: collusion
• Collusion: an agreement among firms in a market about
quantities to produce or prices to charge
• T-Mobile and Verizon could agree to each produce half of the
monopoly output:
• For each firm: Q = 30, P = $40, profits = $900
• Cartel: a group of firms acting in unison,
e.g., T-Mobile and Verizon in the outcome with collusion
 Collusion vs. self-interest

P Q Duopoly outcome with collusion:

$0 140 Each firm agrees to produce Q = 30,
5 130 earns profit = $900.
10 120 If T-Mobile reneges on the agreement and produces Q = 40,
15 110 what happens to the market price? T-Mobile’s profits?
20 100 Is it in T-Mobile’s interest to renege on the agreement?
25 90
If both firms renege and produce Q = 40, determine each
30 80
firm’s profits.
35 70
40 60
45 50
 Answers
P Q If both firms stick to agreement,
$0 140 each firm’s profit = $900
5 130 If T-Mobile reneges on agreement and produces Q = 40:
10 120 Market quantity = 70, P = $35
15 110 T-Mobile’s profit = 40 x ($35 – 10) = $1000
20 100 T-Mobile’s profits are higher if it reneges.
25 90 Verizon will conclude the same, so
30 80 both firms renege, each produces Q = 40:
35 70 Market quantity = 80, P = $30
40 60 Each firm’s profit = 40 x ($30 – 10) = $800
45 50
 The Economics of Cooperation

• The prisoners’ dilemma

• Particular “game” between two captured prisoners
• Illustrates why cooperation is difficult to maintain even when
it is mutually beneficial
• Dominant strategy
• Strategy that is best for a player in a game
• Regardless of the strategies chosen by the other players

66
 The prisoners’ dilemma
Bonnie’s decision
Confess Remain silent

Bonnie gets 8 years Bonnie gets 20 years

Confess

Clyde’s Clyde gets 8 years Clyde goes free

Decision
Remain
Bonnie goes free Bonnie gets 1 year
silent

Clyde gets 20 years Clyde gets 1 year

In this game between two criminals suspected of committing a

crime, the sentence that each receives depends both on his or
her decision whether to confess or remain silent and on the 67

decision made by the other

 The Economics of Cooperation

• Oligopolies as a prisoners’ dilemma

• Game oligopolists play
• In trying to reach the monopoly outcome
• Similar to the game that the two prisoners play in the prisoners’
dilemma
• Firms are self-interest
• And do not cooperate
• Even though cooperation (cartel) would increase profits
• Each firm has incentive to cheat

68
 Oil prices Actual price
$ per barrel
Cost in 1973 prices
35
Iraq invades Impending
Iran OPEC’s first war
30 quotas with Iraq

Iraq invades
Revolution Kuwait
25 World-wide
in Iran recovery

20 First oil from

North Sea
World-wide
15 slowdown
Cease-fire in New OPEC
10 Iran-Iraq war quotas Recession
in Far East
Yom Kippur
5 War: Arab oil
embargo
0
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02
 Monopoly
P P

loss
profit

Q Q
 Perfect competition
P P

profit
Loss

Q Q
Monopolistic competition Perfect competition
P (long-run) P (long-run)

MR

Q Q