Business Economics

Chapter 9, Market Structure

Dr.Dimple Pandey
• Define the concept of market

• Identify different types of market structures

• Discuss monopolistic competition

• Explain the concepts of oligopoly and monopoly

• Define the concept of profit maximisation

• Measure the market power

• Identify the determinants of market power

 1. Defining Market

Market can be defined as a physical space where large numbers of sellers offer a
variety of products to consumers for sale. . It includes a variety of systems,
procedures, social interactions, and infrastructures for successful exchange between
various parties (buyer and sellers). As per the definition given by Cournot, following
are the essentials of a market:

• Products, which are dealt with

• Presence of buyers and sellers

• A place, whether a certain region, country, or the whole world

• A type of interaction between buyers and sellers, so that the same price prevails
for the same product at the same time
 2. Defining Market

Geographical area

Bases for classifying

markets

Competition
 3. Defining Market

Let us discuss these bases in detail.

• Geographical area: The geographical area of a market is dependent upon the
region where buyers and sellers are dispersed. on the basis of geographical area,
markets can be classified into local markets, national markets and international
markets.

• Competition: On the basis of competition, markets are classified as perfect

markets and imperfect markets. A perfect market exists when both the buyers
and sellers have complete knowledge about the prices of products prevailing in
the market. Thus, the price of a product is same all over the market. On the
contrary, an imperfect market exists when the price of a product is different all
over the market. This is because, buyers and sellers are not aware about the
prices of the products.
1. Types of Market Structures

Types of market structures

Perfect competition

Imperfect competition
 Types of Market Structures- Perfect Competition

• “The perfect competition is characterised by the presence of many firms. They all
sell identical products. The seller is a price taker, not price maker.” The main
characteristics of perfect competition are

Large number of buyers and sellers

Homogenous product

Ease of Entry and exit from the market

Perfect knowledge

Firm is price taker

 Why Perfect Competition
needs to be studied
• The perfectly competitive model has strong assumptions.

• When we use the model we assume market forces determine prices.

• We can understand most markets by applying the supply and demand model.

• With this framework we can see how competition affect firms, consumer, and
markets.
 Examples of Perfect
Competition
In the real world, it is hard to find examples of industries which fit all the criteria of
‘perfect knowledge’ and ‘perfect information’. However, some industries are close.
Foreign exchange markets. Here currency is all homogeneous. Also, traders will have
access to many different buyers and sellers. There will be good information about
relative prices. When buying currency it is easy to compare prices
Agricultural markets. In some cases, there are several farmers selling identical
products to the market, and many buyers. At the market, it is easy to compare prices.
Therefore, agricultural markets often get close to perfect competition.
 Price and Revenue
• Total revenue is a firm’s output multiplied by the
price at which it sells that output.

=
TR
PQ

• Marginal revenue is the increase in total

revenue from a one-unit increase in quantity.
MR=P
• Average revenue is total revenue divided by
quantity.
TR P Q
AR= = =P
Q Q
AR=MR=P
 Price, Marginal Revenue, and
Average Revenue
A perfectly competitive firm
faces a horizontal demand
curve.

A single firm has no influence on price. The individual firm demand curve under perfect
competition is parallel to x-axis. Hence, we can say that the demand curve under perfect
competition is perfectly elastic.
For a firm in perfect competition, demand is perfectly elastic, therefore MR=AR=D.
 The firm as price taker
The single firm takes its price from the industry, and is, consequently, referred to as
a price taker. The industry is composed of all firms in the industry and the market
price is where market demand is equal to market supply. Each single firm must
charge this price and cannot diverge from it.
The individual firm will maximise output where MR = MC at Q1
 Types of Market Structures-Imperfect Competition

Imperfect competition is a competitive market where a large number of sellers are

engaged in selling heterogeneous (dissimilar) goods as opposed to the perfectly
competitive market. Imperfect competition can be classified into three categories:

Monopolistic
competition

Types of
imperfect
competition

Monopoly Oligopoly
 Monopolistic Competition

Monopolistic competition is a type of imperfect competition, wherein a large number

of sellers are engaged in offering heterogeneous products for sale to buyers.. Some
important characteristics of monopolistic competition are:

• Large number of sellers and buyers

• Product differentiation

• Ease of entry and exit

• Price control policy- Organisations
do not have much control over the
price of the product.
 Oligopoly

Oligopoly is a type of imperfect competition, wherein there are few sellers dealing
either in homogenous or differentiated products. The characteristics of oligopoly are o

Existence of few sellers

Identical or differentiated
products

Impediments in entry

Enhanced role of government

Mutual interdependence

Existence of price rigidity

 Oligopoly

Let us discuss the characteristics of oligopoly in detail.

• Existence of few sellers: One of the primary features of oligopoly is the existence
of a few sellers who dominate the entire industry and influence the prices of each
other, greatly.

• Identical or differentiated products: An important characteristic of oligopoly is

the production of identical products or differentiated products. This implies that
organisations may either produce homogenous products or differentiated
products

• Impediments in entry: Another important characteristic of oligopolistic

competition is that organisations cannot easily enter the market; nor can they
make an exit from the market.
 Oligopoly

• Enhanced role of government: Under oligopolistic market structure, the

government has a greater role as it acts as a guard to anti-competitive behaviours
of oligopolists. It is often observed that oligopolists may engage in the illegal
practice of collusion, where they together make production and pricing decisions.

• Mutual interdependence: Under oligopoly market structure, mutual

interdependence refers to the influence that organisations create on each other’s
decisions, such as pricing and output decisions. In oligopoly, a few numbers of
sellers compete with each other. Therefore, the sale of an organisation is
dependent on its own price of products, as well as the price of its competitor’s
products
 Oligopoly

• Existence of price rigidity: Under oligopolistic market, organisations do not prefer

to change the prices of their products as this can adversely affect the profits of
the organisation. For instance, if an organisation reduces its price, its competitors
may reduce the prices too, which would bring a reduction in the profits of the
organisation. On the other hand, the increase in prices by an organisation will
lead to loss of buyers.
 Oligopoly

The Cartel Model in Oligopoly

• The cartel model can be defined as a special case of oligopoly in which rival firms
in an industry come together as a cartel to create formal agreements to make
decisions to attain high profits.

• The formation of a cartel is more applicable to oligopoly where there are a small
number of firms.

• In a cartel, all the firms sell at the same price, and each organisation set its
individual production volume for sale, so that the marginal cost of operation
remains same.
 Monopoly

Monopoly can be defined as a market structure, wherein a single producer or seller

has a control on the entire market. Some important characteristics of monopoly are

Existence of a single seller

Absence of substitutes

Barriers to entry

Limited information-
 Monopoly

Let us discuss these characteristics:

• Existence of a single seller: Under monopoly market structure, there is always a
single seller producing large quantities of the products.

• Absence of substitutes: Another important characteristic of monopoly is the

absence of substitutes of the products in the market.

• Barriers to entry: The reason behind the existence of monopoly is the various
barriers that restrict the entry of new organisations in the market. These
barriers can be in the form of exclusive resource ownership, copyrights, high
initial investment and other restrictions by the government.

• Limited information: Under monopoly, information cannot be disseminated in the

market and is restricted to the organisation and its employees.
 Monopoly

Price Discrimination Under Monopoly

Personal price
discrimination

Geographical Utility based

price price
discrimination discrimination

Types of price
discrimination
 Monopoly

Price Discrimination Under Monopoly

• Geographical price discrimination: In this type of price discrimination, a
monopolist charges different prices for the products in different areas.

• Personal price discrimination: In this type of price discrimination, a monopolist

charges different prices from different users or buyers.
• Utility based price discrimination: In this type of price discrimination, the seller
charges different prices from buyers in accordance with the use of the products.
https://www.economicsdiscussion.net/price-discrimination/price-discrimination-
definitions-types-conditions-and-
degrees/7270#:~:text=Geographical%20Price%20Discrimination%3A,at%20the%20ot
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Summary
 Relationship between Different Costs
• The AVC and ATC curve are both U shaped which can
be explained on the basis of Law of Diminishing
Returns. When more and more units of a variable
input are employed at a given quantity of fixed
inputs, the total output may initially increase at an
increasing rate and then at a constant rate, and then
it will eventually increase at diminishing rates. Costs
decline when there are increasing returns, stabilise
with constant returns and increase with diminishing
returns. ATC being the sum of AFC and AVC lies
above. When both AFC and AVC fall, ATC also falls.
AVC soon reaches a minimum and starts rising.
 Relationship between Different Costs
• The magnitude of MC is interlinked with changes in
average costs. When Average Costs decline, MC lies
below ATC, when ATC are constant(at their
minimum), MC equals ATC, When ATC rises, MC lies
above them.
 Profit Maximisation
Marginal cost at first declines as production increases

from 10 to 20 to 30 packs of raspberries. But then

marginal costs start to increase, due to diminishing
marginal returns in production. If the firm is producing
at a quantity where MR > MC, like 40 or 50 packs of
raspberries, then it can increase profit by increasing
output. The reason is since the marginal revenue
exceeds the marginal cost, additional output is adding
more to profit than it is taking away. If the firm is
producing at a quantity where MC > MR, like 90 or 100
packs, then it can increase profit by reducing output.
The firm’s profit-maximizing level of output will occur
where MR = MC (or at a level close to that point).
 Relationship between AR and MR-Perfect
Competition(Short Run)
• Since firms are price takers, they can only adjust
quantity at a fixed price.

• Each firm can sell as much as it wishes at the market

price OP. MR is the additional revenue that a firm
makes by selling one extra unit of output(MR=P)

• AR is the total revenue earned divided by the total

quantity produced.

• Since firms are price takers and can supply as much

as they want at the existing price in the market,
AR=MR=P.

• In case of Perfect competition the demand curve is

perfectly elastic, hence AR curve is horizontal and
coincides with MR curve.
 The effect of an increase in demand for the industry-
Short Run
• If there is an increase in demand there will be an increase in price Therefore the
demand curve and hence AR will shift upwards. This will cause firms to make
supernormal profits. Supernormal profit is also known as abnormal
profit. Abnormal profit means there is an incentive for other firms to enter the
industry.
 The effect of an increase in demand for the industry-
Long run
However, in the long run, firms are attracted into the industry if the existing firms are
making supernormal profits. This is because there are no barriers to entry. The effect of
this entry into the industry is to shift the industry supply curve to the right, which
drives down price until the point where all super-normal profits are exhausted. The
super-normal profit derived by the firm in the short run acts as an incentive for new
firms to enter the market, which increases industry supply and market price falls for all
firms until only normal profit is made.
 Relationship between AR and MR-Imperfect
Competition(Short Run)
• In case of imperfect competition, the firm faces a
normal demand curve which is highly inelastic,
therefore AR curve is downward sloping and MR
curve lies below AR curve. In case of imperfect
competition the firms can reduce the price of all units
of its product if it wants to sell an additional unit. As
such, the addition to revenue resulting from selling
this additional unit would be less than the price the
firm would receive for this unit, so MR is less than the
price and would lie below the AR curve.
 Profit Maximisation In Short
Run-Imperfect Competition

• D=AR is the downward slopping demand curve

for the market and in the short run demand is
equal to average revenue

• The firm maximizes its profits and produces a

Average revenue is nothing but quantity where the firm's marginal revenue
Total Revenue divided by Quantity and (MR) is equal to its marginal cost (MC). The
total Revenue is nothing but Price firm is able to collect a price based on the
multiplied by quantity of output. Each average revenue (AR) curve.
point on the curve represents the price The difference between the firm's average
of the product in the market. Price revenue and average cost, multiplied by the
determines the demand for a product, quantity sold (Qs), gives the total profit.
hence Average revenue curve is
also demand curve.
Profit Maximisation In Long Run-Imperfect competition
• Long-run equilibrium of the firm under
imperfect competition. If any firm is earning
supernormal profits, this would attract new
firms to enter industry in the long run which
would shift AR and MR curve downwards. The
firm still produces where marginal cost and
marginal revenue are equal; however, the
demand curve (and AR) has shifted as other
firms entered the market and increased
competition. The firm no longer sells its goods
above average cost and can no longer claim an
economic profit.
 Profit Maximisation In Long Run-Imperfect competition

• Firms make normal profits in the long run but could make supernormal profits in
the short term
 Measurement of Market Power

•Market power can be defined as the ability of an organisation to raise the market
price of a good or service over marginal cost to achieve profits. It can also be defined
as the degree of control an organisation has over the price and output of a product in
the market.

•A firm with total market power is in a position to raise the prices without any loss of
customers. This type of control generally occurs in imperfect competition.

•Organisations having total market power are also known as price makers. On the
contrary, organisations have no market power in perfectly competitive markets. Such
organisations are known as price takers.
 Measurement of Market Power

• The most common measure for determining the market power is concentration
ratios. These ratios are used to determine the degree of control of firms in the
market. There are two types of concentration ratios:

• Four firm concentration ratio: It can be defined as the fraction of output produced
by the top four organisations in an industry. For Example, market share of
various search engines at the global level are given as follows: Google - 91.99%,
Bing - 2.75%, Yahoo! - 1.8%, Baidu - 1.68%, YANDEX RU - 0.49% and YANDEX -
0.36%.

• Hence, in this case, four firm concentration ratios will be calculated as 91.99% +
2.75% + 1.8% + 1.68% = 98.22%. It means that top four firms namely Google,
Bing, Yahoo! and Baidu has captured 98.22 per cent market share and this shows
high level of concentration.
 Measurement of Market Power

• Eight firm concentration ratio: It can be defined as the fraction of output

produced by the top eight organisations in an industry. For example, Soft drink
market share of various popular brands in Johnson County of United States are
given as follows: Omni Cola – 23%, Juice up – 17.5%, Super Soda – 11.25%, King
Caffeine – 9.5%, Mega Cola – 6.15%, Hometown Brew – 4.35, Frosty Grape –
3.6%, Cola Riffic – 3.15% and Others – 21.5%.

• Hence, in this case, eight firm concentration ratios will be calculated as: 23% +
17.5% + 11.25% + 9.5% + 6.15% + 4.35 + 3.6% + 3.15% = 82.85%. It means that
the top eight firms namely Omni Cola, Juice up, Super Soda, King Caffeine,
Mega Cola, HometownBrew, Frosty Grape and Cola Riffic has captured 82.85%
market share and this shows high level of concentration.
 Measurement of Market Power

The concentration ratios fall under three types of concentration:

• Low concentration: An industry is considered to be under low concentration ratio

if its concentration ratio falls bewteen 0 and 50 percent. Monopolistic competition
falls into the bottom of this with oligopoly emerging near the upper end.

• Medium concentration: An industry is considered to be under medium

concentration if its concentration ratio is from 50 to 80 percent. Example of such
industries are very much oligopoly.

• High concentration: An industry is considered to be highly concentrated if its

concentration ratio falls between 80 and 100 percent. Government regulators
generally fall under this category.
 Measurement of Market Power
• In addition to Concentration ratios, there is another method that is used to
determine the market power, i.e., Herfindahl-Hirschman Index (HHI).

• This index helps in determining if the industry is competitive or moving towards

monopoly.

• HHI comes close to zero in a perfectly competitive market, for example, in the
perfect competition market assume that there are fruit vendors in your town and
out of these market shares of fruit vendors is 0.1% each. Then in this case HHI is
(0.1)^2 × 50 = 0.5%. Now you can see that in this HHI has nearly approached to
zero in the case of perfect competition.

• However, in monopoly market HHI is nearly 10,000, for example, in the case of
Indian Railways there is no other competitor and there is monopoly situation.
The Indian Railways has a market share of 100% and its HHI will be calculate as
(100)^2 = 10000
 Measurement of Market Power

• Assume that there are four grocery stores in your town: A, B, C and D and their

market shares are: A = 25%, B = 50%, C = 20%, D = 5%

• HHI = 25^2 + 50^2+ 20^2+ 5^2 = 3550

 Determinants of Market Power

There are various determinants of market power that explain the existence of
organisations’ control in the market.

Economies of scale

Governmental regulations

Control of raw materials

Customer loyalty
 Determinants of Market Power

• Economies of scale: when a new organisation decides to enter the market, it has
to produce in large quantities to keep its cost low in comparison to the market
rulers. Thus, economies of scale actually indicate the market power of an
organisation in the market.

• Governmental regulations: In the market, where these regulations are strict and
numerous, there is a strong control on the existing organisations. For instance, by
licensing and franchising monopolies are created along with government decree
 Determinants of Market Power

• Control of raw materials: For instance, an organisation that controls the supply
of all the raw materials required for a product in the market may refuse to sell
the raw materials at low prices to make the manufacturing organisations
compete. .

• Customer loyalty: Due to brand establishment in the market, the market power
of the organisation remains high making it difficult for new entrants to gain
share in the market.
 Let’s Sum Up

• Market can be defined as a system, wherein buyers and sellers interact to

establish a price and quantity of a product for making transactions.

• Market structure is classified into three categories, namely, pure competition,

perfect competition and imperfect competition.

• Under pure competition, there is large number of sellers offering homogenous

products to equal population of buyers.

• Under perfect competition various firms exist offering identical products for sale
along with a large number of buyers who are well aware of the prices.

• Under imperfect competition, there are three categories: monopolistic

competition, oligopoly and monopoly.

• Profit maximisation is a long-run or short-run process, wherein price and output

levels are determined to increase the profits.
 Quiz

1. Under _____ competition various firms exist offering identical products for sale
along with a large number of buyers who are well aware of the prices.

2. Under _____, a single producer or seller has a control on the entire market.

3. In _______ competition, a large number of sellers exist in the market offering

heterogeneous products for sale to buyers.

4. _____________can be defined as an organisation’s ability to increase the market

price of a good or service over marginal cost to achieve profits.
 Quiz

1. Under Perfect competition various firms exist offering identical products for sale
along with a large number of buyers who are well aware of the prices.

2. Under Monopoly, a single producer or seller has a control on the entire market.

3. In Monopolistic competition, a large number of sellers exist in the market offering

heterogeneous products for sale to buyers.

4. Market power can be defined as an organisation’s ability to increase the market

price of a good or service over marginal cost to achieve profits.
 Quiz

5. Which of the following is not a correct assumption for monopoly?

a. Single sellers and many buyers

b. Firm is price taker

c. Barriers to entry

d. No close substitutes

6. Which one of the following is not a determinant of market power?

a. Economies of scale

b. Governmental regulations

c. Control of raw materials

d. Outdated technology
 Quiz

5. Which of the following is not a correct assumption for monopoly?

a. Single sellers and many buyers

b. Firm is price taker

c. Barriers to entry

d. No close substitutes

6. Which one of the following is not a determinant of market power?

a. Economies of scale

b. Governmental regulations

c. Control of raw materials

d. Outdated technology
Caselet
 Competition in Publishing Industry

• Initially, only few organisations began operating in the magazine publication

industry. To promote the sales and create maximum awareness in the market,
these organisations offered various free gifts, such as audio and video CDs, DVDs
and scented candles, to customers along with the magazines. This led to
increased customer base. However, after some time, the costs of production
increased, which made it difficult for the organisations to continue the offers.
Some organisations ceased to provide free gifts in order to reduce the overall
costs of production. As a result, these organisations lost some of their customers.
 Competition in Publishing Industry

• On the other hand, some organisations increased the prices of magazines to

overcome the costs of production. However, customers did not prefer to buy
magazines at a higher price, resulting in the failure of the price increase strategy.
There were few organisations that reduced the prices of magazines to increase
the number of customers, generate revenue and overcome the production cost.
Consequently, rest of the organisations were forced to reduce their prices to
maintain their existence in the industry. This caused heavy losses to the
organisations that initially reduced the prices. At last, the organisations were
compelled to sell magazines at a fixed price along with free gifts.
 Questions

1. Identify the type of market structure in the magazine industry? Justify the
identification.
2. State the problems faced by the organisations in the above case study?
 Questions

1. Identify the type of market structure in the magazine industry? Justify the
identification.
(Hint: Oligopoly is the market structure because of the existence of few
organisations.)

2. State the problems faced by the organisations in the above case study?
• (Hint: Influence of one seller’s decision on others in the industry led to the
reduction in the prices, which finally resulted in heavy losses.)