Market structures

Market structure is best defined as the organisational and other characteristics of a

market. We focus on those characteristics which affect the nature of competition and
pricing – but it is important not to place too much emphasis simply on the market
share of the existing firms in an industry.
Generally there are 4 main types of market structures and these are
i. Perfect competition
ii. Monopolistic
iii. Oligopoly
iv. Monopoly

Rules that apply to all firms regardless of the type of Market Structure.

All firms should produce an output level whose last output will equate MC to M
Revenue in order to maximise profits.
It is generally accepted that all firms aim to maximise profits.
In order to maximise profit a firm will have to produce an output level at which MC
= MR.
MC is the addition to costs incurred as a result of producing an additional unit of
output.
MR is the additional unit of output.

What happens if MC > MR

It means the unit of output produced is adding more costs than it does to the revenues
of the firm.
It is not wise to produce the unit concerned, the firm will have an incentive to reduce
production in order to minimise costs.
Therefore, if MC >MR is a disequilibrium condition, no firm will produce at this level
of output.

What happens if MC < MR

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 It means the last unit of output produced is adding more revenues than to the costs of
the firm. In this case a firm is encouraged to increase production until MC = MR.
The above analysis will make one conclude that a stable output level is only created
when MC = MR.
It is the equilibrium output of a firm.
The firm has no reason to increase or decrease output level.
It is the profit maximising output.
MC = MR is a necessary condition for profit maximising but however it not
sufficient.

PERFECT COMPETITION

Perfect Competition – a Pure Market

 We can take some useful insights from studying a world of perfect competition and
then comparing and contrasting with imperfectly competitive markets and industries

 Economists have become more interested in pure competition partly because of the
growth of e-commerce as a means of buying and selling goods and services. And also
because of the popularity of auctions as a device for allocating scarce resources
among competing ends.

What are the main assumptions for a perfectly competitive market?

1. Many sellers in the market - each of whom produce a low percentage of market
output and cannot influence the prevailing market price – each firm in this market is
a price taker - i.e. it has to take the market price

2. Many individual buyers - none has any control over the market price

3. There is freedom of entry and exit from the industry. Firms face no sunk
costs and entry and exit from the market is feasible in the long run. This assumption
means that all firms in a perfectly competitive market make normal profits in the
long run

4. Homogeneous products are supplied to the markets that are perfect substitutes. This
leads to each firms being “price takers" with a perfectly elastic demand curve for
their product

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 5. Perfect knowledge – consumers have all readily available information about prices
and products from competing suppliers and can access this at zero cost – in other
words, there are few transactions costs involved in searching for the required
information about prices. Likewise sellers have perfect knowledge about their
competitors

6. Perfectly mobile factors of production – land, labour and capital can be switched in
response to changing market conditions, prices and incentives. We assume that
transport costs are insignificant

Profit Maximisation under Perfect Competition:

Under perfect competition, the firm is one among a large number of producers. It
cannot influence the market price of the product. It is the price-taker and quantity-
adjuster. It can only decide about the output to be sold at the market price.
Therefore, under conditions of perfect competition, the MR curve of a firm coincides
with its AR curve. The MR curve is horizontal to the X-axis because the price is set
by the market and the firm sells its output at that price.
The firm is, thus, in equilibrium when MC = MR = AR (Price). The equilibrium of the
profit maximisation firm under perfect competition is shown in Figure 1. Where the
MC curve cuts the MR curve first at point A.
It satisfies the condition of MC = MR, but it is not a point of maximum profits
because after point A, the MC curve is below the MR curve. It does not pay the firm
to produce the minimum output when it can earn larger profits by producing beyond
OM.

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 It will, however, stop further production when it reaches the OM1 level of output
where the firm satisfies both conditions of equilibrium. If it has any plans to produce
more than OM1 it will be incurring losses, for the marginal cost exceeds the marginal
revenue after the equilibrium point B. Thus the firm maximises its profits at M1B
price and at the output level OM1.

The firm’s demand curve.

The firm faces a perfectly elastic demand curve.

Any attempt to increase the price means a firm will sell nothing and zero revenue is received.
It is impossible to increase price and sell
There is no incentive to reduce price because a firm can sell as much as possible at the price
set by the industry.
Each unit of output brings the same revenue (P=MR). Because of the above point Price =
average revenue (AR)

Short run profit maximization in perfect competition

Short‐run profit maximization. A firm maximizes its profits by choosing to supply the
level of output where its marginal revenue equals its marginal cost. When marginal
revenue exceeds marginal cost, the firm can earn greater profits by increasing its
output.
When marginal revenue is below marginal cost, the firm is losing money, and
consequently, it must reduce its output. Profits are therefore maximized when the firm
chooses the level of output where its marginal revenue equals its marginal cost.
In the short run, a firm in perfect competition will earn supernormal profits because of
absence of competition.

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 The shaded area represents supernormal profits that are being enjoyed by a firm in
perfect competition.
The diagram below shows a firm in perfectly competitive market structure suffering
from subnormal profits (losses)

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 Shut down rule.
A firm in perfect competition will shut down operations when it fails to cover its
variable costs of production. A firm has a mandate of paying its fixed costs even if it
is not producing anything. Therefore if a firm manages to cover its variable costs, but
fails to cover its fixed costs it should continue operating.

Below price P2, the firm would have ceases its operations.
The firm’s supply curve in perfect competition in the short run is that part of marginal
cost which above the average variable cost curve.

LONG RUN EQUILIBRIUM

In the long run, firms respond to profits through a process of entry, where existing
firms expand output and new firms enter the market.
Conversely, firms react to losses in the long run through a process of exit, in which
existing firms reduce output or cease production altogether.
Through the process of entry and exit, the price level in a perfectly competitive
market will move toward the zero-profit point, where the marginal cost curve crosses

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 the average cost—or AC—curve at the minimum of the AC curve.

The above diagram shows what happened as a firm moves from short run to long run.

Perfect competition and efficiency

In the LR all firm in PC earn normal profits.

The condition brings with it the following conditions :

(i) There is allocative efficiency

 Allocative efficiency is a condition of efficiency or economic efficiency or

optimum resource allocation in which price is equal to MC
 It means that a firm is producing the right goods for the society.
 In this case the price represents the value that a society and the producer
place on the commodity.
 MC represents the opportunity cost or sacrifices to the society.
 When the value or benefit of consuming = to the sacrifice or opportunity
costs, it means therefore that the society is at equilibrium.

(ii) There is productive efficiency

 Productive efficiency refers to a situation whereby a firm is able to

produce at lowest possible cost.

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  With productive efficiency a firm will be incurring the minimum possible
average costs.
 NB for productive efficiency to take place a firm must produce at the
minimum not falling part of the average cost curve.
 From the firm’s point of view, a firm is said to be productivity efficient
when P=AC
 Price represents the value the producers and consumers place on a
commodity.
 Average cost represents the amount of resources used to produce a unit.
 Therefore productive efficiency means the price charged is equal to the
lowest average cost.
 AC represents the true economic cost of producing a good or a service.
 From the industry point of view productive efficiency is met when all
firms incur the same marginal cost.
 This is because all firms in the industry produce a similar identical
product.
 The market price is the same for all units produced by the firms and that
firms must incur the same MC.

 If MC are the same it means no one is better than the other and resources
cannot be transferred from one firm to another.

 Productive efficiency from the economy as a whole’s point of view is

met when the economy is producing on it’s the production possibility
curve (PPC).

 For the entire economy production efficiency means full utilisation of an

economy’s resources.

 The economy will be operating at full employment (full capacity).

 Any reallocation at full employment will make the production of a good

increase by reducing the production of another.

 Despite the efficiency of perfect competition however many critiques

argue that in PC there is no much incentive to research and develop.

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  Firms are reluctant to work very much on sound and effective research and
development because of the following conditions:-

a) There is perfect competition

Firms know quite well that any major work on cost reaction or technical progress can
be easily copied by rivals therefore no incentive for an individual firm to commit
much of its resources on research and development.

b) Freedom of entry and exit.

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