market structure now

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Market structure Goal of the firm 1. Profit maximization This occurs at the level of output where profits cannot be increased any further ie MR>MC. Profit maximization occurs where MR=MC. 2. Growth – Businesses want to increase their size 3. Sales and Revenue Maximization – firms are prepared to accept a lower price and produce above the profit maximization output in order to increase its market share. 4. Market Dominance – The pursuit of sales or revenue maximization 5. Satisficing – Making reasonable profits that is sufficient to satisfy the shareholders as well as to keep the work force and consumers happy. Revenue Total Revenue – the firm’s total earnings per period from the sale of particular amounts of output. TR = P x Q Average Revenue – earnings per unit TR/Q 1

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Page 1: Market structure now

Market structure

Goal of the firm

1. Profit maximization

This occurs at the level of output where profits cannot be increased any further ie

MR>MC. Profit maximization occurs where MR=MC.

2. Growth – Businesses want to increase their size

3. Sales and Revenue Maximization – firms are prepared to accept a lower price and

produce above the profit maximization output in order to increase its market

share.

4. Market Dominance – The pursuit of sales or revenue maximization

5. Satisficing – Making reasonable profits that is sufficient to satisfy the

shareholders as well as to keep the work force and consumers happy.

Revenue

Total Revenue – the firm’s total earnings per period from the sale of particular amounts

of output. TR = P x Q

Average Revenue – earnings per unit TR/Q

Marginal Revenue – The additional revenue from the sale of an additional product.

∆TR/∆Q

Profit

This occurs when revenue is greater than cost. It is the minimum return the owner must

make in order to remain in business. There are two types of profit namely normal and

abnormal (pure/economic/supernormal/excess) profits.

Normal Profits (MR =MC)

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The opportunity cost of being in business ie the profit that could have been made

in the next best alternative business. It is the profit necessary to persuade firms to

stay in business in the long run but not enough to attract new firms to the industry.

If normal profits are not being made in the long run it would be best to shut down

the business.

Abnormal Profit

TR>TC or MR>MC. This is where profits are greater than normal. In the long run new

firms are attracted to the industry.

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Loss TC>TR or MC>MR

Less than normal profits. Firms want to leave the industry.

Market Structure

The characteristics of a market that influence the behaviour and performance of firms that

sell in the market

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Major types

1. Perfect competition

2. Monopoly

3. Monopolistic competition

4. Oligopoly

Perfect Competition

A market that consists of a large number of firms producing an homogeneous product.

This market structure does not really exist.

Assumptions/ features/characteristics

1. There are many suppliers who do not own a significant share of the market.

Therefore firms do not have control over price and are considered price takers.

2. Products are identical. Therefore they are perfect substitutes for each other.

3. Consumers have perfect information about prices. Therefore firms cannot charge

a higher price as consumers can easily find cheaper substitutes for the ruling

price.

4. All firms have equal access to resources

5. No barriers to entry and exit in the long run. This cause firms to only make

normal profits in the long run.

Profit Maximization

Firms can sell any amount at the existing market price as they are price takers. Revenue

is the market price and quantity produced. TR = PxQ. For instance if the price of Pepsi

Bubbla is $50 and 20 Bubblas are produced then TR is $50 x 20 = $1000. Note that MC

varies with output firms will continue producing in the short run as long as MC is equal

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to market price and in the long run as long as market price is greater than the AVC. Profit

is maximized where MR=MC=P. The market sets the price so in order to increase sale

the produce has to supply and sell large amounts. A firm operating under Perfect

Competition will always produce at the level of output where the MC of the last unit

produced is just equal to the market price.

Short-run

The industry sets the price through the forces of demand and supply. The firms will then

have to sell at this price. Any amount of output can be sold at this price (perfect

elasticity). If one firm were to increase the price consumers would not buy their products

and if the firm were to sell at a lower price it would loose. Therefore it would be best to

sell at the market price. Abnormal profits can be made in the short run.

Abnormal Profits

Price is constant therefore AR=MR. Profit maximization occurs where MR=MC. The

profit maximization quantity is Q1. Price in greater than average cost therefore abnormal

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profits are made. However if the market price is lower than the AC then losses would

occur in the short run.

Losses

Firms may also make normal profits in the short run.

Long run curves

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In the long run abnormal profits will attract new firms to the industry because there are

no barriers and firms have perfect knowledge of what is happening in the market causing

supply to increase forcing down the market price, demand increases to AR2 = MR2.

Abnormal profits will be competed away or exhausted and only normal profits (zero

economic profits) are made. Existing firms will remain in the industry; however no new

firms will enter the industry.

As it relates to losses in the short run, in the long run firms will exit the industry shifting

the supply curve to the left. Price will increase until normal profits are made.

Graph

Long run industry supply curve

Constant cost – more is supplied at the same price in the long run. The curve is

horizontal. Demand increases and abnormal profits are made. New firms enter the

industry shifting the supply curve to the right until the price returns to its old level.

Graph

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Decreasing cost

As firms expand/buy new technology they experience economies of scale. Price falls. In

the long run the supply curve slopes downwards, more is supplied at a lower price in the

long run

Graph

Increasing cost

As new firms enter the industry price/cost of raw materials increase, more is supplied at a

higher price in the long run. The long run supply curve slopes upwards.

Graphs

Shut down

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Short run – price must cover AVC. Supply is MC above AVC. If this is not happening

shut down.

Long run – Firms must cover AC or ATC. Supply is MC above ATC or AC. If this is not

happening shut down.

Benefits of Perfect Competition

1. In the long run firms only make normal profits which is good for the consumer

2. They are allocative efficient as they produce where P=MC

3. They are productive efficient as they produce at the lowest possible cost per unit

ie the bottom of the AC

4. More efficient firms make abnormal profits in the short run so it is an incentive

for firms to be innovative and efficient.

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Disadvantages

1. Firms cannot afford research and development to earn economies of scale in the

long run because only normal profits are made in the long run

2. Firms lack variety

3. Firms are too small to have any dominance over the market.

Total Approach

Comparing total revenue with total cost to get the largest possible positive difference

ie TR>TC. (see cape book page 101- 102)

Marginal Approach

Compares the addition profit form the production and sale of an additional product.

This is the most widely used method of determining profit maximization. MR>MC

firm can produce more, MR<MC profits are falling so reduce production, MR=MC

profit is maximized. (see cape book page 102- 103)

Monopoly

Definition

Monopoly is characterized by the absence of competition. It is a situation where single

company owns all or nearly all of the market for a given type of good or service. The

firms are able to operate without competition by establishing barriers to entry.

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Reasons for the existence of monopolies/ Barriers to entry

1. Secret formula that no other competitor or potential competitor is able to breach.

The firm may patent its unique formula for instance KFC

2. Access to strategic raw materials

3. The size of the market allows for only one firm to subsist. These monopolies are

called natural monopolies eg public utility firms in CARICOM

4. An industry may have more than one firm. However the most efficient firm with

the largest resource base can charge a lower price for its commodity compared to

its rival. Through what is known as limit pricing the most efficient firm can out-

compete its rivals and gain control of the market. A more established firm can

build their goodwill and establish credit ratings to obtain preferential access to

credit from financial institutions.

5. The government may offer permission to franchise for instance KFC is owned by

Prestige Holdings in T&T.

6. Economies of scale

7. mergers and takeovers

8. Product loyalty

9. Intimidation and aggressive tactics

Sources of monopoly

1. Natural monopolies

2. Capital requirement – expensive to set up (nuclear plant)

3. Technological – reduces cost per unit

4. Legal - government grants patent or copyrights

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5. Public- monopoly by law like the post office

Assumptions/ Features/Characteristics

1. There is one seller and many buyers therefore monopolies have significant control

over price. Hence they are price makers. They can increase prices at anytime

unlike those firms operating under perfect competition.

2. The product is unique and does not have close substitutes. JPS, NWC

3.  Profit Maximizer: Maximizes profits where MR=MC

4. High Barriers to entry and exit: Other sellers are unable to enter the market of the

monopoly to compete away their supernormal profits made in the short run.

5. Price Discrimination: A monopolist can change the price and quality of the

product. He sells more quantities charging less for the product in a very elastic

market and sells less quantities charging high price in a less elastic market.

6. The demand curve tends to be downward sloping and more inelastic than the

oligopoly.

The demand curve

The firm and industry demand curve is the same. It is downward sloping which

means in order to sell more market price must fall. The downward sloping curve

means that MR curve at the firm diverges from the AR curves. The MR falls below

the AR or demand curve unlike perfect competition where MR=AR=D.

AR and MR

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Total Revenue curves

In the elastic portion of the curve MR is positive and so increasing quantity increases

TR. But where demand is price inelastic MR is negative and increases in quantity

produced reduces TR. Where elasticity is 1 MR is zero TR is at its highest. The

monopolist should therefore operate along the elastic portion of the curve.

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Profit maximization

The monopolist's profit maximizing level of output is found by equating its marginal

revenue with its marginal cost, which is the same profit maximizing condition that a

perfectly competitive firm uses to determine its equilibrium level of output. Indeed,

the condition that marginal revenue equal marginal cost is used to determine the

profit maximizing level of output of every firm, regardless of the market structure in

which the firm is operating.

Short run equilibrium of the firm and industry

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The monopoly like ant other firm maximizes profits where MR=MC so it would be

ideal to sell at this price. However, in order to make abnormal profits the firm will

sell Qm at Pm which is above the AC curve. These abnormal profits may remain in

the long run because of barriers to entry and imperfections in the market.

The firm may make normal profits where AR=AC

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It is also possible for monopolies to make losses where AC is greater than AR

The long run position of the monopolist

Barriers to entry and imperfect knowledge cause abnormal profits to remain in the

long run.

Monopoly and deadweight loss

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This occurs because the monopoly produces less at a higher price unlike the perfect

competitor who produces where MC=AR=D. The monopoly is therefore allocative

inefficient because P>MC resulting in deadweight loss.

Advantages of monopoly

A monopoly enjoys economics of scale as it is the only supplier of product or

service in the market. The benefits can be passed on to the consumers.

Due to the fact that monopolies make lot of profits, it can be used for research and

development and to maintain their status as a monopoly.

Monopolies may use price discrimination which benefits the economically weaker

sections of the society. For example, Indian railways provide discounts to students

travelling through its network.

Monopolies can afford to invest in latest technology and machinery in order to be

efficient and to avoid competition.

Monopoly avoids duplication and hence wastage of resources.

Disadvantages

They are allocative inefficient as P>MC which cause market failure

They are productive inefficient as they do not produce at the bottom of the ATC

curve.

Compared to s perfectly competitive industry with the same cost and demand

conditions, the monopolist will charge a higher price for less output.

Poor level of service, inefficiency and complacency

No consumer sovereignty.

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Consumers may be charged high prices for low quality of goods and services.

Lack of competition may lead to low quality and out dated goods and services.

Natural Monopoly

An industry in which the firm produces enough to meet the entire demand at a lower

cost than two or more other firms. Left unregulated it produces where P=AR;

regulated it produces where P=MC. The size of the market allows for only one firm to

subsist eg public utility firms in CARICOM. An industry in which economies of scale

makes it possible for a firm to dominate the entire market as a result of a AC. This

type of monopoly is especially likely to occur if the market is small. The firm does

not have to be large but its size relative to the total market demand for the product

does matter.

Supernormal profits are made when only one firm is in the industry but when another

firm enters the industry they may have to share the market the demand curve may

pivot inwards and both firms may end up losing.

Graph

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New Entrants and the existing monopoly

Graph

The existing firm set their prices below the average cost of the new entrant making it

difficult for the firm to survive in the industry.

Price Discrimination

Where the same commodity is sold to different consumers in different markets for

different prices for reasons that have nothing to do with cost, for this to occur:

1. Markets must be separable , with different price elasticities of demand

2. Arbitrage (taking advantage of a price difference between two or more markets)

must not be possible.

First-degree price discrimination

The seller can charge each consumer the maximum amount they are willing to pay for

each unit of the product purchased. The producer gets the entire consumer surplus. For

instance doctor charges his patient based on the patient’s perceived willingness and

ability to pay. This is perfect discrimination because the firm has perfect knowledge

about their consumers and uses this knowledge to receive the highest payment possible.

Graph

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Second-degree Price discrimination

This is called quantity discrimination. The firm does not have perfect knowledge of the

consumer. This is where the consumer is charged different prices based on the quantity of

the commodity purchased. The consumer will pay more for the first unit of the

commodity and less for successive units of the commodity, so they may want to pay $60

for the on unit of water but $40 for each unit of water when buying a case of water. You

tend to pay relatively less for a larger soda than a smaller one.

Graph

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Third-degree price discrimination

This is the most common type where distinct prices are charged in each of the different

markets. The monopolist can only discriminate if the elasticity of demand can be

identified and exploited. The monopolist can charge the highest price in the market for

which demand tends to be inelastic than in the market where demand is elastic.

Graph

Market a Market b The firm

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Quantity supplied for each market is where MC= MRa = MRb. However in market ‘a’

the firm can charge as much as P to earn a greater revenue than in market ‘b’ where it can

charge as much as P2.

Monopolistic Competition

This is a market structure in which large number of firms produces differentiated

products but compete for the same consumers. Examples:

The restaurant business

Hotels and bars

General specialist retailing

Consumer services, such as hairdressing

Assumptions/ Features/Characteristics

1. Large number of buyers and sellers. Each firm controls a small portion of the

market. Each firm act independently of each other in terms of pricing and output

policies.

2. Weak barriers to entry and exit

3. Perfect knowledge of the market

4. products are differentiated

5. Firms are price makers

6. Firms advertise

7. The demand curve is downward sloping and fairly elastic

Nature of the product

Product differentiation means that products have attributes which make them different

for instance in terms of material used to produce the good, colour, taste etc. There

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may be a perceived difference as a result of advertising. The aim of differentiation is

for the consumer to think that the product is unique. Product differentiation implies

that the products are different enough that the producing firms exercise a “mini-

monopoly” over their product this depends on the company’s success at

differentiation. The firms compete more on product differentiation than on price.

Entering firms produce close substitutes, not an identical or standardized product.

The firm has multiple dimensions

One dimension of competition is product differentiation.

Another is competing on perceived quality.

Competitive advertising is another.

Others include service and distribution outlets.

Profit Maximization

Profit is maximized where MR=MC

Like a monopoly

• The monopolistic competitive firm has some monopoly power so the firm faces a

downward sloping demand curve

• Marginal revenue is below price

• At profit maximizing output, marginal cost will be less than price

Like a perfect competitor, zero economic profits exist in the long run

A monopolistically competitive firm prices in the same manner as a monopolist—

where MC = MR.

But the monopolistic competitor is not only a monopolist but act like a perfect

competitor as well.

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In the short run the firm can make abnormal profits though product development and

advertising. However if the addition cost of advertising is greater than the additional

revenue from advertising then losses will occur. Normal profits can also be made in

the short run.

Profit is maximized where MR=MC. Supernormal profit are made in the short run.

The size of this profit depends on the strength of demand, the elasticity of demand,

and the uniqueness of the product.

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1. At equilibrium, ATC equals price and economic profits are zero.

2. This occurs at the point of tangency of the ATC and demand curve at the output

chosen by the firm.

In the long run new firms enter the industry and abnormal profits are competed away.

Non-Price Competition

The firm attempts to establish its product as a different product from that offered by

its rivals.

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Differentiation means that in the consumer’s mind, the product is not the same.

Marketing is often the key to successful differentiation. Firms may differentiate

products by perceived quality, reliability, colour, style, safety features, packaging,

purchase terms, warranties and guarantees, location, availability (hours of

operation) or any other features.

Brand names may signal information regarding the product, reducing consumer

risk. A brand name is valuable to a firm; it makes the demand less elastic and can

enable the firm to earn higher profits. Once a consumer has had a positive

experience with a good, the price elasticity of demand for that good typically

decreases—the consumer becomes loyal to the product.

Monopolistic competitive firms are allocatively inefficient because P>MC and

productively inefficient since they are not producing at their lowest cost per unit ie the

minimum AVC.

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Advantages of Monopolistic Competition

1. The Promotion of Competition (lack of Barriers to Entry) 

2. Differentiation Brings Greater Consumer Choice and Variety 

3. Product and Service Quality – Development – greater incentive to increase this to earn

supernormal profits

4. Consumers become more knowledgeable of products through marketing and

Advertising

Disadvantages

1. They can be wasteful -- Liable of Excess Capacity - Some firms don't produce enough output to efficiently lower the average cost and benefit from economies of scale and reduces their economic profits. The cost of packaging, marketing and advertising can be considered extremely wasteful on some levels.

2. Allocatively Inefficient 

3. Higher Prices 

4. Advertising - It distorts what consumers’ desire, as well as reduces competition as consumers become captivated over the perception of differentiation.

Limitations of Monopolistic Competition

1. Firms do not have perfect knowledge of the market

2. It is impossible to derive an industry demand curve because products are

differentiated

3. The firm may take part in non-price competition in order to maximize profits

4. Entry is not completely unrestricted because some firms have cost advantages or

their products are difficult to duplicate.

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5. It may be difficult to forecast the effects that product development and advertising

will have on demand

6. Advertisements may have different effects at different price levels and different

profit maximization points

Oligopoly

Oligopoly refers to a market with "few sellers". Oligopolies interact among

themselves. When an oligopolist changes a price, it must take into account how other

firms in the industry will respond. Within an oligopoly, the products can be similar or

differentiated. Oligopoly markets have high barriers to entry.

Examples of Oligopoly

Automobile industry

Airline industry

Cigarettes

Cleaning products

Electrical appliance

Characteristics of Oligopoly

1. Industry dominated by small number of large firms - Supply is concentrated in the

hands of a relatively few firms.

2. Many firms may make up the industry

3. High barriers to entry - Substantial barriers, similar to monopoly but not as

restrictive may be present. Oligopolies are large firms and benefit from economies

of scale. It takes considerable “know-how” and capital to compete in this industry.

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e.g. Petroleum or oil industry. In the long run dominant firms can maintain

supernormal profits.

4. Products could be highly differentiated – branding or homogenous -

Homogeneous product- pure oligopoly. e.g. Raw materials (oil, petrol, tin).

Differentiated product- imperfect/ differentiated oligopoly. e.g. (Cars, detergent)

5. Non–price competition - Compete not through price but other methods

(advertising, after-sales service, free gifts). Practiced by oligopoly and

monopolistic competition. Various forms:

a. Competitive advertising – to reinforce product differentiation and harden

brand loyalty.

b. Promotional offers – e.g.. Household detergent, toothpaste, shampoo (buy

2 get 1 free), (25% extra at no extra cost).

c. Extended guarantees/after sales service – esp. for consumer durables, by

offering free spare parts, labour guarantee.

d. Better credit facility

e. Attractive gift wrappings

6. Price stability within the market - kinked demand curve? - Prices are very

inflexible. Despite changes in underlying costs of production, firms are often

observed to maintain prices at a constant level. The kinked demand curve theory

is used to show price rigidity in an oligopoly market structure.

7. Potential for collusion? - Make agreement amongst them so as to restrict

competition and maximize their own benefit.

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8. High` degree of interdependence between firms - Oligopoly firms are large

relative to the market in which they operate. If one oligopoly firm changes its

price or its market strategy, it will significantly impact the rival firms. E.g. if

Pepsi lowers its price to 60 dollars a bottle, coco cola will be affected. If coco cola

does not respond, it will loose significant market share. Therefore coco cola will

most likely lower its price too. In oligopoly a firm not only considers the market

demand for its products but also the reaction of other firms in the industry.

Advantages

1. When firms collude – monopoly –supernormal profit – extra profit – extra capital –

to fund R&D – benefit to consumer.

2. Product differentiation – non-price competition– greater variety to consumers.

3. Price stability/rigidity – helps in planning, reduce uncertainty.

Disadvantages

1. Collusive oligopoly - if they agree upon output – no variety and improvement in

quality – bad for consumers.

2. Acting like a monopoly

Restrict output and charge a higher price

Producer sovereignty

Consumer sovereignty not respected

Greater inequality in income (supernormal profits)

Profit maximization

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Non-price competition (Collusion)

Oligopolies have strong incentives to collude or form Cartels ( a formal collusive

agreement) because while acting together, they can restrict output and set prices

so that abnormal economic profits are earned. The individual oligopolist has an

incentive to cheat because the firm's demand curve is more elastic than the overall

market demand curve. By secretly (tacitly) lowering prices, the firm can sell to

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customers who would not buy at the higher price, as well as to customers who

normally buy from the other firms.

The companies act like a single firm. The cartel as a whole will sell at P0 with a per-

unit cost of A0 resulting in the cartel earning supernormal profits.

Oligopolistic agreements tend to be unstable due to these conflicting tendencies.

Obstacles to collusion

1. Low entry barriers

Particularly as time goes on, more firms will be attracted to the potential economic

profits, which will not be sustainable. For example, the OPEC's raising of oil prices

during the 1970s and early 1980s enticed more non-OPEC producers to produce

more. The market share of OPEC producers was drastically reduced and they had to

reduce prices in order to gain market share. In the long run, cartels are not usually

successful at raising prices.

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2. Antitrust laws

These laws prohibit collusion. Although firms may make secret agreements, those

agreements will not be enforceable in a court of law.

3. Unstable demand conditions

These laws prohibit collusion. Although firms may make secret agreements, those

agreements will not be enforceable in a court of law.

4. Increasing the number of firms

An increasing number of firms in an oligopolistic industry will make agreements

harder to discuss, negotiate and enforce. Differences of opinion are more likely. As

the number of firms in the industry increases, the industry will behave more like a

competitive market.

5. Difficulties with detecting and stopping price cuts

These difficulties will undermine effective collusion. Sometimes oligopolistic firms will

cheat by enacting quality improvements, easier credit terms and free shipping. If quality

changes can be used to compete, collusive price agreements will not be effective.

Non-collusive Behaviour (the Kinked Curve)

This model recognizes that demand for a firm’s product is determined both by the market

demand for a product as well as by rival firm’s behavior. Firms compete for consumers.

The demand curve has two distinct parts that are relatively elastic and relatively inelastic.

The firm sells Q0 at P0. If the firm were to increase price above P0, other firms will not

respond cause the firm to loose a substantial amount of its market share. But if the firm

were to decrease it price below P0 then other firms would do the same in order for them

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not to loose their market share. This would lead to small increases in output along the

inelastic segment of the demand curve.

The Kinked Curve

The non-collusive firm and MC and MR

The MR will have a kink at Q0 which corresponds to the point where the demand curve

is kinked. The profit maximization point is Q0 where the MC cuts the MR anywhere

within the break or gap. Although the cost level changes that is MC1 moves from MC0 to

MC the market price of the commodity remains the same. Therefore oligopolists are

characterized by price stickiness and therefore are more likely to engage in non-price

competition rather than compete on the basis of price.

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Game Theory applied to oligopoly

Firms consider their rival when making policy decisions. Game theory is useful in

explaining individual

Concentration ratio – the proportion of market share accounted for by top X number

of firms:

◦ E.g. 5 firm concentration ratio of 80% - means top 5 five firms account for

80% of market share

◦ 3 firm CR of 72% - top 3 firms account for 72% of market share

e.g. The music industry has a 5-firm concentration ratio of 75%. Independents make up

25% of the market but there could be many thousands of firms that make up this

‘independents’ group.

An oligopolistic market structure therefore may have many firms in the industry

but it is dominated by a few large sellers.

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Characteristics Perfect

competition

Monopoly Monopolistic

competition

Oligopoly

Barriers to entry and

exit

Freedom of

entry and exit

Strong barriers None Some

Control over the

market and price

The industry

sets the price.

The firm is a

price taker.

Firms have no

control over

prices. P=MC

P=MR

Significant

market power

and set prices

P=AR

No firm has

strong control

over the

market price

because there

are a large

number of

firms. In the

short run

P= AR>MC

in the long

run P>ATC

P=AR

Control over

prices and

firms engage

in price

fixing. P=AR

Nature of the goods Homogenous/

identical

Unique Differentiated

but similar to

the

competitor’s

product

Homogenous

or

differentiated

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Competitive

behaviour and

performance/conduct

No sales

promotion

etc. has to

increase

output and

reduce cost to

make profits.

Practice price

discrimination

but no

advertising

and sales

promotion etc.

Price is at AR

above MC.

Competition

is based on

advertising,

branding,

packaging and

sales

promotion.

Does some

advertising

and sales

promotion

Number of buyers

and sellers

Many buyers

and sellers

One seller and

many buyers

Large number

of buyer and

sellers

Few large

sellers and

many buyers

Information Perfect

knowledge

imperfect Imperfect but

more perfect

than a

monopoly

imperfect

Profitability Short-run –

abnormal

profits or

losses are

made but in

the long run

only normal

Earn

supernormal

profit in both

the short run

and the long

run

Earn

supernormal

profits only in

the short run

as in the long

run new firms

enter the

Firms make

supernormal

profit in the

short run and

long run

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profits are

made.

industry and

compete away

these profits

to normal i.e

MR=MC

Efficiency/output Output is

determined

where

MR=MC

Pareto

efficient

Productive

efficient as it

produce at the

bottom of the

ATC.

Allocative

efficient as it

sells where

P=MC

Output is

determined

where

MR=MC.

Output is

determined

where

MR=MC in

the short run.

They have

excess

capacity in the

long run as

output is

below the

minimum

level.

Productive

and allocative

inefficient.

Output is

determined

where

MR=MC in

the short run.

They have

excess

capacity in

the long run

as output is

below the

minimum

level.

Productive

and allocative

inefficient.

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Natural Monopoly

An industry in which the firm produces enough to meet the entire demand at a lower cost

than two or more other firms. Left unregulated it produces where P=AR; regulated it

produces where P=MC

3 approaches to determine pricing

1. Do nothing - the firm produces the monopoly output and charges the monopoly price

causing inefficiency

2. P=MC – efficiency as a larger output is available at a lower price. However the firm

cannot cover its cost of production and will have to be subsidized.

3. P=AC the firm breaks even but efficiency is not achieved.

Concentration Ratio and Herfindahl Hirschman Index (HHI)

Concentration Ratio is usually used to show the extent of market control of the largest firms in the industry. It is the combined production of the leading 4 or 8 firms in the industry.

Or

The percentage of sales of the 4 or 8 largest firms in the industry.

Formula: Sum of the market share of the leading firms/Total market share X 100%

Procedure for calculating concentration ratio

1. Total the amount of production/sales for the entire market2. Find the share of the market each firm has3. Add up the market share of the 4 or 8 firms 4. Interpret

Interpretation – 0 -40% low concentration (perfect competition)40 – 60% medium/moderate concentration (monopolistic competition)60 -100% high concentration (oligopoly, monopoly)

Herfindahl Hirschman Index (HHI)

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The square of the percentage market share of each firm summed over all the firms

Steps – 1. Square the market share of each firm

2. Sum the squared market share of the firms

Interpretation – 0 -1000 or 0.01 low concentration (perfect competition)1000 ( 0.01) – 1800 (0.18) medium/moderate concentration (monopolistic

competition)1800 (0.18) or more high concentration (oligopoly, monopoly)

Contestable markets

In the traditional model of oligopoly it is assumed that there are barriers to entry; in reality it is likely that other firms can enter the market ie it is possible for competition to increase within them and this puts pressure on existing firms to behave efficiently.Firms may act in a competitive manner even when producers are few if the market is easy to enter. High profits will attract new firms to the industry therefore existing firms must be competitive.

Assumptions

1. freedom of entry and exit2. The number of firms competing will vary eg. It may be a monopoly at one time

and then there may be many other firms competing at other times3. firms compete

For contestable markets, abnormal profits are earned in the short run which attracts other firms to the market and in the long run only normal profits are earned.

A perfectly contestable market is one in which the costs of entry and exit is zero. Firms must be competitive; abnormal profit will attract more firms to the industry leading to lower prices, better quality service, more choice and higher output. Eg banking, in particular internet banking.

Sunk cost deters entry into the market and make it less contestable.

Hit and run - when firms enter a market and target a particular niche (segment) rather than compete throughout the market.

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