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Market StructuresSection: 7 Market Structures
It is hard to imagine a firm that operates successfully without having any clue as to who its customers and competitors are, their relative size and the decisions they undertake. A successful firm ought to be well informed about the market environment it functions in. This is exactly why studying market structures is important. The motivation to study them stems from three important sources: their usefulness in depicting firm behavior, in revealing pricing and output decisions and lastly, in functioning as an evaluative space, allowing firms to know where they stand in terms of profits and efficiency.
It is needless to mention that firms operate differently in different market situations. The structure of a market is explained by many factors, such as the number of buyers and sellers, nature of the product, the degree of freedom of entry and exit, and the nature of information. The four market structures are Perfect Competition, Monopolistic Competition, Oligopoly and Monopoly. The characteristics of these market structures are briefly given in the following table:
Table 7.1
Type No. of firms
Size of firms
Nature of the product
Entry &
Exit
Price Control of a firm
Nature of information
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Market Structuresand decisions of countless number of buyers and sellers. A perfectly competitive firm faces a straight horizontal demand curve showing that the firm can sell infinite quantities at the prevailing market price. Since buyers have perfect knowledge and products are homogenous, a firm‟s decision to charge a price higher than the market price results in zero sales. Charging anything below market price attracts the entire market demand but the firm‟s small size doesn‟t allow it to cater to such a large customer base. Consider the following pair of diagrams:
Output Output
D D
S
P0
P P
Market Firm
Diagram 7.1(a) Diagram 7.1(b)
The panel on the left shows how equilibrium price is determined by the intersection of demand and supply curves at P0. The demand curve faced by any particular firm is a straight horizontal line at the market price. The price elasticity of demand is infinity because of the existence of perfect substitutes.
Revenue curves of a perfectly competitive firm
The demand and revenue schedule for a hypothetical firm operating in the conditions of perfect competition is given below.
Table 7.2
Price (P) = Average
Revenue (AR) Quantity (Q) Total Revenue (TR) Marginal Revenue (MR)
10 0 0 -
10 1 10 10
10 2 20 10
10 3 30 10
10 4 40 10
10 5 50 10
10 6 60 10
To verify that Average Revenue (AR) always equals sale price, consider the following set of equations:
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Market StructuresTotal Revenue = Sale Price × Quantity
Quantity Quantity Price
Sale Quantity
Revenue Total
Revenue
Average = Sale Price
Thus AR
PriceSince a perfectly competitive firm can sell infinite amounts at the prevailing market price, revenue generated from the sale of an additional unit (MR) equals sale price.
Diagram 7.2 shows the revenue curves of a perfectly competitive firm.
Diagram 7.2
Price Revenues
D = P = AR = MR
Output Cost curves of a perfectly competitive firm
Diagram 7.3 shows cost curves assuming law of variable proportions.
Diagram 7.3
AC AVC Cost MC
Output
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Market StructuresPrice and output determination in perfect competition
The intersection of MC and MR determines the equilibrium output for a perfectly competitive firm.
The following set of diagrams show the five possible short run equilibria for a perfectly competitive firm. In each case, firms choose to produce the profit maximizing (or loss minimizing) output, Q*, determined by the intersection of upward rising MC and MR.
Diagram 7.4(a)
AC AVC MC
Output
P = AR = MR = D Revenue
Cost
Q*
a d
c b
Diagram 7.4(b)
AC AVC MC
Output
P = AR = MR = D Revenue
Cost
Q*
Diagram 7.4(c)
AC AVC MC
Output
P = AR = MR = D Revenue
Cost
a
d c
b
Q*
f e
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Market StructuresDiagram 7.4(d)
AC AVC MC
Output
P = AR = MR = D Revenue
Cost
Q*
b
d c a
Diagram 7.4(e)
AC AVC Revenue MC
Cost
Output
P = AR = MR = D a
f e
b
d
c Q*
Diagram 7.4(a) shows equilibrium where sale price exceeds average cost, resulting in supernormal profit. It is measured by the area abcd, the product of per unit profit i.e. the vertical distance between sale price and average cost and the profit maximizing quantity.
The firm shown in diagram 7.4(b) earns normal profit as sale price exactly equals average cost.
Firms shown in diagram 7.4(a) & 7.4(b) continue to operate in the long run.
Diagram 7.4(c) shows losses for the firm (abcd) but sale price exceeds per unit variable cost. The excess of sale price over per unit variable cost (ce or df) is contribution margin and area dcef is total contribution towards fixed cost. This firm should continue in the short run but shut down in the long run.
Diagram 7.4(d) shows a firm at the shut down point. A small increase in price allows it to continue in the short run and a marginal decrease necessitates immediate shut down.
The firm shown in diagram 7.4(e) should shut down immediately as the price it charges is below per unit variable cost. The firm‟s losses, abcd, reduce to fixed cost, abef, if the business shuts down.
Fixed cost is the product of the vertical distance between AC and AVC (i.e. per unit fixed cost) and
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Market Structuresthe quantity produced. In the given situation, losses are minimized at zero output level and not where rising MC equals MR.
Put briefly, the intersection of rising MC and MR determines loss minimizing quantity provided sale price exceeds per unit variable cost. Businesses should shut down immediately to minimize losses where sale price is below average variable cost.
Long run equilibrium of a perfectly competitive firm
Unlike the short run, there exists only a single equilibrium for a perfectly competitive firm in the long run- where it earns normal profits. When firms making short run losses exit the industry in the long run, the remaining firms get to charge higher prices and start earning normal profits. On the other hand, firms earning supernormal profits in the short run attract new firms into the industry, increasing market supply, lowering prices and diluting profits. Ease of entry and exit makes it impossible for a perfectly competitive firm to charge a price higher than average cost in the long run. The maximum price it may charge is minimum average cost, thus only normal profits can be earned. The following pair of diagrams explains the conversion of supernormal profits earned in the short run to just normal profits in the long run.
Diagram 7.5 S0
D1
Q1 Q2 Output
D0
S1
P0
P1
P
Market
Firm
q1
q2
AC MC
P0
P1
P
D0
In the panel on the left, D0 and S0 show the initial demand and supply curves of the perfectly competitive industry. Equilibrium price is P0 and market output, Q1. The perfectly competitive firm shown on the right chooses to produce the profit maximizing output q1. The firm makes supernormal profit in the short run which attracts new firms into the industry. Due to ease of entry/exit, the market supply curve shifts towards right and the industry moves downwards along its demand curve, lowering market price. Entrants enter till price becomes equal to average cost at P1
and allows firms to make only normal profits. The output made by the industry increases to Q2 and that made by an individual firm reduces to q2. Firms produce a smaller output but overall industry‟s output stands increased due to the increased number of firms.
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Market StructuresShort run supply curve of a perfectly competitive firm
The supply curve of a firm shows the relationship between price and the quantity it chooses to supply. For a profit maximizing perfectly competitive firm, quantity supplied is determined by the intersection of rising MC and MR. As price equals MR in a perfectly competitive setting, the intersection of price and MC determines the output firm supplies. Thus, the MC curve becomes the supply curve of a perfectly competitive firm. However, Marginal Cost Curve fails to determine output if price is below Average Variable Cost. In such a case, the business shuts down immediately. Thus the short run supply curve of a perfectly competitive firm is the rising portion of MC over and above AVC. Refer to the following diagram which shows the supply curve for a perfectly competitive firm. The firm chooses to produce Q1 if the price is P1. However, no quantity is supplied at P2 as this price is below AVC.
Diagram 7.6
P1
P2
O Q1
MC
AVC Price
Output
Industry’s supply curve
The supply curve of a perfectly competitive industry is the horizontal summation of firms‟
individual supply curves i.e. the summation of rising portions of all individual Marginal Cost Curves over and above the minimum Average Variable Cost.
Output determination in perfect competition (Total Revenue and Total Cost approach)
The following four diagrams show short run equilibrium positions of a perfectly competitive industry. In the first three cases (diagrams 7.7 (a, b and c)) firm produces X1. At this output Total Revenue and Total Cost are parallel meaning MR equals MC. In diagram 7.7 (a) firm makes supernormal profit i.e. ab. In diagram 7.7 (b) firm is making only normal profit. This is the long run equilibrium of a perfectly competitive firm. In diagram 7.7 (c) firm is incurring losses (a – b) but it should continue in the short run as losses are less than Fixed Cost (c – a). The vertical distance between the hypothetical line drawn from the vertical intercept of Total Cost curve and the Total Revenue curve measures Fixed Cost. In diagram 7.7 (d) the firm should immediately shut down since losses are higher than Fixed Cost.
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Market StructuresDiagram 7.7 (a)
Output TC TR
Revenue Cost
X1
a b
Diagram 7.7 (b)
Output
TC TR
Revenue Cost
X1
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Market StructuresDiagram 7.7 (c) Revenue Costs
Output TC
TR
X1
a b
c
Diagram 7.7 (d) Revenue Costs
Output TC
TR
X1
a b c
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