UNIT 3: MARKET STRUCTURE
Introduction
Firms, new and perhaps even experienced entrepreneurs must know at what
market structure they are engage in business. The less competitive market they are
in, the higher their chance in surviving and staying in the market.
This module will teach the reader the nature of market structures and their
pricing strategies.
Learning Outcomes
At the end of the module, the student is expected to:
1. Understand the nature of four market structure and be able to identify real
examples present in the locality.
2. Examine the best market structure for the consumer, business, and the
economy.
3. Create strategies for firms belonging to different market types in order to
survive in the market.
Lesson 1: Market Structure
Firms operates in four types of markets namely, perfect competition,
monopolistic competition, oligopoly, and monopoly. These markets can be
determined by measuring the concentration in the market.
The most used measure of concentration uses total revenue and puts five
firms in the group of largest firms. The result is the five-firm concentration ratio, which
is the percentage of total revenue (or the value of sales) in an industry accounted for
by the five firms with the largest value of sales. The range of the concentration ratio
is from almost zero for perfect competition to 100 for monopoly.
Below is an example how to calculate the concentration ratio.
The five-firm concentration ratio helps to measure the degree of
competitiveness of a market. A low concentration ratio specifies a high degree of
competition, and a high concentration ratio on the other hand indicates an absence of
competition. In the extreme case of monopoly, the concentration ratio is 100%
because the biggest (and only) firm makes the entire industry sales. Between these
two extremes, the five-firm concentration ratio is viewed as being a useful pointer of
the likelihood of collusion among firms in an oligopoly. If the concentration ratio is
more than 60 per cent, it is possible that firms have a high degree of market power
and may engage in collusion and act like a monopoly. If the concentration ratio is
less than 40 per cent, the industry is regarded as competitive. A concentration ratio in
between 40% and 60% specifies that the market structure is oligopoly.
Lesson 2: Perfect competition
Perfect competition is an industry having the following characteristics:
Many firms sell identical products to many buyers.
There are no restrictions on entry into the industry
Existing firms have no advantage over new ones.
Sellers and buyers are well informed about prices.
Farming, wood pulping, fishing, paper milling, grocery retailing, photo finishing,
plumbing and dry cleaning are examples of highly competitive industries.
Firms in perfect competition are considered price takers because they cannot
influence the market price. The reason why they are considered price takers is
because they only produce a small portion of the total output of a certain good and
buyers/consumers know the market price.
The Firm’s Decision in a Perfect Competition
Firms in a perfectly competitive industry faces market and technology constraint.
Firms face a particular market price, and the technology available to the firm
eventually determines its costs.
The objective of the firm in a competitive market is to make maximum profit,
and it must undertake the following four key decisions:
1. Short-run Decisions
The short run period of production is a time frame in which the quantity of
firms in the industry is fixed and each firm has a fixed plant size. However, changes
happens in the short run and the firm should react to these changes. For example,
the price at which the firm can sell its output/product might change in time or it might
fluctuate with general business conditions. The firm should react to such short-run
price fluctuations and decide:
Whether to produce or to temporarily shut down
If the decision is to produce, what quantity to produce.
2. Long-run Decisions
The long run period of production is a time frame in which each firm can
change/alter the size of its plant and can decide to leave or enter an industry. In the
long run, the plant size of each firm as well as the number of firms in the industry can
change. Likewise in the long run, the limitations that the firm faces can also change.
For example, the demand for a good can always fall, or a technological advance can
change an industry’s costs. Firms react to these long-run changes and decide:
Whether to increase or decrease their production or plants size
Whether to stay in an industry or leave it
The Firm’s Decision in a Perfect Competition
The firm in a perfectly competitive market should produce an output in which
total revenue surpasses total cost in order to gain economic profit.
Observe the table below copied from the book of Parkin et al. (2005). It shows
total revenue, total cost, and economic profit. At what output is profit maximized?
Profit Maximization through Marginal Analysis
Economic profit is achieved when MR>MC
If MR<MC, the firm incurs economic loss
If MR=MC, then profit is maximized
Take a look at the graphical presentation below.
Source: Parkin et.al. (20).Economics 6th edition. Pearson Education Limited. Pp.233
Lesson 3: Monopoly
Monopoly is a firm that produces a good or service having no close substitute
that exists and which is protected by a barrier preventing other firms from selling that
good or service. The firm is considered the industry in monopoly. Example is the
Microsoft Corporation.
Barriers to Entry in Monopoly
1. Legal Barriers to Entry
Monopoly franchise- exclusive right granted to a firm to supply a good or
service. Example of this is the right granted to the Post Office to carry
first-class mail.
Government License- controls entry into particular occupations,
professions and industries. Examples of this type of barrier to entry occur
in medicine, law, dentistry and many other professional services. A
government license doesn’t always create a monopoly, but it does restrict
competition.
Patent- exclusive right granted to the inventor of a product or service.
Copyright- is an exclusive right granted to the author or composer of a
literary, musical, dramatic or artistic work.
2. Natural Barriers to Entry
Natural barriers to entry form natural monopoly, an industry in which one
firm can supply the whole market at a lower price than two or more firms
can.
Pricing Strategies of Monopoly
1. Price Discrimination - is the practice of selling different units of a good or
service at different prices. Diverse customers might pay different prices for
the same item.
2. Single-price Monopoly - is a monopoly that must sell a unit of its output for
common price to all its customers.
Maximizing Profit in Monopoly
Profit is maximized when MC=MR. When MR exceeds MC, profit increases if
output increases. When MC exceeds MR, profit increases if output decreases.
Lesson 4: Monopolistic Competition
Monopolistic competition is a market structure having the following
characteristics:
A large number of firms compete.
Each firm produces a differentiated product.
Firms compete on product quality, price, marketing and branding.
Firms are free to enter and exit.
Examples of monopolistic competition are frozen foods, canned foods,
clothing, sporting goods, and petrol stations. In these industries, a large number of
firms compete, selling differentiated products that are heavily advertised, and firms
come and go under the pressure of competition.
In monopolistic competition, a firm does product differentiation. Differentiation
is making a product that is slightly different from the products of competing firms. A
differentiated product is one that is a close substitute but not a perfect substitute for
the products of the other firms.
Through differentiation the firm must market its product through in advertising
and advancing in packaging.
Firms also performs branding of their product to create quality differences.
For example, pharmaceutical companies make brand names for the drugs that they
develop and patent the drugs and copyright the brand names.
Pricing in Monopolistic Competition
Because of product differentiation, a firm in monopolistic competition faces a
downward-sloping demand curve. So, like a monopoly, the firm can set both its price
and its output. But there is a trade-off between the product’s quality and price. A firm
that makes a high quality product can charge a higher price than a firm that makes a
low-quality product.
Lesson 5: Oligopoly
Oligopoly is a market structure with the following characteristics:
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
High degree of interdependence between firms
Firms in oligopoly may collude and form a cartel in order to raise their profits.
They may do this by limiting output and raising prices.
There are two traditional oligopoly models; The Kinked Demand Curve Model
and The Dominant Firm Model.
Kinked Demand Curve Model
The oligopoly’s kinked demand curve model was grounded on the postulation
that each firm have faith in that if it raises its price, others will not follow, however if it
cuts its price, other firms will cut also their price
The kink in the demand curve generates a break in the marginal revenue
curve (MR). In order to maximize profit, the firm produce the quantity in which
marginal cost equals marginal revenue.
The Dominant Firm Model
A dominant firm oligopoly arises when one firm – the dominant firm – has a
big cost advantage over the other firms and produces a large part of the industry
output. The dominant firm is the one who sets the price in the market and the other
firms are price takers. Example of dominant firm oligopoly is the big petrol retailer
that dominates its local market.
Game Theory
Economists contemplate oligopoly as a game and to study oligopoly they use
a set of tools named game theory. Game theory is an instrument for studying
strategic behaviour – behaviour that takes into account the expected behaviour of
others and the recognition of mutual interdependence. Game theory was designed by
John von Neumann in 1937 and extended by von Neumann and Oskar Morgenstern
in 1944.
One of the most common game is the “Prisoners’ Dillema”. Like other games
it has rules, strategies, pay-offs, and outcome which is elaborated below.
Rules
Each prisoner (player) is placed in a separate room and cannot communicate
with the other prisoner. Each is told that he is suspected of having carried out the
bank robbery and that if both of them confess to the larger crime, each will receive a
sentence of 3 years for both crimes. If he alone confesses and his accomplice does
not, he will receive an even shorter sentence of 1 year while his accomplice will
receive a 10-year sentence.
Strategies
In game theory, strategies are all the possible actions of each player. Art and
Bob each have two possible actions:
1 Confess to the bank robbery.
2 Deny having committed the bank robbery.
Payoffs
Because there are two players, each with two strategies, there are four
possible outcomes:
1 Both confess.
2 Both deny.
3 Art confesses and Bob denies.
4 Bob confesses and Art denies.
Suggested Readings
Parkin, M. et. al.(2005).Economics.6th edition. England: Pearson
Education Limited. Pp. 177-273
Case, K. et al. (2012). Principles of Economics. 10th ed. Philippines:
Pearson Education South Asia PTE. Pp. 269-313
Assessment
Name: _________________________ Course, Yr.& Section: _________ Date:
______
1. Differentiate oligopoly from monopolistic competition.
2. What market structure is best market structure for the consumer, business, and
the economy? Explain your answer.
3. Given that you have an operating business, how would you do the price
discrimination? Give an example
