Market Structures
Market Structures |
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Key Learning Outcomes
- Describe and critique the main features of perfectly competitive, monopolistic and oligopolistic product markets
- Demonstrate and analyse how a change in demand or supply in a market structure impacts on equilibrium
- Graphically represent, describe and compare market equilibrium under perfect competition, monopoly and monopolistic
competition in the short and long run - Graphically represent and evaluate the point of profit maximization for a firm in a monopoly market and a firm in
a perfectly competitive market
Introduction:
1. PERFECT COMPETITION
The assumptions underlying the theory of perfect competition.
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There are many buyers in the industry
No individual buyer can influence by his/her own actions the market price of the goods.
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There are many sellers in the industry
No individual seller can influence by his/her own actions the market price of the goods.
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Firms produce homogeneous goods
The goods, which are supplied by the producers, are identical goods, hence there is no competitive advertising.
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Free entry and exit
Firms already in the industry cannot prevent new firms from entering the industry.
No barriers to entry/exist within the industry.
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Perfect knowledge
In the market every firm has full knowledge as to profits made by the other firms in the industry. Consumers
are fully aware of the prices being charged for different products. -
Firms try to maximise profits
The aim of each firm is to produce that quantity where MC = MR. Each firm will try to minimise costs.
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Elastic supply of factors of production
Firms can acquire the scarce factors of production at existing prices. Scarcity of factors of production will
not force their prices upwards
The short run equilibrium position of the firm in Perfect competition
(Previous LCQ - 25 marks)
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Marking Scheme: 9 marks: 9 × 1 mark each
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Explanation: SPECS (16 marks)
S – In the short run the firm can earn SNP if AR exceeds AC as is the case in the above diagram. At Q1 the
AR is P1 and the AC is C1, Therefore AR>AC. The SNPs are the shaded area in the diagram.
P – The firm will produce Q1 and sell this output at price P1
E - Equilibrium is achieved where (a) MC = MR & (b) MC is rising (the profit maximizing position). This
occurs at point A in the diagram.
C – the cost of production is at point ‘C’. The firm is not producing at the minimum point of the AC curve.
S – Scarce resources - in the short run the firm is not operating efficiently because it is not operating
at the lowest point on the AC curve.
The long run equilibrium position of the firm in Perfect competition
(Sample LCQ – 25 marks)
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Marking Scheme: 9 marks: 9 × 1 mark each
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Explanation: SPECS (16 marks)
S = In the long run the firm is not earning SNP’s. It will only earn normal profits because AR = AC. At
Q1 the AR is P1 and the AC is also P1
P = The firm will produce Q1 and sell this output at price P1
E = Equilibrium is achieved where (a) MC = MR & (b) MC is rising (the profit maximizing position). This
occurs at point G in the diagram. In the long run equilibrium position, AR= AC= MR = MC
C = cost of producing is at point ‘G’ and normal profit is earned
S = In the long run the firm produces at the lowest point on the AC curve and thus is operating at the most
efficient level.
How does the firm move from the SR equilibrium position to the LR equilibrium position?
| In the Short Run the firm earns SNPs since AR>AC at Q1, the equilibrium position.
Because prefect knowledge of profits exists within the industry and there are no barriers to entry, the The supply curve then shifts to the right from S1 to S2 and the market price falls from P1 to P2. At this point only normal profits are being earned (AR =AC) and this is the long run equilibrium |
Advantages of Perfect Competition:
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The consumer gets the lowest price possible
Because the consumer has perfect knowledge, they will only purchase from the supplier charging the lowest price.
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No waste of resources
There is no waste of scarce resources on competitive advertising.
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Efficient Production
The firms operate at the lowest point on the AC curve and hence are totally efficient. Any firm not operating
at this point will not survive in the long run. -
No Barriers to entry or exit
The factors of production can move to the industries where they receive the highest rate of return.
Disadvantages of Perfect Competition:
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No choice for consumers
Each firm produces an identical product and therefore the consumers have no choice to make.
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No innovation
Because the firms must operate at the lowest point on the AC curve they cannot invest any money in R&D and
thus no innovation takes place. -
Limited employment in the advertising industry.
As there is no competitive advertising in the industry there will only be a limited employment in the advertising
industry.
2. IMPERFECT COMPETITION
The assumptions underlying Imperfect Competition
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There are many buyers in the industry
Each buyer acts independently. No individual buyer can influence, by his/her own actions, the market price of
the goods. -
There are a large number of sellers within the industry
Each seller acts independently. An individual seller can influence the quantity sold by the price it charges
for its output. -
Product Differentiation exists
The goods which are supplied by the producers are not identical goods but are close substitutes. Firms try to
establish in the minds of the public that the goods are not perfect substitutes by selling their goods under
brand names or engaging in advertising. -
No Barriers to entry exist within the industry
Firms already in the industry cannot prevent new firms from entering the industry. It’s possible for firms to
enter or leave the industry as they wish. - Widespread (but not perfect) knowledge as to profits made by other firms / prices being charged on the market. In the market every firm has almost full knowledge as to profits earned by other firms in the industry.
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Each firm tries to maximise profits.
The sole aim of each firm is produce that quantity which will maximise profits. Therefore it will produce where
MC = MR. -
Elastic supply of factors of production
Firms can acquire the scarce factors of production at existing prices. Scarcity of factors of production will
not force their prices upwards.
The short run equilibrium position of the firm in imperfect competition
(Sample LCQ - 25 marks)
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Marking Scheme:
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Explanation: SPECS (16 marks)
S - In the short run the firm can earn SNP if AR exceeds AC as is the case in the above diagram. At Q1 the
AR is P1 and the AC is D, Therefore AR>AC. The SNPs are the shaded area in the diagram.
P - The firm will produce Q1 and sell this output at price P1
E - Equilibrium is achieved where (a) MC = MR & (b) MC is rising (the profit maximizing position). This
occurs at point E in the diagram.
C – The cost of producing is shown at point B. The firm is not producing at the minimum point of the AC
curve
S - The firm is not producing at the lowest point of AC (point A). Hence, this firm is wasting scarce resources.
Possible Leaving Cert Question:
How does the firm move from short run to long run equilibrium?
In the Short Run the firm earns SNPs since AR>AC at Q1, the equilibrium position.
Because widespread knowledge of profits exists within the industry and there are no barriers to entry, the existence
of SNPs attracts new firms into the market.
The supply curve then shifts to the right from and the market price falls.
This will continue until all SNP’s have been eroded.
At this point the individual firm achieves long run equilibrium, where MC = MR and MC is rising (profit maximizing position)
and also where AR = AC, the firm is earning normal profits.
The long run equilibrium position of the firm in imperfect competition
(LCQ – 25 marks)
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Marking Scheme:
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Explanation: SPECS (16 marks)
S = In the long run the firm will not earn SNP’s. It will earn normal profits because AR =AC.
At Q1 the AR is P1 and the AC is also P1.
P = The firm will produce Q1 and sell this output at price P1
E = Equilibrium is achieved where (a) MC = MR & (b) MC is rising (the profit maximizing position).
C = The cost of producing this output is shown at point ‘C’. The firm is not producing at the minimum point
of the AC.
S = The firm is not producing at the lowest point of AC. Hence this firm is wasting scarce resources.
Comparing Imperfect Competition with Perfect Competition
- The firms in both of these markets earn normal profit where AR = AC in the long run.
- The perfectly competitive firm produces at the lowest point of the AC, indicating efficient use of resources. This
is not the case in imperfect competition. - Price is equal to MC in perfect competition, which is not the case in imperfect competition. In the latter, price
is greater than MC, indicating that more of the good could be produced. - The perfectly competitive firm faces a horizontal demand curve and the imperfectly competitive firm faces a downward
sloping demand curve.
Advantages of Imperfect Competition
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Contestable markets
There are few barrier to entry, making market relatively competitive and thus benefiting consumers in the form
of lowers prices. -
Choice of goods
Differentiation creates diversity of goods for consumers. Although this may mean higher prices, consumers are
compensated by higher perceived value. People like to have a wide variety of goods and services to choose from,
which is why many different restaurants offering several cuisines cam be found in most towns. -
Dynamically efficient
Monopolistic firms are constantly striving to provide a better product or service. They are innovative, developing
new production processes or products to gain a competitive edge over their rivals e.g. retailers often must develop
new ways to attract and retain buyers. - Normal Profit In the long run consumers are not being exploited, as the firm is earning normal profit (AC = AR).
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Access to information
Consumers have more information available to them because of the extensive competitive advertising used within
the industry.
Disadvantages of Imperfect Competition
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Production is not at the minimum point of the AC curve
In equilibrium the firm is not producing at a level where costs are at their lowest, as in perfect competition.
This is because money is spent on advertising, differentiate packaging etc., which increases the cost of production
and is inevitably passed on to the consumer. -
Excess capacity
Production is not where average costs are at a minimum, which is considered wasteful of scarce resources. The
firm could produce a greater output than it does, meaning that it has overcapacity. Thus, resources are considered
to be wasted. -
Price is greater than MC
The price charged by a firm in imperfect competition will exceed marginal cost. In perfect competition, price
equals MC.
3. MONOPOLY
The assumptions underlying Monopoly
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There is only one firm in the industry, i.e. the firm is the industry.
One firm produces all of the output in the industry and faces no competition
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Barriers to entry exist within the industry
New firms are prevented by barriers to entry from entering the industry and competing with the monopoly supplier
for the SNP’s being earned. -
Each firm tries to maximise profits
The aim of the monopoly firm is produce that quantity which will maximise profits. Therefore it will produce
where MC = MR. -
The firm has the ability to earn SNP’s even in the long-run
Because of the existence of the barriers to entry, the firm can earn SNPs in the short run and the long run.
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The monopoly firm can control price or quantity but not both
No matter how powerful the monopolist is, he cannot control both price and quantity. He can fix the price and
let the market decide what quantity will be demanded. Alternatively, he can decide on a certain quantity and
let the market decide on the price.
Explaining, with the aid of a labeled diagram, the long run equilibrium position of a monopoly
(Sample LCQ – 25 marks)
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Marking Scheme :
9 marks: 9 × 1 mark each
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Explanation: SPECS (16 marks)
S = In the long run the firm can earn SNP if AR exceeds AC as is the case in the above diagram. At Q1 the
AR is P1 and the Average Cost is D, Therefore AR>AC. The SNPs are the shaded area in the diagram.
P = The firm will produce Q1 and sell this output at price P1
E = Equilibrium is achieved where (a) MC = MR & (b) MC is rising (the profit maximizing position). This
occurs at point E in the diagram.
C = the cost of producing is at point ‘B’. The firm is not producing at the minimum point of the AC.
S = The firm is not producing at the lowest point of AC (point A). Hence, this firm is wasting scarce resources.
Comparing Imperfect Competition and Monopoly
- Neither produces at the lowest point of the AC, indicating a wasteful use of resources.
- Both face a downward sloping demand curve – price must be lowered to increase the quantity demanded.
- In both markets, price is greater than MC, indicating that more of the good could be produced.
- The monopolist earns SNP in both the long and short run. The imperfectly competitive firm earns SNP only in the short
run and normal profit in the long run.
Advantages of Monopoly
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Economies of scale
Production on a large scale allows the firm to benefit from economies of scale. These cost savings may be passed
on the consumer in the form of lower prices. -
Guaranteed supply of product/service
In some state monopolies the product or service may be sold at very low profit margins, so consumers benefit.
These services may not be provided by private enterprise e.g. regular bus services to remote or low-density areas. - Secure employment As there is no competition, employees have greater security or tenure and may have better conditions of employment.
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Reduced use of scarce resources
There may be less duplication in the provision of products/services. There may be less need for competitive advertising,
so society’s resources are not wasted. Some services may be best provided by one provider, e.g. postal service.
Disadvantages of Monopoly
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Exploitation of consumers
The SNP’s that monopolists achieve may be due to the exploitation of consumers. As the sole supplier of a good
or service, the monopolist may abuse their position by pushing up prices and leaving the consumer with no alternative
but to purchase it. -
Inefficient use of scarce resources
The monopolist makes inefficient use of society’s scarce resources. It does not produce where average cost is
at its minimum but where MC = MR. This is due to a lack of competition and it wastes economic resources. -
The production of fewer goods at a higher price than perfect competition
Consider two companies operating in a market with similar cost conditions. The monopolist will produce a lower
quantity at a higher price than the perfectly competitive firms. -
Less efficient / innovative
It is often argued that monopolies tend to become less efficient and innovative over time. Due to the fact that
monopolies have a dominant position, they may not necessarily have to compete in the marketplace and consequently
may not engage in R&D or innovation.
4. OLIGOPOLY
Key features of an oligopolistic market.
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Few Sellers in the industry
Because of this each seller can influence the price of the commodity/or the output sold.
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Interdependence between firms
Firms in oligopoly do not act independently of each other. They will each take into the account the likely reactions
of their competitors. Hence, prices tend to be sticky. -
Barriers to entry
These are common in an oligopolistic market as existing firms will wish to maintain their share of the market.
Examples of barriers include high costs of setting up in the industry, brand proliferation, which means having
several different variations of the same product on the market. e.g. Proctor and Gamble (Daz, Tide, Bold, Ariel,
Dreft) and Lever Brothers (Surf, Persil, Omo, Lux). -
Product Differentiation occurs
The commodities which firms sell are close substitutes. Firms will engage in advertising to persuade consumers
to buy their product rather than a competitor’s product. -
Collusion may occur
Firms within the industry may meet to control the output in the industry and/or control prices e.g. OPEC.
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Non-price competition is more common than price competition
Due to the fear of how their competitors will react firms tend not to engage in price competition but rather
they engage in non-price competitive measures to gain consumers. -
Pursuing objectives other than profit maximisation
Firms may have objectives other than maximizing their profits i.e. increasing their share of the total market,
limiting profits to discourage government investigation, satisfaction with the existing level of profits (e.g.
in a small family business).
The long run equilibrium position of this firm
(Sample LCQ – 25 marks)
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Marking Scheme :
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Explanation:
S = This firm is earning SNPs because AR > AC or barriers to entry exist.
P = The firm will produce Q1 and sell this output at price P1
E = Equilibrium occurs at point G where (a) MC = MR & (b) MC is rising.
C = The firm’s cost of production is shown at point G (Average Cost). Should costs rise between points D
and E then market price tends to remain constant at P1.
S = the firm is producing at the lowest point of the AC, therefore scarce resources are being used efficiently
Explaining the shape of the demand curve facing a firm in oligopoly.
This firm faces an
ELASTIC Demand Curve - demand curve AB.
If a firm increases its price other firms leave their prices unchanged - so this firm will lose many customers (because
the goods are close substitutes).
The firm faces an
INELASTIC Demand Curve - demand curve BY.
If a firm lowers its price other firms will match this price decrease (because the firms are interdependent) - the
firm will gain few additional customers. If the price leader sets price at point B, then the firm will face a distinct
demand curve ABY, kinked at B.
Explaining the relationship between this Demand Curve and the firm’s marginal revenue curve:
Because the
Demand Curve is kinked the firms MR curve consists of 2 distinct parts and is constant between point D and
point E, so irrespective of what happens to costs the firms revenue does not change.
Types of collusion which may occur in an oligopolistic market.
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Pricing Policy / Limit Pricing
One firm, with the tacit agreement of others, could reduce prices forcing unwanted entrants out of the industry.
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Production/output policy
Firms could join together to limit output to certain agreed amounts.
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Sales Territories
Firms could divide up the markets between them and agree not to compete in each other’s market segments.
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Refusal to supply firms
Firms may not supply those firms who buy from firms not in the cartel.
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Implicit Collusion
Each firm recognises that behaving as if they were branches of a single firm their joint profits would be higher.
So firms do not provoke their rivals by cutting prices. Instead they try to increase market share by engaging
in non-price competitive measures.
Other Possible Questions
Explain what is meant by the term ‘Price Rigidity’ in an oligopoly
This occurs when prices tend not to change when costs change in an oligopolistic industry. This is because firms are
fearful of the likely reaction of their competitors should they change prices and relates to the shape of the demand
curve. Because the firm faces an elastic demand curve AB and an inelastic demand curve BY it follows that by either
lowering or increasing price the firm will earn less revenue. Therefore the firms in an oligopoly tend to maintain
the same price.
Explain what is meant by the term ‘Price Constancy’ in an oligopoly
This is similar to price rigidity, in that it helps explain why prices do not change as costs change. However price constancy
relates to the MR curve and not the demand curve. We know that the firm is going to produce where MR = MC. In the
graph above we see that the MR curve is constant between D and E. Therefore if MC changes MR does not change and
hence Q1 and P1 remain the same.
Explain what is meant by the term ‘Price Leadership’ in an oligopoly
This occurs when the dominant firm in an oligopoly sets the price fro a specific good, in the knowledge that the other
competing firms in the industry will follow suit. The price leader is usually though not always, the largest firm
in the industry. All of the other firms follow suit rather than engaging in a price war with the dominant firm.
What is the difference between price competition and non-price competition?
Price competition occurs when firms compete for customers by changing their prices. Non-price competition occurs when
firms compete for customers using methods other than changing their prices, e.g advertising, sales promotions etc.
Which is better for consumers?
Answer: Price competition.
Why: Because…
(i) The consumer gets the good at a
lower price
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(ii) The consumer then has a
greater disposable income
which he/she can spend on other goods if he/she wishes. The
choice
of which goods to purchase is entirely which the consumer prefers.
Sample Exam Q&A
Question 1 |
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(1a) |
Using suitably labeled diagram, compare the long run equilibrium position of the monopoly firm with (?? marks) |
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Efficiency The monopolist makes inefficient use of society’s scarce resources, as it does not produce at the Price The monopolist charges a higher price (Pm) than the perfectly competitive firm (Pp). In monopoly, Output A monopolist produces a smaller output than perfect competition (Qm and Qp, respectively). Profits SNP is earned by the monopolist, as AR > AC (PmACmB), while AR = AC in perfect competition and Demand Curve A monopolist faces a downward sloping demand curve, while a perfectly competitive firm faces a horizontal |
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1b |
If firms wish to enter a monopoly market they will face barriers to entry.
Explain (15 marks) |
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1) Legal / Statutory Monopoly.
Other firms may not be allowed into the industry because the government confers on a firm the sole right to supply a particular good or service i.e. Aer Rianta. 2) Ownership of a patent / copyright. If a firm has the sole right to a manufacturing process then no other firm can compete with it. Other firms are not allowed to use this patent until the time period for it has expired. 3) Sole rights to raw materials. A firm may have complete control over the source of essential raw materials i.e. an oil drilling company. 4) Large capital investment. In some industries the minimum size of a firm required to operate efficiently is so large that there By entering trade agreements with other firms, a firm can share out the market so that no competition
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