Lecture-7

Market Structure
The word market originates from the Latin word ‘maracatus’. It is a market where diverse
commodities are bought and sold at specific retail prices. Marketing is a sub-concept that is
directly related to the activities of the players present within a market environment. In
Economics, marketing is referred to as a strategy which is implemented to boost the sales of a
product that is listed in a defined market. However, with the introduction of the internet, the
entire marketing meaning has changed significantly. The modern-day meaning of marketing is
directly correlated to the concept of digital marketing. Advertisement and research are the two
most fundamental pillars of marketing and must be considered by sellers to boost their overall
sales potential.
Classification of Market Structure
Classification of market structure is made into four types:
Perfect Competition: It describes a market structure, where a large number of small firms
compete against each other. Here, a single firm doesn't have any significant market power. Due
to this, the industry as a whole produces an optimal level of output because none of the firms can
influence the market pieces.
Monopolistic Competition: Monopolistic competition is a market structure which combines
elements of monopoly and competitive markets. Essentially a monopolistic competitive market is
one with freedom of entry and exit, but firms can differentiate their products. Therefore, they
have an inelastic demand curve and so they can set prices. However, because there is freedom of
entry, supernormal profits will encourage more firms to enter the market leading to normal
profits in the long term.
A monopolistic competitive industry has the following features:

 Many firms.
 Freedom of entry and exit.
 Firms produce differentiated products.
 Firms have price inelastic demand; they are price makers because the good is highly
differentiated
 Firms make normal profits in the long run but could make supernormal profits in the
short term
 Firms are allocatively and productively inefficient.

Oligopoly: It describes a market structure that is dominated by a small number of firms. The
firms may compete or collaborate in this way they can drive up prices and earn more profit. This
market structure builds on the following:
1. Oligopolies can set prices
2. All the firms can maximize the profits
3. Only a few firms can dominate the market
Monopoly: It refers to a market structure where a single firm has control of the entire market. It
is formed based on the assumptions like the monopolies can set the market price, there are high
barriers to entry and exit, they can maximize the profits and only one firm can dominate the
entire market.

Perfect Competition- Breakeven Point.

For a price taker (a firm in a perfectly competitive market):

Profit = Total Revenue - Total Cost = (Price - Average Total Cost) x Quantity

However, maximum profit is not always a positive economic profit. In the short run, the firm
might break even (making a normal profit), make an economic profit, or incur an economic loss.
1. If the price equals the minimum average total cost, the firm breaks even and makes a normal
profit. A normal profit is a zero economic profit. In this case total revenue = total cost. The
minimum ATC point is often referred to as the breakeven point.

The Shutdown Point is the output and price at which the firm just covers its total variable cost.

 This point is where average variable cost is at its minimum.

 It is also the point at which the marginal cost curve crosses the average variable cost
curve.
 At the shutdown point, the firm is indifferent between producing and shutting down
temporarily. It incurs a loss equal to total fixed cost from either action.

If the market price is below the firm's average variable cost, a temporary shutdown is preferable
to short-run operation. If the firm continues to operate, operating losses merely add to losses
resulting from the firm's fixed costs. Shutdown will reduce losses.
Summary
A firm should stay in the market:

 In the short run, if TR >= TVC (shutdown point), or

 In the long run, if TR >= TC (breakeven point).

Monopoly –

Regulating Natural Monopolies

Most true monopolies today in the U.S. are regulated, natural monopolies. A natural monopoly
poses a difficult challenge for competition policy, because the structure of costs and demand
seems to make competition unlikely or costly.

A natural monopoly arises when average costs are declining over the range of production that
satisfies market demand. This typically happens when fixed costs are large relative to variable
costs. As a result, one firm is able to supply the total quantity demanded in the market at lower
cost than two or more firms—so splitting up the natural monopoly would raise the average cost
of production and force customers to pay more.

Public utilities, the companies that have traditionally provided water and electrical service across
much of the United States, are leading examples of natural monopoly. It would make little sense
to argue that a local water company should be broken up into several competing companies, each
with its own separate set of pipes and water supplies. Installing four or five identical sets of pipes
under a city, one for each water company, so that each household could choose its own water
provider, would be terribly costly. The same argument applies to the idea of having many
competing companies for delivering electricity to homes, each with its own set of wires. Before
the advent of wireless phones, the argument also applied to the idea of many different phone
companies, each with its own set of phone wires running through the neighborhood.

The Choices in Regulating a Natural Monopoly

What then is the appropriate competition policy for a natural monopoly? Figure 10.3 illustrates
the case of natural monopoly, with a market demand curve that cuts through the downward-
sloping portion of the average cost curve.

Figure - Regulatory Choices in Dealing with Natural Monopoly

A natural monopoly will maximize profits by producing at the quantity where marginal revenue
MR=MC and by then looking to the market demand curve to see what price to charge for this
quantity. This monopoly will produce at a quantity of QM and a price of PM. If antitrust
regulators split this company , then it would produce at price PR with output QR. A perfectly
competitive firm operates at price PC and QC. The gover4nment sets the price of Monopoly
services a price higher than PC. So that it can still make a profit out of that lowered price (PR).
Consequently supply rises from QM to QR.

Pricing of Product under Natural Monopoly

There are many production processes where average cost of production declines over the
entire range of market demand (as in Fig. 11.26) because of economies of scale. This
implies that one firm can satisfy the entire market demand more cheaply than a multiple of
firms could.

That is why it is thought that monopoly may arise naturally in these production processes.
Such a monopoly is called a natural monopoly. Virtually, all public utilities are natural
monopolies.
 Use the figure and calculations from your class lecture here

Municipal waterworks, electrical power companies, telephone companies, transportation

services are examples of the production processes which may be organised as natural
monopolies. We shall see that if a natural monopoly is not regulated, if it is left free to make
its own profit-maximising price-output policy, then the inefficiency of monopoly would be
too much for the society to accept.

Monopolistic Competition –

In short run, the diagram for monopolistic competition is the same as for a monopoly.
The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to
supernormal profit

i) Short run supernormal profit of a firm (MC=MR)

In the

ii) Short run Loss (MC=MR)

Companies in monopolistic competition can also incur economic losses in the short run, as
illustrated below. They still produce equilibrium output at a point where MR equals MC in which
losses are minimized. The cyan-colored rectangle shows the economic loss incurred.
iii) Long run normal profit (MC=MR and AC=AR)

Demand curve shifts to the left due to new firms entering the market. In the long-run,
supernormal profit encourages new firms to enter. This reduces demand for existing firms and
leads to normal profit.

Examples of monopolistic competition

 Restaurants – restaurants compete on quality of food as much as price. Product
differentiation is a key element of the business. There are relatively low barriers to entry
in setting up a new restaurant.
  Hairdressers. A service which will give firms a reputation for the quality of their hair-
cutting.
 Clothing. Designer label clothes are about the brand and product differentiation
 TV programmes – globalisation has increased the diversity of tv programmes from
networks around the world. Consumers can choose between domestic channels but also
imports from other countries and new services, such as Netflix.

Efficiency of firms in monopolistic competition

 Allocative inefficiency- The above diagrams show a price set above marginal cost
 Productive inefficiency- The above diagram shows a firm not producing on the lowest
point of AC curve
 Dynamic efficiency- This is possible as firms have profit to invest in research and
development.
 X-efficiency- This is possible as the firm does face competitive pressures to cut cost and
provide better products.