Chapter 6: Market Structures

Principles of Microeconomics
By Tran Thi Kieu Minh, MSc
Contents
 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly

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The four types of market structure

Economists who study industrial organization divide markets into four types:
monopoly, oligopoly, monopolistic competition, and perfect competition.

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 6.1 Competitive market

Perfectly Competitive Markets

Profit Maximization
Competitive Firm
Competitive Market Supply Curve
Producer Surplus
4 ©Kieu Minh, FTU, 2024
6.1.1 Perfectly Competitive Markets
 Competitive market: a market with many buyers
and sellers trading identical products so that each
buyer and seller is a price taker.
1. Price Taking
 The individual firm sells a very small share of
the total market output and the individual
consumer buys too small a share of industry
output, therefore, cannot influence market price. o
have any impact on market price.
 Price taker
2. Product Homogeneity
 The products of all firms are perfect substitutes.
3. Free Entry and Exit
 Buyers can easily switch from one supplier to
another.
 Suppliers can easily enter or exit a market.
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Firms in the competitive market

Table 1 shows the revenue for the Vaca Family Dairy Farm. Columns (1) and (2)
show the amount of output the farm produces and the price at which it sells its
output. Column (3) is the farm’s total revenue.

6 ©Kieu Minh, FTU

Vaca Farm’s decision: The Vacas can find the profit-maximizing quantity by
comparing the marginal revenue and marginal cost of each unit produced.
7 ©Kieu Minh, FTU
Firms in the competitive market

Price
$ per
Vaca Farm Price Milk Market
gallon $ per
gallon

MC S

D=AR=MR
$6 $6

5 Output 100 Output

(gallons) (millions
of gallons)
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Competitive Firm’s optimum decision
 Demand curve faced by an individual firm is a horizontal
line at the market price P
 Firm’s sales have no effect on market price
 Average revenue: AR = P
 Marginal revenue: MR = P
 Profit Maximizing:
 For a perfectly competitive firm, profit maximizing output (q*)
occurs when

MC (q) = MR = AR = P

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 Profit maximization for a competitive firm
Costs
and The firm maximizes profit
Revenue by producing the quantity
at which marginal cost MC
equals marginal revenue.
MC2 ATC

P=MR1=MR2 P=AR=MR
AVC

MC1

0 Q1 QMAX Q2 Quantity
At the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising production
increases profit. At the quantity Q2, marginal cost MC2 is above marginal revenue MR2, so
reducing production increases profit. The profit-maximizing quantity QMAX is found where the
horizontal price line intersects the marginal-cost curve.
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Marginal cost as the competitive firm’s supply curve
Price
MC

P2
ATC

P1 AVC

0 Q1 Q2 Quantity

An increase in the price from P1 to P2 leads to an increase in the firm’s profit-maximizing

quantity from Q1 to Q2. Because the marginal-cost curve shows the quantity supplied by
the firm at any given price, it is the firm’s supply curve.

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Competitive Firm’s Decision
 The firm’s short-run decision to shut down
 Short-run decision not to produce anything during
a specific period of time because of current market
conditions
 Firm still has to pay fixed costs
 Shut down if TR<VC (P<AVC)
 Competitive firm’s short-run supply curve
 The portion of its marginal-cost curve
 That lies above average variable cost (AVCmin)

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 The competitive firm’s short-run supply curve
Costs
1. In the short run, the MC
firm produces on the
MC curve if P>AVC,...
ATC

AVC

2. ...but
shuts down
if P<AVC.

0 Quantity

In the short run, the competitive firm’s supply curve is its marginal-cost curve (MC) above
average variable cost (AVC). If the price falls below average variable cost, the firm is
better off shutting down.

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 Profit as the area between price and average total cost
(a) A firm with profits (b) A firm with losses
Price Price
MC MC

Profit ATC ATC

Loss
P
P=AR=MR ATC
ATC
P
P=AR=MR

0 Q Quantity 0 Q Quantity
(profit-maximizing quantity) (loss-minimizing quantity)
 If P > ATC • If P < ATC
• Loss = TC - TR = (ATC – P) ˣ Q
 Profit = TR – TC = (P – ATC) ˣ Q
= Negative profit
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Case study: Near-empty restaurants
 Restaurant – stay open for
lunch?
 Fixed costs
 Not relevant
 Are sunk costs in
short run
 Variable costs – relevant
 Shut down if revenue
from lunch < variable
costs
 Stay open if revenue
from lunch > variable
costs

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Quiz 1

A competitive Firm ABC has average production cost ($) of

75
ATC = 2 + q +
q
a. What is the marginal cost function of Firm ABC?
b. If market price is $30, what is the optimum quantity of
the firm? How much is the maximum profit?
c. What is the firm’s decision if market price decreases to
$10? Explain.
d. What is the short-run supply curve of the firm?
e. How much is the ATCmin ?

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 Short-run market supply
(a) Individual firm supply (b) Market supply
Price Price
MC Supply

$2.00 $2.00

1.00 1.00

0 100 200 Quantity 0 100,000 200,000 Quantity

(firm) (market)

In the short run, the number of firms in the market is fixed. As a result, the market supply curve,
shown in panel (b), reflects the individual firms’ marginal-cost curves, shown in panel (a). Here,
in a market of 1,000 firms, the quantity of output supplied to the market is 1,000 times the
17 supplied by each firm.
quantity
Quiz 2
A competitive market of a good A has 1000 similar sellers,
each has production cost of:
1 2
TC = q − 5q + 8
2
Market demand of good A is :
Q = 20000 − 500 P
1. What is the suppy curve of one seller?
2. What is the market supply curve of good A?
3. What is the market equilibrium price and quantity?
4. What is the optimum selling quantity of each seller?

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 6.2 Monopoly
Monopolist
Demand and Marginal Revenue
Profit maximization
Market power
Price discrimination

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6.2.1 Monopolist
 Firm that is the sole seller of a product without close substitutes
(Firm = industry)
 Price maker
 Barriers to entry
 Monopoly resources
 A key resource required for production is owned by a single firm
 Government regulation
 Government gives a single firm the exclusive right to produce some good or service
 Government-created monopolies
 The production process
 A single firm can produce output at a lower cost than can a larger number of
producers
 Natural monopoly
 Arises because a single firm can supply a good or service to an entire market at a smaller cost
than could two or more firms
 Economies of scale over the relevant range of output
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 Demand, Revenue, Cost and Profit
 A Monopolist’s Demand Curve Marginal cost
 Price maker $
 Market demand curve: P = f (Q)
 A monopolist’s revenue
 Total revenue: TR = Px Q = f (Q) x Q
 Marginal revenue: MR = TR’(Q)
 Can be negative
 MR < P : MR curve – is below the
demand curve
Demand
 Profit maximization
 If MR > MC – increase production
 If MC > MR – produce less 0 Q
 Maximize profit MR
 Produce quantity where MR=MC
 Intersection of the marginal-revenue curve
and the marginal-cost curve
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 Profit maximization for a monopoly
2. . . . and then the demand curve shows the
Costs price consistent with this quantity.
and
Revenue Marginal cost

1. The intersection of the marginal-revenue

curve and the marginal-cost curve
Monopoly B determines the profit-maximizing quantity . . .
price
Average total cost
A

Demand

Marginal revenue

0 Q1 QMAX Q2 Quantity
A monopoly maximizes profit by choosing the quantity at which marginal revenue equals
marginal cost (point A). It then uses the demand curve to find the price that will induce
consumers
23 to buy that quantity (point B).
 The monopolist’s profit
Costs
and
Revenue Marginal cost

Monopoly E B
Average total cost
price

Monopoly
profit
Average Demand
total
cost D C

Marginal revenue

0 QMAX Quantity
The area of the box BCDE equals the profit of the monopoly firm. The height of the box
(BC) is price minus average total cost, which equals profit per unit sold. The width of the
box (DC) is the number of units sold.
24 ©Kieu Minh, FTU, 2014
 Average
Average total cost
total
cost D
Marginal cost

E B
Monopoly
price
Monopoly
profit
C Demand

Marginal revenue
QMAX
0 Quantity
The area of the box BCDE equals the profit of the monopoly firm. The height of the box
(BC) is price minus average total cost, which equals profit per unit sold. The width of the
box (DC) is the number of units sold.
25 ©Kieu Minh, FTU, 2014
6.2.3 Market Power
 A firm's market power: its ability to price above
marginal cost.
 Lerner index, named after the Russian-born
British economist and professor Abba Lerner
(1903-1982), was formalized in 1934.
P − MC 1
L= =−
P 𝐸𝐷𝑃

 Higher numbers implying greater market power.

 For a perfectly competitive firm (where P=MC),
L=0; such a firm has no market power.

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6.2.4 The Welfare Cost of Monopolies

Perfect competition Market Monopoly

 Produce at the socially  Produce quantity where

efficient quantity of MC = MR, less than the
output where P =MC socially efficient
 Total Surplus (CS + PS) quantity of output
is maximum.  The deadweight loss:
 Triangle between:
demand curve and MC
curve

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 The inefficiency of monopoly
Costs
and
Revenue
Marginal cost
Deadweight
loss
QA
Monopoly
price DWL =  ( P − MC ).dQ
Q*

Demand

Marginal revenue

0 Monopoly Efficient Quantity

quantity quantity
Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than
its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The
deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value
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of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer).
The Welfare Cost of Monopolies
 The monopoly’s profit: a social cost?
 Monopoly
 Higher profit
 Not a reduction of economic welfare
 Bigger producer surplus
 Smaller consumer surplus
 Monopoly profit
 Not a social problem

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Quiz 3
A monopolist has MC = 4 + Q and FC of $1000.
He faces the demand of P = 160 – Q
(P & C: $/kg, Q : kg)
1. What are the optimum quantity and price of the
monopoly? How much is the maximum profit?
2. How much is the consumer surplus created by this
monopoly?
3. How much is the DWL?
4. Government places a tax of $4/kg for the product of
the monopoly. How does profit change?
5. Graph the results

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 6.3 Monopolistic Competition

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6.3.1 Monopolistically Competitive Market
1. Many firms
 Not a price – taker
 Having market power for their own products.
2. Free entry and exit
3. Differentiated but highly substitutable products
4. The amount of monopoly power depends on the
degree of differentiation
Examples of this very common market structure :
Toothpaste, Soap
Cookies and Cake
Instant noodles
Fashion

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Elasticity of Demand for
Brands of Colas and Coffee

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 A Monopolistically Competitive Firm
 Downward sloping
$/Q Short Run demand – differentiated
MC
product
ATC
 Demand is relatively
PSR
elastic – good substitutes
 MR < P
DSR  Profits are maximized
when MR = MC
 This firm is making
MRSR
economic profits
QSR Quantity
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Monopolistic Competition
 If inefficiency is bad for consumers, should monopolistic
competition be regulated?
 Market power is relatively small.
 Usually there are enough firms to compete with enough
substitutability between firms
 Deadweight loss small.
 Inefficiency is balanced by benefit of increased product
diversity – may easily outweigh deadweight loss.

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 6.4 Oligopoly

Nash Equilibrium
Game Theory
Cartel

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6.4.1 Oligopoly Market
 Small number of firms
 Product differentiation may or may not exist
 Barriers to entry
 Scale economies
 Patents
 Technology
 Name recognition
 Strategic action
 Examples
 Automobiles
 Steel
 Aluminum
 Petrochemicals
 Electrical equipment

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Oligopoly
 Management Challenges
 Strategic actions to deter entry
 Threaten to decrease price against new competitors by keeping
excess capacity
 Rival behavior
 Because only a few firms, each must consider how its actions will
affect its rivals and in turn how their rivals will react

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6.4.2 Oligopoly Equilibrium
 If one firm decides to cut their price, they must consider
what the other firms in the industry will do
 Could cut price some, the same amount, or more than firm
 Could lead to price war and drastic fall in profits for all
 Actions and reactions are dynamic, evolving over time
 Defining Equilibrium
 Firms are doing the best they can and have no incentive to change
their output or price
 All firms assume competitors are taking rival decisions into account
 Nash Equilibrium
 Each firm is doing the best it can given what its competitors are doi

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6.4.3 Competition Versus Collusion:
Game Theory
 The Prisoners’ Dilemma : An example in game theory, called the
Prisoners’ Dilemma, illustrates the problem oligopolistic firms face
 Two prisoners have been accused of collaborating in a crime
 They are in separate jail cells and cannot communicate
 Each has been asked to confess to the crime

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Oligopolistic Markets
 In some oligopoly markets, pricing behavior in time can
create a predictable pricing environment and implied
collusion may occur
 In other oligopoly markets, the firms are very aggressive and
collusion is not possible
 Firms are reluctant to change price because of the likely response
of their competitors
 In this case, prices tend to be relatively rigid
Conclusions
1. Collusion will lead to greater profits
2. Explicit and implicit collusion is possible
3. Once collusion exists, the profit motive to break and lower
price is significant

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Cartels
 Producers in a cartel explicitly agree to cooperate in
setting prices and output
 Typically only a subset of producers are part of the cartel
and others benefit from the choices of the cartel
 If demand is sufficiently inelastic and cartel is enforceable,
prices may be well above competitive levels

 Examples of successful cartels  Examples of successful

 OPEC cartels
 International Bauxite Association  OPEC
 Mercurio Europeo  International Bauxite
Association
 Mercurio Europeo
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