Describe the characteristics of different market structures: perfect competition, monopolistic competition, oligopoly, and pure monopoly

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1 Describe the characteristics of different market structures: perfect competition, monopolistic competition, oligopoly, and pure monopoly Prerequisite

2 Characteristics of different market structures Market Structure Perfect competition Monopolistic competition Number of Sellers Many Degree of Product Differentiation Homogeneous/ Standardized Barriers to Entry Pricing Power of Firm Very Low None None Non price Competition Many Differentiated Low Some Advertising and Product differentiation Oligopoly Few Homogeneous/ Standardized High Some or Considerable Advertising and Product differentiation Monopoly One Unique Product Very High Considerable Advertising 2

3 Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure Describe and determine the profit-maximizing price and output for firms under each market structure Explain the effects of demand changes, entry and exit of firms, and other factors on long-run equilibrium under each market structure

4 Characteristics of Perfect Competition Large number of both buyers and sellers hence no firm controls prices Identical goods with no major differentiation Prices are determined by market forces (demand and supply) causing Firms to become price takers with Demand curves taking shape of perfectly elastic No barriers to entry hence no economic profit in long term Market price will equal to ATC in long term Buyers and sellers are well informed about price - perfect information 4

5 Characteristics of Perfect Competition Market supply & demand determine price hence: Each firm s sees a perfectly elastic (horizontal) demand curve. Firm is a price-taker Price P Price Taker Demand Demand 5

6 Profit-Maximizing Output For A Price-Taker Firm will produce until MR=MC MR: Marginal Revenue MC: Marginal Cost MR is the increase in total revenue from selling one more unit of a good. For a price taker, MR = Price (P) 6

7 Profit-Maximizing Output For A Price-Taker Profit-maximizing firm will produce optimum quantity, Q, when MC = MR = P If firm keeps increasing production after Q, MC will be greater than MR and firm will incur economic loss Price MC D=Market Price=MR Q* Profit Maximizing o/p for a Price Taker 7

8 Economic Profit Economic profit = Total Revenues explicit costs and implicit costs including cost of capital and normal profit Price MC ATC Revenue (Costs) Economic Profit TC TR P MR TR-TC is Maximum Q Profit maximizing o/p Q Profit Maximizing O/P Short run profit Maximization-Marginal Approach Short run profit Maximization-Total Approach 8

9 Economic Profit Figure A illustrates that using marginal approach, economic profit is maximized at Q when MR = MC = P; Figure B shows that using total approach, profit maximization also occurs at Q when total revenue exceeds total cost by the maximum amount 9

10 Equilibrium in a Perfectly Competitive Market No firm will earn economic profits in the long run If they can due to no entry barriers new firms will enter industry to earn profits supply (shifts towards right) price until Price = firm's average total cost (ATC) In equilibrium, each firm is producing the quantity for which P = MR = MC = ATC And no firm earns economic profit Each firm is producing the quantity for which ATC is a minimum 10

11 Equilibrium in a Perfectly Competitive Market Price D S Price and costs MC ATC P* P* MR Q* Equilibrium For the Industry Q* Equilibrium For Firm 11

12 Short-run loss in Perfect competition Economic losses occur when the price is less than the average total cost(atc) Firms continue to operate in short run even if ATC >P, but the price > AVC Firm covering variable and to some part of fixed cost will have losses less than its fixed cost, and if the firm covers only its AVC then its operating at the shutdown point If the price never exceeds its ATC, going out of business is a fair choice 12

13 Short-run loss in Perfect competition Long run equilibrium output is where MR=MC=ATC, where the ATC is at a minimum Short run loss MC Price Economic Loss ATC AVC ` MR=P 13

14 Short-Run Supply Curves Firm will shut down at a price below P1 as it will not even be able to realise AVC At P2 the firm is earning a normal profit (meaning zero economic profit) At prices above P2, firm is making supernormal profits Will expand production along the MC line. Short-run supply curve for a firm is its MC line firm produces by moving up and down along the supply curve as MC = MR = P SR market (industry) supply curve is horizontal sum of the MC curves for all firms 14

15 Short-Run Supply Curves Price MC Price S SHORT-RUN ATC AVC P 2 P 1 Short run supply Curve - Firm Supply Short run supply Curve - Market Supply 15

16 Figure: Short-Run Adjustment to an Increase in Demand Price Market SR Industry Supply Price Firm MC=SR firm Supply P 2 P 1 D 2 P 2 P1 MR 1 MR 0 D 1 Figure A: Demand price and quantity. Figure B: Q 1 Q 2 Q 1 FIRM Q 2 FIRM Short run adjusted to an increase in demand under perfect competition As Price firm will earn an economic profit in the short run In the long run firms will increase production and/or new firms will enter 16

17 Effects of a Permanent Increase in Demand The initial equilibrium is at price P 0 and quantity Q 0, earning normal profits With a permanent increase in demand- The demand curve shift to D 1 The new market price will be P 1 (increases as demand increases) Output will increase to Q 1 (to meet demand) In short run since P 1 > ATC earning an economic profit P 1 P 0 P 1 P 0 Industry Price S 0 S 1 D 0 D 1 Q 0 Q 1 Q 2 Price and cost Firm MC ATC MR 1 MR 0 q 0 q 1 17

18 Effects of a Permanent Increase in Demand With positive economic profit new firms enter the industry which increases total industry supply causing the supply curve shift to S 1 and decreasing the price back to P 0 eliminating the economic profits 18

19 Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure Describe and determine the profit-maximizing price and output for firms under each market structure Explain the effects of demand changes, entry and exit of firms, and other factors on long-run equilibrium under each market structure

20 Characteristics of Monopolistic competition A large number of independent sellers and buyers like perfect competition Each firm has a relatively small market share with no significant power over price. Firms focuses on average marker price not of individual competitors Product differentiation (products are not similar) but remains a close substitute This causes firms to compete based on marketing, quality and price Marketing is a must to advertise product (differentiating) characteristics Due to close substitution, demand curves are highly elastic 20

21 Characteristics of Monopolistic competition Low Barriers to Entry Firms in monopolistic competition face downward sloping demand curves Firms compete on Price, Quality and Marketing Strong correlation between quality and the price that firms can charge. E.g. :- Market for hair oil or soaps; quite similar but differentiation occurs due to taste preferences. 21

22 Price Short-Run Output and long-run output Firms maximize economic profits at quantity Q production where MR = MC Firm earns positive economic profit because price, P > ATC. Due to Low Barriers to entry competitors will enter the market in long run P* ATC* MC ATC D MR Q Short Run O/P decision for a firm 22

23 Price Short-Run Output and long-run output New firms entry causes firm s demand curve downwards to the point where price equals avg. total cost (P*=ATC*) such that economic profit becomes 0. At this point, there is no longer an incentive for new firms to enter the market creating a LR equilibrium P*, ATC* MC ATC D MR Q Long Run O/P decision for a firm 23

24 Price Price Firm Output Under Monopolistic and Perfect Competition MC ATC MC ATC P P D MR D MR Q Firm O/P under Monopolistic Competition Q Firm O/P under Perfect Competition 24

25 Firm Output Under Monopolistic and Perfect Competition In short run, perfect competition firms do not earn economic profit as P=ATC but in monopolistic competition, firm earns economic profit since P>ATC though optimum quantity occurs when MR = MC in both markets Inefficient allocation of resources : ATC is not at a minimum for the quantity produced Inefficient scale of production: Price is slightly higher than under perfect competition Mark up = Excess of price over MC, under monopolistic competition Under Perfect competition, Mark up = 0 25

26 Efficiency, Product Innovation & Advertising in Monopolistic Competition Efficiency of monopolistic competition is unclear Consumers benefit from advertising make better purchasing decisions But is it worth the additional cost of advertising is largely subjective Impact of Product innovation: it is necessary Firms that bring new and innovative products face less-elastic demand curves, enabling them to increase price and earn economic profits. However, close substitutes and imitations will cause initial economic profit to disappear in long run Advertising expenses: These are high Create or increase a perception of differences between products 26

27 Efficiency, Product Innovation & Advertising in Monopolistic Competition Generally it increases ATC curve Due to being relatively fixed cost economies of scale Advertising may also reduce ATC When it causes substantial increase in output where economies of scale bring down overall ATC Demand Curve becomes more elastic, because every firm will advertise Overall, Price reduces, increases (due to more elastic demand curve) and markup reduces 27

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