Chapter Five: Market Structure

5.1. Introduction

 Market: means which by the exchange of goods and service takes place as the result of buyer
and seller being in contact with one another or, either directly or through mediating agents or
institutions or through digital.

 Market structure: is the description of characteristics of a market that influence the behavior
and results of the firms working in that market.

 Major determinants of Market structure

 Number of buyer and sellers in the market
 Nature of goods and service offered by the firms
 Concentration ratio of the company
  Entry and exit barriers in the particular market
 Economics of scale
 Degree of vertical integration
 Customer turnover
 Market structure are classified into two categiories
 Competitive and
 Imperfect competitive
5.2. Perfectly Competitive Market Structure
 Perfect competition is an extreme situation where competition reaches its maximum
possible degree.
 The model of perfect competition however can not be realistically expected to exist in
totality in everyday life.

 Characteristics of perfectly competitive market

 Many buyers and many sellers

 Identical(Homogenous) products

 All firms in the industry produce and sell exactly identical products.

 Since there is no product differentiation, purchasers have no preference for one

producer/seller to another.

 Perfect knowledge: all participants (buyers and sellers) have knowledge about prices,
quality, outputs levels and all other market conditions.
 Free entry and exit
 Goal of all firms is profit maximization
 Perfect mobility of factory of production
 Perfect mobility of factors of production simply means that inputs (resources) are free
to move from one firm to another.
 No government interference: - government does not interfere in any way with the
functioning of the market.
 The firm under perfect competition is powerless to exert any influence on the price and is
known as a ‘price taker’.
 Buyers are also price taker.
 Demand curve
 Thus, the demand curve that an individual firm faces is a horizontal line.
 The demand curve indicates a single market price at which the firm can sell any
amount of the commodity demanded.
 The demand curve also indicates the average revenue (AR) and marginal revenue
(MR)of the firm (P=AR=MR ).
5.3. Short run equilibrium of the firm
 Firm is said to be in equilibrium when it maximizes its profit ().
 Profit is the difference between total revenue and total cost.
 Total Revenue (TR): it is the total amount of money a firm receives from a given
quantity of its product sold (TR = P).
 Total Cost is the actual cost incurred in the production of a given level of output.
 Under perfect competition, the firm is said to be in equilibrium when it produces that level
of output which maximizes its profit, given the market price.
 Average revenue (AR):- it is the revenue per unit of item sold. It is calculated by dividing
the total revenue by the amount of the product sold.
AR = = => AR = P
 Marginal Revenue: it is the additional amount of money/ revenue the firm receives by
selling one more unit of the product.
 In other words, it is the change in total revenue resulting from the sale of an
extra unit of the product.

MR = = = = P, since is constant.
Therefore, MR = P
 The level of output which maximizes the profit of the firm can be obtained in two
ways:
 Total approach
 Marginal approach
 Total approach
 In this approach, the profit maximizing level of output is that level of output at
which the vertical distance between the TR and TC curves is maximum.
 Provided that the TR curve lies above the TC curve at this point.
 The profit maximizing output level is Qe because it is at this out put level that the
vertical distance between the TR and TC curves (or profit) is maximum.
 For all out put levels below Q0 and above Q1 profit is negative because TC is above
TR.
  Marginal Approach
 In this approach the profit maximizing level of output is that level of output at which:
MR=MC , and MC is increasing (Slope of MR < Slope of MC)
 MR = MC ------------------------- (First order condition necessary condition).
 MC is increasing => Slope of MR < Slope of MC ( < ; > 0 ……. sufficient
condition
 Short-run Profit or Loss and Firm's Supply Curve
 Price exceeds average cost (i.e. P>AC), a perfectly competitive firm realizes
positive or supernormal profit.
 If P=AC, the firm is at break-even point.
 Here, the firm earns only normal profit (zero profit ).
 If AVC<P<AC, P = AVC a competitive firm incurs losses, but it continues
operation with the hope of revival.
 If P<AVC, the firms shuts down operation
Example: Suppose that the firm operates in a perfectly competitive market. The market
price of his product is$10. The firm estimates its cost of production with the following cost
function: TC=10q-4q2+q3
Required:
A. What level of out put should the firm produce to maximize its profit?
 Answer: Q = 8/3 ( the slope of MC is positive when Q = 8/3)
B. Determine the level of profit at equilibrium.
 Answer:  = TR – TC => 26.67 – 23.12 = $ 3.55
C. What minimum price is required by the firm to stay in the market?
 Answer: to stay in the market the firm should get a minimum price of $6.
 The short run supply curve of the firm
 Thus, the short run supply curve of a perfectly competitive firm is that part of MC
curve which lies above the minimum average variable cost (Shut down point).
 The industry/market supply curve is a horizontal summation of the supply curves of
the individual firms.
  Short run equilibrium of the industry is defined by the intersection of the market
demand and market supply.
 The long-run Equilibrium
 The optimum level of output for a perfectly competitive business firm in the long-run
is at the point where P or MR equals long-run marginal cost (LMC) and LMC is rising.
 If at this level of output, the firm is making profit, more firms will enter the perfectly
competitive industry until all profits are squeezed out.
 •Thus since price is equal to long run AC (LAC now on) at the long run equilibrium,
firms will be earning just normal profits (zero profits).
 Long run shut down decision: If the market price falls below the minimum AVC, the
firm is well advised to shut down.
5.4. Imperfect Competition
 Imperfect competition previals in an industry whenever individual sellers have some
measures of control over the price of the product in the industry and quantities of
product.
 However it does not imply that a firm has absolute control over price and quantities
of product.
 It can be divided into three market structure
 Monopoly market
 Monopolstic competition and
 Oligopoly
 1. Monopoly
 A pure monopoly concerns the existence of a single seller of a good for which there is no
close substitute.
 Characteristics of monopoly markets
 There is only one seller so that there is no distinction between firm and industry.
 The product is unique and there is no close substitute.
 The monopoly firm is a price maker.
 Existence of barriers to entry in to the market
 Source of monopoly
 Legal restrictions
 Natural factor endowments
 High entry costs
  Patent and copy rights
 Agreements between producers
 Price discrimination
 Examples of monopoly market in Ethiopia are Ethio Telecommunication, Electricity
service, Airport Service.
2. Monopolistic competition
 Monopolistic competition is one form of imperfect competition.
 It is a market structure in which many sellers compete to sell a differentiated
product.
 As the name suggests, it combines some aspects of both perfect competition and
monopoly.
 Characteristics of monopolistic competition
 Many sellers and buyers
 Product differentiation: production of different varieties or brands of the same product
in the industry which consumers buy according to their preferences.
o The difference can be in quality, style, color, durability, brand name etc.
 Free entry and exit
 No collusion: firms do not cooperate to fix either price or quantity of output.
 Market power: since the existence of product differentiation, firms have monopoly
power.
 Non-price competition: For monopolistic competitive firms there is not only price
competition but also non-price competition such as advertisement.
o grocery stores, laundries, clinics, retail stores, Hotel services, beauty shops, textile
manufactures, are categorized under monopolistic competitive market.
 3. Oligopoly
 Oligopoly is market structure where a few sellers dominate and many buyer of homogenous
or differentiated product in the market.
 Characteristics of oligopoly
 Barriers to entry
 Few sellers
 Mutual interdependence
 Products are either identical or differentiated
 Keen competition
 Excessive expenditure on advertisement
 Presence of Monopoly power
 Price rigidity
 Oligopoly may classified as collusive and Non Collusive
 Collusive: Firms openly agree(communicate) on price, output and other decisition
aimed to reduce competition and maximizes their profit.
 Non collusive: Fims cannot agree(communicate), and decide their own strategy.
 Some terminologies on market structures
 Monopoly – one seller but many buyers
 Monopsony – one buyer but many sellers
 Duopoly – two sellers but many buyers
 Duopsony – two buyers but many sellers
 Oligopoly – few sellers but many buyers
 Oligopsony – few buyers but many sellers
 Perfect competitive market – many buyers and many sellers
 Bilateral monopoly – a single buyer facing a single seller

‘’End of Chapter Five’’