AN INTRODUCTION TO

MARKET STRUCTURE
Definition: Market
• In ordinary language, a market refers to a
place where the buyers and sellers of a
commodity gather and strike bargains.
• In economics, however, the term “Market”
refers to a market for a commodity. E.g. Cloth
market; furniture market; etc.
• According to Chapman, "the term market
refers not necessarily to a place and always to
a commodity and buyers and sellers who are
in direct competition with one another”.
Features of a Market
• A region – A market does not refer to a fixed place. It covers a
region, which may be a town, state, country or even world.
• Existence of buyers and sellers – Market refers to the
network of potential buyers and sellers who may be at
different places.
• Existence of commodity or service – The exchange
transactions between the buyers and sellers can take place
only when there is a commodity or service to buy and sell.
• Bargaining for a price between potential buyers and sellers.
• Knowledge about market conditions – Buyers and sellers are
aware of the prices offered or accepted by other buyers and
sellers through any means of communication.
• One price for a commodity or service at a given time.
 There are three main metrics by which we
measure a market’s structure:
• Are individual firms price takers or price
searchers?
• Are there barriers to entry that firms face
to enter the market or barriers to exit
that firms have to pay to leave the
market?
• How many firms are there in the market?
 Perfect Competition
Characteristics of perfectly competitive market
• There are many buyers and sellers in the
market.
• Each company makes a similar product.
• Buyers and sellers have access to perfect
information about price.
• There are no transaction costs.
• There are no barriers to entry into or exit from
the market.
• All goods in a perfectly competitive market
are considered perfect substitutes.
• The demand curve is perfectly elastic for
each of the small, individual firms that
participate in the market.
• These firms are price takers–if one firm
tries to raise its price, there would be no
demand for that firm’s product.
• Because consumers would buy from
another firm at a lower price instead.
Firm’s objective is to maximize Profit
• Profit (∏) = Revenue – Total Cost
• Total Cost = Fixed Cost + Variable Cost
• Total Revenue = Price X Quantity
– Since perfectly competitive firm is a
price taker, it has only one major
decision to make—namely, how much
quantity to produce?
 Firm’s Revenue
• Total Revenue = Price X Quantity
• AR (Average Revenue) = Total Revenue / Quantity
• MR (Marginal Revenue) = Change in Total
Revenue / Change in Quantity
• The average revenue (AR) is the amount of
revenue a firm receives per unit of output.
• The marginal revenue (MR) is the change in total
revenue from an additional unit of output sold.
• For all firms in a competitive market, both AR
and MR will be equal to the price.
Price and Revenue
Total Revenue (TR = P x Q)
 Price, Marginal Revenue, and Average
Revenue
• The slope of a total revenue curve equals the
change in the vertical axis (total revenue)
divided by the change in the horizontal axis
(quantity) between any two points.
• It measures the rate at which total revenue
increases as output increases.
• Price also equals average revenue, which is
total revenue divided by quantity.
Marginal Revenue, Price, and Demand for the
Perfectly Competitive Firm
Economic Profit in the Short Run
 Marginal Decision Rule
• The slope of the total revenue curve is marginal revenue.
• The slope of the total cost curve is marginal cost.
• Economic profit, the difference between total revenue and
total cost, is maximized where marginal revenue equals
marginal cost (MC = MR).
• This is consistent with the marginal decision rule, which
holds that a profit-maximizing firm should increase output
until the marginal benefit of an additional unit equals the
marginal cost.
• The marginal benefit of selling an additional unit is measured
as marginal revenue.
• Finding the output at which marginal revenue equals marginal
cost is thus an application of our marginal decision rule.
Applying the Marginal Decision Rule
Economic Losses in the Short Run
• A firm that is experiencing economic losses—
whose economic profits have become
negative—in the short run may either
continue to produce or shut down its
operations, reducing its output to zero.
• The crucial test of whether to operate or shut
down lies in the relationship between price
and average variable cost.
 Relationship b/w Price & Average Variable
Cost
• The market price for radishes falls to $0.18 per
pound, which is below average total cost $0.23.
Consequently the firm experiences negative
economic profits—a loss.
• Though, the new market price falls short of
average total cost, it still exceeds average
variable cost $0.14 , shown in Panel (b) as AVC.
• Therefore, the firm. should continue to produce
an output at which marginal cost equals
marginal revenue.
Firm Continue Production to Minimize Loss

• At 4,444 pounds of radishes per month, the firm

faces an average total cost of $0.23 per pound.
• At a price of $0.18 per pound, he loses a $0.05 on
each pound produced. Total economic losses at an
output of 4,444 pounds per month are thus
$222.20 per month (=4,444×$0.05).
• Thus, a firm is better off by continuing producing
where marginal cost equals marginal revenue
because at that output price exceeds average
variable cost.
Loss solution is better than shutting down

• No producer likes a loss, but the loss solution

is the best a producer can attain.
• Zero production (i.e., shut down) decision
would make him lose $ 400.
• Fixed cost is $ 400 is constant even at zero
level of production.
• By continuing production, firm minimizing loss
by $222.20 per month (=4,444×$0.05).
Shutting Down to Minimize Economic Loss

• Suppose price drops below a firm’s average variable

cost.
• Now the best strategy for the firm is to shut down,
reducing its output to zero.
• The minimum level of average variable cost, which
occurs at the intersection of the marginal cost curve
and the average variable cost curve, is called the
shutdown point.
• Any price below the minimum value of average
variable cost will cause the firm to shut down.
 Imperfect Competition: Monopolistic
• Monopolistic competition is a model characterized
by many firms producing similar but differentiated
products in a market with easy entry and exit.
• Thus, this model differs from the model of perfect
competition in one key respect: it assumes that the
goods and services produced by firms are
differentiated.
• This differentiation may occur by virtue of
advertising, convenience of location, product quality,
reputation of the seller, or other factors.
• Product differentiation gives firms producing a
particular product some degree of price-
setting or monopoly power. However, because
of the availability of close substitutes, the
price-setting power of monopolistically
competitive firms is quite limited.
• Examples of monopolistic competition include
retail stores, barber and beauty shops, auto-
repair shops, service stations, banks, and law
and accounting firms.
 Profit Maximization
• Since products in a monopolistically competitive
industry are differentiated, firms face downward-
sloping demand curves.
• If a firm faces a downward-sloping demand curve,
then its marginal revenue curve will also a
downward-sloping line that lies below the demand
curve
Demand Price TR MR

0 40 0 0

1 32.5 32.5 32.5

2 25 50 17.5

3 17.5 52.5 2.5

4 10 40 -12.5
 Explanation
• Graph shows the demand, marginal revenue,
marginal cost, and average total cost curves facing
a monopolistically competitive firm, Tango Pizza.
• Given the downward-sloping demand curve,
Tango’s marginal revenue curve MR1 lies below
demand.
• To sell more pizzas, Tango’s must lower its price,
and that means its marginal revenue from
additional pizzas will be less than price.
• At the intersection of the marginal revenue
curve MR1 and the marginal cost curve MC,
we see that the profit-maximizing quantity is
2,150 units per week.
• Reading up to the average total cost curve
ATC, we see that the cost per unit equals
$9.20. Price, given on the demand curveD1, is
$10.40, so the profit per unit is $1.20.
• Total profit per week equals $1.20 times 2,150,
or $2,580; it is shown by the shaded rectangle
• Given the marginal revenue curve MR and
marginal cost curve MC, Tango’s will maximize
profits by selling 2,150 pizzas per week.
• Tango’s demand curve tells us that it can sell
that quantity at a price of $10.40.
• Looking at the average total cost curve ATC,
we see that the firm’s cost per unit is $9.20.
• Its economic profit per unit is thus $1.20.
Total economic profit, shown by the shaded
rectangle, is $2,580 per week.
 Monopolistic Competition
• Monopolistic Competition is a type of market
structure where there are many firms in the
market, but each offers a slightly different
product.
• It is characterised by low barriers to entry and
exit, which creates fierce competition.
• This market structure is a mixture between
a monopoly and perfect competition.
• Firms in this market structure compete on factors
other than price; such as quality, and reliability.
 Characteristics of
Monopolistic Competition
• Many buyers and sellers
• Slightly differentiated products
• Low barriers to entry and exit
• Maximize profits
• Potential supernormal profits in the short term
• Normal profits in the long-run
• Imperfect information
• Non-price competition
 Oligopoly Market
• An oligopoly is defined as a type of market
structure few firms have market control.
Combined, they are able to dictate prices
and supply. Yet, they are unable to influence the
market on their own.
• Firms in an oligopoly can have varying degrees of
market share.
• Oligopolies are also characterized by their
interdependent. In other words, they are highly
responsive to competitors actions.
 Characteristics of An Oligopoly
• A Few Firms with Large Market Share
• High Barriers to Entry
• Interdependence
• Each Firm Has Little Market Power In Its Own
Right
• Higher Prices than Perfect Competition
• More Efficient
 Monopoly Market
• Monopoly is a market situation in which there
is only one seller of a product with barriers to
entry of others.
• The product has no close substitutes.
• The monopoly firm is itself an industry and
the monopolist faces the industry demand
curve.
• He is a price-maker who can set the price to
his maximum advantage.
Characteristics of Monopoly
• Single seller
• High barriers to entry
• Price maker
• Profit maximizer
• Price discrimination