CHAPTER 5
Market Structures and The Decision of a Firm
The Concept of Market Structure

The concept of market structure is a tool for providing some
framework to the theories investigating the market situations.

The commonest three elements of market structure had been
deposited by economists as the number, size, and size
distribution of sellers and buyers, the degree of product
differentiation, and the conditions of entry into the market.

The setting or "place of competition to the firm" is called
"market structure."
…cont

The market structure is the setting in which the enterprise
receives competitive 'discipline' or through which the rule of
competition is made effective.

Therefore, one can say that market structure involves the
important, small number of strategic environmental factors
affecting all basic decisions of the firm.

The concept of market structure is included in the broader
concept of the environment of the enterprise.
…cont

1.
2.
3.

The environment of enterprise can be viewed in three
overlapping parts:
The general environment or institutional setting
(institutional environment)
The economic basic conditions (basic conditions) and
The specific environment which hears so directly upon
the enterprise that it affects all important decisions
(market structure).
Firms sell goods and services under different market
conditions, which is generally referred to as market
structures.
…cont

A market structure describes the key traits of a market, including
the number of firms, the similarity of the products they sell, and
the ease of entry info and exit from the market.

The business sector of an economy is constituted by firms
operating in different market structures.

The four major market structures are Perfect competition,
Monopoly, Monopolistic competition and Oligopoly. Others
are Duopoly and Monopsony.
5.1. Perfect competition

Perfect competition is a market structure where an infinitely large
number of buyers and sellers operate freely and sell a homogeneous
commodity at a uniform price.

It has the features of unlimited contestability (no barriers to entry),
unlimited number of producers and consumers, and a perfect elastic
demand curve.
5.1.1. Characteristics

of PCM
Major Characteristics of Perfect Competition are presented as follows
i. Large number of buyers and sellers

There is a very large number of buyers and sellers as no
individual can influence the market price.

When the number of firm is high, each firm or seller in a
perfectly competitive market forms an insignificant part of
the market.

Hence, each firm in the market has no significant share of
total output and, therefore, no ability to affect the product's
price. Each firm acts independently, rather than coordinating
decisions collectively.
…cont

For example, assume there are thousands of independent shoes manufacturers
in the Ethiopia.

If any single manufacturer raises the price, the going or general market price
for shoes will remain unaffected.

The question becomes, who determines the price in such a market?

In a perfectly competitive market, it is the forces of market demand and market
supply that determines the price of the commodity.

Since each firm accepts the price that is determined by the market, it becomes
a Price-taker.

As the market determines the Price, it is the Price-maker.
ii. Homogenous Product

In a perfectly competitive marker, all firms produce a
standardized or homogenous product.

Homogenous products are those that are identical in all respects,
that is, there is no difference in packaging, quality, colors etc.

As the output of one firm is exactly the same as the output of all
others in the market, the products of all firms are perfect
substitute for each other.

This assumption rules out rivalry among firms in advertising and
quality differences.
iii. Free Entry and Exit

Very easy entry into a market means that a new firm faces
no barriers to entry.

Barriers can be financial, technical, or government-imposed
barriers, such as licenses permits, and patents.

The implication of this feature is that while in the short run,
firms can make either supernormal profits or losses, but in
the long run all firms in market earn only normal profits.
iv. Perfect Knowledge of Market

Buyers and sellers have complete and perfect knowledge about the
product and prices of other sellers. This feature ensures that the market
achieves a uniform price level.
v. Perfect Mobility of Factors Production
 The factors of production are free to move from one firm to another
throughout the economy.

It is also assumed that workers can move between different jobs, which
imply that skills can be learned easily.

Hence, there is perfect competition in the markets of factors of production.
…cont

In conclusion, Perfect competition requires that resources be
completely mobile to freely enter or exit a market.

No real-world market exactly fits the five assumptions of perfect
competition.

The perfectly competitive market structure is a theoretical or
ideal model, although some actual markets do approximate the
model fairly closely.

Examples include farm products markets, the stock market, and
the foreign exchange market.
5.1.2. Market Price under PCM

In a perfectly competitive industry, market price is
determined by the intersection of the demand and supply
curves.

The market demand curve shows the total amount that
individual buyers of the commodity will purchase at any
price; the market supply shows the total amount that
individual suppliers of the commodity will supply at any
price.
…cont

The figure above shows the market demand and supply curves for a good
produced in a perfectly competitive market.

As is ordinarily the case, the market supply curve (S) slopes upward to the right.
That is, increases in price generally result in higher industry output because firms
find it profitable to expand production.

Similarly, the market demand curve (D) slopes downward to the right. That is,
increases in price generally result in less of the product being demanded.

The equilibrium price (P*) prevailing in the market will therefore be determined
where the market supply equates market demand.
5.1.3. The Output Decision of
Perfectly Competitive Firm

a
As a purely competitive firm is a price taker, it can maximize its economic profit (or
minimize its loss) only by adjusting its output.

In the short run, the firm has a fixed factor of production. Thus, it can adjust its
output only through changes in the amount of variable resources it uses.

The firm adjusts its variable resources to achieve the output level that maximizes its
profit.

There are two ways to determine the level of output at which a competitive firm will
realize maximum profit or minimum loss.

One method is to compare total revenue and total cost, the other is to compare
marginal revenue and marginal cost.

Both approaches apply to all firms whether they are pure competitors, pure
monopolists, Oligopolists.
5.1.4. Profit Maximization in the Short Run:
Total Revenue – Total Cost Approach


The firm is in equilibrium when it maximizes its
profits defined as the difference between total cost
and total revenue: II = TR - TC.
The firm is in equilibrium when it produces the
output that maximizes the difference between total
revenue and total costs.
Figure shows the Total cost –Total revenue approach of profit maximization
…cost



Figure II represents the total revenue and the total cost
curves of a firm in a perfectly competitive market.
The total revenue curve is a straight line through the
origin showing that the price is constant at all levels of
output.
The firm is a price-taker and can sell any amount of
output at the going market price, with its TR increasing
proportionately with its sales. The slope of the TR curve
is the marginal revenue.
…cost


It is constant and equal to the prevailing market price,
since all units are sold at the same price. Thus in pure
competition MR = AR = P.
The firm maximizes its profit at the output level X0,
where the distance between the TR and TC is the
greatest. At lower and higher level of output, total
profit is not maximized: at level smaller than X1 and
larger than X2 the firm has losses.
5.1.5. Profit Maximization in the Short-Run:
Marginal Revenue-Marginal Cost Approach

In the second approach, the firm compares the amounts that each
additional unit of output would add to total revenue and to total cost.

In other words, the firm compares the marginal revenue (MR) and the
marginal cost (MC) of each successive unit of output.

Assuming that producing is preferable to shutting down, the firm should
produce any unit of output whose marginal revenue exceeds its marginal
cost because the firm would gain more in revenue from selling that unit
than it would add to its costs by producing it.

Conversely, if the marginal cost of a unit of output exceeds its marginal
revenue, the firm should not produce that unit.
e1
…cont




Producing it would add more to costs than to revenue and profit would decline or
loss would increase.
In summary,
 If MC < MR, total profit has not been maximized and it pays the firm to
expand its output.
 If MC > MR, the level of total profit is being reduced and it pays the firm to
cut its production.
 If MC - MR, short run profits are maximized.
In figure below, the first condition of MC - MR is satisfied at point e1 although the
firm is not in equilibrium.
The second condition for equilibrium requires that the MC be rising at the point of
its intersection with the MR curve. This means that the MC must cut the MR curve
from its minimum point (from below).
…cont

The slope of MC is positive at point e, while the slope of
the MR curve is zero at all levels of output. Thus at point
e, both conditions for equilibrium are satisfied. Again,
the MC is always positive because the firm must spend
some money in order to produce an additional unit of
output. Thus at equilibrium, the MR is also positive.
Long-Run Equilibrium for a Perfectly Competitive Firm

In the long run, a firm can change its plant size or any
input used to produce a product. This means that an
established firm can decide to leave an industry if it
earns below normal profits (negative economic profits)
and that new firms may enter an industry if the earnings
of established firms exceed normal profits (positive
economic profits).
…cont

This process of entry and exit of firms is the key to long-run equilibrium. If
there are economic profits, new firms enter the industry and shift the short
run supply curve to the right.

This increase in short-run supply causes the price to fall until economic
profits reach zero in the long run.

On the other hand, if there are economic losses in an industry, existing
firms leave, causing the short-run supply curve to shift to the left, and the
price rises.

This adjustment continues until economic losses are eliminated and economic
profits equal zero in the long run.
…cont

The firm operates where the price equals the minimum point
on its long run average cost curve. At this point, the short-run
marginal cost curve intersects both the short-run average
total cost curve and the long run average cost curve at their
minimum points.

With SRMC representing short-run marginal cost, the
conditions for long run perfectly competitive equilibrium can
also be expressed as equality:
Monopoly

Monopoly is the form of market organization in
which there is a single seller of a commodity for
which there are no close substitutes. Thus, it is at the
opposite extreme from perfect competition as a pure
monopoly exists when a single firm is the soleproducer of a product.
Major Characteristics/Features of Monopoly
A.
Single Seller - There is only one producer of a product. It may be due
to some natural conditions prevailing in the market, or may be due to
some legal restriction in the form of patents, copyright, sole
dealership, stale monopoly, etc. Since, there is only one seller; any
change in supply

plans of that seller can have substantial influence over the market price.
That is why a Monopolist is called a Price Maker. Again, a Monopolist's
influence on the market price is not total as price is determined by the
forces of demand and supply while the Monopolist solely controls the
supply.
B.
Products without substitute - The commodity sold by (he Monopolist has no
close substitute available for it. Therefore, if a consumer does not want the
commodity at a particular price, the likelihood of getting closely or similar
product may not be possible. Therefore, the elasticity of demand for the
products sold by a monopolist is relatively inelastic.
C.
Restriction of entry for new firms - There are barriers to entry into industry for
the new firms. It may be due to the ownership of strategic raw material or
exclusive knowledge of production, patent rights or government licensing. The
implication of barriers to entry is that in the short run, monopolist may earn
supernormal profit or losses. However, in the long run, barriers to entry ensure
that a monopolistic firm earns only super normal profits.
D.
Price Discrimination - Price Discrimination exists when the same product is sold
at different price to different buyers. A monopolist practices price discrimination
to maximize profits. For example electricity charges in Nigeria are different for
domestic users and commercial and industrial users.
E.
Limited Consumer Choice - As the firm is the single producer of the commodity,
in the absence of any close substitute, the choice for consumer is limited.
F.
Price in Excess of Marginal Cost - Monopolists fix the price of a commodity (per
unit) higher than the cost of producing one additional unit as they have absolute
control over price determination.
Sources of Monopoly Power (Barriers to Entry)
I.
Existence of large economies of scale - Economies of scale is the major
barrier to entry. This occurs where the lowest unit cost and low unit prices
for consumers depend on the existence of a small number of large firms, or
in the case of monopoly, only one firm with a large market share is most
efficient. In summary, one firm can provide a lower price than two or more
firms.
II.
Patent Law - Legal barriers exist in the form of patents and licenses granted
to newly invented products or to radio and TV stations.
III.
Sole ownership of a resource - Ownership or control of
essential resources is another barrier to entry. An
example of this is the case of professional sports
leagues that control player contracts and leases on
major city stadiums.
IV.
Others are limited size of the market, import restrictions
and formation of a cartel e.g. OPEC