Managerial Economics
Market Structures
Aalto University
School of Science
Department of Industrial Engineering and Management
January 12 – 28, 2016
Dr. Arto Kovanen, Ph.D.
Visiting Lecturer
General considerations
Mankiw, Principles of Economics
General considerations
 Firms face two type of constraints, which influence
the profit maximization
 The first is technological: all types of production plans
are not physically possible (also costs differ)
 The second constraint is the market environment
 A firm usually is not able to unilaterally to decide at what
price to sell its output
 How firms determine the price for their outputs and
what price they are willing to purchase inputs
Forces that shape competition
 Forces that shape competition (from firm’s point of
view)





Rivalry among existing companies in an industry
Customers
Suppliers
Potential entrants
Substitute products
 These forces define industry’s structures and shape
the nature of competition within an industry
 Drivers of profitability are similar to all industries
 See Michael E. Porter (2008), “The Five Competitive
Forces That Shape Strategy”, Harvard Business Review
Chart (Porter) – Five Forces
Forces that shape … (cont.)
 We will analyze these factors during this course and
link them to behavior of consumer, producers, and
market structures
 The bottom line: when these forces are intense, it will
be very difficult to ear attractive returns on
investments
 Average return on invested capital varies markedly
from industry to industry
 From low rates in industries such as airlines and hotels
 To high rates in industries such as pharmaceuticals and
securities brokers
 See chart (Porter): return on invested equity (1992 –
2006)
Chart (Porter) – Profitability
Forces that shape … (cont.)
 Industry structures drive competition and profitability,
not whether an industry is emerging or mature, high or
low tech, regulated or unregulated
 Threat of entry and sources of barriers to entry:






Economies of scale in the production
Demand-side benefits of scale (network effects)
Switching costs (when changing suppliers)
Capital requirements
Incumbency advantages regardless of size
Access to distribution channels
Pricing and output decisions
 There are four basic market types




Percent competition
Monopolistic competition
Oligopoly
Monopoly
 Each of them differ in terms of the number of firms in
the market, differentiation between products, and the
pricing power of buyers and/or seller
 To understand the role of the markets in firm’s pricing
and output decisions, it is helpful to begin with the one
where the nobody has any market power and cannot
separate itself from the operators in the market
Market structures
Webster, Managerial Economics
Perfect competition
 In a perfectly competitive market consumer and
suppliers are price takers, which means that they
cannot influence the price of the product
 Were do we see perfectly competitive markets in real
life? Or are they non-existing?
 How does the demand curve of the firm product look
like? What is the price elasticity of demand?
 The objective of the firm is to maximize its profits
Perfect competition
 The demand curve facing the firm is horizontal, hence
demand is perfectly elastic
 That means that at any price higher that that set by
the market there will be no demand for firm’s output
 In the opposite case where the firm offers to sell its
output at below market price, it will face infinite
demand for its output
 Demand is given by Q(D) = P
 What are total, average and marginal revenues?
Perfect competition
 The firm chooses its output level by equating MR with
MC, as discussed earlier, to maximize its profits
 In the case of perfect competition, MR = P. Why?
 Graphically, find the output level where P = MC
 Graphically, find the area of total profits
π = TR – TC = P*Q* – AC*Q*
= Q* (P – AC)
Profit maximization
Mankiw, Principles of Economics
Perfect competition
 The above means that if AC > P, the firm will incur a
loss of (AC – P) per unit of output
 The firm may still operate in the market in the shortrun if its variable cost is below P
 This, however, is not sustainable since the firm will
not be able to cover its fixed costs
 The shutdown point is the lowest price at which the
firm would still produce where P = MC = AVC
 If P < AVC, the firm will shut down
Perfect competition
 In the long run, the price in the competitive market
will settle at the point where firms earn a normal
profit
 Economic profit invites entry of new firms, which will
shift the supply curve to the right, put downward
pressure on the price and reduce profits
 Economic loss has the opposite effect
 In equilibrium, entry and exit ensure that profits are
zero in the long run
Monopoly
Mankiw, Principles of Econommics
Monopoly
 A monopoly market is the other extreme and consists
of a single firm; that is, the firm is the market
 Monopoly is often associated with limited market entry
(either because of regulation or uniqueness of
product)
 As a result, the firm has complete power to price its
product
 The only limitation to the firm’s pricing power comes
from the demand (which is downward sloping) and its
elasticity (elastic/inelastic)
 How much should the firm produce to maximize its
profits?
Monopoly
 As before, the optimal condition is MR = MC
 Unlike in the case of perfect competition where MR =
P, with monopoly MR is a declining function of the
level of output
 That is, MR = f(Q) where dMR/dQ < 0
 Monopoly maximizes it profits where MC ≠ AC, hence
producing less than a firm in the competitive market
(where MC = AC) CHECK!!!!
Monopoly’s optimum
Mankiw, Principles of Economics
Mark-up pricing
 Mark-up pricing refers to the extent to which the
price is higher than the marginal cost
(P – MC)/P = 1/εP (called Lerner index)
P = [1/(1 + 1/εP)]*MC
 Mark-up is related to the price elasticity of demand
(and hence pricing power of the firm)
 When demand is perfectly elastic, then the elasticity
is infinite and P = MC (perfect competition)
 When demand is inelastic, P > MC (monopoly power)
 Because -1 ≤ εP < - infinity, demand is price elastic and
thus monopoly will produce on the part of demand
curve that is elastic
Competition in the long run
 This is determined by two effects:
 The first is ease of entry and exit
 If entry and exit is free in the industry, in the long run all
firms zero economic profits
 The second condition is technological advancement
 If long-run average costs are constant and entry
restricted, a fixed number of firms operate with a
constant-return-to-scale technology
 If long-run average costs are constant and entry is free,
the number of firms vary (any number of firms is possible)
 If long-run average costs are increasing and entry limited,
firms can make positive profits (MC > AC); e.g., farming in
which entry is limited by the fixed amount of land
Monopoly vs. perfect competition
 For the society, perfect competition is preferable
since it results in greater output and lower prices
 Perfectly competitive firms are making only normal
profits in the long run while monopoly is making an
economic profit
 Hence monopoly results in an inefficient allocation of
resources
 There are also welfare effects that are different for a
monopoly compared to a competitive market
Monopoly vs. perfect competition
 Consumer surplus is the difference between what
consumers would be prepared to pay for a given
quantity of good or service and the amount they
actually pay
 This is the area below the downward-sloping demand
curve and above the setting price
 Producer surplus is the difference between the total
revenues earned from production and sale of output
and what the firm would have been willing to accept
for its output
 This is the area above the upward-sloping supply curve
and below the price in the market
Monopoly vs. perfect competition
 Deadweight loss is the loss of consumption and
production efficiency arising from monopolistic market
structures
 Total deadweight loss is the sum of the losses of
consumer and producer surplus for which there are no
offsetting gains
 Examples of monopolies and perfect competition
 Drug companies – patent protection creates a monopoly
 Utilities – natural monopolies (high capital requirement)?
 Is monopoly profit needed for innovation (e.g., Apple)?
Monopolistic competition
 An intermediate alternative between a monopoly and
pure competition
 There is limited number of producers who sell similar,
but not identical products (few = oligopoly)
 The demand facing the i-th firms is dependent on the
demand for the products of other firms
 In the long-run, the price charged by a producer must
equal the average cost for each firm
 That is, in the long-run, monopolistic competition
leads to zero economic profit (i.e., P = AC)