CHAPTER FIVE
MARKET STRUCTURE
5.1. The concept of market in physical and digital space
Market according to American Marketing Association
(1985) is the process of planning and executing the
conception, pricing, promotion, and distribution of goods,
services and ideas to create exchanges that satisfy individual
and organizational objectives.
Digital marketing is the marketing of products or services
using digital technologies, mainly on the internet but also
including mobile phones, display advertising, and any other
digital media.
Physical market is a set up where buyers can physically meet
their sellers and purchase the desired merchandise from them
in exchange of money.
5.2. PERFECTLY COMPETITIVE MARKET
Perfect competition is a market structure characterized by a
complete absence of rivalry among the individual firms.
5.2.1. Assumptions of perfectly competitive market
A market is said to be pure competition (perfectly
competitive market) if the following assumptions are
satisfied.
1) Large number of sellers and buyers
2) Homogeneous product
3) Perfect mobility of factors of production
4) Free entry and exit
5) Perfect knowledge about market conditions
6) No government interference
5.2.2. Short run equilibrium of the firm
The main objective of a firm is profit maximization. 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 X Q, where P = price
of the product, Q = quantity of the product sold.
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 = TR / Q = (P.Q)/Q =>AR = P
Therefore, the firm‘s demand curve is also the average revenue
curve.
Marginal Revenue: it is the additional amount of money/ revenue
the firm receives by selling one more unit of the product.
MR = (∆TR/ ∆Q) =P(∆Q)/ ∆Q = P
Thus, in a perfectly competitive market, a firm‘s average revenue,
marginal revenue and price of the product are equal, i.e. AR = MR =
P =D
CONT….
There are two ways to determine the level of output at which a
competitive firm will realize maximum profit or minimum loss.
Method is to compare TR, TC, MR, MC.
a) Total Approach (TR-TC approach)
In this approach, a firm maximizes total profits in the short run
when the (positive) difference between total revenue (TR) and
total costs (TC) is greatest.
b) Marginal Approach (MR-MC)
In the short run, the firm will maximize profit or minimize loss by
producing the output at which marginal revenue equals marginal
cost.
π =TR- TC π is maximized when ∂π/∂Q = 0
That is, ∂π/∂Q (∂TR- ∂TC)/∂Q =0
MR = MC….. First order condition (FOC)
CONT…
Second order condition of profit maximization is
2 2 2 2 2
∂ π /∂Q = ∂TR / ∂Q - ∂TC / ∂Q < 0
2
∂MR / ∂Q - ∂MC/ ∂Q =< 0
∂MR / ∂Q < ∂MC/ ∂Q
Where ∂MR/∂Q = slope of MR and ∂MC/∂Q=slope of MC
Therefore, Slope of MC > slope of MR ------- Second order
condition (SOC)
MC, MR MC
MR
The profit maximizing output is
Qe, where MC=MR and MC
curve is increasing.
Figure 5.3: Marginal approach of profit maximization Q
Q* Qe
…SHORT-RUN EQUILIBRIUM
Whether the firm in the short- run gets positive or zero or
negative profit depends on the level of ATC at equilibrium (i.e.
based on the r/n ship b/n price and AT at equilibrium).
* Economic/positive profit - If the AC is below the market price
at equilibrium.
..CONT’D
Loss - If the AC is above the market price at equilibrium.
• Normal Profit (zero profit) or break- even point – when
the AC is equal to the market price at equilibrium.
*Shutdown point - The firm will not stop production b/c of
loss (AC >P) in the short-run rather the firm will continue as
far as the price is sufficient to cover the average variable
costs. This is because if P >AVC but P<AC, the firm
minimizes total losses.
But if P < AVC, the firm minimizes total losses by shutting
down. Thus, P = AVC is the shutdown point for the firm.
NUMERICAL EXAMPLE
Suppose that the firm operates in a perfectly competitive market.
The market price of its product is $10. The firm estimates its cost
of production with the following cost function: TC=2+10q-4q2+q3
a) What level of output should the firm produce to maximize its
profit?
b) Determine the level of profit at equilibrium.
c) What minimum price is required by the firm to stay in the
market?
Solution
Given: p=$10 and TC= 2+10q - 4q2+q3
A) The profit maximizing output is that level of output which
satisfies the following condition MC=MR & MC is rising
Thus, we have to find MC& MR first
Alternatively, MR= ∂TR/∂P where TR=P.Q = 10Q
MR= ∂TR/∂P = ∂10Q/ ∂P = 10
CONT…
=> Where; MC= ∂TC/∂P = 10 - 8q + 3q2
To determine equilibrium output just equate MC & MR
And then solve for q.
– 8q + 3q2 = 10 - 8q + 3q2 = 0
q(-8 + 3q) = 0…. q=0 or q=8/3
To determine which level of output maximizes profit we have to use the
second order test at the two output levels. That is, we have to see
which output level satisfies the second order condition of increasing
MC.
To see this first we determine the slope of MC
Slope of MC = ∂MC/ ∂q = -8 + 6q
At q = 0, slope of MC is -8 + 6 (0) = -8 which implies that marginal cost
is decreasing at q = 0. Thus, q = 0 is not equilibrium output because it
doesn‘t satisfy the second order condition.
At q = 8/3, slope of MC is -8 + 6 (8/3) = 8, which is positive, implying
that MC is increasing at q = 8/3
Thus, the equilibrium output level is q = 8/3
CONT…
B) Above, we have said that the firm maximizes its profit
by producing 8/3 units.
To determine the firm‘s equilibrium profit we have to
calculate the total revenue that the firm obtains at this level
of output and the total cost of producing the equilibrium
level of output.
TR = Price * Equilibrium Output = $10*8/3= $80/3
TC at q = 8/3 can be obtained by substituting 8/3 for q in
the TC function, i.e., TC = 2+10 (8/3) – 4 (8/3)2 + (8/3)3 »
19.18
Thus, the equilibrium (maximum) profit is
π =TR–TC
26.67 – 19.18 = $ 7.48
CONT….
C) To stay in operation the firm needs the price which equals at
least the minimum AVC. Thus, to determine the minimum price
required to stay in business, we have to determine the minimum
AVC.
AVC is minimal when derivative of AVC is equal to zero. That is:
∂AVC/∂Q = 0
Given the TC function: TC 2+10q – 4q2+q3, TVC = 10q–4q2+q3
AVC= TVC/q = 2+10q – 4q2 +q3//q = 10 – 4q + q2
∂AVC/ ∂q= 0 d (10 - 4q + q2) = 0 -4 + 2q = 0
q = 2 i.e. AVC is minimum when output is equal to 2 units.
The minimum AVC is obtained by substituting 2 for q in the AVC
function i.e.,
Min AVC = 10 – 4 (2) + 22 = 6. Thus, to stay in the market the
firm should get a minimum price of $ 6.
5.3. MONOPOLY MARKET
5.3.1. DEFINITION AND CHARACTERISTICS
Pure monopoly exists when a single firm is the only
producer of a product for which there are no close
substitutes.
The main characteristics of this market structure
include:
Single seller
No close substitutes
Price maker
Blocked entry
The major sources of barriers to entry are:
Legal restriction
Control over key raw materials
Efficiency (probably large size firm)
Patent rights
5.4. MONOPOLISTICALLY COMPETITIVE MARKET
This market model can be defined as the market
organization in which there are relatively many firms
selling differentiated products. It is the blend of
competition and monopoly.
This market is characterized by:
Differentiatedproduct,
Many sellers and buyers,
Easy entry and exit,
Existence of non-price competition
5.5. OLIGOPOLY MARKET
This is a market structure characterized by:
Few dominant firms: are few firms although the exact
number of firms is undefined. Each firm produces a
significant portion of the total output.
Interdependence
Entry barrier: are considerable obstacles that hinder a
new firm from producing and supplying the product.
The barriers may include economies of scale, legal,
control of strategic inputs, etc.
Products may be homogenous or differentiated
Lack of uniformity in the size of firms
CONT….
Market models
Pure
Characteristi Pure Monopolistic Oligopoly Monopoly
cs Competition Competition
Number of Large Many Few One or Single
firms
Unique, no
Type of Homogeneous Differentiated close
product substitutes
Homogeneous or
differentiated
Control over None Some, but within Limited by mutual Significant
rather narrow
price limits interdependence and
collusion
Very easy Relatively easy Considerable Blocked
Condition of
entry barriers/obstacles
Examples Agricultural Clothes, Shoes Steel, Automobiles Local utilities
products
