Market Structure Analysis: Introduction

1. Market Structure Analysis: Introduction

2. Market Structure • Market structure is the pattern or form or manner in which its different constituents, i.e. sellers and buyers, are linked together • The following 4 main features of the market-structure: • The degree of sellers concentration:This is the number and size distribution of firms producing a particular commodity or types of commodities in the market. • The degree of buyers concentration: This shows the number and size distribution of buyers for the commodities in the market. • The degree of product differentiation:This shows the difference in the products of different firm in the market. • The condition of entry to the market:This shows the relative ease with which new firms can join the category of sellers (i.e. firms) in the market. • Market structure is a multidimensional concept. • Each of these 4 dimensions of the market structure is important in determining the behaviour of the firms which in turn affects their performance as well as the performance of the industry as a whole.

3. Market Conduct • This is defined as the pattern of behaviour that firms follow in adopting or adjusting to the market in which they operate to achieve the well defined goal(s). • Given the market conditions and goals, a firm will be acting alone or jointly to decide about price levels for the products, the types of products and their quantities, advertisement, etc. • Also, the firm under such situation has to devise the ways for interactions, cross-adaptation and coordination among competing group of sellers in the market.

4. Market Performance • This relates to economic efficiency. • For the entire economic system of a community, economic efficiency means efficient selection of goods to be produced, efficient allocation of resources in the production of these goods and efficient choice of the methods of production, and efficient allotment of the goods produced among the consumers. • Allocative efficiency occurs when output is at that level where MC equals price in each product for each firm. • Among the factors affecting economic efficiency include the organisational or structural conditions prevailing in the industry to which firm belongs, short-term fluctuations in the market for both input and output, etc.

5. MARKET CONDUCT Price behaviour, Product behaviour, Finan cial policy, R&D – Innovation, Advertisement, Collusion, etc. MARKET PERFORMANCE Profitability, Growth rate, Technological advance, Equity content, Efficiency , Full - employment, etc. THE STRUCTURE-CONDUCT-PERFORMANCE (S-C-P) APPROACH BASIC CONDITIONS Social & Political choices; Technol ogy elasticities; tastes, etc. Input prices MARKET STRUCTURE Concentration, Size distribution , No. of firms, Barriers to entry, Vertical integration, Cost structure , Product differentiation, etc.

6. Narsee Monjee Institute of Management StudiesNMIMS University Market Structure Analysis: I Dipankar De Mumbai, September 2007

7. Profit Maximization • The assumption of profit maximization predicts business behavior reasonably accurately and avoids unnecessary analytical complications • But whether firms do maximize profit has been controversial • For smaller firms managed by their owners, profit is likely to dominate almost all the firm’s decisions • In larger firms, however, managers who make day-to-day decisions usually have little contact with the owners (shareholders). As a result, the owners of the firm can not monitor the managers’ behavior on a regular basis. • Managers may be more concerned with goals such as revenue maximization to achieve growth or the payment to dividend holders rather than profit maximization • Managers may be overly concerned with the firm’s short-run profit – perhaps to earn a promotion or bonus – at the expense of LR profit. (Principal-Agency Problem)

8. Profit Maximization Cost, Revenue, Profit C(q) R(q) A B Output O q0 q* π(q) π(q) = R(q) – C(q) Profit is maximized when the following condition is fulfilled MR(q) = MC(q)

9. Perfect Competition

10. Perfect Competition • A market is said to be under perfect competition when the following conditions are met: • Numerous small buyers and sellers:A large no. of sellers and buyers exist in the market, each one of them individually have no noticeable influence upon the market price and quantity of the product • Homogeneity of product: The product of any one firm is identical to the product of every other seller in the market. The buyers are, therefore, indifferent to the sellers and can buy from any one • Freedom of entry and exit: There are no barriers to entry or exit. Sellers and buyers are free to join or leave whenever they want • Perfect information: Each buyer and seller has complete information about the market, i.e. about the prices, nature of product, costs, and demand, etc. There is complete absence of advertisement and selling expenses

11. Perfect Competition • In addition to the above, • There are no artificial restraints in the market. The factors of production are perfectly mobile. No middle-man, such as whole-sellers, brokers, jobbers, retailers, etc. exists. The transactions are supposed to be costless • The sellers and buyers are independent in decision making. There is no collusion of any kind among the buyers and sellers.

12. Perfect Competition Demand Curve facing the Firm Market Demand Curve Price Price d D Q= Quantity Quantity • In a perfectly competitive market, a firm is a price-taker

13. Perfect Competition Price, Cost MC S AC AVC AR=MR=P D q* Quantity Quantity

14. Short-run Profitability: No-Shut Down Condition Price, Cost AC MC B AVC C D A D AR=MR=P F E q* Quantity • A firm will find it profitable to shut-down (produce no output) when the price of its product is less than the minimum AVC. • In this situation, revenues from production will not cover variable costs, and losses will increase

15. Perfect Competition: The Long Run • If in the short run, price is greater than min. AC, the firm would earn ‘super-normal profit’ or ‘pure economic profit’, which is in excess of the ‘normal profit ’. • This would attract new firms into the industry, and there would be increase in the number of firms. • The firms would compete among themselves for scarce resources, and hence the level of competition in the industry would increase. The overall market supply increases due to increased number of firms, and price would fall. A few firms would make losses, and would exit the industry. • The exodus of firms would continue, and industry supply would shift backwards to the left. The interaction of industry supply and demand would lead to increase in the price and it settles at the minimum of LRAC. • At this point, there is no incentive for the firms to entry or exit the industry - the long run equilibrium

16. Perfect Competition: The Long Run • A long run equilibrium occurs when three conditions hold: • All firms in the industry are maximizing profit • No firm has an incentive either to enter or exit the industry because all firms in the industry are earning zero economic profit • The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by the consumers.

17. Perfect Competition: Impact of Output Tax on Firm • Tax imposed on any particular firm will not affect the market price. However, as the tax would raise the cost of producing each unit, MC cost curve shifts upward to the left (by the amount of tax per unit). It also raises the AVC curve by the amount of tax per unit. • A tax might have 2 possible impact: • If the tax is less than the profit margin, the firm will maximise its profit by choosing an output at which MC+ t = P; as result output falls, firm’s SR supply curve shifts to the left. • If the tax> profit margin, the AVC curve will rise, and the min. AVC > P. The firm may choose not to produce.

18. Perfect Competition: Impact of Output Tax on Industry • Tax imposed on all firms will have a cut in their output & production. Thus, at the current market price, total output supplied falls, causing the price of the product to increase. • This increase in the price of the product diminishes some of the effects on the individual firms output decision, as they would reduce their output less than they would without a price increase • Output taxes may also encourage some firms (those whose costs are somewhat higher than the others) to exit the industry, as it would make production unprofitable for those firms. • Industry supply curve shifts to the left, and price rises and quantity sold in the market falls • LR equilibrium will have fewer firms and less output.

19. Monopoly • Monopoly is characterised as: existence of only one firm supplying the goods in the market, and it produces single or differentiated goods which do not have any close substitutes in the market. There are substantial barriers to entry existing in the market. • A monopoly would recognise its influence over the market price and chose that level of price and output that maximised its overall profits. • However, it cannot choose price and output simultaneously. • The monopolist chooses the output where MR = MC.

20. Equilibrium condition under Monopoly Price, cost MC Pm MR=MC D MR Qm Quantity AC • If MR<MC, it would pay the firm to decrease output since the savings in cost would more than make up for the loss in revenue. If MR>MC, it would pay for the firm to increase output. The point where the firm has no incentive to change output is where MR = MC. • A monopolist will never choose to operate where the demand curve is inelastic. For if elasticity is less than unity, then MR is negative, so it can’t equal MC.

21. Inefficiency of Monopoly Price MC Pm PC Deadweightloss Demand MR QmQC Quantity • A competitive industry operates at a point where P = MC. A monopolised industry operates where P > MC. • Thus, the price will be higher and output lower if a firm behaves monopolistically rather than competitively. For this consumers will be worse off under monopoly.

22. Monopoly Power • Monopoly power is defined as the ability of a firm to profitably charge a price higher than marginal cost. A natural way to measure monopoly power is to examine the extent to which the profit-maximising price exceeds marginal cost. • Lerner’s degree of Monopoly Power is given as: • This Lerner’s Index always has a value between zero and one. For a perfectly competitive firm, P = MC, so that L = 0. The larger L is, the greater the degree of monopoly power.

23. Sources of Monopoly Power • It implies from the Lerner’s index is that the less elastic its demand curve, the more monopoly power it has. • 3 factors determine a firm’s elasticity of demand: • The elasticity of market demand • The number of firms • The interaction among the firms

24. Price Discrimination • If a firm has some degree of monopoly power it has more options open to it than a firm in a perfectly competitive industry. For example, it can use more complicated pricing and marketing strategies. • First degree price discrimination or Perfect price discrimination • Second degree price discrimination • Third degree price discrimination

25. Price Discrimination • If a firm has some degree of monopoly power it has more options open to it than a firm in a perfectly competitive industry. For example, it can use more complicated pricing and marketing strategies. • First degree price discrimination or Perfect price discrimination: The monopolist sells different units of output for different prices and these prices may differ from person to person. • Second degree price discrimination: The monopolist sells different units of output for different prices, but every individual who buys the same amount of the good pays the same price. Thus prices differ across the units sold, but not across people. An example of this is bulk discounts • Third degree price discrimination: The monopolist sells output to different people for different prices, but every unit of output sold to a given person sells for the same price. This is the most common form of price discrimination, and examples include senior citizens’ discounts, student discounts, etc.