Market Structures

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4008AFE The Economics Environment of Business
Week 5: Market Structures
Dr Alban Asllani
Lecture Outline
1 Introduction
2 Perfect Competition
3 Monopolistic competition
4 Monopoly
5 Oligopoly
6 Market Structures Summary
7 Conclusion
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Previously on 101LON
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Market Equilibrium.
Every firm seeksto maximize profits and chooses the Q.
Wedistinguish between the short-run (when at least one
factor is fixed) and the
long-run (when everything canvary).
Different types of cost (revenue, product) usedto analyse
different aspects of production.

Learning Outcome
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You will acquire an understanding of the different market
structures
You will beable to distinguish and discussthe differences
between them
Who setsthe price and what kind of profits the firms get.
Perfect Competition
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Assumptions
There aremany firms and none of them dominates the market.
All firms produceidentical products (product is
homogeneous).
No entry barriers. Firms arefreeto enter or leave the market.
Perfect information. Firms and consumersknow everything
about themarket.
The firms areprice takers, i.e. the demandcurve (for the
firm) is horizontal.

Perfect Competition
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Unrealistic
It is obvious that most of the assumptionsarenot realistic.
Products areneveridentical, they havesomedegree of
differentiation, e.g. high endandroidphones.
Also it is not completely freeto enter or leave the market.
Imperfect information. Firms and consumersdo not know
everything about the market.
Perfect competition is auseful tool that providesinsights into
how marketsoperate.

Perfect Competition
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The long-run equilibrium of the firm
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Perfect competition
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Perfect competition is sociallyoptimal.
Pricesequal marginal costs. P = MC
Long-run production is at minimum averagecost and the firm
makesonly normal profits, i.e.zero.
Survival of the fittest: Firms areencouraged to beasefficient as
possible.
Goods areproduced at minimumcosts
Consumersget maximum benefit from their income.
Under perfect competition resources areoptimally allocated in the
most efficient wayof production.

Economies of scale
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As wediscussedin the previous lecture:
Economies of scale refer to reduced costsper unit that arisefrom
increasedtotal output of aproduct.
lower long run averagecost
gain market power, becomeprice maker
However for perfect competition:
weneedMANY small firms (price takers)
they operate for zero profit
Perfect Competition
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Perfect Competition is unrealistic.
There are no real world examples.
weneedit asatool to understand theprocess
Monopolistic Competition
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There are many producers and many consumers
Competition exists but is not perfect
Firms differentiate their products to beat their rivals.
They havepower over prices
Monopolistic Competition
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Demand is highly elastic dueto many closesubstitutes
Demandcurve is not horizontal.
The barriers to entry and exit into and out of the market are
low

The long-run equilibrium of the firm
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Monopoly
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Just onecompany operating in the market
Restricted entry into the industry or evencompletely blocked,
by law or otherwise
Unique product, e.g. Water, train or ferry routes, etc.
Product differentiation, brand loyalty
Monopolies
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Competitive firms areprice takers.
Monopoly firm is aprice setters.
Price setter: downward sloping demandcurve, rather inelastic
Monopolies
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Lower costsfor established firms, i.e. Economies of Scale
can achievesupernormalprofits
The fundamental causeof monopoly is barriers to entry.
Barriers to entry
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Legal Barriers to Entry: Competition and entry are restricted
by the concentration of ownership of anatural resourceor by
the granting of apublic franchise, government license,patent,
or copyright.
Example: Microsoft, railway, postal system.
Natural Barriers to Entry: Production technology allows
onefirm to meet the entire market demandat alower price
than two or more firms could.
Example: The monopoly hasthe control of akeyresource.
DeBeerscontrols about 80% of diamonds.

Natural Monopolies
Definition
William Baumol (1977): ”An industry in which multi-firm
production is more costly than production by a monopoly” (p.
810).
A natural monopoly could be the result of the high fixed costs or
startup costsof operating a business in aspecific industry,
e.g supply of electricity.
And/or extremely high fixed costsof distribution, suchasexist
when large-scale infrastructure is required to ensure supply.
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Regular vs Natural Monopolies
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What is the difference between aregular and anatural monopoly?
Average Total Cost (ATC) isflatter.
ATC minimized at a higher quantity.
A natural monopoly hasahigher advantagein cost.
Cost – Price
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Price is set when: MR = MC
Social optimum: D = MC
The natural monopoly can chargean evenhigher price than
the socialoptimum.
Rule of thumb: If D intersects ATC while it is still downward
sloping
Natural Monopoly, i.e. there is not enough demand
to justify another firm.

Monopoly
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Monopoly
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Monopoly
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Monopoly
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Monopoly
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Monopoly vs Perfect Competition
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Monopolies tend to
Produce less
For higher prices
Natural monopoly hasasignificant advantagein the
production of the good (e.g. control of a key resource).
Monopolies are inefficient in allocating production resources.
compared with prefect competition

Oligopoly
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Small number of large firms
Interdependenceof firms
Barriers to entry
Collusive oligopoly: Firms club together and behave like a
monopoly (informal or formal asa“cartel”)
Non-collusive oligopoly: Firms compete against eachother
Oligopoly
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The main reason oligopolies exist arebarriers to entry.
In many casesalargeinvestment is neededto start abusiness
Or the legal framework actsasabarrier.
Example: Oil companies (OPEC) needalargeinvestment to
start drilling.
Example: Google vsMicrosoft for office softwareapplication.
Collusive Oligopoly
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Only very few firms with power over the market
Firms areopen to each other
Similar products
Similar production methods and AC
Collusive Oligopoly
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There is adominant firm
Barriers to entry exist, thus little fearof disruption by new
firms
The market is stable
The governmentdoesnot intervene
Collusive oligopoly acts like a Monopoly
Collusive Oligopoly
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Non-Collusive Oligopoly
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Not many factors favouringcollusion
Breakdown of acollusive oligopoly
Gametheory: what is the best strategy?
Game Theory
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Game theory is ”the study of mathematical models of conflict
and cooperation between intelligent rational decision-makers”,
(Myerson, 1991)
We can use it to understand how firms decide what, how and
when.
If we reduce prices or produce more, what will the competitors
do?
Two players,decidewhat is their best strategy.
NashEquilibrium: Every player plays his best strategy.
Nash Equilibrium
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To find aNash Equilibrium you needto ask
Knowing the strategies of the other players, and treating the
strategies of the other playersasset in stone, can I benefit by
changing mystrategy?
If any playersanswerYESit is not aNashequilibrium as
they can chooseadifferent strategy and improve their
outcome.
If all playersanswer NO Nash Equilibrium
NashEquilibrium: Every player plays his best strategy.
Prisoner’s Dilemma
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Two people, Amelia and Bill, aresuspected of committing a
crime and arebeing interrogated in separate rooms.
Both want to minimize their jail sentences
Both of them facethe same scenario
They can chooseto blamethe other party or denythe crime
Prisoner’s Dilemma
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Player Amelia
Blame Deny
Player
Bill
Blame
Deny

5,5 10,0
0,10 1,1

Prisoner’s Dilemma
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Amelia’s beststrategy
Player
Amelia
Blame Deny
Player
Bill
Blame
Deny

5,5 10,0
0,10 1,1

Prisoner’s Dilemma
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Bill’s Best Strategy
Player
Amelia
Blame Deny
Player
Bill
Blame
Deny

5,5 10,0
0,10 1,1

Prisoner’s Dilemma
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Nash Equilibrium
Player
Amelia
Blame Deny
Player
Bill
Blame
Deny

-5,-5 10,0
0,10 1,1

Prisoner’s Dilemma
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Cooperation (denying the crime) rather than awar would
havebenefited bothplayers.
Even if they did collude both would still betempted to cheat
and cut sentences.
This type of gamesareknown asprisoner’s dilemma.
Non-Collusive Oligopoly
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Oligopoly
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Collusive Oligopolies tend to havethe samedisadvantages as
monopolies
And mayhaveevenlessscopefor economiesof scale
engagein morecostly advertising
However they havemore incentives for innovation than
monopolies
Non-price competition maylead to morechoice
Market Structures Compared
Table: Market Structures Compared

Product
Competition (approx.) is a price taker
Monopolistic A lot Almost Differentiated
Restaurants
Downward sloping,
Competition Unrestricted but relatively elastic
Oligopoly Few Restricted Either Oil, Downward sloping
broadband
Utilities,
train
Relatively inelastic
Downward sloping: more
inelastic than oligopoly.
Firm has considerable
control over price
Monopoly One Blocked Unique

 

Type # of
firms
Entry
Barrier
s
Nature of Example Implications
Perfect Many Unrestricted Homogeneous Cabbages Horizontal: firm

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Conclusion
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Review today’s lesson.
Readthe relevant chapters in the book (Ch. 14,15, and 16,
including all boxes and case studies)
Searchonline for moresources.
Ask questions in seminar if anything isunclear.
Do self-test questions at the endof the chapter and online.
Thank youfor your attention.
Questions?
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