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 firms point of
view)

Rivalry among existing companies in an industry

Customers
Suppliers
Potential entrants
Substitute products

These forces define industrys 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 firms 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 firms 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
= 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 firms 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!!!!

Monopolys 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/P (called Lerner index)
P = [1/(1 + 1/P)]*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 P < - 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)