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Introduction to Economics
Module III: THE MARKET STRUCTURE
LESSON OBJECTIVES:
At the end of the lesson, the student is expected to:
1. describe a pure/perfectly competitive market structure; and
2. describe pricing and quantity decisions of a pure/perfectly competitive firm.
P1 D = MR
D
Q Q
Pc Firm Pc Industry (Market)
ATC
P1 A
MR
B C
O Q1
At that point, we derive that the Pc firm would produce up to Q1 if it wants to
maximize profit. What is the size of this extraordinary profit? Pi ACB where the Pc firm is
making profits in excess of all costs (i.e., as long as the price level Pi is above ATC).
Figure 1.3
P
MC
ATC
P1
MR
In figure 1.3, the Pc firm is still maximizing profit but it is just covering all costs. In
this situation, MC = MR = Price = ATC. In Figure 1.4, the Pc firm is still maximizing
profit. But this time, it gets normal, not extraordinary, profits. Sometimes, this situation is
called the minimum loss (shaded area) level of production, P1 = MR = MC = AVC, as
long as P1 is equal to the lowest level of the AVC.
Figure 1.4
P
MC
ATC
P1
MR
Q
If the market price level still decreases further, below AVC level, our Pc firm should
cease production - a shutdown situation. 1.3 Short-Run Competitive Equilibrium of
the Pc Firm. A purely competitive market is in short-run equilibrium when the individual
Pc firms are maximizing profits so that MC = MR = Price. Within the short-run time
period, no new sellers enter into the market, so that quantity demanded is equal to
quantity supplied (Qd = Q8), on an industry viewpoint.
If the Pc firm's AVC < industry price, profit > 0.
If the Pc firm's AVC = industry price, profit = 0.
If the Pc firm's AVC > industry price, profit < 0.
We have discussed above how a firm in a single price system, like the purely
competitive structure, estimate an output level that would maximize its profit or minimize
its loss. The size of the Pc firm's profit would depend on the market (or industry) price
level touching the cost levels of the Pc firm. Because of the profit motive, new entrants
into the industry are attracted. With the increase in supply (Figure 1.5) the industry
supply curve shifts to the right (from S1 to S2). This results in a decrease in the industry
price (from P to P2) so that the already existing P firm's profit margin is consequently
sliced, too.
Figure 1.5
P P
S1 S2 MC
ATC
P1 D1 = MR 1
AVC
P1 D2 = MR 2
D
Q Q
Pc Industry Pc Firm
ECONOMICS 1A, Module 3, Lesson 1
SELF-PROGRESS CHECK TEST
LESSON OBJECTIVES:
At the end of the lesson, the student is expected to:
1. describe a pure monopoly market structure; and
2. describe pricing and quantity decisions of a pure monopoly.
In the previous lesson, we have analyzed how a price-taken, like the purely
competitive (Pc) firm, reacts to certain market situations as new entrants into the same
industry press down prices due to excessive supply.
In today's lesson, let's look into the other extreme case - the monopoly model.
P1 A
B C
D=P
Q
Q1 Q2 MR
This implies that in order to sell a larger quantity (Q1 to Q2), the monopolistic must
lower the price (P 1 to P2) on all units of the good. While it is true that the reduction in
price increases sales volume, the marginal revenue at this point would be less than its
price (MR < price).
Let us refer to the table below (Table 2.1) to illustrate this point.
Table 2.1: Hypothetical Data of a Pure Monopolist
Price Quantity Total Revenue Marginal Revenue
P8 1 P8 8
7 2 14 6
6 3 18 4
5 4 20 2
Price Discrimination
One of the profit-maximizing strategies of a monopolized industry is price
discrimination (unlike in the Pc firm which adopts a single price system). Price
discrimination occurs when a producer sells a specific commodity to different buyers at
two or more different prices, for reasons not associated with differences in cost. Here,
the monopolist separates the market and charges different prices for the product in
each market.
However, price discrimination is only possible where the supplier(s) can control the
amount and distribution of supply and where the buyers can be separated into classes
among which resale is not possible or is very costly. The fact that consumers have
differences in income and in taste would lead us to predict that different subgroups
would have different elasticities of demand for a given commodity.
Let us illustrate the above concept.
Movie theaters charge different prices although they see the same movies.
Orchestra tickets are paid lowest rate, followed by balcony tickets. Lodge tickets are
charged the highest rate. The difference in charges is on the basis of location of the
moviegoers.
Lawyers and physicians charge service fees on the basis of their client's ability to
pay. The more affluent clients can be charged more than the less affluent.
Prices will be higher where demand is inelastic. When markets can be segregated,
profits can be increased. The Pm will maximize profits by equating marginal cost and
marginal revenue (MC = MR) in each of the markets. The prices will depend upon the
elasticity of demand in each market. The higher the elasticity, the lower the price in a
market. Segmenting the different income groups, for example, Magnolia Ice Cream has
introduced 3 types of ice cream: the Gold Label Ice Cream (for those who have "very
discriminating taste"), the Special Flavors of the Month and the Regular Flavors. The
first classification has the highest market price. Its target clientele belong to the high-
income group. The second classification targets the middle-income households; and the
third type's price level tries to attract the ice cream "needs" of the lower-middle income
groups.
In the above argument, price discrimination is possible and profitable. But why
should a monopolist discriminate his pricing structure? Let us recall that the marginal
revenue (MR) of the monopolist is always less than the Price = Demand (P = D) level
because of the lower price that the Pm firm is forced to charge for the units previously
saleable at a higher price. Through price discrimination, this reduction in price is not
necessary and the affecting loss in revenue is not experienced.
P MC
B
A
Z
P1
MR
Q
Q1
Evils of Monopoly
Why are monopolies unpopular? Nobody wants the existence of monopolies.
Inasmuch as the monopolist is a price-giver and a sole supplier of a good/commodity,
he has the capacity or tendency to restrict or manipulate quantity in order to maximize
profit. Secondly, there is a possibility of degeneration of quality in of a quality of good or
service. Since the monopolist may not have any competitive spirit, there is no real
motivation for product improvement.
But there are necessary monopolies. There are industries which have relatively large
or high fixed cost inherent to technology. Examples of these are privately owned
electrical power firms, telephone companies, and natural water firms. Their MC and
ATC do not meet with a short term (Figure 2.3). Hence, entry of new firms is blocked.
Figure 2.3
ATC
To allow competition here would mean only a shift in the demand curve to the left, so
that prices would decrease. Each producer would be operating at very low capacity and,
therefore, at a very high average cost. If this situation happens, there would be a
tremendous waste of resources. Nevertheless, the National Government, through the
Board of Investments, checks on the overcrowding of industries, blocks the entry on
new firms to engage in necessary monopolies, and limits the rate of return (or profit) of
existing monopolies.
ECONOMICS 1A, Module 3, Lesson 2
SELF-PROGRESS CHECK TEST
LESSON OBJECTIVES:
At the end of the lesson, the student is expected to:
1. describe a "monopolistic competition" market structure; and
2. describe pricing and quantity decisions of a monopolistic firm.
MR
Q
Short-run Equilibrium of an Mc Firm
Equilibrium will occur when all firms of the same product line are simultaneously in
equilibrium. To maximize profit, each Mc firm would select quantity levels (Qmc) for
which its MR = MC. In the short run, a firm attains equilibrium when it continues to
produce as long as the industry price exceeds its average variable cost (Pmc > AVC).
Figure 3.2
P
MC
AVC
Pmc
MR
Q
Qmc
ECONOMICS 1A, Module 3, Lesson 3
SELF-PROGRESS CHECK TEST
LESSON OBJECTIVES:
At the end of the lesson, the student is expected to:
1. describe an "Oligopoly" market structure; and
2. describe pricing and quantity decisions of an oligopolist.
In the previous lessons, we have seen how market power can be subjected to price-
takers and price-givers. Another shade of imperfect competition, aside from
monopolistic competition, is the oligopoly structure.
Assumptions of an Oligopoly
An oligopoly is a market structure where there are few sellers of a commodity
(competing within a given industry). Actions of each seller will affect the other sellers.
They are subject to enough rivalry that they cannot consider the market demand curve
as their own.
The following are the assumptions of an oligopoly type of market organization.
1. There are only a few sellers in the market. The action of one seller has an
effect upon the other sellers.
2. Products may be standardized (or homogeneous just like in pure competition)
or differentiated (just like in monopolistic competition).
3. There are some barriers to entry into the market.
4. There is perfect knowledge concerning prices and quantities 5. There is
mobility of factors of production.
D1
Q
Thus, the demand curve (Di) is elastic in shape. However, if our oligopolist
decreases his price to capture a bigger share of the market, there is a bigger possibility
that the other oligarchs would follow him, or they lose their clients. Thus, the demand
curve, at times, becomes inelastic in shape (D2). Because of the above situation, the
resulting demand curve of the oligopolist is kinked in shape at the existing market price.
Consequently, the marginal revenue curve (MR) of the oligopolist becomes
truncated (Figure 4.2) below the demand curve corresponding to the latter's kink. The
gap in the MR curve implies that marginal revenue is different when rival firms match
price cuts than when they don't. It takes a larger price cut to increase output by a given
amount when rival firms march price cuts.
Figure 4.2
D
MR
P
Short-run Equilibrium of the Oligopolist
Because of the gap in MR curve, prices may be stable even if costs change. A firm
has no reason to change its price if marginal cost shifts (MCI to MC2) are confined within
the gap (area of truncation) in the MR curve (Figure 4.3). Prices may remain stable over
extended periods in spite of changes in the MC and AVC. Within this gap, therefore, MC
= MR, a condition at which profit is maximized. The oligopolist has achieved its
equilibrium.
Figure 4.3
P
MC1
D
MR
With the above discussion, we end our study of Microeconomics and look forward to
Module 4.
Lesson 1
Test I.
1. c 4. a 7. b
2. g 5. d
3. e 6. f
Test II.
1. True 5. False 9. True
2. True 6. True 10. True
3. False 7. True 11. False
4. False 8. True 12. True
Test III.
1. d 8. c 15. c
2. d 9. a 16. d
3. a 10. a 17. c
4. d 11. d 18. b
5. c 12. c 19. d
6. c 13. b 20. d
7. c 14. a
Lesson 2
Test I.
1. f 5. b 9. h
2. c 6. a 10. j
3. g 7. d
4. e 8. i
Test II.
1. True 5. False 9. True
2. False 6. True 10. True
3. True 7. True
4. True 8. False
7. a 15. a
Test III. 8. b 16. c
1. d 9. a 17. b
2. c 10. b 18. a
3. d 11. b 19. b
4. d 12. a 20. d
5. b 13. d
6. d 14. a
Lesson 3
1. b 6. b 11. b
2. c 7. b 12. c
3. d 8. a 13. c
4. b 9. d 14. c
5. a 10. d 15. d
Lesson 4
1. b 6. c 11. b
2. c 7. d 12. d
3. b 8. c 13. a
4. d 9. c 14. b
5. d 10. a 15. b