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MARKET STRUCTURE

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 Chapter 7
MARKET STRUCTURE
Ezenekwe, R. Uju & Uzonwanne, M. Chinecherem
7.1 The Concept of Market Structure
The concept of market structure is a tool for providing some framework to the theories investigating
the market situations. The commonest three elements of market structure had been deposited by
economists as the number, size, and size distribution of sellers and buyers, the degree of product
differentiation, and the conditions of entry into the market. The setting or "place of competition to the
firm" is called "market structure." The market structure is the setting in which the enterprise receives
competitive 'discipline' or through which the rule of competition is made effective. Therefore, one can
say that market structure involves the important, small number of strategic environmental factors
affecting al] basic decisions of the firm. The concept of market structure is included in the broader
concept of the environment of the enterprise. The environment of enterprise can be viewed in three
overlapping parts:
1. The general environment or institutional setting (institutional environment)
2. The economic basic conditions (basic conditions) and
3. The specific environment which hears so directly upon the enterprise that it affects all
important decisions (market structure).
Firms sell goods and services under different market conditions, which is generally referred to as
market structures. A market structure describes the key traits of a market, including the number of
firms, the similarity of the products they sell, and the ease of entry info and exit from the market. The
business sector of an economy is constituted by firms operating in different market structures. The four
major market structures are Perfect competition, Monopoly, Monopolistic competition and Oligopoly.
Others are Duopoly and Monopsony.
7.1.1 Perfect competition
Perfect competition is a market structure where an infinitely large number of buyers and sellers operate
freely and sell a homogeneous commodity at a uniform price. It has the features of unlimited
contestability (no barriers to entry), unlimited number of producers and consumers, and a perfect elastic
demand curve.
Major Characteristics of Perfect Competition
a. Large number of buyers and sellers - There is a very large number of buyers and sellers as
no individual can influence the market price. When the number of firm is high, each firm or seller in a
perfectly competitive market forms an insignificant part of the market. Hence, each firm in the market
has no significant share of total output and, therefore, no ability to affect the product's price. Each firm
acts independently, rather than coordinating decisions collectively. For example, assume there are
thousands of independent tyre manufacturers in the Nigeria. If any single manufacturer raises the price,
the going or general market price for tyre will remain unaffected. The question becomes, who
determines the price in such a market? In a perfectly competitive market, it is the forces of market
demand and market supply that determines the price of the commodity. Since each firm accepts the
price that is determined by the market, it becomes a Price-taker. As the market determines the Price, it
is the Price-maker.
b. Homogenous Product - In a perfectly competitive marker, all firms produce a standardized or
homogenous product. Homogenous products are those that are identical in all respects, that is, there is
no difference in packaging, quality, colours etc. As the output of one firm is exactly the same as the
output of all others in the market, the products of all firms are perfect substitute for each other. This
assumption rules out rivalry among firms in advertising and quality differences.
c. Free Entry and Exit - Very easy entry into a market means that a new firm faces no barriers
to entry. Barriers can be financial, technical, or government-imposed barriers, such as licenses permits,
and patents. The implication of this feature is that while in the short run, firms can make either
supernormal profits or losses, but in the long run all firms in market earn only normal profits.
d. Perfect Knowledge of Market - Buyers and sellers have complete and perfect knowledge
about the product and prices of other sellers. This feature ensures that the market achieves a uniform
price level.
e. Perfect Mobility of Factors Production- The factors of production are free to move from one
firm to another throughout the economy. It is also assumed that workers can move between different
jobs, which imply that skills can be learned easily. Hence, there is perfect competition in the markets
of factors of production.
In conclusion. Perfect competition requires that resources be completely mobile to freely enter or exit
a market. No real-world market exactly fits the five assumptions of perfect competition. The perfectly
competitive market structure is a theoretical or ideal model, although some actual markets do
approximate the model fairly closely. Examples include farm products markets, the stock market, and
the foreign exchange market.

Market Price under Perfect Competition

In a perfectly competitive industry, market price is determined by the intersection of the demand and
supply curves. The market demand curve shows the total amount that individual buyers of the
commodity will purchase at any price; the market supply shows the total amount that individual
suppliers of the commodity will supply at any price.
The figure above shows the market demand and supply curves for a good produced in a perfectly
competitive market. As is ordinarily the case, the market supply curve (S) slopes upward to the right.
That is, increases in price generally result in higher industry output because firms find it profitable to
expand production. Similarly, the market demand curve (D) slopes downward to the right. That is,
increases in price generally result in less of the product being demanded. The equilibrium price (P*)
prevailing in the market will therefore be determined where the market supply equates market demand.

The Output Decision of a Perfectly Competitive Firm

As a purely competitive firm is a price taker, it can maximise its economic profit (or minimize its loss)
only by adjusting its output. In the short run, the firm has a fixed factor of production. Thus, it can
adjust its output only through changes in the amount of variable resources it uses. The firm adjusts its
variable resources to achieve the output level that maximizes its profit.
There are two ways to determine the level of output at which a competitive firm will realize maximum
profit or minimum loss. One method is to compare total revenue and total cost, the other is to compare
marginal revenue and marginal cost. Both approaches apply to all firms whether they are pure
competitors, pure monopolists, Oligopolists.
Profit Maximization in the Short Run: Total Revenue – Total Cost Approach
The firm is in equilibrium when it maximizes its profits defined as the difference between total cost
and total revenue: II = TR - TC.
The firm is in equilibrium when it produces the output that maximizes the difference between total
revenue and total costs.

Figure II represents the total revenue and the total cost curves of a firm in a perfectly competitive
market. The total revenue curve is a straight line through the origin showing that the price is constant
at all levels of output. The firm is a price-taker and can sell any amount of output at the going market
price, with its TR increasing proportionately with its sales. The slope of the TR curve is the marginal
revenue. It is constant and equal to the prevailing market price, since all units are sold at the same
price. Thus in pure competition MR = AR = P.
The firm maximises its profit at the output level X0, where the distance between the TR and TC is the
greatest. At lower and higher level of output, total profit is not maximised: at level smaller than X1 and
larger than X2 the firm has losses.
Profit Maximization in the Short-Run: Marginal Revenue-Marginal Cost Approach
In the second approach, the firm compares the amounts that each additional unit of output would add
to total revenue and to total cost. In other words, the firm compares the marginal revenue (MR) and
the marginal cost (MC) of each successive unit of output. Assuming that producing is preferable to
shutting down, the firm should produce any unit of output whose marginal revenue exceeds its marginal
cost because the firm would gain more in revenue from selling that unit than it would add to its costs
by producing it. Conversely, if the marginal cost of a unit of output exceeds its marginal revenue, the
firm should not produce that unit. Producing it would add more to costs than to revenue and profit
would decline or loss would increase.
In summary, (a) If MC < MR, total profit has not been maximised and it pays the firm to expand its
output.
(b) If MC > MR, the level of total profit is being reduced and it pays the firm to cut its
production.
(c) If MC - MR, short run profits are maximised.
In figure III below, the first condition of MC - MR is satisfied at point e1 although the firm is not in
equilibrium. The second condition for equilibrium requires that the MC be rising at the point of its
intersection with the MR curve. This means that the MC must cut the MR curve from its minimum
point (from below).

The slope of MC is positive at point e, while the slope of the MR curve is zero at all levels of output.
Thus at point e, both conditions for equilibrium are satisfied. Again, the MC is always positive because
the firm must spend some money in order to produce an additional unit of output. Thus at equilibrium,
the MR is also positive.
Long-Run Equilibrium for a Perfectly Competitive Firm
In the long run, a firm can change its plant size or any input used to produce a product. This means
that an established firm can decide to leave an industry if it earns below normal profits (negative
economic profits) and that new firms may enter an industry if the earnings of established firms exceed
normal profits (positive economic profits).
This process of entry and exit of firms is the key to long-run equilibrium. If there are economic profits,
new firms enter the industry and shift the short run supply curve to the right. This increase in short-run
supply causes the price to fall until economic profits reach zero in the long run. On the other hand, if there
are economic losses in an industry, existing firms leave, causing the short-run supply curve to shift to the
left, and the price rises. This adjustment continues until economic losses are eliminated and economic
profits equal zero in the long run.
Figure IV below shows a typical firm in long-run equilibrium, Supply and demand for the market as a
whole set the equilibrium price. Thus, in the long run, the firm faces an equilibrium price P*. Following
the MR-MC rule, the firm produces an equilibrium output of N* units per hour. At this output level,
the firm earns a normal profit (zero economic profit) because marginal revenue (price) equals the
minimum point on both the short-run average total cost (SRATC) curve and the long-inn average cost
(LRAC) curve. Given the U-shaped LRAC curve, the firm is producing with the optimal factory size.

Long-run equilibrium occurs at point E. In the long run, the firm earns a normal profit. The
firm operates where the price equals the minimum point on its long run average cost curve. At
this point, the short-run marginal cost curve intersects both the short-run average total cost
curve and the long run average cost curve at their minimum points.
With SRMC representing short-run marginal cost, the conditions for long run perfectly competitive
equilibrium can also be expressed as equality:
P – MR - SRMC - SRATC - LRAC
As long as none of the variables in the above formula changes, there is no reason for a perfectly
competitive firm to change its output level, factory size, or any aspect of its operation. Everything is
just right! Because the typical firm is in a state of equilibrium, the industry is also at rest. Under long-
run equilibrium conditions, there are neither positive economic profits to attract new firms to enter the
industry nor negative economic profits to force existing firms to leave. In long-run equilibrium,
maximum efficiency is achieved. The adjustment process of firms moving into or out of the industry
is complete, and the firms charge the lowest possible price to consumers.
7.1.2 Monopoly
Monopoly is the form of market organization in which there is a single seller of a commodity for which
there are no close substitutes. Thus, it is at the opposite extreme from perfect competition as a pure
monopoly exists when a single firm is the sole-producer of a product.

Major Characteristics/Features of Monopoly

a. A Single Seller - There is only one producer of a product. It may be due to some natural
conditions prevailing in the market, or may be due to some legal restriction in the form of patents,
copyright, sole dealership, stale monopoly, etc. Since, there is only one seller; any change in supply
plans of that seller can have substantial influence over the market price. That is why a Monopolist is
called a Price Maker. Again, a Monopolist's influence on the market price is not total as price is
determined by the forces of demand and supply while the Monopolist solely controls the supply.
b. Products without substitute - The commodity sold by (he Monopolist has no close substitute
available for it. Therefore, if a consumer does not want the commodity at a particular price, the
likelihood of getting closely or similar product may not be possible. Therefore, the elasticity of demand
for the products sold by a monopolist is relatively inelastic.
c. Restriction of entry for new firms - There are barriers to entry into industry for the new firms.
It may be due to the ownership of strategic raw material or exclusive knowledge of production, patent
rights or government licensing. The implication of barriers to entry is that in the short run, monopolist
may earn supernormal profit or losses. However, in the long run, barriers to entry ensure that a
monopolistic firm earns only super normal profits.
d. Price Discrimination - Price Discrimination exists when the same product is sold at different
price to different buyers. A monopolist practices price discrimination to maximize profits. For example
electricity charges in Nigeria are different for domestic users and commercial and industrial users.
e. Limited Consumer Choice - As the firm is the single producer of the commodity, in the
absence of any close substitute, the choice for consumer is limited.
f. Price in Excess of Marginal Cost - Monopolists fix the price of a commodity (per unit) higher
than the cost of producing one additional unit as they have absolute control over price determination.

Sources of Monopoly Power (Barriers to Entry)

i. Existence of large economies of scale - Economies of scale is the major barrier to entry. This
occurs where the lowest unit cost and low unit prices for consumers depend on the existence
of a small number of large firms, or in the case of monopoly, only one firm with a large market
share is most efficient. In summary, one firm can provide a lower price than two or more firms.
ii. Patent Law - Legal barriers exist in the form of patents and licenses granted to newly invented
products or to radio and TV stations.
iii. Sole ownership of a resource - Ownership or control of essential resources is another barrier
to entry. An example of this is the case of professional sports leagues that control player
contracts and leases on major city stadiums.
iv. Others are limited size of the market, import restrictions and formation of a cartel e.g. OPEC

Pricing and Output Decisions under Monopoly

The demand curve of a monopolist is different from that of the pure competitor. This is because the
monopolist is the industry; its demand curve is the market demand curve. Again, because the market
demand is not perfectly elastic, the monopolist's demand curve is down-sloping. An unregulated
monopolist maximises profit by choosing the price and output where the difference between total
revenue and cost is the largest. Under monopoly just as perfect competition, the firm maximises profit
if it sets the output rate at the point where marginal eost equates marginal revenue. Hence, a monopolist
can set a fairly high price, as it has no competitors to drive down price. . .

The curve above is the demand (D), marginal revenue (MR), average total cost (ATC) and marginal
cost {MC) of a profit maximising monopolist. The profit maximising output occurs at point Q* where
the marginal revenue (MR) and marginal cost (MC) curves intersect. At that point, MR - MC. The
profit maximising price and quantity for the firm is given by points P and Q* respectively. The firm's
product price lies above the average total cost, implying economic profit maximization for the firm.
Thus, per unit profit is P - A, where A is the average total cost of producing Q* units of output. The
economic profit is therefore determined by multiplying per unit profit by the profit maximising output
Q*. - .

Price Discrimination

Price discrimination is the practice of selling a specific product al more than one price when the price
differences are not justified by cost differences. A monopolist charges a single price to all buyers. But
under certain conditions, the monopolist can increase its profit by charging different prices to different
buyers. In doing so, the monopolist is engaging in price discrirnination. Price discrimination can take
three forms;
a. Charging each customer in a single market the maximum price he or she is willing to pay-
b. Charging each customer one price for the first set of units purchased and a lower price for
subsequent units purchased.
c. Charging some customers' one price and others another price.
It is important to note that price discrimination is possible only when the seller has a monopoly power,
where there is market segregation or when the original purchaser cannot resell a product or service.
7.1,3 Monopolistic Competition
A monopolistic competition refers to a market structure with a relatively large number of sellers
offering similar but not identical products. Monopolistic competition is a situation in which the market,
basically, is a competitive market but has some elements of a monopoly. In this form of market there
are many firms that sell closely differentiated products. Therefore, a monopolistic competition is a
market structure in which no cooperation occurs among the many sellers. Examples of this form of
market are mobiles, cosmetics, detergents, toothpastes, fast food restaurants, clothing stores, etc.
The following characteristics of monopolistic competition borrow from both the competitive market
structure and (he monopoly market structure:
a. Product differentiation - Monopolistic competitors produce heterogeneous or differentiated
products. This means that the products are the same though brands sold by different firms may differ
in terms of packaging, size, colour features etc. The importance of product differentiations is to create
an image in the minds of the buyers that the product sold by one seller is different from that sold by
another seller. Products are very similar to each other, but not identical. This allows substitution of she
product of one firm with that of another. Due to a large number of substitutes being available, demand
for a firm's product is relatively elastic.
b. Many buyers and sellers - Similar to the perfect competition, monopolistic competition has many
buyers and sellers in the market although the number of sellers is not as large as that under perfect
competition. Therefore, each firm has the ability to alter or influence the price of the product it sells to
some extent. They also have a relatively small market share in comparison to a monopolist withlOO
percent market share.
e. Reduced likelihood of minimizing cost -Firms may have an incentive to produce goods and services
that are "over the top" or differentiated. They will therefore incur high production costs such as
advertisements, sale promotions, warranties, customer services, packaging, colours and brand creation.
d. Fr«e Entry and Exit of Firms - Like perfect competition, free entry and exit of firms is possible under
this market form. Since there are no barriers to entry and exit, firms operating under Monopolistic
Competition, in the long run, earn only normal profits.
e. Price setters - Each firm has its own demand curve and is A price setter (rather than a price taker).
In a sense, each firm has its own market. Thus, the price for a good or service is set higher than it would
be if the market was perfectly competitive. Under monopolistic competition, brand loyalty is essential.
If consumer loyalty is high, the seller has the ability to increase prices without the risk of losing its entire
customer base. For example, many (but definitely not all) patients have long-standing relationships with
their physicians. The personal lies between patients and physicians give providers monopolist] call y
competitive power.
A monopoUstically competitive firm can earn a profit in the shorl run. Higher profit levels lead to
more providers entering the market to try to reap some of the potential profit, and existing providers
further differentiating their products to attract more customers.
Price and Output Decisions under Monopolistic Competition
In monopolistic competition, each firm in the industry is assumed to be producing a specific
differentiated product and hence, the demand curve facing each firm will slope downward to the right.
That is, if the firm raises its price slightly, it will lose some, but by no means ail its customers to its
rivals. The reverse will abo be the case if the firm lowers its price slightly.
Quantity
Figure VI: Equilibrium in the short
Quantity
Figure VII: Equilibrium in the
Fig VI shows the short-run equilibrium of a monopolistically competitive firm. The firm in the short-
run will set its price at PO arid its quantity at QO since this combination of price and output maximises
its profit given the marginalist condition. Economic profits are earned because price, PO exceeds
average tola! cost, CO given the quantity of output.
Fig VII shows the long-run equilibrium of ihc firm. One condition for long-run equilibrium is that each
firm makes no economic profits or losses since entry or exit of firms occur. Another condition for long-
run equilibrium is that each firm maximise its profits. The equilibrium maximising price and quantity
for the firm in the long-run is depicted by PI and QI. The zero economic profit condition is met at this
combination of price and output since the firm's average cost at this output equals the price, PI. The
profit maximisation is therefore met sine the marginal revenue curve intersects the marginal cost curve
at the level of output.

7.1.4 Oligopoly

The term Oligopoly means 'Few Sellers'. An Oligopoly is an industry composed of only few firms, or
a small number of large firms producing bulk of its output. In other words, oligopoly exits where few
large firms producing a homogeneous or differentiated product dominate a market. Since, the industry
comprises only a few firms, or a few large firms, any change in Price and Output by an individual firm
is likely to influence the profits and output of the rival firms. Automobile and gasoline industries, major
soft drink firms, airlines and milk firms can be cited as an example of Oligopoly.
Features of Oligopoly
a. A Few firms - Oligopoly as an industry is composed of few firms, or a few large firms controlling
bulk of its output. In other words, it is a market structure that consists of a few dominant sellers.
b. Interdependence - Each firm in oligopoly market carefully considers how its actions will affect its
rivals and how its rivals are likely to react. Any change in price and output by one firm lias a direct
effect on the profits of the other firms. Hence, if one firm makes a change, the other Firms also change
their price and output. Simply put, the firms under oligopoly market structure are interdependent.
c. Barriers to the Entry of Firms - The main cause of a limited number of firms in oligopoly is the
barriers to the entry of firms. One barrier is that a new firm may require huge capital to enter the
industry. Patent lights are another barrier.
d, Non Price Competition -When there are only a few firms, tliey are normally afraid of competing
with each other by lowering the prices; it may start a Price War and the firm who starts the price war
was may ultimately loose. To avoid price war, the firm uses other ways of competition like: Customer
Care, Advertising, Free Gifts etc. Such a competition is called non-price competition.
e. Reliance on advertising -Firms must spend a considerable amount on advertisements and other
promotional measures to gain market share. Under perfect competition and monopoly, large
expenditures on marketing are not necessary.
f. Demand uncertainty -Mutual interdependence creates uncertainty for all of the firms. As a result,
estimating the quantity demanded at different price levels is extremely difficult.
g. Product differentiation -When firms produce slightly different products and that differentiation
can be discerned by consumers, each firm behaves as a monopolist in terms of price setting and output
determination. Each provider offers a different experience. Differences between providers include (but
are not limited to) technology, human interaction, and diagnostic capabilities.
h. Sticky prices -Under an oligopoly structure, prices tend to be fairly "sticky" (meaning prices do not
budge). If any firm reduces its price (in an attempt to gain market share), its rival firms immediately
make the same price cut. Then, all firms have reduced profits. Hence, prices remain fairly stable and
higher than they would be in a perfectly competitive situation.

Collusive and Competitive Oligopoly

Collusive oligopoly arises when few firms of the oligopolist market come to a common understanding
or act in collusion with each other in fixing price and outpm. While competitive oligopoly is an absence
of such undeistanding among the firms and they compete with each other.
Conditions for successful collusion
a. Small number of firms
b. Similar production methods
c. Homogeneous products
d. Significant barriers to entry
e. Stable market
f. No government intervention. Example, Competition Policy

Price Leadership Model

Another form.of collusion is price leadership. In this form of coordinated behaviour of Oligopolists,
one firm sets the price and the others follow it because it is advantageous to them or because they
prefer to avoid uncertainty about competitors' reactions even if this implies departure of the followers
from their profit maximising position. Price leadership entails a type <_•: implicit understanding by
which Oligopolists can coordinate prices wifhout engaging in .Outright collusion based on formal
agreements and secret meetings. This means that price leadership may be practiced either by explicit
agreement or informally. In nearly all cases, price leadership is tacit since open agreements are illegal
in most countries. Therefore, a practice evolves whereby the dominant firm (usually the largest or most
efficient in the industry) initiates price changes and all other firms more or less automatically follow
the leader. Many industries including cement, steel, beer, and tin are practicing or hiive In the past
practiced price leadership.
An examination of price leadership suggests that the price leader is likely to observe the following
tactics
a. Rigid price or infrequent price changes.
b. Communications
c. Limit pricing.
Price and Output Decisions in an Oligopolistic Market without Collusion Due to interdependence, an
oligopolistic firm cannot assume that its rival firm will keep their prices and quantities constant when
it makes changes in its price or quantity. When an oligopolistic firm changes its price, its rival firms
will retaliate or react and change their prices which in turn would affect the demand of the former firm.
Therefore, an oligopolistic firm cannot have sure and definite demand curve since it keeps shifting as
the rivals change their prices in reaction to the price changes by it. Hence, when an Oligopolist does
not know Ins demand curve or the price and output to fix, he cannot ascertain that by economic
 analysis. However, economists have established a number of price output models for oligopoly market
depending upon the behaviour pattern of other firms in the market.
The oligopolistic prices are assumed to be slieky and hence the kink demand curve. The demand curve
of an Oligopolist has a kink reflecting the following behavioural pattern.
a. If the entrepreneur reduces his price, he expects that his competitors will follow suit, matching the
price cut so that, although the demand in the market increases, the shares of competitors will remain
unchanged. This gives rise to the inelastic'demand curve (PD) below the kink (P).
b. The entrepreneur expects that his competitors will not follow him if he increases his price, so that
he will lose a considerable part of his customers. This therefore is depicted by the upper section of the
kink-demand curve (KP) which has a higher price elasticity.

MR
Figure VIII: Kink-Demand curve of an Oligopolist
The marginal revenue curve corresponding to this kinked demand curve is composed of two
discontinuous dotted line segments. Now, assume that the prevailing price in the market is NPo, that
is, the height of the kink curve. If the Oligopolist's marginal cost is given by the curve labeled MC,
then the most profitable output and price clearly occurs at the point of the kink. Since the MR curve is
discontinuous at N, we cannot say that MR - MC. However, little marginal analysis makes it clear that
the profit-maximizing output is N and any deviation from N reduces profit. We should mote that even
though cost may change substantially as repifesented by MC1 or MC2, the optimal output does not
change. The besi price still remains at the height of the Kink. The way Oligopolist perceives the nature
of their mutual independence is reflected in their pricing behaviour.
Revision Questions
1. What is a market? Explain the difference between a perfect competition and a monopoly
2. What is monopolistic competition? Illustrate with the aid of a diagram the profit maximizing position
of a monopolistically firm.
3. What is the different between collusive and competitive market? What are the conditions for
successful collusion?
4. Enumerate and explain the features of oligopolistic market

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