Market Structures

Q1. What do you mean by market structures? Explain its characteristics.

Ans. The concept of a market is central to the understanding of the determination of price and quantity
of output of a commodity under consideration. In ordinary language, the term market refers to a public
place in which goods and services are bought and sold. In economics, it has a different meaning.
Different economists have tried to define market in different ways.

Cournot defines market as, “not any particular market place in which things are bought and sold, but the
whole of any region in which buyers and sellers are in such free intercourse with each other that the
prices of the same goods tend to equality easily and quickly”.

To Ely, “Market means the general field within which, the force determining the price of particular
product operate”. Stonier and Hague explain the term market as “any organisation whereby buyers and
sellers of a good are kept in close touch with each other”.

Thus a market has the following basic components.

– BUYERS: There should be buyers of the product. If a country consists of people who are very poor,
there can hardly be market for luxuries like cars, VCR etc.

– SELLER: A commodity should be offered for sale in the market. Otherwise there is no question of
buying the commodity. Therefore, existence of sellers is a necessity for any market.

– CONTACT: Buyers and sellers should have close contact with each other.

– PRICE: There should be a price for the commodity.

The exchange of commodities between buyers and sellers occurs at a particular price which is mutually
agreeable to both the buyers and sellers. This is because, in a modern economy, most of the production
does not take place for self-consumption by the producers themselves. Thus, by the term market of a
good, it should not be taken to mean a place where the buyers and sellers meet each other and conduct
purchase and sale transactions.

The market consists of two components;

– A Firm

– An Industry

A firm is a business unit engaged in the task of producing and selling of goods or services. It is identified
by the fact that it is only one unit of entrepreneurship. The entrepreneurship may not be provided by a
single individual. It may be exercised jointly by a board or a group of individuals in some defined
manner. However, the firm has a unified and coordinated authority of decision making. In essence,
these decisions relate to the objectives (such as, profit maximisation, or sales maximisation, etc.) and
other policy decisions (such as, what to produce) of the business unit.

An industry is a set of firms which are conceptually closely associated in the sense of having some
common type(s) of activities. A good example of an industry is a set of firms which are producing a
certain type of a manufactured good or providing a certain type of service. The good supplied by the
firms of the industry may be homogenous in the sense that the buyers believe that products of all firms
are perfect substitutes of each other.

There is no pre-determined number of firms which an industry must have. Their number can vary
according to the structure of the market. At one extreme, it may have only one firm in which case it is
called a monopoly or a one-firm industry. At the other extreme, an industry may have such a large
number of firms that each of them accounts for an extremely small portion of the total supply of the
industry and is not able to influence the price of the product. Between these two extremes, there can
be several other possibilities. There are various kinds of markets prevailing in the economy.

– PERFECT COMPETITION

– MONOPOLY

– MONOPOLISTIC COMPETITION

– OLIGOPOLY

In economics, market structure is the number of firms producing identical products

which are homogeneous. The types of market structures include the following:

1. Monopolistic competition, also called competitive market, where there is a large

number of firms, each having a small proportion of the market share and slightly
differentiated products.

2. Oligopoly, in which a market is by a small number of firms that together control the
majority of the market share.

3. Duopoly, a special case of an oligopoly with two firms.

4. Monopsony, when there is only one buyer in a market.

5. Oligopsony, a market in which many sellers can be present but meet only a few
buyers.

6. Monopoly, in which there is only one provider of a product or service.

7. Natural monopoly, a monopoly in which economies of scale cause efficiency to

increase continuously with the size of the firm. A firm is a natural monopoly if it is
able to serve the entire market demand at a lower cost than any combination of two
or more smaller, more specialized firms.

8. Perfect competition, a theoretical market structure that features no barriers to entry,

an unlimited number of producers and consumers, and a perfectly elastic demand
curve.
Q2. What do you mean by Perfect Competition? Discuss its features.

Ans.

Perfect Competition Market is a hypothetical market structure where in every seller takes the market
prices as the price of his own product, firms are incapable of influencing the market price either by
acting singly or in a group.

Perfect Competition in economic theory has a meaning diametrically opposite to the everyday use of the
term. In practice, businessmen use the word competition as synonymous to rivalry. In theory, Perfect
Competition implies no rivalry among firms. Perfect Competition, therefore, can be defined as a market
structure characterized by complete absence of rivalry among the individual firms. That is to say perfect
competition is a market structure where there is a perfect degree of competition and single price
prevails.

Main Features

(i) Homogeneous Product: In a perfect competition, it is not possible to distinguish between

the products of individual firms. There are no distinctive features of the product associated
with any specific firm. The product, in that sense, is homogeneous and undifferentiated. To
the buyer, product supplied by one firmis a perfect substitute of that supplied by another.
(ii) Large Number of Sellers: Perfect competition is characterized by a large number of firms.
Here, the termlarge denotes the fact that no individual firm is in a position to significantly
influence the total supply of the industry and thereby affects the price of the product. Every
firm in the industry is thus, a price taker. It can sell any quantity of its own product at the
going price. For it, the demand for its product is perfectly elastic. It, of course, must be
remembered that the maximum quantity, which this firm can supply, is insignificantly small
when viewed in relation to the aggregate supply of the industry as a whole.
(iii) Large Number of Buyer: Perfect competition is also characterized by a large number of
buyers who are in competition with each other for the available supply. Their number is so
large that any single buyer may change the quantity purchased without significantly
affecting the total demand in the market and affecting the price of the product. Like an
individual firm, an individual buyer is also a price taker. He can buy any quantity of the
product he likes at going price. To him, the product has perfect elasticity of supply.
(iv) Full Knowledge of Market: It is assumed that in perfect competition, every buyer and seller
has full knowledge of the prevailing price of the product, as also the prices being asked by
the sellers and being offered by the buyers. This ‘perfect knowledge’ enables every buyer
and seller to make use of any opportunity that may exist to strike a better bargain.
(v) Economic Rationality: Economic rationality is another feature of perfect competition. It
means that every buyer and seller is motivated by his own economic interest in his decisions
to buy or sell. This, coupled with the assumption of perfect knowledge, ensures that a
uniform price prevails in the market.
(vi) No Transportation Cost: It is assumed that there is no transaction cost to be incurred by
buyers and sellers in their activities. The price paid by a buyer is exactly equal to the price
received by the seller. There is no resource cost in terms of time or other expenses to be
incurred i.e. there are no transaction costs. In particular, a seller has no need to incur any
selling expenses (say, in the form of advertisements) because his product is not
differentiated from the products supplied by other sellers.
(vii) Free Entry and Exit: Perfect competition is also characterized by free entry and exit.
Basically, the terms entry and exist apply to the suppliers, though their coverage can be
extended to buyers also. It means that, given enough time, any existing firm can close down
and leave the industry or any new firm can enter the industry. There is no legal,
institutional, or technical hurdle in ding so. It is only estimated economic benefits or losses
that guide the firms in these decisions. Similarly, any existing buyer of the product can
increase his purchases, cut them or reduce them to zero. New buyers can also enter the
market and offer to buy any quantity they like.
Q3. Explain how the equilibrium of the firm is determined under Perfect Competition?

Or

Q3. Explain price and output determination of a firm under perfect competition.

Ans.

(Note- First describe the characteristics of Perfect Competition firm given above)

Under perfect competition, the firms are unable to alter the price of the product by changing the
quantity of its own output. The prices of the input are given; therefore, cost conditions are also given. In
other words, under perfect competition, it can only decide to alter the quantity of its output without
changing price of the product.

A firm is said to be in equilibrium when its profits are maximum, which in lieu depends on the cost and
revenue conditions of the firm. The concepts of cost and revenue vary in short run and long run. Thus a
competitive firm has four equilibrium states differing on the basis of period of operation as follows:

– Short Run equilibrium of a Competitive Firm

– Long Run equilibrium of a Competitive Firm

Short Run Equilibrium of a Competitive Firm

Under the short run period, the following are the major assumptions;

– Price of product is given in the market at which a firm can sell any quantity

– Plant size of firm is given(constant)

– Firm is facing given short run cost curves

There are two approaches to deriving the maximum profit i.e.

1. (Profit) π= TR less TC or
2. at a point where MR equates MC.

Since a perfectly competitive firm is a price taker, it is faced with a straight line demand curve i.e. AR is
parallel to X axis as its Marginal Revenue (MR).

Given the assumption of profit maximization by the firm, it will be in equilibrium when there is no scope
for either increasing its profit income or reducing its loss by changing the quantity of output. It cannot
improve its economic position by changing the output.
 Equilibrium of a Firm using TR and TC Curves

A general case of this equilibrium of the firm, in the

short run and under perfect competition, is
illustrated in Fig

X axis shows levels of output and Y axis shows costs

and revenues.

TR is Total Revenue Curve

TC is Total Cost Curve

P is Equilibrium Point, where the distance between

TR and TC is maximum

The equilibrium point is attained when,  = TR – TCis maximum; where TR = P x Q (P is given as

constant) and TC is total cost.

Therefore, in short run since prices are given, the TR curve is a straight line through the origin O as
shown in the figure. Its slope is positive and equal to the price of the product and Average Revenue (AR).
In the short run, a firm has to incur both fixed and variable costs. Fixed costs are there even when the
output is reduced to zero. As a result, total cost (TC) curve starts from Y-axis at a positive distance from
origin O. Assuming that fixed costs are OF, the TC curve starts from point F on the Y-axis. The short run
average cost curve (SAC) is U-Shaped. The total cost curve in the figure is represented by TC.

Thus, OM is the equilibrium output of the firm in the short run under perfect competition. At any other
output, its total profit is less than PE. It is also noted that if the output is reduced to OM’ or increased to
OM”, the profit of the firm is reduced to zero. Further, for output less than OM’ or greater than OM”, TC
exceeds TR and results in a loss for the firm. The conditions of profit maximisation (or loss minimization)
can be translated into what are known as marginal conditions. Thus profit,  = TR - TC is maximized if

– its first derivative is zero

– second derivative is negative

Differentiating = TR – TC with respect to Q;

Graphically, this condition states that for equilibrium of the firm, MC curve should intersect MR curve
from below and, after intersection, lie above MR curve. If we translate this condition in ordinary words,
it means the following. The firm should keep on adding to its output as long as MR > MC because
additional output adds more to its revenue than to its cost and thus its profit income increases.
Furthermore, if its MC is equal to MR but the firm finds that by adding to its output, MC becomes
smaller than MR, then the firm should decide to increase its output.

Equilibrium of a Firm using MC and MR Curves

On account of perfect competition, the demand for the product of the firm is perfectly elastic. The firm
can sell all its output at the going price in the market. Accordingly, its demand curve (AR curve) runs
parallel to X-axis throughout its length and its MR curve coincides with AR curve.

As regards the supply side, the set of four cost curves of the firm, namely, the AFC, the AVC, the MC and
the ATC. Out of these, the supply curve of the firm is that portion of the MC curve which lies above AVC
curve and is upward sloping. The actual equilibrium of the firm is determined by the intersection of its
supply and demand curves. An explanation of this phenomenon is provided below.

In the short run, the firm cannot avoid fixed costs. They have to be incurred even if production is
reduced to zero. However, the variable costs are directly related to the quantity of output. The
implication is that, in the short run, the firm cannot avoid losses by not producing. Therefore, it decides
to continue production even at a loss, provided the loss does not exceed its fixed costs. It means that
the firm would decide to produce if its average price (that is, per unit price of the good) equals or
exceeds its AVC.

On account of the law of variable proportions, the average variable cost curve is U-shaped. Marginal
cost represents a change in the total cost so that it is related only to the variable costs and not fixed
costs. And since AVC curve is U-shaped, MC curve is also U-shaped. It lies below AVC curve when the
latter is downward sloping. However, MC curve starts rising when the rate of fall in AVC curves slows
down, intersects it at its lowest point, and rises above it.

A firm attains its best possible position (that is, the position of maximum profit or minimum loss) when
its MC curve cuts its MR curve from below. At the same time, price per unit of the product must be able
to recover at least the average variable cost. When the price exceeds AVC, the firm is able to recover a
part of its fixed costs also with a resultant reduction in its losses. In case the price equals the average of
total cost, the firm is able to recover its full costs (including the component of ‘normal profit’). And if the
price is still higher, it earns an abnormal profit.

Thus, in determination of short term equilibrium of the firm, two conditions should be satisfied:

– MC must equal MR and cut it from below

– AR must equal or exceed AVC

we consider five different prices to illustrate the supply behaviour and associated equilibrium of the
firm. There is an average revenue curve corresponding to each price. It runs parallel to X-axis and the
MR curve also coincides with it.

1. When the price is OP0 , the corresponding MR0 curve cuts MC curve at two points, A and B. At point A,
none of the above-stated two conditions of equilibrium is satisfied. At point B, MC curve cuts MR 0 curve
from below but the second condition is not satisfied. AR is still less than AVC. Therefore, the firm incurs
a loss greater than its fixed cost if it decides to produce when the price is OP0 . The firm, therefore,
decides to close down but it cannot leave the industry.

2. If the price happens to be higher and equal to OP1 (that is, equal to the least possible average variable
cost), the firm decides to produce. In this case, not only MC curve cuts MR 1 curve from below (a point
C); AR1 is also equal to AVC. Thus, we find that either the firm does not produce at all, or it produces at
least equal to OM1 .

3. In the third case, price (OP2) exceeds AVC but is still less than ATC. MR2 and MC curves intersect each
other at point D. The firm produces OM2 . It still incurs a loss but less than its fixed costs because it is
able to recover a portion of the latter.

4. In case the price rises to OP3 , the firm is able to recover its full cost including fixed costs. Its MC curve
cuts MR3 curve from below at point E and AR3 = ATC. All the conditions of its equilibrium are satisfied. It
produces OM3 .

5. If the price rises even further, say, P4 , the point of intersection of MR4 and MC curves moves to F. The
firm is able to recover not only its total cost but is able to earn an abnormal profit also. It produces OM 4.

In the short run, existing firms can close down but they cannot leave the industry and new ones cannot
enter it. Therefore, when our firm is incurring a loss, it continues production so long, its’ loses do not
exceed fixed costs. Similarly, if it earns an abnormal profit, they are not wiped out by new firms entering
the industry.

Long Run Equilibrium of a Competitive Firm

 Long term is defined as that period
in which the firm has the
opportunity of varying all its inputs.
There are no fixed costs and
therefore average fixed cost curve
vanishes. The average cost (AC)
curve denotes average total cost
(ATC) curve. More precisely, in the
long run the firm can decide to go in
for any of the alternative plants of
different scales.

In the long run, the average cost (AC

or LRAC) curve of the firm formed by
its short run average cost curves
(that is, plant curves) is also U-
shaped. Up to a certain scale, there are increasing returns and LRAC curve slopes downwards. This is
followed by the phase of constant returns in which LRAC curve is neither rising nor falling. And the third
phase is that of diminishing returns to scale in which LRAC curve slopes upwards. Corresponding to the
U-shaped LRAC curve, long term marginal cost (LRMC) curve is also U-shaped and that it cuts LRAC from
below at the lowest point of the latter.

Since the firm can vary all its inputs in the long run, it follows that it has the option to close down and
leave the industry. Similarly, new firms can also enter the industry. This condition, termed ‘free entry
and exit of firms’ has two implications.

– The firm is not compelled to operate when incurring a loss. It can leave the industry

– No firm is able to earn an abnormal profit (that is, a profit in excess of the ‘normal‘one). It can only
earn ‘normal profit’ which forms a part of its costs and is incorporated in its LRAC curve. This happens
because abnormal profit earned by existing firms attracts new firms. And as they enter the industry,
supply increases, price comes down and abnormal profit is wiped out.

Two conditions have to be satisfied for the firm to be in state of long run equilibrium.

– MC curve must intersect MR curve from below

– AR  AC, so that the firm does not incur a loss and close down. In practice, however, on account of
free entry and exit of firms, AR cannot exceed AC and is equal to the latter

Determination of long run equilibrium of the firm under perfect competition is explained in Fig. in which
output is measured along X-axis and costs are measured along Y-axis.

The firm is a price taker. For it the price of its product is given and fixed.

It can sell any quantity it can produce at the going price.

Its AR curve runs parallel to X-axis and MR curve coincides with it.

For the purpose of explaining the determination of firm’s equilibrium, we are considering three
alternative prices given to the firm by the industry.
In long run equilibrium, the firm produces an ‘optimum’ output at the least possible average cost. It is
this position where the firm is operating under ‘constant returns’ to scale. Consequently, its MC = AC. At
the same time, MC = MR and AR = AC , so that we get AC = AR = MC = MR.
Q4. Explain how the equilibrium of the industry is determined under Perfect Competition?

Or

Q4. Explain price and output determination of industry under perfect competition.

Answer:

EQUILIBRIUM OF INDUSTRY UNDER PERFECT COMPETITION

An industry comprises all the firms which are producing goods which the buyers consider substitutes of
each other. As such the determination of price of such a product is the result of interaction between
total demand for the output of all the firms taken together and their supply

On the demand side, the important fact to be noted is that a change in its supply affects the price of the
product also. The industry is not a price taker. Though the contribution of an individual firm in total
supply is so insignificant that it cannot make any noticeable difference to the price of the product, this is
not so with the industry. The change in supply made by the firms taken together alters the aggregate
supply to such an extent that it cannot sell more without lowering the price. This results in a downward
sloping demand curve for the industry.

The fact of a negatively sloped demand curve for the industry can also be understood as follows. A firm
can sell more of its output by attracting customers from its competing firms. In the process, the total
sales of the industry need not increase. But an industry can sell more when the existing buyers buy more
of its product and/or new buyers enter the market and buy its product. Now it follows that existing
buyers are already equating their marginal utility with the price. They would buy more only if price falls.
Similarly, for the new buyers, the existing price is higher than the marginal utility of the product. And,
therefore, they would also buy more of the good only if the price is reduced. Accordingly, the demand
curve for the product of the firm must have a negative slope indicating that more of the product can be
sold only by reducing its price.

The exact location and slope of the demand curve varies from product to product and also for the same
product from one time interval to the other. There can also be several reasons on account of which its
demand curve may shift in its slope and location. However, there is no theoretical basis for predicting
these changes. Therefore, even while recognising that demand curve for a product can and often does
shift over time, the economists assume that it retains its position when we move from short term to
long term. In other words, demand curve for the industry is always drawn with a negative slope without
specifically providing for a change in either its exact slope or its exact location.

Short Run Equilibrium of a Competitive Industry

When an industry changes the quantity of its supply, there is a corresponding change in the price of its
product also. It follows, therefore, that when it is in equilibrium, there is no tendency on its part to
change the quantity of its output. We also know that the price of the industry’s product is determined
by intersection of its demand and supply curves. Having seen the nature of industry’s demand curve, we
may look into the nature of its supply curve which is obviously the summation of individual supply
curves of the firms constituting it. That is to say, we get the industry’s supply curve by adding the
quantities which its firms are ready to sell at alternative prices. Since the supply curve of a firm, in the
short run, is that upward sloping portion of its marginal cost curve which lies above its average variable
cost curve, therefore, the supply curve of the industry also is upward sloping.
 DD is demand curve and SS is
supply curve. The intersection
of both curves at E is the
equilibrium of a competitive
industry.

In case the industry happens to

be in a non-equilibrium
position, it automatically gets
adjusted to its equilibrium
position This is because, in
such a case, there is either an
excess of supply or an excess of
demand at the existing price.
In case of excess supply, the
firms are left with unsold
stocks which they try to
dispose off by reducing price.
And in case of excess demand, some customers are not able to buy the quantities they wanted to. They,
therefore, bid up price in competition with each other.

Long Run Equilibrium of a Competitive Industry

The slope of the demand curve of industry remains negative even in the long run, implying that it can
sell more of the product only by reducing the price and vice versa.

However, the long run supply curve of the industry cannot be derived by horizontal summation of the
supply curves of the individual firms. The reason is that in the long run, existing firms can leave the
industry and new ones can join it. Moreover, it is possible that due to various reasons, the industry may
suffer from some internal/ external diseconomies or enjoy some economies. These factors can shift the
position of the long term supply curve of the industry. Another fact which complicates the derivation of
long run supply curve of the industry is that while in the short run, individual firms may incur losses or
enjoy abnormal profit, in the long run, these possibilities tend to be wiped out. When the industry is in
equilibrium, its individual firms are also simultaneously in such equilibrium that they neither make an
abnormal profit nor incur a loss.

Thus, long run supply curve of the industry is derived by taking into account all these determining
variables. It is not derived by adding those portions of the MC curves of the individual firms which lie
above the AC curves of the firms. Instead it is the locus of the pairs of those points which represent
quantities of its output and the least average cost at which its firms can produce it.

Economists believe that the factors at work in the long run may result in one of the three situations,
namely, that of diminishing, constant, and increasing returns, indicating the shift in the average cost of
its firms. These three cases are explained below.

Long Run Equilibrium of a Competitive Industry under Constant Returns

In this case, the expansion of the industry does not lead to net economies or diseconomies. They are
either not there or they get neutralized by each other. As a result, the average cost of the industry as a
whole remains constant as it expands. Its demand curve is downward sloping and its supply curve is
parallel to X axis. It means that while the quantity demanded responds, to a limited extent, to a change
in price of the product, the elasticity of supply is perfect. The industry curtails its supply to zero if the
price offered is reduced even by a small margin. On the other hand, at the going price, it is ready to sell
as much as the buyers are ready to buy.

In Fig. 4.6, the supply curve of the industry is SS’ and its demand curve is DD1 . The two intersect at
point E1 with OM1 and E1M1 as equilibrium output and price respectively. At the same time, all the
firms of the industry are also at equilibrium such that for each firm, its MC = MR = AC = AR and it
operates at the least possible average cost. As a result, there is no incentive for any firm to leave the
industry or enter it.

Fig. 4.6 also depicts the alternative equilibrium position if demand curve happens to be differently
located. It is seen that shifting of the demand curve does not result in a change in price. It only results in
a change in the quantity of supply.

Diminishing Returns

Let us assume that when existing firms of an industry expand their output, their average cost of
production increases. Similarly, let us assume that if new firms enter the industry, they also face higher
average product cost. This implies that the expansion of the industry generates more diseconomies than
economies and the net result is an increase in the average cost of production. The supply curve of the
industry, therefore, slopes upwards and implies that the industry will be ready to sell more only if the
price offered increases.
Increasing Returns

In this case, the average cost of production of the industry declines with its expansion and its supply
curve has a negative slope.
What is Monopoly? How price and output determination is done in monopoly?
Answer
Q. Explain the concept of Discriminating Monopoly. What are the various degrees of discrimination.
Explain.
Q Explain Monopolistic Competition. Discuss its salient features.
Answer
Explain equilibrium of the firm under monopolistic competition.

EQUILIBRIUM OF THE FIRM UNDER MONOPOLISTIC COMPETITION

Explain price and output determination under Oligopoly.

Answer

Oligopoly refers to a market wherein only a few firms account for most or all of total production.

Features of Oligopoly Market

Cau ses for the existence of Oligopoly
PRICE AND OUTPUT DETERMINATION UNDER OLIGOPOLY
CO-OPERATIVE VS. NONCOOPERATIVE BEHAVIOUR
Types of Cooperative Behaviour
Types of Non-Cooperative Behaviour