Market Structures

Economists distinguish between market structures on the basis of the extent of strategic interaction between sellers in the market.

1. Perfect competition -> many sellers
2. Oligopoly -> "few" sellers
3. Monopoly -> one seller

Perfectly Competitive Market

Perfect competition is an idealized market, that act as a benchmark. It is based on following assumption

1. Homogenous product: A large number of firms produce identical goods consumed by a large number of buyers

2. Ease of Entry and Exit: It is easy for new firms to enter the market and for existing ones to leave

3. A Large Number of Buyers and Sellers: There are so many buyers and sellers that none of them has any influence on the market price regardless of how much any of them purchases or sells. That means, every seller or buyer in the market is a price-taker.

4. Perfect Information: Buyers and sellers have complete information about market conditions

With above definition of perfectly competitive market, it means:

• everybody (buyers or sellers) are price-taker in the market. In other words, market decide the price and it is fixed at the equilibrium price
• All firms have same production function and cost function
• All firms are aware of prices of inputs and opportunity 

Profit-Maximization

In a perfect competition market:

Total revenue (TR) = PQ

Price P = constant i.e. dP/dQ = 0 or e = infinity

Thus,

Marginal revenue (MR) = Average revenue (AR) = Price (P) = constant

& so for profit-maximization at output-quantity Q*

Price = Marginal cost(MC)

i.e. Marginal cost must be raising at the profit-maximization output

At Q*  (i.e. MR = MC) , profit (or loss) is given by

Profit = (P - ATC) Q*

 That means,
firms will make profit when,  P > ATC
firms will make loss when, ATC > P > AVC
firms should shut-down when, ATC > AVC > P

Refer for profit, loss, shut-down decision tree.

Industry supply curve: summation of all firm's supply curve.

Supply curve exists only for perfectly competitive industry.

In short rum, Super-normal profit -> when SMC > SAC (short-run)

In long run, more supply will come -> LMC = LAC i.e. no super-normal profit i.e zero economic profit i.e. firms are covering the opportunity cost at equilibrium.
Long run equilibrium, @ quantity of output Q*, economic profit = 0

MR = MC
P = LMC = LAC

At perfect competition, firm can make zero economic profit and it is like a trap for them. And so firm makes efforts to come out of perfect competition scenario by various strategies viz

1. Product differentiation

2. Create entry barriers

3. Collusion : cooperative price decision by several firms

4. Use of propriety information

5. Non-price competition

Monopoly

Monopoly is the sole producer of a commodity that has no close substitutes and faces many buyers. The demand curve of the firm is itself as the demand curve of the industry. The demand curve of the firm is downward-sloping industry demand curve. It acts as a price-maker. The monopoly can happen due to several reason, few are mentioned below:
1. Government blocks the entry of the more than one firm in the market. E.g. patent control, copyright, public franchise
2. One firm control the key resource necessary to produce the product
3. Economies of scale are so large that one firm has natural monopoly
4. Being first to produce the new product

In monopoly market the demand curve are inelastic and low coefficient of elasticity of demand curve indicates the barriers to prevent competitors from entering in the market. Due to the barriers, unlike to perfectly competitive market where super-normal profits are zero, a monopoly can preserve excess or super-normal profits.

In a perfectly competitive market, price equals marginal cost, however, in a monopoly, price is set above marginal cost. A monopoly maximizes profits by producing where marginal revenue equals marginal costs. In monopoly there is no supply curve as the firm produce one quantity and sell at one price.

MR = P (1 - 1/e)

AR > MR

when MR > MC firm should expand the production level

when MR < MC firm should reduce the production level

For profit maximization, At Q*,  MC = MR

For straight line demand curve, AR, P = a - b Q

=> MR curve is given by, P = a - 2bQ

 

Lerner index of Monopoly Power of  a firm

Lerner Index = (P - MC) / P 

The index ranges from 0 to 1.

For Perfectly competitive market, P = MC, so LI = 0

For Monopoly, MC = MR. As MR = P ( 1 - 1 / e), so LI = 1 / e.
 

 Smaller the elasticity e and so higher the Lerner's Index.

Oligopoly