MARKET STRUCTURES

Concentration Ratios

The concentration ratio measures the size of firms in relation to their industry as a whole.

It is calculated as the sum of the market share percentages held by the largest specified number of firms
in an industry.

The concentration ratio ranges from 0% to 100%, where:

- A low concentration ratio (close to 0%) indicates greater competition in an industry, suggesting a
perfectly competitive market.

- A high concentration ratio (close to 100%) indicates less competition, suggesting a monopoly.

A rule of thumb is that an oligopoly exists when the top five firms in the market account for more than
60% of total market sales.

For example, if we want to calculate the four-firm concentration ratio (CR4) in an industry, we would sum
up the market shares of the four largest firms in that industry.

Industry

In a competitive market structure, the industry is simply the sum of all the firms making the same
product. This is the total market supply.

In other markets, the industry is taken to be the total number of firms producing within the same
product group, i.e, things that are close substitutes for each other.

MARKET STRUCTURES

Market structure refers to the way in which a market is organised/arranged in terms of the number of
firms and the barriers to the entry of new firms.
1) Perfect Competition/ Total Competition

Perfect competition is an ideal market structure that has many buyers and sellers, identical or
homogeneous products, no barriers to entry.

Perfect competition has the following characteristics:

■ There is a large number of buyers and sellers who have perfect knowledge of market conditions and
the price that is charged. (Perfect information)

■ No individual firm has any influence on the market price. Firms are described as being price takers.
The ruling price is determined by the forces of market demand and the output of all the firms.

■ The products are homogeneous or identical. This means that they are all of the same quality and are
identical in the eyes of the consumer.

■ There is complete freedom of entry into and exit from the market.

■ All firms and consumers have complete information about products, prices and means of
production.

- There are low search/purchasing costs like eBay, where there are no transport costs to the marketplace,
and all products can be easily searched.

Perfect competition is a theoretical(extreme) market structure for benchmarking real-world competition.

Perfect Competition Graphs in the short and long run for the entire industry and each firm.
**Implications of Perfect Competition from the graph:**

1) Market Ruling Price: In perfect competition, a firm cannot influence the market price due to its
minimal contribution to the total industry output/supply. It can produce any quantity and sell it at the
prevailing/ruling market price. The demand curve is perfectly elastic at this price, making the marginal
revenue equal to the price or average revenue (D = AR = MR).

2) Profit Maximisation decision and Allocative Efficiency: The firm's only decision is output selection,
based on production costs. The output maximizing profits is where marginal cost equals marginal
revenue (MC = MR).

Profit maximization condition: MC = MR

Firms in perfect competition are allocatively efficient (P=MC) and productively efficient (output is
produced at minimum cost i.e., Average Cost is at its minimum).

3) TR vs TC: If total cost is lower than total revenue, the firm makes an abnormal profit. If total cost
equals total revenue (TC = TR), the firm breaks even, making a normal profit.

If costs exceed revenue, the firm may exit the industry. However, it can continue production making
short-run losses if the price covers the average variable cost (AVC), typically wages and materials. This is
the shut-down price. The firm incurs a loss equivalent to fixed costs and hopes for a market price
increase or cost reduction.

4) Abnormal profit is a short-run feature of perfect competition. Its existence incentivizes entry of new
firms since there are no barriers to entry. This increases total market supply, causing the market price to
fall and abnormal profit to diminish. When abnormal profit disappears, new firms stop entering, and
existing ones cover costs. The competitive force of numerous new entrants destroys abnormal profit.

5) Firms exit the industry in the long run if total costs exceed total revenue:This reduces market supply,
raising the market price.
In the long run, firms will only supply the market if they can cover all costs(TR = TC) and make a normal
profit. The minimum supply will be the optimum output where average costs are lowest. In perfect
competition, firms only differ in profit if they have different cost structures. Their behaviour is limited,
and the only way to increase profit is to boost productivity and lower average total cost.

6) X-efficient firms in the long run: The long-run equilibrium is where only the most efficient firms
remain(X-efficiency), making a normal profit. In this situation, a firm cannot prosper at rivals' expense as
it has no market power. Firms' behaviour is easy to understand. The model's appeal is that abnormal
profit is competed away, and only productively and allocatively efficient firms participate in the long run.
This efficient economic performance in perfect competition is used to critique real-world market
structures.

**Dynamic Efficiency:** Firms are unlikely to be dynamically efficient because they have no profits to
invest in research and development.

2) Monopolistic competition

This is the market structure closest to the model of perfect competition because of the large number of
competing suppliers.

Monopolistic competition characteristics:

■ There is a large number of buyers and sellers.

■ There are few barriers to entry into the market and it is easy for firms to recoup their capital
expenditure on exit from the market.

■ Consumers face a wide choice of differentiated products. Each firm has a slight degree of
monopoly power in that it controls its own brand through quality and physical differences.

■ Firms have some influence on the market price and are therefore price makers.

Monopolistic competition curves

Elastic Demand curve and Profitability

In a market with many similar producers, each firm faces a downward-sloping, relatively price-elastic
demand curve due to the presence of substitutes. Firms can reduce their price to increase total revenue.
They can make abnormal profit in the short run, but the free entry of rivals restricts their power. In the
long run, profit-maximising firms can only achieve normal profit, covering all production costs and the
opportunity cost of capital.

Role of Product Differentiation and Branding

The behaviour of firms in this market structure is influenced by product differentiation. Developing a
strong brand image is an investment for the individual firm, highlighting the importance of advertising
and promotions. Successful advertising can shift the firm's demand curve to the right at the expense of
rivals and reduce the price elasticity of demand if consumers perceive no close substitutes, leading to
brand loyalty.

Advertising as a Competitive Tool

However, advertising is a competitive tool used by all firms. The advantage may be temporary and add to
the firm's costs with little benefit to its demand curve. Successful firms might leverage their greater
market share and brand loyalty to charge a higher price, increasing their sales revenue and moving to
the inelastic portion of the demand curve.

Balancing Market Power and Entry Constraints

Each firm can try to strengthen its market power in the short run. The constraint on firms is the freedom
of entry into the market, which threatens the existence of abnormal profit in the long run. Through
marketing and product innovation, individual firms may postpone the long-run equilibrium if the total
market is growing.

Competitive Nature and Real-world Examples

This model of competition involves a large number of competitors using a combination of price and non-
price competition to increase their market power. If there are few barriers to entry, their success will be
temporary. Examples of this market structure include take-away food outlets, local privately owned
restaurants, local hairdressers' shops, market stalls, driving schools, and travel agents.

Efficiency versus Profit Maximisation

In monopolistic competition, the profit-maximising firm makes abnormal profits in the short run. These
will be competed away by the entry of new firms, shifting the firm's original demand curve to the left.
This process continues until all firms in the industry make normal profit. However, in both the short and
the long run, the firm is inefficient because it operates above the minimum point of its average total cost
curve, resulting in excess capacity. Additionally, the firm is not allocatively efficient as P > MC.

. **Derivation of a Firm’s Supply Curve in a Perfectly Competitive Market**: A firm's supply curve in a
perfectly competitive market is derived by plotting the firm's marginal cost curve above its average
variable cost curve[^30^]. The point where the two curves intersect is the minimum point of the average
variable cost curve, which represents the firm's shutdown point

3) Oligopoly Market Structure

A natural monopoly is a type of monopoly that occurs when the most efficient number of firms in the
industry is one. This situation often arises due to the high fixed costs associated with certain industries,
making it impractical for multiple firms to operate profitably.

For instance, consider the delivery of utility services like water. It doesn't make sense to have multiple
pipelines because of the high infrastructure costs involved. Therefore, one large business can supply the
entire market at a lower long-run cost.

Sure, here's a concise summary of each paragraph while retaining all the details:

### 1. Examples of Oligopolistic Markets

Oligopolistic markets exist in various sectors, such as the telecommunications industry in Pakistan, the
UK's retail grocery supermarket business, and China's growing car manufacturing and assembly industry.

### 2. Behaviour in Oligopolies

Studying oligopolies is challenging due to the diverse behaviours exhibited by firms, ranging from
aggressive competition to cooperation and even collusion.

### 3. Price Wars in Oligopolies

Oligopolists, as price makers, risk engaging in price wars. A price war could be a result of industry
overcapacity, new firms entering the market, or a defensive tactic when an oligopoly is losing market
share.

### 4. Non-Price Competition

Despite their market power, firms may prefer non-price competition due to the uncertainty surrounding
the outcome of competitive tactics. Prices tend to be similar among oligopolists and are stable over time.

### 5. Strategies for Increasing Revenue

Firms may focus on non-price competition to increase revenue, including advertising and promotions,
product innovation, brand proliferation, market segmentation, and process innovation.

■ advertising and promotions

■ product innovation – the attempt to make the products more appealing to consumers

■ brand proliferation – where the firm produces lots of brands to saturate the market and to
leave no gaps for rivals

■ market segmentation – producers may decide that there are markets where the consumers
have different characteristics and needs, and these market niches will be catered for through
product innovation

■ process innovation – usually seen as a way of reducing average costs, allowing the firm to cut
the price without sacrificing profits

### 6. Growth Strategies in Oligopolies

A firm can grow rapidly by taking over a rival (horizontal integration) or by producing in different
countries and eventually becoming a multinational corporation.

### 7. Changing Firm Objectives

The difficulty of choosing competitive strategies and predicting rivals' responses may lead firms to shift
their objectives. Profit-maximising strategies may be replaced by 'satisficing', with a focus on maintaining
market share.

Firms can operate together as a monopoly shown below.

Collusion and cooperation among oligopolies:

### 1. Cooperation Among Oligopolists

In certain situations, large firms find it beneficial to cooperate with rivals. This is particularly true when
research and development costs constitute a significant portion of total costs and the rate of
technological change is rapid. In such cases, firms may find it advantageous to pool their knowledge,
agree on technical standards, and possibly engage in joint ventures.

### 2. Collusion Among Oligopolists

Collusion, on the other hand, is an anti-competitive practice by producers. While formal collusion, such
as cartels that agree on prices or output to restrict competition, is illegal, informal or tacit collusion is
not. Tacit collusion often takes the form of price leadership, where firms automatically follow the price
set by a dominant firm. The goal is to maximize the profits of the entire group by acting as a single
monopolist.

### 3. Cartels as a Form of Collusion

A cartel is a formal agreement between firms in an industry to restrict competition, which is illegal.
When firms join a cartel and agree on prices, they operate as a monopoly, maximizing their profits.

### 1. Tacit Collusion and Price Leadership

Tacit collusion occurs when firms indirectly cooperate with unwritten agreements. An example is a
follow-the-leader agreement where firms adjust prices following the dominant firm's lead. Other price
leadership models include using a typical firm as the yardstick for price, which changes only if a rise in
costs affects the profit margin.

### 2. Identifying Collusion

Identifying tacit or formal agreements is challenging. Price similarities can result from aggressive pricing
in a competitive oligopoly or a collusive agreement, making investigations into anti-competitive behavior
difficult and often inconclusive.

Prisoner's Dilemma in Oligopolistic Markets:

Prisoner's Dilemma arises—in collusions—where individual firms have an incentive to cheat and
undercut their competitors for higher profits. This dilemma leads to a less cooperative outcome and may
result in a Nash equilibrium where firms compete rather than collude.

4)Natural Monopoly

A natural monopoly arises when a monopolist has an overwhelming cost advantage(economies of scale),
often due to sole ownership of a resource or expensive-to-duplicate capital resources. (high fixed costs).
### 2. Public Ownership and Natural Monopolies

The case for natural monopolies is often used to support public ownership of services like water, gas,
electricity, railways, and canals. In these cases, fixed costs are a high percentage of total costs, and as
output increases, average fixed costs decline, offering substantial benefits from economies of scale.

### 3. Representation of a Natural Monopoly

A natural monopoly is typically represented by a falling long-run average cost curve, indicative of
continuing economies of scale. A monopoly firm would set price at P1, provide Q1 output, and earn
abnormal profits. If it behaved like a competitive firm, the equilibrium position would be where price
equals long-run marginal cost, resulting in a lower price (P2) and higher quantity (Q2). This is a loss-
making position unless the government subsidises the monopoly on the grounds that it provides an
essential public service.

### 4. Strong Cases for Natural Monopolies

The case for natural monopolies is particularly strong in the case of railways, canals, piped water
supplies, and electricity. There is little economic logic in having rival companies compete with each other,
especially as government subsidies are often required to keep systems like rail functioning at a socially
optimal level.
2. **Economies of Scale**: These industries also tend to exhibit strong economies of scale, meaning that
the average cost of production decreases as the quantity of output increases¹²⁴. As a result, one large
firm can produce the good or service at a lower cost per unit than could several smaller firms¹²⁴.

3. **Inefficiency of Competition**: In some cases, competition can be inefficient. For example, it

wouldn't make sense to have two sets of water pipes running to every home because it would double
the cost without providing any additional benefit¹²⁴.

Examples of natural monopolies include the gas network, electricity grid, railway infrastructure, and
national fiber-optic broadband network¹.

However, natural monopolies can lead to issues related to lack of competition, such as higher prices and
lower output. Therefore, they are often regulated by the government to prevent abuse of market power..

7.6.4 Performance of Firms in Different Market Structures: Summary

Efficiency and X-Inefficiency in the Short Run and the Long Run:

In perfectly competitive markets, firms operate at allocative and productive efficiency in the long run,
producing at the lowest possible cost and allocating resources efficiently. However, in monopolistic
competition, oligopoly, and monopoly, inefficiencies can arise. X-inefficiency occurs when firms do not
operate at the lowest possible cost due to a lack of competitive pressures.

Contestable Markets: Features and Implications:

Contestable markets are characterized by low barriers to entry and exit, allowing new firms to enter and
compete with existing firms. Even if a market is dominated by a few firms, the threat of potential
competition can lead to efficient outcomes. In contestable markets, incumbents are incentivized to keep
prices competitive and avoid inefficiencies.