Market Structure and Profit Maximization in Competitive Markets

The Importance of Market Structure

Firms behaviour and choices are influenced not only by internal characteristics such as cost trends and production function but also by the Market Structure in which a firm is embedded. . For example, companies with the same cost structure will produce different quantities depending on whether they are in a monopolistic market (one producer and many consumers) or in a competitive market (many producers and consumers)

Market Structure Characteristics

Market structures are different for 5 distinctive characteristics:

1. Firm size: a firm is small if its production is a negligible share of the total production.
2. Agent number: Firms may be one, a few, or many; consumers/labours may be numerous or not.
3. Product type: omogenous meaning that all firms produce the same product or heterogenous meaning that each firm produces a specific product different from the others.

Market Structure Characteristics: Barriers and Information

1. Presence or absence of barriers: entering or exit a market may be free of or hindered by barriers. These may be:

1. Technological: when entering with a small plant, a firm may not be competitive
2. Legal: patents, trademarks and government licences
3. Commodity-related: when a licence gives the opportunity to expliot a specific natural resource

1. Information dissemination: the hypothesis is perfect and complete information among agents

Main Market Structures Overview

• There are 4 main market structures:

1. Perfect competition
2. Monopolistic or imperfect competition
3. Oligopoly
4. Monopoly

• Firms operating in different market regimes differ mainly in the ability they have to influence the market price

Main Market Structures: Competition Types

• Perfect competition: there are many consumers and many, at least infinite, producers, so that a single firm is unable to influence the price level, i.e., a firm is a price-taker
• Monopolistic or imperfect competition: there are a consistent numerous of firms that have a certain capability to influence the price level, due to process and product innovations. These offer a certain but temporarly advantage to the firm since it disappears as soon as other firms apply the same technology or better

Main Market Structures: Oligopoly and Monopoly

• Oligopoly: there are few firms that have a substantial capability to influence the price level.
• If a few large buyers dominate, the market structure is an Oligopsony where the concentration of demand in just a few consumers gives each substantial power over the sellers to effectively keep prices down.
• Monopoly: there is a single firm which, being alone in the market, has a great capability to influence the price level, i.e., a firm is a price-maker.
• If only one consumer dominates, the market structure is a Monopsony where a Monopsonist may be able to cause downward pricing pressure.

Perfect Competition Hypotheses

• Main hypotheses of competitive markets:

1. Multi-players: there are many firms and consumers
2. Small size of firms: the supply is offered by many small firms, at least infinite firms, that produce a negligible share of the total product
3. Homogeneity: firms sell products with minimal differences in capabilities, features, and pricing. This ensures that buyers cannot distinguish between products based on physical attributes, such as size or color, or intangible values, such as branding.

Perfect Competition: Barriers and Information

1. Absence of barriers: new firms can enter the market and sell the good homogenous with that produced by existing firms.
2. Perfect information: The availability of information ensures that each firm can produce its goods or services using the same production techniques as another firm in the market. Everyone knows what everyone else is doing.
3. Perfect mobility of inputs: production factors are free to move from one firm to another.

Price-taker Firms in Competitive Markets

• In a competitive market, the price is determined on the basis of the interaction between supply and demand.
• As the market demand is the sum of individual consumer demands, the market supply is the sum of the offers of all companies.
• Individual firms cannot influence the market price but can only decide to produce or not the amount required.

Profit Maximization in a Competitive Market

• In a competitive market, price is given and determined by the market
• This because:
• if a firm wants to increase the price, then all consumers will shift towards the other firms since the good is homogenous.
• A firm does not have any incentive to decrease the price since it can sell any amount of goods at the given price.

Profit Maximisation in a Competitive Market: Conditions

• Recalling the cost and revenue functions, we may say that in a competitive market to maximise profit a firms should satisfy the following condition: MR = MC
• That, in the case of prices independent from quantities, we may rewrite as: P = AR = MR = MC

Profit Maximisation in a Competitive Market: Revenue Functions

. In this specific case, we have that:

• Total revenues (TR): the product between price and quantity TR = P * Q
• Imply that:
• Marginal revenue (MR): the incremental change in earnings resulting from the sale of one additional unit: MR = ATR AQ = P
• Average revenue (AR): the total amount of revenue gained divided by the total quantity of goods sold: AR = TR 𝑄 = P * Q = P

Profit Maximisation in a Competitive Market: Graphical Representation

S MC E P=AR=MR D Q Q MARKET INDIVIDUAL FIRM

The Optimal Choice of a Firm

• Given the market price, the firm makes its own choice on quantity.
• Quantity A corrisponds to the optimal choice because in A the profit maximisation condition is satisfied: P = AR = MR = MC

MR; MC MC D C P=AR=MR A Q

Firm Choice in the Short Run

• REVENUES: is the area obtained by multiplying the quantity sold (OA) with the level of price (OD), so this area is the rectangle OACD.
• COSTS: are equal to the average cost (OE) multiplied by the number of units produced (OA), so this area is the rectangle OABE.
• PROFITS: is the area of the rectangle EBCD as the difference between the revenue and cost rectangles.

MR; MC MC ATC C D P=MR profits E B costs Q O A

Firm Choice in the Long Run

• In the long run, if profits are present then new firms are incentivised to enter the market.
• This leads to an increase in supply and thus a decrease in price.
• The price decrease continues until the point, where firms no longer make profits, is reached.

P MC ATC P1 P2 Q

Monopoly Market Structure

• In contrast to competition, there is the monopolistic market structure.
• In monopoly, there is only one firm in the market and the firm coincides with the sector.
• In monopoly, there are barriers to entry that prevent other firms from entering the market. These can be of a different nature.

Monopoly: Barriers to Entry

• Economies of scale: this occurs when the average cost (ATC) decreases as production increases, so we have the so-called Natural Monopoly.
• Lower costs: due to, for example, greater efficiency or better production techniques.
• Ownership or control of specific inputs: this allows the unique firm to produce the good that needs that particular input.
• Legal protection: as in the case of a patent, so the unique firm has the right to produce that specific good.

Monopoly: Price-maker Firm

• When there is only one firm, the demand curve it faces coincides with the market curve and therefore has a negative slope.
• The price is not independent from the quantity produced and sold.
• The unique firm can influence the price level since it is a price-make.

Monopoly: Price-maker Firm Decisions

• If the monopolist aims to increase the price, the consumer is left with only two options:
• Either buy the good at a higher price
• Or choose not to buy the good.
• The monopolist may decide the level of quantity to produce and through the demand curve may define the level of price.
• In general, demand is less elastic in this market.

Profit Maximisation in Monopoly

• The monopolist maximises profit when the following condition is satisfied: MR = MC
• Unlike competition, the profit cannot be reduced by competing firms.
• Revenue area is the POQH rectangle
• Cost area is the the MOQK blue-rectangle
• Profit area is the PMKH red-rectangle

MC I P H AC M K D A O Q MR

Monopsony Market Structure

• In a Monopsony, there is only one buyer.
• Assuming that a firm has a dominant position in the factor market, it can influence the factor price.
• The product of this firm is produced using only this factor Q = f (L)

Monopsony: Factor Price and Quantity

• The relationship between factor price and quantity is defined in the following factor supply function: w = w (L)
• The more the firm wants to use, the higher the price it will pay.
• Thus, the factor supply function has a positive slope.
• The unique buyer firm is a price-maker.

Monopsony Profit Maximization

• The monopsonist maximises its profit when: max TR -TC = pf(L) -w(L) L
• So, the optimal condition is: MR = MC
• Where the optimal level of L is defined: L*
• Then, on the supply curve, we define the price: w*
• The optimal point in this market is not Pareto-efficiency since the quantity and the price of L are less than in a competitive market.

W MC w(L) E W* MR L* L