2.1 Microeconomics 2: Market Structure

Question 1

Economic Market Structures

Answer 1

1. Perfect Competition
2. Perfect Monopoly
3. Monopolistic Competition
4. Oligopoly

Question 2

Perfect Competition

In a perfectly competitive market, a firm is a “price taker” that must (and can) sell any quantity of its commodity at market price. Therefore, for firms in a perfectly competitive market, the demand curve is a straight line for any price.

Answer 2

1. A large number of independent buyers and sellers, each of which is too small to separately affect the price of a commodity
2. All firms sell homogeneous products or services
3. Firms can enter or leave the market easily
4. Resources are completely mobile
5. Buyers and sellers have perfect information
6. Government does not set prices

Question 3

Short-Run Analysis

Answer 3

Short-run profit would be maximized where MC intersects MR (also D), labeled PMAX at Q1 in the graph. Each unit of output up to that quantity would add more to the total revenue than to the total cost; therefore total profit would increase. Units after that quantity (Q1) would cost more to produce than the price at which the additional units could be sold; therefore, the amount of profit would decline with each additional unit greater than Q1.

Question 4

Long-Run Analysis

Answer 4

When firms in a perfectly competitive market are making profit in the short-run, in the long-run more firms will enter the market. As more firms enter the market, supply (output) increases and the market price will fall until all firms just break even. When firms in a perfectly competitive market are suffering losses in the short-run, some of the firms will exit the market, causing the market price to increase until all firms just break even. Therefore, in a perfectly competitive market there are no long-run economic profits.
Because demand, price and marginal revenue are the same, long-run equilibrium occurs where marginal revenue, marginal cost and the lowest long-run average cost intersect. Thus, in the long-run, at Q1 inputs are used most efficiently and price is the lowest possible.

Question 5

Perfect Monopoly

Answer 5

1. A single seller
2. A commodity for which there are no close substitutes
3. Restricted entry into the market

Question 6

A monopoly may exist as a result of:

Because of differences in market characteristics between a monopolistic market and a competitive market, and the reasons a monopoly may exist, a monopolistic firm will have greater ability to influence its buyers than a firm in perfect competition.

Answer 6

1. Control of raw material inputs or processes (e.g., a patent)
2. Government action (e.g., a government granted franchise)
3. Increasing return to scale (or natural monopolies) (e.g., public utilities)
   C. In a perfect monopoly market, a single firm is the industry. Therefore, for that firm the demand curve takes the traditional negative slope (down and to the right).

Question 7

Short-Run Analysis

Since demand is fixed in the short-run, the monopolistic firm can increase revenue only by selling at different prices to different customers. For example, the firm could sell at different prices to different classes of customers or in different markets. Since some of Q1 will be sold at more than P1, total revenue and total profits will increase.

Answer 7

In the short-run, a monopolistic firm will maximize profit where marginal revenue is equal to (rising) marginal cost. Because the demand curve is downward sloping, in order to sell additional units, the firm must (continuously) lower its price. Therefore, the marginal revenue curve will be below the demand curve. The price charged at the point of profit maximization (MR = MC) is determined by the level of the demand curve for that quantity.

Question 8

Long-Run Analysis

Answer 8

If a firm maintains its monopolistic position in the long run, it has two basic ways to improve its total profits:
1. Reduce its cost by changing the size of its plant so as to produce the best level of long-run production.
2. Increase demand for its commodity through advertising, promotion, etc.
Like the firm in a perfectly competitive environment, the monopolistic firm will produce where MR = MC. In either environment, to produce at a lesser quantity (MR greater than MC), or at a greater quantity (MC greater than MR), would result in less total revenue than MR = MC. For the monopolistic firm, however, production at MR = MC results in an inefficient use of resources, and a higher price than would result from a firm with the same costs under perfect competition. These less than optimum outcomes occur because for the monopolistic firm facing a downward sloping demand curve MR (at MC) is less than P, whereas for an individual firm in perfect competition MR = P (=D). (Recall that in a perfectly competitive environment the market demand is downward sloping, but for a single firm in that environment the demand curve is horizontal and the firm can sell any quantity at the market price.)

Question 9

Monopolistic Competition

Answer 9

1. A large number of sellers
2. Firms sell a differentiated product or service (similar but not perceived as identical), for which there are close substitutes
3. Firms can easily enter or leave the market
   Thus, this market environment has elements of both perfect competition and perfect monopoly.

Question 10

Short-Run Analysis

Answer 10

A monopolistic competitive environment has a downward sloping demand curve that is highly elastic. It is downward sloping because of product differentiation and highly elastic because there are close substitutes for the goods or service. Again, optimum profit (and output) occur where MR = MC (provided P > AVC).

Question 11

Long-Run Analysis

Answer 11

A. If firms in a monopolistic competitive environment experience short-run profits, in the long-run more firms will enter the industry. More firms in the industry result in a lower demand curve for each firm. Equilibrium will result where the demand curve becomes tangential to the average cost curve and each firm just breaks even. Conversely, if firms are experiencing losses in the long run, firms will leave the industry and the demand curve will shift up so that remaining firms just break even.
B. A firm in a monopolistic environment incorrectly allocates economic resources in the long-run because the price at which it sells is greater than the marginal cost of production. Further, such firms operate with smaller scale plants than the optimum, and consequently, more firms than would exist in perfect competition.

Question 12

Oligopoly

Because there are few firms in an oligopolistic market, the actions of each firm are known by, and affect, other firms in the market. Therefore, if one firm lowers its price to increase its share of the market (demand), other firms in the market are likely to reduce their prices as well. In the extreme, a “price war” will result. Consequently, oligopolistic firms tend to compete on factors other than price (e.g. quality, service, distinctions, etc.).

Answer 12

1. A few sellers
2. Firms sell either a homogeneous product (standardized oligopoly) or a differentiated product (differentiated oligopoly)
3. Restricted entry into the market

Question 13

Short-Run/Long-Run Analysis

There is no one, universally accepted theory of an oligopoly. As a result of the observed inflexibility of prices in oligopolistic markets, the most common economic representation uses a kinked demand curve.

As with monopolies and monopolistically competitive firms, oligopolistic firms produce at the quantity of output where MR = MC and, therefore, where P > MC. Consequently, the oligopolistic firm under allocates resources to production and produces less, but charges more than would occur in a perfectly competitive market.

Answer 13

The kinked demand curve results from the fact that there are few firms each of which knows and responds to the actions of other firms. If you assume from that characteristic that rival firms will lower prices if you lower your price, but not raise prices if you raise your price, the demand curve will kink at the established current price. That reflects that prices will be more elastic above the kink (if a firm raises its price it loses a disproportionate number of customers) and more inelastic below the kink (if a firm lowers its price, others will too, so you don’t gain a disproportionate number of customers).
1. With the kinked demand curve, the MR curve will have a vertical portion at the quantity of the kink.
2. If MC changes along the vertical portion of the MR curve, neither quantity nor price would change. The quantity will be at the level where MR = MC and, because MR is vertical, there is no change in quantity (Q1 in the graph). The price will not change either; it will still be at the level of the kink in the demand curve (P1 in the graph).
C. In the short run the oligopolistic firm will produce where MC = MR and may make a profit, break even, or have a loss, depending on the relationship between price and average cost for the quantity produced. In the long run, however, firms incurring losses (because average cost exceeds market price) will cease to operate in the industry. Further, firms operating at a profit (because average cost is less than market price) can continue to make profits in the long-run because new firms are restricted from entering the market.