MODULE 5: MARKET STRUCTURE

Market – interplay of demand and supply

Market Structure – defined by 3 parameters. It is diff types of market. How do we define each
market. No of buyers seller, types of goods, entry-exit of sellers.

Two kinds of extreme market structures – perfect competition and monopoly.

Market structures are classified on the basis of intensity of competition. This intensity depends
on no. of buyers seller, types of goods, entry-exit conditions.

On the basis of intensity of competition decided by 3 factors

• No. of buyers and sellers

• Nature of product
• Entry and exit conditions

Markets can be perfect or imperfect, on their ability to control the prices.

DEFINITIONS –

Leftwitch – according to him, perfect competition is a market in which there are many firms
selling homogeneous product, with no firm large enough relative to enter market to be able
to influence market prices.
Robinson – she defines perfect competition on the basis of price elasticity of demand.
according to her, perfect competition prevails when demand for the output of each producer
is infinite.

Chamberlin – talks that perfect competition is pure competition + 2 more conditions. The term
perfect competition is wider and the other is narrower.

1. Pure competition assumptions

(a) Large number of buyers and large number of sellers – the position of each buyer
and each seller is just like a drop of water in the vast ocean. It means that seller
has no control over the price. When it comes to the determination of price, how
are prices determined in perfectly competitive market? In perfect competition,
there’s a diff between firms and industry. The prices are determined in the industry
[group of firms] on the basis of demand and supply, and on the basis of that price,
firms decide the quantity. Each seller has no control over the price. They can only
slightly temper with it, not more. Like, agriculture. The price is the limiting factor,
in a sense that sellers are price-takers. They have to accept the price decided by
the industry. Elasticity of demand is hence infinite.

(b) Nature of product – what kind of goods they are. In case of pc, there are
homogeneous goods, they are identical in the eyes of buyers, there is no difference
in the nature of goods. It means there is no product differentiation in terms of
quality, packaging, color, design, etc. Buyers are indifferent to all of them. We are
trying to create perfect conditions so we can understand real market which is full
of imperfections.

(c) Free entry & exit of sellers – free entry and free exit, there’s no barriers. Even if
firms shut down their operations, they are not bound by anything. No license, no
permissions, nothing. It implies that each firm in this market earns normal profit
or zero economic profit, it means a minimum profit which is req for a firm to remain
in business. You as a producer is earning supernormal or abnormal profit, [total
revenue >>> total cost], now, sellers will be attracted by this. They will also enter
 → the market supply increases → prices go down → profit goes down. Hence,
because of this assumption, producers earn only normal profit.

(d) Goal of firm – we assume that each buyer and each seller are acting independently.
The goal of their firm is profit maximization.

(e) No govt interference – there’s no interference by govt when carrying out business.
No taxes, no regulations, no subsidies. Not required to comply with any legal
obligations.

If these conditions fulfilled – market is purely competitive.

2. Other two conditions –

(f) Perfect information / knowledge – sellers provide perfect info about prices. There
should be no moral hazards or asymmetric info, buyers and sellers should be equal
as far as knowledge about the prices or goods is concerned. We assume that each
buyer is at par with the seller in terms of knowledge.

(g) Unrestricted/perfect mobility of resources – free flow / movement of labour

capital. All are perfectly mobile. No restrictions on them, zero transportation costs.

We infer from these is that, perfect competition occurs when market is purely in the hands of
demand and supply.

Is perfect competition a myth or a reality? If it is a myth, then why economists pay attention
on understanding this perfect competition? If it is hard to find, why are we spending our time
to study it?

MYTH DEBUNKED

Large number of buyers and Wkt, it makes the firm to be a price taker. But it doesn’t
sellers happen every time, firms cannot be the price takers in all
the cases. Like, Pepsi and Coke, they themselves are
deciding the price and not the soft-drink industry.

Nature of product Homogeneity is lost. Products are not always

homogeneous, there will always be differences in terms
of quality, packaging, brand, etc. Like, cement is almost
homogeneous but people will still prefer Ambuja Cement.
Another example, milk can be homogeneous, but Amul
breaks this myth – it introduces product differentiation.

Free entry & exit of sellers Entry and exit are not free. Patents (providing exclusive
rights, not allowing others to use), copyrights, IP rights,
etc. create barriers to enter in the market. They’re
 supposed to seek permissions in many instances. Barriers
can also be in the form of high capital cost.

Goal of firm “Business of business is not only business.” The goal

cannot always be profit maximization, there’s social
responsibility also. Like, a firm cannot degrade
environment just to make profit. If the firm takes heed to
protect environment, profit will be less than highest
possible value.

No govt interference It is not possible that govt is not interfering in the

business. Taxes and subsidies. Like, to enter the liquor
industry, a firm will require a license by the govt. Govt
interferes as and when required, like raids in sweet shops
during festival time.

Perfect information / Sellers and buyers not always have the equal information.
knowledge Like, Patanjali toothpaste and Bournvita; Mutual Funds
are subject to market risks – very fast earlier – but now
slow.

Unrestricted mobility of There will always be costs to transport labour and capital
resources from one place to another.

We study this because –

1. Real oligopoly, monopoly, & monopolistic competitions are imperfect markets. Thus,
the perfect competition is the benchmark [telling how market should be] we
strive/aim for; we need to study how away are we from this benchmark in the real-
world scenario.
2. It gives birth to present welfare economics, whenever we try to evaluate the
outcomes, it is only possible with a given yardstick of how things should be – and
perfect competition provides us with this yardstick so we can trace out the gap and
can make policy decisions.
3. The entire microeconomics is a contribution of Classists [classical economists]. This
term is used by Keans though he himself is not one. He used this term for all those
writers who had written before 1930s. If you look at classical models, the assumption
of them is perfect competition that there exists PC in each market. They take the
standard assumption of perfect competition to base their theories on that.
4. Dominance per se is not bad, abuse of dominance is anti-competitive, in case of
imperfect markets, the social optima is higher, we wish for the producer to produce
more. Society wishes for a greater quantity. When market finds that the benefits are
not only conferred to the one who is paying, market will always undersupply [the
vaccine example]. But secondly, when firms decide the price of their product in
imperfect competition, they don’t take into consideration the cost which they are
conferring upon the society.
BASICALLY: market produces less when there are positive externalities associates with
it and produces too much when there are negative externalities associated with it. But
in perfect market everything is perfect in the sese that there is efficiency.
 PROFIT MAXIMISING OUTPUT – QMAX

It is the point where both the

conditions are fulfilled,
– Where MC = MR
– Where MC cuts MR from
below

QMAX – point at which both these

conditions are satisfied.

I. MC = MR
– π is maximum, Q is
maximum.
II. MC > MR
– MC lies ahead of MR
– Producer will reduce the
output
III. MR > MC
– MR lies ahead of MC
– Producer is willing to increase output

Difference between shut down and exit?

Shut Down Exit

Temporary situation. Permanent situation.

A firm decides not to produce anything for A firm decides to leave the market
specific period of time due to change in permanently.
market conditions. But it doesn’t leave the
industry.
It is short run. It is long run.

Under what circumstances firm decides to do either of this?

Sunk costs – are those cost which are already being committed. Means the expenditure has
bene made and now we cannot recover it. Suppose farmer has done some research --- phrase
which works for sunk costs – bygones are bygones. Shut down – you will incur sunk costs but
in exit you will not.

ASK SUHANA

In short run, whether a competitive firm will earn profit, loss, or break-even??? zero economic
profit? All three possibilities are possible. But in long run, firm will always break even. Why?
OLIGOPOLY
Oligopoly – competition among few. There are few dominant firms, and these are in
competition with each other. Characteristics –

1. No. of sellers – There are few players competing, they are less in number but
dominant.
2. Product – two kinds –
(i) pure – sellers producing homogeneous products. Like cement, gas, there is no
product differentiation.
(ii) differentiated – the products are differentiated from each other, like fridge,
cars, etc.
3. Conditions to enter and exit the market – strong barriers to trade. Its veery difficult for
the oligopoly firms to enter and exit the industry. The factors which decide the
boundaries of these entries and exits, are the same as monopoly.
(i) If a firms have access to key resources, they will command the market.
(ii) Similarly, if a firm has high capital base, it will act as a barrier.
(iii) If a firm is enjoying huge economies of scale, other firms find difficult to enter.

4. Mutual interdependence or strategic interaction – so far in market structure we

discussed that there was no interdependence. In monopoly – single seller, their output
decisions were not dependent on each other. But in oligopoly, the strategies of the
firms will be dependent on each other.

This characteristic is unique to this market. There is strategic interdependence about

price, output, profitability, etc. This characteristic arises because there are only a few
but dominant sellers in the market, so it is possible that if we have 10 sellers, it is quite
easier to see what the other sellers are doing and what are their strategies.

PROBLEMS

• In all other market structures, we have a clearly defined demand curve. Mutual
interdependence makes this market unique. Since there are few players in this market
structure, we cannot tell clearly what kind of a demand curve will be there in oligopoly.
Here the problem is that there’s action-reaction, whatever one firm adapts, the other
will accordingly react/retaliate to it. When few players are formulating their strategy
in such a manner that they are concerned with what others are doing, then the pricing
and output decisions are not as determinant as they were in other market structures.

When this action-reaction is taking place, it becomes difficult to determine price and
output. Hence, we do not have a clearly defined demand curve. It can even lead to
price war and cause death of the firm.
 • Here, we do not have a general theory of oligopoly because price and output are
indeterminant. Different scholars have different explanations for the behaviour of
oligopoly firms.

Because of the mutual interdependence, we have different models of oligopoly or sets of

theories.

Models –
1. Collusive
2. Non-collusive
3. Game Theory approach

Broadly there are three models of oligopoly.

COLLUSIVE

The model we are discussing in Collusive is Price Leadership Model. What is collusive? When
two firms work together, they combine or cooperate their decisions w.r.t. price. In PLM, out
of the few firms of oligopoly, you can say that there is a kind of a leader-follower interaction
also. Firms they may co-operate with each other or combine, the idea here is to decide P and
Q. They try to determine the price and output through their coordinated effort. In this PLM,
out of few firms – one firm is chosen as a leader; means one firm will set the price (price
setter) and other firms will chase/follow it. It is price leadership as one firm is acting as a leader
by deciding price. This price which they have decided, will be given to other firms who are
termed as ‘followers’.

Which firm can be taken as leader?

Price leadership
- Dominant firm – firm which has a large market share can be considered price leaders.
- Low-cost firm – Price leader might be the firm which is able to produce and supply at
a low cost. The decision to decide price might be given to the firm which has acquired
low cost

From the other two, group of economists believe or infer that size (first) as well cost
(second), they both matter. A firm might be a dominant one as well as a low-cost firm,
that can be considered as a price leader.

- Barometric firm – the firm which knows the pulse of the market – which is in business
for many years. Few firms are much ahead in terms of the future development or
making forecast about future market conditions, these firms can be considered as a
price leader. If every firm had the ability to make these predictions, fate of many
products would be different today. It’s important to make predictions about the
market conditions which involves cost as most of the business fail on the grounds of
cost only, not everyone can make predictions which causes products to fall. This is how
barometric firms have advantage over the others.
If TATA is a barometric price leader, what are the advantages which will be passed on to other
firms in the automobile industry? The benefit is that they are not expected to calculate the
costs as the barometric firms know the pulse and they are always doing the calculations – the
price that they take up can be used by other firms – the latter is not required to re-calculate.
The followers are not supposed to calculate and in turn save their time and money. The
benefits spill-over to the followers.

NON-COLLUSIVE

Sweezy’s Kinked Demand Curve

Price rigidity.

Before we begin, know that this model doesn’t tell us how prices and output are determined.
In case of oligopoly firms, prices are administered – they are those prices which do not change
frequently. Prices are rigid and firms are not willing to temper with the prices – they are sticky;
firms are reluctant to increase or decrease prices. Ques arises, why prices are sticky? When
we take into consideration the stickiness of these prices, the reasons might be –

1. Fear of rival firms – prices are rigid because there is always fear of reaction by the
rivalry firms. Oligopoly firms are guided by long-run. They know there is always threat
of reaction by their rivalry firms when they change their prices. They want to retain
their loyal customers.
2. Average Cost Pricing Principle – given by Hall & Hitch. They maintained that firms fix
their price according to their average cost. Now this price which is so determined, this
price takes into consideration the average cost as well as the normal profit margin also.
This is also known as Full Cost Pricing Principle – whatever the firms decide, it must
cover the cost of production and keep in mind the reasonable/conventional profit
margin also. If the price is covering your cost and giving you reasonable profit, firms
don’t need to change it.
3. Cost of changing price – The cost which is there in making changes. Suppose you own
a restaurant and you make changes in the pricing of your meals, now these new prices
have to be made available to the costumer, the menus need to be changed so printing
cost in involved.
Secondly, they have to incur advertisement cost which in itself a costly affair. Any
change in price will be at a cost (which may be high or less) but there will be a cost.

In this model, we don’t determine price. The question in this model is why prices are rigid.
There are two significant assumptions of this model –

1. Firms are interdependent on each other – oligopolists recognize their mutual

interdependence – but they act without collision. There is no agreement like Cartel,
their working is completely independent, i.e., they do things like deciding prices
independently only.
2. Price cut is matched/followed but price rise is not followed. If one firm cuts price, the
other will follow and do the same. If one firm increases the price, the others will not
 follow as there is fear of losing the customers. This assumption helps us to discuss
what kind of demand curve is faced.

Important observation here is that: usually, oligopolists do not compete on prices but on non-
price variants like quality, advertisement, services, etc.

DEMAND CURVE

• What kind of a demand curve do we sense in oligopoly? The demand curve here is not
continuous like a downward sloping demand curve. There is a kink in the demand curve.
This kink represents rigidity, stickiness. This demand curve is divided into two segments.
• The upper segment shows that firms don’t have any incentive to increase or decrease the
price, rather, they maintain the price. If they increase price, they will lose their customers.
Hence this is elastic as a small change in price can disturb the potential customers.
• The lower segment is inelastic as if prices are reduced, there might be a price war. And
this price war can go to such an extent that it might be disastrous for the firm.
• If prices are changed frequently, there will be such a cut-throat competition which can
even lead to the death of the firm.
• Demand curve is not uniform rather it is broken in two parts. The upper is elastic --- lower
is inelastic. It doesn’t explain how prices are determined, rather it explains why oligopolists
are rigid in changing prices.

GAME THEORY APPROACH

In this, we are treating oligopoly like a game, firms are like players and they are strategizing in
their business. This approach is used to understand the behaviour of the firms in uncertain
scenarios. Also called Prisoner’s Dilemma. This concept was given by Von Neuman and Oskar
Morgenstun in 1944 in the paper “Theory of Games and Economic Behaviour”

Talks about the dilemma in the mind of two people. They are caught at a site where a bank
robbery has occurred. Police caught these two persons as they were carrying unlicensed guns
and happened to be at the sight. Police does not have any sufficient evidence to prove they
have committed the crime but they are major suspects. The two people are put in separate
rooms and interrogated separated, they don’t know what the other prisoner might be
strategizing. Police gives four situations –
1. If you remain silent – 1 year imprisonment. (1,1)
2. If one of you confesses but implicate your partner – police will allow you to go free
and the one implicated will be 20 years imprisonment and vice versa. (0,20) and (20,0)
3. If both confess of each other’s crime, they get imprisonment of eight years. (8,8)

The deal made by police can be shown by Pay-off Matrix. The pay-off in this dilemma
represents the term of imprisonment in this scenario.

Person 2
Confess Remain silent
Person 1 Confess (8,8) (0,20)
Remain silent (20,0) (1,1)

In terminology of game theory, the strategies adopted by the companies are nothing but their
moves. These moves cannot be independent of the strategies of another. If we look at this
matrix given, the best strategy is to remain silent. But it is easy for the two persons to get
driven by self-interest as they do not know what the other might be thinking. So, the strategy
of remaining silent is the best but they don’t know it as they haven’t discussed about what to
say!

If they remain silent, they get 1 year, but if they implicate on other, they are set free. So, the
person gets motivated by self-interest. Then they apply ‘dominant strategy’.

Dominant strategy is the best strategy for a player to follow regardless of the strategy used by
the other player or irrespective of the fact which strategy is followed by the other player. Here
prisoner 1 does not know about the strategy of prisoner 2. So, in this case the best or
dominant strategy for them is to confess. Now if they are in the same room. They can easily
decide to remain silent.

Implication of prisoner dilemma - It is difficult for firms to cooperate because they are guided
by their own self-interest. They consider that confessing is the dominant strategy for them,
but it proves to be inefficient. What firms think is the best strategy is not actually the best
one.

NASH EQUILIBRIUM

Dominant strategy is when people don’t know about the strategy of others. Nash equilibrium
occurs when the know about each other’s strategy. It describes a set of strategies in which a
player believes he is doing the best he can, given the strategy of other players.

PRISONER’S DILEMMA AND INSTABILITY OF CARTEL

Cooperation means abiding to the conditions of cartel and cheat is to temper with those
conditions like making changes in the price. Players sometimes leave cartel because they
believe that their monopolic profit can be much higher than being in the cartel. Here, the pay-
off matrix is about the profit. Here each firm will get 15 crore profit if they cooperate. If one
firm decides to cheat, it gets more profit like 25 crores. If both cheat, they both end up getting
just 5 crores.

Firm 2
Cheat Cooperate
Firm 1 Cheat (5,5) (2,25)
Cooperate (25,2) (15,15)

The incentive for the firm to cheat is higher monopolic profits, making self-interest to prevail.
That’s how cartel breaks down – because of this very self-interest.