We will now examine the problem of determining price and output levels in alternative market structures. Market structures are categorized in terms of number of firms or the number of sellers present in the market and whether we are considering a homogeneous or differentiable commodity. We will consider four types of market structures: 1. Pure Competition 2. Pure Monopoly 3. Monopolistic Competition 4. Oligopoly Market classifications from the buyer’s angle are, 1. Pure Competition 2. Pure Monopsony 3. Oligopsony A bilateral monopoly is a situation where a single seller confronts a single buyer.
Answers to two questions are sought throughout the analysis: 1. How do firms make pricing and production decisions? 2. What are the social welfare implications of those decisions? Homogeneous Vs Differentiable Commodity A product is homogeneous if all units of the product offered for sale are of the same quality at least in the eyes of the buyer. When an industry produces a homogeneous product, each firm produces a commodity which is identical to that produced by every other firm in the industry. Hence, as long as firms charge the same price, buyers are indifferent about the firm they actually buy the good from.
Differentiated products are imperfect substitutes and buyers are particular about the source of the good. Characteristics of Pure Competition 1. A large number of independent sellers 2. Standardized homogeneous product 3. All sellers are price takers 4. Free entry and exit 5. Perfect factor mobility 6. Perfect knowledge about market conditions These are extremely restrictive assumptions and may be hard to replicate in real life. Closest approximations are the agricultural product market (grains), stock market etc.
However, the pure competition model is extremely useful in predicting real world situations in terms of economic efficiency and optimal allocation of resources. Pure Competition is characterized by many producers of a homogenous product. The demand curve of a perfectly competitive firm is perfectly elastic, or horizontal, because the firm is a price taker. Now, by definition, TR=P*Q AR=TR/Q AR = P*Q / Q = P These three equalities hold for each type of market structure. However, in case of pure competition alone, P=MR where MR or Marginal Revenue is the addition to total revenue by selling one extra unit of output.
Profit Maximization in The Short Run TR-TC approach The firm achieves maximum profit where the vertical distance between the total revenue and total cost curves is greatest. MR-MC approach In the short run, the firm will maximize profit or minimize loss by producing that output at which marginal revenue equals marginal cost (MR=MC). Features of the MR=MC rule: •This is a general rule for all types of market structures. •Firms choose to produce rather than shut down. •To maximize profit or minimize loss, the competitive firm should produce at that point where price equals marginal cost (P=MC).
This is a special rule for pure competition. Hence here, P=MC=MR The Individual firm and the Market We can derive a market supply curve by adding up individual supply curves. Then we combine this market supply curve with the market demand curve to get the market price, which in turn, determines whether a perfectly competitive firm has enjoyed economic profit or has suffered a loss. Graphical Analysis: Remember, MC curve crosses both the ATC and the AVC curves from below at their minimum points and moves above. Let us consider three cases: 1. P>minimum ATC: Profit maximizing case 2. minimum AVC