Unit 4: Market and its types (IDC 101)

---

Market and Competition

Market

In economics, a market does not refer to a physical place. Instead, it is a mechanism or arrangement through which buyers and sellers interact to determine the price and quantity of a good or service.

A market can be local (vegetable market), national (stock market), or international (crude oil market). The key elements are the presence of buyers, sellers, a product, and a price at which exchange happens.

Competition

Competition refers to the rivalry among firms (sellers) to attract customers. The degree of competition in a market is the most important factor used to classify different market structures.

Types of Market Structures (The Spectrum of Competition)

Markets are classified based on the number of firms, the nature of the product, and the ease of entry for new firms.

[]

Feature	Perfect Competition	Monopolistic Competition	Oligopoly	Monopoly
Number of Firms	Very large (infinite)	Large	Few (e.g., 2-10)	One
Nature of Product	Homogeneous (identical)	Differentiated (e.g., brands)	Homogeneous or Differentiated	Unique (no close substitutes)
Barriers to Entry	None (Free entry & exit)	Low (Easy entry & exit)	High	Very High / Blocked
Firm's Control over Price	None (Price Taker)	Some (due to differentiation)	Significant (interdependent)	Considerable (Price Maker)
Example	Agriculture (e.g., wheat)	Restaurants, Hair Salons	Cars, Soft Drinks, Airlines	Local Water Company, Patented Drug

---

Price and Output Determination under Perfect Competition

Features of Perfect Competition (Recap):

• Large number of buyers and sellers.
• Homogeneous (identical) product.
• Free entry and exit of firms.
• Perfect information for all.
• No transport costs.

The most crucial outcome of these features is that the individual firm is a price taker. It must accept the market price determined by industry demand and supply. Because it can sell all it wants at that price, its demand curve is perfectly elastic (horizontal).

For a perfectly competitive firm: Price (P) = Average Revenue (AR) = Marginal Revenue (MR)

Equilibrium Condition (For ALL markets):

A firm maximizes its profit (or minimizes its loss) at the output level where:

1. Marginal Revenue (MR) = Marginal Cost (MC)
2. The MC curve must cut the MR curve from below.

Short Run Equilibrium of the Firm

In the short run, a firm can be in one of three positions:

1. Supernormal Profit (Economic Profit):
   • Occurs when Price (AR) > Average Total Cost (ATC) at the equilibrium output.
   • The firm earns more than the minimum required to stay in business.

   []

2. Normal Profit (Zero Economic Profit):
   • Occurs when Price (AR) = Average Total Cost (ATC).
   • The ATC curve is tangent to the P=AR=MR line at the equilibrium output.
   • The firm is earning just enough to cover all its costs, including implicit costs (opportunity cost). This is the minimum required to stay in business.

   []

3. Loss:
   • Occurs when Price (AR) < Average Total Cost (ATC).
   • The firm is not covering all its costs.

   []

Long Run Equilibrium of the Firm

In the long run, the feature of free entry and exit ensures that all firms in perfect competition earn only Normal Profit.

• If firms earn Supernormal Profit (Short Run): New firms are attracted to the industry. This increases market supply, which drives the market price down until P = ATC and only normal profits are left.
• If firms make Losses (Short Run): Existing firms will leave the industry. This decreases market supply, which drives the market price up until P = ATC and the remaining firms earn normal profit.

Therefore, the long-run equilibrium condition is:

P = AR = MR = MC = min ATC (both short-run and long-run)

This is a point of maximum efficiency (both productive and allocative).

[]

---

Imperfect Competition

Imperfect Competition is a market structure that lies between the two extremes of perfect competition and pure monopoly. It includes:

• Monopoly (covered next)
• Monopolistic Competition
• Oligopoly

The key feature of all imperfectly competitive firms is that they face a downward-sloping demand curve. This means that if they want to sell more, they must lower their price. As a result, their Marginal Revenue (MR) is always less than their Price (AR).

---

Monopoly: Price and Output Determination

Features of Monopoly (Recap):

• Single seller.
• No close substitutes for the product.
• High barriers to entry (e.g., patents, government licenses, control of a resource).
• The monopolist is a price maker (or price setter).

Demand and Revenue Curves:

The monopolist is the industry, so it faces the entire market demand curve, which is downward-sloping. Because it must lower the price on all units to sell one more, the marginal revenue (MR) from selling that extra unit is less than the price. The MR curve lies below the AR (Demand) curve and is twice as steep.

[]

Price and Output Determination (Equilibrium)

The monopolist follows the same profit-maximization rule:

1. Find the output level (Q*) where MR = MC.
2. From that output level (Q*), go up to the Demand Curve (AR) to find the price (P*) the monopolist will charge.

In the short run, a monopolist can earn supernormal profits, normal profits, or losses (just like a competitive firm). However, due to high barriers to entry, a monopolist can maintain supernormal profits even in the long run, as new firms cannot enter to compete the profits away.

[]

---

Monopolistic Competition - Features

This market blends features of both monopoly and perfect competition. It is the most common market structure for many retail businesses.

Key Features:

1. Large Number of Firms: Like perfect competition, there are many firms, but not infinite. Each firm has a small market share, and they act independently (no collusion).
2. Product Differentiation (The "Monopolistic" part): This is the most important feature. Firms sell products that are similar but not identical. They differentiate through:
   • Brand names (e.g., Nike, Adidas)
   • Quality (e.g., different restaurant food)
   • Design/Style (e.g., clothing)
   • Location (e.g., the local convenience store vs. a distant supermarket)
   • Service (e.g., friendly staff, free delivery)
   Because its product is unique, the firm has a "mini-monopoly" and faces a downward-sloping, but highly elastic, demand curve.
3. Free Entry and Exit (The "Competition" part): Like perfect competition, there are low barriers to entry. This has a crucial implication for long-run profits.
4. Non-Price Competition: Since products are different, firms compete using methods other than just price. This includes advertising, branding, packaging, and service.

Long Run Outcome:

Just like in perfect competition, free entry ensures that firms in monopolistic competition earn only Normal Profit in the long run. If short-run supernormal profits are made, new firms enter, which takes customers away from existing firms (shifting their demand curves to the left) until P = ATC.

The long-run equilibrium is at a point where the demand (AR) curve is tangent to the ATC curve.

---

Oligopoly - Features

This market is dominated by a "few" large firms.

Key Features:

1. Few Large Firms: The market is controlled by a handful of firms (e.g., 2 to 10). A market with only two firms is a Duopoly.
2. Interdependence (The "Hallmark" Feature): This is the most important feature. Because there are so few firms, each firm must consider the likely reactions of its rivals to any decision it makes (about price, advertising, etc.). This creates strategic, game-like behavior.
3. High Barriers to Entry: It is difficult for new firms to enter dueto factors like economies of scale, high start-up costs, patents, or brand loyalty.
4. Product: The product can be either homogeneous (e.g., steel, aluminum, crude oil) or differentiated (e.g., cars, smartphones, airlines).
5. Non-Price Competition: Firms often avoid price wars (as they hurt everyone) and instead compete vigorously through advertising, branding, and product innovation.
6. Indeterminate Demand Curve: Because of interdependence, a firm cannot know its demand curve for sure. If it raises its price, will rivals follow? If it lowers its price, will rivals follow? This uncertainty is why there is no single, simple model of oligopoly (unlike the other three markets).

Oligopolistic Behavior:

• Collusion (Cooperative): Firms may illegally agree to act like a monopoly. They form a cartel (like OPEC) to jointly set prices and output to maximize industry profits. This is unstable as each member has an incentive to cheat.
• Competition (Non-Cooperative): Firms compete, leading to outcomes like price wars or the "kinked demand curve" model (which explains price rigidity).