Unit 2: Imperfect Market Structure
Paper: Principles of Microeconomics (ECODSM 251/252)
This unit examines market structures that deviate from the ideal of perfect competition, focusing on how firms with market power determine prices and output levels.
1. Monopoly
A monopoly is a market structure where a single firm is the sole seller of a product for which there are no close substitutes.
Key Features:
- Single Seller: The firm is the entire industry.
- Barriers to Entry: High barriers (legal, technical, or resource-based) prevent other firms from entering the market.
- Price Maker: The firm has complete control over the price, subject to the market demand curve.
Equilibrium: A monopolist maximizes profit by producing at the quantity where Marginal Revenue (MR) equals Marginal Cost (MC). Since the demand curve is downward sloping, the price (AR) is always greater than MR.
2. Price Discrimination
Price discrimination occurs when a monopolist charges different prices to different consumers for the same product, for reasons not associated with differences in cost.
Degrees of Price Discrimination:
- First Degree (Perfect): Charging each consumer the maximum price they are willing to pay.
- Second Degree: Charging different prices for different quantities or "blocks" of consumption (e.g., utility bills).
- Third Degree: Dividing consumers into groups based on their price elasticity of demand (e.g., student discounts).
Exam Tip: For third-degree discrimination to be successful, the firm must be able to prevent "arbitrage" (reselling the product from low-price groups to high-price groups).
3. Monopolistic Competition
Monopolistic competition is a market structure where many firms sell products that are similar but not identical.
Price and Output Determination:
- Product Differentiation: Firms use branding and quality to distinguish their products, giving them some "monopoly" power over their specific brand.
- Short-run: Firms can earn supernormal profits or incur losses, determined where MR = MC.
- Long-run: Free entry and exit lead to a situation where firms only earn normal profits (Price = Average Cost), but they do so with "excess capacity" because they do not produce at the minimum of the AC curve.
4. Oligopoly
An oligopoly is a market structure dominated by a few large firms.
Strategic Interdependence:
The most important feature of an oligopoly is that each firm must consider the potential reactions of its rivals when making decisions about price or output.
- Collusion: Firms may cooperate (formally in a cartel or informally) to set prices like a monopoly.
- Non-collusive: Firms compete aggressively, often leading to price wars or rigid prices as explained by the Kinked Demand Curve.
5. Government Intervention
Governments intervene in imperfect markets to correct inefficiencies and protect consumer welfare.
- Anti-trust Laws: To prevent the formation of monopolies and restrictive trade practices.
- Price Regulation: Setting price ceilings on natural monopolies (like water or electricity).
- Subsidies or Taxes: To address market failures and externalities associated with imperfect competition.