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IFT Notes for Level I CFA® Program

R13 The Firm and Market Structures

Part 1


1.  Introduction

This reading covers:

  • Analysis of market structures: degree of competition, how the management determines pricing and output strategy.
  • Characteristics, demand, supply, optimal price, and output for different types of market structures: perfect competition, monopolistic competition, oligopoly, and pure monopoly.
  • Techniques used by analysts to identify what market structure a firm is operating in.

2.  Analysis of Market Structures

The market is defined as a group of buyers and sellers that are aware of each other, and are able to agree on a price for the exchange of goods and services.

2.1. Economists’ Four Types of Structures

The market structure is classified into the following four categories:

  • Perfect competition
  • Monopolistic competition
  • Oligopoly
  • Monopoly

Perfect competition and monopoly are two extremes of the market structure in terms of number of firms and profits with the other types falling somewhere in between.

2.2. Factors that Determine Market Structure

The five factors that determine market structure are:

  • The number and relative size of firms supplying the product. The higher the number of firms, the higher the degree of competition.
  • The degree of product differentiation.
  • Pricing power of the sellers. Are they price takers, or can they influence market prices?
  • The relative strength of the barriers to market entry and exit.
  • The degree of non-price competition.

The table below summarizes the basic characteristics of the four market structures:

  Perfect Competition Monopolistic Competition Oligopoly Monopoly
Number of Sellers Many firms Many firms Few firms Single firm
Barriers to Entry and Exit Very low Low High Very high
Product Differentiation Homogeneous Substitutes but differentiated Close substitutes or differentiated Unique product
Non-price Competition None Advertising and product differentiation Advertising and product differentiation Advertising
Pricing Power None. Price taker. Some Some to significant Considerable
Example Oranges; Milk; Wheat Toothpaste Prices of commercial airlines for a given route Electricity provider/any utility company (water, cooking gas) as they are typically controlled by a government authority

Note: This table is important from an exam perspective.

The most preferred market structure by producers is monopoly/oligopoly because they offer the highest pricing power. The most preferred market structure by consumers is perfect competition as prices are lower.

3.  Perfect Competition

The characteristics of perfect competition are as follows:

  • There are a large number of potential buyers and sellers.
  • The products offered by the sellers are homogenous i.e. they are identical.
  • There are few or easily surmountable barriers to entry and exit.
  • Sellers have no market-pricing power. Each firm is so small relative to the market that it does not have any influence on market prices.
  • Non-price competition is absent.

3.1. Demand Analysis in Perfectly Competitive Markets      

The graph below shows the market demand curve for a perfectly competitive market. Here price is plotted on the y-axis and quantity on the x-axis and the market demand curve is downward sloping:

econ r15 3.2 1

To understand this curve, let’s assume that the market demand is given by the following equation:

Q = 50 – 2P where Q = quantity demanded and P = product’s price.

Rearranging, we get P = 25 – 0.5Q

Total revenue: TR = P * Q = 25 Q – 0.5Q2

\rm MR =   \frac{\Delta{TR}}{\Delta{Q}}  = 25 - Q_p

(Using calculus, the first derivative of 0.5 * Qis 2 * 0.5 * Q = Q)

We derived this based on two assumptions which are often not true in the real world:

  • Only price determines quantity demanded.
  • A linear relationship between price and quantity demanded.

Movement along the demand curve happens only if the price and quantity demanded of the product changes, all else constant. If any factor other than price/quantity demanded changes, then there is a shift in the demand curve. For instance, an increase in income will cause the demand curve to shift up.

Elasticity of Demand

Price elasticity of demand measures the sensitivity of quantity demanded to a change in price. It depends on the following three factors:

Factors affecting price elasticity of demand
Substitutes Elasticity is high if there are more close substitutes i.e. customers are more sensitive to price changes. If the price of a substitute goes down, the quantity demanded of the substitute goes up and the quantity demanded of the original product goes down.
The share of the consumer’s budget spent on the item The greater the share, the higher the price elasticity.

Ex: Expensive goods such as cars are highly elastic.

Grocery essentials such as cereals, sugar and salt are inelastic.

A 10% increase in the price of cars and cereals will affect the demand for cars but not that of cereals.

Length of time within which demand schedule is being considered The longer the period, the higher the elasticity.

Ex: If the price of cooking gas increases, the demand will not change much in the short run; however, demand will decline in the long run as consumers switch to electric stoves.

Numerically, price elasticity of demand falls into three categories:

Price elasticity of demand
Elastic demand |ε| > 1; a 1% change in price will cause a more than 1% change in quantity demanded. Ex: furniture (ε = 3.15).
Unitary elastic demand |ε| = 1
Inelastic demand |ε| < 1; a 1% change in price will cause a less than 1% change in quantity demanded. Ex: coffee (ε = 0.16).
Special Cases
Perfectly elastic or horizontal demand schedule Horizontal demand curve. At a given price, quantity demanded is infinite. ε = ∞. Ex: corn.
Perfectly inelastic or vertical demand schedule Vertical demand curve. Quantity demanded is fixed irrespective of price. ε = 0. Ex: insulin.

Income elasticity of demand is the percentage change in the quantity demanded, divided by a percentage change in income, all else equal. It measures how sensitive the quantity demanded is to changes in income.

  • For normal goods, income elasticity is positive.
  • For inferior goods, income elasticity is negative.

Cross-price elasticity of demand measures how the quantity demanded of a good changes when there is a change in the price of another good.

  • If the cross price elasticity is positive, then the two products are substitutes. Ex: cereals and oats.
  • If the cross price elasticity is negative, then the two products are complements. Ex: cereals and milk.

Instructor’s Note: Changes in own price causes a movement along the demand curve, whereas, changes in income and price of substitutes cause a shift in the demand curve.