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2022 Curriculum CFA Program Level I Economics

The Firm and Market Structures

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Introduction

The purpose of this reading is to build an understanding of the importance of market structure. As different market structures result in different sets of choices facing a firm’s decision makers, an understanding of market structure is a powerful tool in analyzing issues such as a firm’s pricing of its products and, more broadly, its potential to increase profitability. In the long run, a firm’s profitability will be determined by the forces associated with the market structure within which it operates. In a highly competitive market, long-run profits will be driven down by the forces of competition. In less competitive markets, large profits are possible even in the long run; in the short run, any outcome is possible. Therefore, understanding the forces behind the market structure will aid the financial analyst in determining firms’ short- and long-term prospects.

Section 2 introduces the analysis of market structures. The section addresses questions such as: What determines the degree of competition associated with each market structure? Given the degree of competition associated with each market structure, what decisions are left to the management team developing corporate strategy? How does a chosen pricing and output strategy evolve into specific decisions that affect the profitability of the firm? The answers to these questions are related to the forces of the market structure within which the firm operates.

Sections 3, 4, 5, and 6 analyze demand, supply, optimal price and output, and factors affecting long-run equilibrium for perfect competition, monopolistic competition, oligopoly, and pure monopoly, respectively.

Section 7 reviews techniques for identifying the various forms of market structure. For example, there are accepted measures of market concentration that are used by regulators of financial institutions to judge whether or not a planned merger or acquisition will harm the competitive nature of regional banking markets. Financial analysts should be able to identify the type of market structure a firm is operating within. Each different structure implies a different long-run sustainability of profits. A summary and practice problems conclude the reading. 

Learning Outcomes

The member should be able to:

  • describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly;
  • explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure;

  • describe a firm’s supply function under each market structure;

  • describe and determine the optimal price and output for firms under each market structure;

  • explain factors affecting long-run equilibrium under each market structure;

  • describe pricing strategy under each market structure;

  • describe the use and limitations of concentration measures in identifying market structure;

  • identify the type of market structure within which a firm operates. 

Summary

In this reading, we have surveyed how economists classify market structures. We have analyzed the distinctions between the different structures that are important for understanding demand and supply relations, optimal price and output, and the factors affecting long-run profitability. We also provided guidelines for identifying market structure in practice. Among our conclusions are the following:

  • Economic market structures can be grouped into four categories: perfect competition, monopolistic competition, oligopoly, and monopoly.

  • The categories differ because of the following characteristics: The number of producers is many in perfect and monopolistic competition, few in oligopoly, and one in monopoly. The degree of product differentiation, the pricing power of the producer, the barriers to entry of new producers, and the level of non-price competition (e.g., advertising) are all low in perfect competition, moderate in monopolistic competition, high in oligopoly, and generally highest in monopoly.

  • A financial analyst must understand the characteristics of market structures in order to better forecast a firm’s future profit stream.

  • The optimal marginal revenue equals marginal cost. However, only in perfect competition does the marginal revenue equal price. In the remaining structures, price generally exceeds marginal revenue because a firm can sell more units only by reducing the per unit price.

  • The quantity sold is highest in perfect competition. The price in perfect competition is usually lowest, but this depends on factors such as demand elasticity and increasing returns to scale (which may reduce the producer’s marginal cost). Monopolists, oligopolists, and producers in monopolistic competition attempt to differentiate their products so that they can charge higher prices.

  • Typically, monopolists sell a smaller quantity at a higher price. Investors may benefit from being shareholders of monopolistic firms that have large margins and substantial positive cash flows.

  • Competitive firms do not earn economic profit. There will be a market compensation for the rental of capital and of management services, but the lack of pricing power implies that there will be no extra margins.

  • While in the short run firms in any market structure can have economic profits, the more competitive a market is and the lower the barriers to entry, the faster the extra profits will fade. In the long run, new entrants shrink margins and push the least efficient firms out of the market.

  • Oligopoly is characterized by the importance of strategic behavior. Firms can change the price, quantity, quality, and advertisement of the product to gain an advantage over their competitors. Several types of equilibrium (e.g., Nash, Cournot, kinked demand curve) may occur that affect the likelihood of each of the incumbents (and potential entrants in the long run) having economic profits. Price wars may be started to force weaker competitors to abandon the market.

  • Measuring market power is complicated. Ideally, econometric estimates of the elasticity of demand and supply should be computed. However, because of the lack of reliable data and the fact that elasticity changes over time (so that past data may not apply to the current situation), regulators and economists often use simpler measures. The concentration ratio is simple, but the HHI, with little more computation required, often produces a better figure for decision making.