Table of Contents market structures The basic market structures include: perfect competition, monopoly, monopolistic competition and oligopoly. Perfect competition is characterized by: very large number of buyers and sellers easy entry standardized product buyer & seller have no control over the market price — each firm is a price taker that faces a horizontal demand curve for its product
A monopoly market is characterized by: single seller producing a product with no close substitutes effective barriers to entry into the market firm is a price maker, also called a price searcher because it faces a downward sloping demand curve for its product One special type of monopoly is a natural monopoly, a monopoly that arises because of the existence of economies of scale over the entire relevant range of output. In this case, a larger firm will always be able to produce output at a lower cost than could a smaller firm. The pressure of competition in such an industry would result in a long-run equilibrium in which only a single firm can survive (since the largest firm can produce at a lower cost and can charge a price that is less than the ATC of smaller firms).
A monopolistically competitive market is characterized by: large number of firms product is differentiated (i.e., each firm produces a similar, but not identical, product) entry is relatively easy firm is a price maker that faces a downward sloping demand curve
An oligopoly market is characterized by: small number of firms produce most output product may be either standardized or differentiated significant barriers to entry recognized interdependence exists (i.e., each firm realizes that its profitability depends on the actions and reactions of rival firms)
Most output is produced and sold in oligopoly and monopolistically competitive industries. COMPETITIVE MARKETS I. Characteristics of a Perfectly Competitive Market Structure: Perfect competition is a market structure in which the decisions of buyers and sellers as individuals have no effect on market price. Each firm is so small that it cannot significantly affect the price of the product in question and is a price taker. A) There are a large number of buyers and sellers. B) The product sold by the firms in the industry must be homogeneous. C) Buyers and sellers have equal access to information. D) Any firm can enter or leave the industry without serious impediments. II. Demand Curve of the Perfect Competitor: Since the perfectly competitive firm produces a homogeneous commodity, the individual firm will lose all of its business if it raises it price. The demand schedule for a perfectly competitive firm is thus perfectly elastic at the market supply and market demand determined price. The firm is a price taker, i.e. it must take price as given because the firm cannot influence market price. III. How Much should the Perfect Competitor Produce? The firm has only one decision: how much should it produce? A) Total Revenues: Total revenue is the price per unit times the total quantity sold. B) Comparing Total Costs with Total Revenues: The firm will maximize profits where the total revenue curve exceeds the total cost, the sum of total fixed and total variable costs, by the greatest amount. IV. Using Marginal Analysis to Determine the Profit Maximizing Rate of Production: The use of marginal analysis to determine the profit-maximizing rate of production is preferred to comparing total cost and revenue. The results are the same, but business decisions are really made on the margin where marginal benefits and costs are compared. A) Marginal Revenue: The change in total revenues resulting from a change in output (and sale) of one unit of the product in question. It is computed as the change in total revenue divided by the change in output. B) When Are Profits Maximized?: Profit maximization normally occurs at the rate of output at which marginal revenue equals marginal cost. V. The Meaning of Zero Economic Profits: The average total cost curve includes the full opportunity cost of capital as well as the opportunity cost of all other factors of production used in the production process. Economic profits are that part of accounting profits over and above what are required to stay in business in the long run. At the short-run break-even price, economic profits are, by definition, zero. Accounting profits at that price are not, however, equal to zero. They are positive. A) Factors that Influence the Industry Supply Curve: Anything that affects the marginal cost curves of the firms will influence the industry supply curve. These are factors that cause the variable costs of production to change, such as changes in the individual firm’s productivity, or factor costs (wages paid to labor, price of raw material, etc.). Because these factors affect the position of the marginal cost curve for the individual firm, they affect the position of the industry supply curve. A change in any of these non-price determinants of supply will shift the market supply curve. VI. The Long-Run Industry Situation: Exit and Entry A) Exit and Entry of Firms: If firms in an industry are making economic profits, this will signal owners of capital elsewhere in the economy that they should enter this industry. If firms in an industry are suffering economic losses, the losses signal resource owners within the industry not to reinvest and if possible to leave it. Profits direct resources to their highest-valued use. In the long run, capital and labor will flow to industries where profitability is highest and will flow out of industries where profitability is lowest. In a competitive long-run equilibrium situation firms will be making zero economic profits. B) Long-Run Industry Supply Curves: Market supply curves that show the relationship between price and quantities after firms have been allowed the time to enter into or exit from an industry, depending on whether there have been positive or negative economic profits. Constant-Cost Industries are those whose total output can be increased without an increase in long-run per-unit costs. The long-run supply curve is horizontal. Increasing-Cost Industries are those in which an increase in output is accompanied by an increase in long-run per-unit costs, such that the long-run industry supply curve slopes upward. Decreasing Cost Industries are those in which an increase in output leads to a reduction in long-run per-unit costs, such that the long-run industry supply curve slopes downward. MONOPOLIES
I. Monopolist: A single supplier that comprises its entire industry for a good or service for which there is no close substitute.
II. Barriers to Entry: For any amount of monopoly power to continue to exist in the long run, the market must be closed to entry in some way. Either legal means or certain aspects of the industry’s technical or cost structure may prevent entry. A) Ownership of Resources Without Close Substitutes: If one firm owns the entire supply of raw material input that is essential to production of a particular commodity, then that ownership serves as a barrier to entry until an alternative source of raw material input is found or an alternative technology not requiring the raw material in question is developed. B) Problems in Raising Adequate Capital: Certain industries require a large initial capital investment. Firms already in the industry can, according to some economists, obtain monopoly profits in the long run because no competitors can raise the large amount of capital needed to enter the industry. C) Economies of Scale: When economies of scale exist firms with larger output have lower average costs that enable them to charge a lower price and drive smaller firms out of business. A natural monopoly arises when there are large economies of scale relative to the industry’s demand, and one firm can produce at a lower average cost than can be achieved by multiple firms. D) Legal or Governmental Restrictions 1. Licenses, Franchises and Certificates of Convenience: In many industries it is illegal to enter without a government license, or certificate of convenience and public necessity. Because franchises or licenses are restricted, firms already in the industry can earn long-run monopoly profits. 2. Patents: A patent is issued to an inventor to provide protection from having the invention copied or stolen for a period of 20 years. The patent holder has a monopoly. 3. Tariffs: Tariffs are special taxes that are imposed on certain imported goods. If tariffs are high enough, imports become overpriced and domestic producers gain monopoly advantage as the only suppliers. 4. Regulations: Government regulation has increased in the interest of safety and quality. Large expenditures have been necessary by certain industries to comply. Large fixed costs spread over a larger number of units of output by larger firms can put smaller firms at a competitive disadvantage. This can deter entry of new firms.
E) Cartels: An association of producers in an industry that agree to set common prices and output quotas to prevent competition.
III. Elasticity and Monopoly: The price elasticity of demand for the monopolist depends on the number and similarity of imperfect substitutes. The more numerous and more similar are these imperfect substitutes, the greater the price elasticity of demand of the monopolist’s demand curve. The monopolist faces a downward-sloping demand curve. This means that it cannot charge just any price with no changes in sales because, depending on the price charged, a different quantity will be demanded. IV. The Social Cost of Monopolies: The monopolist will charge a higher price and produce a lower output than will a perfectly competitive industry, assuming the same cost structure. MONOPOLISTIC COMPETITION I. Monopolistic Competition: A market structure where a large number of firm’s produce similar but differentiated products which they advertise and promote. There is relatively easy entry into the industry. A) Number of Firms: In monopolistic competition, there is a large number of firms, but not as many as in perfect competition. This fact has several implications for a monopolistically competitive industry. 1. Small Share of Market: When many firms exist in an industry each firm has a relatively small share of the total market. Thus, each has only a very small amount of control over the market clearing price. 2. Lack of Collusion: With many firms it is difficult for them to get together to collude; that is, to agree to cooperate to set a pure monopoly price and output. Price rigging in a monopolistically competitive industry is virtually impossible. 3. Independence: Because there are so many firms, each one acts independently of the others; no firm attempts to take into account all of its rival firms.
B) Product Differentiation: Product differentiation is the distinguishing of products by brand name, color, minor attributes and etc. Product differentiation occurs in other than perfectly competitive markets where products are homogeneous. Each separate, differentiated product has numerous similar but not perfect substitutes. The greater the number of substitutes available the greater the price elasticity of demand. The ability of a firm to raise price is limited, and the demand curve slopes downward. C) Ease of Entry: For a monopolistic competitor, potential competition is always a threat. The easier and less costly entry is, the more a current monopolistic competitor must worry about losing business. D) Sales Promotion and Advertising: No individual firm in a perfectly competitive market will advertise. It can sell all it wants at the going market price. Since the monopolistic competitor has some monopoly power, advertising may result in increased profits. Advertising should be carried to the point where marginal revenue from advertising just equals the marginal cost of advertising.
II. Brand Names and Advertising: Because “differentness” has value to consumers, monopolistically competitive firms view their brand names as valuable. Firms advertise their brand to maintain differentiation of their products from those of other firms. A) Brand Names and Trademarks: A firm’s value in the marketplace depends largely on its current profitability and perceptions of its future profitability. B) Advertising: To help ensure that consumers differentiate their products from those of other firms, monopolistically competitive firms engage in advertising. 1. Methods of Advertising: Advertising can be in the form of direct marketing, mass marketing, or interactive marketing. 2. Informational Versus Persuasive Advertising: Informational advertising is advertising that emphasizes transmitting knowledge about features of a product and is more likely to be used with a search good. Persuasive advertising is advertising that is intended to alter a consumer’s tastes and preferences and induce a consumer to purchase a particular product. It is more likely to be used with an experience good. Both promotional and persuasive advertising are likely to be used with credence goods which are difficult for consumers to evaluate without help. 3. Advertising as Signaling Behavior: Signals are compact gestures or actions that convey information. Heavy advertising expenditures that establish brand names or trademarks are signals that the company plans to stay in business.
III. Information Products and Monopolistic Competition: A product produced using information intensive inputs at a relatively high fixed cost but distributed for sale at a relatively low marginal cost is an information product. Creating the first unit of an information product such as a computer program entails a high initial up-front cost. Additional units are very inexpensive to produce. High up-front costs of producing the first unit are fixed costs. OLIGOPOLIES I. Oligopoly: An oligopoly is a market situation in which there are very few sellers. Each seller knows the other sellers will react to its changes in prices and quantities. An oligopoly market structure can exist for either a homogeneous or a differentiated produce. A) Characteristics of Oligopoly 1. Small Number of Firms: An oligopoly exists when a handful of firms dominate the industry enough to set prices. 2. Interdependence: This is also called strategic dependence, which is a situation in which one firm’s actions with respect to output, price, or product differentiation may be strategically countered by one or more other firms in the industry. Such dependence can only exist when there are a few major firms in an industry.
B) Why Oligopoly Occurs 1. Economies of Scale: The strongest reason that has been offered for the existence of oligopoly is economies of scale. Economies of scale are defined as a production situation in which a doubling of output results in less that a doubling of total costs. The firm’s average total cost curve will slope downward as it produces more and more output. Average total cost can be reduced by continuing to expand the scale of operation. 2. Barriers to Entry: These barriers include legal barriers, such as patents, and control and ownership over critical supplies. 3. Oligopoly by Merger: A merger is the joining of two of more firms under a single ownership or control. There are two types of mergers. A horizontal merger involves firms producing or selling a similar product. A vertical merger occurs when one firm merges with another from which it purchases an input or to which it sells an output.
C) Measuring Industry Concentration: The percentage of all sales contributed by the leading four or leading eight firms in an industry is sometimes called the industry concentration ratio.
II. Deterring Entry into an Industry: Existing firms in an industry devise strategies to deter entrance into that industry. By getting a local, state or federal government to restrict entry or by adopting certain pricing and investment strategies they may deter the entrance of new firms. A) Increasing Entry Costs: Any strategy undertaken by firms in an industry with the intent or effect of raising the cost of entry into the industry by a new firm. To sustain a long price war, existing firms might invest in excess capacity so that they may expand output during the price war, thus signaling potential competitors that they will engage in a price war. Existing domestic firms can also raise the cost of entry by foreign firms by getting the U.S. government to pass stringent environmental or health and safety standards. B) Limit-Pricing Strategies: The existing firms may lower their market price until they sell the same quantity as before a new firm entered the industry. Existing firms limit their price to be above competitive prices, but if there is a new entrant, the new limit price will be below the one at which a new firm can make a profit. The limit-pricing model is a model that hypothesizes a group of colluding sellers who together set the highest common price they believe they can charge without new firms seeking to enter the industry. C) Raising Customers’ Switching Costs: If an existing firm can make it more costly for customers to switch from its product or service to a competitor’s, the existing firm can deter entry. In the computer industry switching costs were high because computer operating systems have not been compatible across company lines.
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