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MARKET STRUCTURES

A perfectly competitive firm is one of very many firms producing an identical good that is operating
in a perfectly competitive market. While no real world industry exactly matches the description of a
perfectly competitive industry, there is enough information in the behaviors of a firm in a perfectly
competitive industry that is of value in understanding the real world that it is worth studying.

A market that is perfectly competitive exhibits the following characteristics:


1. There are many sellers, so many that no one firm can have an influence on market price. Each firm
is such a minute part of the total market that however much the firm produces—nothing at all, as
much as it can, or some amount in between—it will have no effect on the market price.
2. The products sold by all the firms in the industry are identical. The product sold by one firm can be
substituted perfectly for the product sold by any other firm in the industry. Products are not
differentiated by packaging, advertising, or quality. As a result, the price elasticity of demand for any
one firm’s product is perfectly elastic.
3. Entry is easy, and there are many potential entrants. There are no huge economies of scale
relative to the size of the market. Laws do not require producers to obtain licenses or pay for the
privilege of producing. Other firms cannot take action to keep someone from entering the business.
Firms can stop producing and can sell or liquidate the business without difficulty.
4. Buyers and sellers have perfect information. Buyers know the price and quantity at each firm.
Each firm knows what the costs of resources are and what its demand curve shows.

24-1b The Demand Curve of the Individual Firm

A firm in a perfectly competitive market structure is said to be a price taker because the price of the
product is determined by market demand and supply, and the individual firm has to sell at that price
or simply not sell.

To illustrate how the individual perfectly competitive firm behaves, let us utilize very straightforward
numbers. Assume the price is $1 per unit of output (per bushel of corn or per cup of bottled water,
for example). What would occur if a single seller tried to set the price at $1.20 per unit of output?
According to the model of a perfectly competitive market, no consumer would purchase the higher-
priced good because the identical product could be obtained without difficulty elsewhere for $1. By
setting a price above the market price, the individual perfectly competitive firm sells nothing.

Is an individual firm likely to set a price of $.80 per unit of output when the market price is $1? Not in
a perfectly competitive market. The firm can sell any quantity it wants at the market price. Why
would a firm sell at $.80 per unit when it can get $1? The individual firm is a price taker because it
cannot charge more than the market price, and it will not charge less.

Market demand and supply curves in a perfectly competitive market are shown in Figure 1(a). The
demand curve of a single firm is shown in Figure 1(b). The market demand and supply curves are the
result of adding all the individual firms’ demand and supply curves. The horizontal line at the market
price is the demand curve faced by an individual firm in a perfectly competitive market structure. It
shows that the individual firm is a price taker—that the demand curve is perfectly elastic. The
question facing the individual firm in a perfectly competitive industry is how much to produce, not
what price to charge.

24-1c Profit Maximization We know that profit is maximized at the quantity where MR 1⁄4 MC. Profit
rises when the revenue brought in by the sale of one more unit of output is greater than the cost of
produc- ing that unit. Conversely, if the cost of producing one more unit is greater than the amount of
revenue brought in by selling that unit, profit declines with the production of that unit.

Monopoly is a market structure in which there is a single supplier of a product. A monopoly firm
(monopolist) may be large or small, but whatever its size, it must be the only supplier of the product.
In addition, a monopoly firm must sell a product for which there are no close substitutes. This means
the demand curve for a monopolist’s good or service is very inelastic; it need not be perfectly
inelastic since consumers may decide to do without the item rather than pay a higher price. You
purchase products from monopoly firms every day, perhaps without realizing it. Congress created
the U.S. Postal Service to provide first-class mail service. No other firm is allowed to provide that
service. In the United States, the currency you use is issued and its quantity is controlled by the
Federal Reserve; in other countries, there is a central bank like the Federal Reserve that controls the
money supply. It is illegal for any organization or individual other than the central bank to issue
currency.

The Creation of Monopolies

If a product is valuable and the owners are getting rich from selling it, will others develop substitutes
and also enjoy the fruits of the market? Yes, unless something gets in the way. The name given to
that something is a barrier to entry. There are three general classes of barriers to entry:
 Natural barriers, such as economies of scale
 Actions on the part of firms that create barriers to entry
 Governmentally created barriers

25-1b-1 Economies of Scale Economies of scale can be a barrier to entry. For instance, if there are
economies of scale in the generation of electricity, then the larger the generating plant, the lower the
cost per kilowatt-hour of electricity produced. A large generating plant could produce each unit of
electricity much less expensively than several small generating plants. In this case, size would
constitute a barrier to entry, since to be able to enter the market and compete with existing large-
scale public utilities, a firm would have to be large enough that it could produce each kilowatt-hour
as inexpensively as the large-scale plants.

25-1b-2 Actions by Firms Entry is barred when one firm owns an essential resource. The owners of a
desiccant clay mine in New Mexico had a monopoly position because they owned the essential
resource, clay. No one could produce a close substitute for many years; eventually, a synthetic clay
was developed. But until that time, the mine owners had a monopoly. Inventions and discoveries
may be essential resources, at least until others develop close substitutes.
25-1b-3 Government Barriers to entry are often created by governments. The U.S. government issues
patents, which provide a firm with a monopoly on certain products, inventions, or discoveries for a
period of 20 years. Such was the case with the Glaxo-Wellcome monopoly. The company was
granted a patent on AZT and thus was, by law, the only sup- plier of the drug. Domestic government
policy also restricts entry into many industries.

25-1c Types of Monopolies

The word monopoly is often part of another term, such as natural monopoly, local monopoly,
regulated monopoly, monopoly power, and monopolization. A natural monopoly is a firm that has
become a monopoly because of economies of scale and demand conditions. The adjective natural
indicates that the monopoly arises from cost and demand conditions, not from government action. If
costs decline as the quantity produced rises, only very large producers will be able to stay in
business. Their lower costs will enable them to force smaller producers, who have higher costs, out
of business. Large producers can underprice smaller producers, as illustrated in Figure 1. The larger
firm, operating along ATC2, can set a price anywhere between P1 and P2 that is lower than the
smaller firm, operating along ATC1, can sell its products at and still survive. If the market can
support only one producer or if the long-run average-total-cost curve continually slopes downward,
the monopoly that results is said to be natural.

Electric utilities are often considered to be natural monopolies because there are large economies of
scale in the generation of electricity. One large power plant can generate electricity at a lower cost
per kilowatt-hour than can several small power plants. The transmission of electricity is different,
however. There are diseconomies of scale in the transmission of electricity. The farther electricity
has to be transmitted, the higher the cost per kilowatt- hour. Together, generation and transmission
imply an MES (minimum efficient scale) that is sufficiently large for a local monopoly but not for a
national or international monopoly.

A local monopoly is a firm that has a monopoly within a specific geographic area. An electric utility
may be the sole supplier of electricity in a municipality or local area. A Cable TV companies may
have monopolies within municipalities. An airline may have a monopoly over some routes.

A regulated monopoly is a monopoly whose prices and production rates are controlled by a
government entity. Electric utility companies, telephone companies, cable TV companies, and water
companies are or have been regulated monopolies. A state corporation or utility commission sets
their rates, determines the costs to be allowed in the production of their services, and restricts entry
by other firms.

Monopoly power is market power, the ability to set prices rather than just be a price taker. Market
power exists whenever the demand curve facing the producer is downward sloping. All firms except
those operating in perfectly competitive markets have some monopoly power. Apple, for instance,
has market power because of its brand name and the quality of its products. It x can set the prices
on its iPhone and other products above the prices of competitors without losing sales. A firm that
has monopoly power is a price maker rather than a price taker. A firm that has to lower prices to sell
more is a price maker—it will maximize profit by finding the quantity where MR 1⁄4 MC and then
setting price according to demand.
Monopolization refers to the attempt by a firm to take over a market—that is, the attempt to become
the only supplier of a good or service. As we will discuss in the chapter “Antitrust and Regulation,”
the law forbids monopolization even though it does not always forbid monopolies.

Monopolistic competition is a market structure in which (1) there are a large number of firms, (2) the
products produced by the firms are differentiated, and (3) entry and exit occur easily. The definitions
of monopolistic competition and perfect competition overlap. In both structures, there are a large
number of firms. The difference is that each firm in monopolistic competition produces a product
that is slightly different from all other products, whereas in perfect competition the products are
standardized. The definition of monopolistic competition also overlaps with that of monopoly.
Because each firm in monopolistic competition produces a unique product, each has a “mini”
monopoly over its product. Thus, like a monopolist, a firm in a monopolistically competitive market
structure has a downward-sloping demand curve, marginal revenue is below the demand curve, and
price is greater than marginal cost. What distinguishes monopolistic competition from monopoly is
ease of entry. Any time firms in monopolistic competition are earning above-normal profit, new firms
enter, and this entry continues until firms are earning normal profit. In a monopoly, a firm can earn
above-normal profit in the long run. Table 1 summarizes the differences among perfect competition,
monopoly, and monopolistic competition.

26-1a Profits and Entry Firms in monopolistic competition tend to use product differentiation more
than price to compete. They attempt to provide a product for each market niche. Even though the
total market may not be expanding, they divide the market into smaller and smaller segments by
introducing variations of products. You can think of a market demand curve for clothes, but within
that market there are many niches and many demand curves. In fact, there is a separate demand
curve for each firm and for each product the firm sells. Each individual demand curve is quite price
elastic because of the existence of many close substitutes.
26-1a-1 In the Short Run Figure 1(a) shows the cost and revenue curves of a monopolistically
competitive firm providing a single product in the short run. As with all profit- maximizing firms,
production occurs at the quantity where MR 1⁄4 MC. The price the firm charges, P1, is given by the
demand curve at the quantity where MR 1⁄4 MC. Price P1 is above average total cost, as indicated by
the distance AB. Thus, the firm is earning above-normal profit, shown as the rectangle CBAP1. In
Figure 1(b), the firms in a monopolistically competitive market are earning normal profit. The price is
the same as the average total cost at Q1, so a normal profit is obtained. If a firm is earning a loss,
then its average-total-cost curve lies above the demand curve at the quantity produced, as shown in
Figure 1(c). In Figure 1(c), at Q1, the firm is earning a loss, the rectangle P1BAC. The firm must
decide whether to temporarily suspend production of that product or to continue producing it
because the outlook is favorable. The decision depends on whether revenue exceeds variable costs.

26-1a-2 In the Long Run Whenever existing firms in a market structure without barriers to entry are
earning above-normal profit, new firms enter the business and, in some cases, existing firms expand
until all firms are earning the normal profit. In a perfectly competitive industry, the new firms supply a
product that is identical to the product being supplied by existing firms. In a monopolistically
competitive industry, entering firms produce a close substitute, not an identical product.

Oligopoly and Interdependence In Mexico, only two or three companies provide goods and services
in areas such as finance, telecommunications, broadcasting, and retailing. And in Poland, a
candidate for finance minister argued that the country’s current economic problems are due to the
dominance of just one or a few firms in the fuel sectors and the financial markets. When a few firms
dominate a market, an oligopoly is said to exist. Oligopoly is a market structure characterized by (1)
few firms and (2) difficult entry. Oligopoly may take many forms. It may consist of one dominant firm
coexisting with many smaller firms or a group of giant firms that dominate the industry. The
characteristic that describes oligopoly is interdependence; an individual firm in an oligopoly does not
decide what to do without considering what the other firms in the industry will do. When a large firm
in an oligopoly changes its behavior, the demand curves of the other firms are affected significantly.

In perfectly competitive markets, what one firm does affects each of the other firms so slightly that
each firm essentially ignores the others. Each firm in an oligopoly, however, must watch the actions
of the other firms closely because the actions of one can dramatically affect the others. This
interdependence among firms leads to actions not found in the other market structures.
26-2a The Creation of Oligopolies In the chapter titled “Monopoly,” it was noted that a monopoly
could, theoretically, arise as a result of natural barriers to entry such as economies of scale, actions
on the part of firms that create barriers to entry, or governmentally created barriers. Oligopolies can
arise for similar reasons. The roots of Mexico’s oligopolies, for example, reach back to the 1950s
and 1960s, when the government funded private businesses and closed the domestic market to
international competition. During that era, the government created a culture in which the state
supported companies—government officials forced mergers to create larger companies, and later
helped their friends who headed those companies. Large companies owned by powerful dynasties
such as the mining company Grupo Mexico, the transportation company TMM, and Bancomer, the
country’s biggest bank, date from this period. Today this is known as “crony capitalism.” In Russia,
crony capitalism dominated after the fall of the Soviet Empire. Former government officials, red
directors, and oligarchs grabbed assets and took control of former state-owned enterprises such as
mining, oil, and utilities.

It is not just developing nations whose governments create oligopolies. In Japan, busi- nesses
require government approval for many actions, including entering a new business.

For instance, from the early 1990s through 2005, the government allowed only three phone
companies—NTT DoCoMo Inc., KDDI Corp., and Vodafone KK—to offer services, although it is now
widening the market to allow six new firms to enter the business. In the European Union, the large
monopolies and oligopolies created by national governments must now restructure as union-wide
companies.

Oligopoly can arise as the result of economies of scale. Since the cost per unit of output declines as
a firm gets larger, only the larger firms can remain in business. A small business cannot offer goods
and services at as low a price as a larger business can. Thus, the number of companies is
determined by the size of the market—where the market-demand curve intersects the long-run
average-total-cost curve. Whereas in a monopoly or a government- created oligopoly, competition
may be very limited or nonexistent, in an oligopoly that is not supported by the government, the firms
must constantly innovate and seek other barriers to entry. Cutthroat competition—competition
through innovation, patents, and other means—is often the companion of oligopoly.

Walmart is the dominant retail firm in the United States, Boeing the dominant airplane manufacturer,
Amazon.com the dominant online retailer, and Starbucks the dominant coffee retailer. But none of
them is the only firm in its industry. The firms dominate because of the efficiencies they have
experienced as they have grown and because of the strategies they have undertaken to maintain
their dominance.
26-2b Oligopoly and Competition Firms compete not just with prices but with quality, packaging,
marketing, location, innovation, service, and so on. In computer hardware and software, for example,
firms race to see which will be the first to come out with a new product or which can obtain the
patent on an innovation. Consumers are constantly being presented with upgrades and
improvements to existing products as well as with brand-new products. Pharmaceutical companies
race to create new drugs.
Firms earning economic profit must attempt to sustain the profit—to keep others from entering and
eroding the profit. Firms looking to enter must figure out how best to do that, by lowering price,
offering better quality, mimicry, or innovation. Strategy is the process of making decisions—choosing
what to do and what to forgo. Strategic behavior occurs when what is best for A depends on what B
does, and what is best for B depends on what A does. It is much like a card game—bridge, say—
where strategies are designed depending on the cards the players are dealt. Underbidding,
overbidding, bluffing, deceit, and other strategies are used. In fact, the analogy between games and
firm behavior is so strong that economists and mathematicians developed the field of game theory
to apply to competitive behavior among firms. Oligopoly is the general market structure economists
refer to when they mean that one firm’s actions affect other firms and one firm is affected by the
actions of others. So it seems a perfect fit for the use of game theory to describe the behavior of
firms in an oligopoly. Managers of each firm must make decisions in the context of existing rivals
and must even take into account the possible actions of potential rivals. There is no doubt that all
managers are absorbed in their own firm’s situations, but putting themselves in the shoes of
competitors and focusing on the competitors’ probable responses to actions they might undertake
can be a useful exercise.1

26-2c The Dilemma: Noncooperative Games Consider the situation in which firms must decide
whether to devote more resources to advertising. When a firm in any given industry advertises its
product, its demand increases for two reasons. First, people who had not used that type of product
before learn about it, and some will buy it. Second, other people who already consume a different
brand of the same product may switch brands. The first effect boosts sales for the industry as a
whole, whereas the second redistributes existing sales within the industry.

Assume that Figure 6 illustrates the possible actions that two firms might take and the results of
those actions. The top left rectangle represents the payoffs, or results, if both A and B advertise; the
bottom left is the payoffs when A advertises but B does not; the top right is the payoffs when B
advertises but A does not; and the bottom right is the payoffs if neither advertises. If firm A can earn
higher profits by advertising than by not advertising, whether or not firm B advertises, then firm A will
surely advertise. This is referred to as a dominant strategy—a strategy that produces the best results
no matter what strategy the opposing player follows.

Firm A compares the left side of the matrix to the right side and sees that it earns more by
advertising, no matter what firm B does. If B advertises and A advertises, then A earns 70, but if B
advertises and A does not advertise, it earns 40. If B does not advertise, then A earns 100 by
advertising and only 80 by not advertising. The dominant strategy for firm A is to advertise. And
according to Figure 6, the dominant strategy for firm B is also to advertise. Firm B will earn 80 by
advertising and 50 by not advertising if A advertises, and will earn 100 by advertising but only 90 by
not advertising if A does not advertise. But notice that both firms would be better off if neither
advertised; firm A would earn 80 instead of 70, and firm B would earn 90 instead of 80. Yet the firms
cannot afford to not advertise because they would lose more if the other firm advertised and they
did not. This situation is known as the prisoners’ dilemma; see the Economic Insight “The Prisoners’
Dilemma” for a more complete description of why it has this name.

This is exactly the situation cigarette producers were facing in the 1960s. None of the cigarette
manufacturers wanted to do much advertising. Yet strategic behavior suggested that they must.
Firm A advertises, so firm B must also do so. Each firm ups the advertising ante. How can this
expensive advertising competition be controlled?

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