BACC1 – Basic Microeconomics

Module V (Market Structures)

Introduction

In order for us to know what type of market we are working at, it is very important for us to
know the features that will determine the type of market structure, are there lots of producers
or only few, is my product the same as everyone else is or is it unique. The characteristic of the
market will give a clue as to the type of market you are dealing with.

Let’s take a look at the first type of market structure. At one extreme we have “Perfect
Competition”, when we say competitive; we need to consider how many producers are we
talking about? A lot, and how many is a lot or a large number? Economists aren’t really specific
about this, but a large number of producer means that there are so many competitors that each
one is too small to affect the market. In my mind, I tend to think of maybe a hundred or more so
that each competitor will have at least one percent or less shares in the market. Since nothing
you do affects the market, no one really cares what you do and you are free to make decisions
without worrying about what the competition will react.
How else can we recognize a perfectly competitive market besides having a large number of
sellers? Each of those sellers will be producing exactly the same thing. The product is identical
or homogeneous or non-differentiated no matter who produces it. Another characteristic, it is
easily for firms to come and go from the industry, which means that there’s a free entry and
exit. If we think about it, this industry has a lot of producers, why? It’s because it is easy to get it
and set up shops. In an industry like this, lots of producers all produce exactly the same thing.
How much market power (market power is defined as the ability to control the price) does an
individual firm has? The answer is none. You have no ability to drive the price because one,
you’re so small, and two, everyone is producing exactly the same thing that you do.

Time to think!
What do you think will happen if you try to raise your price?

Now let’s take a look at the opposite extreme of the spectrum, instead of a huge number of
producers there’s only one producer for the entire market or a “Monopoly”. (The prefix mono,
meaning one.) Furthermore, the monopolist product is unique; there really are no substitutes
for this product. Lastly, in a monopolistic industry, entry by other firms is nearly impossible
due to the extremely high barriers of entry. We will be dealing with this later, but barriers of
entry could be, high cost or legal protection like patents or copyrights. Given all this
characteristics, only one producer, a unique product, and no one else can get in the industry to
compete with you, how much market power does the monopoly producer have? The
monopolist has complete control over the price within the boundaries of what consumers are
willing to pay.

Are there other structures? In fact there are, most of the real world industries will fall
somewhere in the middle ground not at the theoretical extreme of perfect competition and
monopoly. Two of these mid-range structures are Monopolistic Competition and Oligopoly.

A monopolistic competition is still competitive so there’s still a lot of producers, given that
there’s a lot of producers, we can assume that the entry and exit in the industry is easy, unlike
perfect competition however, products are not exactly the same, highly similar yes, highly
substitutable, yes, but not identical. Think about toothbrushes, you go a store and you will find
a lot of types of toothbrushes, you will find square heads, diamond heads, rubber gripped
handles, bi-level brushes, toothbrushes that play music, glow in the dark toothbrushes. All of
them are toothbrushes, all highly similar and substitutable but with slight differences. If I
believe as a consumer that having a rubber grip handle helps clean my teeth better, then this
differentiation will give the producer a small amount of market power. Here, she could raise the
price a little bit and I would still buy that rubber gripped handle toothbrush, if she raises the
price too high though, I will switch to some other kind of toothbrush.

Oligopoly on the other hand is different. The prefix “oli” mean few, so we have large producers
making up the market, each have a large amount of control or market power, there are some
barriers of entry so it’s hard but not impossible to get in. Product in an oligopolistic market can
be identical, like the members of the OPEC (countries that produces oil) were differentiated like
car manufacturing firms. Also, the small number of producers could be just a handful like cars
producers. The key is that there are few enough producers that each one has a fairly large
amount of the chunk in the market, large enough that every individual producer can affect what
happen in the market because every ones actions matter the producers become mutually
interdependent, whatever one does affects everyone else. This mutual interdependence actually
makes oligopoly one of the most complicated types of structure to operate in.

Now that you have an idea on the different characteristics of market structures, here a question
for you, what type of product or products will fit the four market structures discussed?

PERFECT COMPETITION

So, what do we remember about perfect competition? One, there are large number of sellers
and there are large numbers of buyer too. No individual is large enough to affect the market.
Two, the product is homogeneous or identical or none differentiated, for example milk, when
you go to buy milk in the market, what brand do you buy? If you are like me, you buy whatever
is on sale, I have no brand loyalty whatsoever because milk is milk. Three, there’s perfect
information, it is not enough for products to be identical, everyone needs to know that the
products are identical, otherwise, we could be fooled by things like pretty packaging, or
celebrity endorsement. In a perfectly competitive industry firm vs. firm advertising is useless,
all you’d be doing is driving up your individual cost and customers will just buy from cheaper
competitor. However, you may see industry-wide advertising. Four, easy entry and exit.
Because firms can enter and exit the industry at will, long-term profits would be affected. For
the individual firm owner, the combined effect of these characteristics is that he/she has no
power to control the price, and will earn zero economic profit in the long run.

If the individual firm cannot set the price, then where does the price come from? Think back
from our lesson in supply and demand, in a market that has a lot of buyers and seller, the price
is determined collectively by the market supply and demand. This then, is the prevailing price
for each firm. What happens if the firm does not like the price? If it tries to charge more than the
equilibrium price, all of the customers will go somewhere else, so the firm will be forced back
down the market price equilibrium. If they try to charge less than the market equilibrium price,
then all customers in the industry will come to this firm. Sounds good right? Wrong, this firm
cannot accommodate the entire industry demand; costs would skyrocket, and firm will be
forced back up to the market price equilibrium. All of this means that the firm is a price taker,
they are forced to accept the market price equilibrium, the market determined equilibrium
price.
Note that this would also mean that since firm charges market price equilibrium regardless of
the quantity demanded, the market price equilibrium will also represent the firm’s demand as
well. Remember that perfectly elastic demand curve from our previous lessons where
consumers are highly sensitive to price, that price is all that matters, this is what perfectly
competitive market is all about.

In the point of view of the producers, it is known that you cannot control the price. Is there
anything you do have control over? A perfectly competitive firm may not be able to choose its
price, but it can choose how much output to produce. The firm owner will choose the level of
output that will maximise his/her profits. The firm will always choose the level of output where
marginal revenue is equals to marginal cost.

Marginal revenue is the additional revenue that you earn when you sell an additional unit of
output. For perfectly competitive firm, since all units are sold for the same price. Each unit sold
always adds the same amount of revenue at market price equilibrium. For example, if the price
is 5 pesos, then the total revenue for zero units is zero, for one unit is 5pesos, and two units is
10pesos and so on. Selling one more unit generates five additional pesos of revenue each time.
Therefore marginal revenue is equal to the equilibrium price. Note that this is only true in a
perfect competition market. Profits derived from a perfect competition market can only be
realized in the short-run. Reiterating short-run, because those short-run profit will attract the
sharks (other outside firms) and they will try to enter the industry to set up shops. This causes
industry supply to increase, driving the price downwards. In the end, the entry would only
stops when there are no more profits to attract the sharks; until price is equal to the average
cost, and the firms just break even. In the long-run, a perfectly competitive firm’s profits are
always equal to zero.

MONOPOLY

How will you know monopoly when you see one? Think back to the characteristics; there’ll be a
single seller, someone who sells a product for which there are no close substitutes, and there are
significant barriers to entry, barriers that are so high, in fact, that no other producers can enter
the industry. What kinds of barriers could there be that would keep competitors out? Patents
will keep others out, at least until the patent expired, or unless you sell the right to use the idea
to other people; sole ownership of a key resource would prevent competition. For example if
you are a large bookstore that owns the only book distributor, then there’s not really any way
for other bookstores to get inventory. Cost, extremely high cost would keep many other
producers out; in fact, in the case of extraordinarily high fixed costs, you get a situation where
economies of scale kick in, and you’re actually better off to have only one producer.

Think about power generation plants. It not only costs billions of pesos to build the plant itself,
but then you need the power grid, all those towers and lines to deliver the electricity. So, if
there’s just one company incurring all those upfront costs, that firm can spread the costs out
over a large quantity of production and the cost per unit ends up being low. But if you break
this company up, creating 10 smaller firms that would compete with each other, each firm must
repeat these initial costs, yet has only 1/10 of the customers seen on the example on the slide.
Cost per unit ends up being very high. In a case like this, with huge economies of scale, it’s
actually more efficient to have only one producer, as a natural outcome of the cost structure.
This would be a natural monopoly. With the natural monopoly, the enormous fixed costs
dominates, so that effectively, the average total cost curves look like what we’re accustomed to
seeing in an average fixed cost curve, the more you produce, the lower the cost per unit. This
type of monopoly is the exception, though, and not the rule. This type of monopoly is also
considered as atypical monopoly.

In a typical monopoly, since the monopoly is the only seller of the product, anyone who wants
to buy the product must buy from the monopoly. This means that the demand faced by the
monopolist is the entire industry, or market, demand. What happens to the monopolist’s profit
in the long run? If a competitive firm makes a profit in the short run, then overtime, other firms
enter and profits go to zero. So what happens to the monopolist’s profit? NOTHING
HAPPENS. That is because of the barriers of entry, those barriers will keep competitors out,
protecting the monopolist’s profit. Does a monopolist necessarily earn profit? No, just because
you’re the only producer of something doesn’t guarantee you’ll earn a profit. If the cost per unit
exceeds the price, you’ll be losing money just like any other business. What will happen in the
long run? Any producer who’s losing money in the short run will get out in the long run, taking
his/her resources elsewhere. Where does this leave the industry? If this producer leaves, there
is no industry.
Why do so many people consider the monopolist to be the bad guy? This is just a producer,
trying to maximize profits like any other producer. Most people are opposed to a monopoly
because they prefer the alternative competition. Remember that in a competitive market, the
market supply and the market demand determine the price and quantity. We know already that
the monopoly faces the industry, or market demand. Monopolist also is the industry supply. So
why do people consider monopolist the bad guy? It is because the monopolist charges more,
and provides fewer products. The people who do not like the monopolist are the consumers,
who would rather see the lower prices and greater quantities associated with a competitive
market.

MONOPOLISTIC COMPETITION

Since we already know what competition and monopoly from previous discussion it would be
easy to analyse this type of monopolistic competition. As the name suggests, it’s something of a
mashed up of the characteristics of a perfectly competitive market and monopoly. It is
competitive, so, like perfect competition there are large numbers of sellers, large enough so that
no individual can affect the overall market. There is also free entry and exit; firms find no
substantial barriers to entering or departing this market. But moving the direction of the
monopoly, the monopolistic competitor’s product is differentiated (slightly) from the products
produced by its rivals. This product differentiation gives the monopolistically competitive firm
a small amount of control over the price it can charge. Not a lot of control, because the products
are still highly similar, but a little control. Think back on the toothbrush example, toothbrushes
are toothbrushes, with small differences, like angled heads, or rubber-grip handles, or the
ability to play a song to tell you how long to brush your teeth. If I, as the customer, believe that
the rubber grip handle is the key to good dental health then the rubber-grip handle toothbrush
manufacturer will be able to get me to pay a bit more for the product that for any other kind of
tooth brush. Not too much more, though, or I’ll switch to a close substitute. Notice that in my
toothbrush example, there’s a real differentiation, where there are physical differences in the
product. It is possible in this market structure to have artificial differentiation, where two
products are physically identical, but through marketing (attractive packaging, celebrity
endorsements) consumers are convince that the products are different. This couldn’t happen in
a perfectly competitive market, because of the assumption of perfect information being
available. But in a monopolistically competitive market, perfect information does not exist, and
consumers can be fooled into believing that products are different by the use of advertising and
marketing. In the end, as long as consumers perceive the products to be different, then the
products are different; it doesn’t matter whether the difference is real or artificial. So, in
monopolistic competition, there lots of competitors, with highly substitutable products that
have slightly differences, and there’s free entry and exit. What does the market look like, well
the demand facing each producer will be a small fraction of the overall market demand, and the
demand will be highly, but not perfectly, elastic.

So, whereas the perfectly competitive firm’s demand was horizontal, showing that they had no
control over price, the monopolistically competitive firm’s demand will be downward sloping ,
if fairly flat, showing that the firm has a small amount of control over its price.

OLIGOPLY

Oligopoly is the most complex market structure, in an oligopoly you would only find only a
small number of sellers, few enough so that any individual seller can affect the market, and
firm’s action will have an impact on all the other sellers. The product can be either the same,
like oil, or differentiated, like automobiles, and there are fairly high barriers of entry.

Having seen the other market structures, you should be able to make some predictions about
the implications of the oligopoly characteristics. What will prices and output look like? What is
the potential for profit? As you’d expect, the oligopoly market structure will result in a higher
price that either competitive market, although not so high as a monopoly, and will be able to
maintain some profit, if it exists, into the long run because of the barriers to entry. Having said
that oligopoly is the most complex structure; it is because the actions of any one firm will have
an impact on all of the other players in the market. This mutual interdependence among firms
means that each firm keeps an eye on everyone else, trying not only to anticipate moves but also
to have their own reaction plan in place. Will the other guy raise his price? Lower his price? If
he makes a move, what will I do? You can see the increased complexity of this market just by
looking at the oligopolistic firm’s demand. It would look like a kinked demand curve. We have
not encountered a demand curve that looks like this before so, why does it look like it? This
demand is effectively compose of two different demand curves, because the game-playing
behaviour, if you will, of the firms in this industry will change depending on whether the firm
is implementing a price increase, or a price decrease. When the oligopolistic firm goes to
increase its price, the rivals will not follow; they will let that one firm increase its price, and then
they will gain the customers as buyers are driven away by the initiating firm’s higher prices.
What this means to firm is that, if it raises its price, and no other producer follow, then the
initiating firm will see a huge decrease in the quantity demanded, i.e. the demand is more
elastic when the firm attempts to increase its price.
What will happen if the firm will lower its price? The rivals are aware that they could lose
substantial market share if they do not follow along and lower their prices as well, but what
happens if everyone lower their prices? The firm that initiated the price decrease would see
very little change in quantity demanded because for the most part, customers stay where they
are; that is, the demand faced by the firm is inelastic when there is a price decrease. So, if the
firm raises price, no rivals will follow, it loses a lot of customers, and the demand is elastic; but
if it lowers its price, everyone follows, and not much is gained by that firm in terms of sales, or
you have inelastic demand.

This will also result in a very unusual marginal revenue curve. Think about the marginal
revenue that would be associated with the more elastic price increase scenario. Then, consider
the marginal revenue that would be associated with more inelastic price decrease demand. The
marginal revenue associated with a kinked demand curve would look like this (refer to the
slide).

Again, the oligopolistic firms can still earn profit in the short-run, and they may also earn
profits in the long-run because of the barriers of entry.