CHAPTER 7: MARKET STRUCTURES Economics Mr. Robinson

Section 1: Perfect Competition

The Four Conditions for Perfect Competition 1. Many Buyers and Sellers There are many participants on both the buying and selling sides. 2. Identical Products There are no differences between the products sold by different suppliers. 3. Informed Buyers and Sellers The market provides the buyer with full information about the product and its price. 4. Free Market Entry and Exit Firms can enter the market when they can make money and leave it when they can't.

What is Perfect Competition?

Why is market price accepted as given? Goods in a perfectly competitive market are commodities. All commodities are essentially the same. The buyer will not pay extra for one particular company’s goods. Because there are many buyers and sellers, no one is powerful enough to influence the market.

S D pepe qeqe Marty’s Price Why is market price accepted as given? Perfect Information: ▫Consumers have access to price information for a variety of gas stations. ▫Suppose Marty’s Mobil sets its price above the market equilibrium price… ▫Consumers will buy their gas from another local station.

Barriers to Entry Factors that make it difficult for new firms to enter a market are called barriers to entry. Start-up Costs The expenses that a new business must pay before the first product reaches the customer are called start-up costs. Technology Some markets require a high degree of technological know-how. As a result, new entrepreneurs cannot easily enter these markets.

Barriers to Entry, cont. Landscaping presents few technical challenges and start- up costs are low. However, an auto repair shop requires advanced technical skills and the equipment needed to run the shop makes start-up costs another significant barrier to entry.

Price and Output One of the primary characteristics of perfectly competitive markets is that they are efficient. In a perfectly competitive market, price and output reach their equilibrium levels. Prices are the lowest sustainable prices Market Equilibrium in Perfect Competition Quantit y Price Supply Demand Equilibriu m Price Equilibriu m Quantity

Section 2: Monopoly

MONOPOLY A market structure characterized by a single seller of a unique product with no close substitutes. As the single seller of a unique good with no close substitutes, a monopoly has no competition. The demand for output produced by a monopoly is THE market demand, which gives monopoly extensive market control. The inefficiency that results from market control also makes monopoly a key type of market failure.

Characteristics of Monopoly Single Supplier: First and foremost, a monopoly is a monopoly because it is the only seller in the market. The word monopoly actually translates as "one seller." As the only seller, a monopoly controls the supply-side of the market completely. If anyone wants to buy the good, they must buy from the monopoly.

Characteristics of Monopoly Unique Product A monopoly achieves single-seller status because the good supplied is unique. There are no close substitutes available for the good produced by a monopoly.

Characteristics of Monopoly Barriers to Entry: A monopoly often acquires and generally maintains single seller status due to restrictions on the entry of other firms into the market. Some of the key barriers to entry are: 1. government license or franchise, 2. resource ownership, 3. patents and copyrights, 4. high start-up cost, and 5. decreasing average total cost.

Characteristics of Monopoly Specialized Information: A monopoly often possesses information not available to others. This specialized information comes in the form of legally-established patents, copyrights, or trademarks.

Why does a monopoly form? Monopolies achieve their single-seller status for three interrelated reasons: 1. economies of scale 2. government decree 3. resource ownership

Why does a monopoly form? Economies of Scale: Many real world monopolies emerge due to economies of scale and decreasing average cost. If average cost decreases over the entire range of demand, then a single seller can provide the good at lower per unit cost and more efficiently than multiple sellers. This often leads to what is termed a natural monopoly. Many public utilities (such as electricity distribution, natural gas distribution, garbage collection) have this natural monopoly inclination.

Economies of Scale If a firm's start-up costs are high, and its average costs fall for each additional unit it produces, then it enjoys what economists call economies of scale. ATC is total cost divided by quantity of output Example: A firm doubles output, but the total cost of inputs does not double, but increases by a smaller amount Average total cost without economies of scale Cost Output ATC Average total cost with economies of scale Cost ATC Output

Why does a monopoly form? Government Decree: The monopoly status of a firm can be established by the mandate of government. Government simply gives one and only one firm the legal authority to supply a particular good. Technological Monopolies Franchises and Licenses Industrial Organizations

Why does a monopoly form? Resource Ownership: A monopoly is likely to arise if a firm has complete control over a key input or resource used in production. If the firm controls the input, then it controls the output. Monopolies have arisen over the years due to control over material resources, labor resources or information resources

A Monopoly’s Revenue The monopolist has a downward- sloping demand curve. This is because the industry demand curve is the firm’s demand curve. Demand Curve for a firm in a Perfectly Competitive market

A Monopoly’s Revenue Even a monopolist faces a limited choice – it can choose to set either output or price, but not both. Because a monopoly is a price maker with extensive market power, it faces a negatively-sloped demand curve. To sell a larger quantity of output, it must lower the price. The monopoly can sell 1 unit for $10. However, if it wants to sell 2 units, then it must lower the price to $9.50.

A Monopoly’s Revenue The marginal revenue generated from selling extra output is less than price. While the price of the second unit sold is $9.50, the marginal revenue generated by selling the second unit is only $9. While the $9.50 price means the monopoly gains $9.50 from selling the second unit, it loses $0.50 due to the lower price on the first unit ($10 to $9.50). The net gain in revenue, that is marginal revenue, is thus only $9 = ($ $0.50).

Demand and Marginal-Revenue Curves for a Monopoly Quantity of Water Price $ –1 –2 –3 –4 Demand (average revenue) Marginal revenue If a monopoly wants to sell more, it must lower price. Price falls for ALL units sold. This is why MR is < P. ($9, 2) ($8, 3)

A Monopoly’s Revenue A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. All profit-maximizing firms set MR = MC. It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Profit Maximization for a Monopoly Quantity QQ0 Costs and Revenue Demand Average total cost Marginal revenue Marginal cost Monopoly price Q MAX B 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity... A and then the demand curve shows the price consistent with this quantity.

Price Discrimination Price discrimination is the division of customers into groups based on how much they will pay for a good. Can be practiced by any company with market power. Price discrimination requires some market power, distinct customer groups, and difficult resale. Examples: student discounts & manufacturers’ rebate offers

Section 3: Monopolistic Competition and Oligopoly

Monopolistic Competition A market structure characterized by a large number of relatively small firms. While the goods produced by the firms in the industry are similar, slight differences often exist. As such, firms operating in monopolistic competition are extremely competitive but each has a small degree of market control.

Four Conditions of Monopolistic Competition 1. Many Firms A monopolistically competitive industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market. This ensures that all firms are relatively competitive with very little market control over price or quantity. In particular, each firm has hundreds or even thousands of potential competitors.

Four Conditions of Monopolistic Competition 2. Few Artificial Barriers to Entry Monopolistically competitive firms are relatively free to enter and exit an industry. There might be a few restrictions, but not many. These firms are not "perfectly" mobile as with perfect competition, but they are largely unrestricted by government rules and regulations, start-up cost, or other substantial barriers to entry.

Four Conditions of Monopolistic Competition 3. Slight Control over Price Each firm in a monopolistically competitive market sells a similar, but not absolutely identical, product. The goods sold by the firms are close substitutes for one another, just not perfect substitutes. Most important, each good satisfies the same basic want or need. Buyers treat the goods as similar, but different and allows a firm to have limited control over price

Four Conditions of Monopolistic Competition 4. Differentiated Products The goods produced by firms operating in a monopolistically competitive market are subject to product differentiation. The goods are essentially the same, but they have slight differences. Product differentiation is the primary reason that each firm operating in a monopolistically competitive market is able to create a little monopoly all to itself and profit.

Nonprice Competition 1. Characteristics of Goods ▫ New size, color, shape, texture, or taste. 2. Location of Sale ▫ Differentiation of goods by where they are sold 3. Service Level ▫ Offer customers a higher level of service. 4. Advertising Image ▫ Use advertising to create apparent differences between their own offerings and other products. Nonprice competition is a way to attract customers through style, service, or location, but not a lower price.

Monopolistically Competitive Firms: Prices, Profits, and Output Prices ▫ Firms have a small amount of power to raise prices. ▫ Monopolistic Competition > Perfect Competition Profits ▫ Competitive firms can earn profits in the short run ▫ Have to work hard to keep their product distinct enough to stay ahead of their rivals. Costs and Variety ▫ Cannot produce at the lowest average price due to the number of firms in the market. ▫ Offer a wide array of goods and services to consumers.

Oligopoly A market structure characterized by a small number of large firms that dominate the market, selling either identical or differentiated products, with significant barriers to entry into the industry. Because an oligopolistic firm is relatively large compared to the overall market, it has a substantial degree of market control.

Behavior of Oligopolies Interdependence: Each oligopolistic firm keeps a close eye on the activities of other firms in the industry. Decisions made by one firm invariably affect others and are invariably affected by others. Competition among interdependent oligopoly firms is comparable to a game or an athletic contest. One team's success depends not only on its own actions but on the actions of its competitor

Behavior of Oligopolies Rigid Prices: Many oligopolistic industries (not all, but many) tend to keep prices relatively constant, preferring to compete in ways that do not involve changing the price. The prime reason for rigid prices is that competitors are likely to match price decreases, but not price increases. As such, a firm has little to gain from changing prices.

Behavior of Oligopolies Nonprice Competition: Because oligopolistic firms have little to gain through price competition, they generally rely on nonprice methods of competition. Three of the more common methods of nonprice competition are: advertising, product differentiation, and barriers to entry. The goal for most oligopolistic firms is to attract buyers and increase market share, while holding the line on price.

Behavior of Oligopolies Mergers: Oligopolistic firms perpetually balance competition against cooperation. One way to pursue cooperation is through merger--legally combining two separate firms into a single firm. Because oligopolistic industries have a small number of firms, the incentive to merge is quite high. Doing so then gives the resulting firm greater market control.

Behavior of Oligopolies Collusion: Another common method of cooperation is through collusion--two or more firms that secretly agree to control prices, production, or other aspects of the market. When done right, collusion means that the firms behave as if they are one firm, a monopoly. As such they can set a monopoly price, produce a monopoly quantity, and allocate resources as inefficiently as a monopoly. A formal method of collusion, usually found among international produces is a cartel.

Comparison of Market Structures Markets can be grouped into four basic structures: perfect competition, monopolistic competition, oligopoly, and monopoly

Section 4: Regulation and Deregulation

Market Power Market power is the ability of a company to control prices and output. Markets dominated by a few large firms tend to have higher prices and lower output than markets with many sellers. To control prices and output like a monopoly, firms sometimes use predatory pricing.

Predatory Pricing How it works: 1. The predatory firm lowers its price below the average cost of itself and its competitor(s). 2. The competitor(s) must either a. Lower its prices, or b. Lose any market share, due to loss of sales, that it previously held. 3. The prey goes out of business due to bankruptcy (variable costs > revenue) 4. The predator then increases its price to restore its profits.

Government and Competition Government policies keep firms from controlling the prices and supply of important goods. Antitrust laws are laws that encourage competition in the marketplace. Regulating Business Practices Breaking Up Monopolies Blocking Mergers Preserving Incentives

Deregulation Deregulation is the removal of some government controls over a market. Deregulation is used to promote competition. Many new competitors enter a market that has been deregulated. This is followed by an economically healthy weeding out of some firms from that market, which can be hard on workers in the short term.