1. Introduction to Market Structure
Micro:
Econ: 21 57
Module
Introduction to Market Structure
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

2. What you will learn in this Module:
The meaning and dimensions of market structure.
The four principal types of market structure—perfect competition, monopoly, oligopoly, and monopolistic competition.
The purpose of this module is to introduce the four market structures studied in economics. Future modules will go into much more depth. This module serves as a preview of the important characteristics of each of the market structures.

3. Market Structures
The way a product is supplied depends on how the industry is structured. Economists define four different market structures; perfect competition, monopoly, oligopoly, and monopolistic competition.

4. Defining Market Structures
How many Firms?
Type of product?
There are many ways to separate markets into one of these four structures, but two important characteristics stand out.
-How many firms are in the market?
-Do they produce a differentiated or a standardized (identical) product?
If we lined up the market structures on the basis of the number of firms, we would put perfect competition at one end (many firms) and monopoly at the other end (one firm).
However if we look at the second question of product differentiation, it gets a little more complicated.
Perfect competition: all firms produce a standardized product (soybeans)
Monopolistic competition: products are differentiated (clothing)
Oligopoly: both standardized (oil) and differentiated (soft drinks) exist.
Monopoly: only one producer of a product with no close substitutes.

5. Perfect Competition Two necessary conditions for perfect competition
Firms are price-takers
Free entry and exit
Real-world examples of perfect competition are very rare. We study this market structure because it provides us with a benchmark for studying and evaluating the market structures that do exist. In many ways, though not all, perfect competition produces ideal outcomes that cannot be attained by the many real-world markets.
In previous modules we have assumed one of the key characteristics of perfect competition: price taking behavior for both firms and consumers. This simply means that no individual firm, or consumer, can affect the market price of the product being sold, or bought. The basic model of supply and demand assumes price-taking behavior. The equilibrium price is determined in the market and firms sell as much as they want at that price.
For firms to be price-takers, two important characteristics are necessary.
1. There are many of them, so many that each firm’s share of the market output is miniscule.
Market share for Firm Z = (Firm Z’s output)/(total combined output for all firms)
2. The product of one firm is identical to the product of all other rivals. Firms A-Z produce the same thing.
Free Entry and Exit
One other characteristic helps to define perfect competition, but is not unique to this structure.
It is easy for new firms to enter the industry or for firms that are currently in the industry to leave.
Freedom of entry and exit means that there are no significant obstacles preventing firms from entering or leaving the industry.
We will see that this is important because it insures that the market will adjust quickly to the presence of economic profits or losses. If economic profits exist, new firms will enter the market and drive profits downward to zero. If economic losses are being incurred, existing firms will exit the market and drive losses upward to zero.

6. Monopoly
A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry controlled by a monopolist is known as a monopoly.
A monopoly industry has barriers to entry.
Ownership of essential resources
Economies of scale
Technological superiority
Government created barriers
Why is there only one producer in a market? There are “barriers to entry”.
While there are many barriers to entry, we can identify a few that commonly occur;
1. Ownership or control of essential resources is another barrier to entry.
Obviously, if a product requires a key resource to produce, and if one firm can control that resource they will control the market for the product.
2. Economies of scale
The lowest LRATC and, therefore, low unit prices for consumers depend on the existence of a small number of large firms or, in the case of monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale.
3. Technological Superiority.
One firm controls the knowledge to make a particular product, so they become a monopolist.
The text gives Intel as an example, but acknowledges that other companies (AMD to name one) have developed comparable technology in the production of microprocessors so Intel’s near-monopoly has been eroded.
4. Government created.
Legal barriers to entry into a monopolistic industry also exist in the form of patents and copyrights.
Patents grant the inventor the exclusive right to produce or license a product for years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits. Copyrights gives the creator of a literary or artistic work the sole right to profit from that work, usually for a period equal to the creator’s lifetime plus 70 years.

7. Oligopoly
An oligopoly is an industry characterized by a small number of large firms with some degree of market power.
Characteristics of an oligopoly industry include;
a few large firms
barriers to entry
interdependence
Some key characteristics of oligopolies include:
A few large firms that produce almost all of the total output in the industry.
Strong barriers to entry.
A product that could be identical (like oil) or differentiated (like cars).
Strategic behavior and mutual interdependence.

8. Measuring Market Power
Four-firm Concentration Ratio (CR4): Add up the market share of the four largest firms in the industry.
Herfendahl-Hirschmann Index (HHI): The sum of the market shares, squared, for all firms in the industry.
Four-firm Concentration Ratio (CR4): Add up the market share of the four largest firms in the industry.
Example:
The four largest firms in industry A have market shares equal to: 30%, 20%, 10% and 5%.
CR4 = 65%. The four largest firms have a combined 65% of the market.
Industry B has the four largest firms with market share equal to: 12%, 10%, 8% and 4%
CR4 = 34%.
If we compared these two industries, we would say that industry A has more concentration and is much closer to being an oligopoly than industry B.
Herfendahl-Hirschmann Index (HHI): The sum of the market shares, squared, for all firms in the industry.
Suppose a industry is perfectly competitive and has 100s of firms with market shares each at approximately zero percent of the market.
If we square a bunch of market shares close to zero, we will get an HHI close to zero.
What if we have a monopoly? Only one firm has market share of 100% so the HHI is 10,000.
So real-world industries have HHI that lie between zero (the most competitive) and 10,000 (the least competitive).

9. Measuring Market Power
Four-firm Concentration Ratio (CR4): Add up the market share of the four largest firms in the industry.
Example:
The four largest firms in industry A have market shares equal to: 30%, 20%, 10% and 5%.
CR4 = 65%. The four largest firms have a combined 65% of the market.
Industry B has the four largest firms with market share equal to: 12%, 10%, 8% and 4%
CR4 = 34%.
If we compared these two industries, we would say that industry A has more concentration and is much closer to being an oligopoly than industry B.
Four-firm Concentration Ratio (CR4): Add up the market share of the four largest firms in the industry.
Example:
The four largest firms in industry A have market shares equal to: 30%, 20%, 10% and 5%.
CR4 = 65%. The four largest firms have a combined 65% of the market.
Industry B has the four largest firms with market share equal to: 12%, 10%, 8% and 4%
CR4 = 34%.
If we compared these two industries, we would say that industry A has more concentration and is much closer to being an oligopoly than industry B.
Herfendahl-Hirschmann Index (HHI): The sum of the market shares, squared, for all firms in the industry.
Suppose a industry is perfectly competitive and has 100s of firms with market shares each at approximately zero percent of the market.
If we square a bunch of market shares close to zero, we will get an HHI close to zero.
What if we have a monopoly? Only one firm has market share of 100% so the HHI is 10,000.
So real-world industries have HHI that lie between zero (the most competitive) and 10,000 (the least competitive).

10. Measuring Market Power
Herfendahl-Hirschmann Index (HHI): The sum of the market shares, squared, for all firms in the industry.
Suppose a industry is perfectly competitive and has 100s of firms with market shares each at approximately zero percent of the market.
If we square a bunch of market shares close to zero, we will get an HHI close to zero.
What if we have a monopoly? Only one firm has market share of 100% so the HHI is 10,000.
So real-world industries have HHI that lie between zero (the most competitive) and 10,000 (the least competitive).
Four-firm Concentration Ratio (CR4): Add up the market share of the four largest firms in the industry.
Example:
The four largest firms in industry A have market shares equal to: 30%, 20%, 10% and 5%.
CR4 = 65%. The four largest firms have a combined 65% of the market.
Industry B has the four largest firms with market share equal to: 12%, 10%, 8% and 4%
CR4 = 34%.
If we compared these two industries, we would say that industry A has more concentration and is much closer to being an oligopoly than industry B.
Herfendahl-Hirschmann Index (HHI): The sum of the market shares, squared, for all firms in the industry.
Suppose a industry is perfectly competitive and has 100s of firms with market shares each at approximately zero percent of the market.
If we square a bunch of market shares close to zero, we will get an HHI close to zero.
What if we have a monopoly? Only one firm has market share of 100% so the HHI is 10,000.
So real-world industries have HHI that lie between zero (the most competitive) and 10,000 (the least competitive).

11. Monopolistic Competition
Monopolistic competition is a market structure characterized by
Many firms
Differentiated product
No barriers to entry/exit
Somewhere in between perfect competition and oligopoly lies monopolistic competition.
Characteristics:
-Many firms exist in the market, but not as many as perfect competition. You might think of monopolistic competition as measured in dozens of firms, while perfect competition is measured in hundreds of firms.
-The product is differentiated.
-Each firm has some ability to set the price of their product.
-There are no barriers to entry or exit.

12. Table The HHI for Some Oligopolistic Industries Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers