An investigation into the four market models allows the student to gain a better understanding of business behaviors and strategies and how prices are established. Below is an illustration of the range of markets. As you move from left to right, you will notice that the number of sellers decreases, and the ability to control price increases.
As we progress through the different market models, you will notice different features for each. The table below summarizes the characteristics of each model.
Overview of the Four Market Structures
|Market Structure||Number of Sellers||Type of Product||Entry Condition||Examples|
|Perfect Competition||Large||Homogenous||Very Easy||Agriculture|
|Monopolistic Competition||Many||Differentiated||Easy||Retail trade|
|Oligopoly||Few||Homogenous or differentiated||Difficult||Autos, steel, oil|
It is quite common in the field of economics to describe the other markets based on how they differ from a perfectly competitive market. So let’s find out about perfect competition.
The model of perfect competition serves as a benchmark of economic efficiency against which real world markets can be measured. Although there are few real world examples of pure competition, it is still beneficial to study it as a model. Market power refers to the ability to influence price of a product. In a perfectly competitive market, there is little market power for producers.
A perfectly competitive market requires a number of conditions. The first is that there need to be many buyers and sellers. This is necessary so that no individual or group can influence price. Second, the goods or services need to be identical to one another. If the product differed evenly slightly, sellers might be able to convince buyers to purchase their product even at a higher price. In other words, the products are perfect substitutes for one another. Third, buyers and sellers must have complete and equal knowledge of market conditions, so that no buyer or seller knows more than the other. This means that no one buyer or seller can dominate the market and raise price. The fourth condition, is that there must be freedom for buyers and sellers to enter the market at will. If there are profits to be made, new firms need to have access to the market. These conditions mean that firms in a competitive market have no control over price. They can only make a decision on how much to produce. Therefore, firms in a perfectly competitive market are price takers, in other words, sellers that have no control over the price of the product being sold. For example, wheat farmers cannot get more than the market price for their wheat since the amount they supply individually is so small relative to the entire market.
It should be remembered that sellers in a perfectly competitive market are still motivated by profit maximization. The ability to make profits is influenced by whether the firm is operating in the short run or the long run. In the short run firms can make profits or losses. In the long run, they make zero profits. If firms are making profits in the short run, then new businesses will enter the industry. This will have the affect of increasing supply. This will lead to a surplus, which will decrease prices and eliminate profits. If firms experience losses, then businesses will leave the industry. This will decrease supply creating a shortage. Because of the shortage, price increases lead to the elimination of losses.
The closest example of a perfectly competitive market would be a farmers market. Many farmers bring their produce to the same location. This meets the first condition of a perfectly competitive market. The goods and services need to be identical to one another. Let’s suppose you are looking for tomatoes at the farmers market. One tomato should be able to be substituted in for another. The third condition is that all the farmers should be aware of all the different market conditions, so that no farmer is able to offer a huge reduction in price. This means farmers are equally aware of growing conditions, transportation costs, cost for rental of space to sell the product at the market, and so on. Finally, if it is known that the price of tomatoes is high, other people need to be able to enter the market and sell tomatoes. There can not be barriers to entry.
Much of our daily lives is spent dealing with firms that operate as monopolistic competitive firms. Stops to a local restaurant for lunch, a service station for gas, or to pick up clothes from the dry cleaners, are all examples of how this market structure impacts our lives. The information below should help students to better understand monopolistic competition.
Monopolistic Competition contains elements of both perfect competition and monopolies. It is like a monopoly in that it relies on product differentiation so that it is the sole seller of a slightly different, narrowly defined good. It is like perfect competition because of the intense competition from the many sellers. Since the products are not perfect substitutes, if a firm raises its price, consumers may leave to use a product of a competitor.
Characteristics of Monopolistic Competition
The definition of monopolistic competition is a market that has many small firms selling products that are similar but not identical. It is a market structure that contains many firms, product differentiation, and ease of entry into the market. Most of the retail firms in a community belong to this type of market. Consumers benefit from the ease of entry and exit to this type of market because it allows entrepreneurs to experiment with new ideas.
One of the main features of monopolistic competition is the concept of product differentiation. This refers to how a firm will try to make their product seem different from those of their competitors through such things as style, shape, size, color, texture, quality, location, packaging, advertising, and service. When products are slightly different we can no longer assume that buyers will automatically select the product with the lowest price. For example, look at barber shops and beauty salons. Even though one of these establishments might offer the lowest price for a haircut, you might go to a competitor who charges a little more because of such things as location, the ability to cut different styles, air conditioning, comfortable chairs, or good conversation.
Monopolistic competitive firms receive short run profits, not long run profits. This is because entry of new firms, advertising, and other expenses will cause profits to decline. These firms do not always allocate resources efficiently (think of gas stations open 24 hours a day). Although monopolistic competitive firms compete on price, they compete even harder on intangibles like service (think of waitresses working in restaurants).
If you have ever been annoyed at the endless commercials on television from automobiles, beer, and soda companies, then you have experienced the market known as an oligopoly. The information below should help you to better understand oligopolies.
Oligopoly refers to a market where a few large firms sell a product which may be alike or different which dominates an industry. Steel and aluminum are examples of products that are alike that make up an oligopoly market. Cars and cigarettes are examples of products that are different that constitute an oligopoly market. Economists often use a concentration ratio, to measure if a market is an oligopoly. Economists usually use a four-firm concentration ratio. If four firms control over 40% of a market, then it is an oligopoly. For example, in the cigarette industry, the four-firm ratio is 95%. What can increase the concentration ratio? One way would be through mergers within the industry or a second way would be if one of the larger firms in the industry gained market share at the expense of one of the smaller firms.
Oligopolies in Selected Industries in the United States
Characteristics of an Oligopoly Market
There are a number of characteristics that define an oligopoly market. The first is that price is not determined by the market, but by the actions of a few large firms. Each firm is trying to hold onto or enlarge their share of the market. Consequently, each firm is aware of the actions and reactions of all its competitors. An example of this is how automobile companies adjust their interest rates to those of their competitors. Mutual interdependence is a term used in economics to describe how an action by one oligopoly firm will cause a reaction by other oligopoly firms. Once again, if General Motors produces a new type of vehicle or a price change, it needs to consider how the other automobile manufacturers will react. In an oligopoly market there also exists price leadership. This is when a dominant firm sets a price, and others follow. For example, if Phillip Morris decides to increase the price of cigarettes, other cigarette producing firms will follow. There are often many barriers that exist to discourage entry into the oligopoly market. Most of these barriers are related to economies of scale. This is because there are huge start up cost to enter an oligopoly market.
Price leadership discussed above assumes that firms do not collude to avoid price competition. But is that always the case? Collusion refers to when companies in an oligopoly market try to restrict production and keep prices high. These companies want to avoid a price war. When oligopolists avoid a price war, they are in a sense agreeing to a peace treaty. Instead of being rivals, companies work together to coordinate the price and output of a product. Businesses in an oligopolistic market recognize their interdependence and seek to act cooperatively to maximize profits. Collusion is illegal in the United States. In the 1950’s officials of General Electric, Westinghouse, and Allis Chalmers met secretly at hotels to fix the prices of some of the products. In 1961 the Supreme Court found them guilty of price fixing. In the 1980’s Major League Baseball owners attempted to collude to drive down player salaries.
With so few firms in an industry, there is a temptation to band together and reduce output. Cartels are a form of collusion. A cartel is a group of firms formally agreeing to control the price and output of a product. An example would be OPEC (Organization of Petroleum Exporting Countries). The members of OPEC divide output of oil amongst themselves according to quotas openly agreed upon at meetings. Cartels are illegal in the United States but not in other parts of the world. Cartels can sometimes work. But often they fail to achieve their goals. One reason is because it is tempting for a member to increase production, and therefore profits as well. For any one firm, expanding output and selling at a price that undercuts the cartel price can achieve extra profits. Unfortunately if one firm does this, it is in each firm’s interests to do exactly the same and, if all firms break the terms of their cartel agreement, the result will be excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement can break down. A second reason is that if prices become too high, new suppliers might be interested in entering the market. Finally, overtime higher prices can lead to the development of substitutes for the cartel’s product. Collusion is easier to achieve in a market with a small number of firms. This is why they tend to occur in oligopoly markets and not in monopolistically competitive ones.
The Problems Associated With Oligopolies
There are a number of reasons why economists don’t like oligopolies. An oligopoly produces less than it can which means there is a shortage, which means prices will be higher than in a perfectly competitive market. There is always the temptation to collude, which would result in lower production and higher prices. Price wars may emerge, which in the short run benefit consumers, but which in the long run will drive competitors out of the market and force prices up. there may be waste to society in the form of high advertising costs. Finally, the size of oligopolies may allow such companies in an oligopolistic industry to have too much influence on politicians, who might legislate laws in their favor.
A few years ago, Microsoft was brought to trial by the Justice Department because of suspected monopoly practices. The court ruled that Microsoft had indeed been engaged in monopoly practices. How is it that a popular company with a popular product can be viewed as monopolistic? The information below should provide the reader with a better understanding of how monopolies affect the economy.
The Case Against Monopolies
Monopolies exist because of a concept known as market power. Market power refers to the ability of a firm to influence the price of a product. As you have probably figured out, the fewer the sellers in a market, the more market power the firm has. Monopolies have more market power than the other types of markets discussed. Consumers want the monopolist to use more resources and produce additional units, but the monopolist restricts output to maximize profit. A monopolist is characterized by inefficiency because resources are under allocated to the production of its product. A monopolist has no incentive to reduce cost because barriers to entry insulate the monopoly firm from competition. Monopolies also encourage firms to waste resources in their effort to secure and maintain the monopoly. This means a great deal of money will be spent hiring lobbyists and donating to political campaigns to convince government officials that their firm should keep their legal monopoly. Additionally, monopolies encourage the distribution of income from the poor, (who have fewer choices and power), to the rich ( who have more choices and power).
For the most part, economists dislike monopolies. They tend to restrict output and keep prices high which is wasteful and inefficient. They may acquire too much political power which reduces the effectiveness of both the market and democratic forms of government. How does this happen? A monopoly firm, which is likely to make a profit, will use some of its profits to erect barriers to entry or to grant monopoly power through licenses, franchises, or tariffs. This can be accomplished by hiring lobbyists to influence legislators. Monopolists may also not operate in the public’s interest. For example, a monopolist may intentionally lower its price to force out the competition, and once the competition is gone, they will raise the price back up. The monopolist may encourage inefficiency by resting on their laurels, and not striving to introduce new ideas. Finally, the monopolist may reduce consumer choices. They may not have the desire to meet small, niche markets. Henry Ford once said, “You can have any color of car you want, as long as it is black.”
Characteristics of a Monopoly Market
There are a number of characteristics that define a monopoly market. The first is that there is a single seller or supplier. This means that one firm provides the entire supply of a market. The second is that there exist no close substitutes. This means that the monopolist faces no competition. The idea that there exists a good or service which has no close substitute is difficult to prove. For example, if you don’t like paying high prices at the campus bookstore, you could purchase textbooks online. A third characteristic is that there are barriers to entry. These may be created by circumstance or by law. Examples would be the location of minerals or a legal barrier like a patent. The last feature is that monopolies have some control over price.
There are degrees to a monopoly. One firm may have 85% of the market, and although they may not have complete market share, they will act as if they do. Sometimes two firms may control almost all output and they will act jointly to restrict production and keep prices high. This is called a duopoly.
Reasons Why Some Monopolies May be Beneficial
Although economists tend to be united in their opposition to monopolies, there are a few times when monopolies may provide benefits. One reason to support is that the profits from a large monopolist can be used in research and development which can lead to product improvement and potential lower costs. A second reason is that monopolists can reap the benefits of economies of scale. This is the main justification for natural monopolies which are discussed below.
Different Types of Acceptable Monopolies
There are three different types of monopolies which to some degree all receive government support. They are outlined below.
1. Natural Monopolies
A natural monopoly exists when one firm can supply the entire market at a lower per unit cost than could two or more separate firms. Natural monopolies exist because of economies of scale. Costs keep falling as the size of the firm increases. Public utilities, such as water, gas and electricity, are examples of natural monopolies. It wouldn’t make sense or be economically practical, if there were multiple water or gas lines running under our streets.
2. Government Created or Legal Monopolies
There are times when the government awards a monopoly. This is usually done to promote and reward new ideas. Examples of government created monopolies are:
Patents: A patent is an exclusive right to sell a product for a specific amount of time. Since the 1995 GATT agreements, patents are now awarded for 20 years.
Copyrights: A copyright is a monopoly given to an author for their creation of a particular work that has been published. From the U.S. Copyright Office: The term of copyright for a particular work depends on several factors, including whether it has been published, and, if so, the date of first publication. As a general rule, for works created after January 1, 1978, copyright protection lasts for the life of the author plus an additional 70 years. For an anonymous work, a pseudonymous work, or a work made for hire, the copyright endures for a term of 95 years from the year of its first publication or a term of 120 years from the year of its creation, whichever expires first.
Trademark: a special design, name, or symbol that identifies a product, service or company, such as the Olympic rings or the Nike swoosh. Trademarks exist to discourage other companies from using a logo that they could profit from because of consumers being confused.
Government franchise: when the government designates a single firm to sell a good or service, such as bandwidth for local radio stations.
3. Resource Monopoly
The third type, resource, is rare. This is where a natural resource, because of its location, is controlled by one company. An example would be DeBeers diamonds. DeBeers controls about 80% of the world’s diamonds. When this occurs there is usually some government oversight of the industry. Other examples of resource monopolies would be the Aluminum Company of America (ALCOA) and the International Nickel Company of Canada.
The Debate Over Monopolies
There is not a consensus amongst economists as to whether the benefits from government created monopolies (development of new products) exceed the costs (continuation of monopoly power). Patents are a good example. Pharmaceutical companies want to recover the costs of their research and development and won’t bring a new drug to the market unless they are given enough time to recover their costs. Granting a monopoly benefits society by bringing new helpful drugs to the market. On the other hand, monopolists produce less output than society would like keeping prices high, and monopoly companies spend/waste a lot money trying to keep their monopoly power. The Federal Trade Commission has prosecuted many drug companies for using a variety of methods to try to extend their patents and not allow cheaper, generic drugs to the market.
Although price discrimination is not the exclusive domain of monopolies, it is however, a widely used practice and deserves mention. Price discrimination occurs when a seller charges different prices for the same product not justified by cost differences. The seller must be able to segment the market by distinguishing between consumers willing to pay different prices. Examples include senior and student discounts and different prices at movie theaters for adults and children. Why would a business owner want to engage in price discrimination? Let’s take a look at the airline industry. If we look at a random flight out of a major hub, we would notice that most people on the flight paid different prices. One person might have bought a first class ticket the day of departure and paid $1,000. Another paid $500 because they purchased their ticket online earlier. Another person is paying nothing because they have accumulated frequent flyer miles. Why would an airline do this? Because to make money the airline wants to fill every possible seat. The airline needs to project how many tickets to sell at a discount without running out of seats for the business traveler, who usually books at the last minute. It makes no sense for the airline to charge someone $300 for a seat when they are willing to pay $800 for it. Airlines use price discrimination to maximize their revenues. Do you think the price discrimination used by the airlines is unfair?
In summary, a business will use price discrimination to offer a discount (lower price) to some types of consumers. The challenge for a business is to find out which groups of consumers should get the discounts.
Can a company have too much market power? Can bigness be bad? These are questions our government wrestles with each year. In our history the government has sometimes answered yes to these questions. The government has passed anti-trust laws, which are used to try to break up the power of monopolies. The first major anti-trust law was the Sherman Anti-Trust Act of 1890. This act outlawed contracts and conspiracies in restraint of trade. Two key interpretations by the courts in this act are 1) whether it is illegal to control a large share of a market, and 2) whether a merger is likely to produce monopoly power.
The Clayton Antitrust Act of 1914, banned certain specific actions that reduce competition. The Federal Trade Commission Act of 1914 created the Federal Trade Commission, which is a government agency that investigates allegations of unfair trade practices. These various acts are intended to curb abuses of market power. These acts do not make monopoly illegal, nor do they apply only to monopolies. What sort of practices does the FTC prohibit? A short list is provided below.
1) Exclusive Dealing: A firm prohibits its distributors from selling competitors’ products. Example, Safeway carries Kellogg’s, but cannot then also sell Post.
2) Exclusive territories: A firm assigns a geographic area to a distributor and prohibits other distributors from operating in that territory.
3) Predatory pricing: A firm prices a product below the marginal cost of producing it to drive rivals out of business.
4) Tie-in sales: A firm conditions the purchase of one product upon the purchase of another.
Below are a list of movies that exhibit economic concepts learned in this unit.
1. Monopoly. The movie centers on a boy, from the game’s modest Baltic Avenue, on a quest to make a fortune.
Below are a list of books that exhibit sociological concepts learned in this unit.
1. The Winner Take All Society by Robert H. Frank and Philip J. Cook
Parkin, Michael 2000 Economics (5th Edition) New York: Addison- Wesley
Slavin, Stephen L. 1999 Economics (5th Edition) New York: Irwin McGraw-Hill
Taylor, John B.
2001 Economics. Boston: Houghton Mifflin Company
2000 Economics (2nd Edition) New York: Worth Publishers
Tucker, Irvin B. 1995 Survey of Economics New York: West Publishing Company
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