Unit 7: Market Structure: Competitive and Non-Competitive Markets
In this unit, we study how firms operate and compete within different market environments defined by the degree of competition. We introduce the concept of perfect competition, an ideal model that serves as a benchmark economists use to analyze real-world market structures. The model of perfect (or pure) competition results in an efficient allocation of resources. However, unregulated markets (which are central to perfect competition) often fail to create desired outcomes in the real world. Economists refer to these situations as examples of imperfect competition.
Keeping the perfect competition model as the analytical benchmark, we transition to its polar opposite, the monopoly model. Following that, we venture into the realm of imperfect competition, encompassing two distinct models: monopolistic competition and oligopoly. Within the context of oligopoly, we introduce some concepts of game theory, such as the prisoner's dilemma model and the Nash Equilibrium.
Completing this unit should take you approximately 5 hours.
Upon successful completion of this unit, you will be able to:
- explain the assumptions made about and the differences between perfectly competitive markets, non-competitive markets, and imperfectly competitive markets;
- discuss the characteristics of the model of perfect competition in the short run and the long run;
- describe the characteristics of the model of monopoly and how a monopolist maximizes profit;
- analyze how monopolistic competition affects the short-run equilibrium and the long-run equilibrium;
- describe the characteristics of an oligopoly and how it compares to other competitive and non-competitive models; and
- explain how the United States has used regulations to protect consumers
and limit the effects of imperfect competition via antitrust policies.
7.1: Perfect Competition
Perhaps you have had the opportunity to explore the vibrant street markets in Europe, where a multitude of vendors and stalls present an array of products. These markets feature everything from fresh produce to handmade crafts, and sellers can easily set up shop, engaging in fierce competition with similar offerings. Transactions occur directly between buyers and sellers, ensuring transparency, and prices are established through the interplay of supply and demand, with individual vendors having minimal influence on market prices due to the similarity of their products.
These types of markets are probably the best real-world analogy for our study in this section: perfectly competitive markets. Perfectly competitive markets are best understood within the context of the various market structures. Watch this video, which explains the market structure spectrum, including perfectly competitive markets.
A market is only considered perfectly competitive if it fulfills four conditions:
- Many companies produce the same or identical products;
- Many buyers are available to buy the product, and many sellers are available to sell the product;
- Buyers and sellers have the relevant information they need to make rational decisions about the product they are buying and selling; and
- Companies can freely enter and leave the market without any restrictions.
Complement the text with the explanations in this video for a comprehensive understanding of the distinction between the supply and demand graph for a perfectly competitive market and a perfectly competitive firm. What is the relationship between the firm that is a price taker and the fact that its demand curve in a perfectly competitive market is a horizontal line? What is the price elasticity of demand of a fully horizontal demand curve?
In any market structure, firms must determine their optimal output level to maximize profits. This also applies in a perfectly competitive market, where products are homogeneous, allowing consumers to easily substitute one firm's product with an identical one from another company.
Read this text on how perfectly competitive firms decide the amount of units they need to produce to maximize profits. Firms can find the profit-maximizing output level by comparing total revenue and total cost or marginal revenue and marginal cost. Make sure you understand the written explanations and the graphs. Why is total revenue an upward-sloping line while marginal revenue is a straight line?
Once you have fully understood that a firm maximizes profit by producing the quantity of output at which marginal revenue equals marginal cost, you are well-equipped to calculate the economic profit for that level of output by simply subtracting total cost from total revenue for that specific quantity. You can follow the explanation in the text above or in the following video. You may need to review the cost curves in Unit 6 (section 6.2.).
Students are usually taken aback by the concept that the output level that maximizes profit may result in losses (negative economic profit). How does this happen? Is it a sustainable scenario in the long run?
Revisit "Shutdown Point at How Perfectly Competitive Firms Make Output Decisions" in the text you just read in this section, "How Perfectly Competitive Firms Make Output Decisions," and analyze it carefully. You can also review the shutdown point by watching this video on how a baker decides whether to keep their bakery open or closed in the short run.
We have now concluded our analysis of how a firm makes output decisions in the short run in a perfectly competitive market. But will the results change if the firm can modify all factors of production and all costs become variable, indicating a shift in the long run? Read this text on entry and exit decisions in the long run to find the answer and delve into the interaction between the firm's profit level and the market's supply and demand in the long run. Why do entry and exit lead to zero profits in the long run?
7.2: Non-competitive Markets: Monopoly
As discussed, perfect competition, when extended to the long run, serves as a theoretical benchmark. In contrast, market structures like monopoly, monopolistic competition, and oligopoly, which are more commonly encountered in the real world than perfect competition, do not consistently operate at the minimum average cost, nor do they always equate price with marginal cost. In this section, we explore the concept of monopoly, which stands as the polar opposite of perfect competition within the spectrum of market structures.
Monopoly, a market structure at the far end of the competitive spectrum, presents a stark contrast to the perfect competition model we discussed in the previous section.
We can define a monopoly as a firm that produces a good or service for which no close substitute exists. In fact, a monopoly is a market where a single firm is shielded from competition by barriers that prevent the entry of new firms. Read this introductory text to analyze monopolies. Can a monopoly charge any price it wishes?
In line with the long-term dynamics we discussed in the previous unit, you may expect that when a monopoly generates a positive profit, it would naturally draw other firms into its market. However, that is not the case. Monopolies are safeguarded by barriers to entry, effectively blocking other companies from entering this attractive market. Read this text on how monopolies form. Make sure you understand how economies of scale can give rise to a natural monopoly.
Watch this video on how a monopoly chooses the amount of output that maximizes profit and how to identify the profit obtained when such an amount is produced. The analysis extends to the long run. Make sure you understand the shape of all the curves we use to graph a monopoly and the relations between those curves.
Read this section to make sure you understand the distinctions between demand curves for perfectly competitive firms and monopolies. This text will also help you review the calculation of a monopoly's profit, which should be familiar since the process is similar to what you have already studied for perfect competition.
Since a monopoly leads to a reduction in market efficiency (resulting in higher prices and lower output compared to perfect competition), governments are sometimes compelled to intervene and limit their economic power. In the last section of this unit, we will analyze these government policies.
7.3: Imperfect Competition: Monopolistic Competition and Oligopoly
Companies like McDonald's, Burger King, and Wendy's offer similar products but differentiate themselves through branding, menu items, and marketing strategies. Similarly, consumers encounter numerous choices for clothing and fashion items that share relative similarities in the apparel industry, such as brands like Gap, H&M, and Zara, among many others. How do we classify these markets?
On the other hand, the pharmaceutical industry is often characterized by the dominance of a few major players, including Pfizer, Merck, and Johnson & Johnson. These companies wield substantial market influence and affect drug prices. In what type of market does the U.S. pharmaceutical industry operate? Clearly, it is not perfectly competitive. But is it a monopoly?
Read this introductory text, which defines two forms of imperfect competition: monopolistic competition and oligopoly. How do differentiated products promote monopolistic competition? What are the benefits of variety and product differentiation? Do governments need to protect consumers from monopolistic competition?
We begin our analysis of imperfect competition with monopolistic competition. Monopolistic competition, as described, is a unique market structure where multiple firms compete among themselves while offering products that possess some degree of distinctiveness. It is probably the single most common market structure in the U.S. economy.
We begin our analysis of imperfect competition with monopolistic competition. Monopolistic competition, as described, is a unique market structure where multiple firms compete among themselves while offering products that possess some degree of distinctiveness. It is probably the single most common market structure in the U.S. economy.
Watch this video on monopolistic competition to strengthen your grasp of this market structure after reading the previous section. Pay attention to the note that you have what it takes to analyze a monopolistically competitive market since you have already looked at perfect competition and monopoly. If this does not sound right to you, you may need to revisit the section on perfect competition.
Now that you have a comprehensive understanding of monopolistic competition, let's shift our focus to oligopoly, where a small number of dominant firms shape the market landscape. Oligopoly is considered the most complex market structure. Can you guess why?
American Airlines introduced its AAdvantage frequent flyer program in 1981. Within days, United Airlines launched its Mileage Plus program, and that same year, Delta Airlines and TWA offered similar programs. This is a clear example of the complexities that can arise in a market with just a few firms that compete fiercely against each other. It illustrates one of the key characteristics of an oligopolistic market: the interdependence among the firms.
Read this text on why oligopolistic firms exist and whether they should cooperate to function as a monopoly. Given the complexities introduced by oligopolistic interaction, there is no single model that can explain the oligopoly. Pay attention to the explanation of game theory as a tool to analyze the dynamics of oligopolistic behavior.
Watch the video on the Prisoners' Dilemma and Nash Equilibrium to improve your understanding of these two game theory tools.
Now that you have studied monopolistic competition and oligopoly as imperfectly competitive market structures, watch this video that compares the two so you can assess your understanding of the materials.
7.4: Monopolies and Antitrust Policies
In this section, we explore antitrust policies and other regulations U.S. policymakers have enacted to protect consumers from the loss of efficiency created by imperfectly competitive markets, particularly monopolistic and oligopolistic market structures. Policymakers must figure out the extent of their involvement to strike a balance between harnessing the potential advantages of widespread production and mitigating the risk of reduced competition when companies aim to exploit economies of scale.
Read this short text introducing this section on competition policy (antitrust measures). Make sure you understand why the author states that imperfect competition can generate a loss of potential consumer surplus, a concept that we introduced in Unit 4.
Policymakers need tools to measure the level of competition in an industry or market and enhance allocative efficiency while safeguarding consumer welfare from potential losses in consumer surplus due to firms' market power. Read this text on how to calculate concentration ratios and the Herfindahl-Hirschman Index. Why does the text start describing corporate mergers? What is the relationship between mergers (or mergers and acquisitions) and the degree of competition in an industry?
Antitrust legislation is complex and must evolve with changing market dynamics. Read this text to learn how certain firm strategies, which may have saved you money, can be anti-competitive. Examples of these potentially restrictive practices include exclusive dealing, tying sales, bundling, and predatory pricing.
A natural monopoly creates yet another challenge for competition policy because it makes a single firm more cost-effective than multiple firms. Read this text, which explores how to create an appropriate competition policy for a natural monopoly. Make sure you fully understand the graph depicted in Figure 11.3. If you find it challenging to follow the explanation, revisit Section 7.2 to review the theory and accompanying graphs that explain the economic behavior of a monopoly.
We wrap up this section and chapter with a video that explains how policymakers deal with monopoly power in a particular market. Make sure you can understand the graphs.
Note that there is no consensus on whether government regulation and taxation are necessary to rectify inefficient market outcomes. Some economists argue that such intervention is essential, as market failures often result from private decision-making. They propose taxing negative externalities to internalize costs and subsidizing positive externalities for the common good. Conversely, some argue that market mechanisms can naturally resolve these externalities (Coase theorem). They believe that mutually beneficial contracts between parties, such as agreements between landlords and polluters, can lead to efficient outcomes, thus questioning the need for extensive government involvement.
Unit 7 Assessment
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Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
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