ECON101 Study Guide

Unit 7: Market Structure: Competitive and Non-Competitive Markets

7a. Explain the assumptions made about and the differences between perfectly competitive markets, non-competitive markets, and imperfectly competitive markets

What is a market structure?
How many companies can exist in each of the four types of markets?
What market structures display barriers to entry?
What market structures are characterized by differentiated products?
Under what market structures can companies sustain positive economic profit in the long run?

Producers must consider the market structure when determining their best output level and pricing strategies. This includes assessing the competitive landscape, including the number of rivals, product similarity, and the ability to influence market prices. These are fundamental factors to address when making crucial decisions. The market structure holds the key to answering these questions.

The table below summarizes the distinctions between the four primary market structures. Note that mixed or hybrid structures, which encompass a mixture of characteristics, exist in addition to these four structures (perfect competition, monopoly, oligopoly, and monopolistic competition).

Market Structure	Number of Companies	Barriers to Entry	Nature of Product	Control Over Prices	Positive Economic Profit in the Long Run
Perfect Competition	Many or Infinite	No	Homogeneous	No	No
Monopoly	One	Yes	Unique	Yes	Yes
Oligopoly	Few	Yes	Homogenous or Differentiated	Some	Yes
Monopolistic Competition	Many	Few	Differentiated	Little	No

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7b. Discuss the characteristics of the model of perfect competition in the short-run and the long-run

What is perfect competition?
How is the demand curve for the firm different from the market demand curve under perfect competition?
What sequence of events indicates a market change that will cause existing companies to earn a positive economic profit under a perfectly competitive market structure?
What sequence of events indicates a market change that will cause existing companies to experience negative economic profit under a perfectly competitive market structure?
Why do companies experience zero economic profit in the long run under perfect competition?
Why are consumers and firms price takers under a perfectly competitive market structure?
Identify the firm's economic profit level in a perfectly competitive market diagram.

With perfect competition, a market is characterized by a large number of firms and consumers, making it impossible for any single one of them to influence the market price. Firms have the freedom to enter and exit the market, and the products offered are homogenous. This homogeneity of products leads to a perfectly elastic demand curve for the firm while the market demand curve itself slopes downward (as you have already learned in Unit 2).

Market demand shifts directly influence total revenues (price times quantity sold) and economic profit levels. For example, if consumer demand increases, causing prices and quantities to increase, the profit level of each company will also increase. The higher the economic profit potential, the more attractive it becomes for businesses to enter the market.

Free from entry barriers, firms will enter the market, causing the supply curve to shift downward. This process of entry and exit continues until economic profits reach zero, establishing the long-run equilibrium.

It may seem counterintuitive that firms continue to operate in the long run, even when economic profits are zero. To understand this concept, it is essential to recall the calculation for economic profit: accounting profit minus opportunity costs. A company that makes zero economic profit is covering its costs, paying its workers, and doing the best it can without a better alternative use of its resources. In this situation, the company will remain in business.

Review the graphs below, which illustrate the dynamics that result from short-run economic profit or loss outcomes.

Figure: Eliminating Economic Profits in the Long Run

In Panel (b), a single company's profit is shown by the shaded area. Entry continues until companies in the industry are operating at the lowest point on their respective average total cost curves and economic profits fall to zero.

Figure: Eliminating Economic Losses in the Long Run

Note that in these graphs, (Q) is the quantity supplied in the market, and (q) is the quantity supplied by one typical company.

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7c. Describe the characteristics of the model of monopoly and how a monopolist maximizes profit

What is a monopoly?
What is a natural monopoly?
What is the profit-maximizing rule?
What is the profit-maximizing output and price for a monopoly?
How is the monopoly's demand curve different from the marginal revenue curve?
How can you display the economic profit level of a monopoly graphically?
What are the effects of monopoly on consumer and producer surplus?
Why are firms operating under monopolies less efficient than firms operating under perfect competition?
Can a monopoly experience negative economic profit?
What is price discrimination?
Can you name some real-world examples of price discrimination and a natural monopoly?

A monopoly appears when one firm, protected from competition by barriers to entry, produces products or services without close substitutes. While the monopolist has full (or almost full) market power, it still faces a downward-sloping demand curve. Because the monopoly's position can remain unchallenged for a long period of time, positive economic profit is possible in the long run. A natural monopoly occurs when a single firm can supply a good or service to an entire market at a lower cost than two or more firms could due to economies of scale.

Follow these steps to determine the monopoly's profit-maximizing price and output:

Determine demand, marginal revenue, and marginal cost curves.
Choose the output level where the marginal revenue and marginal cost curves intersect.
Determine the price from the demand curve for the quantity found in step two. Remember that the demand curve illustrates how much the consumer is willing to pay for a specific quantity.

Once we have determined the monopoly company's price (P_m) and output (Q_m), we can find its economic profit level by calculating the area in the green rectangle in the graph below [(P – ATC) * Q].

Figure: Computing Monopoly Profit

Monopoly analysis is straightforward once you understand this diagram and the principles behind it. It helps explain the inefficiency of monopolies compared to perfectly competitive markets, the ability of monopolies to engage in price discrimination (setting prices based on consumer willingness to pay), and the government's role in regulating monopolies.

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7d. Analyze how monopolistic competition affects the short-run equilibrium and the long-run equilibrium

What are the main features of a monopolistically competitive market structure?
What is the optimization rule for monopolistically competitive firms?
How do monopolistically competitive firms compare with perfectly competitive firms?
How do monopolistically competitive firms compare with monopoly firms?
Why and how is the economic profit of monopolistically competitive firms reduced to $0 in the long run?

Monopolistic competition lies in the middle of the market structure spectrum: between perfect competition and a monopoly. In this type of structure, we see many producers, as in perfect competition, and fierce competition drives long-run economic profits to zero. However, companies in monopolistic competition produce differentiated products and have the ability to exert some market power. They have some control over prices, and limited barriers protect them from other companies that want to enter their market.

The graphical analysis for a monopolistically competitive company in the short run resembles that of a monopoly company.

Figure: Short-Run Equilibrium in Monopolistic Competition

As you review this chart, examine the intersection of the marginal revenue curve MR1 and the marginal cost curve MC to see that the profit-maximizing quantity is 2,150 units per week. Reading up to the average total cost curve ATC, we see the cost per unit equals $9.20. The price, given on the demand curve D1, is $10.40, so the profit per unit is $1.20. Total profit per week equals $1.20 times 2,150, or $2,580 (area of the shaded rectangle).

When companies in monopolistic competition make positive economic profits in the short run, new companies enter the market to produce similar products. This is the same process that takes place under perfect competition. It is always a good idea to review the long-run dynamics in perfect competition while studying the long-run equilibrium in monopolistic competition.

Figure: Monopolistic Competition in the Long Run

In the diagram above, positive economic profits in the industry attract new firms. As new firms enter in the long run, the demand curve D1 and marginal revenue curve MR1 facing a typical firm will shift to the left to D2 and MR2. Eventually, this shift produces a profit-maximizing solution at zero economic profit, where D2 is tangent to the average total cost curve ATC (point A). The long-run equilibrium solution here is an output of 2,000 units per week at a price of $10 per unit.

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7e. Describe the characteristics of an oligopoly and how it compares to other competitive and non-competitive models

What are oligopoly, cartel, collusion, and the prisoner's dilemma?
How is game theory used to study strategic behavior in oligopolies?
What is a dominant strategy?
Define Nash Equilibrium and how it is determined.

An oligopoly lies between a monopoly and perfect competition on the market spectrum.

Oligopolies have the following features:

There are a few competing and mutually interdependent firms. The quantity supplied by each firm is a large share of the market.
There are enough barriers to entry to prevent other firms from entering the market.
Each firm has enough market power to prevent it from being a price-taker, but there is enough rivalry between firms to prevent it from considering the market demand as its own market demand.
Each firm's strategies regarding pricing and quantities have an impact on the profitability of other firms.
Each firm realizes that its competitors might react to its strategies (output, price, or both). Firms typically engage in strategic behavior, which involves constant vigilance.

Oligopoly firms face the temptation to act as if they were a monopoly by acting together to control output and keep prices high. This is called collusion. A cartel is a formal agreement between firms to engage in collusion.

The Prisoner's Dilemma (a game theory scenario where two individuals acting in their own self-interest do not produce the optimal outcome, leading both to worse results than if they had cooperated) is a type of game theory that offers an interesting framework for analyzing strategic behavior among oligopoly companies. The Nash Equilibrium exists where each player's choice is the best response to what the other player has chosen, and none of the players has an incentive to change their choice in equilibrium. We need these analytical tools because of the complexity inherent to oligopolistic markets.

Examples of strategic behavior include a company that may try to outspend its competitors' advertising budgets when deciding how much to allocate to advertising next year. Another company may decide to pre-emptively invest in a large amount of capital to communicate a credible threat to its opponents to capture market share.

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7f. Explain how the United States has used regulations to protect consumers and limit the effects of imperfect competition via antitrust policies

What are antitrust laws?
Why would policymakers implement regulations for the approval of mergers?
What are restrictive practices? Can you give some examples?
What are concentration ratios? How are they calculated and interpreted?
What is the Herfindahl-Hirschman Index?

Real-world markets generally fall under the category of imperfect competition. When imperfect competition or actions taken by firms, such as mergers or acquisitions, lead to decreased competition, governments implement measures to ensure that the market continues to function efficiently.

The United States uses antitrust laws and other regulations to protect consumers from the effects of imperfect competition.

Some examples of antitrust laws include:

Regulations for approving mergers and acquisitions. These regulations are complex as they require the calculation of the degree of market power by using tools such as the Herfindahl-Hirschman Index (HHI).
Rules against restrictive practices such as exclusive dealing agreements, tying sales, and bundling practices.
Regulations to prevent collusion.
Natural monopoly regulations.

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Unit 7 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

antitrust laws
cartel
collusion
game theory
imperfect competition
market structure
monopolistic competition
monopoly
Nash Equilibrium
natural monopoly
oligopoly
perfect competition
price discrimination
prisoner's dilemma