ECON101 Study Guide
Unit 6: Market Structure: Competitive and Non-Competitive Markets
6a. Identify the characteristic differences between various market structures, namely, perfectly competitive markets, non-competitive markets, and imperfectly competitive markets, and discuss differences in their operations
- Define differentiated, and homogeneous products.
- How many companies can exist in each of the four types of markets?
- Do additional companies experience any barriers to entry?
- Are products differentiated among different sellers?
- Do companies have market power, which means they are able to control supply and prices?
- Can companies sustain the amount of profit they receive for the long run?
Let's review different market structures and their characteristics. Monopolistic competition is the most common market structure, characterized by brand name and slightly differentiated products with many substitutes. The market structures perfect competition and monopoly offer theoretical extremes – they rarely exist in their purest forms, but we use these concepts as benchmarks to compare more common structures, such as monopolistic competition and oligopoly.
This table summarizes important distinctions among the four market structures. Note that mixed or hybrid structures, which encompass a mixture of characteristics, exist in addition to these four structures. For example, a market leader with a fringe of small competitors is a common market structure that combines monopoly and monopolistic competition.
Differentiated products means that each product is slightly or significantly different from the other and appeals to different customer wants or needs (think about different types of shoes, cars, or computer equipment). Undifferentiated or homogeneous means that all of the products are the same (think about a natural resource, such as oil, milk or sugar cane).
- Define perfect competition.
- What sequence of events indicates a favorable market change that will cause existing companies to earn economic profit?
- What sequence of events indicates an unfavorable market change that will cause existing companies to suffer an economic loss?
- Why is it difficult for companies to sustain short-run profits or losses, causing them to make zero economic profits in the long run?
A perfectly competitive market assumes a large number of companies sell identical products and additional companies can enter and exit the industry freely. We call these companies "price takers" because they have no market power whatsoever, such as the ability to control prices.
Some students fail to recognize that zero economic profit is a reasonable and worthwhile outcome for a business. Remember the calculation for economic profit: accounting profit minus opportunity costs.
For example, an owner runs a business that earns $60,000 a year in accounting profit. However, the economic profit for the business is zero because the owner quit their corporate job where their salary was the same amount ($60,000). Accounting profit ($60,000) minus the opportunity cost of the owner's previous corporate job ($60,000) equals zero.
A company that makes zero economic profit is paying its bills and doing the best it can, without a better alternative use of its resources. In this situation, the company will remain in business.
Review these graphs from Competitive Markets for Goods and Services, which illustrate the dynamics that result from short-run economic profit or loss outcomes.
Eliminating Economic Profits in the Long Run
If companies in a particular industry are making an economic profit, other companies will join them 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.
Eliminating Economic Losses in the Long Run
Panel (b) shows that at the initial price P1, companies in the industry cannot cover average total cost (marginal revenue, MR1, is below average total cost, ATC). This induces some companies to leave the industry, shifting the supply curve in Panel (a) to supply, S2, reducing industry output to quantity, Q2, and raising price to P2. At this price (MR2), companies earn zero economic profit, and companies stop leaving the industry.
Panel (b) shows that when the company increases output from q1 to q2; total output in the market falls in Panel (a) because there are fewer companies. Notice that in Panel (a) quantity is designated by uppercase Q, while in Panel (b) quantity is designated by lowercase q. Note that in these graphs, (Q) is the quantity supplied in the market and (q) is the quantity supplied by one typical company.
Review the characteristics of a perfectly competitive market structure and company behavior in response to changes in market conditions in:
- Competitive Markets for Goods and Services
- Perfect Competition
- Introduction to Perfect Competition
- Perfect Competition
- Define monopoly.
- Define the profit maximizing rule.
- Is this monopoly company making a positive economic profit?
- Why are firms operating under monopolies less efficient than firms operating under perfect competition?
- What are the effects of monopoly on consumer and producer surplus?
- How does public policy attempt to resolve issues associated with monopoly?
- Define price discrimination.
- Define a natural monopoly.
- Name some real-world examples of price discrimination and a natural monopoly.
A monopoly is at the opposite end of the market structure spectrum from perfect competition. A monopoly includes just one producer who is a "price maker", which has full control over the market price and quantity. There are no competitors and significant, strong barriers that restrict additional companies from entering this market. A monopoly can remain profitable during the long run since its position is unchallenged. Can you think of an example of a company that enjoys a monopoly?
We can determine a monopoly firm's profit-maximizing price and output by following three steps:
- Determine consumer 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 consumer demand curve for the quantity found in step 2.
Once we have determined the monopoly company's price and output, we can determine its economic profit by calculating the area shaded in green in the below graph.
Computing Monopoly Profit
Read up from Qm to the demand curve to find the price Pm where the monopoly company can sell Qm units per period. Point E on the demand curve is the profit-maximizing price and output.
The average total cost (ATC) at an output of Qm units is ATCm. Consequently, the company's profit per unit is Pm minus ATCm. Determine the total profit by multiplying the company's output, Qm, by profit per unit. Total profit equals Qm(Pm minus ATCm): the area of the shaded rectangle.
A monopoly maximizes profit by producing an output Qm at point G, where the marginal revenue and marginal cost curves intersect. It sells this output at price Pm.
An important distinction between a monopoly and perfect competition is that the monopoly meets the demand of the entire industry, is free to charge customers more for what it produces, and is able to sell less product than it would if it were a perfectly competitive company.
Review the monopoly structure in:
- Monopoly I
- Introduction to a Monopoly
- Monopoly Basics
- Review of Revenue and Cost Graphs for a Monopoly
- Monopolist Optimizing Price (Part 1): Total Revenue
- Monopolist Optimizing Price (Part 2): Marginal Revenue
- Monopolist Optimizing Price (Part 3): Deadweight Loss
- Price Discrimination
- Marginal Costing Quiz and Monopoly Quantitative Exercise
- 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.
It is easy to point to examples of companies operating in monopolistically competitive market structure since they use brand names to differentiate their product, and each one typically has many close, but not identical, substitutes.
As with a monopoly, companies in monopolistic competition face the entire market demand for their product. Their demand curve slopes downward since consumers will buy fewer products as their price increases. The graphical analysis for a monopolistically competitive company resembles that of a monopoly company.
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. 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; it is shown by 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. Eventually, profits decrease due to this fierce competition, and profits are eliminated in the long run.
Monopolistic Competition in the Long Run
As you review this chart, the existence of economic profits in a monopolistically competitive industry will induce entry in the long run. As new firms enter, 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.
Review monopolistic competition in:
- Monopolistic Competition: Competition among Many
- Monopolistic Competition
- Oligopolies and Monopolistic Competition
- Monopolistic Competition and Economic Profit
- Define oligopoly.
- Define cartel and collusion.
- Name some real-world examples of companies that fall under oligopoly structure.
- How was OPEC able to inflate prices for oil and gas to enrich oil-producing countries in the Middle East?
- How is game theory used to study strategic behavior in oligopolies?
- Define dominant strategy.
- Define what a Nash Equilibrium is and how it is determined.
- What are some examples of the use of game theory to study oligopoly behavior?
An oligopoly lies between a monopoly and perfect competition on the market spectrum but leans more toward a monopoly since a group of companies work together to create monopoly-like conditions they can all profit from. By colluding, or cooperating among each other (either secretly or openly via a formal cartel), oligopoly companies "artificially" prop up prices to ensure they all maintain collective profitability. In an oligopoly, a few companies produce a differentiated product, enjoy significant market power, control prices, and are able to sustain positive economic profits in the long run.
Oligopoly companies have a tremendous impact on each other's operations: while they all benefit when they can work together, they are often fraught with discord and mistrust. They typically engage in strategic behavior, which involves constant vigilance, as they counteract any actions other cartel members might take to promote their market position.
Since they do not enjoy a complete monopoly, cartel members need to be sure to keep up with any product improvements other members make, match their advertising spending, and make sure their product is similarly placed among their customers, so no one member of the group obtains a competitive advantage above the others.
Additionally, one rogue member of the cartel may try to undercut the lowest price the group had agreed to charge, to attract all of the customers, because they are greedy or need the extra money. Another cartel member may try to secretly sell more product than the group had agreed to supply at the higher price. According to the laws of supply and demand, if one cartel member floods the market with their product, the price for the good will fall, and everyone in the cartel will suffer.
Oligopoly companies often work together to avoid public officials who aim to curtail the inflated prices on behalf of their political constituents and consumers. However, when cartel members can no longer agree to work together to limit their supply to inflate prices, their disputes run the risk of triggering a price war that will benefit public consumers, but damage the mutually-inflated profit margin the cartel members previously enjoyed.
Monopoly through Collusion
Two identical firms have the same horizontal marginal cost curve MC. Their demand curves Dfirm and marginal revenue curves MRfirm are also identical. The combined demand curve is Dcombined; the combined marginal revenue curve is MRcombined. The profits of the two firms are maximized if each produces 1/2 Qm at point A. Industry output at point B is thus Qm and the price is Pm. At point C, the efficient solution output would be Qc, and the price would equal MC.
The Prisoner's Dilemma offers an interesting framework for analyzing strategic behavior among oligopoly companies. Companies engage in strategic behavior as they consider the actions of their competitors when making decisions, and intend to preempt or change final outcomes. For example, a company may want to outspend the advertising budget of its opponent when it decides how much money it should allocate to advertising next year. Another company may decide to preemptively invest in a large amount of capital to communicate a credible threat to its opponents of its intention to capture market share.
Figure 11.4 shows the decisions and outcomes available to players: two prisoners weigh "confessing" against "not confessing" to a crime. The four cells represent each possible outcome of the Prisoner's Game. Since the choice of the other prisoner will affect the final outcome on their prison sentence, what do the prisoners choose? Competitors often choose an option that is not mutually beneficial as they try to outplay each other.
Payoff Matrix for the Prisoner's Dilemma
Review the strategies of each player, note any dominant strategy, and the final outcome of the game, the Nash Equilibrium, if it exists. 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. Why do both players "confess" when "not confessing" is clearly a better outcome for them both?
Review the oligopoly market structure, game theory, the Prisoner's Dilemma, and the Nash Equilibrium in the following resources.
- Oligopoly: Competition among Few
- Oligopolies, Duopolies, Collusion, and Cartels
- Game Theory of Cheating Firms
- More on Nash Equilibrium
- Why Parties to Cartels Cheat
- Prisoner's Dilemma and Nash Equilibrium
6b. Compare and contrast as well as discuss the three main kinds of economic systems
- Define, compare, and contrast the three main kinds of economic systems: traditional economy, command economy, market economy.
Review this material in How Economies Can Be Organized: An Overview of Economic Systems.
Unit 6 Vocabulary
- Command economy
- Competitive advantage
- Dominant strategy
- Economic loss
- Economic profit
- Game theory
- Marginal profit
- Marginal revenue
- Market economy
- Monopolistic competition
- Nash Equilibrium
- Natural monopoly
- Perfect competition
- Price discrimination
- Price war
- Prisoners' dilemma
- Profit maximizing rule
- Strategic choice
- Traditional economy