Match up the words below to make collocations from the text.

1. bargaining 5. inter-firm	2. business 6. market	3. competitive 7. new	4. cost 8. production
a. advantage e. power	b. costs f. rivalry	c. entrants g. segment	d. leadership h. units

EXERCISE 3

What are the verbs related to the following nouns and adjectives, all found in the text above?

For example: advertising > advertise

1. competitive 2. constraints 3. consumers 4. deterrent 5. differentiation 6. diversification 7. entrants 8. influential

.................. .................. .................. .................. .................. .................. .................. ..................

9. investment 10. leadership 11. optimum 12. production 13. success 14. suppliers 15. sustainable 16. threat

.................. .................. .................. .................. .................. .................. ..................

IV. MARKET STRUCTURE IN TERMS OF COMPETITION

СHARACTERISTICS OF A MARKET STRUCTURE

So far, we have talked only about firms in general without worrying about the sort of market in which they operate. But in this chapter we will see that the type of market in which the firm operates makes a great deal of differ­ence for the way in which it can and does behave. Under some market forms, for ex­ample, the firm has no control over price. In others, the firm has the power to adjust price in a way that adds to its profits and which, in the opinion of some, constitutes exploitation of consumers. Economists distinguish among different kinds of markets according to certain key characteristics. The characteristics are: (1) the number of firms in the market, (2) type of the product sold in the market i.e., whether the products of the dif­ferent firms are identical or somewhat different, (3) control over the price of the relevant product, (4) how easy it is for new firms to enter the market, i.e. barriers to new firms entering the market, (5) existence of non-price competition in the market. Each of these characteristics is briefly discussed below.

NUMBER OF FIRMS IN THE MARKET

The number of firms in the market supplying the particular product under consideration forms an important basis for classifying market structures. The number of firms in an industry, according to economists, determines the extent of competition in the industry. Both in perfect competition and monopolistic competition, there are large numbers of firms or suppliers. Each of these firms supplies only a small portion of the total output for the industry. In oligopoly, there are only a few (presumably more than two) suppliers of the product. When there are only two sellers of the product, the market structure is often called duopoly. Monopoly is the extreme case where there is only one seller of the product in the market

TYPE OF THE PRODUCT SOLD IN THE MARKET

The extent to which products of different firms in the industry can be differentiated is also a characteristic that is used in classifying market structures. Under perfect competition, all firms in the industry sell identical products. In other words, no firm can differentiate its product from those of other firms in the industry. There is some product differentiation under monopolistic competition—the firms in the industry are assumed to produce somewhat different products. Under an oligopolistic market structure, firms may produce differentiated or identical products. Finally, in the case of a monopoly, product differentiation is not truly an issue, as there is only one firm—there are no other firms from whom it should differentiate its product.

CONTROL OVER PRODUCT PRICE

The extent to which an individual firm exercises control over the price of the product it sells is another important characteristic of a market structure. Under perfect competition, an individual firm has no control over the price of the product it sells. A firm under monopolistic competition or oligopoly has some control over the price of the product it sells. Finally, a monopoly firm is deemed to have considerable control over the price of its product.

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BARRIERS TO NEW FIRMS ENTERING THE MARKET

The difficulty or ease with which new firms can enter the market for a product is also a characteristic of market structures. New firms can enter market structures classified as perfect competition or monopolistic competition relatively easily. In these cases, barriers to entry are considered low, as only a small investment may be required to enter the market. In oligopoly, barriers to entry is considered very high—huge amounts of investment, determined by the very nature of the product and the production process, are needed to enter these markets. Once again, monopoly constitutes the extreme case where the entry of new firms is blocked, usually by law. If for whatever reasons, new firms are allowed to enter a monopolistic market structure, it can no longer be termed a monopoly.

EXISTENCE OF NON-PRICE COMPETITION

Market structures also differ to the extent that firms in industry compete with each other on the basis of non-price factors, such as, differences in product characteristics and advertising. There is no non-price competition under perfect competition. Firms under monopolistic competition make considerable use of instruments of non-price competition. Oligopolistic firms also make heavy use of non-price competition, Finally, while a monopolist also utilizes instruments of non-price competition, such as advertising, these are not designed to compete with other firms, as there are no other firms in the monopolist's industry.

We now turn to discussing each of the four market forms mentioned at the beginning, in light of the preceding characteristics used to classify market structures. The discussion that follows also provides additional details about the four market structures

FOUR MARKET STRUCTURES - GENERAL COMPARISON

Four market structures result from the successively declining degrees of competiton in the market for a particular commodity. The table below summarizes the main features of the four market structures. Perfect competition is obviously at one extreme (many small firms selling an identical product), while pure monopoly (a single firm) is at the other. In between are hybrid forms — called monopolistic competition (many small firms each selling products slightly different from the others) and oligopoly (a few large rival firms) —that share some of the characteristics of perfect competition and some of the characteristics of monopoly. Based on the differing outcomes of different market structures, economists consider some market structures more desirable, from the point of view of the society, than others

Perfect competition is far from the typical market form in world economies. Indeed, it is quite rare. Pure monopoly—literally one firm—is also infrequently encountered. Most of the products you buy are no doubt supplied by oligopolies or monopolistic competitors. So, most of American industry is neither as perfectly competitive as the “pure competition” model requires, nor as monopolistic as the “pure monopoly” model requires. Most of industries lie somewhere between those two extremes.

Type of market structure	Number of sellers	Nature of the product	Barriers to entry	Where to find it
Perfect competition	Many	All firms produce identical products (wheat)	None	Some agricultural markets and parts of retailing sales
Monopolistic competition	Many	Different firms produce different products (restaurant meals)	Minor	Most of the retailing sector, textiles, restaurants
Oligopoly	Few	Firms may produce identical or differential products(toothpaste)	May be considerable	Much of the manufacturing sector, esp.autos, steel, cigarettes
Pure monopoly	One	Unique product	May be considerable	Public utilities

V. PERFECT COMPETITION

PERFECT COMPETITION DEFINED

Perfect competition is an idealized version of market structure that provides a foundation for understanding how markets work in a capitalist economy. The other market structures can also be understood better when perfect competition is used as a standard of reference. Even so, perfect competition is not ordinarily well understood by the general public. For example, when business people speak of intense competition in the market for a product, they are, in all likelihood, referring to rival suppliers, about whom they have quite a bit of information. However, when economists refer to perfect competition, they are particularly referring to the impersonal nature of this market structure. The impersonality of the market organization is due to the existence of a large number of suppliers of the product—there are so many suppliers in the industry that no firm views another supplier as a competitor. Thus, the competition under perfect competition is impersonal. To understand the nature of competition under the perfectly competitive market form, one should briefly examine some conditions that are necessary before a market structure is considered "perfectly competitive.":

1. Numerous participants. This condition, existence of many buyers and sellers, leads to an important outcome. When there is a large number of buyers or sellers, each individual buyer or seller is so small relative to the entire market that he or she does not have any power to influence the price of the product under consideration. As a result, whether a person is a buyer or a seller, he or she must accept the market price. All buyers and sellers in the market are effectively price takers, not price makers. The market as a whole establishes product prices, and individual buyers or sellers simply decide how much to buy or sell at the given market price. So each seller and purchaser constitutes so small a portion of the market that their decisions have no effect on the price. This requirement rules out trade associations or other collusive arrangements strong enough to af­fect price.

2. Homogeneity of the product sold in the industry. Homogeneity of product means that the product sold by any one seller in the market is identical to the product sold by any other supplier. The homogeneity of product has an important implication for the market: if products of different sellers are identical, buyers do not care who they buy from, so long as the price is also the same. While this condition of a perfect market sounds extreme, it is, in fact, met in markets for many products. Wheat of a given grade and corn are good examples. Wheat and corn produced by different farmers is essentially the same, and can thus be considered identical. (Different brands of toothpaste are not).

3. Freedom of entry and exit. New firms desiring to enter the market face no impediments that the existing firms can avoid. Similarly, if production and sale of the good proves unprofitable, there are no barriers preventing firms from leaving the market.

4. Perfect information. Each firm and each customer is well informed about the available products and their prices. They know whether one supplier is selling at a price lower than another is.

5.. The next condition, perfect mobility of resources, requires that all factors of production (resources used in the production process) can be readily switched from one use to another. Furthermore, it is required that all buyers, sellers, and owners of resources have full knowledge of all relevant technological and economic data. The implication of this condition is that resources move to the most profitable industry

6. An absence of any collusion (secret agreements) among producers on price, quantities, or quality of goods sold.

No industry in the world (now or in the past) satisfies all these conditions stipulated above fully. Thus, no industry in the world can be considered perfectly competitive in the strictest sense of the term. However, there are token examples of industries that come quite close to being a perfectly competitive market. Some markets for agricultural commodities, while not meeting all these conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation. The wheat market is characterized by an almost homogenous product, and it has a large number of buyers and sellers. It thus satisfies the first two conditions fairly well. However, it is difficult to assert that resources employed in the wheat industry are perfectly mobile. Many farming and fishing industries approximate perfect competition, as do many financial markets (such as the New York Stock Exchange).

Our interest in perfect competition is surely not for its descriptive realism. Despite the fact that no industry is truly perfectly competitive, it is still worthwhile to study perfect competition as a market structure. The economists’ model of perfect competition is highly theoretical but it provides a useful tool of economic analysis and a “standard of comparison”. It is under perfect competition that the market mechanism performs best. So, if we want to learn what markets do well, we can put the market's best foot forward by beginning with perfect competition. The economist’s model of perfect competition is highly theoretical but it provides a useful tool of economic analyses and a ‘standard of comparison’.

As Adam Smith suggested some two centuries ago, perfectly competitive firms use society's scarce resources with maximum efficiency. And as Friedrich Engels suggested, only (perfect) competition can ensure that the economy turns out just those varieties and relative quantities of the various goods that match the preferences of consumers. So by studying perfect competition, we can learn just what an ideally functioning market system can accomplish. Conclusions derived from the study of the idealized version of perfect competition are often helpful in explaining behavior in the real world.

THE ECONOMICS OF PERFECT COMPETITION.

The study of the idealized version of perfect competition leads to some important conclusions regarding solutions to key economic problems, such as quantity of the relevant product produced, price charged, the mechanism of adjustment in the industry.

As mentioned earlier, under perfect competition, an individual supplier of the product has to take the market price as given. Given this price, the supplier determines how much to produce and sell. The quantity he or she decides to produce is the quantity that maximizes profit for the firm (more technically, where marginal cost of producing the product equals the market price of the product). The total production of all firms in the industry determines the market supply of the product under consideration. This market supply of the product, in conjunction with the total demand for the product by all consumers, determines the market price. Thus, while an individual buyer or seller is a price taker, the collective decisions affect the market price. Since the consumers of the product receive a price that is equal to the cost of production (on the margin), it is argued that consumers are treated fairly under perfect competition.

In addition, the total output produced under perfect competition is larger than, for example, under monopoly. To understand this, we should look at the mechanics of maximizing profit, the guiding force behind a supplier's output decision. In order to maximize profits, a supplier has to look at cost and revenue. Usually, it is assumed that a supplier's marginal cost (the cost of producing an additional unit of the product under consideration) rises ultimately. The producer then, in making the output decision, must compare the cost of producing an additional unit of the product with the revenue the sale of that additional unit (called the marginal revenue) brings to the firm. So long as the marginal revenue from the sale exceeds the marginal cost, there is a gain from producing that additional unit—the unit adds more to revenue (proceeds) than to costs. The supplier will continue producing while the process is profitable (i.e., it increases profits or reduces loss). The firm will stop production where marginal revenue equals marginal cost—this output level maximizes profits (or minimizes loss). In the case of a perfectly competitive firm, the market price for the product is also the marginal revenue. Since the firm is a price taker and supplies an insignificant portion of the total market supply of the product, it can sell as many units of the product as it desires at the going price. We will later show that this is not the case with a monopolist, for example. A monopolist stops production of the product before reaching the point where marginal cost of the product equals the market price of the product.

THE DESIRABILITY OF PERFECT COMPETITION

Perfect competition is considered desirable for society for at least two reasons. First, the price charged to individuals equals the marginal cost of production to each firm. In other words, one can say sellers charge buyers a reasonable or fair price. Second, in general, output produced under a perfectly competitive market structure is larger than other market organizations. Thus, perfect competition becomes desirable also for the amount of the product supplied to consumers as a whole. Third, in fact, to maintain a reasonable amount of competition in a market is generally considered a goal of government regulatory policies. No single firm dominates the market under perfect competition: this parallels the status of an individual citizen in a democracy, a widely practiced form of government in capitalist countries.

VI. MONOPOLISTIC COMPETITION

For years, economic theory told us little about market forms in between the two ex­treme cases: pure monopoly and perfect competition. This gap was partially filled, and the realism of economic theory increased, by the work of Edward Chamberlin of Harvard University and Joan Robinson of Cambridge University during the 1930s. As pointed out above, industries in the real world rarely satisfy the stringent conditions necessary to qualify as perfectly competitive market structures. The world in which we live is invariably characterized by competition of lesser degrees than stipulated by perfect competition. Many industries that we often deal with have market structures that are monopolistic competition or oligopoly. Apparel retail stores (with many stores and differentiated products) provide an example of monopolistic competition.

The market structure they analyzed is called monopolistic competition.

A market is said to operate under conditions of monopolistic competition if it satisfies four conditions, three of which are the same as under perfect competition:

(1) Numerous participants — that is, many buyers and sellers, all of whom are small;

(2) freedom of exit and entry;

(3) perfect information; and

(4 heterogeneity of products — as far as the buyer is concerned, each seller's product is at least somewhat different from every other's.

Notice that monopolistic competition differs from perfect competition in only one respect (item 4 in the definition). While under perfect competition all products must be identical, under monopolistic competition products differ from seller to seller — in quality, in packaging, or in supplementary services offered (such as car window washing by a gas station). The factors that serve to differentiate products need not be "real" in any objective or directly measurable sense. For example, differ­ences in packaging or in associated services can and do distinguish products that are otherwise identical. On the other hand, two products may perform quite differently ' in quality tests, but if consumers know nothing about this difference, it is irrelevant,

In contrast to a perfect competitor, a monopolistic competitor's price will change when its quantity supplied varies. Each seller's product differs from everyone else's. So, in effect, each deals in a market that is slightly separated from the others and caters to a set of customers who vary in their "loyalty" to the particular product. If the firm raises its price somewhat, it will drive some of its customers into the arms of competitors. But those whose tastes make them like this firm's product very much will not switch. If one monopolistic competitor lowers its price. it may expect to attract some trade from rivals. But, since different products are im­perfect substitutes, no one competitor will attract away all the business.

Thus, if Harriet's Hot Dog House reduces its price slightly, it will attract those customers of Sam's Sausage Shop who were nearly indifferent between the two. A bigger price cut by Harriet will bring in some customers who have a slightly greater preference for Sam's product. But even a big cut in Harriet's price will not bring her the hard-core sausage lovers who hate hot dogs. So the monopolistic competitor's demand curve is negatively sloped, like that of a monopolist, rather than horizontal, like that of a perfect competitor.

Since each product is distinguished from all others, a monopolistically..competi­tive firm appears to have something akin to a small monopoly. Can we therefore ex­pect it to earn more than zero economic profit? As with a perfect competitor, perhaps this is possible in the short run. But in the long run, high economic profits j will attract new entrants into a monopolistically competitive market—not entrants with products identical to an existing firm's, but with products sufficiently similar to hurt.

If one ice-cream parlor's location enables it to do a thriving business, it can
confidently expect another, selling a different brand, t6 open nearby. When one
seller adopts a new, attractive package, rivals will soon follow suit, with slightly
different designs and colors of their own. In this way, freedom of entry ensures that
the monopolistically competitive firm earns no higher return on its capital in the
long run than it could earn elsewhere. Just as under perfect competition, price will
be driven to the level of average cost, including the opportunity cost of capital. In
this sense, though its product is somewhat different from that of everyone else, the firm under monopolistic competition has no more monopoly роwег than one..operat­ing under perfect competition.

Let us now examine the process that assures that economic profits will be driven to zero in the long run, even under monopolistic competition, and see to what prices and outputs it leads.

MAJOR CHARACTERISTICS OF MONOPOLISTIC COMPETITION.

As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers. Usually, if an industry has 50 or more firms (producing products that are close substitutes of each other), it is said to have a large number of firms. However, the number of firms must be large enough that each firm in the industry can expect its actions go unnoticed by rival firms. Unlike perfect competition, the sellers under monopolistic competition differentiate competitive product. In other words, the products of these firms are not considered identical. It is, in fact, immaterial whether these products are actually different or simply perceived to be so. So long as consumers treat them as different products, they satisfy one of the characteristics of monopolistic competition. This product differentiation is considered a key attribute of monopolistic competition. In many U.S. markets, producers practice product differentiation by altering the physical composition, using special packaging, or simply claiming to have superior products based on brand images and/or advertising. Toothpastes and toilet papers are examples of differentiated products.

In addition to the existence of a large number of firms and product differentiation, relative ease of entry into the industry is considered another important requirement of a monopolistically competitive market organization. Also, there should be no collusion among firms in the industry, like price fixing or agreements regarding the market shares of individual companies. With the large number of firms that monopolistic competition requires, collusion is generally difficult, though not impossible. The above mentioned characteristics of monopolistic competition basically yield a market form that is very competitive, but probably not to the extent of perfect competition.

THE ECONOMICS OF MONOPOLISTIC COMPETITION.

As in the case of perfect competition, a firm under monopolistic competition decides about the quantity of the product produced on the basis of the profit maximization principle—it produces the quantity that maximizes the firm's profit. Also, conditions of profit maximization remain the same—the firm stops production where marginal revenue equals marginal cost of production. But unlike perfect competition, a firm under monopolistic competition has some control over the price it charges, as the firm differentiates its products from those of others. However, this price making power of a monopolistically competitive firm is rather small, since there are a large number of other firms in the industry with somewhat similar products. Remember that a perfectly competitive firm has no price making power—each firm is a price taker, as it produces a product identical to those produced by a large number of other firms in the industry.

An important consequence of the price making power of a monopolistically competitive firm is that when such a firm reduces price, it can attract customers buying other "brands" of the product. The opposite is also true when the firm increases the price it charges for its product. Because of this, price charged for a product is different from the marginal revenue for the product (marginal revenue refers to the increase in total revenue as a result of selling one more unit of the product under consideration). To understand this, consider, for example, that a firm reduces the price for its product. The firm must now sell all units at this lower price. Because the lower price applies to all units sold, not just the last or the marginal unit, price for the product is higher than the marginal revenue at each level of sale. It should be noted that as there are a large number of firms under monopolistic competition, individual firms in the industry are not appreciably affected by a particular firm's behavior.

As mentioned above, a monopolistically competitive firm stops production where marginal revenue equals marginal cost of production—the output level that maximizes its profits (often called the equilibrium output for the firm).

THE DESIRABILITY OF MONOPOLISTIC COMPETITION.

Aforementioned profit maximizing behavior of a monopolistically competitive firm implies that now the price associated with the product (at the equilibrium or the profit maximizing output) is higher than marginal cost (which equals marginal revenue). Thus, the production under monopolistic competition does not take place to the point where price equals marginal cost of production. Remember that, with increased production, price charged (which is higher than marginal revenue at every level of output) is successively falling while the marginal cost of production is rising. Therefore, if a monopolistically competitive firm were to stop production where price is equal to marginal cost (a condition met under a perfectly competitive market structure), output produced would be greater than when it stops production where marginal revenue equals marginal cost (its profit maximizing output). The net result of the profit maximizing decisions of monopolistically competitive firms is that price charged under monopolistic competition is higher than under perfect competition. In addition,

quantity of the commodity produced under monopolistic competition is simultaneously lower. Thus, both on the basis of price charged and output produced, monopolistic competition is less socially desirable than perfect competition.

VII. OLIGOPOLY

Oligopoly is a fairly common market organization. In the United States, both the steel and auto industries (with three or so large firms) provide good examples of oligopolistic market structures.

MAJOR CHARACTERISTICS OF OLIGOPOLY.

An important characteristic of an oligopolistic market structure is the interdependence of firms in the industry. The interdependence, actual or perceived, arises from the small number of firms in the industry. However, unlike monopolistic competition, if an oligopolistic firm changes its price or output, it has perceptible effects on the sales and profits of its competitors in the industry. Thus, an oligopolist firm always considers the reactions of its rivals in formulating its pricing or output decisions.

One more important characteristic is that there are huge, though not insurmountable, barriers to entering an oligopolistic market. These barriers can involve large financial requirements, availability of raw materials, access to the relevant technology, or simply patent rights of the firms currently in the industry. Several industries in the United States provide good examples of oligopolistic market structures with obvious barriers to entry. The U.S. auto industry provides an example of a market where financial barriers to entry exist. In order to efficiently operate an automobile plant, one needs upward of half a billion dollars of initial investment. The steel industry in the United States, on the other hand, provides an example of an oligopoly where barriers to entry have been created by the ownership of raw materials needed for producing the product. In this industry, a few huge firms own most of the available iron ore, a necessary raw material for steel production.

An oligopolistic industry is also typically characterized by economies of scale. Economies of scale in production imply that as the level of production rises the cost per unit of product falls for the use of any plant (generally, up to a point). Thus, economies of scale lead to an obvious advantage for a large producer. Once again, the automobile industry provides an example of a market structure where firms experience economies of scale. It should be noted that there may exist economies of scale in promotion just as there exist economies of scale in production. In the automobile industry, the promotion cost per unit of product falls as sales increase since promotion costs rise less than proportionately to sales.

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