Market Structures

Firms have to know not only about costs, discussed in Costs of Production, but also about revenues when they make pricing and output decisions. In order to understand, for example, the relationship between output, revenues, and price, a firm has to know the structure of the market, or industry in which it is selling its product. There are various market structures, all dependent upon the extent to which buyers and selling decisions do not affect market price. At one extreme, when buyers and sellers indeed can correctly assume that they cannot affect market price, the market structure is one of perfect competition. Whenever buyers and sellers must take into account how their individual actions affect market price, we are not in a market structure of perfect competition but have entered imperfect competition.

The Meaning of Competition

Economists use the term to mean two different things. In its most general sense, the term competition relates to a relatively relaxed view of the competitive process that focuses on the concept of rivalry among economic transactors. After all, in a world of scarce resources, there will be rivalry among sellers and buyers. Behaviour among sellers where rivalry exists takes many forms: advertising, improvement in the quality of the product, sales promotion, development of new products, modification of old products, and so on. Rivalry among buyers also takes many forms: finding better deals, figuring out ways to take advantage of quantity discounts, offering a higher price to obtain a product that is in fixed supply, and so on. Rivalry is the real-world aspect of competition that is happening all around, because competition in the real world is a dynamic process. The second use of the term competition is much more specific and well defined, for it relates to a particular model of market organisation in which buyers and sellers do not and cannot affect the market price because there are so many of them. In this sense, competition means perfect competition will relate specifically to a particular market structure, the characteristics of which we will set out below. To get an overview of the market structures in perfect and

Perfect Competition
The economist's model of perfect competition is highly theoretical, but it does provide a useful tool of economic analysis and helps us to make some sense of real world conditions. The real world is much too complicated to understand all at once; it is necessary to examine one feature at a time. Economists are able to use their model of perfect market as a means of assessing the degree of competition in real world markets. They set out the conditions necessary for a perfect market and then contrast these with situations found in the markets for goods and services. The degree of competition in these real markets is based upon the extent to which they approximate to the model of perfect competition. It is necessary to point out that the competition referred to here is price competition. Firms are assumed to be engaged in a rivalry for sales which takes the form of underselling competitors. In a market operating under the conditions of perfect competition, there will be one, and only one, market price, and this price will be beyond the influence of any one buyer or any one seller. These conditions can only be satisfied in a market which contains certain characteristics. They are:

All units of the commodity are homogeneous(i.e. one unit is exactly like another). If this condition exists, buyers will have no preference for the goods of any particular seller. There must be many buyers and sellers so that the behaviour of any one buyer, or any one seller, has no influence on the market price. Each individual buyer comprises such a small part of total demand and each seller is responsible for such a small part of total supply that any change in their plans will have no influence on the market price. Buyers are assumed to have perfect knowledge of market conditions; they know what prices are being asked for the commodity in every part of the market. Equally sellers are fully aware of the activities of buyer and sellers. There must be no barriers to the movement of buyers from one seller to another. Since all units of the commodity are identical, buyers will always approach the seller quoting the lowest price.

Finally, it is assumed that there are no restrictions on the entry of firms into the market or on their exit from it.

We can see why, in a perfect market, there will be one and only one market price which is beyond the control of any one buyer or any one seller. Firms cannot charge different prices because they are selling identical products, each of them is responsible for a tiny part of the total supply , and buyers are fully aware of what is happening in the market

Imperfect Competition - 1. Monopolistic Competition

This is a market structure in which there are a large number of firms selling commodities which are very close substitutes. There are weak barriers to entry and firms may enter the industry with ease. Modern capitalism is characterised by a large number of 'limited' monopolies. They are sole suppliers of branded goods, but other firms compete with them by selling similar goods with different brand names. This is the market structure described as monopolistic competition. Thus the commodities produced by any one industry are not homogeneous; the goods are differentiated by branding and the use of trade marks. The individual firm has a monopoly position(e.g. only ICI can supply Dulux paint), but it faces keen competition from firms supplying very similar goods. It has, therefore, only a limited degree of monopoly power - how much depends upon the extent to which firms are free to enter the industry. Product differentiation is emphasised(some would say, created) by the practice of competitive advertising which is, perhaps, the most striking feature of monopolistic competition. Advertising is employed to heighten in the consumer's mind the differences between Brand X and Brand Y. It is important to realise that we are concerned with the differentiation of goods in the economic sense and not in the technical sense. Two branded products may be almost identical in their technical features or chemical composition, but if advertising and other selling practices have created different images in the consumer's mind, then

these products are different from our point of view because the consumer will be prepared to pay different prices for them.

Imperfect Competition - 2. Oligopoly

In many industries, especially the science-based, and technologically advanced industries, we find a market situation known as oligopoly. As the name implies, this is where the market is dominated 'by the few'. They are clearly not competitive in the sense that we have used the term; they are clearly not even monopolistically competitive. We call such a situation an oligopoly, which means few sellers that are interdependent. There are several characteristics of oligopoly that we now comment on: 1. Small Number of Firms. We have already mentioned that there is a small number of firms in an oligopolistic industry. Does that mean more that two but less than 100? The question is not easy to answer. Basically, though, we are interested in several firms dominating the entire industry so that these several firms really are able to set the price. By domination, we must be specific, however. We are referring to the percentage of total industry output accounted for by the few top firms. You can probably think of quite a few examples of an oligopolistic structure. The retail petrol industry is dominated by a few firms as is the chocolate industry, the retail banking system, building material suppliers and biscuit manufacturers. 2. Interdependence. When there are only a few large firms dominating the industry, they cannot act independently of one another. In other words, they recognise that there is mutual interdependence. Each firm will react to what the other firms do in terms of output and price, as well as to changes in quality and product differentiation. To specify a complete model of oligopoly, we would have to somehow specify the manner in which an oligopolist expects his or her rivals to react. Remember, in a perfectly competitive market each firm ignores the reactions of other firms because each firm can sell all that it wants at the going market price. In the pure monopoly model, the monopolist does not

have to worry about the reaction of rivals, since, by definition, there are none. We must stress here that the mutual interdependence results from a small number of firms in the industry that produce the largest share of total industry output. In fact, we might state that in an oligopoly market structure, the firms must try to predict the reaction of rival firms. Otherwise, poor business decisions could be made that would spell lower profits.

Imperfect Competition - 3. Duopoly

The simplest way to approach the operation of cartel pricing is to consider the case of just two firms in an industry. This is called duopoly. Therefore we can say that Oligopoly and Duopoly are very similar market structures. In this situation they differentiate their product with heavy advertising and service. Again there are major barriers to entry, and because the market is dominated by these two firms, they face inelastic demand. Examples in New Zealand include domestic airlines, with Qantas NZ and Air NZ, the major brewers Lion Nathan and Dominion Breweries, and also within telecommunications Clear and Telecom. The recent difficulties of the oil-producing countries to agree on a common pricing policy illustrate the difficulties that face a cartel like OPEC(organisation of Petroleum Exporting Countries). But at least one major oil producer has tried to provide some stability to the oil cartel and achieved some success through its relative importance in this market. This stabilizing role as performed by Saudi Arabia as a major oil-producer takes us on to yet another form of price determination within the the world of oligopoly, that of price leadership.

Imperfect Competition - 4. Monopoly

The word monopoly or monopolist probably brings to mind a business that takes undue advantage of the consumer, sells faulty products, gets rich and any other bad thoughts that one can have about big business. If we are to succeed in analysing and predicting the behaviour of non-competitive firms, however, we will have to be somewhat more objective in defining a monopolist. Our definition of monopoly is one that will be as applicable to small businesses as it is to companies selling on a nation-wide basis. Thus, a monopolist is defined as a single supplier that constitutes the entire industry. A seller prefers to have a monopoly rather than to face competition. In general, we think of monopoly prices as being higher than competitive prices, and of monopoly profits as being higher than competitive profits. How does a firm obtain a monopoly in an industry? Basically, there must be barriers to entry that enable firms to receive monopoly profits in the long run. We define barriers to entry as those difficulties facing potential new competitors in an industry. What sort of difficulties might a new competitor face?

Ownership of Resources: Consider the possibility of one firm owning the entire supply of a raw material input that is essential to the production of a particular commodity. The exclusive ownership of such a vital resource serves as a barrier to entry until an alternative technology not requiring the raw material in question is developed.

Government Restrictions - Licenses: In many industries it is illegal to enter without a license provided by the Government. For example in NZ you could not operate an unlicensed Casino or radio service.

Patents: A patent is issued to an inventor to protect him/her from having the invention copied for a period of years. At the end of the patent period the patented invention is no longer private property but public property which anyone can copy or reproduce.

Problem in Raising Adequate Capital: Certain industries require a large capital investment. The firms already in the industry can, according to some economists, obtain monopoly profits in the long run because no competitors can raise the large amount of capital needed to enter the industry.

Economies of Scale: Sometimes it is not profitable for more than one firm to exist in an industry. Such a situation may arise because of a phenomenon we have already discussed known as economies of scale. When economies of scale exist, costs increase less than proportionately to the increase in output. The first firm that is established is able to enjoy very low average costs per unit. If it charges a price that reflects a favourable cost situation then no rival firm can threaten its position.

Non-Price Competition
By their very nature, oligopolistic firms do not exhibit active price competition. The benefits from cutting prices tend to be small given the reactions of rivals. Hence a situation where rivals keep trying to undercut one another in the battle for supremacy in the market in a so-called price war is unlikely to persist. The likelihood of becoming a victor is slim if cost conditions are similar. Thus price wars do erupt occasionally, but these are only temporary. Therefore, competition for an increased percentage of total sales in the market must take some other form. The alternative form is what is generally called non-price competition. Non-price competition cannot be neatly subdivided into categories because it takes on a large number of aspects. The only thing that we can say about non-price competition is that it is an attempt by one oligopolistic form to attract customers by some means other than a price differential. Two types of product differentiation are: 1. Advertising As we pointed out previously, the primary purpose of advertising is to shift the demand curve to the right. This allows the seller, whether it be an oligopolist, a monopolistic competitor, or a monopolist, to sell more at each

and every price. Advertising may also have the effect of differentiating the product and of making the product's availability better known. A firm will advertise as a way of gaining a non-price competitive advantage over other firms. Whatever can be said about advertising, its effect on the oligopolistic firm is certainly not completely predictable. 2. Quality Variations Quality differentiation results in a division of one market into a number of sub-markets. We talked earlier about differentiating product through quality variation when we discussed monopolistic competition. Now we can apply the same discussion to oligopoly. The prime example of product differentiation is the motor vehicle industry. There are specific physical definable differences between different automobiles models within one single firm. A Land Rover Defender and a Land Rover Discovery are certainly not the same product. If we examine cars, we see that the competition among oligopolistic firms creates a continuous expansion and redefinition of the different models sold by any one company. There is competition to create new quality classes and thereby gain a competitive edge. Being the first in the market in a new quality class has often meant higher profits. Thus oligopolists are always looking for best-selling new models. New products can promise higher sales and profits in a way that avoids the alternative risk of engaging the price competition with rivals.

Comparing Market Structures

Now that we have looked at Perfect Competition, pure monopoly, monopolistic competition, and oligopoly(and Duopoly), we are in a position to compare attributes of these four different market structures. We do this in summary form in the Table where we compare the number of sellers, their ability to set price, and whether product differentiation exists.

Market Structure Perfect competition Monopolistic competition

Unrestricte Number Ability to d entry and of sellers set price exit Numerous Yes Many Yes Partial No None Some Some

Longrun Product economic differentiation profits No No Yes None Considerable Typical The product is unique

Oligopoly/Duopoly Few Pure Monopoly One

Considerable Yes

Key Points

The market consists of Perfect and Imperfect Competition. A perfectly competitive firm is a price-taker. It takes price as given. It can sell all that it wants at the existing market price. There is freedom of entry and exit from the market and it produces a homogeneous product. Monopolistic competition is a market structure that lies between pure monopoly and perfect competition. A monopolistically competitive structure has (1) a large number of sellers, (2) differentiated products, and (3) advertising. Oligopoly means few sellers; an oligopoly is a market situation in which there are few independent sellers An oligopolistic market structure can come about because of (1) returns to scale, (2) barriers to entry, and (3) horizontal mergers. A monopolist is defined as a single seller of a product or a good for which there are no close substitutes. In order to maintain a monopoly there must be barriers to entry. These include ownership of resources without close substitutes, large capital requirements, licenses, franchises, patents and economies of scale. Non-price competition is typical of oligopolistic market structures since if one firm tries to expand sales through price competition it is unlikely to be successful without damage to its profit situation.