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    Competing in a Free Market – Introduction to Business

    8 COMPETING IN A FREE MARKET

    What are the four types of market structure?

    One of the characteristics of a free-market system is that suppliers have the right to compete with one another. The number of suppliers in a market defines the market structure. Economists identify four types of market structures: (1) perfect competition, (2) pure monopoly, (3) monopolistic competition, and (4) oligopoly. (Figure) summarizes the characteristics of each of these market structures.

    Perfect Competition

    Characteristics of perfect (pure) competition include:

    A large number of small firms are in the market.

    The firms sell similar products; that is, each firm’s product is very much like the products sold by other firms in the market.

    Buyers and sellers in the market have good information about prices, sources of supply, and so on.

    It is easy to open a new business or close an existing one.

    Comparison of Market Structures

    Characteristics Perfect Competition Pure Monopoly Monopolistic Competition Oligopoly

    Number of firms in market Many One Many, but fewer than perfect competition FewFirm’s ability to control price None High Some SomeBarriers to entry None Subject to government regulation Few ManyProduct differentiation Very little No products that compete directly Emphasis on showing perceived differences in products Some differencesExamples Farm products such as wheat and corn Utilities such as gas, water, cable television Retail specialty clothing stores Steel, automobiles, airlines, aircraft manufacturers

    In a perfectly competitive market, firms sell their products at prices determined solely by forces beyond their control. Because the products are very similar and each firm contributes only a small amount to the total quantity supplied by the industry, price is determined by supply and demand. A firm that raised its price even a little above the going rate would lose customers. In the wheat market, for example, the product is essentially the same from one wheat producer to the next. Thus, none of the producers has control over the price of wheat.

    Perfect competition is an ideal. No industry shows all its characteristics, but the stock market and some agricultural markets, such as those for wheat and corn, come closest. Farmers, for example, can sell all of their crops through national commodity exchanges at the current market price.

    Pure Monopoly

    At the other end of the spectrum is pure monopoly, the market structure in which a single firm accounts for all industry sales of a particular good or service. The firm is the industry. This market structure is characterized by barriers to entry—factors that prevent new firms from competing equally with the existing firm. Often the barriers are technological or legal conditions. Polaroid, for example, held major patents on instant photography for years. When Kodak tried to market its own instant camera, Polaroid sued, claiming patent violations. Polaroid collected millions of dollars from Kodak. Another barrier may be one firm’s control of a natural resource. DeBeers Consolidated Mines Ltd., for example, controls most of the world’s supply of uncut diamonds.

    Public utilities, such as gas and water companies, are pure monopolies. Some monopolies are created by a government order that outlaws competition. The U.S. Postal Service is currently one such monopoly.

    Monopolistic Competition

    Three characteristics define the market structure known as monopolistic competition:

    Many firms are in the market.

    The firms offer products that are close substitutes but still differ from one another.

    It is relatively easy to enter the market.

    Under monopolistic competition, firms take advantage of product differentiation. Industries where monopolistic competition occurs include clothing, food, and similar consumer products. Firms under monopolistic competition have more control over pricing than do firms under perfect competition because consumers do not view the products as perfect substitutes. Nevertheless, firms must demonstrate product differences to justify their prices to customers. Consequently, companies use advertising to distinguish their products from others. Such distinctions may be significant or superficial. For example, Nike says “Just Do It,” and Tylenol is advertised as being easier on the stomach than aspirin.

    Oligopoly

    An oligopoly has two characteristics:

    A few firms produce most or all of the output.

    Large capital requirements or other factors limit the number of firms.

    Boeing and Airbus Industries (aircraft manufacturers) and Apple and Google (operating systems for smartphones) are major players in different oligopolistic industries.

    With so few firms in an oligopoly, what one firm does has an impact on the other firms. Thus, the firms in an oligopoly watch one another closely for new technologies, product changes and innovations, promotional campaigns, pricing, production, and other developments. Sometimes they go so far as to coordinate their pricing and output decisions, which is illegal. Many antitrust cases—legal challenges arising out of laws designed to control anticompetitive behavior—occur in oligopolies.

    The market structure of an industry can change over time. Take, for example, telecommunications. At one time, AT&T had a monopoly on long-distance telephone service nationwide. Then the U.S. government divided the company into seven regional phone companies in 1984, opening the door to greater competition. Other companies such as MCI and Sprint entered the fray and built state-of-the-art fiber-optic networks to win customers from the traditional providers of phone service. The 1996 Telecommunications Act changed the competitive environment yet again by allowing local phone companies to offer long-distance service in exchange for letting competition into their local markets. Today, the broadcasting, computer, telephone, and video industries are converging as companies consolidate through merger and acquisition.

    Source : opentextbc.ca

    The Firm and Market Structures

    In this Refresher Reading learn about perfect and monopolistic competition, oligopoly, monopoly and the relationship between price, MR, MC, demand elasticity for each of them. Determine a firm’s optimal output and long-term pricing strategy.

    Refresher Reading

    The Firm and Market Structures

    2022 Curriculum CFA Program Level I Economics

    The Firm and Market Structures

    Download the full reading (PDF)

    Available to members

    Introduction

    The purpose of this reading is to build an understanding of the importance of market structure. As different market structures result in different sets of choices facing a firm’s decision makers, an understanding of market structure is a powerful tool in analyzing issues such as a firm’s pricing of its products and, more broadly, its potential to increase profitability. In the long run, a firm’s profitability will be determined by the forces associated with the market structure within which it operates. In a highly competitive market, long-run profits will be driven down by the forces of competition. In less competitive markets, large profits are possible even in the long run; in the short run, any outcome is possible. Therefore, understanding the forces behind the market structure will aid the financial analyst in determining firms’ short- and long-term prospects.

    Section 2 introduces the analysis of market structures. The section addresses questions such as: What determines the degree of competition associated with each market structure? Given the degree of competition associated with each market structure, what decisions are left to the management team developing corporate strategy? How does a chosen pricing and output strategy evolve into specific decisions that affect the profitability of the firm? The answers to these questions are related to the forces of the market structure within which the firm operates.

    Sections 3, 4, 5, and 6 analyze demand, supply, optimal price and output, and factors affecting long-run equilibrium for perfect competition, monopolistic competition, oligopoly, and pure monopoly, respectively.

    Section 7 reviews techniques for identifying the various forms of market structure. For example, there are accepted measures of market concentration that are used by regulators of financial institutions to judge whether or not a planned merger or acquisition will harm the competitive nature of regional banking markets. Financial analysts should be able to identify the type of market structure a firm is operating within. Each different structure implies a different long-run sustainability of profits. A summary and practice problems conclude the reading.

    Learning Outcomes

    The member should be able to:

    describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly;

    explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure;

    describe a firm’s supply function under each market structure;

    describe and determine the optimal price and output for firms under each market structure;

    explain factors affecting long-run equilibrium under each market structure;

    describe pricing strategy under each market structure;

    describe the use and limitations of concentration measures in identifying market structure;

    identify the type of market structure within which a firm operates.

    Summary

    In this reading, we have surveyed how economists classify market structures. We have analyzed the distinctions between the different structures that are important for understanding demand and supply relations, optimal price and output, and the factors affecting long-run profitability. We also provided guidelines for identifying market structure in practice. Among our conclusions are the following:

    Economic market structures can be grouped into four categories: perfect competition, monopolistic competition, oligopoly, and monopoly.

    The categories differ because of the following characteristics: The number of producers is many in perfect and monopolistic competition, few in oligopoly, and one in monopoly. The degree of product differentiation, the pricing power of the producer, the barriers to entry of new producers, and the level of non-price competition (e.g., advertising) are all low in perfect competition, moderate in monopolistic competition, high in oligopoly, and generally highest in monopoly.

    A financial analyst must understand the characteristics of market structures in order to better forecast a firm’s future profit stream.

    The optimal marginal revenue equals marginal cost. However, only in perfect competition does the marginal revenue equal price. In the remaining structures, price generally exceeds marginal revenue because a firm can sell more units only by reducing the per unit price.

    The quantity sold is highest in perfect competition. The price in perfect competition is usually lowest, but this depends on factors such as demand elasticity and increasing returns to scale (which may reduce the producer’s marginal cost). Monopolists, oligopolists, and producers in monopolistic competition attempt to differentiate their products so that they can charge higher prices.

    Typically, monopolists sell a smaller quantity at a higher price. Investors may benefit from being shareholders of monopolistic firms that have large margins and substantial positive cash flows.

    Competitive firms do not earn economic profit. There will be a market compensation for the rental of capital and of management services, but the lack of pricing power implies that there will be no extra margins.

    Source : www.cfainstitute.org

    The Four Types of Market Structures

    There are four basic types of market structures with different characteristics: perfect competition, monopolistic competition, oligopoly, and monopoly.

    The Four Types of Market Structures

    By Raphael Zeder | Updated Aug 24, 2020

    There are quite a few different market structures that can characterize an economy. However, if you are just getting started with this topic, you may want to look at the four basic types of market structures first: perfect competition, monopolistic competition, oligopoly, and monopoly. Each of them has its own set of characteristics and assumptions, which in turn affect the decision making of firms and the profits they can make.

    It is important to note that not all of these market structures exist in reality; some of them are just theoretical constructs. Nevertheless, they are critical because they help us understand how competing firms make decisions. With that said, let’s look at the four market structures in more detail.

    1. Perfect Competition

    Perfect competition describes a market structure, where a large number of small firms compete against each other. In this scenario, a single firm does not have any significant market power. As a result, the industry as a whole produces the socially optimal level of output, because none of the firms can influence market prices.

    The idea of perfect competition builds on several assumptions: (1) all firms maximize profits (2) there is free entry and exit to the market, (3) all firms sell entirely identical (i.e., homogenous) goods, (4) there are no consumer preferences. By looking at those assumptions, it becomes obvious that we will hardly ever find perfect competition in reality. That is an essential aspect because it is the only market structure that can (theoretically) result in a socially optimal level of output.

    Probably the best example of a market with an almost perfect competition we can find in reality is the stock market. If you are looking for more information on perfect competition, you can also check our post on perfect competition vs. imperfect competition.

    2. Monopolistic Competition

    Monopolistic competition also refers to a market structure, where a large number of small firms compete against each other. However, unlike in perfect competition, the firms in monopolistic competition sell similar but slightly differentiated products. That gives them a certain degree of market power, which allows them to charge higher prices within a specific range.

    Monopolistic competition builds on the following assumptions: (1) all firms maximize profits (2) there is free entry, and exit to the market, (3) firms sell differentiated products (4) consumers may prefer one product over the other. Now, those assumptions are a bit closer to reality than the ones we looked at in perfect competition. However, this market structure no longer results in a socially optimal level of output because the firms have more power and can influence market prices to a certain degree.

    An example of monopolistic competition is the market for cereals. There is a vast number of different brands (e.g., Cap’n Crunch, Lucky Charms, Froot Loops, Apple Jacks). Most of them probably taste slightly different, but at the end of the day, they are all breakfast cereals.

    3. Oligopoly

    An oligopoly describes a market structure that is dominated by only a small number of firms. That results in a state of limited competition. The firms can either compete against each other or collaborate (see also Cournot vs. Bertrand Competition). By doing so, they can use their collective market power to drive up prices and earn more profit.

    The oligopolistic market structure builds on the following assumptions: (1) all firms maximize profits, (2) oligopolies can set prices, (3) barriers to entry and exit exist in the market, (4) products may be homogenous or differentiated, and (5) only a few firms dominate the market. Unfortunately, it is not clearly defined what a “few firms” means precisely. As a rule of thumb, we say that an oligopoly typically consists of about 3-5 dominant firms.

    To give an example of an oligopoly, let’s look at the market for gaming consoles. This market is dominated by three powerful companies: Microsoft, Sony, and Nintendo. That leaves all of them with a significant amount of market power.

    4. Monopoly

    A monopoly refers to a market structure where a single firm controls the entire market. In this scenario, the firm has the highest level of market power, as consumers do not have any alternatives. As a result, monopolies often reduce output to increase prices and earn more profit.

    The following assumptions are made when we talk about monopolies: (1) the monopolist maximizes profit, (2) it can set the price, (3) there are high barriers to entry and exit, (4) there is only one firm that dominates the entire market.

    From the perspective of society, most monopolies are not desirable because they result in lower outputs and higher prices compared to competitive markets. Therefore, they are often regulated by the government. An example of a real-life monopoly could be Monsanto. This company trademarks about 80% of all corn harvested in the US, which gives it a high level of market power. You can find additional information about monopolies in our post on monopoly power.

    Summary

    There are four basic types of market structures: perfect competition, imperfect competition, oligopoly, and monopoly. Perfect competition describes a market structure, where a large number of small firms compete against each other with homogenous products. Meanwhile, monopolistic competition refers to a market structure, where a large number of small firms compete against each other with differentiated products. An Oligopoly describes a market structure where a small number of firms compete against each other. And last but not least, a monopoly refers to a market structure where a single firm controls the entire market.

    Source : quickonomics.com

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