Final Research Paper: Market Structures
ECO204: Principles of Microeconomics
Perfect competition, monopolistic competition, oligopoly, and monopoly are the four market structures in economics. These market structures affect economy, government, and international trade differently because the characteristics of each market are different. These characteristics determine each market’s role and influence in different aspects of the overall economy. Government involvement is variable dependent of the market structure, while international trade affects all market structures. Other elements to consider with regards to market structures are high entry barriers, long run profitability, competitive pressures present and price elasticity of demand.
Market Structures and their Characteristics
“Perfect competition is a market structure in which there are many sellers and buyers, firms produce a homogeneous product, and there is free entry into and exit out of the industry” (Amacher & Pate, 2013). There are six characteristics of a perfect competitive market: a large number of sellers, a large number of buyers, production of a homogenous product, free entry into and free exit out of the market, perfect knowledge (everyone knows what is going on in the industry), and lastly other resources can easily move in and out of the industry. A homogenous product is a product that is the same regardless of the firm that produced it. For example, a carrot bundle purchased from Farmer Joe is the same as a carrot bundle purchased from Farmer John. It is important for a perfect competitive market to have a large number of buyers so that no single buyer can affect the market price by withholding purchases. In a perfect competition there is only one price and products are identical, the buyer cannot distinguish one firm’s product from another firm’s product. This structure is ideal for buying products because price is not influenced by the sellers but rather is determined by supply and demand. Further, both buyers and sellers have all the information about the product with regards to price and alternate options.
“Monopoly is the market structure in which there is a single seller of a product that has no close substitutes. The monopoly firm faces a negatively sloped demand curve and a marginal revenue curve that lies below that demand curve. The monopolist maximizes profits by producing the output level at which marginal revenue equals marginal cost” (Amacher & Pate, 2013). These firms have monopoly power and are price searchers, meaning they set price in order to maximize profits and exercise power over output. Since there are no other competitors, as a profit maximizer, it can set prices above what the price would be in a competitive market. An example of monopolies are controlled public utilities or the United States Postal Service for first class mail delivery. Monopolies are ideal for selling products because the firm controls pricing since there are no substitutes and no competition.
“The model of the monopolistic competition describes an industry composed of large number of sellers. Each of these sellers offers a differentiated products, which is a good or service that has a real or imagined characteristics that are different from those of other goods or services” (Amacher & Pate, 2013). One characteristic of this market is differentiated products which can take many forms such as packaging of the product, delivery, endorsements, design, etc. For example, Nike associates with Michael Jordon to differentiate their sneaker from other firms. Another characteristic of this market is easy entry into the industry meaning new firms can sell a product already in production in other firms. In other words, a baker can enter the market for cupcake production with minimal barriers and start selling next to another bakery on the same block.
“Oligopoly is the market structure in which there are only a few firms or a few firms dominate the market” (Amacher & Pate, 2013). An example of an oligopoly in the United States is the beer industry, of which there are two major producers. It is important to recognize there are only a few firms in a oligopoly and thus create interdependence on each other. Since the firms in a oligopoly are interdependent, attempts at communication, coordination, and collusion to determine pricing and output are characteristic of this market structure. Another characteristic of the oligopoly market structure are cartels, or groups of interdependent firms in accordance instead of competition to determine pricing and output. In the United States this behavior is outlawed, however, around the world certain governments encourage and monitor cartels.
Real-Life Monopolistic Competitive Market
Travel agencies are a real life example of a monopolistic competitive market. As previous stated, monopolistic competitive markets have a large number of firms offering differentiated products. There are hundreds of thousand travel agencies worldwide, both online and local retailer, offering many different kinds of travel solutions. The Internet provides consumers with more options to competitive pricing. For example, websites companies that are based in Europe can sometimes offer lower priced flights to a consumer living in the United States then could their local travel agency. To differentiate their products, travel agencies use many tools. One such example is Priceline’s “name your own price” tool. This tool allows the consumer to offer a price for their travel solution and if the agency accepts it, it is automatically booked. Other agencies like Expedia use other tools like “deals of the day” or “last minute deals” to attract consumers to purchase travel solutions from their site. These prices set by the firms. Another characteristic of a monopolistic competitive market is easy entry and exit to the industry. There are few barriers to start up a travel agency. A firm can operate from home and require low capital to begin an online travel site.
High Entry Barriers and Long-Run Profitability
High entry barriers are associated with two of the four market structures, monopolies and oligopolies. “Barriers to entry are natural or artificial obstacles that keep new firms from entering an industry” (Amacher & Pate, 2013). Natural barriers can result from long-run costs. If one firm is significantly larger than the few others in the industry, it can afford price cuts to attract more market share, and eventually becoming the only firm in that industry. Public utilities can be considered a natural monopoly. Artificial barriers are deliberate actions by the firm to keep other competitors out. Such actions can include violence, legal ownership of raw materials, or obtaining patents to technology and processes.
Long-run Profitability of the Firms
High entry barriers are important for oligopolies and monopolies to have long-run profitability. These barriers serve to profit existing firms within these market structures and safeguard their revenues from potentially new competitors. Monopolies produce output where marginal cost equal marginal revenue, not in response to demand. Since they control supply and therefore price, these firms can maintain long-run profitability because there are no other competitors to share profits with.
Cost Efficiency of the Firms in the Industry
Cost conditions will determine if a firm is to survive in a oligopolistic or monopolistic market. This is mostly influenced by the economies of scales, as output increases the cost of each unit decrease. Existing firms which produce higher volumes will effectively lower their average total costs (Scherer & Ross, 1990) enabling these firms to make a profit. New competitors to these market structures face the challenge of sustaining long-run profitability because as the larger firms lower prices and output more efficiently.
Likelihood that Inefficient Firms Survive
Inefficient firms are less likely to survive against monopolistic or oligopolistic firms because they do not make a profit at lower prices and lower output. New competitors must innovate and create a superior product to attract market share despite lower prices of the original product.
Incentives to the Entrepreneurs
One incentive to entrepreneurs to enter markets with high barriers is the need for alternative products or technology to develop substitutes at a lower price. For example, cable providers ran a monopoly for television broadcasting and were able to charge high prices because there were few competitors if any. However, with the invention of satellite television, these entrepreneurial firms invested in this new technology were able to force cable companies to lower prices.
Competitive Pressures in Markets with High Barriers
Competitive pressures are present in markets with high barriers to entry (Foster, Haltiwanger & Krizan, 2006). The reason lies in alternative products. As stated, monopolies incentivize entrepreneurs to create substitute products to compete for market share. Entrepreneurs who revamp existing products at a lower cost present competition to monopolistic firms. Firms in an oligopoly market also face competitive pressures despite high barriers to entry. These firms are interdependent and consider each other’s reaction when pricing their product. The price decision of one firm ultimately influences the price and output of the other firms thus making competitive pressure very high in this market.
Price Elasticity of Demand and Its effect on Pricing
In perfect competition, there are a large number of sellers of the same product and therefore the quantity of production does not affect market price of its output. In this market structure the marginal costs equals the marginal revenue thus maximizing profit. There is perfect elastic demand in perfect competition. An increase in total revenue is a result of a decrease in price, whereas a decrease in total revenue is a result of an increase in price.
In monopolistic competition, there are a large number of buyers and seller of differentiated products. As a result of these differentiations, firms can exert some control over price, making demand both elastic and inelastic in this market structure. Demand is elastic in higher price ranges and inelastic in lower price ranges.
Monopoly markets have a single firm that controls the supply of a product and therefore is able to manipulate the price to the firm’s interest. The market demand curve is also the firm’s demand curve since there are no other competitors and it curves downwards. Price is consistent with the level of output where marginal revenue is equal to marginal cost. If marginal revenue is greater than marginal costs, the firm will decrease price and increase output, likewise if marginal revenue is less than marginal cost, the firm will increase price and decrease output. When the marginal revenue is positive the demand is considered elastic, if marginal revenue is negative the demand is inelastic.
Lastly, in a oligopoly market the firms are interdependent on each other and price depends on a few competitors. Due to this, the demand curve for an oligopoly is kinked, meaning there are two lines with different slopes. In general, when one firm increases their prices the others do not, but if one firm decreases their pricing then the others follow suit.
The Role of the Government and the Affect on Price
In perfect competition, the government does not affect pricing because of the low barriers of entry. In this market structure supply and demand ultimately determines price of products. Buyers and sellers do not affect the price. In monopolistic competition market the government can instill policies to protect consumers and keep prices fair and affordable. Governments play the largest role in monopolistic markets because they act as a high barrier of entry. In this market structure, governments use restrictions such as patents and tariffs to limit firms from entering. These policies and regulations serve to allow monopoly firms control prices (Jayasuriya, 2007). In oligopolistic markets, collusion is not uncommon when interdependent firms are establishing price. However, governments can use policy to deem such behavior illegal and instill agencies to review business practices and impose fines or jail time to offenders.
The Effect of International Trade
In perfect competition and monopolistic competition, there are no barriers to entry (Economics, 2009). This means other firms both domestic and international can enter and exit freely. On the other hand, monopolies and oligopolies use government tariffs to create high barriers of entry. Tariffs are used to raise the price of imported good and thus create more demand for lower prices domestic alternatives. Quotas can also be used as a means to reduce the number of imports for products in these markets. One disadvantage of these methods is trade war between countries. According to Davies and Cline, quotas and tariffs harm consumers most and benefit foreign and domestic producers because they gain from higher prices. International trade lowers the prices for products because it increase the number of substitutes for a product, thus encouraging free trade and discouraging monopolies. Other benefits of international trade are improved quality of products and lower costs per unit.
To sum up, perfect competition, monopolistic competition, oligopoly, and monopoly are the four market structures in economics. These characteristics influence every market’s role in numerous aspects of the economy. Government involvement is variable dependent of the market structure, whereas international trade affects all market structures. Market structures with high entry barriers are monopolies and oligopolies. Markets with low entry barriers are perfect competition and monopolistic competition. Long run profitability is dependent on high entry barriers associated with monopolies and oligopolies. In response, entrepreneurs are encouraged to innovate better products and create competitive pressures. The price elasticity of demand for each market structure varies based on the characteristics of the market. Government intervention does not occur in perfect competition but does occur in the other three markets using tools like patents, tariffs and quotas. Lastly, international trade affect all markets and is overall beneficial to consumers with regards to price and quality. To conclude, these market structures have a different effect on the economy, government, and international trade as a result of the characteristics of each market.
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