In the last article, we talked about how firms make decisions based on their marginal costs and marginal revenue. In this article, we will further that discussion by breaking down the different market structures that firms operate in, and how that affects decision making. These market structures, perfect competition, monopoly, and monopolistic competition are important concepts that extend to other disciplines, such as finance and strategy. Understanding their characteristics and implications on firm behavior builds a good foundation for future courses, case competitions and work.
Market structure describes how a particular market is organized. For example, the fast food market is largely dominated by a few well known players: McDonald’s, KFC, Burger King, and Subway. The market players are slightly differentiated and the barriers to entry is relatively low. Common market structures classified into categories and are given names, for example the fast food market would be a monopolistic competition market. We will go over perfect competition, monopoly, and monopolistic competition in this post.
Perfect competition is defined by the following characteristics:
- Large number of buyers and sellers, each relatively small
- Sellers produce undifferentiated goods and services, easy to substitute
- Buyers and sellers have perfect information
- Little to no transaction costs
- Very low or no barriers to entry, can exit or enter market easily
Typical examples would be farm products like eggs or milk.
In perfectly competitive markets, firms can only charge one price, the market price. The firms are known to be price takers, as they cannot influence the price. The market price is determined by the market supply curve and market demand curve, and is perfectly elastic for the individual firms.
Intuitively, as all goods provided by the firms in the market are the same, firms that charge more for their goods will get no customers (substitute away) and firms that charge less will immediately sell out (substitute in). This means that firms have no incentive to price their goods anything more or less than the market price.
To maximize profits, firms will produce a Q* such that marginal cost equals marginal revenues, which in this case is the price. Therefore, in perfect competition, a special long run profit maximization condition exists, where:
MC = MR = P
As profit is revenue minus costs, and marginal costs equal total costs, the long run economic profit for firms in perfect competition is zero. Firms in perfect competition are willing to operate at a loss in the short run, as long as their revenues are higher than their variable costs. The profit could deviate away from zero in the short run, as market demand or supply shifts, but firms will enter or exit from market until price gets back to equilibrium. For example, if milk prices rise from demand increases due to lower coffee prices, then farmers will produce more milk and shift supply out until milk prices falls back to normal.
Monopoly is defined by the following characteristics:
- Single seller dominating the whole market
- Seller producing highly differentiated goods that cannot be substituted away from
- High barriers to entry
Monopolies, as the only firm in the market, can charge any price they want. They do not have to be large firms, just a firm that dominates a specific market, like the only gas station in a small town. They are, however, still bound by the demand curve, as consumers will buy less of the goods if they charge higher prices. The firm is known to be a price maker, and the firm’s demand curve is equivalent to the market demand curve.
For monopolies, the demand curve is downwards sloping. The marginal revenue curve is downwards sloping as well, at twice the slope of the demand curve if the demand curve is linear. This means that for a demand curve P(Q) = a – bQ, the MR curve is P(Q) = a – 2bQ. The derivation for this is simple, it is the first derivative of the revenue function (R(Q)) with respect to Q.
R(Q) = P(Q) * Q
R(Q) = (a – bQ) * Q = aQ – bQ2
R(Q) dQ = MR = a – 2bQ
To find the MR for non-linear demand functions, you would do the same thing.
Monopolists typically enjoy long run positive economic profits, compared to zero economic profits for firms in perfect competition. This is a result of its market power, which can come from a variety of factors, including:
- Economies of Scale
- Economies of Scope
- Cost Complements
- Patents and Other Barriers
All these factors keep competition from entering the market and reducing economic profit to zero.
To maximize profit, monopolists typically produce a quantity below social optimum, thus generating a dead weight loss.
Monopolistic competition contains elements of both perfect competition and monopolies. It is defined by the following characteristics:
- Many buyers and sellers
- The products are somewhat differentiated
- There is free entry and exit from the market
Typical examples would be Consumer Packaged Goods (CPGs) like shampoo, or fast food restaurants.
Monopolistic competition differs from perfect competition in that the firms have somewhat differentiated products, which means the product demand curves faced by the firms are not perfectly elastic. It differs from monopolies in that there are many sellers, and there are no strong barriers to entry. This means firms can no longer make long run positive economic profit, as other firms can and will move in. For example, if prices for fast food drops from lower demand due to a shift towards healthy eating, then some restaurants will exit the market and shift supply down. Prices will then move back up until firms are making zero economic profit.
Firms in monopolistic competition also produce at below social optimum when they maximize profit. At the profit maximizing quantity Q*, the firms do not take full advantage of economies of scale, as there are too many other firms in the market. Elasticity of demand for products will depend on how differentiated the products are — the harder it is to substitute away the less elastic the demand curve for that firm will be. Due to the importance of differentiation, firms in monopolistic competition, like CPGs, will spend significant amounts on advertising. To persuade consumers that their product is truly different, firms will use comparative ads to build brand equity, and introduce new products to fill niches.