The notion of competition is very widely used in economics in general and in
microeconomics in particular. Competition is also considered the basis for capitalist
or free market economies. In standard usage of the term, competition
may also imply certain virtues. Markets are the heart and soul of a
capitalist economy, and varying degrees of competition lead to different
market structures, with differing implications for the outcomes of the
market place. This entry will discuss the following market structures
that result from the successively declining degrees of competition in
the market for a particular commodity. These elements are perfect competition, monopolistic competition,
oligopoly, and
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.
Each
of the above mentioned market structures describes a particular
organization of a market in which certain key characteristics differ.
The characteristics are: (a) number of firms in the market, (b) control
over the price of the relevant product, (c) type of the product sold in
the market, (d) barriers to new firms entering the market, and (e)
existence of nonprice 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.
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.
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.
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.
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 the three conditions that are
necessary before a market structure is considered "perfectly
competitive." These are: homogeneity of the product sold in the
industry, existence of many buyers and sellers, and perfect mobility of
resources or factors of production. 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 the first condition of a perfect market
sounds extreme, it is, in fact, met in markets for many products. Wheat
and corn are good examples. Wheat and corn produced by different farmers
is essentially the same, and can thus be considered identical.
The
second condition, existence of many buyers and sellers, again 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. The third 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 the third condition is that resources move to
the most profitable industry.
No industry in the world (now or in
the past) satisfies all three 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
three 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.
Despite the fact that
no industry is truly perfectly competitive, it is still worthwhile to
study perfect competition as a market structure. 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.
These
are two reasons why a capitalist society adores the virtues of perfect
competition. 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.
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.
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.
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.
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.
ECONOMICS AND DESIRABILITY OF OLIGOPOLY.
There
is no single theoretical framework that provides answers to output and
pricing decisions under an oligopolistic market structure. Analyses
exist only for special sets of circumstances. For example, if an
oligopolistic firm cuts its price, it is met with price reductions by
competing firms; however, if it raises the price of its product, rivals
do not match the price increase. For this reason, prices may remain
stable in an oligopolistic industry for a prolonged period of time.
It
is hard to make concrete statements regarding price charged and
quantity produced under oligopoly. However, from the point of view of
the society, one can say that an oligopolistic market structure provides
a fair degree of competition in the market place if the oligopolists in
the market do not collude. Collusion occurs if firms in the industry
agree to set price and/or quantity. In the United States, there are laws
that make collusion illegal.
Monopoly
can be considered the opposite of perfect competition. It is a market
form in which there is only one seller. While at first glance a monopoly
may appear to be a rare market structure, it is not so. Several
industries in the United State have monopolies. Some utility companies
provide examples of a monopolist.
CAUSES AND CHARACTERISTICS OF MONOPOLY.
There
are many factors that give rise to a monopoly. For example, in the
United States the inventor of an item has the exclusive right to produce
that product for 17 years. Thus, a monopoly can exist in an industry
because a patent was obtained for a product by its inventor. The United Shoe Machinery
Company held such a monopoly in certain important shoe making equipment
until 1954, when the monopoly was broken under the antitrust laws. A
monopoly can also arise if a company owns the entire supply of a
necessary material needed to produce a product. The Aluminum Company of
America exercised such power until 1945, when its monopoly was also
broken under provisions of the antitrust laws. A monopoly can be legally
created by a government agency when it sells a market franchise a
particular product or service. Often a monopoly so established is also
regulated by the appropriate government agency. Provision of local
telephone service in the United States provides an example of such a
monopoly. Finally, a monopoly may arise due to declining cost of
production for a particular product. In such a case the average cost of
production falls and reaches a minimum at an output level that is
sufficient to satisfy the entire market. In such an industry, rival
firms will be eliminated until only the strongest firm (now the
monopolist) is left in the market. This is often called a case of
natural monopoly. A good example of a natural monopoly is the
electricity industry. The electric power industry reaps benefits of
economies of scale and yields decreasing average cost. A natural
monopoly is usually regulated by the government.
THE ECONOMICS OF MONOPOLY.
Generally
speaking, price and output decisions of a monopolist are similar to
those of a monopolistically competitive firm, with the major distinction
of a large number of firms under monopolistic competition and only one
firm under monopoly. Thus, one may technically say that there is no
competition under monopoly. This is not strictly true, as even a
monopolist is threatened by indirect and potential competition. Like
monopolistic competition, a monopolistic firm also maximizes its profits
by producing up to the point where marginal revenue equals marginal
cost. As the monopolist is a price maker and can increase the amount of
sales by lowering the price, a monopolist does not lure consumers away
from rivals, rather he or she induces them to buy more. Nevertheless, at
any output level, the price charged by a monopolist is higher than the
marginal revenue. As a result, a monopolist also does not produce to the
point where price equals marginal cost (a condition met under a
perfectly competitive market structure).
DESIRABILITY OF MONOPOLY.
An
industry characterized by a monopolistic market structure produces less
output and charges higher prices than under perfect competition (and
presumably under monopolistic competition). Thus, on the basis of price
charged and quantity produced, a monopoly is less desirable socially.
However, a natural monopoly is generally considered desirable if the
monopolist's price behavior can be regulated.
