The previous two chapters analyzed markets with many competitive firms and markets with a single monopoly firm. In Chapter 14, we saw that the price in a perfectly competitive market always equals the marginal cost of production. We also saw that, in the long run, entry and exit drive economic profit to zero, so the price also equals average total cost. In Chapter 15, we saw how monopoly firms can use their market power to keep prices above marginal cost, leading to a positive economic profit for the firm and a deadweight loss for society. Competition and monopoly are extreme forms of market structure. Competition occurs when there are many firms in a market offering essentially identical products; monopoly occurs when there is only one firm in a market.
Although thecases of perfect competition and monopoly illustrate some important ideas about how markets work, most markets in the economy include elements of both these cases and, therefore, are not completely described by either of them. The typkal firm in the economy faces competition, but the competition is not so rigorous as to make the firm a price taker like the firms analyzed in Chapter 14. The typical firm also has some degree of market power, but its market power is not SO great that the firm can be described exactly by the monopoly model presented in Chapter 15. In other words, many industries fall somewhere between lite polar cases of perfect competition and monopoly. Economists call this situation impetfed eampelHIon.
One type of imperfectly competitive market is an oligopoly, which is a market with only a few sellers, each offering a product that is similar or identkal to the products offered by other sellers. Economists measure a market's domination by a small number of firms with a slatistk called the oMuvnlmfiiW! ratio, which is the percentage of total output in the market supplied by the four largest firms. In the U-S. economy, most industries have a four-firm concentration ratio under 51) percent, but in some industries, the biggest firms play a more dominant role. Highly concentrated industries include breakfast cereal fwhkh has a concentration ratio of 83 percent), aircraft manufacturing (85 percent), clcetric lamp bulbs (89 percent), household laundry equipment (90 percent), and cigarettes (99 percent). These industries are best described as oligopolies.
A second type of imperfectly competitive market is called monopolistic competition This describes a market structure in which there arc many firms selling products that are similar but not identkal. In a monopolist kaliy competitive market, each firm has a monopoly over the product it makes, but many other firm» make similar products that compete tor the same customers.
To be more precis»?, monopolistic competition describes a market with the following attributes:
• Many sellers: There are many firms competing for the same group of customers.
• Product different tat ton: Each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downward-sloping demand curve.
oligopoly a market structure m wh>:h only a few sailors offer »»nllar or identical product*
monopolist!« competition a market structure m which many firms %oll product» that ane slmllw but not identical
• Free entry and exit: Firms can enter or exit ihe market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero.
A moment's thought reveals a long list of markets with these attributes: books, music CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, and so on.
Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of competition and monopoly. But oligopoly and monopolistic competition are quite different, Oligopoly departs from the perfectly competitive ideal of Chapter 14 because there are only a few sellers in the market. The small number of sellers makes rigorous competition less likely and strategic interactions among them vitally important. By contrast, under monopolistic competition, there are many sellers, each of which is small compared to the market. A monopolis-ticallv competitive market departs from the perfectly competitive ideal because each of the sellers offers a somewhat different product.
Figure 1 summarizes the four types of market structure. The first question to ask about any market is how many firms there are. If there is only one firm, the market is a monopoly. If there are only a few firms, the market is an oligopoly. If there are many firms, we need to ask another question: l\> the firms sell identical or differentiated products? If the many firms sell differentiated products, the market is monopolistically competitive. If the many firms sell identical products, the market is perfectly competitive.
Because reality is never as clear-cut as theory, at times you may find it hard to decide what structure best describes a market. There is, for instance, no magic number that separates "lew" from "many" when counting the number of firms. (Do the approximately dozen companies that now sell cars in the United States make this market an oligopoly or more competitive? The answer is open to debate.)
Similarly, there is no sure way to determine when products are differentiated and when they are identical. (Are different brands of milk really the same? Again, the answer is dilutable.) When analyzing actual markets, economists have to keep in mind the lessons learned from studying all types of market structure and then apply each lesson as it seems appropriate.
Now that we understand how economists define the various types of market structure, we can continue our analysis of them. In the next chapter we analyze oligopoly. In this chapter we examine monopolistic competitkm.
QUICK QUIZ Deflrvs oJ.'gopoly and monopoAstic competition and give an example of each.
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