Market structure analysis begins with the study of perfect competition and monopoly. Competition is said to be perfect when producers offer what buyers want at prices just sufficient to cover the marginal cost of output. Monopoly is socially less desirable given its tendency for underproduction, high prices, and excess profits.
• Market structure describes the competitive environment in the market for any good or service. A market consists of all firms and individuals willing and able to buy or sell a particular product. This includes firms and individuals currently engaged in buying and selling a particular product, as well as potential entrants. A potential entrant is an individual or firm posing a sufficiently credible threat of market entry to affect the price/output decisions of incumbent firms.
• Perfect competition is a market structure characterized by a large number of buyers and sellers of essentially the same product, where each market participant's transactions are so small that they have no influence on the market price of the product. Individual buyers and sellers are price takers. Such firms take market prices as given and devise their production strategies accordingly.
• Monopoly is a market structure characterized by a single seller of a highly differentiated product. Monopoly firms are price makers that exercise significant control over market prices.
• A barrier to entry is any factor or industry characteristic that creates an advantage for incumbents over new arrivals. A barrier to mobility is any factor or industry characteristic that creates an advantage for large leading firms over smaller nonleading rivals. A barrier to exit is any restriction on the ability of incumbents to redeploy assets from one industry or line of business to another.
• Monopsony exists when a single firm is the sole buyer of a desired product or input.
• A natural monopoly occurs when the market-clearing price, where P = MC, occurs at a point at which long-run average costs are still declining.
• Underproduction results when a monopoly curtails output to a level at which the value of resources employed, as measured by the marginal cost of production, is less than the social benefit derived, where social benefit is measured by the price customers are willing to pay for additional output.
• Countervailing power is an economic influence that creates a closer balance between previously unequal sellers and buyers.
• Business profit rates are best measured by the accounting rate of return on stockholders' equity measure. ROE is defined as net income divided by the book value of stockholders' equity, where stockholders' equity is the book value of total assets minus total liabilities. High ROE is derived from some combination of high profit margins, quick total asset turnover, and high leverage or a high rate of total assets to stockholders' equity. Business profits are also sometimes measured by the return on assets, defined as net income divided by the book value of total assets. Although ROA is a useful alternative indicator of the basic profitability of a business, it fails to account for the effects of financial leverage decisions on firm performance.
• Business profit rates often display a phenomenon known as reversion to the mean. Over time, entry into highly profitable industries tends to cause above-normal profits to regress toward the mean, just as bankruptcy and exit allow the below-normal profits of depressed industries to rise toward the mean.
• The nature of competition determines the suitability of managerial decisions and the speed with which they must be made. Survival of the fittest translates into success for the most able, and extinction of the least capable. Competitive strategy is the search for a favorable competitive position in an industry or line of business.
• In perfectly competitive industries, above-normal returns sometimes reflect economic luck, or temporary good fortune due to unexpected changes in industry demand or cost conditions. In other instances, above-normal returns in perfectly competitive industries reflect economic rents, or profits due to uniquely productive inputs. Another important source of above-normal profits in perfectly competitive industries is disequilibrium profits. Disequilibrium profits are above-normal returns that can be earned in the time interval between when a favorable influence on industry demand or cost conditions first transpires and the time when competitor reactions finally develop. Disequilibrium losses are below-normal returns that can be suffered in the time interval that often exists between when an unfavorable influence on industry demand or cost conditions first transpires and the time when exit or downsizing finally occurs.
• Only new and unique products or services have the potential to create monopoly profits. In many instances, these above-normal profits reflect the successful exploitation of a market niche. A market niche is a segment of a market that can be successfully exploited through the special capabilities of a given firm or individual.
Many real-world markets do in fact closely approximate the perfectly competitive ideal, but elements of monopoly are often encountered. As a result, these market structure concepts often provide a valuable guide to managerial decision making.
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