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Chapter 7 M a r ke t S t r u c t u r e

market structure Important features of a market, including the number of buyers and sellers, product uniformity across sellers, ease of entering the market, as well as forms of competition

perfect competition A market structure with many fully informed buyers and sellers of an identical product and ease of entry

commodity A product that is identical across sellers, such as a bushel of wheat

203

7.1 P E R F E C T C O M P E T I T I O N A N D M O N O P O LY

Learning Objectives

L 1 Identify the features of perfect competition.

L 2 Describe the barriers to entry that can create a monopoly.

L 3 Compare the market structures of monopoly and perfect competition in terms of price and quantity.

In Your WorldAt this point you already know something about competitive markets and how they work, but there are other types of markets besides competitive markets. Market structure describes the important features of a market, including the number of buyers and sellers, the product’s uniformity across suppliers, the ease of entry into the market, and the forms of competition among fi rms. To get a better feel for the economy, you need to learn more about diff erent types of market structures. All fi rms that supply output to a particular market—such as the market for cars, shoes, or wheat—are referred to as an industry. Th erefore, the terms industry and market are used interchangeably. Th e fi rst two market structures you will consider are per-fect competition and monopoly.

Key Termsmarket structure 203

perfect competition 203

commodity 203

monopoly 205

market power 205

barriers to entry 205

PERFECT COMPETITIONTo begin your study of market structures, familiarize yourself with the four market features shown in Figure 7.1. Th e term market structure describes the important characteristics, or features, of a market. Th e fi rst market structure to consider is perfect competition. Perfectly competitive markets are assumed to have the following features:

1. Th ere are many buyers and sellers—so many that each buys or sells only a tiny fraction of the total market output. Th is assumption ensures that no individual buyer or seller can infl uence the price.

2. Firms produce a standardized product, or a commodity. A commodity is a product that is identical across suppliers, such as a bushel of wheat, a bushel of corn, or a share of Google stock. Because all suppliers off er an identical product, no buyer is willing to pay more for one particular supplier’s product.

3. Buyers are fully informed about the price, quality, and availability of products, and sellers are fully informed about the availability of all resources and technology.

4. Firms can easily enter or leave the industry. Th ere are no obstacles prevent-ing new fi rms from entering profi table markets or preventing existing fi rms from leaving unprofi table markets.

L 1Identify the

features

of perfect

competition.

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UNIT 2 THE MARKET ECONOMY204

If these conditions exist in a market, individual buyers and sellers have no control over the price. Price is determined by market demand and market supply. Once the market establishes the price, each fi rm is free to supply whatever quantity maximizes its profi t or minimizes its loss. A perfectly competitive fi rm is so small relative to the size of the market that the fi rm’s quantity decision has no eff ect on the market price. Any profi t in this market attracts new fi rms in the long run, which increases the market supply. Th is reduces the market price. Th e lower price drives down the profi t in this market.

Examples of Perfectly Competitive MarketsExamples of perfect competition include markets for the shares of large cor-

porations such as Google or General Electric; markets for foreign exchange, such as yen, euros, and pounds; and markets for most agricultural products, such as livestock, corn, and wheat. In these markets, there are so many buyers and sellers that the actions of any one cannot infl uence the market price.

In the perfectly competitive market for wheat, for example, an individual supplier is a wheat farm. In the world market for wheat, there are tens of thou-sands of wheat farms, so any one supplies just a tiny fraction of market output. For example, the thousands of wheat farmers in Kansas together grow less than 3 percent of the world’s supply of wheat. No single wheat farmer can infl uence the market price of wheat. Any farmer is free to supply any amount he or she wants to supply at the market price.

Market PriceIn Figure 7.2, the market price of wheat of $5 per bushel is determined in

panel (A) by the intersection of the market demand curve D and the market sup-ply curve S. Once the market price is established, each farmer can sell however much he or she wants to sell at that market price.

Each farm is so small relative to the market that each has no impact on the mar-ket price. Because all farmers produce an identical product—bushels of wheat—any farmer who charges more than the market price sells no wheat. For example, if a farmer charged $5.25 per bushel, wheat buyers simply buy from other sellers.

Of course, any farmer is free to charge less than the market price. But why do that when all wheat can be sold at the market price? Th e demand curve facing an individual farmer is, therefore, a horizontal line drawn at the market price. In this exam-ple, the demand curve in panel (B) is drawn at the market price of $5 per bushel.

MARKET STRUCTURE DESCRIBES THE IMPORTANT CHARACTERISTICS OF A MARKET.

Market Feature Questions to Ask

1. Number of buyers and sellers Are there many, only a few, or just one?

2. Product’s uniformity across suppliers

Do fi rms in the market supply identical products or are products diff erentiated across fi rms?

3. Ease of entry into the market Can new fi rms enter easily, or do natural or artifi cial barriers block them?

4. Forms of competition among fi rms

Do fi rms compete based only on prices, or are advertising and product diff erences also important?

FIGURE 7.1 Market Structure



monopoly The sole supplier of a product with no close substitutes

market power The abilityof a fi rm to raise its price without losing all sales to rivals

barriers to entryRestrictions on the entry of new fi rms into an industry

205

It has been said, “In perfect competition there is no competition.” Two neigh-boring wheat farmers in perfect competition are not really rivals. Th ey both can sell all they want at the market price. Th e amount one sells has no eff ect on the market price or on the amount the other can sell. Likewise, no two buyers compete for the product because they both can buy all they want at the market price. Each farm, or fi rm, tries to maximize profi t. Firms that ignore this strategy don’t survive.

What are the features of perfect competition?

MONOPOLYTh e monopoly market structure is the opposite of the perfect com-petition structure. A monopoly is the sole supplier of a product with no close substitutes. Th e term monopoly comes from a Greek word meaning “one seller.” A monopolist has more market power than does a business in any other market structure. Market power is the ability of a fi rm to raise its price without losing all its sales to rivals. A perfect competitor has no market power.

Barriers to EntryA monopolized market has high barriers to entry, which are restrictions on

the entry of new fi rms into an industry. Barriers to entry allow a monopolist to charge a price above the competitive price. If other fi rms could easily enter the

L 2 Describe

the barriers

to entry that

can create a

monopoly.

FIGURE 7.2 Market Equilibrium and Firm’s Demand Curve: Perfect CompetitionIn panel (A), the market price of $5 is determined by the intersection of the market demand and supply curves. Each perfectly competitive fi rm can sell any amount at that price. The demand curve facing each perfectly competitive fi rm is horizontal at the market price, as shown by demand curve d in panel (B).

S

D0

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Bushels of wheat per day

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(A) MARKET EQUILIBRIUM

Bushels of wheat per day0

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d



market, they would increase the market supply and thereby drive the price down to the competitive level. Th ere are three types of entry barriers: legal restrictions, economies of scale, and control of an essential resource.

Legal Restrictions Governments can prevent new fi rms from entering a market by making entry illegal. Patents, licenses, and other legal restrictions imposed by the government provide some producers with legal protection against competition.

Governments in some cities confer monopoly rights to sell hot dogs at civic auditoriums, collect garbage, off er bus and taxi service, and supply other ser-vices ranging from electricity to cable TV. Th e government itself may become a monopolist by supplying the product and outlawing competition. For example, many states are monopoly sellers of liquor and lottery tickets. Th e U.S. Postal Service (USPS) has the exclusive right to deliver fi rst-class mail.

Economies of Scale A monopoly sometimes emerges naturally when a fi rm experiences substantial economies of scale. A single fi rm can sometimes satisfy market demand at a lower average cost per unit than could two or more smaller fi rms. Put another way, market demand is not great enough to allow more than one fi rm to achieve suffi cient economies of scale.

Flower Auction HollandFive days a week in a huge building 10 miles outside Amsterdam, some 2,000 buyers gather to participate in Flower Auction Holland. At this auction, more than 19 million fl owers and 2 million plants from 5,000 growers around the globe are auctioned off each day. The auction is held in the world’s largest commercial building, and it is spread across the equivalent of 100 football fi elds. Flowers are grouped and auctioned off by type—long-stemmed roses, tulips, and so on. Hundreds of buyers sit in theater settings with their fi ngers on buttons. Once the fl owers are presented, a clock-like instrument starts ticking off descending prices until a buyer stops it by pushing a button. The winning bidder gets to choose how many and which items to take. The clock starts again until another buyer stops it, and so on, until all fl owers are sold. Buyers also can bid from remote locations. Flower auctions occur swiftly—on average one transaction occurs every four seconds. This is an example of a Dutch auction, which starts at a high price and works down. Dutch auctions are common where multiple lots of simi-lar, though not identical, items are sold, such as fl owers in Amsterdam, tobacco in Canada, and fi sh in seaports around the world.

Think Critically Is Flower Auction Holland a perfect example of a perfectly competitive market? Why or why not?


Chapter 7 M a r ke t S t r u c t u r e 207

Th us, a single fi rm emerges from the competitive process as the sole supplier in the market. For example, the transmission of electricity involves economies of scale. Once wires are run throughout a community, the cost of linking additional households to the power grid is relatively small. Th e cost per household declines as more and more households are wired into the system.

A monopoly that emerges due to the nature of costs is called a natural monopoly. A new entrant cannot sell enough output to experience the economies of scale enjoyed by an established natural monopolist. Th erefore, entry into the market is naturally blocked.

In less-populated areas, natural monopolies include the only grocery store, movie theater, or restaurant for miles around. Th ese are geographic monopolies for products sold in local markets.

Control of Essential Resources Sometimes the source of monopoly power is a fi rm’s control over some resource critical to production. Following are some examples of the control of essential resources barrier to entry.

• For decades, Alcoa controlled the world’s supply of bauxite, the key raw material in aluminum.

• China is a monopoly supplier of pandas to the world’s zoos. Th e National Zoo in Washington, D.C., for example, rents a pair of pandas from China for $1 million per year. As a way of controlling the panda supply, China stipulates that any off spring from the Washington pair becomes China’s property. Other zoos have similar deals with China.

• A key resource for any professional sports team is a large stadium. Pro teams typically sign exclusive, long-term leases for stadiums in major cities. Th ese leases help block the formation of another league in the sport.

Monopolists May Not Earn a Profi tBecause a monopoly, by defi nition, supplies the entire market, the demand

curve for a monopolist’s output also is the market demand curve. Th at demand curve, therefore, slopes downward, refl ecting the law of demand. Price and quantity demanded are inversely, or negatively, related.

Even a monopolist with iron-clad barriers to entry may go broke. Although a monopolist is the sole supplier of a good with no close substitutes, the demand for that good may not be great enough to keep the fi rm in business. After all, many inventions are protected from direct competition by patents, yet most patented products never get produced and many that are produced fail to attract enough customers to survive.

True Monopolies Are RareLong-lasting monopolies are rare because a profi table monopoly attracts com-

petitors and substitutes. Even where barriers to entry are initially high, technolog-ical change tends to create substitutes. For example, railroads at one time enjoyed a natural monopoly in shipping goods across country. Th e monopoly ended when the trucking industry was born. Th e development of wireless transmission of long-distance telephone calls created competitors for the monopolist AT&T and



is erasing the monopoly held by some local cable TV providers and some local phone services. Likewise, fax machines, email, the Internet, text messaging, and delivery fi rms such as FedEx and UPS have all cut into the U.S. Postal Service’s monopoly on fi rst-class mail delivery.

Name and describe the three barriers to entry into a market.

MONOPOLY AND EFFICIENCYMonopolists are not guaranteed a profi t. Monopolies can lose money. Monopolies are relatively rare. So, then, what’s the problem?

Monopoly vs. Perfect CompetitionOne way to understand the problem is to compare monopoly

to perfect competition. Competition forces fi rms to be effi cient—that is, to produce the maximum possible output from available resources—and to supply that output at the lowest possible price. Consumers get a substantial consumer surplus from this low price. However, a successful monopolist typically charges more than competitive fi rms do. Th us, the biggest problem with monopo-lies is they charge higher prices, so fewer consumers can aff ord the product.

To compare monopoly and perfect competition, suppose D in Figure 7.3 is the market demand curve for a product sold in perfect competition. Suppose the market supply curve (which is not shown) intersects the market demand curve at point c. Th e market price is pc and the market quantity is Q c. Consumer surplus is the triangular area below the demand curve and above the price, measured by acpc. (Recall that consumer surplus is the diff erence between the most that consum-ers are willing to pay for a given quantity of a good and what they actually pay.)

What if one fi rm buys up all the individual fi rms in the perfectly competi-tive market, creating a giant monopoly? In this case, the market demand curve becomes the monopolist’s demand curve. Suppose the average cost per unit is the same with monopoly as with perfect competition. What we can say for sure is that a monopoly supplies less output and at a higher price than would a perfectly competitive market. To maximize profi t, the monopolist restricts quantity to Q m and increases the price to pm. With monopoly, consumer surplus shrinks to the blue triangle, which is much smaller than with perfect competition.

Other Problems With MonopolyMonopolies may reduce social welfare for other reasons besides higher prices to

consumers. Th ese include a possible waste of resources and ineffi ciencies that may develop in their operation.

Resources Wasted Securing Monopoly Privilege Because of their size and economic importance, monopolies may have too much infl uence on the political system, which they use to protect and strengthen their monopoly power.

L 3Compare

the market

structures

of monopoly

and perfect

competition.



Lawyers’ fees, lobbying expenses, and other costs associated with gaining a special privilege from government are largely a social waste because they use up scarce resources but add not one unit to output.

Monopolies May Grow Inefficient Th e monopolist, insulated from the rigors of market competition, could grow fat and lazy, and thus become inef-fi cient. Executives might waste resources by creating a more comfortable life for themselves. Lavish salaries and company perks could boost the average cost of production above the competitive level. Monopolists also have been criticized for being slow to adopt the latest production techniques, reluctant to develop new products, and generally lacking in innovation.

Why Monopoly Might Not Be So BadFor several reasons, some monopolies may not be as socially wasteful as was

just described.Economies of Scale If economies of scale are substantial, a monopolist

might be able to produce output at a lower average cost than competitive fi rms could. Th erefore, the price, or at least the cost of production, could be lower with monopoly than with perfect competition.

Government Regulation Government intervention can increase social welfare by forcing the monopolist to lower the price and increase output. Th e

FIGURE 7.3 Monopoly, Perfect Competition, and Consumer SurplusSuppose the market supply curve (which is not shown) intersects the market demand curve at point c. A perfectly competitive industry would produce output Q

c and sell

at a price pc. A monopoly that could produce at that same average cost would supply

output Qm

and sell at price pm

. Output is lower and price is higher under monopoly than under perfect competition. With perfect competition, consumer surplus is the entire triangle acp

c. With monopoly, consumer surplus shrinks to the blue-shaded triangle.

D

c

Qc0

pc

Quantity per period

pm

a

Qm

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government can either operate the monopoly itself, as it does with most urban transit systems, or it can regulate a privately owned monopoly, as it does with lo-cal phone services and electricity transmission. You will read more about govern-ment regulation later in this chapter.

Keeping Prices Low to Avoid Regulation A monopolist might keep prices below the profi t-maximizing level to avoid government regulation. For example, the prices and profi ts of drug companies, which individually are monopoly suppliers of patented medicines, come under scrutiny from time to time by public offi cials who threaten to regulate drug prices. Drug fi rms might try to avoid such treatment by keeping prices below the level that would maximize profi t.

Keeping Prices Low to Prevent Competition Finally, a monopolist might keep the price below the profi t-maximizing level to avoid attracting com-petitors. For example, at one time Alcoa was the only U.S. producer of alumi-num. Industry observers claimed that the company kept prices and profi ts below their maximum to discourage the entry of new fi rms.

How does monopoly compare to perfect competition in terms of price

and quantity?

ESSENTIALQUESTION

Standard CEE 9: Competition and Market StructureCompetition among sellers usually lowers costs and prices, and encourages producers to produce what consumers are willing and able to buy. Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most for them.

What are the effects on the economy of competition among sellers and competition among buyers?

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7.1 ASSESSMENT

Think Critically 1. What characteristics of farms suggest that these fi rms operate in perfectly competitive

markets?

2. One decade ago, the town of Mt. Utopia had fi ve fast-food restaurants. The town’s popula-tion has grown rapidly since then. As the town grew, the sales and profi ts of these restaurants increased. There now are 15 fast-food restaurants in Mt. Utopia. None of them earns a large profi t. What feature of competitive markets does this demonstrate? Explain your answer.

3. Identify a fi rm that operates in your community that you think has a signifi cant amount of market power. Explain why you chose this fi rm.

4. At one time, the American Telephone and Telegraph Corp. (AT&T) had a great deal of monopoly power and earned large profi ts. The growth in the use of cellular technology caused AT&T to lose money. What happened to AT&T’s monopoly power?

Graphing Exercise 5. Use data in the table to draw two graphs: the market demand and supply curves, and the

individual demand curve for the Apex Coal Mine. Assume this is a perfectly competitive market, and that Apex is one fi rm in that market. What is the market equilibrium price? How did you derive the individual demand curve for Apex?

Working in small teams, identify two local businesses that have a signifi cant amount of market power. Describe the barrier(s) to entry that allows these fi rms to set prices. Are consumers better served or harmed by these businesses? Compare your team’s answers with the work of other teams.

TeamWork

MARKET COAL DEMAND AND SUPPLY SCHEDULE PER MONTH

Price per Ton Market Demand (tons) Market Supply (tons)

$200 4,000,000 8,000,000

$175 5,000,000 7,000,000

$150 6,000,000 6,000,000

$125 7,000,000 5,000,000

$100 8,000,000 4,000,000

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Make Academic Connections 6. History Between 1880 and 1900, the Standard Oil Company came to control almost

90 percent of oil production in the United States. It did this by buying up or driving other fi rms out of business. With this monopoly power, the fi rm’s owners were able to earn as much as a 20 percent profi t on the value of the fi rm’s assets, such as its refi neries, pipelines, etc. Much of the fi rm’s profi t was used to develop new technologies that, according to the owners, contributed to lower prices. In your opinion, is it possible for monopolies to be good for consumers? Explain your answer.


Throughout history, some individuals have enjoyed greater income and wealth than most other people. In the United States names such as Andrew Carnegie, John D. Rockefeller, and Cornelius Vanderbilt come to mind. More recently, Bill Gates and Warren Buf-fet have made vast fortunes by leading successful businesses. What is interesting is the fact that, having made their fortunes, these men chose to use much of their wealth to help others who were less fortu-nate. Consider the following.

• Carnegie used his wealth to establish more than 3,000 public libraries in the United States, Canada, and England.

• Rockefeller gave funds to educational organizations including $80 million to the University of Chicago.

• Vanderbilt donated funds to establish Vanderbilt University in Tennessee.

• Gates pledged $50 billion to the Bill and Melinda Gates Foundation that is dedicated to bringing innovations in health, development, and learning to the global community.

• Buff et pledged roughly $30 billion in Berkshire Hathaway stock to the Bill and Melinda Gates Foundation.

Wealth and ResponsibilityIt has been said that with great wealth goes great responsibility. Each of the men cited above gained wealth by leading successful fi rms. Carnegie domi-nated steel production. During the 1890s Rockefell-er’s Standard Oil produced most of the petroleum in the United States. Vanderbilt controlled several rail-roads. Gates created Microsoft. And, Buff et became wealthy as the head of Berkshire Hathaway, a con-glomerate, multi-industry holding company.

Some people believe most of these men took unfair advantage of market power to accumulate their wealth. Antitrust laws were used against several of them in an attempt to limit their power. In 1911, for example, Rock-efeller’s Standard Oil Co. was dissolved into 34 smaller fi rms. In 1998, the U.S. Department of Justice brought suit against Microsoft, accusing the fi rm of monopoliz-ing the computer software market. Regardless of how these men accumulated their wealth, history shows that they ultimately used a large part of their fortune to help others. If you had been in their situations, what would you have done with your wealth and power?

Leadership and Responsibility on a Smaller ScaleOn a smaller scale, most people have the opportu-nity to use the wealth and power they accumulate to help others. Millions of Americans choose to share their wealth with people who are in need. Which of these factors would you weigh when you decide whether to contribute part of your wealth to people who are less fortunate than you?

• The need of the people you might help

• Your ability to sacrifi ce

• Contributions made by others

• Whether you are related to those who are in need

Apply the SkillImagine that a natural disaster has occurred in a foreign nation. You have seen TV reports that show thousands of victims who are suff ering from a lack of food, shelter, water, and medical care. Describe three specifi c factors you would consider in order to decide whether or not to help. Would you work to encourage others to contribute? Explain why or why not.

LEADERSHIP AND RESPONSIBILITY

To Protect and Serve

212 UNIT 2 THE MARKET ECONOMY



monopolistic competition A market structure with low entry barriersand many fi rms selling products diff erentiated enough that eachfi rm’s demand curve slopes downward

MONOPOLISTIC COMPETITIONIn monopolistic competition, many fi rms off er products that diff er slightly. As the expression monopolistic competition suggests, this structure contains elements of both monopoly and competition. Th e “monopolistic” element is that each fi rm has some market power. In other words, a fi rm can raise its price with-

out losing all its customers. Because the products of diff erent suppliers diff er slightly, each fi rm’s demand curve slopes downward. Th e “competition” element of monopo-listic competition is that barriers to entry are so low that any short-run profi t attracts new competitors, and this will erase profi t in the long run.

Market CharacteristicsBecause barriers to entry are low, fi rms in monopolistic competition can, in

the long run, enter or leave the market with ease. Consequently, there are enough sellers that they behave competitively. Th ere also are enough sellers that each tends to get lost in the crowd, like a golfer in a tournament who is striving for a personal best. A particular fi rm, in deciding on a price, does not worry about how other fi rms in the market will react. For example, in a large city, an individual restaurant, gas station, drugstore, dry cleaner, or convenience store tends to act independently from its many competitors—it tends to get lost in the crowd.

Product DifferentiationIn perfect competition, the product is identical across suppliers, such as a

bushel of wheat. In monopolistic competition, the product diff ers slightly among sellers, as with the diff erence between one rock radio station and another. Sellers diff erentiate their products in four basic ways.

7.2 M O N O P O L I S T I C C O M P E T I T I O N A N D O L I G O P O LY

Key Termsmonopolistic competition 213

oligopoly 214

cartel 216

Learning Objectives

L 1 Identify the features of monopolistic competition.

L 2 Identify the features of oligopoly, and analyze fi rm behavior when these fi rms cooperate and when they compete.

In Your WorldYou are now aware of the extreme market structures of perfect competition and monopoly. Next you will learn about monopolistic competition and oligopoly, the two structures between the extremes in which most fi rms operate. Firms in monop-olistic competition are like golfers in a tournament in which each player strives for a personal best. Firms in oligopoly are more like players in a tennis match, where each player’s actions depend on how and where the opponent hits the ball.

213

L 1Identify the

features of

monopolistic

competition.


UNIT 2 THE MARKET ECONOMY

Physical Differences Th e most obvious way products diff er is in their physical appearance and their qualities. Th e diff erences among products are seemingly endless. Shampoos, for example, diff er in color, scent, thickness, lather-ing ability, and bottle design. Packaging also is designed to make a product stand out in a crowded fi eld, such as drinking water in green, tear-shaped bottles or potato chips in a can.

Location Th e number and variety of locations where a product is available also are a means of diff erentiation. Some products seem to be available every-where, including the Internet. Finding other products requires some search and travel.

Services Products also diff er in their accompanying services. For example, some restaurants off er home delivery. Others don’t. Some retailers off er product demonstrations by a well-trained staff . Others are mostly self-service.

Product Image A fi nal way products diff er is in the image the producer tries to foster in the consumer’s mind. For example, some products use celebrity endorsements to boost sales.

Costs of Product DifferentiationFirms in monopolistic competition spend more on marketing to diff erentiate

their products than do fi rms in perfect competition. Th is increases average cost. Some economists argue that monopolistic competition results in too many fi rms and in product diff erentiation that is artifi cial. Others argue that consumers are willing to pay a higher price for a wider choice.

Excess CapacityFirms in monopolistic competition are said to operate with excess capacity,

which means that a fi rm could lower its average cost per unit by selling more. Such excess capacity exists, for example, with gas stations, banks, convenience stores, motels, bookstores, and fl ower shops. As a specifi c example, industry analysts argue that the nation’s 21,000 funeral homes could effi ciently handle 4 million funerals a year, but only about 2.5 million people die each year. So the industry operates at about 60 percent capacity. Th is results in a higher aver-age cost per funeral because most resources remain idle much of the time.

What are the important features of monopolistic competition?

OLIGOPOLYOligopoly is a Greek word meaning “few sellers.” When you think of “big business,” you are thinking of oligopoly, a market that is dominated by just a few fi rms. Perhaps three or four fi rms account for most market output. Because this market has only a

Would you be willing to pay more for food if it means you would have more restaurant choices?

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Brainstorm a list of mar-kets in your area in which fi rms seem to be operat-ing with excess capacity. Cite evidence for each market.

oligopoly A marketstructure with a small numberof fi rms whose behavior is interdependent

214



few fi rms, each must consider the eff ect of its own actions on competitors’ behavior. Oligopolistic industries include the markets for steel, oil, automobiles, breakfast cereals, and tobacco.

In some oligopolies, such as steel or oil, the product is identical, or undiff eren-tiated, across producers. Th us, an undiff erentiated oligopoly sells a commodity, such as an ingot of steel or a barrel of oil. In other oligopolies, such as automobiles or breakfast cereals, the product is diff erentiated across producers. A diff erentiated oligopoly sells products that diff er across producers, such as Ford versus Toyota or General Mills’ Wheaties versus Kellogg’s Corn Flakes.

Firms in an oligopoly are interdependent, like tennis players. Th erefore, each fi rm knows that any changes in its price, output, or advertising may prompt a reac-tion from its rivals. Each fi rm may react if another fi rm alters any of these features.

Barriers to EntryWhy have some industries evolved into an oligopolistic market structure,

dominated by only a few fi rms, whereas other industries have not? Although the reasons are not always clear, an oligopoly often can be traced to some barrier to entry, such as economies of scale or brand names built up by years of advertising. Most of the entry barriers that apply to monopoly also apply to oligopoly.

Economies of Scale Perhaps the most signifi cant barrier to entry is econo-mies of scale. As noted in Chapter 5, the minimum effi cient scale is the lowest rate of output at which a fi rm takes full advantage of economies of scale. If a fi rm’s mini-mum effi cient scale is large compared to industry output, then only a few fi rms are needed to produce the total amount demanded in the market. For example, an automobile factory of minimum effi cient scale could make enough vehicles to supply nearly 10 percent of the U.S. market. To compete with existing producers, a new entrant must sell enough automobiles to reach a competitive scale of operation.

Figure 7.4 presents the long-run average cost curve for a typical fi rm in an indus-try with economies of scale. If a new entrant can expect to sell only S cars, the aver-age cost per unit would be $50,000. Th is far exceeds the average cost of $10,000 for a manufacturer that sells M cars, which is the minimum effi cient size. Because autos sell for less than $50,000, a potential entrant can expect to lose money on every car sold, and this prospect usually discourages entry. For example, John Delorean tried to break into the auto industry in the early 1980s with a modern design that was later featured in the Back to the Future movies. But his company managed to build and sell only 8,583 Deloreans before going bankrupt. If an auto plant costs $3 billion to build, just paying for the plant would have cost more than $300,000 per Delorean.

The High Cost of Entry Th e total investment needed to reach the mini-mum effi cient size may be huge. A new auto factory or computer chip plant can cost more than $3 billion. Th e average cost of developing and testing a new drug exceeds $800 million. Advertising a new product to compete with established brands also could require enormous outlays. A failed product could bankrupt a new fi rm. Th at’s why most new products usually come from large, existing fi rms, which can better withstand the possible loss. For example, McDonald’s spent $100 million in its unsuccessful attempt to introduce the Arch Deluxe. Unilever lost $160 million when its new laundry detergent, Power, failed to catch on.


UNIT 2 THE MARKET ECONOMY

Product Differentiation Costs An oligopolist often spends millions and sometimes billions trying to diff erentiate its product. Some of this provides valuable information to consumers and off ers them a wider array of products. However, some forms of product diff erentiation appear to be of little value. Slogans such as “It’s the Cola” or “Open Happiness” convey little real informa-tion, yet Pepsi and Coke spend huge sums on such messages. For example, Coke spends more than $2 billion per year on advertising. Product diff erentiation expenditures create barriers to entry.

When Oligopolists ColludeTo decrease competition and increase profi t, oligopolistic fi rms, particularly

those that off er identical products, may try to collude, or agree on a market price. Collusion is an agreement among fi rms in the industry to divide the market and fi x the price. A cartel is a group of fi rms that agree to act as a single monopolist to increase the market price and maximize the group’s profi ts.

Compared with competing fi rms, colluding fi rms usually produce less, charge more, earn more profi t, and try to block the entry of new fi rms. Consumers lose consumer surplus because of the higher price, and potential entrants are denied the chance to compete in the market.

Collusion and cartels are illegal in the United States. However, monopoly profi t can be so tempting that some fi rms break the law. Other countries are more tolerant

cartel A group of fi rms thatagree to act as a single monopo-list to increase the market price and maximize the group’s profi ts

FIGURE 7.4 Economies of Scale as a Barrier to Entry to OligopolyAt point b, an established fi rm can produce M or more automobiles at an average cost of $10,000 each. A new fi rm trying to break into this market that is able to sell only S automobiles would incur a much higher average cost of $50,000 at point a. If automobile prices are below $50,000, that new entrant would suff er a loss. In this market, economies of scale serve as a barrier to entry, insulating fi rms achieving minimum effi cient scale from new competitors.

0 S MAutos per year

$10,000

$50,000

Long-runaverage cost

a

b

216



of cartels. Some even promote them, as with the 12 nations of OPEC, the world oil cartel. If OPEC members were ever to meet in the United States, those offi cials could be arrested for price fi xing. Even though they are outlawed in some countries, cartels still operate worldwide because there are no international laws banning them.

Th e biggest obstacle to maintaining a profi table cartel is the powerful temptation that each member has to cheat on the cartel agreement. By off ering a price slightly below the established price, for example, individual fi rms in the cartel usually can in-crease their own sales and profi t. A cartel collapses once cheating becomes widespread.

A second obstacle to cartel success is the entry of rival fi rms. Th e profi t of the cartel attracts entry, entry increases market supply, and increased supply forces the market price down. A cartel’s continued success therefore depends on the ability to block the entry of new fi rms or to get any new fi rms to join the cartel.

Finally, cartels, like monopolists, must be concerned that technological change can erode their market power. For example, hydrogen-powered fuel cells may eventually replace gasoline in automobiles. Th is could undermine OPEC.

OPEC’s initial success with raising the price attracted so many other oil suppliers that OPEC now accounts for only about 40 percent of the world’s oil output. As a result, OPEC has lost much of its market power. Eff orts to form cartels in the world markets for bauxite, copper, coff ee, and some other products have failed so far.

When Oligopolists CompeteBecause oligopolists are interdependent, analyzing their behavior is complicated.

At one extreme, the fi rms in the industry may try to coordinate their behavior so they act collectively as a single monopolist, forming a cartel, as was just discussed. At the other extreme, oligopolists may compete so fi ercely that price wars erupt, such as those that fl are up in markets for computers, airline fares, and long-distance phone service. Consumers benefi t from the lower prices resulting from price wars.

You have now worked through the four market structures: perfect competition, monopolistic competition, oligopoly, and monopoly. Features of the four are summarized and compared in Figure 7.5.

Perfect Competition

Monopolistic Competition Oligopoly Monopoly

Number of fi rms the most many few one

Control over price none limited some complete

Product diff erences none some none or some none

Barriers to entry none low substantial insurmountable

Examples wheat, shares of stock

convenience stores, bookstores

automobiles, oil, cereal

local electricity and phone service

FIGURE 7.5 Comparison of Market Structures

What are the important features of oligopoly, and how do oligopolists

that cooperate compare to those that compete?


UNIT 2 THE MARKET ECONOMYUNIT 2 THE MARKET ECONOMY

Working in small teams, brainstorm fi ve additional examples to those given in Figure 7.5 on page 217 of industries that compete in each of the four market structures (perfect competition, monopolistic competi-tion, oligopoly, and monopoly). For each example describe the specifi c characteristics of the industry’s market structure that allowed your group to identify it. Compare your team’s work with that of other teams.

TeamWorkWorking in small teams brainstorm five additional examples to those given in Figure 7 5 on page 217 of

Think Critically 1. There are probably 20 or more brands of laundry detergent in the grocery store where your

family shops. Make a list of different ways in which producers try to differentiate one deter-gent brand from another. Why can some brands have prices that are much higher than the price of others and still sell well?

2. Why would a new oil refi nery have diffi culty competing successfully with large oil refi ners such as Chevron, Shell Oil, or ExxonMobil?

3. In the 1990s, many nations that grew coffee beans tried to set up a cartel that would have limited coffee production and stabilized prices at a higher level. This effort failed. Explain why it is so diffi cult to create a successful cartel when there are many producers.

Graphing Exercise 4. The graph shows the long-run

average cost curve (discussed in Chapter 5) for Sleepwell Mattresses, one of several fi rms that manufacture mat-tresses. Suppose the fi rm maximizes profi t in the short run by producing at the rate of output where its long-run average cost is $150 per mattress. The fi rm’s owners realize they could reduce their long-run average cost by expanding output so as to benefi t from economies of scale. Based on the graph, what is the smallest rate of output at which the fi rm would take full advantage of economies of scale? What, approximately, would be the long-run average cost at that output rate? Identify two ways the fi rm could try to increase the amount sold.

Make Academic Connections 5. Research In 2011 the cost of a 30-second TV advertisement during the Super Bowl was

$3 million. Investigate the cost of this type of advertising during the most recent Super Bowl. Why are businesses willing to spend this amount for a 30-second advertisement? What are they trying to accomplish?

7.2 ASSESSMENT

218

0 1 2 3 4 5 6 7

200

150

100

50

Pric

e

Quantity in hundreds per day

$250LRAC

LONG-RUN AVERAGE COST FORSLEEPWELL MATTRESSES


Geolocation applications are hot, high-tech additions to social networking platforms, and Naveen Selvadurai is leading the way. Together with part-ner Dennis Crowley, he invented the

smartphone application FourSquare, which combines geolocation software and social networking.

FourSquare helps people get around their cities using the global positioning capabilities of their cell phone. It allows users to connect with friends and update their location via mobile phone or on social networking sites such as Twitter or Facebook. Users can earn points and badges for “checking in” at bars, restaurants, and other venues. With more than 7.5 million registered users, and growing at an estimated 100,000 new users per week, FourSquare is a hit. Of his motivation Naveen says, “I live in the East Village [of New York City], which has so much rich history and so much to do and I real-ized that I’d seen maybe 5 percent of it. I was looking for a way to get me and my friends to go out and do more things.” Naveen says that people use FourSquare for three reasons:

• It has a game-like nature to it.

• It creates competition among friends.

• It keeps track of what you do.

Born in Tamil Nadu, India, into a family of engineers, Naveen grew up in an environment that encouraged tinkering with electronics. He said, “I knew I wanted to be an engineer. I knew I wanted to do something with computers. I got both my bachelor’s and my master’s [degrees]. My parents made me kind of have this wholesome education. They really wanted that on my résumé before I moved on to other things.” Naveen graduated with degrees from King’s College in London, England, and Worcester Polytechnic Institute in Massachusetts. He has worked at Sony Music Enter-tainment, Nokia, and Socialight. He is currently half-owner of FourSquare and an adjunct professor at The Cooper Union.

In explaining why he was driven to develop Four-Square, Naveen said, “I wanted to do and build


Naveen SelvaduraiCo-Founder, FourSquare Labs Inc.

eolocation applictech additions toplatforms, and Nleading the way. ner Dennis Crow

smartphone application FourSqgeolocation software and social

FourSquare helps people get arothe global positioning capabilitiIt allows users to connect with fr

something that helps us learn more about where we live and learn more about locations to go where our friends go, and to learn more about the world in which we interact every day.”

Naveen’s advice to young entrepreneurs is:

• be passionate about what you do

• don’t be afraid to take risks

• understand that you won’t get it right the fi rst time

• talk to people about your ideas, and get feedback.

The New York-based company FourSquare Labs Inc. is valued, at the time of this writing, at $600 million. The service attracts revenue from big brands and faces competition from location-based services such as Facebook Places and Twitter. By creating partnerships with local businesses, FourSquare hopes to increase profi ts. They want to give users recommendations on the hottest places to have dinner or have a snack after a concert or show. Selvadurai said, “Other sites want to keep you inside at the computer, while our entire goal is to get you out of the house.”

Think Critically Identify the structure of the market in which FourSquare's geolocation software competes. Justify your answer.

Sources: http://www.encompasssocial.com/naveen-selvadurai-bio.html; http://www.zeitgeistminds.com/videos/founding-foursquare; http://www.fastcompany.com/100/2010/30/naveen-selvadurai; http://span.state.gov/nov-dec2010/eng/57-60-South-Asian.html; and http://www.bloomberg.com/news/2011-01-23/foursquare-valued-at-more-than-250-million-to-seek-new-funding.html

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