Only Exceptional Proff

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Market Structures

I. Competition, accumulation, and market structures

The search for income forces firms to compete against each other. This is not only true of

firms selling similar commodities but of firms that are selling dissimilar commodities, that is

firms in different industries. This competition is the result of the fact that during any one time

period there is a limit to aggregate spending. The aggregate spending that the various classes of

people undertake sets a constraint to the amount of revenue that firms, as a group, will be able to

capture from the selling of commodities. With a fixed flow of aggregate spending, an increase in

the proportion of that spending that is allocated to the output of any one firm must come at the

expense of some other firm in the system. It is in this sense that every firm, in its search for

income, is forced to compete against every other firm.

Of course, the level or intensity of competition is not the same for all firms. In the case of

firms that have a considerable number of rivals selling substitutable commodities, commodities

that fulfill a similar need or desire, the intensity of competition is quite high. In contrast, the

intensity of competition is much smaller in the case of firms that have little to no rivals selling

similar goods. Nevertheless, while the structure of competition varies from one market to the

next, all firms must compete against each other for the same pool of income.

The competition for income takes on a number of different forms. At one level, it is

intimately associated with the process of investment and capital accumulation. A common

method by which firms try to capture income is through the creation of new commodities and

thus new productive capacity. The introduction of a new commodity can have the effect of

siphoning off income that had previously gone towards the purchase of other commodities. Of

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course the extent to which this occurs depends on the extent to which buyers are willing to alter

their consumption pattern in favor of the new good, and on the rate at which income has been

growing. However this works out, the point is that the introduction of a new commodity has the

effect of threatening the existing or potential income flow of other firms. And this threat places

pressure on firms to be continually attentive to the nature and quality of the commodities they are

selling.

Closely related is the fact that, in the context of economic growth, economic survival

generally requires that firms increase their productive capacity to remain competitive. As the

overall level of spending increases, firms wishing to hold on to their relative position will be

forced to increase their productive capacity even if new commodities are not being introduced.

Failure to keep up with the growth in aggregate spending will eventually lead to a decline in the

share of the market controlled by the firm. This will lead to a decline in the firm's degree of

monopoly power, and thus its ability to control its profit flow.

Another version of this same phenomenon is that the competition for income frequently

manifests itself in the concentration of capital. That is, rather than producing new productive

capacity, the competition for income often expresses itself in battles over the ownership of

existing productive capacity. Firms will be buying each other out through various types of

mergers or consolidations. The more aggressive firms will be buying the smaller firms (or

forcing them out of business and then purchasing their remaining assets), so as to increase their

asset base. From the perspective of the system as a whole, this type of competition does not lead

to the creation of new productive capacity. But from the perspective of the individual firm, these

maneuvers have the effect of increasing capacity, and thus the ability to capture a greater flow of

income. Even if the overall level of gross income remains unchanged and the same volume and

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type of commodities continues to be produced, the acquiring firm will now be in the position of

being able to capture a greater share of total sales revenue. The competition for income is thus

closely related to the process of capital accumulation. The creation of new capacity, along with

struggles over the ownership of that capacity, is an on-going feature of the competition for

income.

Closely associated with these forms of competition are the pricing policies and

advertising campaigns employed by the firms. When a firm invades a new market, it is not

uncommon to have that firm introduce its products at a price that is lower than the competition.

The reduced price is supposed to siphon off some of the income that had previously gone to

purchase the output from the competition. If the new firm is providing a commodity that is

comparable to that of the competition, the reduced price may very well have the effect of

reducing the revenue of the competing firms. In response, the existing firms tend to react by

reducing their prices as well. In this fashion, the competition for income may take the form of a

price war. A more intensive propaganda war is usually carried out as well. Firms will be trying to

entice customers away from the competition through advertisements of various sorts.

This type of competition has its limits. Price reductions can only go so far. In the short-

term, firms can live with prices that fall below unit cost, but this position cannot be sustained for

long. Eventually the price will have to drift above unit cost. This can happen either because a

sufficient number of firms leave the market and/or declare bankruptcy or, as in the case of price

setters, they set a higher price. Over the long run, firms caught in competitive markets generally

have to content themselves with a price that is just enough to capture the going long run rate of

return.

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The kind of price competition that takes place depends on the number of firms competing

against each other and the share of the market controlled by the representative firm. In general,

price competition is always much more intense in an environment where there are large numbers

of firms competing against each other and each firm has a relatively small to insignificant share

of the market. In such a context, it is not uncommon to find the price of the commodity just

above its unit cost of production. In contrast, in the case of markets that are dominated by a small

number of firms, the extreme case being that of a monopoly, price wars are much less frequent

and the commodity tends to sell at a price that far exceeds unit cost.

There are a number of different factors that account for these forms of price competition,

but among the most important is the technology of production. Some commodities require a

greater commitment of capital than others. Those commodities requiring a greater amount of

capital per unit of labor, as in the case of automobiles, tend to have a smaller number of firms

producing and selling the good. In contrast, those commodities requiring a relatively small

amount of capital per unit of labor, such as barbershops or pizza parlors, tend to have a large

number of firms involved in their production and sale.

With a fixed level of aggregate spending there is only so much output that each market

can absorb. This places a constraint on the amount of physical capacity that can be profitably

applied to the production of that output. Given the technology of production (that is, the capital-

labor ratio), this also places a constraint on the number of firms that any one market can

profitably sustain. This constraint is one of the major reasons for the variation in the structure of

price competition that exists across markets and why that variation tends to remain stable over

long stretches of time.

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It is common to categorize price competition as falling into one of the following four

types: perfect, or pure, competition; monopolistic competition; oligopoly; and monopoly. If we

think of these market structures as falling along a continuum that measures the intensity of

competition, the most competitive market structure would be perfect or pure competition,

followed by monopolistic competition, then oligopoly, and finally monopoly.

A purely competitive market environment refers to a situation where there are so many

firms that each firm's market share is insignificant. Each firm is a price taker forced to accept the

going market price. There is easy entry and exit into this type of market and each firm is

producing the same homogenous commodity.

Monopolistically competitive markets are similar to purely competitive markets in that

each firm also has an insignificant share of the market and there is easy entry into, and exit from,

the market. However, unlike a purely competitive firm, a monopolistically competitive firm is

selling a product that is differentiated from that of the competition. As a result, each firm in this

type of market has a modest amount of monopoly power.

An oligopolistic environment is one where there are a few firms that dominate the

market. Each firm controls a significant share of the market, providing it with a considerable

amount of monopoly power. Entry into, and exit from, these markets is quite costly - primarily

because of the amount of capital that must be committed to the production of the commodity.

A monopoly is a market that is dominated by one firm. Like an oligopolist, entry into,

and exit from, this type of a market is costly because of the capital commitment that is generally

required. Unlike an oligopoly, however, a monopolist is the sole seller of the commodity. In this

case the firm has the highest possible degree of monopoly power.

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One way to think of these market structures is in terms of the markup that the typical firm

can use. As pointed out earlier, the size of the markup is directly related to the price elasticity of

demand. The less elastic the demand for the product, the greater the degree of monopoly power,

and thus the higher the markup; or stated differently, the less competitive the market structure,

the less elastic the demand for the product, and the higher the markup. So, as market structures

go from pure competition to monopoly, the price elasticity of demand becomes increasingly less

elastic, and the markups get larger.

II. Pure (or perfect) Competition

The type of competition envisioned by the Classical economists was one were the typical

firm found itself at the mercy of the market, having no choice but the accept the going market

price. This notion of competition has been with economists every since the time of Adam Smith,

but it was the Neoclassicals who laid out all the conditions that would have to exist for such a

market to actually exist. The Neoclassical economists noted that for a market to be purely

competitive there would have to be so many firms and consumers that no one firm or consumer

could influence the price, the entry into, or exit from, the market by any one firm or consumer

would have no discernable effect on market price. In addition, entry and exit into and out of such

a market would be very easy, and the product being sold in such a market would be

homogeneous (meaning that the product sold by any one firm is identical to the product sold by

another firm in the same market).

The Neoclassicals make a distinction between what they call purely competitive markets

and perfectly competitive markets. The above conditions are sufficient to meet the definition of a

purely competitive market. But, if in addition to the above conditions, we also imagine that all

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the agents in the market (the firms and consumers) have perfect knowledge of the commodity

and do not confront any transactions costs (such as the costs associated with looking for a

commodity, bargaining over its price, or paying for the policing and enforcement of contracts),

then the market is said to be perfectly competitive.

Obviously perfectly competitive markets do not exist in the real world. They are

theoretical constructs developed by neoclassical economists to describe the equilibrium

outcomes they claim represent the position toward which real competitive markets are forever

approximating. In contrast, purely competitive markets do capture the behavior of some of the

markets observed in the real world, but they represent a small proportion of total economic

activity. Yet, despite their rarity, studying competitive market structure helps to clarify the

underlying forces that are forever exerting pressure on prices and quantities in real competitive

market systems.

In this section we’ll be focusing on purely competitive markets. The case for perfectly

competitive markets is almost identical, but with the exception that the outcomes occur more

quickly because, of course, the agents have perfect knowledge and there are no transactions

costs.

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In the above, the graph on the left represents the typical or representative firm in the

market, and the graph on the right represents the entire market (made up of all the firms and

consumers). The long-run equilibrium characteristic of purely competitive markets is depicted by

the point at which market supply (the Se curve) meets market demand (the D curve). The price

that emerges at that point (i.e. Pe) is such that the representative firm is making no more than

normal profits. That is, in long-run equilibrium, the price of the product will be just enough to

cover the firm’s explicit cost of production as well as the implicit cost involved in owning and

running the business (or, stated differently, the owners will be earning normal profits; which is

just enough to make it worth their effort to remain in business). At the same time, the

representative firm in such a market will be using its capacity in the most efficient way possible.

That is, the representative firm will be producing at a level (in this case qe) that allows it to

generate the product at the lowest possible unit cost; any other level of production would involve

higher unit costs. Finally, in long-run equilibrium, the total number of firms in the market will be

no more, or no less, than what’s needed to meet the demand of consumers in the most efficient

way possible.

The Purely Competitive Market

Firm Market

mc ac

avc

S1 Se

S2

D

Q Q2 Qe Q1 q q1 qe q2

P1 Pe P2

$ $

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If market supply and demand conditions are such that the representative firm is making

above normal profits (represented above by the point at which S1 meets D, resulting in a price of

P1), then the existence of above normal profits will induce capitalists throughout the economy to

invest in that market by creating a new firm. As productive capacity is increased in that market,

as a result of the increased investment, supply will begin to expand (relative to demand), putting

downward pressure on price.

If market supply and demand conditions are such that the representative firm is making

below normal profits, incurring losses (represented above by the point at which S2 meets D1,

resulting in a price of P2), then this will induce capitalists in this market to exit by liquidating

their assets and investing the proceeds elsewhere. As productive capacity is decreased in the

market, as a result of the disinvestment, supply will begin to contract (relative to demand),

putting upward pressure on price.

III. Monopoly

From the time of Adam Smith until the early 20th century, economists generally operated

with two polar market types: competitive and monopolistic. The assumption, going back to

Adam Smith, was that most markets approximated the type of competition portrayed in the

theory of pure competition. Monopoly was assumed to be the exception to the rule. And with the

exception of natural monopolies or government-sanctioned monopolies, Smith imagined that

most monopolies would be short lived; lasting no more than a decade or so, as other firms invade

the market and eventually eliminate the original monopoly.

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Monopolized markets represent conditions in which one firm is the single seller of a

product for which there are no available alternatives. Under these conditions consumers have no

option but to buy the product from the monopolist. These conditions are particularly onerous if

the product happens to be a necessity; the consumer has no option but to purchase the good from

the one producer.

The monopolistic firm will maximize profits by restricting supply, causing the price to

rise to whatever the market will bear. This is depicted in the above diagram by noting that the

profit-maximizing monopolist would produce at the point where marginal revenue equals

marginal cost; and this occurs when the price is Pm and quantity is Qm units per time period. If

the above market were purely competitive then the long run price would be PC and the long run

level of output would be QC. However, as can be seen, the monopolistic price is higher than PC

and the monopolistic quantity is lower than QC. Monopolized markets, in short, charge higher

prices and deliver a smaller volume of the product, than purely competitive markets.

Monopoly

Q

$

D mr

avc

ac mc

Qm

Pm

QC

PC

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The standard argument is that monopolies are not in the best interest of society since they

impose an unwarranted tax on society, forcing consumers to purchase the monopolized

commodity at prices that far exceed the unit social cost of production (average cost). The

monopolist makes its profits by purposefully restricting capacity, forcing the price above what it

would be under more competitive conditions.

It’s important to note, however, that the threat that monopolies pose to the social order

aren’t confined to the inefficiencies they introduce into the economic sphere of life, they also

influence the political order by creating the conditions through which the wealth of the

monopolist can be used to alter public policy. Monopolies, in short, can and do have undue

influence on government.

Because of the threats that monopolies pose to society (both economic and political),

democratic governments intent on promoting the common good have sought to minimize the

damage monopolies can do by either nationalizing them or forcing them to conform to the

expectations set up by public regulatory boards (public utilities). In both cases the hope is that

the nationalized industry or the public utility will force the monopoly to produce and sell the

commodity at a price that’s equal to what would be achieved if the market were competitive.

This is generally easier to do if the monopolist is nationalized; and usually more complicated if

the monopoly is brought under the oversight of a public utility. It’s well known that government

regulators are often taken over by monopolies, with the regulators coming from the monopolized

industry. The economist George Stigler summarized this behavior in his capture theory of

regulation, i.e. that regulators end up being captured by the monopolist ensuring that the public

utility ends up being a defender of the monopoly rather than a suspicious overseer acting on

behalf of the public good.

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IV. Increasing Returns to Scale, Oligopoly and Monopolistic Competition

The early part of the 20th century saw a number of innovative theories introduced by

neoclassical economists who had misgivings about the theory of pure competition. Until then,

the theory of pure competition was used by economists as a way of talking about the long-run

tendencies of capitalist societies. But, the emergence of monopolies and oligopolies in the late

19th century began to change this view of the world. The first economist to sow doubt on the

usefulness of the theory of pure competition was Piero Sraffa who, in the 1920s, pointed out that

the classic belief that economic freedom was enough to ensure markets would remain

competitive was wrong. Until that time period, it was generally believed that economic freedom

would be enough to keep markets operating within a reasonable distance to purely competitive

long-run outcomes. That is, leaving markets alone would ensure that, on the whole, prices would

be close to their social unit cost (average cost) of production and resources would be used more

or less efficiently. But Sraffa destroyed this belief by noting that industries that are subject to

increasing returns to scale are virtually assured of becoming monopolies or oligopolies. This, in

turn, means that leaving markets alone will not guarantee that markets remain competitive;

instead, it can lead to it’s polar opposite, namely monopoly.

This led to a different way of conceiving of market competition and its effects. Industries

that are left unregulated will not necessarily remain competitive; they may instead become, and

indeed are virtually guaranteed of becoming, oligopolistic or monopolistic. Karl Marx had come

to similar conclusions several decades earlier. He had argued that competition encourages the

capitalist firm to merge with other firms and/or eliminate them, creating growing concentrations

of capital in the various industries. Competition, in short, doesn’t lead to competitive markets; it

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instead leads toward concentrated capital in the form of oligopolistic or monopolistic market

structures. Sraffa had argued that the reason for this was the existence of increasing returns to

scale, which is ubiquitous in the manufacturing sector of capitalist economies. The existence of

increasing returns to scale means that the more aggressive firms in an industry, those that are

growing at a faster pace than the other firms, will be able to take advantage of their economies of

scale and undersell their competitors. The lower unit cost made possible by increasing returns to

scale, means that the larger firms will be able to sell the product at a price that is below the unit

cost of the smaller firms. This, of course, means that the smaller firms will be eliminated from

the market, leaving a reduced number of firms, in the extreme only one firm, dominating the

industry. Unregulated free markets, in short, will not guarantee that markets remain competitive,

they might instead guarantee, and in the case of manufacturing are assured of guaranteeing,

monopoly or oligopoly.

It’s against this background that the contributions of Joan Robinson and Edward

Chamberlain to the development of the theory of monopolistic competition need to be

understood. They introduced the commonsensical notion that the kind of competition one

observes in most markets does not conform to the price-taking format that had dominated

economic thought since the time of Adam Smith. They instead argued that the vast majority of

firms operate in environments where a certain degree of monopoly power exists. That is, rather

than being price takers, the vast majority of firms are price setters. What’s more this is true even

in markets that can be reasonable defined as being competitive, in the sense that there are large

number of firms competing against one another.

What’s common to these kinds of markets is that even though there are large numbers of

firms and there is easy entry into, and exit from, such markets, each firm has the ability to set the

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price for its product. What gives the firm the power to set its own price is that the commodity

being sold by the firm is perceived to be different from that of other firms. That is, in these

markets, the firms are all selling commodities that are differentiated from one another, even

though the commodities themselves fulfill the same utilitarian need or desire. For example, in the

automobile industry, firms produce cars fulfilling the utilitarian need for private transportation,

yet each automobile manufacturer produces a range of automobiles that differ from those

produced by the other manufacturers.

Monopolistically competitive markets are made up of a large number of firms that

produce differentiated products, that is, products that are slightly different from each other, even

though they fulfill the same end. What’s more, what makes the output of one firm different from

that of another firm need not be an actual physical difference, it can instead be a difference in the

way the firm sells the product, or the set of services associated with the product, or it can be a

unique location. In short, a differentiated commodity doesn’t necessarily mean that the

commodity is physically different; it can instead mean that the consumer perceives it as different.

This feature of monopolistically competitive markets is what sets them apart from purely

competitive markets. They share all the attributes of purely competitive markets, except for the

requirement of homogeneity. The commodities sold in monopolistically competitive markets are

differentiated.

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In the above, the graph on the left represents the condition of the typical, or

representative, firm making above normal profits in a monopolistically competitive market. The

existence of above normal profits serves as an incentive for capitalists and entrepreneurs in the

rest of the economy to invade this market and set up similar businesses. As more firms enter the

market, the share of total demand available to any one firm begins to shrink. This is displayed, in

the graph on the right, by showing the demand curve (and corresponding marginal revenue

curve) shifting inward, to the left. In the long-run, the typical firm finds itself setting a price

which is just equal to unit cost, though not minimum unit cost; while, at the same time, operating

at a level which is below optimal capacity. Thus, monopolistically competitive markets tend to

generate inefficient outcomes in the sense that there are too many firms in the market; that is, too

much capital and labor are allocated to the production and delivery of the product than is, strictly

speaking, necessary. Thus, in these markets it’s common to find firms operating with excess

capacity.

Monopolistic Competition

mc mc ac ac

avc avc

D D

mr mr

P1

P2

q1 q2

Typical firm with above normal profits Typical firm in long-run

$ $

q q

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The theory of oligopoly emerged at roughly the same time period. The basic idea

underscoring the theory of oligopoly is that it consists of a market structure dominated by a

handful of firms with enormous economic power. Because there’s such a small number of a large

firm, there’s constant pressure on each firm to be attentive to the behavior of the other firms in

the market. Spying and/or collusive behavior are common in these kind of markets, even though

collusion is against the law in the U.S. When the firms collude they are, in effect acting as a

monopoly and the outcomes typical of a monopoly apply just as easily to the case of an

oligopoly. When the firms do not collude they nevertheless tend to behave in ways that suggest

there’s close coordination. Part of the reason for this is that the firms tend to become quite

conservative when it comes to pricing and would much rather match the price changes (almost

always increases) of their competitors, than challenge it. As a result a common feature of

oligopolistic markets is that prices tend to remain fairly constant for fairly long periods of time

(it’ll vary depending on the production cycle of the industry). But then when the price leader in

the industry changes its price (almost always a price increase), the remaining firms in the same

market also increase their prices by the same percentage and, usually, within hours of the price

leader’s change.

While oligopolists generally do not compete on the basis of price, they do compete, and

often ferociously, on the basis of product quality, differentiation, and advertising. They try to

increase their market share not necessarily by charging lower prices for their products but by

instead creating product lines that are better, more attractive, or enticing.

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The defining feature of oligopolistic markets is that they consist of a small number of

very powerful firms. Since the number of competitors is very small, each firm is keenly aware,

and sensitive to, the behavior of the other firms in the same market. They are forever monitoring

each other’s behavior and figuring out strategies that might enhance their market share and/or

permit them to react successfully to the actions and threats of the competing firms. At the same

time, since each firm controls a significant share of the market and can, as a result of that power,

inflict economic harm on the remaining firms, each firm avoids price competition so as to shield

itself from the damage that can occur if a price war breaks out. As a result, the temptation to

collude and coordinate pricing and production decisions is very strong. Indeed, prior to the

enactment of anti-trust legislation, oligopolistic firms inevitably colluded and acted as one.

When that occurs, the oligopolistic market is for all intents and purposes a monopoly; and all the

results that are normal to monopolies are also normal to oligopolies; that is, they restrict capacity

and keep the price high (relative to purely competitive outcomes).

Oligopoly Kinked Demand Curve

Q

$

D

mr

avc ac mc

Qe

Pe

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Even though collusive behavior is now against the law in the United States, it does

nevertheless occur. Sometimes such collusion is explicit, in which case the firms are unlawfully

entering collusive agreements with one another and running the risk of being fined by the anti-

trust division of the U.S. Justice Department. In other cases the collusion is implicit or tacit, that

is the firms are not explicitly making agreements but their actions nevertheless suggest

coordination. What happens in this latter case is that the firms are so attentive to each other that

they end up mimicking the pricing and production decisions of the largest firm in the group,

often referred to as the price leader. In this case, the firms do not change their prices, and thus

production levels, unless the price leader makes a change. This allows each firm to avoid price

competition, though they continue competing on the basis of product differentiation and

marketing strategies. Because of this, prices in oligopolistic markets tend to remain stable for

fairly long period of time; but when the price leader changes its price (almost always upward),

the other firms in the market immediately follow, causing the prices of all the firms to change by

similar amounts and in similar directions over a very short period of time (within a few hours or

days of the price leader’s changed price).

The theory of the kinked demand curve, pictured above, provides a visual summary of

this idea. The cost structure depicts the cost condition of the average oligopolist, while the

kinked demand curve represents the demand conditions as perceived by the oligopolist. For

example, at the existing price Pe the typical oligopolist is convinced that if he/she raises its price

the other firms will hold onto theirs (in the hope of capturing consumers fleeing the now higher

priced firm). That is, each firm is convinced that the demand for its product is very elastic above

the existing price. At the same time, each firm is convinced that if he/she lowers its price, the

other firms will immediately follow (in the hope of preventing the first firm from taking away

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their customers through lower priced goods). That is, each firm is convinced that the demand for

its product is very inelastic below the existing price. As a result of this kink, the marginal

revenue curve for each firm is also kinked, but with an important difference; there’s a vertical

portion of the marginal revenue curve at the existing price and output level. Each firm can thus

experience rising unit cost, specifically rising marginal cost, over this range and yet not be

motivated to change its price or output levels; profits remain at a maximum at the existing price

and output level, despite changing cost conditions. Thus, the kinked demand curve helps explain

why it is that oligopolists hold onto existing prices for quite some time, despite changing cost

conditions. Of course, once the marginal cost curve begins to drift beyond the vertical region,

and moves into the downward sloping portion of the marginal revenue curve, then a new price

and output level will be chosen and the process will begin all over again.