Reading Essentials and Study Guide

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1 Lesson 1 Market Structures ESSENTIAL QUESTION How do varying market structures impact prices in a market economy? Reading HELPDESK Academic Vocabulary theoretical existing only in theory; not practical equate to represent as equal or equivalent Content Vocabulary industry the supply side of the market market structure market classification according to number and size of firms, type of product, and type of competition; nature and degree of competition among firms in the same industry pure competition a theoretical market structure that requires three conditions: very large numbers of buyers and sellers, identical products, and freedom of entry and exit perfect competition theoretical market structure characterized by a large number of wellinformed independent buyers and sellers who exchange identical products and have freedom of entry and exit monopolistic competition market structure having all conditions of pure competition except for identical products; a form of imperfect competition product differentiation real or imagined differences between competing products in the same industry nonprice competition competition based on a product s appearance, quality, or design, rather than its price oligopoly market structure in which a few large sellers dominate and have the ability to affect prices in the industry; form of imperfect competition collusion illegal agreement among producers to fix prices, limit output, or divide markets price fixing illegal agreement by firms to charge a uniform price for a product monopoly market structure characterized by a single producer; form of imperfect competition laissez-faire philosophy that government should not interfere with business activity natural monopoly market structure in which average costs of production are lowest when all output is produced by a single firm geographic monopoly market structure in which a firm has a monopoly because of its location or the small size of the market technological monopoly market structure in which a firm has a monopoly because it owns or controls a manufacturing method, process, or other scientific advantage government monopoly monopoly created and/or owned by the government 1

2 TAKING NOTES: Key Ideas and Details Use the graphic organizer below to compare the characteristics of different market structures. Pure Competition Market Structure Characteristics Perfect Competition Oligopoly Monopoly Pure Competition Guiding Question Why do we study pure competition even though there are no purely competitive markets? A market structure is a way of describing the competition among firms in the same industry. Markets are often described by the number of firms and the amount of competition. For example, pure competition is a theory. That means it is an ideal market structure with three necessary conditions. Very Large Numbers There must be a very large number of buyers and sellers. None can be large enough or powerful enough to single-handedly affect the price. Identical Products Buyers and sellers deal in identical products. With no difference in the products, there is no need for brand names. With no differences between products, one seller s goods are the same as another s, so there is no need to advertise. This keeps prices low. Freedom of Entry and Exit Buyers and sellers are free to enter into, conduct, or get out of business. This freedom makes it difficult for producers in any industry to keep the market to themselves. Producers have to keep prices competitive. If they don t, new firms could take away some of their business. When a fourth condition is added to the first three, we have perfect competition. In this market, all buyers and all sellers have perfect knowledge of all conditions in the market. Perfect competition is perfect in every way, with no complications. However, it is also a theoretical condition. This is because there are no markets in the world today with all four necessary conditions. Because no markets have all these conditions, the terms pure and perfect are often used interchangeably. After all, competition in purely competitive or perfectly competitive markets would ensure that prices would be kept low and quality the same. 2

3 Profit Maximization In pure competition, market supply and demand set the equilibrium price for the product. Because the price is decided in the market, and each firm alone is too small to influence the price, the pure competitor is often called a price taker. The firm then must find the level of output it can produce that will maximize of its profits. To understand this, it helps to look at Figure 7.1. The firm in Figure 7.1 is the same one that appeared earlier in Figure 5.6. While the number of workers is not shown in Figure 7.1, its total production, marginal cost (the extra cost of producing one additional unit of production), and marginal revenue (the extra revenue from the sale of one additional unit of output) are the same in both figures. However, Figure 5.6 shows the data in the form of a table, while Figure 7.1 shows the same data in the form of a graph. The graph in Panel A shows that supply and demand set the equilibrium market price at $15 per unit of output. The firm in Panel B receives $15 for the first and every additional unit it sells. Therefore, the market price is the same as the firm s marginal revenue curve (MR). Marginal Analysis Again When it comes to the profit-maximizing quantity of output in Figure 7.1, the logic of marginal analysis is the same as before. For example, Panel B tells us that the firm would make a profit on the 110th unit of output. This is because it would only cost $4.50 to produce and could be sold for $15. As long as the marginal cost of making one more unit of output is less than the marginal revenue from the sale of that output, the firm could keep hiring more workers. It can also keep enlarging its output. Given its marginal cost and marginal revenue conditions, the firm in Figure 7.1 can hire enough workers to expand production until it reaches 144 units of output. Of course, total output would continue to go up if the firm hired more workers and further expanded production. However, at this point total profits would start to go down. This is because the marginal cost of production would become increasingly larger than the $15 marginal revenue from sales. So, the profit-maximizing quantity of output is where the marginal cost of production equals the marginal revenue from sales. This is where MC = MR. This is at 144 units of output. Other levels of output may make equal profits, but none will make more. This is exactly the same result we reached when we examined Figure 5.6 earlier. However, this time we come to the same conclusion by reading a graph rather than a table. Less Than Pure Competition Pure competition does not really exist, but it is important. Economists use it to evaluate less-competitive market structures. These are structures that lack one or more of the three conditions for pure competition. Specifically, these structures are monopolistic competition, oligopoly, and monopoly. Most firms and industries in the United States today fall into one of these categories. Firms in each of these categories face less competition. This generally means higher prices for consumers, and fewer products offered. This is why purely competitive markets are theoretically ideal situations that can be used to evaluate other market structures. 3

4 Reading Progress Check Describing What are the conditions required for perfect competition? Monopolistic Competition Guiding Question What role does advertising play in monopolistic competition? Sometimes a market has monopolistic competition. This is a market structure with all the conditions of pure competition except for identical (the same) products. Under monopolistic competition, products are similar. They include things such as designer clothing, cosmetics, gourmet food, and shoes. For this term, monopolistic describes the seller s efforts to convince consumers that their product is unique enough to have a higher price. The competition aspect means that if sellers raise the price too much, customers will ignore any differences and change brands. Almost anything with a brand name is involved in monopolistic competition. For example, a cereal producer might claim that its brand of flakes is better than a competitor s. The consumer may or may not believe this claim. But as long as the product is claimed to be different, and as long as there are a large number of similar firms in the industry, the industry is likely to be one of monopolistic competition. How Monopolistic Competitors Compete Monopolistic competition is identified by a great deal of product differentiation. This is real or perceived differences between competing products in the same industry. Almost all items produced today are differentiated in one way or another. To make their products stand out, monopolistic competitors try to make consumers aware of product differences. They use things like advertising, giveaways, or other promotions to convince buyers that their product is unique or better than that of the competitors. This is called nonprice competition. In a monopolistic competitive industry, advertising is important. This explains why producers of designer clothes spend so much on advertising and promotion. If a seller can differentiate its product in the mind of the buyer, the firm may be able charge more for it. But advertising is expensive. It raises the cost of doing business for the seller, and that raises the price the consumer pays. Profit Maximization Monopolistic competitors try to maximize their profits the same was as other firms. In fact, the MR and MC curves in Figure 7.1 can represent any of the market structures from pure competition to monopoly. The monopolistic competitor will expand its production until its marginal cost is equal to its marginal revenue. This is where MC = MR. If the firm s advertising convinces consumers that its product is better, then it can charge a higher price. If not, the firm must charge less. 4

5 Finally, it is easy for firms to enter the monopolistic competitive industry. Each new firm makes a product only a little different from others in the market. The result is many firms producing a variety of similar products. Figure 7.2 summarizes all these characteristics. Reading Progress Check Comparing How is profit maximization in a monopolistic firm different from that of a pure competitor? Oligopoly Guiding Question Why do markets dominated by oligopolies result in high prices for the consumer? Oligopoly is another type of market structure. In this structure, a few very large sellers dominate the industry. The product of an oligopolist may have distinct features. One example is the many makes and models of cars in the auto industry. Oligopolies can also have standardized products, or products that are much the same, as in the steel industry. As a result, oligopoly, summarized in Figure 7.2, is further from pure competition than monopolistic competition. In the United States, many markets are oligopolistic. Many more are becoming so. For example, three companies dominate the fast-food industry. Five companies dominate the cell phone service industry. A few large corporations control other industries. These include the domestic airline and auto industries. Interdependent Behavior Oligopolists are large and they produce generally similar products. So, whenever one firm acts, the other firms usually follow. If they don t, they run the risk of losing customers. The tendency of oligopolists to act together is due to the fact that there are so few firms in the industry. The tendency of oligopolists to act together often shows up in their pricing behavior. One company might copy a competitor s price reduction to attract new customers. For example, suppose that Ford announces zero-interest loans or thousands of dollars back on a new car. Then, its competitors will match the promotion almost immediately. How Oligopolies Compete Oligopolists also like to compete on a nonprice basis. They can do this by adding new or different features to their products. Automobile companies do this every year with new models. If an oligopolist finds a way to enhance a product, its competitors are at a slight disadvantage for a short period. After all, it takes longer to match a new physical feature for a product than it does to match a price cut. 5

6 Sometimes the interdependent behavior takes the form of collusion instead of competition. Collusion is a formal agreement to set specific prices or to act in another cooperative way. One form of collusion is price-fixing. This is an agreement among producers to raise their price for a product and make the prices the same or similar across the industry. The firms also might agree to divide the market so that each is guaranteed to sell a certain amount. Collusion is against the law because it can restrict, or limit, trade. Profit Maximization Like other kinds of firms, the oligopolist maximizes its profits when it finds the quantity of output at which its marginal cost is equal to its marginal revenue. This is where MC = MR. The oligopolist will then charge the price consistent with this level of sales. Nonprice competition is expensive. Therefore, the product s final price is likely to be higher than it would be under monopolistic competition. It will also be much higher than it would be under pure competition. Expenses from nonprice competition are passed on to the consumer. Reading Progress Check Explaining Why do oligopolists frequently appear to act together? Monopoly Guiding Question Why are some types of monopolies considered acceptable while others are not? The opposite of pure competition is monopoly. A monopoly is a market structure with only one seller of a product. This situation is an extreme case. In fact, the American economy has few, if any, cases of pure monopoly. The local cable TV operator or telephone company that your parents grew up with were monopolies in the past. Monopolies today are usually near-monopolies, because there always seems to be some competition. In a laissez-faire economy, monopolies might be more common. Laissez-faire is a French term that means, roughly, to let do. In a laissez-faire economy, government lets companies do business as they choose, with little restriction. However, we have few monopolies today because Americans don t like them and have made them illegal. Another reason is that new technologies compete with existing monopolies. For example, the fax machine allowed businesses to send electronic letters and later, completely displaced the fax. To different degrees, both faxing and have been competition for the U.S. Postal Service. 6

7 Lesson 1 What Is Supply? Types of Monopolies Because the nature of some goods or services, there are times when society would be served best by a monopoly. At other times, the market may only be big enough to support a single firm. Consequently we can recognize several types of monopolies. Natural monopoly A natural monopoly is one in which one firm can produce the product more cheaply than several competing firms. This includes public utility companies. It would be wasteful to duplicate the pipes and wires that distribute water, gas, and electricity throughout a city. The government often gives one public utility the right to do business in a certain area without competition. In return, the company accepts a certain amount of regulation. Geographic Monopoly A geographic monopoly is a monopoly based on the lack of other sellers in a geographic area. A drugstore in a town too small to support two or more such businesses would be a geographic monopoly. Similarly, the owner of the only gas station off a lonely interstate highway exit also has a geographic monopoly. Exploring the Essential Question Imagine that you are traveling and run low on gas in an out-of-the way location, and there is only one gas station for the next thirty miles. How much would you expect to pay for the gas? Do you think this price is reasonable? Are there any practical solutions to this geographic monopoly? Technological Monopoly A technological monopoly owns or controls a manufacturing or scientific method or process. The government may grant a patent to the inventor. A patent is an exclusive right to manufacture, use, or sell any new and useful invention for a specific time. Inventions are covered for 20 years. After that, they become public property and others can manufacture them. Art and literary works are protected through a copyright. This is the exclusive right of authors or artists to publish, sell, or reproduce their work for their lifetime plus 70 years. Government Monopoly A government monopoly is owned and operated by the government. Government monopolies are found at all levels of government. In most cases, they involve products or services that private industry cannot supply very well. Many towns and cities have monopolies that oversee water use. Some states have a monopoly on the sale of liquor. The federal government controls the processing of weapons-grade uranium for military and national security purposes. Profit Maximization Monopolies maximize profits the same way other firms do. They equate marginal cost (MC) with marginal revenue (MR) to find the profit-maximizing quantity of output. Even so, there are differences between the monopolist and other profit-maximizing firms. 7

8 First, the monopolist is much larger than the other types of firms. This is because only one firm supplies the product. Second, because of its size and the lack of competition, the monopolist is able to act as a price maker. This differs from the behavior of firms in the other market structures. Finally, because there is no competition, the result of profit maximization is a very high price for consumers. It is higher than it would be under other market structures. Reading Progress Check Analyzing Why might it be a good idea to support a natural monopoly? 8