Lectures in Managerial Economics

Lecture 5: Market Structure: Perfection Competition, Monopoly, and Monopolistic

Competition
In this chapter we offer a brief review of market structure, that is, the characteristics of the market an
industry may face. We focus on three forms of structure: perfect competition, monopoly, and monopolistic
competition. We postpone detailed discussion of oligopoly until the next chapter. Our discussion of these
three forms of market structure is relatively brief for two reasons. First, for perfect competition and
monopolistic competition, there is limited opportunity for strategic decisions regarding price and output, at
least decisions related to demand considerations. Second, our discussion of pricing strategies in Chapter 3
was, in fact, a discussion of monopoly pricing strategies as strategies such as price discrimination, bundling,
two-part pricing, and joint-product pricing are only possible if a firm has some monopoly power.
5.1

Market Structure

Table 1 gives a summary of the important characteristics that describe a market and enable us to form some
predictions about the behaviors and strategies that might be observed in these markets. Critical to
understanding the behaviors and strategies in an industry is some knowledge of the number of firms in the
industry; whether products are similar or differentiated; costs of information; and whether significant
barriers to entry exist.
Briefly, we can summarize why these characteristics are important in understanding the strategies of firms
in industries with these particular characteristics.

Number of Firms. The number of firms will affect the strategy of the firm in several ways. First, it
will determine whether the firm will need to consider how its own output decisions will affect the
market price for its product. A large number of firms means that a single firm can assume that its
production decisions will not have any impact on market price. However, if it is one of a few firms,
then its output decisions will affect market price and this needs to be considered in its decisions.
Second, since a single firm among a large number of firms will have no impact on the market price,
the firm need to not worry about how other firms "respond" to any changes in the price of its
product or its output. With a few firms, then firms must consider, when choosing output or prices,
what the response will be from their competitors.

Similar or Differentiated Products Similar products will, at least with a large number of firms,
force firms to be "price takers" -- attempts to increase price will lead to dramatic decreases in sales.
The demand curve is horizontal. However, if products are not identical among firms in an industry,
a firm can raise price without losing all its sales. More simply put, the firm has a downward
sloping demand curve.

Cost of Information We do not emphasize this distinction as much as the others. Essentially, we
expect that the lower the cost of information, the fewer opportunities for having pricing policies or
quality distinctions among firms. Cost of information also plays an important role in determining
when collusion or competition is likely to occur in ologopolistic industries.

Barriers to Entry will determine whether economic profits (profits above the normal rate of return)
will exist in the long run. If there are low barriers to entry, if there are positive economic profits,
we should expect entry of firms, increasing supply and reducing price until all firms in the industry
are earning only normal returns on their investments (economic profits equal zero).
5.2. Measures of Market Structure
How can we determine into which of the four categories an industry belongs? There are no hard and fast
1

Market Structure

rules, but there are two well-established measures of how concentrated an industry is, that is, how much of
the market is dominated by a few firms. The two primary measures of concentration are:
5.2.A

Two Alternative Measures

Concentration Ratio. Usually, this is a 4-firm or 8-firm measure. The measure is simply the percentage of
industry sales of the largest four or eight firms in the industry. We use the notation CRj to represent the j
firm concentration ratio.

Lectures in Managerial Economics

Table 1: Market Structure

Type of Market

Perfect Competition

Monopolistic
Competition

Monopoly

Oligopoly

Number of Firms

Many

One

Many

Few

Similar or Differentiated
Products

Identical

Identical

Differentiated

Similar or Differentiated

Cost of Information

Low

Low

Costly

Small to Significant

Barriers to Entry

Low

High

Low

High but not impossible

Examples

Commodities, Personal
Services

Utilities

Restaurants, Retail,
Services

Wholesale, Construction,
Energy, Manufacturing,
Computing

Special Characteristics

Economic profits equal zero

in the long run. Price equals
marginal cost and, in the
long run, price equals the
minimum of the average
total cost in long run.

Economic profit can exceed

zero in the long run, Price
exceeds marginal cost and
there is Deadweight loss
due to an underprovision of
output.

Economics profit equals

zero in the long run. Price
exceeds marginal cost but is
less than the minimum of
average total cost.

There is indeterminate firm

behavior as there is an
incentive to compete or
collude

Market Structure

Herfindahl-Hirschman Index is the sum of squares of the percentage of sales from each firm. To get an
indication of the magnitudes involved using this measure, consider the examples with equally-sized firms in
Table 2.
The advantage of the Herfindahl-Hirschman Index is that it considers the market share of all firms, not
simply, the largest four or eight. In addition, the less equal the share of output, the greater the HHI because
the output is squared.

Table 2: A Listing of HerfindahlHirschman Indexes

# of Equally Sized Firms

Herfindahl-Hirschman
Index
10,000
5,000
3,276
2,500
2,000
1,667
1,000
400

1
2
3
4
5
6
10
25
5.2.B

From Market Share to Market Measures

Given our classifications of market structure and these two measures of concentration, we might ask what
constitutes a competitive market versus an oligopolistic one or one that is essentially monopolistic. The
general guidelines are that an effective monopoly exists when the concentration ratio for a single firm is
above 90 percent, CR1> 1. A market is considered effectively competitive when the CR4 < 40%. A loose
oligopoly is considered to exist when the 40% < CR4 < 60% and a tight oligopoly exists when CR4 > 60%.
Alternatively, the Department of Justice has guidelines based on the Herfindahl-Hirschman Indiex (HHI)
when it considers approving horizontal mergers within the same geographical market. There are three
classifications of mergers based upon the concern the Department of Justice has for post-merger
concentration:
1.
Post-merger HHI below 1,000. These are considered unconsecrated markets (from Table 2 we see
ten equally sized firms would give us this HHI) and the Department of Justice would not be
concerned about mergers.
2.
Post-merge HHI from 1,000 to 1,800. This is an ambiguous region, where mergers may be
challenged if they are large enough. Mergers raising the HHI by 100 points are unlikely to be
challenged while those that raise them above 100 points are very likely to be challenged.
3.
Post-merger above 1,800. This would be considered highly concentrated -- from Table 2 we see
that something between 5 and 6 equally-sized firms would give us this HHI. Here mergers may not
be contested if they increase the HHI by 50 points, but are very likely to be contested if they raise
by more than 50 points.1
5.2.C
1

How Concentrated is the U.S. Economy?

This discussion comes from Blair, Roger D. and David L. Kaserman, Antitrust Economics, Irwin, 1985.

Lectures in Managerial Economics

We provide some aggregate data that may give some indication of the degree of concentration in a number
of industries and services. These concentration ratios are based on aggregate data, which has several flaws
in it for evaluating the degree of true concentration in an industry. First, it is based on data aggregated the
U.S. level. If markets are smaller than the entire nation, this would lead to an understatement of the
concentration since not all of these firms could be considered selling in the same market. Second, it ignores
imports. This will understate the competitiveness of the industry as the imports serve as a competitor with
U.S. producers. Finally, the categories of goods and services are very broad. For example, pharmaceuticals
concentration would not tell us the concentration for the production of a single pharmaceutical item such as
pain-relievers and probably would, therefore, overstate competitiveness.
Table 3 gives a summary of the distribution of gross domestic product (GDP) by market structure for three
years: 1939, 1958, and 1980. As can be seen in Table 3 , the majority of production is effectively done in
competitive industries with the "competitiveness" of the economy increasing dramatically between 1939
and 1980.

Table 3: Competitiveness of US Economy

Market-Structure
Pure Monopoly
Single Dominant Firm
Tight Oligopoly
Effectively Competitive

1939
5.2
5.0
35.4
52.4

1958
3.1
5.0
35.6
55.3

1980
2.5
2.8
18.0
75.7

Table 4 provides data on concentration ratios (4-firm, 8-firm, and some 20-firm) as calculated in the Census
of Manufactures (1992) for selected industries.
Inspection of Table 4 gives some indication of how these figures are misleading. Automobile production by
United States corporations is extremely concentrated. However, automobile sales, including imports, are
much less concentrated and is the more relevant market. A similar argument would apply for running shoes
as there are significant imports in this market as well. Alternatively, the competitive for aircraft engines is
overstated as this production includes both commercial and military equipment. Also overstated,
significantly, is the market for newspapers as this is a very local market and national concentration is not
particularly important.

Table 4: Concentration Ratios in Selected U.S. Industries

Industry of Product
Refrigerators
Motor Vehicles
Soft Drinks
Long-Distance Telephone
Duplicating Machines
Running Shoes
Aircraft Engines
Domestic Air Flights
Soap
Farm Machinery
Personal Computers
Semiconductors
Newspapers

4-Firm
94
94
94
92
91
79
72
68
60
53
45
40
22
5

Concentration Ratio
8-Firm
20-Firm
98
98
97
97
99
97
83
72
73
62
63
57
36

Market Structure

Concrete
Women's Dresses
5.2.D

8
6

12
10

19
17

Concentration and Price

A monopolist, by definition, has the market demand curve, so the elasticity of demand for the monopolist is
determined entirely by the elasticity of demand for the product in the market. At the other extreme, for a
perfectly competitive firm, the price elasticity is infinite regardless of the elasticity for the market demand.
For the cases between these two extremes, where most production occurs, the price elasticity for a firm will
depend on the market demand's price elasticity and the share of the market it has. Then Table 5 gives a
summary of the some alternative elasticities for a single firm based on the assumption that all firms are of
equal size.

Table 5: Price Elasticity for A Single Firm

# of Firms
10
25
50
100
500
1000

= -.5
-5
-12.5
-25
-50
-250
-500

Market Elasticity
=-1
= -5
-10
-50
-25
-125
-50
-250
-100
-500
-500
-2500
-1000
-5000

6.3. Perfect Competition

At one extreme of types of market structure is perfect competition. For much of economic analysis, the
underlying assumption is, in fact, that industries are perfectly competitive. For example, the demand and
supply analysis discussed in Chapter 2 was implicitly based on the assumption that firms are perfectly
competitive. We briefly summarize some of the characteristics of competitive industries focusing on the
production decision and the "shut-down" rule.
5.3A. Market Structure
The following are the characteristics generally associated with perfectly competitive markets:
Many Sellers
Homogeneous (identical) product
No barriers to entry
Many buyers
No information costs
5.3.B Implications of market structure:
Price is equal to marginal revenue (P = MR) or horizontal demand curve. Why? Because there are
many sellers, identical products, and no information costs, each seller must charge the same price. If
any one seller charged a higher price for the commodity, then no one would buy from him. Because
each seller has only a small share of the market, he can sell as much as he can possibly produce without
affecting the commodity price. In fact, often we hear the term a product is a "commodity" -- this simply
means that the producers have no discretion over price as the product is identical to many others

Lectures in Managerial Economics

produced.
Long run economic profits equal zero (=0) and price is equal to average (total) cost in the long run.
Because there are no barriers to entry, price must equal average total cost and profits are zero in long
run. If there are profits, then firms will enter, increasing supply and reducing price.

5.3.C. Short Run Firm Supply

To find profit-maximizing output, we need to know the cost structure. Consider the cost structure depicted
in Figure 1:
Now consider four alternative prices P = 20, P=14, P =10, and P = 4. What are the respective outputs and
profits?
F ig u r e 1
4 0
3 8
3 6
3 4
3 2
3 0
2 8

M C

2 6
2 4

2 2
2 0
1 8

A T C

1 6
1 4
1 2
1 0

A V C
8
6
4
2
0
0

1 0

2 0

30

4 0

50

6 0

7 0

8 0

9 0

1 0 0

1 1 0

1 2 0

1 3 0

1 4 0

1 5 0

1 6 0

1 7 0

18 0

Table 6
P
20

Q
140

ATC
14

Cost
1960

Revenue
2800

840

14
10
4

130
120
0

14
14
16 at Q =90

1820
1680
1440

1820
1200
0

0
(480)
(1440)

With a price of 10, the firm is losing money but less than the fixed costs (1440), so it continues to operate in
the short run. At a price of 4, price is less than average variable cost; the firm shuts down and loses the
fixed costs of $1440.
Lesson in Production: When, at the output level that maximizes profits (marginal revenue equal to marginal
cost) a firm, in the short run, should cease production if revenues are less than variable cost. However, it
should continue to produce as long as revenues exceed variable costs, even if total costs are less than

Market Structure

revenue.
This is one of the most important lessons in economic decision-making and applies to a broad class of
problems and more than simply competitive firms. Essentially, this is a case in which "sunk" or fixed costs
are to be ignored. Thus if a firm is committed to a lease on its facility for another year, the cost of the lease
should play no role in determining whether it should continue to operate. If revenues exceed the variable
costs, costs other than the lease and other long-term nonvariable costs, then the firm should continue to
operate.
5.3.D. Long Run Firm Supply
In the long run, a firm will produce at the minimum of long run acverage cost (LRAC). This is referred to
as the minimum efficient scale (MES). If not, it cannot compete with other firms that may enter.
Nature of Long Run Equilibrium:
1) Firms produce at the minimum of average total cost, that is, they achieve a minimum efficient scale.
There is no excess capacity.
2) Price equals marginal cost (P=MC) or incremental cost equals incremental benefit and the allocation is
efficient.
3) There are zero economic profits in the long run -- firms earn normal profits. Why do we have this
result?
Graphically, we depict long run equilibrium in Figure 2. The cost at the minimum efficient scale (lower
figure) is given by Pe at output per firm of q*. Then if price exceeds Pe, as is the case with the equilibrium
of (P'.Q'), positive profits can be earned and firms will enter, increasing supply to S) and bringing price to Pe.
Analogously, if price is less than Pe, firms will exit, reducing supply and increasing price until it reaches Pe.
This is illustrated by the shift from S" to S0. Note that if a firm does not produce at the minimum efficient
scale with the cost-minimizing combination of capital and labor, it will have costs exceeding Pe and it
cannot remain profitable.
5.4 Monopoly
In Lecture 2, we discussed the pricing and output decisions of firms that had down-ward sloping demand
curves. These firms, then, had some monopoly power. Given our lengthy discussion of monopoly pricing
and output decisions in Chapter 3, we will not offer a reprise of this same discussion.
5.4.A Market Structure
Monopoly market structure is defined by the fact that there is a single firm and if this firm is profitable,
presumably there are not more entrants because of barriers to entry, some of which are discussed below.
Then a monopolized market has the following characteristics:
One Firm
Unique Product/ No substitutes
Barriers to Entry
Many Buyers
Free Information

Lectures in Managerial Economics

Figure 2
S'
S0
S"
> 0, firms enter

p'

< 0, firms exit

pe

p"

D
Qe

Q"

Q"

q*

Market Structure

5.4.B Barriers to Entry

Below is a list of some of the more common barriers to entry in industries, barriers that can lead to the
monopolization of industries.
Economies of Scale (Utilities, Natural Monopolies)
Capital Requirements (Automobile, Aircraft, Chemicals (R&D))
Quality and Cost Advantages
Product Differentiation Niches
Control of Resources (DeBeers, Alcoa (Bauxite), OPEC)
Patents and Copyrights
Strategic Barriers
5.4.C Implications of Market Structure
1.
MR < P. One firm and unique product implies firm demand is market demand and therefore is
downward sloping the firm is a price maker. To sell an additional unit, the firm must lower price
on all units.
2.
> 0 in long run. This is because of the barriers to entry. Even if > 0, firms cannot enter to
increase supply and reduce price.
3.
Inefficient Output too little. Profit maximization implies that MR = MC but P > MR = MC
P >
MC so what people value the good at P > the cost of the good, MC.
5.4.D.

Natural Monopoly and Regulation

A natural monopoly refers to a monopoly (single seller) that exists because of economies of scale. That is,
the market demand is too small to support many firms, each producing at minimum ATC (see Figure 3) and
no small firm can compete with a large one because of the tremendous economies of scale. Is it more
efficient to have many firms in this case?
A. Regulation of Monopolies
For natural monopolies it is efficient to have a single producer. To maximize net benefit, however, the
monopoly must be regulated. We consider two options, marginal cost pricing and average cost pricing.
Each of these corresponds to a government regulatory agency dictating the price the monopoly can charge
and, for average cost pricing, the quantity.

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Lectures in Managerial Economics

Marginal Cost Pricing. The output (Q) is where price equals marginal cost (demand and MC curve
intersect) and price is set equal to marginal cost. If profits are negative, a subsidy must be provided. This
will give efficient output. This is given by PMC in Figure 3 with Q = QMC. Note that in this case the subsidy
is needed with the subsidy the difference between ATC and P for the output produced, QMC.

Figure 3

PMonopoly

PAC

ATC
Subsidy
MC

PMC

MR
QMonopoly

QAC

QMC

Average Cost Pricing. The output (Q) is where price is equal to average total cost (demand and ATC curve
intersect) and price = ATC. This is given by PAC and Q = QAC. This is simply rate of return or cost-plus
pricing.
6.5

Monopolistic Competition

A great deal of production, particularly of services, as well as retail sales can be classified as monopolistically competitive. These industries are competitive in the sense that there are many firms within
the market but "monopolistic" in the sense that they are not simply price-takers as their product is not a
"commodity" -- unique characteristics give the firm an opportunity to have a pricing policy and engage in
alternative pricing strategies.
Monopolistically competitive firms have an advantage over perfectly competitive firms in the sense that
their product is not a commodity and that unique characteristics of their product give rise to downward
sloping demand curves. This uniqueness can arise because of intrinsic differences in products, locational
differences, and differences in perception of the product arising from advertising and packaging. This
means, in contrast to the perfectly competitive firm, that pricing strategies are instruments that the
monopolistically competitive firm can use.
It is important to note, however, that specialized products and downward sloping demand are not enough
11

Market Structure

to sustain long-term profitability. While a firm may have a product that is unique in some way, say
perhaps a restaurant is uniquely located, if it is a profitable location, presumably other restaurants could
enter, reducing the market share of the restaurant and driving its economic profits to zero.
5.5.A. Market Structure
We can classify an industry with the following characteristics as monopolistically competitive:
Many Firms
Differentiated Products
Low Barriers to Entry
Many Buyers
Costly Information

5.5.B Implications of Market Structure

1. Marginal Revenue is less than Price (MR < P). Differences in products means increase price does not
lead to quantity equal to zero.
2. In long run economic profits equal zero.. This is because of the low barriers to entry.
3. Inefficient Output too little. Profit maximization implies that MR = MC but P > MR = MC and
therefore P > MC so what people value the good at P > the cost of the good, MC. Also Q will not
minimize average total cost.
5.5.C

Short Run and Long Run Equilibrium

Figure 4 depicts an example of both the short run and long run equilibrium with monopolistically
competitive firms.
In the short run the firm faces the demand curve DS and associated marginal revenue curve, MRS. Profit

F ig u r e 4
40
38
36
34
32
30
28

MC

26
24
22
20

DS

18

ATC

16
14
12
10

M RL

AVC

M RS

6
4

DL

2
0
0

10

20

30

40

50

60

70

80

90

100

12

110

120

130

140

150

160

170

180

Lectures in Managerial Economics

maximization is at MR = MC with Q = 105 and P = 24 with the firm earning positive profits. Since profits
are greater than 0, firms enter reducing demand. This continues until we have demand given by DL and
marginal revenue given by MRL. Then at Q = 80, MR = MC and P = ATC so = 0. This is the long run
equilibrium -- no firms have an incentive to enter or leave the industry. Note that while P = ATC = 18 this
is not the minimum of the ATC which is 14. The firm is inefficiently small.
5.5.D

An Application: Niche" Creation

Probably if asked about what the purpose of advertising is, most of us would respond by saying that it is to
increase sales volume. Here, however, we provide an example of an alternative use advertising to create a
market "niche." In fact, we show that a firm may wish to engage in advertising even if it does not increase
the demand for a product (sales) at the current price if, instead, it increases attachment to the product.
Essentially, what advertising can do is identify a product as having some unique attributes that change from
commodity or generic product to a "specialty" with a downward sloping demand curve.
Consider the cost curves for a firm illustrated in Figure 5. Assume that the product the firm sells is
"generic" and can be sold at a price of $10 in unlimited quantities but not at a higher price. Then marginal
revenue equals price or MR = 10. Then from Figure 5, we can see that profit maximization (P = MC)
occurs at an output of 100. At a price of P = 10 and quantity Q = 100, average total cost (ATC) equals $10
so profits, = (P-ATC)Q = 0.
Now consider the possibility of the firm undertaking an advertising campaign that will affect the demand for
its product. However, it will not increase sales, instead it will increase what people are willing to pay for
lower quantities than the current amount the firm produces. Would the firm be willing to engage in this
strategy? Formally, the new demand curve is
Q = 200 - 10P or P = 20 - (1/10)Q.(5.1)
This demand curve is depicted in Figure 5. Note that at a price of $10, the quantity demanded is 100. The
profit-maximizing output is given by MR = MC. This now occurs at an output of 65. But at this output given
the new demand the price is $13.50. The average total cost at this quantity is $10.80 so we have
= (P-ATC)Q = (13.50-10.80)(65) = $175.50.(5.2)
The firm would be willing to pay up to $178.57 for this advertising campaign. While creating the "niche"
reduces sales, it made the demand curve more inelastic, that is, it increased consumer loyalty. Even though
sales volume has decreased, the price the firm can charge has increased above costs, leading to positive
profits.

13

Market Structure

Figure 5
20

18
16

MC

14

12

ATC

10
8

D
MR

4
2

0
0

10

20

30

40

50

60

70

80

90

100
Q

14

110

120

130

140

150

160

170

180

190

200