Summary
Introduction to Market Structure
- 1. There are four main types of market structure based on the number of firms in the industry and product differentiation: perfect competition, monopoly, oligopoly, and monopolistic competition.
- 2. In a perfectly competitive market all firms are price-taking firms and all consumers are price-taking consumers—no one’s actions can influence the market price. Consumers are normally price-takers, but firms often are not. In a perfectly competitive industry, every firm in the industry is a price-taker.
- 3. A monopolist is a producer who is the sole supplier of a good without close substitutes. An industry controlled by a monopolist is a monopoly.
- 4. To persist, a monopoly must be protected by a barrier to entry. This can take the form of control of a natural resource or input, increasing returns to scale that give rise to a natural monopoly, technological superiority, or government rules that prevent entry by other firms, such as patents or copyrights.
- 5. There are two necessary conditions for a perfectly competitive industry: there are many firms, none of which has a large market share, and the industry produces a standardized product or commodity—goods that consumers regard as equivalent. A third condition is often satisfied as well: free entry and exit into and from the industry.
- 6. Many industries are oligopolies: there are only a few sellers, called oligopolists. Oligopolies exist for more or less the same reasons that monopolies exist, but in weaker form. They are characterized by imperfect competition: firms compete but possess some market power.
- 7. Monopolistic competition is a market structure in which there are many competing firms, each producing a differentiated product, and there is free entry and exit in the long run. Product differentiation takes three main forms: by style or type, by location, and by quality. The extent of imperfect competition can be measured by the Herfindahl–Hirschman Index.
Perfect Competition
- 8. A producer chooses output according to the optimal output rule: produce the quantity at which marginal revenue equals marginal cost. For a price-taking firm, marginal revenue is equal to price and its marginal revenue curve is a horizontal line at the market price. It chooses output according to the price-taking firm’s optimal output rule: produce the quantity at which price equals marginal cost. However, a firm that produces the optimal quantity may not be profitable.
Graphing Perfect Competition
- 9. A firm is profitable if total revenue exceeds total cost or, equivalently, if the market price exceeds its break-even price—minimum average total cost. If market price exceeds the break-even price, the firm is profitable. If market price is less than minimum average total cost, the firm is unprofitable. If market price is equal to minimum average total cost, the firm breaks even. When profitable, the firm’s per-unit profit is P − ATC; when unprofitable, its per-unit loss is ATC − P.
- 10. Fixed cost is irrelevant to the firm’s optimal short-run production decision. The short-run production decision depends on the firm’s shut-down price—its minimum average variable cost—and the market price. When the market price is equal to or exceeds the shut-down price, the firm produces the output quantity at which marginal cost equals the market price. When the market price falls below the shut-down price, the firm ceases production in the short run. This decision to produce or shut down generates the firm’s short-run individual supply curve.
- 11. Fixed cost matters over time. If the market price is below minimum average total cost for an extended period of time, firms will exit the industry in the long run. If market price is above minimum average total cost, existing firms are profitable and new firms will enter the industry in the long run.
Long-Run Outcomes in Perfect Competition
- 12. The industry supply curve depends on the time period (short run or long run). When the number of firms is fixed, the short-run industry supply curve applies. The short-run market equilibrium occurs where the short-run industry supply curve and the demand curve intersect.
- 13. With sufficient time for entry into and exit from an industry, the long-run industry supply curve applies. The long-run market equilibrium occurs at the intersection of the long-run industry supply curve and the demand curve. At this point, no producer has an incentive to enter or exit. The long-run industry supply curve is often horizontal. It may slope upward if there is limited supply of an input, resulting in increasing costs across the industry. It may even slope downward, as in the case of decreasing costs across the industry. But the long-run industry supply curve is always more elastic than the short-run industry supply curve.
- 14. In the long-run market equilibrium of a competitive industry, profit maximization leads each firm to produce at the same marginal cost, which is equal to the market price. Free entry and exit means that each firm earns zero economic profit—producing the output corresponding to its minimum average total cost. So the total cost of production of an industry’s output is minimized. The outcome is efficient because every consumer with willingness to pay greater than or equal to marginal cost gets the good.