F.  Market Structure

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1.  Perfect competition

a.  Characteristics

(1) Large number of firms

(2) Undifferentiated (homogeneous) product - products sold by all firms are identical

(3) Easy to enter market - no barriers to entry

(4) Complete information available to participants

Ex. - Agriculture, financial markets, trucking

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• Firm's are price takers - have no control over the price

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b.  Short-run equilibrium

(1)  Firm's demand curve

• Price established at the industry level

• Demand for the firm is perfectly elastic

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(2)  Profit maximization

• Assume goal of firm is to maximize profits

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c.  Long-run equilibrium

• Firms will enter or exit in the long-run

(1)  Short-run profits

• Firms will enter market if there are economic profits in the short-run

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(2)  Short-run losses

• Firms will exit market if there are economic losses in the short-run

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2.  Monopoly

a.  Characteristics

(1)  One firm

(2)  Unique product with no close substitutes

(3)  Entry is blocked - many barriers to entry

(4)  Some information protected by patents, copyrights, and trade secrets

Ex. - Public utilities

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• Firm is a price-setter - has substantial control over price

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b.  Profit maximization

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c.  Comparison with perfect competition

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d.  Sources of market power (barriers to entry)

(1)  Economies of scale

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(2)  Barriers created by government

(a)  Licenses

(b)  Patents and copyrights

(3)  Input barriers

• Firm controls a resource needed to produce a product

• Includes knowledge of how to produce the product

Ex. - Alcoa, DeBeers, Ocean Spray, Ecke family

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(4)  Brand loyalties

• Consumers identify with a particular product

• Developed through advertising and marketing

Ex. -

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(5)  Consumer lock-in and switching costs

• More market power if it is difficult to switch from one product to another

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(a)  Contractual commitment

• Legal document locking-in commitments over a period of time

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(b)  Durable purchases

• Products with long lives commits purchaser to that product

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(c)  Brand-specific training

• Training people makes it easier to switch

Ex. - Microsoft Word

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(d)  Information and databases

• Cost of transferring information can be substantial

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(e)  Specialized suppliers

• Fewer alternatives for the customer of these suppliers => more difficult to switch

Ex. - Military contractors

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(f)  Search costs

• Large search costs make it more difficult to switch

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(g)  Loyalty programs

• Benefits lost if not used in a relatively short time

Ex. - Frequent flyer programs

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(6)  Network externalities

• Value of a product increases as the number of consumers increases and vice versa

• Virtuous cycle - customers increase => product more valuable => customers increase

Ex. - Microsoft Windows, e-Bay, Facebook, LinkedIn

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e.  Measures of market power

(1)  Lerner Index

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(2)  Cross-price elasticity of demand

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(3)  Concentration ratios

• Combined market share of the N largest firms in a market

• Most common is the 4-firm concentration ratio

• 8, 20, and 50 also used

Ex. -

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• Not impacted by changes in the shares of the smaller firms

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(4)  Herfindahl-Hirschman Index (HHI)

HHI = ∑ s_i²

s_i =market share of firm i

Ex. -

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• 2012 Economic Census

• Properties

- All firms considered

- More unequal market shares => higher index

- More firms => lower index

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f.  Anti-trust issues

• Illegal to form a monopoly or engage in collusion in the U.S.

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(1)  Antitrust laws and enforcement

(a)  Sherman Act (1890)

• Prohibits contracts, combinations, and conspiracies in restraint of trade

• Prohibits monopolization, attempts to monopolize, and combinations or conspiracies to monopolize

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(b)  Clayton Act (1914)

• Prohibits price discrimination that lessens competition (amended by Robinson-Patman Act (1936))

• Prohibits the use of tie-in sales - consumer can purchase one good only if another good is purchased

• Prohibits mergers that reduce competition (amended by Cellar-Kefauver Act (1950))

• Prohibits interlocking boards of directors

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(c)  Federal Trade Commission Act (1914)

• Established Federal Trade Commission (FTC) to administer antitrust laws

• Prohibits "unfair" competition

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(2)  Department of Justice and FTC guidelines

• Horizontal mergers - mergers between firms in the same industry

• Vertical mergers - mergers between firms at different stages of production of a good

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(a)  Issues

i)  Definition of relevant market

Ex. - Coca-Cola and Dr. Pepper, cereal

ii)  Level of seller competition in market

iii)  Possibility that merging firm might be able to unilaterally affect price and output

iv)  Nature and extent of entry into market

v)  Characteristics of market structure that would influence coordination among sellers

vi)  Extent to which cost savings and efficiencies could offset increase in market power

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(b)  Merger standards

i) Post-merger HHI below 1500

• Markets not concentrated

• Merger unchallenged

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ii) Post-merger HHI between 1500 and 2500

• Markets moderately concentrated

• Merger probably unchallenged if change in HHI is less than 100

• Merger may be challenged if change in HHI is greater than 100

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iii) Post-merger HHI greater than 2500

• Markets highly concentrated

• Merger unchallenged if change in HHI is less than 100

• Merger may be challenged if change in HHI is between 100 and 200

• Merger will be challenged if change in HHI is greater than 200

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3.  Monopolistic competition

a.  Characteristics

(1) Large number of firms in product group

(2) Products are differentiated

(3) Entry and exit is relatively easy

(4)  Relatively good information available

Ex. - Retail, restaurants, services

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• Some control over price

• No interdependence among firms

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b.  Product differentiation

• Also referred to as non-price competition

(1)  Methods

(a) Brand names

• Includes use of logos and trademarks

• Enhanced by advertising and other marketing activities

(b)  Packaging

(c)  Product design

(d)  Quality

(e)  Service or services

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(2)  Objective of product differentiation

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c.  Short-run and long-run equilibrium

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4.  Oligopoly

a.  Characteristics

(1) Small number of firms

(2) Homogeneous or differentiated product

(3) Entry is difficult - many barriers to entry

(4)  Some information available, but limited

Ex. - Steel, oil, autos, soft drinks, gasoline

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• Firms are interdependent

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b.  Cooperative oligopoly models

(1)  Cartels

• Organization of producers that coordinates behavior that maximizes the profit of the organization as a whole

Ex. - OPEC

• Incentive for some members to cheat on the agreement

• Will be most successful if:

- Cartel can raise market price without inducing significant competition from nonmembers

- Punishment for forming cartel is low relative to expected gains

- Costs of establishing and enforcing the agreement are low relative to gains

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(2)  Tacit collusion

• Coordinated behavior without a formal agreement

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(a)  Practices

i)  Uniform prices

ii)  Penalty for price discounts

iii) Advance notice of price changes

iv) Information exchanges

v) Swaps and exchanges

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(b)  Price leadership

• One firm changes price, others may follow