ECONOMICSPaul Krugman | Robin Wellswith Margaret Ray and David Anderson

SECOND EDITION in MODULES

MODULE 21 (57)Introduction to Market Structure

Krugman/Wells

• The meaning and dimensions of market structure

• The four principle types of market structure—perfect competition, monopoly, oligopoly, and monopolistic competition

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Type of Market Structure

• Economists have developed four primary models of market structure: perfect competition, monopoly, oligopoly, and monopolistic competition.• This system of market structure is based on two

dimensions:– the number of firms in the market (one, few, or many)– whether the goods offered are identical or differentiated

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Types of Market Structure

Are Products Differentiated?

How Many Producers Are There?

Oligopoly

Perfect competition

No

One

Few

Many

Yes

Monopolistic competition

Not applicableMonopoly

This system of market structures is based on two dimensions: The number of producers

in the market (one, few, or many)

Whether the goods offered are identical or differentiated

Differentiated goods are goods that are different but considered somewhat substitutable by consumers (think Coke versus Pepsi).

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Perfect Competition

• A price-taking producer is a producer whose actions have no effect on the market price of the good it sells.• A price-taking consumer is a consumer whose

actions have no effect on the market price of the good he or she buys.• A perfectly competitive market is a market in which

all market participants are price-takers.• A perfectly competitive industry is an industry in

which producers are price-takers.

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Two Necessary Conditions for Perfect Competition

1) For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share.– A producer’s market share is the fraction of the total

industry output accounted for by that producer’s output.2) An industry can be perfectly competitive only if

consumers regard the products of all producers as equivalent.– A good is a standardized product, also known as a

commodity, when consumers regard the products of different producers as the same good.

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What’s a Standardized Product?• A perfectly competitive industry must produce a

standardized product. People must think that these products are the same.

• Producers often go to great lengths to convince consumers that they have a distinctive, or differentiated, product even when they don’t.

• So is an industry perfectly competitive if it sells products that are indistinguishable except in name but that consumer’s don’t think are standardized?

• No. When it comes to defining the nature of competition, the consumer is always right.

Free Entry and Exit

• There is free entry and exit into and from an industry when new producers can easily enter into or leave that industry.• Free entry and exit ensure:– that the number of producers in an industry can adjust to

changing market conditions– that producers in an industry cannot artificially keep other

firms out

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Monopoly

• A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry controlled by a monopolist is known as a monopoly, e.g. De Beers.• The ability of a monopolist to raise its price above the

competitive level by reducing output is known as market power.• What do monopolists do with this market power?

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Why Do Monopolies Exist?

• A monopolist has market power and as a result will charge higher prices and produce less output than a competitive industry. This generates profit for the monopolist in the short run and long run. • Profits will not persist in the long run unless there is a

barrier to entry. This can take the form of:– control of natural resources or inputs – increasing returns to scale– technological superiority– government-created barriers including patents and

copyrights

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Oligopoly

• Oligopoly is a common market structure. It arises from the same forces that lead to monopoly, except in weaker form. It is an industry with only a small number of producers. A producer in such an industry is known as an oligopolist.• When no one firm has a monopoly, but producers

nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition.

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Is It An Oligopoly, or Not?

• To get a better picture of market structure, economists often use a measure called the Herfindahl–Hirschman Index, or HHI. • The HHI for an industry is the square of each firm’s

share of market sales summed over the firms in the industry.• For example, if an industry contains only 3 firms and

their market shares are 60%, 25%, and 15%, then the HHI for the industry is:

HHI = 602 + 252 + 152 = 4,450

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Is It An Oligopoly, or Not?

• According to Justice Department guidelines, an HHI below 1,000 indicates a strongly competitive market, between 1,000 and 1,800 indicates a somewhat competitive market, and over 1,800 indicates an oligopoly. • In an industry with an HHI over 1,000, a merger that

results in a significant increase in the HHI will receive special scrutiny and is likely to be disallowed.

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Some Oligopolistic Industries

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Monopolistic Competition

Monopolistic competition is a market structure in which:• there are many competing producers in an industry• each producer sells a differentiated product• there is free entry into and exit from the industry in the

long run

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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 producers are price-taking producers and all consumers are price-taking consumers—no one’s actions can influence the market price.

3. There are two necessary conditions for a perfectly competitive industry: there are many producers, none of whom have a large market share, and the industry produces a standardized product or commodity. A third condition is often satisfied as well: free entry and exit into and from the industry.

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4. 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.

5. Many industries are oligopolies: there are only a few sellers. In particular, a duopoly has only two sellers. 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 market power.

6. Monopolistic competition is a market structure in which there are many competing producers, each producing a differentiated product, and there is free entry and exit in the long run.

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