Idea Transcript
©Bruce Domazlicky
Chapter 7 Market Failure: Imperfect Competition
The world of pure competition that was described in the Chapter 3 is the ideal in terms of allocative and production efficiency. Such a market structure leads to the most efficient use of scarce resources. However, pure competition is not common in our country; only the agricultural industry offers a close approximation. In reality, most markets in the United States are characterized by imperfect competition: monopoly, oligopoly or monopolistic competition. Each of these will be explored in this chapter.
MARKET POWER-A DEFINITION Before we discuss monopoly and other forms of imperfect competition in great detail, it would be useful to consider the concept of market power for a moment. The seller in a purely competitive market has no market power. The price that is set by the market will be the seller's price. Any attempt to charge a higher price will, as we have seen, lead to disaster. The seller's sales will fall to zero. Under imperfect competition, sellers will possess some market power. That means they will be able to raise price and not lose all of their sales. The degree of market power will depend on the number of sellers and the ease of entry into the market (to be discussed below). Where there are few sellers and difficult entry, market power will be great. As the number of sellers increases and entry becomes easier, the market power of the sellers will decline.
MONOPOLY-CHARACTERISTICS Monopoly is market structure in which there is a single seller of a product with no close substitutes. In addition, there are significant barriers to entry such that new firms will find it very difficult or even impossible to enter the market. True monopoly requires one seller, but the additional characteristics are equally important. The lack of close substitutes is necessary if the single seller is to have much market power. For example, in Cape Girardeau, there is only one Chevrolet dealer, Coad of the Road. If buyers wish to purchase a new Chevrolet, they must get it from Coad or drive to another town (about 7 miles to the next dealer). Therefore, Coad of the Road has a monopoly in new Chevrolets in my city. However, there are many close substitutes available for new chevrolets which can be purchased at other dealers: Hondas, Toyotas, Fords, Chryslers, etc. The monopoly that Coad possesses obviously does not convey a lot of market power. The existence of barriers to entry is also very important to the existence of monopoly. A single seller in a market where entry is easy would have very little market power. If a monopoly seller charged a high price and, as a result, earned economic profits, new sellers would enter the market if no barriers existed. This would obviously erode the monopolist's position very quickly. Clearly, if barriers to entry were present in a monopoly market, the seller will have a much greater degree of market power.
BARRIERS TO ENTRY There are several different types of barriers to entry that can exist in markets. One type is product differentiation. In this case, the buyer has come to identify the brand name of the firm with the product. Examples of this would be Kleenex and Jello. Nobody asks you for a paper tissue, they request a Kleenex. Similarly, you would not ask for a bowl of flavored gelatin for dessert, but instead would request a bowl of Jello. In markets where significant product differentiation exists, it is very difficult for new firms to enter. Potential entrants somehow have to overcome the consumers' natural inclination to identify a seller's brand name with the product, and that will not be very easy. A second type of barriers to entry consists of institutional barriers, which are erected by government. These barriers take on many forms. Firms and individuals are issued patents by government for new products and inventions. Patents last for seventeen years (and are not renewable), during which time the owner of the patent has the sole right to produce and sell that product. This definitely confers a monopoly on the holder of the patent. The reason for granting patents, of course, is to stimulate inventive activity since the resulting new products will benefit all of society. By rewarding inventors with a limited monopoly, there will be an incentive for research and development, which is, of course, the goal of patents. A second type of institutional barrier includes licensing restrictions by government. Many different occupations (beauticians, barbers, lawyers, doctors, school teachers, nurses, taxicab drivers, etc.) require some type of government license or certificate. Without the license, a person is not allowed to practice a given occupation. What is the purpose of such a requirement? Ostensibly, it is to protect the consumer and guarantee quality. After all, no one wants to go to a physician who has not been to medical school or to be represented by a lawyer with no legal training. For these individuals and others in the health professions, the licensing restrictions seem appropriate. But what about for barbers and beauticians? Are licenses really necessary for these occupations? The worse that can happen to a buyer is to get a lousy haircut. Why not let the market decide who can be a barber and a beautician? If someone is not very good at cutting hair, the market will soon eliminate that person through lack of customers. In addition, I suspect that you have gone to a barber or beautician and received a lousy haircut, even though the individual was properly licensed. So the license doesn't guarantee that the person with the scissors is competent, only that he or she has been to a beauty school or a barber school. If the license doesn't really guarantee quality for the buyer, there is little reason for it except to restrict the supply. A third type of institutional barrier exists when the government gives exclusive franchise rights to a firm to sell a product. An obvious example of this would be the U.S. Postal Service, which has the sole right to deliver first-class mail. Other examples would include cable TV companies and utility companies as local phone service, electricity, etc. These latter examples are usually perceived as special cases and require further explanation below. Another type of institutional barrier erected by government is the use of tariffs and quotas. Tariffs are taxes on imported goods while quotas consist of a maximum amount of a good that can be imported into a country. By placing tariffs and quotas on imported goods, foreign firms will find it difficult or even impossible to enter U.S. markets. The third category of barriers to entry consists of economic barriers. In some markets, production barriers will limit the feasible number of competitors. In the long run, when all resources are variable, firms increase output by expanding their plant size. The firm is said to be experiencing economies of scale when average cost declines in the long run as output expands. Economies of scale are due to such factors as division of labor tasks and specialization, which become possible as the size of the firm's operations increases. For most markets, average costs cease declining at output levels (and then, perhaps, level out over a long range of output) that are relatively small compared to the market size. This means that many firms can operate in such markets and still be efficient by producing where long run average cost is minimized. But in a few markets, average cost in the long run continues to decline over the entire range of market demand. Therefore, one firm supplying the entire market will have much lower average costs of production than would, for example, two firms supplying the same market. This is illustrated in Figure 7.1 below. Economies of scale are shown by declining long-run average cost. The market demand is for output level Q 1 where minimum average cost has not yet been reached in the long run. One firm in the market supplying Q 1 will have an average cost of C1 . If two firms were in the market, each supplying one-half the market demand or an output level of Q 2 , then their average cost of production would be at C2 , which, of course, is considerably higher than if only one firm served this market. Therefore, in this case of natural monopoly, one firm is preferred. Usually, the government will grant a public-utility franchise to an individual firm, giving it the sole right to provide some product to a market. This is the case with local phone service, electricity, etc. In some markets, the economies of scale are large relative to the size of the market such that only a few sellers are possible. This appears to be the case for automobile production, cement, and aluminum production. These will be discussed later under oligopoly.
Somewhat related to production barriers are financial barriers. In some markets, the initial investment required to construct production facilities is substantial such that new firms may have a difficult time acquiring the necessary money capital. This will especially be the case if economies of scale require entrance into a market on a large scale.
REVENUES AND COSTS UNDER MONOPOLY Since the monopolist is the sole seller of its product in the market, the demand curve that it faces is the market demand curve. This means if the monopolist wishes to increase its sales, it must lower price in order to move down its demand curve. It also means that marginal revenue will not be constant and equal to price but will decline as output increases and be less than price. The first two columns in Table 7.1 comprise the demand curve for product X. Note that price and quantity demanded are inversely related as required by the Law of Demand. The third column gives total revenue, which is found by multiplying price times quantity. Note that total revenue increases to a maximum of $56.00, after which it starts to decline. The final column, marginal revenue, is the change in total revenue from selling one more unit of X. It declines and reaches zero and then becomes negative. Marginal revenue is also less than price as indicated earlier. Why is it, for example, that the third unit of X is sold for $12.00, but the marginal revenue of that third unit is only $10.00? The reason is that to sell the third unit of X, price must be lowered from $13.00 to $12.00. Therefore, the two units that were being sold for $13.00 each are now being sold for $12.00 each. Two dollars of revenue were lost from having to lower the prices of the first two units. The marginal revenue of the third unit is, therefore, $12.00 minus the $2.00 lost from lowering the price on the first two units to $12.00. That gives a marginal revenue of $10.00 as shown in Table 7.1. A graph of the demand curve and the marginal revenue curve is given in Figure 7.2. Table 7.1 Price Quantity Total Rev. Marginal Rev. $15 0 $ 0 -14 1 14 14 13 2 26 12 12 3 36 10 11 4 44 8 10 5 50 6 9 6 54 4 8 7 56 2 7 8 56 0 6 9 54 -2 5 10 50 -4
The firm's costs are depicted in Table 7.2. The total cost (TC) column gives the total cost to the firm of producing the corresponding level of quantity. Therefore, if the firm produces 4 units of output, it will incur a cost of $24. The marginal cost column (MC) gives the additional cost to the firm of producing one more unit of output. In this example, the marginal cost is assumed to be constant such that when the firm increases its output by one unit, its total cost increases by $6. Table 7.2 Quantity Total Cost Marginal Cost 0 0 -1 6 6 2 12 6 3 18 6 4 24 6 5 30 6 6 36 6 7 42 6 8 48 6 9 54 6 10 60 6 Table 7.3 combines the information in Tables 7.1 and 7.2. The monopolist wants to produce the quantity of output that will maximize its profits. Profit is equal to total revenue (TR) minus total cost (TC). From Table 7.3, it is apparent that if the monopolist produces 4 or 5 units of output, its profit will be maximized at $20. The profit maximizing output can also be found by looking at marginal revenue and marginal cost. When the monopolist (or any firm, for that manner) increases its output, marginal revenue (MR) gives the changes in the monopolist's revenue while marginal cost (MC) is the change in the monopolist's costs. If MR exceeds MC, then the monopolist's profits will be increasing since more is added to revenue than to cost. If MR is less than MC, then adding one more unit of output will add more to cost than to revenue and the monopolist's profits will be decreasing. Consider the first unit of output in Table 7.3. Producing that first unit will add $6.00 to cost and $14 to revenue. Clearly, the monopolist should add the first unit of output. Similarly, the MR exceeds the MC for the second unit of output and so that unit should be produced. In general, the monopolist (or any firm) should expand output up to the point where marginal revenue equals marginal cost, or an output of 5 units in our example. Table 7.3 Quant. Price TR MR TC MC Profit 0 $15 $0 --- $0 --- $ 0 1 14 14 14 6 6 8 2 13 26 12 12 6 14 3 12 36 10 18 6 18 4 11 44 8 24 6 20 5 10 50 6 30 6 20 6 9 54 4 36 6 18 7 8 56 2 42 6 14 8 7 56 0 48 6 8 9 6 54 -2 54 6 0 10 5 50 -4 60 6 -10 A graph of the above example is given in Figure 7.3. The MC is marginal cost, which is a horizontal line at $6 in this example. Marginal cost is equal to marginal revenue at an output level of 5. The monopolist charges a price of $10 and earns profits of $20.
If the industry were competitive, the level of production would occur where supply equals demand. Recall that the supply curve in a competitive market is equal to the marginal cost of producing one additional output. This means the competitive industry would produce where marginal cost (MC) crosses the demand curve (D) at an output level of 9. The competitive price would be $6, just equal to the constant marginal cost of production. Therefore, we can see that the monopolist will produce less than the competitive industry and charge a higher price. Also notice that at an output level of 5, the price someone is willing to pay fort he fifth unit is $10, which is greater than the $6 cost of producing the fifth unit. Efficiency demands that more of this good be produced since the benefits of additional units will exceed the marginal cost of producing additional units. But the monopolist will not choose to increase output, since to do so would cause the monopolist's profit to decrease. So once again, we see that the monopolist produces less than the efficient level of output.
THE "SPECIAL CASE" OF NATURAL MONOPOLY While pure monopoly is clearly undesirable, it should be noted that monopoly may be necessary in markets where economies of scale in production are large relative to the size of the market. This would be the case of a natural monopoly that was mentioned above. As mentioned, when conditions of natural monopoly exist, it is most efficient to grant the firm a public utility franchise and then regulate that firm. In applying the theory of natural monopoly, it becomes necessary, first, to identify which markets are characterized by pervasive economies of scale over the relevant range of market demand. Some cases are fairly obvious: electricity and natural gas at the municipal level. A city with more than one electric or natural gas company will experience wasteful duplication of facilities. For local phone service, at least at present, it would appear to be a natural monopoly. However, as cellular phones increase in use, it is not inconceivable that phone lines would no longer be necessary; only microwave transmission towers would be used to pick up and send calls. People would only need to have a cellular phone with no lines attached. If that should occur, then local phone service would become subject to intense competition as has happened with long distance service. Other examples of government-sanctioned monopolies-the U.S. Postal Service and cable TV-don't necessarily fit the requirements of natural monopolies. Given the experience of overnight delivery and parcel post, it would appear that delivery of first-class mail could also be subjected to competition without negative effects on efficiency. In fact, many would maintain that a healthy dose of competition is just what the Postal Service needs to spur it to greater efficiency and power costs. One objection to allowing other mail carriers is that they would engage in cream-skimming. That is, new firms would deliver mail in the most lucrative routes (local delivery or between large cities) and leave the high-cost routes to the Postal Service (between small, rural cities as Tie Siding, Wyoming and Neelys Landing, Missouri). That objection could be easily met by requiring mail firms to provide universal service in order to enter the market. Further, evidence is that such a requirement may not be necessary since overnight delivery firms provide service to virtually anywhere in the U.S. (or even the world) Note also that technology is already starting to erode the Postal Service's markets in this area. The growing use of e-mail, the lowering of long-distance telephone rates, and the increasing use of fax machines all threaten the Postal Service's monopoly. Even with its exclusive monopoly, the Postal Service, apparently, is not safe from competition. Once public utility franchises are granted, then regulation "in the public interest" becomes necessary. Such regulation usually centers around the allowable price the monopolist will be able to charge customers. A regulatory commission is established with the power to set the maximum price of the monopolist. The price must be set high enough so that the firm will be able to attract resources. If the price is set too low, then the firm will not make adequate profits and, therefore, will not be able to provide satisfactory service to its customers. On the other hand, the commission wants to set a maximum price which is below the profit-maximizing price of the monopolist. If the commission did not achieve the latter, then there is no reason for its existence since presumably, the monopolist could set the price at the profit-maximizing level on its own. Most regulatory commissions appear to aim for a price that allows the firm to earn a rate of return that is commensurate with other firms in other markets. This would roughly correspond to setting a maximum price that would allow the firm to earn a normal profit. In the earlier example of this chapter, the maximum price would be set at $6.00. At such a price, the firm would produce 6 units of output to serve the entire demand (a requirement of regulation). Its price of $6.00 would just equal the average cost of production so the firm would earn normal profits. It would have enough profit, therefore, to attract resources and would earn a return similar to other firms in other markets. In general, the attractiveness of such an approach is evident. Consumers get lower prices and higher outputs while the firm is earning a normal profit. However, the reality of regulation is that things do not always work out so smoothly. Allowable costs are sometimes difficult to determine. Since price depends on the level of costs, this is an important consideration. If a regulated firm is inefficient, costs will be too high. But frequently, this will just lead to higher allowable rates so that the firm itself experiences no real penalty from being inefficient. Its inefficiencies, in effect, are merely passed onto consumers in the form of higher rates. The typical utility faces a variety of customers with differing levels and elasticities of demand. To what extent should price discrimination be allowed? As an example, the average residential customer has a very inelastic demand for electricity. There are just no viable alternatives for such a customer. A large industrial user of electricity, however, has alternatives. It may decide to buy from other suppliers or even generate electricity itself. Its demand for electricity, therefore, is much more elastic. Where demand is inelastic, much higher prices could be charged with little loss of business and significant increases in revenue. Where demand is more elastic, price must be kept lower to avoid loss of business and revenue. Will the commission require the utility to charge all customers the same price or will price discrimination be allowed? This is a question that requires an answer under regulation. The process of regulation is also time-consuming and costly. Resources are being used up to support the process, resources that could be used in other markets to produce goods and services. This fact does not necessarily rule out regulation, but it does point out that there are resource costs to regulation. In summary, regulation is necessary whenever firms are granted exclusive franchises. In all cases, we need to be sure that the conditions of natural monopoly are present before setting up a firm with an exclusive franchise. Once that decision is made, regulation then needs to proceed as efficiently as possible.
OLIGOPOLY Finding instances of pure, unregulated monopoly in the U.S. is probably difficult. However, cases of oligopoly are much more common. In this market structure, there are a few sellers such that a great deal of interdependence exists between the firms in the market. The actions of any one of them (eg., lowering price, changing product style, etc.) will have a profound effect on the other firms in the market. This means that decisions cannot be made in isolation; rather firms must consider and try to anticipate the likely reactions of their competitors to any major decision that might be made. The product of the firms in the market may be differentiated or they may be standardized. An example of a differentiated oligopoly would be the automobile industry. The firms produce similar, but differentiated products. The steel and aluminum industries would be examples of standardized oligopolies. The products of the firms in the market are identical in these last two cases. Entry into an oligopolistic market is either blocked or very difficult. New firms will find it very difficult to enter a market characterized by oligopoly, though not necessarily impossible. Technological change can allow for more competition as has happened in the steel industry in the last few years. Small firms operating minimills that use basically scrap steel are quite efficient and are competitive with the larger firms such as USX. Under oligopoly, collusion between the sellers becomes a distinct possibility. Because of the interdependence of the sellers, they have a strong incentive to collude. The basic goal of collusion, typically, is to raise the price of the product over what it would be under independent action. The most formal type of collusion is the cartel. In a cartel, firms will determine the target price and then allocate output quotas among the members to insure that the target is met. If all members adhere to the output quotas, then the cartel should be successful in raising the price of the product. While such cartels are illegal in the U.S. under antitrust laws, they are found in other parts of the world. The Organization of Petroleum Exporting Countries (OPEC) is, perhaps, the most famous of all cartels. What conditions are necessary for the cartel to be most successful in raising the price of the product? First, the demand for the product should be relatively inelastic. With an inelastic demand for its product, the cartel can raise price and expect to increase its total revenue. If the demand for the product were elastic, increasing price would lead to a relatively large loss of sales and, therefore, lower total revenue. Second, the cartel will be more successful the smaller the number of members. Cartels are most effective when the members make agreements and then abide by those agreements. When members cheat on price or output agreements, the ability of the cartel to control price is undermined and it soon loses its effectiveness. If there are only a few members, it will be easier to monitor member behavior and apply pressure to those who are not abiding by the agreements. Third, to be effective, the cartel's sales must be a significant portion of the total market sales. If the cartel members accounted for a relatively small portion of the market, its ability to restrict output and control price will be circumscribed by the existence of noncartel suppliers of the product. At a minimum, the cartel should have around fifty percent of the total market to be effective. Fourth, the response of noncartel suppliers is crucial to the success of the cartel. If the noncartel suppliers are able to expand their output easily, then they will do so when the cartel restricts output and drives price up. The net result is that the cartel will find it merely loses sales to other suppliers by raising price instead of increasing its own revenue. If noncartel suppliers find it difficult to increase output in response to higher prices, the cartel will be more successful. Finally, the cartel will be more effective if the demand for its product is relatively stable. Price and output agreements are much easier to implement and maintain in a world or steady and increasing demand. In a market where demand is unstable, it will be difficult for the cartel to hold together. When demand falls, there will be a tendency for cartels to fall apart as members try to maintain their market share by reducing price. Too many episodes of declining demand will likely cause the cartel to collapse. Because of the many pressures exerted on a cartel, it tends not to stay together very long. Competition from noncartel suppliers, unstable demand, eroding market share all act to undermine the effectiveness of the cartels. The members, themselves, may even cause the breakup of the cartel. The reason is that the members have a strong incentive to cheat either by lowering price or producing more than the allotted share. Because of the high prices and high profits being made, an individual member sees clearly the advantages if it decides to cheat a little on the agreement. If the member is relatively small in terms of total output supplied, it is likely to believe that its action will not have a significant effect on the market. But if several members start thinking that way, the cartel soon falls apart. In general, then, cartels tend to have limited effectiveness over time. Cartels are illegal in the U.S.; under the Sherman Antitrust Act, firms are not allowed to form or join either domestic or international cartels. Nevertheless, the incentive to collude still exists for U.S. firms. A type of behavior that exists in some markets is price leadership. One firm in the industry is the acknowledged price leader; either because it is the largest or, perhaps, the oldest firm in the industry. When it changes its price (usually upward), other firms in the industry will follow. If the product is standardized, the followers will tend to maintain identical prices to the leader. Where the product is differentiated, prices will not necessarily be identical, but price increases will be similar in percentage terms. Since parallel action by firms is not, by itself, evidence of collusion, firms can avoid antitrust actions and still get some of the benefits of collusion by engaging in price leadership behavior. Nonprice competition is likely to be an important feature of an oligopolistic market. Nonprice competition includes advertising and changing the quality of the product. In a purely competitive market with standardized products, there is little to gain from nonprice competition. The individual firm can sell all that it wants at the market price. Therefore, advertising is of little use to the firm. The industry, however, may advertise to try to shift the demand curve for its product to the right. Firms may form an association (Dairy Council, Beef Producers, etc.) for the purpose of promoting its product. Under monopoly, both advertising and product changes may be used. Successful advertising will increase the demand for the monopolist's product while product changes can also impact demand positively. The firms under oligopoly will tend to heavy users of nonprice competition. To avoid "rocking the boat," oligopolistic firms have a tendency to eschew price competition that leads to ruinous price wars which benefit no one (e.g., one firm lowers it price in an attempt to increase market share, other firms follow, lowering theirs, etc.). It is safer to try to attract customers through advertising and product changes. The goal of the oligopolists is the same as for other firms, increase market demand. There are many different forms which oligopoly can take, given that the product may or may not be differentiated, that there may or may not be collusion. Rather than try to discuss all of them, note that the oligopolist will face a downward-sloping demand as does the monopolist. Profits for the oligopolist will be maximized at the output level for which marginal revenue equals marginal cost. Since the demand curve is downward sloping, marginal revenue will also be downward sloping and less than price. This means at the profit maximizing quantity, price will exceed marginal cost (as it did for the monopolist). It was seen in the previous chapter, that allocative efficiency is achieved when output is produced up to the point where price and marginal cost are equal. Since price exceeds marginal cost for the oligopolist at the profit maximizing output level, the firm is producing less than the allocatively efficient level of output. Therefore, similar to the monopolist, the oligopolist does not produce sufficient output to be allocatively efficient. Further, since barriers to entry are significant in oligopolistic markets, firms may earn economic profits in the long run. In addition, there is no guarantee that firms will operate at the minimum of the average cost of production as is the case under pure competition in the long run. Therefore, many of the criticisms made of monopoly apply to oligopoly as well. However, it should be pointed out that the existence of extensive economies of scale relative to market size means that only a few firms are possible in some markets. That is, it may be necessary to accept oligopoly in some instances and hope that competition among the few large firms will be significant.
MONOPOLISTIC COMPETITION The final market structure that will be examined is called monopolistic competition. This market structure is characterized by many firms selling a differentiated product in a market that is easy to enter. Except for the differentiated product, this market structure is similar to pure competition. The firms sell products which are somehow differentiated, but are close substitutes for each other. This means each firm will face a downward-sloping demand curve for its product and this is the monopoly aspect of monopolistic competition. The firm is able to raise its price and not lose all of its customers. However, the demand for its product tends to be relatively elastic since there are so many close substitutes available in the market. A firm that raises its price will retain some customers out of loyalty for its brand. But many of its customers will decide to switch to a competitor's brand if the price hike is significant. The best examples of monopolistic competition are provided by retailing in urban areas. Grocery stores, gas stations, restaurants are all examples of firms in markets which approximate monopolistic competition. The firm under monopolistic competition, similar to the oligopolist and monopolist, must make decisions about price, the level of output, the level of selling effort (or advertising) and about the product itself. Therefore, nonprice competition will be an important part of monopolistic competition as well. In the short run, the monopolistically competitive firm will maximize profits by setting marginal revenue equal to marginal cost. Since the demand curve for the firm is downward-sloping, price will exceed marginal cost for the firm. In this respect, the short run profit-maximizing decision is basically the same as for a monopolist (or an oligopolist). In the long run, the fact that entry is easy will lead to results similar to pure competition. If monopolistically competitive firms are earning economic profits, other firms will tend to enter the market. The demand curves of the existing firms will shift downward as other firms enter, reducing profits until only normal profits are earned, a process similar to what was described in the previous chapter for pure competition. However, the final equilibrium is not identical to the firm under pure competition. Because the demand curve is downward sloping, price will still be above marginal cost for the monopolistically competitive firm in the long run. So firms are producing less than the allocatively efficient levels of output. They also tend to produce at a lower output than where the minimum of their average cost of production occurs. That is, the firms have some excess capacity that is not being effectively. The almost empty grocery store or restaurant on Mondays and Tuesdays are good examples of the excess capacity. However, it happens that the excess capacity is basically due to the downward sloping demand curve of the firm and the negative slope of the demand curve is a result of product differentiation. To the extent that consumers are willing to pay a bit more to have a choice of products, then the excess capacity is, perhaps, not too inefficient.
FROM THEORY TO REALITY: CONCENTRATION RATIOS In actual practice, there are few examples of purely competitive markets as described in the previous chapter. Similarly, it is also difficult to fine pure, unregulated monopolies in the U.S. Most markets fall into the realm of oligopoly or monopolistic competition. Of the two, we would likely prefer a market to be monopolistically competitive because of its similarity (in some aspects at least) with pure competition. Some measure of the degree of competition or concentration in a market is a necessity for identifying which type of market structure exists in a given instance. Economists have devised a simple measure to gauge the extent of concentration in a market and, therefore, the likelihood of competition. The measure is called the concentration ratio. It is the percent of sales in a market (or market share) of the four largest firms in the market. The ratio can also be computed for the largest eight firms. The larger the concentration ratio, then the more market power the largest firms are likely to possess and, therefore, the less competition in the market. The smaller the concentration ratio, the greater is the amount of competition. Table 7.4 shows concentrations ratios for selected U.S. industries. Some markets are quite concentrated: motor vehicles, chewing gum, breakfast cereals; while others exhibit much less concentration: newspapers, book publishing, bottled and canned soft drinks. As useful as the figures in Table 7.4 are, we must exercise caution in using them. In some cases, the ratio overstates the degree of concentration in a market. This is especially true of the automobile industry. The ratio of 84% for the top four firms does not include imports. When they are added to the market, the top four domestic firms would find their share of total sales declining to about 70%. The ratio of 85% for breakfast cereals also indicates a high degree of concentration in that market, and indeed, there is. However, how many of you and your classmates had cereal for breakfast? Clearly, competition from other products (pancakes, waffles, eggs, and the great American breakfast favorite, doughnuts) is significant. So crossproduct competition can be very important in some markets, which means the concentration ratios of narrowly defined markets may overstate their case. Likewise, in some markets, a low concentration ratio may not be indicative of the lack of competition in a market. For example, the ratio of 20% for newspapers appears to indicate a competitive market. But this ratio represents the proportion of total national sales of the four largest newspapers. Clearly, most newspapers are sold in regional markets where frequently little or no competition exists from other papers. The only significant competition comes form other media (radio, TV, magazines), which, admittedly, can be substantial. So cross-product competition may be more relevant once again for this market. In summary, concentration ratios can be useful in assessing the degree of concentration in markets, but they must be used with care. It is important for the user to consider what market is being measured and the products that are included in the ratio.
Table 7.4 Four-Firm Concentration Ratios, Selected Industries, 1992 Motor Vehicles 84 Breakfast Cereals 85 Tires and Inner Tubes 70 Aircraft 79 Farm machinery 62 Blast Furnaces & Steel Mills 37 Petroleum Refining 30 Newspapers 20 Book Publishing 32 Telephones 51 Semiconductors 41 Aluminum 59 Storage Batteries 60 Cigarettes 93 The Bureau of the Census has recently computed concentration ratios for 1997 for some industries. You might take a look and compare them to the above table. Concentration Ratios
VOCABULARY Monopoly Oligopoly Monopolistic Competition Barriers to Entry Natural Monopoly Economies of Scale Cartel Nonprice Competition Concentration Ratio
REVIEW QUESTIONS 1. State the characteristics of the following market structures: monopoly, oligopoly, monopolistic competition. 2. Discuss the various barriers to entry that make it difficult for firms to enter certain markets. 3. What conditions will tend to make a cartel more effective? 4. How is monopolistic competition similar to pure competition and how is it different? 5. Why does the monopoly firm tend to produce an allocatively inefficient level of output? 6. The following gives the demand schedule faced by a monopoly firm and its total costs. a) Use the information to determine marginal revenue and marginal cost for the firm. b) Use marginal revenue and marginal cost to find the profit maximizing output level for the firm. What are the firm's profits? Quantity Price Total Cost 0 $20 $ 10 1 18 20 2 16 30 3 14 40 4 12 50 5 10 60 6 8 70 7 6 80 8 4 90 7. Assume several steel firms are in court because the firms have been charging identical prices for their steel products. They are accused of violating antitrust laws which prohibit collusion and conspiracies by firms. Acting as the prosecuting attorney for the Federal Government, explain why the identical prices the firms are charging constitute evidence of collusion. Then act as the defense lawyer for the firms to explain why the identical prices constitute evidence of competition between the firms. 8. Firms that have market power sometimes use their power to set different prices for the same good. This is known as price discrimination. A personal example I can relate involves an experience I had at a motel in central Georgia on my way to Florida during one Christmas break. In front of me at the motel desk was an older couple (early sixties), neatly dressed (though by no means extravagantly), driving a nice car. They presented an AAA (American Auto Association) card, which entitled them to a discount rate at this particular motel chain. They received a room for $39.00. That sounded pretty good to me and I would have been happy at that rate. When it came to be my turn, I asked for the rate for two parents and two (teenaged) children. I had no AAA card or other discount to present. I was not dressed particularly well, old jeans, old jacket, plus I drive a compact car. The motelkeeper looked at me and said she could give me a good rate-$34.00. I obviously jumped at the offer and spent a quiet night in a clean, but modest motel in central Georgia. This motelkeeper was engaging in price discrimination. What were her thoughts in charging me less? Why didn't she quote me a price of $39.00? How was she using price discrimination to what she thought was her advantage? In answering this question, be sure to realize that an empty motel room for the night earns zero revenue. 9. The convenience store about a mile and a half from my house sells a gallon of milk for $3.29. The same gallon of milk sells for $2.39 at the supermarket three miles from my home. How can there be a different price for an identical good at these two different stores? Why would anyone pay the higher price for the milk? 10. My favorite model of oligopoly involves a crowded beach on a summer day. People are evenly distributed along this beach. There are two ice cream vendors located on the beach as shown in Figure 7.4. Everyone at the beach will buy one ice cream cone and will walk as far as is necessary to get that cone. But they will not walk any farther than necessary to get the cone. Assume you are vendor Y and B is the other vendor. Figure 7.4 |----------Y------------------------------------B-------| Clearly, everybody to the left of Y will buy from you and everybody to the right of B will buy from her. The people in between Y and B will go to the closest vendor so a spot equidistant between Y and B will be the dividing line between the two markets. What could you do to increase your market? How would B react to your change? Where would the two vendors wind up in equilibrium? How far does the average person walk for the cone in equilibrium (in terms of the length of the beach)? Where should the vendors be to minimize the average walk for an ice cream cone of the people at the beach?