Module
24
Introduction to
Market Structure
Module Objectives
Students will learn in this module:
• The meanings and dimensions of market structure.
• The four principle types of market structure-perfect competition, monopoly,
oligopoly, and monopolistic competition. Module Outline
Opening Example: “Doing What Comes Naturally”—The opening story for this section
discusses organic foods and the idea that high prices for organic foods will eventually
lead to an increase in the quantity of organic foods supplied.
I.Types of Market Structure
A.There are four principal models of market structure: perfect competition,
monopoly, oligopoly, and monopolistic competition.
B.Economists use these four models of market structure to develop principles and
make predictions about markets and how producers will behave in them.
C. Market structure is based on two dimensions: the number of producers in the
market (one, few, or many) and whether the goods offered are identical or differentiated.
1. In perfect competition, many producers sell an identical product.
2.In monopoly, a single producer sells a single, undifferentiated product. 3.In oligopoly, a few producers—more than one but not a large number—sell
products that may be identical or may be differentiated. 4. In monopolistic competition, many producers each sell a differentiated
product.
II.Perfect Competition
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A.Definition: A price-taking firm is a producer whose actions have no effect on
the market price of the good or service it sells.
B.Definition: A price-taking consumer is a consumer whose actions have no
effect on the market price of the good or service he or she buys.
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C. Defining perfect competition
1. Definition: A perfectly competitive market is a market in which all
market participants are price-takers.
2. The model of a perfectly competitive market is representative of some but
not all markets.
3. Definition: A perfectly competitive industry is an industry in which
firms are price-takers.
D.Two necessary conditions for perfect competition
1. For an industry to be perfectly competitive, it must contain many producers, none of whom has a large market share.
a.Definition: A firms’s market share is the fraction of the total industry
output accounted for by that firm’s output.
2. An industry can be perfectly competitive only if consumers regard the
products of all producers as equivalent.
a.Definition: A good is a standardized product, also known as a commodity, when consumers regard the products of different firms as the
same good.
E. Free entry and exit
1. Most perfectly competitive industries are also characterized by free entry
and exit.
2. Definition: An industry has free entry and exit when new firms can easily enter into the industry and existing firms can easily leave the industry.
III. Monopoly
A.Definition: A monopolist is a firm that is the only producer of a good that
has no close substitutes. When an industry is controlled by a monopolist, it is
known as a monopoly.
B.True monopolies are hard to find in the economy because of legal
obstacles: Antitrust laws help to prevent monopolies from emerging.
C. Monopolies play an important role in some sectors of the economy, such as
pharmaceutical markets.
D.Why do monopolies exist?
1. Definition: To earn economic profits, a monopolist must be protected by a
barrier to entry, something that prevents other firms from entering the
industry.
2. The four principal types of barriers to entry are:
a.Control of a scarce resource or input.
b.Economies of scale, which exist when average total cost falls as output
increases.
i. Definition: A natural monopoly exists when economies of scale
provide a large cost advantage to a single firm that produces all of
an industry’s output.
c.Technological superiority: Monopolies can be created by network
externalities whereby the value of a good for a consumer rises as more
people use it (such as Microsoft’s Windows operating system).
d.Government-created barriers, such as patents and copyrights.
i.
Definition: A patent gives an inventor a temporary monopoly in
the use or sale of an invention.
ii.
Definition: A copyright gives the creator of a literary or artistic
work the sole right to profit from that work.
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IV. Oligopoly
A.Definition: An oligopoly is an industry with only a small number of firms. A
producer in such an industry is known as an oligopolist.
1. The number of firms determines whether or not a specific market is an
oligopoly, not the size of each firm.
2. Each oligopolist has some market power.
B.Definition: When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition.
C. The most important source of oligopoly is the existence of economies of scale,
which gives bigger producers a cost advantage over smaller ones.
D.Definition: The Herfindahl–Hirschman Index, or HHI, is the square of each
firm’s share of market sales summed over the industry. It gives a picture of the
industry market structure.
1. The more concentrated the industry, the larger the number.
2. The wide-body aircraft industry with two major players has an HHI of
5,098.
3. The retail grocery industry with eight major players has an HHI of 321.
V.Monopolistic Competition
A.Definition: Monopolistic competition is a market structure in which there
are many competing firms in an industry, each firm sells a differentiated product, and there is free entry into and exit from the industry in the long run.
B.Product differentiation plays a crucial role in monopolistic competition; it is
the way firms can enjoy some market power.
Teaching Tips
Types of Market Structure
Creating Student Interest
Ask students if they have ever played the game “Monopoly.” Most of them probably have.
Ask them to tell you the object of the game and the best strategy for winning. Chances
are several different strategies will be defended as the “best” (“buy the yellow properties,”
“buy the railroads or utilities”). Use this discussion to point out that the object of the
game is to become the only seller—a monopolist. Ask students what happens to the rent
of a property when one owner owns all the properties of the same color. Someone will
probably know that the rent on a property doubles when the owner has a monopoly for
that color block. Point out that prices increase when there is a monopoly on one color
property. Students generally become interested when you bring up the game Monopoly—
use this to create interest in how the market structure model is similar to the game.
Presenting the Material
Use the chart in text Figure 24-1 to illustrate the differences between the types of market
structure.
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introduction to market structure
Types of Market Structure
Are products differentiated?
One
How many
firms are
there?
No
Yes
Monopoly
Not applicable
Oligopoly
Few
Many
Perfect
competition
Monopolistic
competition
Give specific examples of industries that fit each classification.
Monopoly (pharmaceutical companies with drugs under patent)
Oligopoly (autos, airlines, photographic film, colas)
Monopolistic competition (fast food, retail clothing stores, sports clubs)
Perfect competition (wheat, corn, soybeans, stock market)
Perfect Competition
Creating Student Interest
Have students imagine that they have decided to help pay for their summer school
tuition by growing tomatoes in their back yard and selling them at the nearby farmers’
market. Ask the students if they think the venture will be successful, and why. Do the
students think they are capable of starting this kind of business and what would they
need to do in order to start? Will they be able to leave the business when school starts in
the Fall? How much will they charge for their tomatoes (the going rate at the farmers’
market), how many other producers will there be in the market and how much market
power will each have (probably many producers each with a small share of the market),
will their tomatoes be different from others’ tomatoes (homegrown tomatoes are basically the same product)? Use this discussion to get students thinking about operating in
a competitive market and set up the discussion of the characteristics of perfect competition. You can return to this example as you go through the rest of this section on perfect
competition.
Presenting the Material
Start by explaining the concept of a market structure and present market structures as a
spectrum, with monopoly on one end and perfect competition on the other end. Remind
students that a model is a representation of reality. The market structures studied in
economics are representations of the way a type of industry will behave. Each market
structure assumes certain characteristics about the environment in which firms operate
(for example, the number and size of firms, firms’ ability to control price, entry and
exit). In the real world, not all industries will fall clearly into one market structure—they
lie somewhere on the spectrum. As an example, looking at the number of firms in an
industry, the smallest number is 1 (because with 0, the industry does not exist). If you
ask students to name the market structure characterized by one firm, they usually know
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it is called a monopoly. They also generally figure out that an industry with two firms is a
duopoly (though they might guess it is called a biopoly). If you tell them that “oli” means
“few”, they can figure out that an industry with a few firms is an oligopoly. When there
are many firms competing in an industry, they will know it is competition (you can add
the “perfect”). And monopolistic competition becomes easy to see when it is shown as
falling between monopoly and competition. You can use the diagram below to show the
spectrum and add the market structure models as the discussion progresses.
Monopoly Duopoly Oligopoly
M.C.
Perfect competition
When considering perfect competition, some students may be skeptical that such a market structure exists. As is generally the case with perfection, perfect competition is hard
to find in the real world. Some would argue that no industry is truly perfectly competitive. Emphasize that it is nevertheless important to study the perfect competition model.
Explain that, just as perfect competition can lead to several beneficial and important
results (which will come to light as you study the model), market structures on the
other end of the spectrum can have certain drawbacks. Therefore, we are interested in
seeing how close to perfect competition an industry can come, and in preventing movement toward the other end of the spectrum. So economists (and economics students)
study the perfect competition model as an “ideal” to use as a benchmark for evaluating
industries in the real world.
Introduce the characteristics of perfect competition and give a few examples of industries
that fit this structure.
Market Structure:
Perfect Competition
1. Many sellers, each with a small market share
2. Consumers see all the products in the market as identical
3. Easy entry and exit of firms
Examples:
Agricultural markets such as dairy farming, organic tomato farming
Monopoly
Creating Student Interest
Ask students if they can think of any cases where only one firm sells a good. Next ask
them why they think only one firm is selling the good. You may suggest cases such as one
gas station in a small town (there is not enough demand to support two) or a bottle of
water at the airport (you have no choice but to buy from the airport once you pass security). Note that in both of these cases the good itself (gas or bottled water) is produced
and sold by other firms but in a different location. The gas station in a small town and
the seller of bottled water at the airport have monopoly power.
Ask students whether the college bookstore has a monopoly on textbooks. Tell them
about how the bookstore worked for previous generations (was your bookstore a
monopoly?). What changes in recent years have affected the market power of the college
bookstore in the market for textbooks? (Online sources, laws that require bookstores to
release textbook requirements before the start of the semester)
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Presenting the Material
This module introduces and defines the four basic types of market structure. Students
will have heard of monopoly before and may be aware that monopoly is illegal. You can
tell them that, in general, total surplus is reduced when there is only one firm controlling
production in the industry, and then leave the details for later. Take some time to talk
generally about the different reasons why monopoly exists, keeping in mind some of the
details will have to wait for later modules. Oliogopoly
Creating Student Interest
To introduce the basic characteristics of oligopoly (a few sellers selling either a homogeneous or differentiated good in a market with some barriers to entry), pose the following
scenario to students. A friend who enjoys cooking and chemistry has been experimenting
in his kitchen and has come up with a recipe for a cola drink. He has let many of his
friends try his cola drink, and he has put it in a blind taste test against the two major cola
brands. His friends all say his cola drink is better than either of the two major brands. Is
it possible your friend could market his cola drink and compete with the major brands?
The general consensus should be that although it would be relatively easy for your friend
to produce and bottle his cola drink, trying to get it distributed and marketed would
prove to be very challenging.
Presenting the Material
Oligopoly is defined as a market with only a “few” sellers, but “few” is not well-defined.
Present the Herfindahl–Hirschman index as one method of determining whether an
industry is an oligopoly. The second method is to look at the market share of the four
largest firms. If the four largest firms control a sizeable percentage of the market, then
the industry is more likely to be an oligopoly. Some examples of industries to discuss
would be soft drinks, chocolate, package delivery, and automobile production. In addition, any relatively isolated town with only two or three firms in the industry can behave
as an oligopoly.
Monopolistic Competition
Creating Student Interest
Ask students to name markets that might be considered monopolistic competition. For
each example considered, discuss the number of firms, the type of product, and evidence
of entry and exit.
Presenting the Material
Make clear that the most important feature of monopolistic competition is many sellers,
which makes it clearly different from monopoly. Give some examples of markets that
fit this type of market structure: cosmetics, fast food, retail clothing stores, restaurants,
coffee houses, hair salons, and nail salons.
If you want to discuss fast food, have students name as many fast-food restaurants as
they can (they do not all have to be burger places). You will find the list rather long. The
following link has a list of the top 50 fast-food restaurants in terms of sales: http://www.
qsrmagazine.com/reports/qsr50-2012-top-50-chart.
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Case Studies in the Text
Economics in Action
What’s a Standardized Product?—This EIA explains what it means for a product to be
“standardized.” The definition of a standardized product is contrasted with the definition
of a differentiated product.
Activities
Classifying Markets (2–3 minutes)
Ask students to classify the following products as being in monopoly, oligopoly, monopolistically competitive, or perfectly competitive industries.
Rental car companies (oligopoly)
Bottled water (monopolistic competition)
College-ruled notebook paper (perfect competition)
Blue jeans (monopolistic competition)
Airline company (oligopoly)
Sugar (perfect competition)
Electricity (monopoly)
Best-selling novel (monopoly)
To expand the activity ask them to explain why each good is classified the way it is. Note
that you may get some disagreement among your students. Some, for example, may not
care about their brand of bottled water.