Welcome to Competitive and Concentrated Markets!

Hello! This chapter is where we explore how businesses behave and how that behaviour affects you, the consumer. We'll look at everything from tiny local markets with hundreds of competing firms to huge industries dominated by a single giant company.

Understanding the structure of a market—how many firms there are and how easily they can enter—tells us a lot about prices, innovation, and whether resources are being used efficiently. Don't worry if some of the terms sound tricky; we will break them down into simple, manageable pieces!

Section 1: How We Categorize Markets (Market Structures)

The economy is full of different types of markets. Economists place them along a spectrum, ranging from highly competitive (like a fruit stall market) to highly concentrated (like a utility company).

1.1 Distinguishing Market Structures (3.1.4.1, 3.3.3.1)

We use three main factors to distinguish between different market structures:

  • Number of Firms: Are there thousands, a handful, or just one?
  • Degree of Product Differentiation: Are all the goods exactly the same (homogeneous) or are they slightly different (heterogeneous)?
  • Ease of Entry and Exit (Barriers to Entry): How easy is it for a new firm to start selling in the market?

The Market Spectrum:
Perfect Competition (Many small firms) ← → Monopolistic Competition ← → Oligopoly ← → Pure Monopoly (One large firm)

1.2 The Objectives of Firms (3.1.4.2)

While traditional theory often assumes firms only care about maximizing profit, real-world firms have many goals.

(a) Profit Maximization

Profit is the difference between Total Revenue (TR) and Total Costs (TC). This is the most important objective for most firms.

(b) Other Key Objectives
  • Survival: Especially important for new firms or during economic downturns.
  • Growth (Increasing Market Share): Trying to grow the business, often measured by sales volume or revenue, even if it means sacrificing some short-term profit.
  • Maximising Sales Revenue: Selling as much as possible, often because managers' bonuses are tied to sales figures rather than pure profit.
  • Satisficing: Managers might not aim for maximum profit, but rather seek a "good enough" level of profit to keep shareholders happy, giving themselves time to focus on other objectives (like work-life balance or personal goals). This links to the idea of the divorce of ownership from control, where owners (shareholders) want high profits, but managers (who control daily operations) may have other priorities.

Key Takeaway: Market structure is defined by three things: number of firms, differentiation, and barriers to entry. Firm objectives are varied, but profit and growth are usually top priorities.

Section 2: Highly Competitive Markets

2.1 Perfect Competition (PC) (3.1.4.3, 3.3.3.2)

Perfect competition is a theoretical benchmark—it rarely exists in its purest form, but understanding it helps us judge other markets. Think of a farmer's market where everyone sells identical tomatoes.

Characteristics of Perfect Competition:
  1. Many Buyers and Sellers: So many that no single firm can influence the market price.
  2. Homogeneous Products: Every unit of the good is identical (e.g., basic wheat, unbranded rice).
  3. Perfect Knowledge: Buyers and sellers know everything about the market (prices, quality, etc.).
  4. Freedom of Entry and Exit (No Barriers): It is easy and cheap to start or stop selling in the market.
The Firm as a Price Taker

Because the product is identical and there are so many competitors, a perfectly competitive firm must accept the price determined by the whole industry's demand and supply interaction.

  • Analogy: If a wheat farmer tries to sell his wheat for even a penny more than the market price, everyone will buy from the farm next door. They are a price taker.
Profits in PC

Due to the freedom of entry, firms can only make normal profit in the long run.

  • If firms make high profits (abnormal/supernormal profit) in the short run, new firms will rush into the market (no barriers).
  • This increase in supply drives the market price down until profits return to normal.
  • In the long run, profits are therefore likely to be lower in competitive markets than in concentrated markets.

2.2 The Efficiency of PC

When certain assumptions (like the absence of externalities) hold, perfect competition results in an efficient allocation of resources.

  • Allocative Efficiency: This occurs when the price (P) charged reflects the marginal cost (MC) of production. This means resources are distributed optimally according to consumer preferences. \(\text{P} = \text{MC}\)
  • Productive Efficiency: This occurs when the firm produces at the lowest point of its average cost (AC) curve. \(\text{P} = \text{Minimum AC}\)

Did you know? Because perfectly competitive firms are forced to produce at the lowest possible cost (Productive Efficiency) and charge a price that reflects the true cost to society (Allocative Efficiency), it is often used as the "ideal" yardstick against which real-world markets are judged.

Quick Review: PC firms are price takers. High competition and zero entry barriers mean long-run profits are only normal, but efficiency (allocative and productive) is achieved.

Section 3: Monopoly and Market Concentration

At the opposite end of the spectrum are markets dominated by one or very few firms.

3.1 Monopoly Power (3.1.4.4, 3.3.3.5)

It is important to distinguish between two concepts:

  • Pure Monopoly: Only one firm exists in the market (e.g., a single provider of water services in a small town). These are rare.
  • Monopoly Power: A firm possesses the ability to set prices or restrict output, even if it is not the only seller. This is much more common.
Factors Influencing Monopoly Power:

The more powerful a firm is, the less elastic the demand curve it faces. Power comes from:

  1. High Barriers to Entry: The main source of power. These might be legal (patents), technical (huge startup costs), or strategic (control over raw materials).
  2. Number of Competitors: Fewer competitors mean more power.
  3. Product Differentiation/Advertising: Successful advertising creates strong brand loyalty (e.g., Apple), making it harder for competitors to steal customers.
Measuring Concentration: Concentration Ratios

We measure how much monopoly power exists in an industry using concentration ratios.

  • A 4-firm concentration ratio (CR4) measures the total market share held by the four largest firms.
  • Example: If Firm A has 30%, B has 20%, C has 10%, and D has 5%, the CR4 is \(30 + 20 + 10 + 5 = 65\%\). A high CR4 suggests a concentrated, less competitive market.

3.2 The Case Against Monopoly (Disadvantages)

The basic model of monopoly suggests they harm consumers and efficiency:

  1. Higher Prices and Lower Output: Monopolists are price makers. They restrict output to charge a higher price than in a competitive market.
  2. Inefficiency and Misallocation:
    • Monopolists often fail the conditions for static efficiency (P > MC and P > Min AC).
    • They may suffer from X-inefficiency: a lack of competitive pressure leads to complacency and higher costs than necessary.
  3. Welfare Loss (Deadweight Loss): Because the monopolist restricts output and charges a higher price, some transactions that would have benefited both consumers and society do not happen. This loss of economic welfare is called the deadweight loss.
  4. Consumer Exploitation: High prices and poor quality service, as consumers have few alternatives.

3.3 Potential Benefits of Monopoly

Monopolies aren't always evil! They can sometimes be beneficial, especially large ones that benefit from huge production scale.

  • Economies of Scale (EoS): Monopolies can produce on a very large scale, achieving very low long-run average costs (LRAC). This EoS can sometimes be passed on to consumers as lower prices (or justify high profits necessary for R&D).
  • Invention and Innovation (Dynamic Efficiency): Because monopolists earn high supernormal profits, they have the financial resources and the incentive (to maintain their dominance) to invest heavily in Research and Development (R&D). This leads to new products and better technology, improving dynamic efficiency over time.
  • Natural Monopoly: In industries where competition is inefficient (e.g., utilities like water pipes or electricity grids), one large firm operating on a massive scale (using EoS) can supply the entire market at a lower average cost than multiple competing firms.

Common Mistake to Avoid: Don't assume monopolies always charge the highest price possible. They charge the price that maximises profit, which is often lower than the absolute highest price, because they need to sell some output.

Section 4: The Middle Ground (Imperfect Competition)

Most real-world markets fall between PC and Monopoly.

4.1 Monopolistic Competition (MC) (3.3.3.3)

Think of the market for local hairdressers, restaurants, or clothing stores.

Characteristics:
  1. Many Firms: Many sellers, but fewer than PC.
  2. Differentiated Products: Products are similar but slightly different (e.g., one cafe has better coffee; another has faster Wi-Fi). This gives firms a tiny bit of monopoly power (the price maker).
  3. Low Barriers to Entry/Exit: Relatively easy for new firms to start up.
Non-Price Competition in MC

Because firms sell differentiated products, they compete fiercely using non-price competition (advertising, better service, location, freebies) rather than just lowering the price. This strengthens their small amount of monopoly power and benefits consumers through choice and quality improvement.

In the long run, because barriers to entry are low, supernormal profits attract new firms, driving profits down to normal profit (just like in PC).

4.2 Oligopoly (3.3.3.4)

An oligopoly is dominated by a few large firms. Think of the global soft drink market (Coke, Pepsi) or national mobile phone networks.

Characteristics:
  1. Few Large Firms: A high concentration ratio (CR).
  2. High Barriers to Entry: Difficult for new firms to join (e.g., requiring huge amounts of capital investment).
  3. Interdependence: This is the most crucial characteristic. Because there are only a few major players, the actions of one firm (like cutting prices) directly and significantly affect the others.
The Significance of Interdependence and Uncertainty

Firms in an oligopoly must constantly second-guess their rivals. This leads to two possible behaviours:

A. Competitive Oligopoly:

  • Price Wars: Firms aggressively cut prices, which may temporarily benefit consumers but often destroys profits for all firms.
  • Non-Price Competition: Heavy spending on advertising, branding, R&D, and improved quality to avoid destructive price wars.

B. Collusive Oligopoly (Collusion and Cartels):

  • Firms may decide to cooperate rather than compete. Collusion is an agreement (formal or informal) to limit competition, usually by fixing prices or market shares, to maximize joint profits (acting like a monopoly).
  • Overt Collusion (or a Cartel) is a formal, illegal agreement (e.g., OPEC setting oil quotas).
  • Tacit Collusion is an informal, unwritten understanding, often achieved through Price Leadership (where one dominant firm sets the price, and others follow).
The Kinked Demand Curve Model

This model helps illustrate interdependence.

  • The logic: If a firm raises its price, rivals will not follow (they want to steal market share). So, demand is elastic (many consumers leave).
  • If a firm cuts its price, rivals will follow (to avoid losing market share). So, demand is inelastic (sales volume barely increases).
  • This creates a "kink" in the demand curve, explaining why firms in an oligopoly are often reluctant to change prices and rely instead on non-price competition.

Key Takeaway: MC is defined by differentiation and low barriers (leads to normal profits). Oligopoly is defined by interdependence, which forces firms to choose between competing (often via non-price) or colluding.

Section 5: Special Concepts in Competition and Monopoly

5.1 Price Discrimination (3.3.3.6)

This is when a firm charges different prices for the same good or service to different groups of consumers, where the difference is not due to cost differences.

Third-Degree Price Discrimination

This is the most common type (e.g., student discounts, peak vs. off-peak train tickets, different country pricing for software).

Conditions Necessary:
  1. Monopoly Power: The firm must be a price maker.
  2. Market Separation: The firm must be able to keep the markets separate (e.g., checking student IDs).
  3. Differing Price Elasticity of Demand (PED): Consumers in the different markets must have different sensitivity to price. The firm charges a higher price in the market with more inelastic demand (those willing to pay more) and a lower price in the market with more elastic demand.

Welfare Effect: Discrimination can be beneficial if it allows firms to serve customers who might otherwise be priced out of the market (e.g., lower student prices). However, it can also lead to higher profits for the firm, diverting consumer surplus into producer surplus.

5.2 Contestable Markets (3.3.3.7)

A market is contestable if there is a low threat of entry from potential competitors, even if there are few actual firms currently selling.

Significance of Contestability

If a monopolist or oligopolist knows a new firm can easily enter and steal their customers, they will behave more competitively (keeping prices low and costs down) to deter that entry.

Sunk Costs and Hit-and-Run Competition
  • Sunk Costs: These are costs that cannot be recovered if a firm exits the market (e.g., specialized advertising costs, installing specific rail tracks). High sunk costs act as a major barrier to entry, reducing contestability.
  • Hit-and-Run Competition: If sunk costs are zero, a new firm can enter, charge low prices, make a quick profit (hit), and then leave easily (run) if incumbent firms react aggressively. This threat forces existing firms to behave efficiently.

5.3 The Dynamics of Competition and Creative Destruction (3.3.3.8)

Competition is not just a snapshot in time; it's a dynamic process that evolves over the long run.

  • Firms constantly compete not just on price, but also by striving to improve products, reduce costs, and improve service quality.
  • This process is called Creative Destruction (coined by economist Joseph Schumpeter). It means that old, inefficient firms and outdated technologies are constantly swept away and replaced by newer, innovative firms.
  • Example: The rise of digital streaming (Netflix) destroyed the older video rental industry (Blockbuster). This innovation improves efficiency and benefits consumers in the long run.

Section 6: Efficiency and Policy

6.1 Defining Static and Dynamic Efficiency (3.3.3.9)

Economists use different measures to assess how well a market structure performs:

  • Static Efficiency: Efficiency measured at a single point in time.
    • Allocative Efficiency (P = MC): Resources are allocated to reflect consumer preferences.
    • Productive Efficiency (Minimum AC): Producing at the lowest possible cost.
  • Dynamic Efficiency: Efficiency measured over time, relating to investment in R&D and technological progress. This leads to product and process innovation.
  • X-Inefficiency: Occurs when a firm lacks competitive pressure, leading to unnecessary organizational slack and higher costs than optimal.

6.2 Consumer and Producer Surplus (3.3.3.10)

These concepts help us measure the welfare (happiness/benefit) gained from market transactions.

  • Consumer Surplus (CS): The difference between the price consumers are willing to pay for a good and the price they actually pay.
  • Producer Surplus (PS): The difference between the price producers receive and the minimum price they were willing to accept.
  • Deadweight Loss (DWL): The net loss of total welfare (CS + PS) that results from market inefficiencies, such as the output restriction caused by a monopoly. This loss benefits neither the consumer nor the producer—it is a societal waste.

6.3 Competition Policy and Regulation (3.3.3.11, 3.3.3.12)

Governments intervene to prevent firms from abusing their power or to promote competitive outcomes.

Tools of Competition Policy:
  1. Abuse of Monopoly Power: Stopping anti-competitive practices like predatory pricing (setting prices below cost to drive out rivals).
  2. Regulation of Mergers and Takeovers: Investigating and blocking large mergers that might lead to excessive market concentration and higher prices.
  3. Reducing Entry Barriers: Measures like deregulation (removing unnecessary rules) and promoting innovation.
  4. Price and Profit Controls: Direct control over how much firms (especially natural monopolies like utility companies) can charge or how much profit they can earn.
Public Ownership, Privatisation, and Regulation
  • Privatisation: Selling state-owned enterprises (SOEs) to the private sector. The argument is that competition and profit incentives increase efficiency.
  • Regulation: The use of rules and government agencies to influence firm behaviour (e.g., environmental standards, price caps).
  • Regulatory Capture: A major risk of regulation. This occurs when a regulatory body, intended to act in the public interest, instead acts in the interests of the firm or industry it is supposed to be regulating (perhaps because staff often move between the regulator and the regulated firms).

Final Takeaway: Competitive markets tend to achieve static efficiency (P=MC, Min AC), but monopolies are better placed to achieve dynamic efficiency through R&D. Competition policy is essential for mitigating the disadvantages of concentrated markets.