Market structure summary

Summary on Market Structures suitable for H2 JC Economics tuition in Singapore

Market structure is best defined as the organisational and other characteristics of a market. We focus on those characteristics which affect the nature of competition and pricing – but it is important not to place too much emphasis simply on the market share of the existing firms in an industry.

Traditionally, the most important features of market structure are:

The number of firms (including the scale and extent of foreign competition)

The market share of the largest firms (measured by the concentration ratio – see below)

The nature of costs (including the potential for firms to exploit economies of scale and also the presence of sunk costs which affects market contestability in the long term)

The degree to which the industry is vertically integrated – vertical integration explains the process by which different stages in production and distribution of a product are under the ownership and control of a single enterprise. A good example of vertical integration is the oil industry, where the major oil companies own the rights to extract from oilfields, they run a fleet of tankers, operate refineries and have control of sales at their own filling stations.

The extent of product differentiation (which affects cross-price elasticity of demand)

The structure of buyers in the industry (including the possibility of monopsony power)

The turnover of customers (sometimes known as “market churn”) – i.e. how many customers are prepared to switch their supplier over a given time period when market conditions change. The rate of customer churn is affected by the degree of consumer or brand loyalty and the influence of persuasive advertising and marketing

Characteristic

Perfect Competition

Oligopoly

Monopoly

Contestable Market

Number of firms

Many

Few dominant firms

One with pure monopoly Effective duopoly in many cases

Many

Type of product

Homogenous

Differentiated

Limited

Differentiated

Barriers to entry

None

High

High

Low entry and exit costs

Supernormal short run profit

ü

ü

ü

Any profit possible

Supernormal long run profit

û

ü

ü

Supernormal invites hit and run entry

Pricing power

Price taker (passive)

Price maker but interdependent behaviour

Price maker – constrained by demand curve and possible regulation

Price maker – but actual and potential competition limits pricing power

Non price competition

û

ü (important)

ü

ü (important)

Economic efficiency

High

Low allocative but scale economies and innovation

Low allocative but economies of scale and reinvested profits Risk of X-inefficiency due to lack of competition

High – depending on strength of contestability

Innovative behaviour

Weak

Very Strong

Potentially strong

Strong

Market structure and innovation

Which market conditions are optimal for effective and sustained innovation to occur? This is a question that has vexed economists and business academics for many years.

High levels of research and development spending are frequently observed in oligopolistic markets, although this does not always translate itself into a fast pace of innovation.

“As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position…But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition which commands a decisive cost or quality advantage and which strikes not at the margins of profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door”

Supernormal profits persist in the long run in an oligopoly and these can be used to finance research and development.

Perfect Competition – Economics of Competitive Markets

Perfect competition – a pure market

Perfect competition describes a market structure whose assumptions are strong and therefore unlikely to exist in most real-world markets. Economists have become more interested in pure competition partly because of the growth of e-commerce as a means of buying and selling goods and services. And also because of the popularity of auctions as a device for allocating scarce resources among competing ends.

Assumptions for a perfectly competitive market

  • Many sellers each of whom produce a low percentage of market output and cannot influence the prevailing market price.
  • Many individual buyers, none has any control over the market price
  • Perfect freedom of entry and exit from the industry. Firms face no sunk costs and entry and exit from the market is feasible in the long run. This assumption means that all firms in a perfectly competitive market make normal profits in the long run.
  • Homogeneous products are supplied to the markets that are perfect substitutes. This leads to each firms being “price takers” with a perfectly elastic demand curve for their product.
  • Perfect knowledge – consumers have all readily available information about prices and products from competing suppliers and can access this at zero cost – in other words, there are few transactions costs involved in searching for the required information about prices. Likewise sellers have perfect knowledge about their competitors.
  • Perfectly mobile factors of production – land, labour and capital can be switched in response to changing market conditions, prices and incentives.
  • No externalities arising from production and/or consumption.

Evaluation – Understanding the real world of imperfect competition!

It is often said that perfect competition is a market structure that belongs to out-dated textbooks and is not worthy of study! Clearly the assumptions of pure competition do not hold in the vast majority of real-world markets, for example, some suppliers may exert control over the amount of goods and services supplied and exploit their monopoly power.

On the demand-side, some consumers may have monopsony power against their suppliers because they purchase a high percentage of total demand. Think for example about the buying power wielded by the major supermarkets when it comes to sourcing food and drink from food processing businesses and farmers. The Competition Commission has recently been involved in lengthy and detailed investigations into the market power of the major supermarkets.

In addition, there are nearly always some barriers to the contestability of a market and far from being homogeneous; most markets are full of heterogeneous products due to product differentiation – in other words, products are made different to attract separate groups of consumers.

Consumers have imperfect information and their preferences and choices can be influenced by the effects of persuasive marketing and advertising. In every industry we can find examples ofasymmetric information where the seller knows more about quality of good than buyer – a frequently quoted example is the market for second-hand cars! The real world is one in which negative and positive externalities from both production and consumption are numerous – both of which can lead to a divergence between private and social costs and benefits. Finally there may be imperfect competition in related markets such as the market for key raw materials, labour and capital goods.

Adding all of these points together, it seems that we can come close to a world of perfect competition but in practice there are nearly always barriers to pure competition. That said there are examples of markets which are highly competitive and which display many, if not all, of the requirements needed for perfect competition. In the example below we look at the global market for currencies.

Currency markets – taking us closer to perfect competition

  • The global foreign exchange market is where all buying and selling of world currencies takes place. There is 24-hour trading, 5 days a week.
  • Trading volume in the Forex market is around $3 trillion per day – equivalent to the annual GDP of France! 31% of global trading takes place in London alone.
  • Most trading in currencies is ‘speculative.’

The main players in the currency markets are as follows:

  • Banks both as “market makers” dealing in currencies and also as end-users demanding currency for their own operations.
  • Hedge funds and other institutions (e.g. funds invested by asset managers, pension funds).
  • Central Banks (including occasional currency intervention in the market when they buy and sell to manipulate an exchange rate in a particular direction).
  • Corporations (for example airlines and energy companies who may use the currency market for defensive ‘hedging’ of exposures to risk such as volatile oil and gas prices.)
  • Private investors and people remitting money earned overseas to their country of origin / market speculators trading in currencies for their own gain / tourists going on holiday and people traveling around the world on business.

Why does a currency market come close to perfect competition?

  • Homogenous output: The “goods” traded in the foreign exchange markets are homogenous – a US dollar is a dollar and a euro is a euro whether someone is trading it in London, New York or Tokyo.
  • Many buyers and sellers meet openly to determine prices: There are large numbers of buyers and sellers – each of the major banks has a foreign exchange trading floor which helps to “make the market”. Indeed there are so many sellers operating around the world that the currency exchanges are open for business twenty-four hours a day. No one agent in the currency market can, on their own influence price on a persistent basis – all are ‘price takers’. According to Forex_Broker.net “The intensity and quantity of buyers and sellers ready for deals doesn’t allow separate big participants to move the market in joint effort in their own interests on a long-term basis.”
  • Currency values are determined solely by market demand and supply factors.
  • High quality real-time information and low transactions costs: Most buyers or sellers are well informed with access to real-time market information and background research analysis on the factors driving the prices of each individual currency. Technological progress has made more information immediately available at a fraction of the cost of just a few years ago. This is not to say that information is cheap – an annual subscription to a Bloomberg or a Reuter’s news terminal will cost several thousand dollars. But the market is rich with information and transactions costs for each batch of currency bought and sold has come down.
  • Seeking the best price: The buyers and sellers in foreign exchange only deal with those who offer the best prices. Technology allows them to find the best price quickly.

What are the limitations of currency trading as an example of a competitive market?

  • Firstly the market can be influenced by official intervention via buying and selling of currencies by governments or central banks operating on their behalf. There is a huge debate about the actual impact of intervention by policy-makers in the currency markets.
  • Secondly there are high fixed costs involved in a bank or other financial institution when establishing a new trading platform for currencies. They need the capital equipment to trade effectively; the skilled labour to employ as currency traders and researchers. Some of these costs may be counted as sunk costs – hard to recover if a decision is made to leave the market.

Despite these limitations, the foreign currency markets take us reasonably close to a world of perfect competition. Much the same can be said for trading in the equities and bond markets and also the ever expanding range of future markets for financial investments and internationally traded commodities. Other examples of competitive markets can be found on a local scale – for example a local farmers’ market where there might be a number of farmers offering their produce for sale.

The internet and perfect competition

  • Advances in web technology have made markets more competitive. It has reduced barriers to entryfor firms wanting to compete with well-established businesses – for example specialist toy retailers are better able to battle for market share with the dominant retailers such as ToysRUs and Wal-Mart.
  • One of the most important aspects of the internet is the ability of consumers to find information about prices for many goods and services. There are an enormous number of price comparison sitesin the UK covering everything from digital cameras to package holidays, car insurance to CDs and jewellery.
  • That said the price comparison web sites themselves have come under criticism. For example the sites offering to compare hundreds of different motor insurance policies or mortgage products draw information from the insurance and mortgage brokers but might use limiting assumptions about the different types of consumers looking for the best price – the result is a range of prices facing the consumer that don’t accurately reflect their precise needs – and consumers may only realise this when, for example, they make a claim on an insurance policy bought over the internet which turns out not to provide the specific cover they needed.
  • And in the market for price comparison sites there is monopoly power too! Moneysupermarket.com currently has around 40% of the overall comparison site market, with Confused.com its nearest rival with a share of about 10%.

Price and output in the short run under perfect competition

Price and output in the short run under perfect competition

  • In the short run, the interaction between demand and supply determines the “market-clearing” price. A price P1 is established and output Q1 is produced. This price is taken by each firm. The average revenue curve is their individual demand curve.
  • Since the market price is constant for each unit sold, the AR curve also becomes the marginal revenue curve (MR) for a firm in perfect competition.
  • For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example is making abnormal (economic) profits.
  • This is not necessarily the case for all firms in the industry since it depends on the position of their short run cost curves. Some firms may be experiencing sub-normal profits if average costs exceed the price – and total costs will be greater than total revenue.

The adjustment to the long-run equilibrium in perfect competition

  • If most firms are making abnormal profits in the short run, this encourages the entry of new firms into the industry
  • This will cause an outward shift in market supply forcing down the price
  • The increase in supply will eventually reduce the price until price = long run average cost. At this point, each firm in the industry is making normal profit.
  • Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. This is shown in the next diagram.

We are assuming in the diagram above that there has been no shift in market demand.

  • The effect of increased supply is to force down the price and cause an expansion along the market demand curve.
  • But for each supplier, the price they “take” is now lower and it is this that drives down the level of profit made towards normal profit equilibrium.

In an exam question you may be asked to trace and analyse what might happen if

  • There was a change in market demand (e.g. arising from changes in the relative prices of substitute products or complements.)
  • There was a cost-reducing innovation affecting all firms in the market or an external shock that increases the variable costs of all producers.

Adam Smith on Competition  “The natural price or the price of free competition … is the lowest which can be taken. [It] is the lowest which the sellers can commonly afford to take, and at the same time continue their business.” Source: Adam Smith, the Wealth of Nations (1776), Book I, Chapter VII

Characteristics of competitive markets

The common characteristics of markets that are considered to be “competitive” are:

  • Lower prices because of many competing firms. The cross-price elasticity of demand for one product will be high suggesting that consumers are prepared to switch their demand to the most competitively priced products in the marketplace.
  • Low barriers to entry – the entry of new firms provides competition and ensures prices are kept low in the long run.
  • Lower total profits and profit margins than in markets which dominated by a few firms.
  • Greater entrepreneurial activity – the Austrian school of economics argues that competition is aprocess. For competition to be improved and sustained there needs to be a genuine desire on behalf of entrepreneurs to innovate and to invent to drive markets forward and create what Joseph Schumpeter called the “gales of creative destruction”.
  • Economic efficiency – competition will ensure that firms move towards productive efficiency. The threat of competition should lead to a faster rate of technological diffusion, as firms have to be responsive to the changing needs of consumers. This is known as dynamic efficiency.

The importance of non-price competition

In competitive markets, non-price competition can be crucial in winning sales and protecting or enhancing market share.

Perfect competition and efficiency

Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency.

  1. Allocative efficiencyIn both the short and long run we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved. At the ruling price, consumer and producer surplus are maximised. No one can be made better off without making some other agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.
  2. Productive efficiency: Productive efficiency occurs when the equilibrium output is supplied at minimum average cost. This is attained in the long run for a competitive market. Firms with high unit costs may not be able to justify remaining in the industry as the market price is driven down by the forces of competition.
  3. Dynamic efficiency: We assume that a perfectly competitive market produces homogeneous products – in other words, there is little scope for innovation designed purely to make products differentiated from each other and allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power.

Some economists claim that perfect competition is not a good market structure for high levels of research and development spending and the resulting product and process innovations. Indeed it may be the case that monopolistic or oligopolistic markets are more effective long term in creating the environment for research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption of perfect information, be immediately and without cost transferred to all of the other suppliers.

That said a contestable market provides the discipline on firms to keep their costs under control, to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and enjoying high profit margins. In this sense, competition can stimulate improvements in bothstatic and dynamic efficiency over time.

The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold – including in related markets. When the assumptions are dropped, we move into a world of imperfect competition with all of the potential that exists for various forms of market failure

Monopolistic Competition

What is Monopolistic Competition (MC)?

  • For a MC to exist there must be low barriers to entry and exit so that new suppliers can come into a market to provide fresh competition.
  • For a perfectly competitive market, entry into and exit out must be costless
  • No market is perfectly competitive but virtually every market is contestable to some degree even when it appears that the monopoly position of a dominant seller is unassailable.
  • This can have implications for the behaviour (conduct) of existing firms and then affects theperformance of a market in terms of allocative, productive and dynamic efficiency.
  • An MC environment is common in most industries – here is an example relating to the main competitors for Costa Coffee

Difference between Monopolistic Competition and Perfect Competition MC are different from PC markets. For example, it is feasible in a MC for one firm to have price-setting power and for firms in a market to produce a differentiated product. There are three main conditions for pure market contestability:

  • Perfect information and the ability and/or the right of all suppliers to make use of the best available production technology in the market.
  • The freedom to market / advertise and enter a market with a competing product.
  • The absence of sunk costs – this reduces the risks of coming into a market.

Sunk Costs – a Barrier to Contestability

Barriers to market contestability exist when there are sunk costs i.e. costs that have been committed by a business cannot be recovered once a firm has entered the industry.

Increasing Contestability of Markets

One feature of the Singapore economy in recent years has been an increase in the number of markets and industries that are genuinely contestable.

Several factors explain this development:

Entrepreneurial zeal: It is often the case that markets become more competitive because of thepersistence of entrepreneurs who simply do not accept that the existing market structure is a given. A new supplier may have the advantage of product innovation or a more competitive business modelbased on different pricing strategies.

The recession – an economic downturn can have the effect of opening up markets to new businesses.

De-regulation of markets – De-regulation involves the opening up of markets to competition by reducing some of the statutory barriers to entry that exist. Good examples of deregulation include the liberalisation of telecommunications (Singtel, M1, Starhub but this is still an oligopoly not MC)(Another good example is JC Economics tuition in Singapore. How is is an MC?)

Competition PolicyTougher competition laws acting against predatory behaviour by existing firms are designed to make markets more contestable. 

Technological Change: New technology has brought down some of the entry costs in some markets leading to an increase in capital mobility.  A huge investment in open source software is changing the contestability of the market for web browsers; there is no fierce competition between Microsoft’s Internet Explorer, Chrome and Android (Google), Firefox (Mozilla) and Safari (Apple).

 

Technological spill-over can see the emergence of products that imitate the characteristics of the products of the incumbent firms. Just a few years after the launch of Viagra, the anti-impotence drug, Levitra, the first market rival to the hugely profitable Viagra, is now being manufactured by the German firm, Bayer AG, and marketed by British firm GlaxoSmithKline.

How does the threat of competition affect a firm’s behaviour?

How might the contestability of a market affect the conduct and performance of businesses? It is worth emphasising in essays and data questions that it is the actual behaviour of agents in the market that is more important that a simple picture of market share.

In the diagram above a pure monopoly might price at P1 – the profit maximising equilibrium.

If a market is contestable, there is downward pressure on price, because the presence supernormal profits signals for new firms to enter the market and if the existing monopolist is producing at too high a price or has allowed their average total costs to drift higher, entrants can undercut the monopolist and some of the abnormal profit will be competed away.

Normal profit equilibrium occurs when average revenue equals average total cost (at output Q2 and price P2). A lower price and higher output causes an increase in consumer surplus.

When markets are contestable – we expect to see lower profit margins than when a monopoly operates without competition.

The threat of competition may be just as powerful an influence on the behaviour of the existing firms in a market than the actual entry of new businesses

If a market is contestable, industry structure and firm behaviour is determined by the threat of competition – ‘hit-and-run’ entry. The market will resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition. Once again, link to how this is similar to JC Economics tuition in Singapore.

Oligopoly – Non Collusive Behaviour

What is an oligopoly?

  • An oligopoly is an industry where there is a high level of market concentration.
  • Examples of markets that can be described as oligopolies include the markets for petrol in the UK, soft drinks producers and the high street banks. In the global market for sports footwear – 60% is held by Nike and Adidas.
  • Oligopoly is best defined by the conduct (or behaviour) of firms within a market.

The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms. A rule of thumb is that an oligopoly exists when the top five firms in the market account for more than 60% of total market sales.

Characteristics of an oligopoly

There is no single theory of price and output under oligopoly. If a price war breaks out, oligopolists may produce and price much as a highly competitive industry would; at other times they act like a puremonopoly.

An oligopoly usually exhibits the following features:

  • Product branding: Each firm in the market is selling a branded product.
  • Entry barriers: Entry barriers maintain supernormal profits for the dominant firms. It is possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on prices and output
  • Inter-dependent decision-making: Inter-dependence means that firms must take into account the likely reactions of their rivals to any change in price, output or forms of non-price competition.
  • Non-price competition: Non-price competition is a consistent feature of the competitive strategies of oligopolistic firms.

Duopoly

  • Duopoly is a form of oligopoly
  • In its purest form two firms control all of the market, but in reality the term duopoly is used to describe any market where two firms dominate with a significant market share.
  • There are many examples of duopoly
    • Coca-Cola and Pepsi (soft drinks), Unilever and Proctor & Gamble (detergents)
    • Bloomberg and Reuters (Financial information services), Sotheby’s and Christie’s (auctioneers of antiques/paintings)
    • Standard and Poor’s and Moody’s (credit rating agencies),
    • BSkyB and ESPN (live Premiership football),
    • Airbus and Boeing (aircraft manufacturers).
  • In these markets entry barriers are high although there are usually smaller players in the market surviving successfully. The high entry barriers in duopolies are usually based on one or more of the following: brand loyalty, product differentiation and huge research economies of scale.

Kinked Demand Curve Model of Oligopoly

The kinked demand curve model assumes a business might face a dual demand curve for its product based on the likely reactions of other firms to a change in its price or another variable. The common assumption is that firms in an oligopoly are looking to protect and maintain their market share and that rival firms are unlikely to match another’s price increase but may match a price fall. I.e. rival firms within an oligopoly react asymmetrically to a change in the price of another firm.

  • If a business raises price and others leave their prices constant, then we can expect quite a largesubstitution effect making demand relatively price elastic. The business would then lose market share and expect to see a fall in its total revenue.
  • If a business reduces its price but other firms follow suit, the relative price change is smaller and demand would be inelastic. Cutting prices when demand is inelastic leads to a fall in revenue with little or no effect on market share.

The kinked demand curve model makes a prediction that a business might reach a stable profit-maximising equilibrium at price P1 and output Q1 and have little incentive to alter prices.

  • The kinked demand curve model predicts there will be periods of relative price stability under an oligopoly with businesses focusing on non-price competition as a means of reinforcing their market position and increasing their supernormal profits.
  • Short-lived price wars between rival firms can still happen under the kinked demand curve model. During a price war, firms in the market are seeking to snatch a short term advantage and win over some extra market share.

Recent examples of price wars include the major UK supermarkets, price discounting of computers in China and a price war between cross channel speed ferry services. Price competition is frequently seen in the telecommunications industry.

Changes in costs using the kinked demand curve analysis

One prediction of the kinked demand curve model is that changes in variable costs might not lead to a rise or fall in the profit maximising price and output. This is shown in the next diagram where it is assumed that a rise in costs such as energy and raw material prices leads to an upward shift in the marginal cost curve from MC1 to MC2. Despite this shift, the equilibrium price and output remains at Q1. It would take another hike in costs to MC3 for the price to alter.

There is limited real-world evidence for the kinked demand curve model. The theory can be criticised for not explaining why firms start out at the equilibrium price and quantity. That said it is one possible model of how firms in an oligopoly might behave if they have to consider the likely responses of their rivals.

The importance of non-price competition under oligopoly

Oligopolistic theory predicts that firms in this market structure will tend to prefer non-price competition rather than price competition due to the self-defeating outcome of a price-war. Non-price competitioninvolves advertising and marketing strategies to increase demand and develop brand loyalty among consumers. Businesses will use other policies to increase market share:

  • Better quality of service including guaranteed delivery times for consumers and low-cost servicing agreements.
  • Longer opening hours for retailers, 24 hour online customer support.
  • Discounts on product upgrades when they become available in the market.
  • Contractual relationships with suppliers – for example the system of tied houses for pubs and contractual agreements with franchises (offering exclusive distribution agreements). For example, Apple has signed exclusive distribution agreements with T-Mobile of Germany, Orange in France and O2 in the UK for the iPhone. The agreements give Apple 10 percent of sales from phone calls and data transfers made over the devices.

 

Advertising

Advertising spending runs in millions of pounds for many firms. Some simply apply a profit maximising rule to their marketing strategies. A promotional campaign is profitable if the marginal revenue from any extra sales exceeds the cost of the advertising campaign and marginal costs of producing an increase in output. However, it is not always easy to measure accurately the incremental sales arising from a specific advertising campaign. Other businesses see advertising simply as a way of increasing sales revenue. Ifpersuasive advertising leads to an outward shift in demand, consumers are willing to pay more for each unit consumed. This increases the potential consumer surplus that a business might extract.

High spending on marketing is important for new business start-ups and for firms trying to break into an existing market where there is consumer or brand loyalty to the existing products in

Brand loyalty

A brand name is a name used to distinguish one product from its competitors. It can apply to a single product, an entire product range, or even a company (e.g. Virgin, Ferrari, Bang and Olufsen) Brand loyalty is hugely important in all kinds of industries and markets. The costs of acquiring a new customer vastly outweigh the expense of selling more to existing buyers and most of the mobile phone suppliers in this oligopolistic industry focus an enormous effort in building brand identity and brand loyalty to reduce the rate of customer churn (people who switch brands).

According to a new report, over eight in ten iPhone users said they would pick iPhone again when they replace their mobile, while 60 per cent of consumers who use smart phones running Google’s Android said they would stick with phones using the same software. Blackberry users have notably less attachment to their mobiles

When brand loyalty is strong, the cross-price elasticity of demand for price changes between two substitutes weakens and fewer consumers will switch their demand when there is a change in relative prices in the market. Robust brand loyalty makes it easier to charge premium prices and enjoy supernormal profits in the long run because loyalty is a barrier to entry.

When we become strongly attached to a brand, our purchasing decisions are more likely to stay in default mode and we may no longer even consider rival products.

Competitiveness – a key to success in an oligopoly

Traditionally, the main measures of competitiveness are in financial or marketing terms. For example, a competitive business might be expected to achieve one or more of the following:

  • A higher growth rate (sales, revenues) than competitors and the market as a whole
  • Higher-than average net profit margin (compared with others in the same industry)
  • Better than average returns on investment – again, compared with competitors
  • A high (perhaps leading) market share – measured in either value or volume terms. The leading firms in a market usually enjoy a significant proportion of the available revenues or customer demand, unless the market is highly fragmented.
  • The strongest brand reputation in the market – e.g. brand awareness
  • A clearly defined unique selling point (“USP”) that enables the business to differentiate its product or service in the eyes of customers
  • Significant access to, or control of, distribution channels in the market (e.g. products or brands that are widely stocked or demanded by intermediaries who provide distribution to the final consumers)
  • Better product quality – e.g. reliability, product features, performance
  • Better customer service – e.g. after-sales support, customer information, handling of problems & complaints
  • Better than average efficiency – e.g. being able to produce at a lower unit cost than most other competitors, either though better productivity or economies of scale
  • Faster and more effective decision-making and communication – e.g. with employees involved in customer-facing roles empowered to handle customer issues or able to pass on key market information to managerial decision-makers.
  • A more motivated and loyal workforce – which in turn should benefit productivity, efficiency, quality, customer service etc.

Monopoly & economic efficiency

The standard case against monopoly is no longer straightforward. Markets are changing all of the time and so are the conditions in which businesses must operate regardless of whether they have any noticeable market power.

When a company lowers its price, is that genuine competition that benefits consumers or an attempt to monopolise the market? If a company gains market share, is that a result of improved efficiency or merely a competitive threat in the long run? When a company develops innovative products that competitors cannot easily duplicate, is that monopolization? If several companies look to limit excess output because of difficult trading conditions – is this necessarily collusive behaviour that competition policy should look to stop?

The economic case against monopoly

  • A profit-maximising firm will produce at the productively and allocatively efficient level of output in a perfectly competitive industry
  • The conventional argument against market power is that monopolists can earn abnormal (supernormal) profits at the expense of efficiency and the welfare of consumers and society.
  • The monopoly price is assumed to be higher than both marginal and average costs leading to a loss of allocative efficiency and a failure of the market. The monopolist is extracting a price from consumers that is above the cost of resources used in making the product and, consumers’ needs and wants are not being satisfied, as the product is being under-consumed.
  • The higher average cost if there are inefficiencies in production means that the firm is not making optimum use of scarce resources. Under these conditions, there may be a case for government intervention for example through competition policy or market deregulation.

X Inefficiencies under Monopoly

  • The lack of competition may give a monopolist less incentive to invest in new ideas. Even if the monopolist benefits from economies of scale, they have little incentive to control their costs and ‘X’ inefficiencies will mean that there will be no real cost savings compared to a competitive market.
  • A competitive industry will produce in the long run where market demand = market supply. Consider the diagrams below. Equilibrium output and price is at Q1 and Pcomp on the left hand diagram and Pcomp and Q1 on the right hand diagram. At this point, Price = MC and the industry meets the conditions for allocative efficiency.
  • If the industry is taken over by a monopolist the profit-maximising point (MC=MR) is at price Pmon and output Q2. The monopolist is able to charge a higher price restrict total output and thereby reduce welfare because the rise in price to Pmon reduces consumer surplus.
  • Some of this reduction in welfare is a pure transfer to the producer through higher profits, but some of the loss is not reassigned to any other agent. This is known as the deadweight welfare loss or the social cost of monopoly and is equal to the area ABC.

A similar result is seen in the next diagram which makes the assumption of constant long-run average and marginal costs under both competition and monopoly. The deadweight loss of welfare under monopoly (whose profit maximising price is P1 and Q1) is shown by the triangle ABC. The competitive price and output is Pc and Qc respectively.

Potential Benefits from Monopoly

A high market concentration does not always signal the absence of competition; sometimes it can reflect the success of firms in providing better-quality products, more efficiently, than their rivals

One difficulty in assessing the welfare consequences of monopoly, duopoly or oligopoly lies in defining precisely what a market constitutes! In nearly every industry a market is segmented into different products, and globalization makes it difficult to gauge the degree of monopoly power.

What are the main advantages of a market dominated by a few sellers?

Economies of Scale

A monopolist might be better placed to exploit increasing returns to scale leasing to an equilibrium that gives a higher output and a lower price than under competitive conditions. This is illustrated in the next diagram, where we assume that the monopolist is able to drive marginal costs lower in the long run, finding an equilibrium output of Q2 and pricing below the competitive price.

Monopoly Profits, Research and Development and Dynamic Efficiency

  • Patents provide legal protection of an idea or process. Generic patents allow legal copying of a product.
  • As firms are able to earn abnormal profits in the long run there may be a faster rate of technological development that will reduce costs and produce better quality items for consumers.
  • Monopoly power can be good for innovation.  Despite the fact that the market leadership of firms like Microsoft, Toyota, GlaxoSmithKline and Sony is often criticised, investment in research and development can be beneficial to society because they expand the technological frontier and open new ways to prosperity. Many innovations are developed by firms with patents on ‘leading-edge’ technologies.

Baumol – Oligopoly and Innovation

William Baumol an economist from Princeton University wrote “The Free Market Innovation Machine” in which he argued that the structure that fosters productive innovation best is oligopoly. The Baumol hypothesis is that oligopolists compete by making their products differ slightly from their rivals. Highly innovative firms are often quick to license new technology or to become members of technology-sharing consortia.

Natural Monopoly

There are several interpretations of what a natural monopoly us

  1. It occurs when one large business can supply the entire market at a lower price than two or more smaller ones
  2. A natural monopoly is a situation in which there cannot be more than one efficient provider of a good. In this situation, competition might actually increase costs and prices
  3. It is an industry where the minimum efficient scale is a large share of market demand such there is room for only one firm to fully exploit all of the available internal economies of scale
  4. An industry where the long run average cost curve falls continuously as output expands
  5. Private utilities are natural monopolies in local markets

The key point is that a natural monopoly is characterized by increasing returns to scale at all levels of output – thus the long run cost per unit (LRAC) will drift lower as production expands. LRAC is falling because long run marginal cost is below LRAC. This can be illustrated in the diagram above. There may be room only for one supplier to fully exploit economies of scale, reach the minimum efficient scale and achieve productive efficiency.

Possible conflicts between economic efficiency and economic welfare It is often said that a natural monopoly raises difficult questions for competition policy because

  • On the one hand – it is more productively efficient for there to be one dominant provider of a national infrastructure e.g. a rail network or electricity generating system
  • Natural monopolies require enormous investment spending to maintain and improve the networks
  • Businesses monopoly power (huge barriers to entry) might be tempted to exploit that power by raising prices and making huge supernormal profits – damaging consumer welfare

The profit-maximizing price is P1 at an output of Q1. Price is well above the marginal cost of supply and high supernormal profits are made – but output is high too and there is still a sizeable amount ofconsumer surplus because of the internal economies of scale that have brought down the unit cost for all consumers. (We are ignoring the possibility of price discrimination here).

Options for competition policy in industries that resemble a natural monopoly

  1. Nationalization: Bringing some of these industries into state ownership
  2. Price controls by the regulatory agencies
  1. Fines for anti-competitive behaviour: In 2008 the Microsoft computer software company was fined €1.68 billion by the European Competition Commission for pre-installing its browser, Internet Explorer, on computers running the Windows operating system. In December 2009, Microsoft agreed to allow consumers to choose their web browser on setup. Removing the pre-installation of the software will mean that more firms will be able to enter the market.
  2. Introducing competition into the industry -this has been a favoured policy