Market Structures

Firms in Competitive Markets

A perfectly competitive market has three specific characteristics that distinguish it from other market structures:

1. Many Buyers and Many Sellers: There are so many participants that no single buyer or seller has any influence over the market price.
2. Identical Goods: The goods offered by the various sellers are largely the same (homogeneous). For example, a bushel of wheat from Farmer A is virtually indistinguishable from a bushel from Farmer B.
3. Free Entry and Exit: Firms can freely enter or exit the market in the long run without significant legal or financial barriers.

The Firm as a “Price Taker”

Because of these characteristics, a firm in a competitive market is a Price Taker. It takes the price as given by market conditions. If the firm tries to charge even slightly more than the market price, buyers will simply go to a competitor.

The Revenue of a Competitive Firm

This is the amount of money the firm receives for its output.

$TR = P \times Q$

This tells us how much revenue a firm receives for the typical unit sold. For all firms, average revenue equals the price of the good.

$AR = \frac{TR}{Q} = \frac{(P \times Q)}{Q} = P$

This is the change in total revenue from the sale of each additional unit. For firms in competitive markets, Marginal Revenue equals the Price ($P$) of the good. Because the firm can sell as much as it wants at the market price, every extra unit sold brings in exactly $P$ dollars.

$MR = \Delta TR / \Delta Q = P$

A firm’s primary goal is to maximize Profit, which is defined as:

$\text{Profit} = \text{Total Revenue (TR)} - \text{Total Cost (TC)}$

To find the point of maximum profit, the firm compares Marginal Revenue (MR) and Marginal Cost (MC):

• Marginal Revenue (MR): The change in total revenue from selling one additional unit. In a competitive market, $MR = P$.
• Marginal Cost (MC): The change in total cost from producing one additional unit.

The Golden Rule of Profit Maximization:

• If $MR > MC$: The firm should increase production (it adds more to revenue than to cost).
• If $MR < MC$: The firm should decrease production (the last unit cost more to make than it earned).
  • Profit is maximized where $MR = MC$.

Sometimes, a firm is better off not producing anything at all. A Shutdown refers to a short-run decision not to produce anything during a specific period because of current market conditions.

• The firm shuts down if the revenue it would get from producing is less than its variable costs.
• Mathematical Condition: Shut down if $P < AVC$ (Average Variable Cost).
• Logic: The firm still has to pay its fixed costs (like rent) whether it produces or not. If it can’t even cover its labor and materials ($AVC$), it’s better to stop production to minimize losses.

In the long run, all costs are variable. A firm will Exit the market if it cannot make a profit.

• Exit Rule: Exit if $P < ATC$ (Average Total Cost).
• Entry Rule: A new firm will enter the market if $P > ATC$ (because there is profit to be made)

Monopoly

A firm is a monopoly if it is the sole seller of its product and if its product does not have close substitutes.

$\text{Marginal Revenue} = \text{Marginal Cost} \quad (MR = MC)$

Deadweight Loss: Unlike a competitive firm, a monopoly charges a price ($P$) that is above its marginal cost ($MC$).

The Logic of Price Discrimination: For a firm to price discriminate, it must have market power and be able to separate customers based on their willingness to pay. It also must be able to prevent arbitrage (buying low in one market and reselling high in another).

Examples of Price Discrimination:

• Movie Tickets: Lower prices for children and seniors.
• Airline Prices: Lower prices for round-trip tickets that include a Saturday night stay (distinguishing leisure travelers from business travelers).
• Discount Coupons: Only people with a lower “opportunity cost of time” will take the time to clip coupons.
• Financial Aid: High tuition for wealthy families and lower net tuition (via aid) for low-income families.

Natural Monopolies (like water or electric companies) where it is more efficient to have only one firm, but the firm cannot be allowed to charge any price it wants

Monopolistic Competition

A market is Monopolistically Competitive if it has three key attributes:

1. Many Sellers: Many firms compete for the same group of customers.
2. Product Differentiation: Each firm produces a product that is at least slightly different from those of its competitors. Rather than being a price taker, each firm faces a downward-sloping demand curve.
3. Free Entry and Exit: Firms can enter or exit the market without restriction. The number of firms adjusts until economic profits are driven to zero.

In the short run, a monopolistically competitive firm follows the same rule as a monopolist:

• It chooses the quantity where Marginal Revenue = Marginal Cost ($MR = MC$).
• It uses the demand curve to find the price.
• If Price > Average Total Cost ($P > ATC$), the firm makes a profit. If $P < ATC$, it makes a loss.

If firms are making profits, new firms enter the market. This increases the number of products customers can choose from

• Zero Economic Profit: Entry and exit continue until the firms in the market are making exactly zero economic profit

Two spatial differences exist in the long run:

1. Excess Capacity: Unlike perfectly competitive firms, monopolistically competitive firms produce below the “efficient scale” (the minimum of $ATC$). They could lower costs by producing more, but they don’t because they’d have to cut prices.
2. The Markup: For these firms, Price > Marginal Cost. Because the firm has some market power, an extra unit sold at the posted price means more profit.

Because products are differentiated, firms have a natural incentive to advertise to attract more customers.

Mankiw highlights a clever theory: the content of an advertisement may be less important than its cost. By spending millions on an ad (even a silly one), a firm “signals” to consumers that its product is high quality, because only a firm with a great product would repeat-sales enough to recoup such a high expense.

Oligopoly

Because an oligopoly has only a small number of firms, the key feature is interdependence: the actions of one seller significantly affect the profits of all other sellers

Collusion and Cartels: Firms would ideally like to collude—agreeing on quantities to produce or prices to charge. A group of firms acting in unison is called a cartel.

• If they form a cartel, they effectively act as a monopoly, maximizing total profit by producing a low quantity and charging a high price.

The Equilibrium for an Oligopoly: Cartels are often unstable because each member has an incentive to “cheat” by producing slightly more to grab more profit.

The Prisoners’ Dilemma: A “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Restraint of Trade and Antitrust Laws: Governments use laws (like the Sherman Act and Clayton Act in the U.S.) to prevent firms from forming cartels or engaging in anti-competitive behavior.