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Market Structures
Taxonomies of Market Structures
Joseph I. Phillips, Jr.,
A motivational device for teaching the four basic market models of Microeconomics is to place the following essay question on the blackboard before beginning the material. Compare and contrast the following: Perfect Competition, Monopoly, Monopolistic Competition and Oligopoly with respect to (1) the nature of the products produced, (2) shape and location of the demand curves faced by a firm, (3) relationship between firms within the industry, and (4) qualifying assumptions associated with each model.
The students are informed that such a question will appear on the next test and will comprise 20% of the test grade. Class concentration tends to rise to a higher level fostering greater understanding of the material and better assignment and test performance.
Richard B. McKenzie,
Students often have difficulty comprehending the dilemma individual competitors face in the market because they are usually exposed only to the conditions for competitive equilibria. One way to offer students a brief experience as competitors is to give them a chance to bid for a given amount of money, say, $2, requiring every student to pay the auctioneer the amounts bid, with the understanding that only the highest bidder will receive the "kitty." Bids are collected on signed slips of paper indicating that the student understands the rules of the game. After the first round of bidding is completed with the professor in the room, the professor leaves the room giving the students a chance to collude in their bids. (Before leaving, chide the students on the expected inability to trust one another.)
This game highlights several important points: (1) the dilemma each student faces in attempting to outdo competitors, (2) the pressure on competitors to collude and the hurdles confronted when many competitors try to form an effective cartel, (3) the benefits of monopoly power, and (4) the consequences of "rent seeking." (In classes of over 30 students, the total bids usually exceed the amount up for bid by several times. The professor should expect a profit and plan to give it away (without telling the students beforehand.) This game was originated by Geoffrey Brennan at VPI.
Domino Diagrams and Market Structures
John Pisciotta,
Micro principles emphasizes the graphics of revenue and cost curves for various market structures. "Domino" diagrams can provide students with a useful first exposure to market structures. These diagrams reflect the numbers of buyers and sellers in various market structures. Figure 24‑1 shows structures typical of pure competition, monopolistic competition, oligopoly, and monopoly. Note that on the buyers' side of these markets, many dots reflect the many potential buyers. The differences are on the sellers' side; there are many sellers in competition, but only one in a monopoly market.
Domino diagrams can also be helpful in discussing the concept of countervailing power as it relates to oligopoly. Part A of Figure 24‑2 shows oligopoly without countervailing power. In Part B we find that oligopoly on the sellers' side is faced with oligopsony with only a few buyers in the market.
Figure 24‑1
Figure 24‑2
Finally, the domino diagram can be used in a discussion of labor as well as product markets. Figure 24‑3 shows a highly competitive labor market, with many sellers and many buyers. The buyers are fewer in number than the sellers since the number of firms would always be less than the number of workers. Figure 24‑4 shows a labor market dominated by a few employers. Notice that while there are many sellers representing individual workers in the market, there are only a few on the buyers' side of the market. The power on the buyers' side of the market can be a factor in unionization where labor unions establish countervailing power. Part A of Figure 24‑5 shows a monopoly union which deals with a few employers in a market. Part B shows a monopoly union which faces only one employer.
Figure 24‑3 Figure 24‑4
Figure 24‑5
Dan LeClair, The
To Minimize Costs: To introduce principles students to the differing views concerning cost minimization and market structure I use the analogy of a race. In the competitive case, there are many runners each with similar abilities and training. In competition, each runner has an incentive to run as fast and he/she can to win the medal, but alas, in perfect competition the best each can do is tie. In fact, each runner must run as fast as possible just to tie, if all the runners are running their fastest (efficiency). In the monopoly case, there is only one runner in the race. Some would argue that without competition there is no incentive for the runner to run as fast as he/she can (inefficiency). Others would counter that even without competitors, the race may be timed, with a greater trophy (profit) for a faster time. This would be enough to cause the lone runner to run as fast as possible (to be efficient).
To Innovate: In the competitive race, what any one runner can do to train for the race the others can do as well and the race ends in a tie anyway (no incentive to innovate). Others argue that anything that can be done (for instance, weight training ) will be done in order to try to get ahead or keep up. But suppose one runner came up with a unique way of increasing his/her speed and endurance (reducing costs), but others were somehow prevented from using that method (e.g. patent - some monopoly power). Of course, this is likely to increase the incentive to innovate. (Possible example: Ben Johnson and his use of a technology no competitor could lawfully use.)
Possible extensions: 1) You could assume that the sole runner is regulated so that he/she can only win a trophy whose size does not vary with the time, so that there is no incentive to run faster. 2) Or, if the trophy size does vary with time, the faster the runner runs the greater the incentive for other runners to enter the next race. Of course, this may provide an incentive for the sole runner to settle only for the small trophy by not running fast.
New
Technologies and Market Revenues:
James K. Shaw,
One of the more intriguing challenges facing established
industries is competition generated from new technologies.
As the data below firmly illustrate,
revenue to
Figure 24‑6
Pure Competition
The Ideal State of Perfect Competition
Steven M. Rock,
Students often fail to understand why so much time is spent describing the model of perfect competition. The model is restrictive and there are few real world applications. To grab their attention, I offer the following analogy. The model of perfect competition is like virginity. Both are held as lofty ideals by which alternative behavior is judged, even if both are rare.
What is a Homogeneous Commodity?
Jim Cobbe,
Most students will agree that USDA inspected homogenized whole milk is a homogeneous commodity. Ask several students to recall the price they last paid for milk. Standardized to a price per ounce, the range will be very large. Milk in a small container from a vending machine may well be two to three times the price per ounce of the cheapest milk in a gallon jug from a supermarket. Ask if there are entry barriers of any significance to retail sale of milk, and remind students of the "law of one price." Discussion should establish that (1) commodities have important characteristics (size of package, storage requirements, location) other than the purely physical; (2) transactions involve significant costs (time, convenience, travel, storage implications) other than monetary price; (3) monopolistic competition based on non‑physical characteristics is possible and common. The homogeneity requirement for perfect competition turns out to be much stricter than that the physical commodity itself be physically homogeneous and perfectly divisible.
The Perfectly Elastic Demand Schedule
Eric K. Steger,
Quite often, my students have difficulty understanding why there is a perfectly elastic demand schedule facing individual firms in perfect competition. I've found that it helps if I use oil production as an example. I stress that the world demand and supply of oil determine its market price. I then explain that oil producers face one price for their oil production and can sell all they produce at one price. If a student complains that they can't sell all they produce, I challenge the person to show one example of oil production not being purchased. Typically, by using graphs and this illustration, they understand perfectly elastic demand curves.
Dale Sievert, University of Wisconsin-Madison
Long run dynamic adjustments towards equilibrium in an industry are among the most striking of economic phenomena. The price line's position relative to the average cost curve's position dictates whether firms leave or enter an industry. Most students do not recognize similar real life situations, though they grasp the graphic presentation. In short, they find it hard to apply the concept, and most cannot fathom why such resource reallocations are necessary.
Two illuminating examples help my students understand this process. The first occurred in the barbering industry. Prior to the Beatles (pre‑1963), fashionable male hair length was shorter. Men required certain amounts of resources (barbering labor, cutting tools, shops, etc.) to maintain desired hair length. By the mid 1960s, fewer such resources were necessary due to a change in taste for hair styles. Society had more barbering resources than necessary.
The competitive model suggests that in such a case, prices would fall, then profits, then the number of firms (resources). Finally, price would return to its original level. However (in my state at least), prices did not fall; the number of firms did fall sharply‑‑ one third of barber shops closed during a two year period. How did this happen? My friend's shop, for example, burned. He then took a job in advertising and never returned to barbering. Why the shop burned at such an auspicious time we never learned‑‑but many have suspicions.
Another example is agriculture. Tours of most farming areas reveal numerous old abandoned farmsteads, reflecting diminished labor resource requirements as agriculture became capital intensive.
Ki Hoon Kim,
When we drop some cookie crumbs on the floor, what do they attract? Ants, of course. In competitive markets, the "ants" are the firms and the crumbs are the excess profits. Ants will come to the place until all the crumbs are gone. Firms will enter the industry until all excess profits are zero. This is possible because competition prevails. When there are no more crumbs, no more ants will come‑‑when there are no excess profits, the entry of firms will stop.
Bernard Newton, Long Island
University‑The
The following illustration worked very well when I gave it in response to a student who exclaimed that she was too excited about getting married to be interested in how maximum profits are obtained by equating marginal revenue and marginal cost. Assume that you wish to maximize the profit on your wedding. Also assume that each person you invite to the wedding will cost you $25 per head no matter how many persons you invite.
First, invite that relative (Uncle Keynes) that will bring you the greatest cash gift, say $1000. Thus, the marginal revenue is $1000 and the marginal cost is $25. The profit is $975, that is $1000 ‑ $25. Then invite the person that will give the next highest amount (Cousin Galbraith), say $750. Thus, the marginal revenue is $750 and the marginal cost is $25. The profit on Cousin Galbraith is $725‑‑ that is $750 ‑ $25, and the profit on both relatives is $975 + $725 = $1700. Then the student should invite the person who will give the next highest valued gift, and the next. Where should she stop? When she reaches the person (co‑worker Malthus) who she estimates will give her a $25 gift. Thus, the marginal revenue will be $25 and the marginal cost remains at $25 for a break‑even result. If the person who is expected to give the next highest valued gift were to be invited, there would be a loss on that one person, for the marginal revenue would be less than $25, while the marginal cost remains at $25. Thus, that person would not be invited.
Steven T. Call, Metropolitan State College‑Denver
Training students to think on the margin is a primary goal in economics principles courses. The following problem provides practice. 95 percent of a class will usually get the wrong answer at first. The example refers to President Nixon's 18 minute tape erasure during Watergate.
Assume your firm sells recording tape erasers and has an average total cost schedule as given below:
Quantity Average Total Cost
200 $200
201 201
202 202
Assume that the firm maximizes profit by selling 201 units. Now suppose that the firm is approached by the White House with an urgent request for a recording tape eraser and offers $300 for it. Assuming that the additional sale will not affect the present market sales, should the firm accept the order if profit maximization is the only criterion?
ANSWER: No. Marginal Revenue ($300) < Marginal Cost ($403). Most Common Answer: Yes, since $300 > 202. This error arises from focusing on averages and failing to properly consider marginal cost.
The Short-Run Decision to Operate or Shut Down
William P. O'Dea, SUNY at Oneonta
To illustrate that a firm deciding whether to continue operating in the short-run will base its decision on the relation between total revenue and variable cost ignoring fixed cost, I use as a case study the Warner Brothers film "Hearts of Fire." I tell the students that the film was produced in 1986 and had a production cost in the $15m-$18m range. I then tell them that the firm was not released to theaters in the United States and ask for an explanation. Some students suggest that Warner Bros. did not release the film to theaters because it felt it could earn more by releasing the film directly to video or pay cable. I point out that the value of a film in these secondary markets is directly related to its performance in theatrical release and ask for another explanation. Some student will generally ask what it costs to release a film to theaters. I tell them that in 1986 the cost of prints and advertising was approximately $8m for a film given a wide release (800-1000 theaters). It then becomes clear that Warners did not release the film because it anticipated that revenues from theater owners would not cover these distribution costs. The final part of the exercise is to translate the elements of the problem into economic terminology. The decision whether to release the film is analogous to the firm's decision to operate in the short-run. The production cost of the film is a fixed cost. In deciding whether to release the film, the marketing department's concern is not to compound a mistake made by the production department. In making this decision the marketing department will focus on those costs which it can control-the variable costs of distributing the film. Be deciding not to release the film, they lose the production cost which is not pleasant. However it would be less pleasant still if Warners had added to this loss by releasing the film and incurring variable costs that were not covered by revenues.
Recognizing Potential Profits or Losses
Ralph T. Byrns
Show your students how the potential for profits or losses can be quickly recognized regardless of the market structures by drawing sets of cost and demand curves so that:
Demand intersects ATC ‑‑‑> Profits
Demand lies below ATC ‑‑‑> Losses
Demand tangent to ATC ‑‑‑> Breakeven.
Gary M. Galles,
Discussing a Dutch auction helps cement the concept of opportunity costs in students' minds. I begin by asking if any student has been to an auction, and have him describe the bidding process. I then ask what determined the price paid, and stress that the price is just barely above the value placed on the item by the last bidder to drop out‑‑which is determined by what he was willing to pay), and may be far below the value placed on it by the actual buyer (e.g., one person could value a good at $1 million, but everyone else drops out at $100,000). In other words, price is determined by opportunity cost‑‑the value to the next highest bidder. I then ask if you need to know how much others value an item for this result to hold; this gets them to see that standard auctions reveal what others are willing to pay. One merely bids slightly more than the last bidder, whose last bid reveals the maximum he was willing to pay, so that one need never pay much above that amount for the item.
I then describe a Dutch auction: an exorbitant opening price is announced for the item to be sold, and is gradually lowered until someone signifies willingness to buy at which point the auction is over and the transaction is consummated. After noting that it is less showy than a standard auction, I ask why an auction would be conducted in such a manner. I lead them to see that a typical auction reveals the values others place on an item, which you barely beat, while a Dutch auction does not reveal such information until it is too late to just beat the last bid, because the first bid is also the last bid. I point out that a Dutch auction is intended to extract a price in excess of opportunity cost (what the second highest bidder would pay) by concealing what those opportunity costs are until it's too late, thereby inducing the buyer placing the highest value on the item to bid an amount closer to the maximum he would be willing to pay than he would under a typical auction arrangement.
I then ask what sorts of items would sellers think appropriate for Dutch. Students should see that only where there may be significant divergences between the values placed on an item by the highest valuation and second highest valuation buyers would a Dutch auction yield significantly higher prices. This tends to restrict such auctions to cases of unusual, rare or one‑of‑a‑kind items, especially if they are of high value (because then small percentage differences in price may generate big absolute differences).
Next, I note that the same sort of tactics could be employed whenever the item involved does not have a well established narrow range of prices. A good example occurs in bazaar trading where both parties start at ridiculously divergent prices and each betters his terms until the other party finally accepts. Both parties are trying to extract as much benefit of the trade as they can: the buyer trying to get a price near the minimum the seller would accept; the seller trying to get a price near the maximum the buyer would pay.
I conclude by reemphasizing how Dutch auctions represent attempts to get above opportunity cost prices and the importance of prices in conveying opportunity costs.
Explaining the Marginal Benefit = Marginal Cost Rule
Charles C. Fischer,
The idea that any activity should be undertaken if its marginal benefits (MB) exceed its marginal costs (MC) and that it should be undertaken until MB = MC is among the most general of economic concepts and the most troubling for students. The game of Economic Simon Says demonstrates the logic of the MB=MC rule and helps drive home sound economic decision making. In this game, students are told to obey Simon only if it is profitable to obey. Then Simon imposes both costs and benefits on participants. Simon says "Take one step forward‑‑I pay you $5 and you pay me $4." Ask students if they would step forward. Yes, for a net gain of $1: MB > MC. Would you move immediately after hearing "I pay you $5"? No, we can't make a good decision based only on benefits or costs. Simon might have said "You pay me $6." Then, we would have made a bad decision and wound up with $1 less in our pockets. Would you move if Simon said "I pay you $4.10 and you pay me $4"? Sure, we could pocket a dime. Simon pays $4.01 and you pay $4? We would still gain a penny. As students exchange money with Simon and watch their wealth grow they become true believers in the MB = MC rule for decision making. Of course, the game doesn't have to be physically played. By explaining Economic Simon Says and then asking students for their responses, its lessons are quickly grasped.
Josef M. Broder,
Elasticity is one of the more difficult concepts to teach or learn. Many graphical/mathematical presentations lack an intuitive explanation for consumer reaction to price changes. The marginal consumer approach provides intuition to presentations on price elasticity of demand by asking students to identify and analyze two distinct groups of buyers of a product. There are both marginal consumers who quickly respond to any price change and loyal consumers who tend to buy regardless of price. The marginal consumer approach contrasts the total revenues received from these groups, and can be simplified by assuming that:
a. Each consumer will purchase only one unit of commodity.
b. Movements along the demand curve represent consumers entering or leaving the market.
The relative contributions to total revenue made by marginal and loyal consumers can be expressed graphically. For example, a price decline from $6 to $5 results in a $1 loss in total revenue from the loyal consumers and a $4 gain in total revenue from marginal consumers for a net increase in total revenue of $3. Likewise, a price decline from $2 to $1 results in a $4 loss in total revenue from loyal consumers and a $1 gain in total revenue from marginal consumers, for a net loss in total revenue of $3.
The total revenue impacts of a price change depend upon the relative sizes and contributions of these consumer groups. Segmenting and labeling the total revenue areas under the demand schedule in this fashion incorporates some real world people into the concept of elasticity and can be used to supplement conventional graphical or mathematical presentations on the subject.
Figure 24‑7 The Marginal Customer and Price Elasticity of Demand
Figure 24-7
The Fallacy of Composition and the Economic Way of Thinking
Thomas L. Wyrick,
The fallacy of composition plays a more important role in economics than a few introductory comments can convey. Many important ideas in economics are the result of avoiding the fallacy, and to the extent the average citizen or politician fails to recognize and avoid the pitfall, we economists have a clearer understanding of the world than they.
Take, for example, the strong preference among politicians for expansionary macroeconomic policies. They realize from personal experience and from communicating with constituents that profits and employment depend critically on the strength of the demand for goods: sellers try to stimulate demand by advertising, manufacturers change product designs to stimulate demand; companies expand and new ones are created to satisfy unfulfilled demands.
Policy makers often draw from these experiences the lesson that government can promote prosperity by stimulating the demand for goods. In each of the cases cited however, it is individual businesses (and their employees) that benefit from the increase in demand. Because the nation faces a resource constraint that individual firms don't, a simultaneous increase in demand for all goods cannot boost the entire economy in the same way relative demand shifts can benefit individual producers.
The fallacy of composition can also be used to help explain how the demand for an individual firm's product can be infinitely elastic while the market demand for the same item has a different shape entirely (and may even be inelastic in the relevant range). Before presenting the usual explanation of the curves' shapes, it is helpful to preface one's remarks with a review of the fallacy of composition. Just because the industry demand curve slopes downward does not mean the demand for each firm's output should have the same shape.
Drawing special attention to the fallacy of composition before discussing the shapes of the two demand curves should be a signal to students that a "common sense" view of matters may lead them to incorrect conclusions. To the untrained, common sense may suggest that a firm with 1% of market sales will face a demand curve that is 1% of the market demand curve. Or common sense may suggest that a company selling 1% of total market volume "controls" that part of the market and can vary price within its "domain" in the same way that an entire industry can influence price. Economic logic permits one to see through these confusions and does so by avoiding the fallacy of composition.
A third way the fallacy of composition can be used is to explain the invisible hand of the marketplace. Although individual sellers mean only to promote their own gain, Adam Smith noted that they "promote an end which was no part of (their) intention," namely, the well‑being of consumers. The competitive market process yields more than a summing of the parts would suggest.
Barry P. Brownstein,
The distinction between marginal and fixed costs is best taught by using examples. An excellent one was related by a student who told of attending a meeting to discuss Amtrak's schedule. The staff economist wanted to add an extra train, arguing that the marginal revenue from that train (passengers' fares on that train minus lost revenue on other trains) would exceed the marginal cost. Since idle capacity existed the marginal cost would amount to the cost of the crew. The accountants, however, argued that each train "has to pay its own way". Presenting figures on the average cost of each train, they argued that the extra train would not be profitable. A good class discussion develops by asking what is included in average cost (which should not be considered as far as the discussion of the extra train goes). Then ask the class to demonstrate that profits are higher or losses less by following the economist's advice.
Fixed Costs, Variable Costs, and Rational Behavior
David
To demonstrate why profit‑maximizing/loss‑minimizing firms will shut down in the short run if variable costs cannot be covered (a result easily demonstrated either numerically, graphically or algebraically), I confront students with situations such as the following: (1) Upon graduation, you find yourself working in a city in which is located a university that offers a graduate program in a field that interests you; you decide to register for one evening course and, at the first class, a syllabus is handed out that is quite different from what you were led to expect‑‑should you continue to take the course simply because the registration fee is not refundable? (2) You heard that a new movie just opened at your local theater and decide to take your chances, although you don't know what it's about; it turns out that after five minutes of viewing, "Terminal" is not about terrorism at a major train depot, but about emotional disorders caused by spending too much time with computers‑‑should you sit through the movie simply because the price of admission is not refundable?
The similarity in these situations is, of course, that the fixed or "sunk" costs associated with one's actions should not affect one's behavior‑‑what matters in either case is whether the potential benefit of continuing with the course (or remaining in the theater) exceeds the sacrifice one would incur from same, which is variable, i.e., over which one has control. Thus, if you believe you could spend your time in some other way which would provide greater benefit than you could expect from the course (or movie), economic rationality (which emphasizes such cost/benefit comparisons) would lead you to leave the classroom (or theater) despite not receiving any refund, just as a firm will shut down in the short run if the additional sacrifice it would incur by remaining open cannot be covered by revenues so earned.
Average Cost vs. Marginal Cost Pricing
Eric K. Steger,
To illustrate the difference between average cost and marginal
cost pricing, I ask my students several questions. I first ask, "Does it
make sense to you that airfare between
Demand Change and Profit Change
David
The power of market supply and demand analysis may be illustrated in many ways. One important area in which it can support our intuition with economic logic is the analysis of the effect of changes in market demand and supply on producers' profit. For example, one's intuition would be that changes in market demand alter producers' profit in the same direction. Further thought on the matter may give rise to some skepticism about such a result since, if demand increases, not only will the equilibrium price and quantity exchanged increase, causing total revenue to rise, the total costs of producers will rise as well and it is not obvious that total revenue will increase more than total cost. However, that this is exactly what happens in the conventional case of down‑sloping demand and up‑sloping supply schedules is revealed by a straightforward graphical analysis of the problem.
In Figure
24‑8, D1 and S1 are the
initial market demand and supply schedules, respectively, and point E1
corresponds to the initial market equilibrium. If demand increases by D2,
the new equilibrium corresponds to E2. The increase in
total revenue enjoyed by producers is the area of ABE2CFE1;
recognizing that S1 is an aggregation of individual firm
supply curves, each of which is a segment of their respective marginal cost
curves, the area of E1 E 2CF is the increase
in total cost incurred by producers, since that increase is simply the sum of
the marginal costs of each additional unit that will be produced. The result is
that producers profit rises (or producers' loss diminishes) by the area of ABE2
E1. If D2 had been the initial
market demand schedule and demand fell to D1, Figure 24‑8
suggests a decline in producers' profit (or a rise in producers' loss) by the
area ABE2 E1.
Figure 24‑8
Entrepreneurs Do Too Use Marginal Cost and Revenue
Jonathan B. Wight,
Students sometimes grouse that business people they know never use marginal cost or marginal revenue in making decisions. This complaint is easy to defuse in an attention‑getting exercise: Hold up a $10 bill and ask a volunteer, say Bob, if he is willing to trade $5 of his own money in exchange for this $10. Bob will eagerly accept, probably grinning greedily to his friends, and wondering if there's a trick. After carrying out this trade ask if he would now exchange $7 for another crisp $10 bill, which again he will do. Continue offering him trades with the "cost" to him rising up to $9.99 for a $10 bill, each time getting a positive response from Bob. Then ask if he will pay $11 or $12 for a $10 bill, which he will refuse.
On the blackboard record in columns Bob's costs, revenues and profits from these actions, then graph and analyze the results (the familiar competitive firm scenario). From here on, students will always equate MC=MR with the entrepreneurial mind‑‑not an ivory tower construct.
Note: In a pinch you can get by with "play" money if your Dean is too cheap to provide meaningful and appropriate teaching aids. However, the surprise and impact of this lesson is greatest if actual currency is utilized.