Market Structure and Competition • 173

TABLE 5.2

Four Classes of Market Structure and the Intensity of Price Competition

In the remainder of this section, we describe each of the four market structures. We begin with brief discussions of perfect competition and monopoly. (More detailed discussions may be found in the Economics Primer and in microeconomics textbooks.) We then provide lengthier discussions of monopolistic competition and oligopoly.

Perfect Competition

Recall from the Economics Primer that a firm maximizes profit by producing a volume of output at which marginal revenue equals marginal cost. Recall, too, that the percentage contribution margin (PCM) equals (P 2 MC)/P, where P 5 price and MC 5 marginal cost. The condition for profit maximization can then be written PCM 5 1/ .4 In a perfectly competitive market, firms behave as if 5 `, so the optimal PCM is 0. In other words, firms expand output until marginal cost of the last unit produced equals the market price.

Market conditions will tend to drive down prices toward marginal costs when at least two of the following conditions are met:

1.There are many sellers.

2.Consumers perceive the product to be homogeneous.

3.There is excess capacity.

We now discuss how each of these features may increase competitive pricing pressures.

Many Sellers

Antitrust agencies vigorously enforce laws designed to promote competition. These agencies are seldom concerned about markets with more than a few sellers. Experience, coupled with economic theory, has taught them that prices tend to fall as the number of sellers increases. This is true for a number of reasons.

First, when there are many sellers, a diversity of pricing preferences is likely. Even if the industry is profitable, a particular seller may prefer a lower price. This is likely to be true for sellers such as Aldi and Wal-Mart that have costs below the industry average. It may also be true for sellers, including many Internet startups, that are attempting to boost market share without regard for short-term profitability.

Second, when sellers maintain high prices, consumers make fewer purchases. Some sellers will have to cut production, or prices will fall. When there are many

174 • Chapter 5 • Competitors and Competition

sellers, it can be hard to convince all of them to cut production, even when they are part of an explicit cartel. This point is illustrated by the contrast between the historical success of cartels in the potash and nitrogen industries.5 The potash cartel that existed before World War II was highly concentrated and generally succeeded in restricting production and keeping prices high. By contrast, the world nitrogen cartel consisted of many firms in the United States, Europe, and South America and was far less successful in its attempts to raise prices above competitive levels.6

The third reason is closely related to the second. When sellers do manage to restrict production and increase prices, some may be tempted to “cheat” by lowering price and increasing production. There are many small firms when a market is relatively unconcentrated, and small firms are often the most willing to cheat. A small firm may view the high prices charged by bigger rivals as an opportunity to increase market share and secure learning benefits and economies of scale that will enhance its long-run competitive position. A small firm may also gamble that its larger rivals will not detect or react to its price reductions.

Homogeneous Products

When a firm lowers its price, it expects to increase its sales. The sales increase may come from three different sources:

1.Increased sales to the firm’s existing customers

2.Sales to customers of a competing firm who switch to take advantage of the lower price

3.Sales to individuals who were not planning to purchase from any firm at the prevailing price

Customer switching often represents the largest source of sales gain. Korean electronics manufacturers Samsung and LG broke into Western markets by undercutting rivals’ prices on comparable-quality televisions and appliances. Customers are more willing to switch from one seller to another when the product is homogeneous, that is, if the characteristics of the product do not vary across sellers. When products are homogeneous, customers tend to be less loyal because any seller’s product will meet their needs. This intensifies price competition because firms that lower prices can expect large increases in sales. Samsung and LG benefited when high-definition televisions were sold using standard technologies (e.g., plasma and LCD) at standard screen sizes (e.g., 50-inch diagonal screens with a 16 3 9 screen aspect). Samsung and LG’s small price advantages were enough to offset the lack of brand-name recognition. Other products, such as medical services, are highly differentiated, and most consumers are unwilling to switch just to obtain a lower price.

Excess Capacity

To understand the role of capacity in pricing, recall the distinction between average costs and marginal costs that we made in the Economics Primer. For production processes that entail high fixed costs, marginal cost can be well below average cost over a wide range of output. Only when production nears capacity—the point at which average cost begins to rise sharply—does marginal cost begin to exceed average cost.

The numerical example in Table 5.3 illustrates the implications of excess capacity for a firm’s pricing incentives. The table depicts the situation facing a diesel engine manufacturer, such as Deere & Company, whose plant has capacity of 50,000 engines

176 • Chapter 5 • Competitors and Competition

per year. Because of a recession, suppose that Deere has confirmed orders for only 10,000 engines during the upcoming year. Deere is confident, however, that it can increase sales by another 10,000 engines by stealing a major customer from one of its competitors, Navistar. To do so, Deere has to offer this customer a price of $300 per engine, well below the average cost of $700.7

It may seem surprising, but Deere is better off offering this price and stealing the business from Navistar. To see this, note that the increase in Deere’s revenue is $3 million, whereas the increase in its total cost is only $1 million. By selling the extra engines at $300, Deere makes a contribution toward fixed costs, and some contribution is better than no contribution. Of course, Navistar may not let Deere steal its business, so the result may be a battle that drives the price for this order below $300. But as long as the order carries a price greater than the average variable cost of $100, Deere would be better off filling the order than not filling it.

In the long run, competition like this can drive price below average cost. If such competition persists, firms may choose to exit rather than sustain long-run economic losses. But if firm capacity is industry specific—that is, it can only be used to produce in this industry—firms will have no choice but to remain in the industry until the plant reaches the end of its useful life or until demand recovers. If demand does not recover, the industry may suffer a protracted period of excess capacity, with prices below average costs.

Monopoly

The noted antitrust economist Frank Fisher describes monopoly power as “the ability to act in an unconstrained way,” such as increasing price or reducing quality.8 Constraints come from competing firms. If a firm lacks monopoly power, then when it raises price or reduces quality its customers take their business to competitors. It follows that a firm is a monopolist if it faces little or no competition in its output market. Competition, if it exists at all, comes mainly from fringe firms—small firms that collectively account for no more than about 30 to 40 percent market share and, more importantly, cannot threaten to erode the monopolist’s market share by significantly ramping up production and boosting demand for their own products.

A firm is a monopsonist if it faces little or no competition in one of its input markets. The analyses of monopoly and monopsony are closely related. Whereas an analysis of monopoly focuses on the ability of the firm to raise output prices, an analysis of monopsony focuses on its ability to reduce input prices. In this chapter we discuss issues concerning monopolists, but all of these issues are equally important to monopsonists.

A monopolist faces downward-sloping demand, implying that as it raises price, it sells fewer units. This is not the same as having a stranglehold on demand. Even monopolists lose customers when they increase price. (If a monopolist raises price without losing customers, then profit maximization behooves it to raise price even further. Eventually, the price will increase to the point where it drives away some customers.) What distinguishes a monopolist is not the fact that it faces downwardsloping demand, but rather that it can set price with little regard to how other firms will respond. This stands in contrast with oligopolists, described below, who also face downward-sloping demand, but must be very mindful of how competitors react to their strategic decisions.

A monopolist selects price so that the marginal revenue from the last unit sold equals the marginal cost of producing it. For example, we shall calculate the