Competition and Market Structures (Industrial Organization)

An Economics Topics Detail
By Arnold S. Kling

What Are Market Structures?

Market structures, or industrial organization, describe the extent to which markets are competitive. At one extreme, pure monopoly means that there is only one firm in an industry. At the other extreme, economists describe a theoretical possibility termed perfect competition. In between are the market structures found most often in the real world, which are oligopoly and monopolistic competition.

What Is a Monopolist?

A pure monopolist is a hypothetical market structure in which a firm faces no competition and is able to earn a significant economic profit. If other firms could enter the market, then they would do so, attracted by the profit opportunity. Therefore, a profitable monopoly could only exist if there were barriers to entry. For example, a patent can give the patent owner a legal monopoly on the production of the patented product.

One barrier to entry is high fixed costs. If it takes a large investment to enter a market, new firms may be deterred from making the attempt. High fixed costs thus can create a natural monopoly.

The monopolist faces the entire demand curve. To sell an additional unit of output, the monopolist must lower its price. It would prefer to lower its price only to the next customer, keeping its price high for existing customers. If it can price discriminate in this way, it earns a higher profit. Oddly enough, this would enhance economic efficiency, by increasing output to the point where price is equal to marginal cost.

If the monopolist is unable to price discriminate, then it will hesitate to try to get an existing customer by lowering its price. That is because it would lower its revenue from existing customers by giving them the lower price. Without price discrimination, the monopolist will restrict output. Relative to the efficient outcome, the monopolist will produce too little and charge too much.

What Is Perfect Competition?

Perfect competition is a hypothetical market structure in which there are very many firms, each of which represents an infinitesimal share of the market. In a perfectly competitive market, if any firm is able to earn an economic profit, other firms will immediately enter the market, driving economic profit to zero.

In a perfectly competitive market, each firm is a price taker, meaning that it has no control over the price. If it tries to raise its price, it loses all its consumers to other firms. If it lowers its price, it can sell as much as it wishes to, but it does not cover its costs. In a perfectly competitive market, price is driven to the point where it is equal to the marginal cost where marginal cost meets average cost. If the firm produces less output, then its average cost goes up. If it produces more output, then its average cost goes up. Thus, it produces at the point of minimum average cost.

What Are Oligopoly and Monopolistic Competition?

In the real world, pure monopoly is rare and perfectly competitive markets are almost nonexistent. The most common types of market structures are oligopoly and monopolistic competition.

In an oligopoly, there are a few firms, and each one knows who its rivals are. Examples of oligopolistic industries include airlines and automobile manufacturers.

When choosing a strategy, an oligopolist must anticipate the response of its rivals. If it raises its price and its rivals do not follow, it may lose a lot of customers. If it lowers its price in order to gain market share, perhaps its rivals will also lower their prices, foiling the attempt. Economists often use simple game theory to describe how oligopolists might arrive at their decisions. But in contrast to the other market structures, there is no precise mathematical solution to the problem of how much output to produce and what price to charge.

In monopolistic competition, there are many firms, each selling slightly differentiated products that are not perfect substitutes for one another. One difference might be location—the drug store that is five blocks away from you is not a perfect substitute for the drug store that is ten miles down the road.

Unlike a perfectly competitive firm, a monopolistically competitive firm can raise its price without driving away every customer. But unlike a monopolist, it does not benefit from barriers to entry. Because other firms can come into the market, profits are limited.

Restaurants are a good example of monopolistic competition. They do not sell identical products. They are free to try to raise and lower prices. But they rarely earn spectacular profits, because it is relatively easy for competitors to swoop in if there seem to be profit opportunities.

Related Topics

Monopoly. Concise Encyclopedia of Economics.

Competition. Concise Encyclopedia of Economics.

Industrial Concentration. Concise Encyclopedia of Economics.


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Aggregate Demand

An Economics Topics Detail
By Arnold S. Kling

What Is Aggregate Demand?

Aggregate demand is a term used in macroeconomics to describe the total demand for goods produced domestically, including consumer goods, services, and capital goods. It adds up everything purchased by households, firms, government and foreign buyers (via exports), minus that part of demand that is satisfied by foreign producers through imports. This is often written as C + I + G + (X-M), where C is personal consumption expenditures, I is investment, G is government purchases of goods and services, X is exports, and M is imports. Together, this is all of Gross Domestic Product, or GDP.

What determines the level of aggregate demand? Keynesians have one view. Monetarists have a different view. And there is a synthesis of the two views known as IS-LM.

Keynesians focus on the ability of investment to absorb desire saving. If firms desire high levels of investment and/or consumers are eager to spend rather than save, then aggregate demand will be high. But if consumers are anxious to save while firms are reluctant to investment, then aggregate demand will be low.

More generally, Keynesians see the flow of spending in terms of injections and leakages. Investment, government spending, and exports all inject demand into the economy. Saving, taxes, and imports all leak demand out out of the economy. When demand is weak, the government can remedy this by injecting more of its own spending or by reducing leakage by cutting taxes. In either case, its own budget moves in the direction of deficit.

Monetarists see aggregate demand as determined by what is called the amount of money in circulation. American monetarists write MV = PY, where M is the quantity of money, V is the velocity of money, P is the aggregate price of output, and Y is aggregate output, or real GDP.

The idea is that households and businesses use money to facilitate purchases of goods and services. The total value of goods and services purchased is nominal GDP, which by definition is PY. At any one point in time, households and firms are holding some cash on hand. The velocity of money measures how quickly they turn over their cash to buy more goods and services. Velocity depends technology, habits, and what we consider to be the definition of “money.”

One advantage of the monetarist approach is that it introduces the price level into aggregate demand. Taking the supply of money and the velocity of money as given, the demand for real output will be higher if the price level is lower. This means that we can draw a downward-sloping aggregate demand curve, just like the demand curve in microeconomics.

A synthesis that was developed in 1937 by John Hicks, called IS-LM, was popular for several decades. In the IS-LM formulation, both the money supply and the saving-investment balance affect aggregate demand.

We can think of IS-LM as introducing the interest rate as a determinant of the velocity of money. Suppose that the government increases spending, which is an injection. This will raise the interest rate and increase the velocity of money, so that nominal GDP will increase.

Although macroeconomists are comfortable with the concept of aggregate demand, it is inconsistent with classical economics. In classical economics, one does not speak of total demand, as if the economy were one giant firm. Demand does not fall for the economy as a whole. Instead, when demand falls for one good, it goes up for some other good.


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Aggregate Supply

An Economics Topics Detail
By Arnold S. Kling

What Is Aggregate Supply?

Aggregate supply is the relationship between the overall price level in the economy and the amount of output that will be supplied. As output goes up, prices will be higher.

We draw attention to factors that shift the aggregate supply curve. An adverse supply shock, such as a bad harvest, will cause supply to contract, raising prices and lowering output. A favorable supply shock, such as a productivity-enhancing innovation, will lower prices and raise output.

Aggregate demand and aggregate supply can be depicted on a diagram relating price and output in a way that is analogous to microeconomic supply and demand curves. But the mechanisms behind the relationships are subtle.

Aggregate demand goes down as the price level rises not because people are thinking “the price of GDP has gone up, so I want to purchase less of it.” Instead, a higher price level means that a given quantity of money can facilitate fewer transactions and business and consumer loans. We say that an increase in the price level reduces the real money supply, which is defined as the ratio of the quantity of money to an overall price index. A lower real money supply raises the interest rate on loans, leading to a reduction in investment and consumer spending, and hence lower aggregate demand.

The reason that aggregate supply rises with the price level is also not straightforward. In fact, if all prices and costs went up by the same amount, then the desired level of output would not change. But many economists believe that wages adjust slowly to prices, at least in the short run. So higher prices of output will reduce the real wage, which is defined as the ratio of average wages to average prices. This in turn will reduce the cost to firms of increasing output, and hence output will rise.

One theory of the aggregate supply curve is that it has three segments. When the economy is deep in a recession, with high unemployment, an increase in aggregate demand will result in little or no increase in price. Instead, unemployed resources will be put to work to fill the demand. When the economy is growing but not yet at full employment, an increase in aggregate demand will raise both output and prices. When the economy is at full employment, supply cannot increase further, so an increase in aggregate demand will primarily raise prices.

The importance of aggregate supply was “discovered” in the 1970s. A cutback in oil supply orchestrated by Saudi Arabia late in 1973 caused the United States to experience both rising unemployment and rising inflation. According to the Phillips Curve, higher unemployment should have produced lower inflation. To explain the anomaly, economists came to describe the situation as an adverse supply shock.

The Phillips Curve is like the aggregate supply curve in that it depicts the relationship between prices and output. But the Phillips Curve looks at the rate of change in prices (inflation) as the price axis and it looks as the unemployment rate (which varies inversely with output) as the quantity axis. The experience of the 1970s can also be characterized as a shift in the Phillips Curve.

Another instance of a supply shock was the COVID-19 pandemic that hit the United States in the Spring of 2020. Many businesses curtailed activities, in some cases because of government-ordered closures. It became difficult to supply goods that were made with foreign components, because some factories were shut down in China and elsewhere. The need for telework and to care for children home from school probably cut into productivity.

The pandemic also reduced aggregate demand, as people chose to cut back on travel, entertainment, and eating in restaurants. Thus, it could be described as a combination of an adverse demand shock and an adverse supply shock.

Related Topics

Phillips Curve. Concise Encyclopedia of Economics.


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