Chapter 10 Perfect Competition

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CHAPTER 10 PERFECT COMPETITION

Assumptions of Perfect Competition
The most competitive market structure is pure or perfect competition, which is as competitive as possible.
As previously mentioned, market structures are models that summarize how certain markets are organized
and behave. For each market structure we have a set of assumptions or characteristics that tell us what
kind of industries the model will explain. Only industries that meet the assumptions will behave in the
way the model predicts. The assumptions of perfect competition are:
Many buyers and sellers: There are so many buyers and sellers in perfect competition that no
one of them has any influence whatsoever on the market. The number of consumers and
producers is so great that any one of them is like a cup of water in the ocean their presence or
absence makes no difference at all to the market.
Identical or homogenous product: Every producer in the market makes exactly the same
product consumers are not able to distinguish between the output of one firm and the output of
another. There are no labels, brands or any other distinguishing features used to make a product
look distinct.
Excellent information: Both buyers and sellers in this market have good information about the
product, especially the fact that there are many other producers all making the same product.
Relatively free entry and exit: Firms are able to move resources in and out of this market
relatively easily with little expense. This makes firms especially quick to respond to changing
consumer demand.
As you would expect from this list, there are few markets that come close to fitting these assumptions.
The most common example used for perfect competition is agriculture. While agriculture does not fit
these assumptions perfectly, it comes closer to perfect competition than to any other market structure.
In the major commodity markets, there are so many producers that any one producer has no effect on the
market. If you are one producer of hard red winter wheat out of thousands, it does not affect market
supply or price if you produce more or less this year. You are so insignificant to the market that you
cannot even set your own price, but have the price set for you in the market perfectly competitive firms
are price takers, their only choice is to take the market price and sell, or leave it and sell nothing.
In the major commodity markets the product is identical from producer to producer there is no
difference in the hard red winter wheat of Farmer Smith in Nebraska and Farmer Jones in South Dakota.
If consumers were presented with a bucket of each, they could not tell any difference.
In the major commodity markets, all the buyers know that the product is identical, they know what
current prices are, and they know how to grade the product. If the going price of hard red winter wheat
were $3 a bushel, a farmer who tried to set his/her price at $3.01 a bushel would sell no wheat. All the
buyers know they can get all the wheat they want at $3. Producers have no power over the market price.
In the major commodity markets there is relatively free entry and exit, stress on the word relatively.
While it is expensive to enter and exit farming in general, it is relatively inexpensive to move from one
agricultural market to another related one. For example, areas suitable to growing corn are generally also
very suitable to grow soybeans. Similar equipment is used to plant, cultivate and harvest corn and
soybeans. If corn prices have been low, corn farmers could easily switch to growing soybeans the next
year.
In recent years we have seen a growing deviation from the perfect competition pattern in agriculture in
that the buyers of agricultural crops are consolidating in some markets. For example, there are a limited
number of meat processors that handle pork and poultry reducing the competition on the buying side of
the market. In time, we may have to adjust our interpretation of at least some of the agricultural markets,
but for the moment the best fit still appears to be perfect competition.
In general, the pattern for this market is a very large number of small powerless producers making
absolutely the same product in a market where they have no influence on price. Competition is so great
that individual firms have no alternative but to operate efficiently in order to survive.
The Perfectly Competitive Model in the Short-run
The Wheat Market

7
6
5
4
Price 3
2
1
0
50
150
250
350
450
550
650
Quantity of Output
In the graph on the left one can see that the

price of a product, here wheat, is determined by the overall market supply and demand. Once the price
has adjusted to the supply and demand in the commodities market, the current going price of wheat has
been established, here $5. From the point of an individual producer, this going market price is set for
them and it appears to them that they can sell any quantity of wheat they wish at this market price, but
cannot charge one cent over or they will sell nothing at all. The demand curve they face is perfectly
elastic.
Individual Wheat Producer
7
6
5
4
Price 3
2
1
0
50
150
250
350
450
550
650
Quantity of Output
This is the only market structure where the demand curve facing an individual producer is perfectly
elastic. This is also the only market structure where the firms marginal revenue curve is the same as its
demand curve. Remember that the marginal revenue is the change in total revenue (P x Q) divided by the
change in quantity of the good. Since we never have to lower price to sell another unit, every unit adds a
constant amount to total revenue, here $5. Once we have the marginal revenue curve, we only need a
marginal cost curve to predict the profit maximizing point of production (Q*).
Output Determination
7
6
5
4
Price
3
2
1
0
50
150
250
350
450
550
650
Quantity of Output
This producer would want to set

production where MR = MC, a quantity of 550 bushels. Farmers will decide how much to plant at the
beginning of the season based on an estimate of the price they expect at the end of the year. This price
will be developed from the prices of the previous year or two, current planting estimates, current weather
forecasts etc. The futures commodities market provides an invaluable service, both because it has
thousands of participants factoring in these variables, but also because it allows farmers to lock in a price
in the future. This takes the risk off of price and puts it on production the farmer has committed to
selling a certain quantity at the futures price on the specified date.
Output Determination
$7.00
MC
$6.00
MR
Price
$5.00
ATC
$4.00
$3.00
$2.00
$1.00
If we added the average cost curve, then we could

calculate the profit of the perfectly competitive firm.
At a price of $5, this firm is best producing 550
bushels. If they make 550 bushels then the average
cost per bushel is $4.50. This means the firm is
making a profit on each bushel of $.5 the $5 price
minus the $4.50 cost. Since the firm is making $.5 a
bushel on 550 bushels, the firms profit is $275.
Remember, this is an economic profit they are
making $275 more than they could growing the next
best crop.
$0.00
50
Use the following steps to find profit for any price in a

perfectly competitive market. Draw a horizontal line
Quantity of Output
at the going price that is the MR curve. Find the point
where MR = MC to establish Q*. Come up from the
Q* quantity until you hit the ATC that is the cost per unit. The price minus the cost per unit is the profit
per unit. Unit profit times Q* gives the total profit.
150
250
350
450
550
650
Calculate the production level,

average cost and economic profit for
this perfectly competitive firm if the
going market price is $8.50. $5.50.
Economic Profit Levels

$11
MC
$10
$9
$8
ATC
$7
$6
$5
AVC
$4
$3
$2
$1
$0
50
100
150
200
250
300
350
400
At $8.50 this firm made a positive

economic profit; however, at $5.50 the firm made a negative economic profit. As price falls the positive
economic profit gets smaller and smaller until it eventually disappears and becomes negative. There is a
specific point that separates the range of prices that results in positive economic profit from the range of
prices that results in negative economic profit. That point is known as the breakeven point this is the
point where the firm makes zero economic profit, or a normal rate of return.
If the firm is producing at this level, it must be a Q*, which means that MR = MC.
If there is zero economic profit, then P = ATC.
In perfect competition P = MR.
Put these facts together and you have that ATC = P = MR = MC.
There is only one point on this curve where the MC and the ATC curve intersect. That is the breakeven
point. In any perfectly competitive firms graph, the breakeven point is always located at the bottom of
the ATC curve where ATC intersects MC. At all prices above this the firm will make positive economic
profit; at all prices below this the firm will make negative economic profit.
The reaction of the firm to negative economic profit depends on the time horizon. The firm does not have
the option of exiting the industry in the short run - in the short run the firm is stuck with some of its
factors of production and therefore some of its costs. The firms only option is to stay open or close
down. If it stays open, it will make the profit that exists at Q* even if that is negative. If it shuts down, it
will automatically lose an amount equal to its fixed costs because if it shuts down both revenue and
variable cost disappear but fixed costs remain. The firms short run decision to produce or not is based
upon where does it lose the least amount of money. If the negative economic profits of Q* are less than
negative economic profits of losing FC, the firm will remain open.
Since ATC = AFC + AVC, then the firm will lose an amount exactly equal to FC if and only if the price of
the product is equal to the AVC. At that point the revenue of the firm is just sufficient to pay for the costs
of staying open the variable costs. There is no revenue left over to pay any of the FC. At that point the
firm would lose the same amount of money whether it stayed open or shutdown. This is known as the
short-run shutdown point.
If the firm is producing at this level, it must be a Q*, which means that MR = MC.
If the firm covers its variable costs but not fixed, P = AVC.
In perfect competition P = MR.
Put these facts together and you have that AVC = P = MR = MC.
There is only one point on this curve where the MC and the AVC curve intersect. That is the short-run
shutdown point. In any perfectly competitive firms graph, the shutdown point is always located at the
bottom of the AVC curve where AVC intersects MC. At all prices below the short-run shutdown point the
firm would be better to close operations and swallow their fixed costs - the price will not even cover the
costs of remaining open. At all prices above the short-run shutdown point the firm would be better to
remain open the price will cover the costs of remaining open and something extra to pay for part of the
fixed costs.
For example, you raise beef cattle and the price of beef falls so low it does not cover your feed bills, labor
costs and vet bills. You will sell or slaughter your young stock and have no beef to sell later in the year.
When the US government under President Nixon put price ceilings on common consumer necessities like
food, including beef, but did not put ceilings on the feed, cattle medicines, electricity for heating barns,
etc, farmers slaughtered their young stock and all but the best of their breeding stock. The US had a lot of
beef for a few months and then a severe shortage for a couple of years until the herds could be bred back
up. As soon as the price ceilings were taken off, the price of beef skyrocketed. Under the controls the
ranchers were operating below the short-run shutdown point.
Suppose the price of beef were low enough that we covered the costs of maintaining the herds but not
enough to cover property taxes, long term barn maintenance and make a normal return on our investment.
We are above the short-run shutdown price but below the breakeven price. We would not slaughter our
herds in the short run as we would be better off to continue selling beef as normal.
Economic Profit Levels
MC
ATC
Breakeven
Pt.
AVC
SRSD Pt.
The Perfectly Competitive Long-run Equilibrium

In the long run, perfectly competitive firms will not continue to produce at a negative economic profit. If
they could make more money elsewhere and it is relatively easy to exit the market, that is exactly what
some of them would do. As those firms leave the industry, the price will rise for the remaining firms
this process will continue until all negative economic profits have been eliminated. If a farmer is
consistently growing corn for an 8% accounting profit and could grow soybeans for a 10% accounting
profit, then he is making a 2% economic profit. He/she will finish the current corn crop and then plant
soybeans. This changes the market supply of both corn and soybeans, reducing the first and increasing
the second. This pushes the price of corn up and the price of soybeans down until, relative to the cost of
producing them, they both yield the same accounting profit.
CORN
One Corn Farmer

S2
S1
D2
D1
D
One Soybean Farmer
While the market supply of corn decreases, an

individual farmer who continues to grow corn will see the demand for his/her corn rise with the new
higher market price, reducing the negative economic profit. Exit will continue until there are no negative
economic profits left.
While the market supply of soybeans increases, an

individual farmer who already grew soybeans will see
the demand for his/her soybeans fall with the new lower
market price, reducing the positive economic profit
growing soybeans. Entry will continue until there are no
positive economic profits left.
Exit eliminates negative economic profits and entry
eliminates positive economic profits.
Perfectly
competitive firms makes zero economic profit in the long
run. Remember that the breakeven point is at the bottom
of the ATC curve so perfectly competitive firms are
driven to the lowest possible average cost, all other
things equal there is no way to be more efficient.
SOYBEANS
S1 S2
What if all other things are not equal? What if the firm experiences economies of scale? The firm will
move from one average total cost curve to another as it expands its capacity. Eventually, it will reach
ATC curves that exist at the most efficient scale and then the firm will be pushed to the breakeven point
on that ATC curve. Lets take the long run cost curve from chapter 3 and combine it with our current
analysis.
$
LRAC
(Long-Run
Average
Cost)
Plant 1
Economies
of Scale
Plant 2
Plant 3
Diseconomies
of Scale
Constant
Returns
To Scale
Q
Scale
When the firm is moving toward the breakeven point operating with the 1 st plant, we reach a point where
it is cheaper to shift to a larger plant, plant 2, than to continue expanding production in plant 1. As we
move closer to the breakeven point operating the 2 nd plant, we also reach a point where it becomes
cheaper to expand the size of the company again. Finally, with the 3 rd plant we reach not only the
minimum average cost on the short run curve, but also the minimum average long run cost as well. Now
the firm is operating at the minimum average cost possible in this industry.
When the Classical economists modeled the efficiency of the free market system and discussed how
responsive it was to consumers, what they really had in mind were perfectly competitive or almost
perfectly competitive industries. The problem is that there are very few of these industries in the
economy.
Journal Topics: Complete the following assignment.
Minimum of 2 pages
Richard Salsman has been heavily attacking the perfectly competitive model as the basis for government
antitrust law. Read and critique his representation of the model in the handout.
CHAPTER 11 MONOPOLISTIC COMPETITION

Equilibrium in Perfect Competition and the Other Market Structures
Once we are out of perfect competition, certain features are common to all the remaining market
structures. The demand curve for a firms output is downward sloping, i.e. the firm will have to lower
price in order to increase sales. This means that the marginal revenue curve is a different curve, distinct
from the demand curve. These two features will lead the other market structures to select an output level
that is not socially optimal. All other things equal, the three other market structures will not be as
efficient as perfect competition.
All other things equal (no externalities, public goods or other market breakdowns), the demand curve
represents the value of a good or service to society. Remember the discussion of consumer surplus in
chapter 2 any point on the demand curve represents the value of the last unit bought to consumers so the
demand curve summarizes the value of all the previous units. All other things equal, the supply curve
represents the cost of a good or service to society, including the alternative production sacrificed.
Perfectly Competitive equilibrium
Perfectly Competitive equilibrium
In perfect competition the demand curve is also the marginal revenue curve, so when a perfectly
competitive firm has a horizontal demand curve set at the market equilibrium price, it is setting Q* at the
point where the marginal benefit the good to society is equal to the marginal cost of the good to society.
This is not the case in the other three markets.
The intersection of the MC curve the representation of social cost and the market demand curve the
representation of social benefit is the socially optimal point of production. Each individual firm in this
market sees a horizontal demand curve set at the equilibrium price. Since the firms demand curve is also
its MR curve, the firm will set its production accordingly. The firms are all using the MC curve as their
supply curve and end up at the socially optimal equilibrium. This is the only market structure where that
is true.
Once you are out of perfect competition, the individual firm sees a downward sloping demand curve and
a separate marginal revenue curve. Firms are price makers they have some power over their own
price. They will not be using the MC curve as a supply curve they will not come over horizontally from
the price to the MC curve to establish the level of production. Since Q* is being set by MR and MC not
supply and demand their equilibrium will not be the socially optimal decision.
Because a firm in any of the other three market structures must lower its price to sell more units, the
marginal revenue curve is set below the demand curve. Imagine you are currently selling 500 units a
week at a price of $3 a unit for a TR of $1500. If you want to raise your sales, say to 1000 a week, you
must lower your price. If price had to be dropped to $2.00 in order to sell 1000 a week, then TR would be
$2000. The marginal revenue would then be $500/500 units or $1. The MR is less than either the old or
new price. Even though we added 500 units to sales, we dropped the price on the existing sales by $1
lowering the benefit to revenue.
Non-Perfectly Competitive
equilibrium
MC
Firm's D
MR
The non-perfectly competitive firm will still

maximize profit at the point where MR = MC. In
perfect competition that was where the firms
demand curve intersected MC but here it is at a
lower Q. The non-perfectly competitive firm will
then set price at the maximum level consumers will
pay for Q* which is set by the demand curve.
Because we have reduced the equilibrium Q, we
have pushed up the equilibrium P. From a social
point of view, the benefit to consumers justifies
making more units up until the demand curve
intersects the MC curve, but from a business point of
view such an expansion would not be profitable.
There is a loss of benefit to society a deadweight
loss that occurs from the lack of competition. The
deadweight loss is the lined triangle.
Q*
These non-perfectly competitive markets end up

with higher prices and less output, all other things
equal. They will not be pushed to a long run equilibrium that combines a lack of excess profits with the
lowest possible average cost of production. The bottom of the ATC is the intersection point with the MC
curve, if we are producing at maximum efficiency then ATC = MC. Since MC must equal MR and MR is
less than P, we would have excess profits in the industry. If we have zero economic profit, then P = ATC,
but P is greater than MR, while MR = MC. MC would then be less than ATC and we would be producing
for a higher average cost than the minimum. The structure of non-perfectly competitive markets is less
efficient than perfect competition.
Monopolistic Competition
The first of the non-perfectly competitive markets is known as monopolistic competition this is a
market structure marked by a high degree of competition its just not perfectly competitive. Each
individual company has its own version of a product, so in one respect it is the only seller of this version.
However, this version is very similar to the other goods in the market so there is a large amount of
competition. Numerically, this is by far the most common market structure in the US as most
proprietorships are in monopolistic competition, and proprietorships are the most common form of
business organization in the US. These firms, however, do not have strong individual power. The
assumptions of monopolistic competition are:

Many buyers and sellers: There are so many buyers and sellers in monopolistic competition
that no one of them has any significant influence on the market. The number of consumers and
producers is not as great as in perfect competition but is still sufficient to be very competitive.
Similar or heterogeneous product: Every producer in the market makes a similar, but not
identical product consumers are able to distinguish between the output of one firm and the
output of another. There can be labels, brands or any other distinguishing features used to make a
product look distinct a process known as product differentiation. This is the biggest
difference between perfect and monopolistic competition.
Relatively good information: Both buyers and sellers in this market have information about the
product, but not as good as in perfect competition. Because the products are somewhat different,
each one has to be investigated separately and consumers do not usually have the time or
inclination to do those completely. Instead, we rely on word of mouth, trial and error and
advertising in order to find goods we are satisfied with. We do not generally proceed to the point
that we know we have the BEST product for the money.
Relatively free entry and exit: Firms are able to move resources in and out of this market
relatively easily with little expense. This makes firms especially quick to respond to changing
consumer demand.
This can be a highly competitive market and consumers usually fare well under monopolistic competition.
There are many producers of a similar product not only is there good competition, but there is great
variety in the nature of the product. This gives consumers a lot of choices.
Product differentiation involves a number of business activities. We may vary the physical properties of
the product adding scents, flavors, textures and colors, changing the shape of the product or the
materials its made of. You can buy soap that has oil added to protect dry skin or soap that has agents in it
to strip oil from oily skin. You can buy soap that is yellow or blue or pink. There is soap that smells like
roses and soap that smells like lavender and soap that smells like pine. There is soap that has oatmeal in it
to remove dead skin or ground up rock in it to remove embedded dirt by removing the top layer of skin.
You can buy soap that is pressed into the shape of seashells or roses.
We can vary the service offered, either as an independent service or in combination with a good. We can
have a 24-hour store, or free delivery or an extended warranty. Out tech support people can come to your
house and move all your old programs onto your new computer. We can accept returns, no questions
asked, or special order material. Stores can be located on major streets with drive through windows.
Finally, we can vary the marketing. The product and service itself might not have any substantive
differences but we could change the package and labeling. Advertising might be used to give our product
a certain image that other versions of this product lack. Prestige and status, attractiveness and sex appeal,
safety and reliability, economy and thriftiness are all common themes stressed in the image of certain
products. Generally, major investments in this kind of marketing are most seen in the next market
structure, but to a lesser extent it can be found in monopolistic competition.
Product differentiation gives consumers a range of choices in the product and service. It is likely,
however, to also raise the cost of production. All other things equal, the cost per unit of producing goods
with special features or extra service will be greater than the cost of making all the goods exactly alike
with the minimum features necessary. All other things equal, the money spent on advertising, packaging
and labeling will raise the cost per unit of the good. All other things equal, the entire ATC curve is higher
with product differentiation.
Advertising may allow the firm to increase its size and enjoy economies of scale. In this case the
advertising might result in a more efficient company rather than a less. Since monopolistic competition is
generally marked by smaller companies that operate in a highly competitive industry, it seems likely that
the economies of scale are limited. Large economies of scale tend to result in very large producers and
that seems more relevant to the next two market structures.
Short-run equilibrium in Monopolistic Competition

In monopolistic competition the production decision will look like this. Q* is set at the intersection of the
marginal cost and marginal revenue, while P is set by the demand curve at Q*. If we add an average total
cost curve to the graph, we can calculate the cost per unit of Q*.
Short-run equilibrium in
MC
MC
Firm's D
ATC
Firm's D
ATC
MR
Q*
MR
Q*
The firm makes a profit on each unit equal to the price minus the
unit cost. This is the vertical distance between the demand and
ATC curve at the Q* quantity. The firms total profit is the profit
per unit times the number of units Q*. Since Q* is the
horizontal distance from the vertical axis out to the Q* quantity,
total profit is the area of the rectangle as shown to the left. The
height is profit per unit, the width is the number of units and the
product (the area) is the total profit.
Long-run equilibrium in Monopolistic Competition
MC
P
ATC
Firm's D
ATC
MR
Q*
The same process works in monopolistic competition

that we see in perfect competition. Relatively free
entry and exit will push the industry to a breakeven
point. The breakeven point is not located in the same
place, however.
In the long run, monopolistic competitive firms will
not continue to produce at a negative economic profit.
If they could make more money elsewhere and it is
relatively easy to exit the market, that is exactly what
some of them would do. As those firms leave the
industry, the price will rise for the remaining firms
this process will continue until all negative economic
profits have been eliminated.
In the long run, monopolistic competitive firms will not continue to produce at a positive economic profit.
If they are making more money than elsewhere and it is relatively easy to exit and enter the markets, that
is exactly what some of the firms will do in the other industries. As those firms exit their market and
enter this market, the price will fall for the original firms this process will continue until all positive
economic profits have been eliminated.
Long Runequilibrium
Equilibrium
Short-run
in
InMonopolistic
MonopolisticCompetition
Competition
MC
ATC
P = ATC
Firm's D
MR
The monopolistically competitive firm on the

left is at a breakeven point. The firm sets
production at Q* - the point where MR = MC.
The demand curve establishes P, but since the
ATC curve is tangent to the demand curve at
that point, the P = ATC. We are breaking
even.
Notice that the firm, although breaking even,
is not operating at peak efficiency. There is
room to lower the ATC by expanding
production; however, in order to sell the good
the price would have to fall even more.
Expansion is therefore not profitable and does
not occur.
Q*
This is the trade-off in monopolistic

competition consumers gain variety at the
expense of some efficiency. If the product differentiation raised the ATC curve, then consumers lose even
more efficiency.
Journal Topics: Complete the following assignment.
Minimum of 2 pages
1) Find several examples of product differentiation and describe them. Use examples with different
kinds of differentiation.
2) Describe several industries that would fall under the monopolistic competitive model.
CHAPTER 12 OLIGOPOLY
Characteristics of Oligopoly
Oligopoly is the first of the market structures that is marked by a limited degree of competition.
Oligopoly covers a multitude of markets from those that are fairly competitive to some that have very
little competition at all. Consumers will face more limited choices in oligopoly and it is within this
market structure that the balance of power shifts against the consumer.
This is the market structure containing the industries that drive the US economy. The major corporations
are in this market structure, and although they are not as numerous as monopolistic competitive firms,
they are far larger, more powerful and account for more production. These companies often hold
significant political influence in addition to their economic influence. The assumptions of oligopoly are:
Relatively few sellers: There are few enough sellers in oligopoly that they can individually have
influence on the market. Producers in oligopoly are interdependent a firms success can be as
influenced by the actions of a competitor as its own. The cut-off for oligopoly is arbitrarily
chosen to be a concentration ratio of .4 or over. In other words, if the top four firms in the
industry have 40% of sales or more, then it is considered to have relatively few sellers. When
firms are this large and control this much market share, then the actions of one significantly
affects its competitors.
Identical or Similar product: In some oligopolies, such as the steel industry, the product can be
identical from producer to producer. In other oligopolies, such as the auto industry, the product is
only similar from company to company. AOTE, the more similar the goods the more
competitively the market will behave. This is because it is easier for consumers to switch from
one good to another reducing the firms power over price.
Good or poor information: Both buyers and sellers in this market could have good information
about the product or not. Good information is more likely to occur when the products are
identical or very similar. The more differences between versions of a good the more data the
consumer has to gather to have good information for comparison. AOTE, the better the
information the more competitively the market will behave. Firms will be pressured to keep
quality and price in line with other producers if they fail to do so, consumers have the
knowledge to go buy the better value.
Barriers to Entry: Firms are not able to move resources in and out of this market relatively
easily with little expense. The barriers to entry are of two types.
Artificial barriers: artificial barriers to entry keep new firms from entering even if they
wish to. These are generally structural features that make entry difficult or
impossible. Artificial barriers to entry include patents, government licenses,
control of a raw material, network advantage (where the size of a system of
associated services is part of the attractiveness of the good) and high start-up
costs.
Natural barrier: there is one natural barrier large economies of scale that
discourages new producers from even trying to enter. There is such a cost
advantage to being big that a few huge firms control this market. A new producer
is reluctant to enter because they cant produce for as low a cost.
Oligopolies vary in the degree of competition some are competitive enough that they are only slightly
different than the least competitive firms in monopolistic competition. Some are uncompetitive enough
that they are almost a monopoly. While there is disagreement among economists on any rule of thumb to
categorize oligopolies, we will use the following generalizations.
Concentration ratio of .4 to .6
Concentration ratio of .6 to .8
Concentration ratio of .8 or over
Weak Oligopoly, not strongly concentrated

Standard Oligopoly neither weak nor strong
Strong Oligopoly, strongly concentrated
Competitive Oligopolies
If an oligopoly market has at least a moderate number of producers that are truly competing with one
another i.e. no cooperation and no basis for anticipating the decisions of the other firms - they may
exhibit an unusual shaped demand curve. Suppose you are running a firm in such a market, and you are
considering changing your price as you search for the profit maximizing point of production. You have to
consider how your competitors will react when you change price, because that reaction will change the
profitability of any decision you could make.
Price
You are currently selling 600 units a week at a price of $6. You are not sure that this is the profit
maximizing point of production and are considering change price to find out. You could lower price and
hope to make up on volume what you lose on profit per unit; you could raise price and hope that the
higher profit margin makes up for a drop in sales. The effect you see will depend on whether the other
firms in the industry ignore your price change, keeping theirs about where it was before or match it.
In this case the competition decided to ignore
your price change. If you raise price you will be
Competition Ignores
the only firm to do so and you will see a large
drop in sales. Some of your consumers are
$12
going to go buy the product from someone else.
If you lower price you will also be the only firm
$10
to do so and you will see a large rise in sales.
$8
The demand curve is relatively elastic.
$6
If this were the situation in the market, it would
$4
D
suggest that you either leave prices alone or cut
$2
them. A price increase is very unlikely to raise
$0
profits; on the contrary, it will probably lower
them.
200
400
600
800
1000
Quantity of Output
If this were the situation in the market, it would

suggest that you either leave prices alone or raise
them. A price decrease is very unlikely to raise
profits; only the consumers win a price war.
$12
$10
$8
Price
In this case the competition decided to match your

price change. If you raise price, so too do the
other firms and there will be a small drop in sales.
Consumers have nowhere to go but out of the
market. If you lower price, the other firms will
match you and you will all gain very few sales,
only receive less profit per unit. The demand
curve is relatively inelastic.
Competition Matches
$6
$4
$2
$0
200
400
600
800
1000
Quantity of Output
Since these two possibilities suggest two contradictory price policies, the question becomes which is true?
The answer might be both of them, depending on the nature of the price change. Oligopoly firms which
are truly competing may match a price decrease but ignore a price increase.
Game Theory
To see why a price decrease would be matched while a price increase is ignored, we can model the
decision making of the firm. The firm controls part of what goes on in the market, but in an environment
of no cooperation or shared information does not know what decisions will be made at the other firms. It
must consider each scenario that would occur depending on the different combinations it and the others
could select.
Game theory is a way of representing the various options available to a decision maker and then showing
how they tend to select strategies. In some cases there is a clear choice - no matter what the other side
does, this choice is the best for the firm - this is known as a dominant strategy. In other cases the best
choice is unclear since it depends on the decisions made by the other player(s).
It isnt very useful to model the dominant strategy because if it is the best choice regardless of the
decisions of the other firms, then there is no reason to study their decisions and the impact they will have.
It is the case where there is no dominant strategy that game theory excels in showing why firms may
make a decision which in the aggregate is not the best selection, but on the individual level may be.
Suppose that Honda announces it will increase car prices next quarter (assume the auto industry meets the
competitive criteria). The management at Ford is considering whether or not they should follow Honda
and increase prices as well. The results at Ford will be affected by the decisions made, not only at Ford
but also General Motors, Toyota, and the other car companies. Suppose Ford's current profit is $4 million
and the following reflects Ford's best estimates of what will happen to Ford under the different possible
outcomes:
GM AND OTHERS
RAISE PRICE
FORD RAISES
PRICE
Higher car prices in general
mean consumers have few
choices. Each company
loses some sales but not a
lot.
FORD DOESN'T
RAISE PRICE
Only Ford has older, lower
prices. Ford steals market
share from all the other
companies.
Ford's profit $4.6 million
Ford's profit $5 million
GM AND OTHERS
DON'T RAISE PRICE
Only Ford and Honda have

the new, higher prices.
They lose market share to
everyone.
Only Honda has the new,

higher prices. Ford and the
other car companies steal
market share from Honda.

There is no dominant strategy here, Ford would do best raising prices IF it knew GM and the other
companies would as well. Given that this is a dangerous strategy for a firm to attempt - they could also
end up with the worst outcome; a company in this situation is most likely to take the safe strategy - Ford
cannot lose maintaining the old prices here. They will probably not follow Honda, unless they can
acquire some information about or cooperation with GM and the other companies.
The Kinked Demand Curve

If firms ignore a price increase then the demand
curve will be fairly flat or elastic at prices higher
than the current one.
Kinked Demand Curve
If firms match a price decrease then the demand

curve will be fairly steep or inelastic at prices
lower than the current one.
$12
$10
Price
$8
This gives us a demand curve that is bent or

kinked. The bend occurs at the existing price in
the market.
$6
$4
$2
$0
200
400
600
800
Quantity of Output
1000
In this situation, the firm is best leaving the price

where it is. Prices in such a market will be very
stable unless underlying costs change or the whole
demand curve shifts significantly.
Price Leadership
Its understandable how the corner or kinked price

persists, but how did the industry establish the corner price to begin with? In some industries there is an
acknowledged leader a firm which is looked to by the other firms when it is time to set a new industry
price structure or technology. This may be because of its size, or technological dominance, or history. In
times of turmoil, when external forces such as a changing technological base or significantly changing
consumer demand render the old equilibrium obsolete, firms will look to this leader to establish the new
stable order in the industry.
But, we may have now relaxed one of the assumptions under the competitive oligopoly model that there
is no basis for anticipating the decisions of the other firms. The industry leader has a past precedent that
other firms follow its lead it may decide to risk raising price when there are no external forces at work.
Kelloggs is the leader in the cereal industry. If Kelloggs knows that every time corn prices change,
General Mills and General Foods follow Kelloggs lead in setting the new price and the timing of the
price change, then Kelloggs knows there is a good possibility that they will follow its lead if it raises
cereal prices when costs arent rising.
The likelihood of this happening is related to the number of major firms in the industry. If there are only
3 or 4 dominant firms, then if one changes price the other three only have to worry about what 2 other
firms are going to do. The probability of a firm taking the risk to follow a price increase by one
competitor is much higher if the number of businesses in the industry is small. Traditionally, in the cereal
industry there were only 3 producers making about 85% of the output.
This can lead to the industry leader essentially setting price for the entire industry a phenomenon known
as price leadership. Price leadership can be used as a way of establishing a near monopoly price as long
as the other firms do not use the opportunity to gain short run sales at the expense of long run profit.
Provided the firms do not actually coordinate their strategy, it is unclear if this behavior is illegal.
Anti-trust Law and Collusion

By the late 1800s, the Federal government was becoming concerned about the noncompetitive behavior
of some American firms. Some companies were cooperating to establish trusts legal agreements that
coordinated the production, pricing and distribution decisions of separate companies in a way to remove
choice from consumers and establish high prices. A company literally signed over these decisions to a
group of trustees to run the industry to the benefit of the major producers. Small or independent
producers were run out of the market by a variety of tactics which by the best interpretation were
unethical.
Powerful monopolies were also rising during this time period people like Rockefeller were establishing
the one company domination of industries like oil refining. Again, this reduces the choices available to
consumers, increases price, as well as reduces production and probably quality. Because of this the
government passed laws to limit the ability of firms to behave in uncompetitive ways, and these were
known as anti-trust laws.
1890 Sherman Anti-Trust Act: The Sherman Act made it illegal for firms to restrain trade and conspire
to create a monopoly in interstate commerce. There were several loopholes in the Sherman Act that
weakened its impact. First, only monopolizing behavior in commerce over state lines was illegal.
Second, the term "restraint of trade" was not clearly defined. Price fixing, where firms cooperate to
establish price together, also known as collusion, was one activity clearly considered to be restraining
trade, and therefore illegal. Third, it only outlawed trying to create a monopoly, not having one. In other
words, the government had to demonstrate that you behaved in ways designed to eliminate competition; it
was considered acceptable to have a monopoly by consumer choice. Although weak, and not upheld by
all Presidents or the Courts in general, the Sherman Act was not useless. Theodore Roosevelt was able to
break up several powerful trusts or monopolies (like Standard Oil) armed with nothing more than the
Sherman Act.
1914 Clayton Act: The Clayton Act more specifically outlawed activities that were considered to threaten
competition. The Clayton Act makes illegal to engage in:
tying contracts: These require a customer to buy goods they do not want, in order to acquire the
good that they do want.
interlocking directorates: These exist when some of the same individuals serve on the Board of
Directors for competing companies.
price discrimination: This is the practice of charging one set of customers a very different price
than another set, without a demonstrable cost basis.
The Clayton Act also granted labor unions an exemption to anti-trust law and limited the scope of
mergers. If a merger significantly reduces competition in an industry, the firms must seek the approval of
the government before combining.
1914 Federal Trade Commission Act: The FTC Act created the Federal Trade Commission, whose role
it was to oversee the level of competition and to investigate mergers. In the early days of the commission,
they had broad powers to define "unfair" business practices and then issue cease and desist orders to stop
the activities. Later these powers were trimmed, but the FTC was also given regulatory authority over
advertising. They are the agency which oversees mergers and must grant approval for significant
mergers. The FTC typically uses the Herfindahl-Hirschman Index to decide if the merger should be
blocked typically if the HHI is over 1800 or rises by more than 200, the FTC is reluctant to allow a
merger to occur.
Throughout much of the early 20 th Century, the courts were disinclined to uphold anti-trust law with any
vigor. The "Rule of Reason" was a legal precedent used to limit the scope of the laws and make it more
difficult for the government to prove its case. The rule of reason basically said that the government had to
prove that the noncompetitive structure of the market had been deliberately sought rather than the result
of natural market force. In other words, it was fine to have a monopoly or powerful oligopoly if it
occurred without intention as the result of making a good product at a good price. Essentially, the
government had to prove that consumers were being hurt by the anti-trust violations. The rule was
abandoned in the 1945 Alcoa case, where Alcoa lost even though their product was good, prices were low
and customers were satisfied. By the 1980s the rule is sneaking back into interpretations of the law and is
a key part of the debate over the Microsoft case. Is the purpose of anti-trust law to protect firms against
large competitors or to protect consumers against noncompetitive markets pushing price up and
quantity/quality down?
Cartels
US anti-trust law regulates the behavior of American firms or foreign firms doing business in the US, but
our laws do not have jurisdiction over foreign firms operating in foreign countries. In some parts of the
world companies or governments have created cartels - formal organizations to control the production
and, therefore, price of a commodity. The track record of cartels is a mixed bag with a few being very
successful and many struggling to coordinate the cooperation.
OPEC, the Organization of Petroleum Exporting Countries, is among the best known of the cartels.
Formed in 1960, OPEC is infamous for the large crude oil price increases it was able to achieve in the
1970s triggering simultaneous serious unemployment and inflation stagflation - in the US economy.
OPEC however, saw its control of oil markets erode in the 1980s and 1990s, only successfully bringing
oil prices back near their 1981 highs at the turn of the century.
In order to be successful, cartels need to have certain factors on their side. In some years OPEC had these
and in others they did not.
Control of the market: In order to be successful, a cartel must have sufficient control of the
market to be able to dominate production level and price. If the cartel does not sufficiently
control the market its production cuts will merely boost price for nonmembers. The greater the
control the better, but a cartel probably needs about 75%-80% control of an industry to truly be
successful in the long-run.
Ability to enforce production agreements: Cartels raise the price of the good they sell by
limiting the production of it. This is one of the greatest challenges of any cartel, trust or collusive
conspiracy keeping the agreement. There is an incentive for the individual members to cheat on
their production quota. If I produce more while everyone else follows the accord, then I get both
the high price and high sales. Since everyone faces the same temptation it is likely that cheating
will occur this is known as the cartel problem. There are a couple of ways that this issue can
be reduced or controlled.
Relatively few members: - all other things equal, a cartel will be more successful
controlling the production and price if it has a smaller number of producers. It is
generally easier to come to an agreement, the consequences of cheating are greater (i.e.
one firms cheating has a larger impact on market price when the firms are big) and its
easier to figure out who is cheating when there are only a small number of participants.
Dominant producer all other things equal, a cartel will be more successful controlling
the production and price if it has one large producer. That large producer is the natural
leader of the cartel and can exert influence on the other members. If the dominant
producer threatens to forego the production quota, it will often hurt the other members
more than it would itself, which is a negotiation weapon.
Similar production costs: Each producer in a cartel will want to set price at the point that
maximizes its own profit. A low cost producer will find it most profitable to produce a higher
level of output than a high cost producer, and a low cost producer will be reluctant to maintain the
large production cuts necessary to keep the price anywhere near the level a high cost producer
would prefer. It will be difficult for them to agree on a target price in the first place and harder
for them to maintain that target price.
High and inelastic demand: A cartel will not be successful if the good it sells has a very low
demand this is the main reason the lead cartel failed. The strategy of cartels is to cut production
in order to boost price; this will only work if the buyers keep buying the product. If the good has
elastic demand, then a rise in price will cause a larger drop in sales, in proportional terms. Total
revenue follows quantity when demand is elastic. The good needs to be one that consumers have
a high necessity for and few substitutes so that they will keep buying it at the higher price. When
demand is inelastic, total revenue will follow price, which the cartel is raising.
Cartels can be the victim of their own successes as they boost price higher and higher they encourage
the entry of new producers into the market. As OPEC pushed the price of oil from several dollars a barrel
to $35 dollars a barrel in less than ten years, a flood of oil exploration and new oil fields resulted. This
reduced OPECs clout during the 1980s and 1990s.
The cartel can be thought of as operating in a gray area between the oligopoly and monopoly market
structures. It is a market with a few large producers which fits the oligopoly profile; however, it is trying
to operate as a single producer which fits the monopoly profile. The more cohesive the cartel the more
the market will behave as a monopoly. Most cartels, however, struggle to coordinate the disparate needs
of the individual members, and in general, behave as oligopolies.
Another case that falls between the two market structures is the oligopoly market with one huge dominate
producer. There comes a point where the dominating firm can be thought of as having achieved virtual
monopoly status even though it has not eliminated all vestiges of competition. Both AT&T and Microsoft
reached near 90% market share or beyond, in industries that had no other major producers; as this
occurred we have shifted them into the monopoly market structure.
Journal Topics: Complete the following assignment:
Use the Commerce Department handout and find 2 examples each of:
monopolistic competitive
weak oligopoly
standard oligopoly
strong oligopoly
case where the HHI indicates a highly concentrated market and the concentration ratio
does not.
Find and summarize a web site on cartels or game theory. Minimum of one page
CHAPTER 13 MONOPOLY
Monopoly is the least competitive market structure of all. A pure monopoly is a market with only one
producer who produces 100% of the output. In a pure monopoly the HHI is 10,000, the highest HHI
possible. Consumers have the least choice in a monopoly market buy from the monopolist or dont buy.
AOTE, we would expect a monopoly market to have the highest price and the lowest total production of
any market structure. The assumptions of monopoly are:
One seller: The classic monopoly has only one seller by definition. In actuality, we also use the
market structure to analyze industries that have essentially one producer controlling almost all the
output.
Unique product: Since there is only one producer, or effectively one producer, the product they
make cannot be compared to alternatives. It is unique. This is important in understanding why a
company like Pepsi is not a monopoly even though it is the only company that can produce its
version. The product is not unique.
Good or poor information is largely irrelevant: Whether the information is good or bad is
essentially irrelevant since there is no other product to compare this one to.
Barriers to Entry: As in oligopoly, firms are not able to move resources in, and out of this
market relatively easily with little expense. The barriers to entry are higher in monopoly and also
include the same two types.
Artificial barriers: artificial barriers to entry keep new firms from entering even if they
wish to. These are generally structural features that make entry difficult or
impossible. Artificial barriers to entry include patents, government licenses,
control of a raw material, network advantage and high start-up costs. A
monopoly that mainly exists because of artificial barriers is called a non-natural
monopoly. Since there are no or few cost advantages to this company, it will
result in higher prices and lower output for the consumer.
Natural barrier: there is one natural barrier large economies of scale that
discourages new producers from even trying to enter. There is such a cost
advantage to being big that the industry has ended up with only one producer. A
new producer is reluctant to enter because they cant produce for as low a cost. A
monopoly that mainly exists because of economies of scale is called a natural
monopoly. The cost efficiency would, by itself, lower price and raise output, but
the lack of competition works in the opposite direction. We are, therefore, not
able to predict the effect on price and quantity in the case of a natural monopoly.
If the economies of scale are large enough, it is possible that the consumer could
get more output at a lower price than if the market were competitive.
Monopolies may not always be bad for consumers. Natural monopolies have large cost efficiencies;
consumers may benefit from having a large unified network; and the temporary monopolies caused by
patents may foster the development of new products and technology. In general, though, we view this
market structure with suspicion for the likelihood that the company will make greater than normal profits
and be less responsive to consumers. The monopoly sees the entire market demand curve - the market
demand curve is less elastic than the firms demand curve allowing the monopolist to raise price more
than a single competitor could or even than a cartel which has to coordinate and defend the collusion
price. This is the main reason why anti-trust law was passed.
The government has four potential policy paths to pursue when faced with a monopoly or powerful
oligopoly it can ignore it, break it up, regulate it or nationalize it. The course of action selected depends
on the nature of the market.
Leave it alone
If the noncompetitive market is temporary based on patents, it would make no sense for the government
to intervene. The whole purpose of patent law is to give the innovator a temporary period of market
power as an inducement to invest in research and development and as a compensation for the risks
involved in new products. Certainly, this is the easiest and cheapest policy.
If the noncompetitive market has very large economies of scale or network advantages then the
consumers may actually be better off with the monopoly or powerful oligopoly than with a more
competitive industry. This is most likely to be true if the good or service being sold has an elastic demand
if firms were to raise price, they would lose a lot of sales. In the early days of the telephone industry
there were large economies of scale and even larger network advantages large companies could offer
larger networks of people to call and were therefore more attractive. It made sense to have one integrated
telephone network that used common technology and systems. The phone was a luxury to most people,
which gave the phone company relatively little power. Under the Kingsbury Agreement, the US
government agreed to leave the emerging virtual monopoly AT&T alone in return for the promise to
create universal telephone access even in rural isolated communities.
There are those who claim that the government should leave the high-tech industries alone, since rapid
technological change has tended to reduce yesterdays monarchs to todays has-beens (both IBM and
Apple dominated the computer industries and then lost much of their market power). Companies have to
stay on the cutting edge producing the best product possible at the best price or be eliminated by new
upstart companies with better systems. By this argument, market dominance in high tech is built upon
consumer benefit; the logical implication is that this is desirable and the government should not interfere.
To paraphrase the position in one of the antitrust cases of recent years, The purpose of anti-trust law is
not to protect the consumer from good products at low prices.
Break it up
If there are no patents, large economies of scale or network advantages, then consumers are gaining no
benefit from the lack of competition. The only effect of the noncompetitive structure will be to raise
price, lower quantity and reduce the incentive of firms to be responsive to the needs and wants of
consumers. In such a case it appears the best action would be to break the company up. Early in the
1900s the US government broke up American Tobacco, the railroad and sugar trusts and Standard Oil
under this logic. In 1982, the government broke up AT&T, a monopoly that had been largely left alone
for many decades, even though the company did not meet the criteria for this tactic. AT&T had large
economies of scale, a network advantage and major patent development. Furthermore, the company was
broken up into regional monopolies rather than a truly competitive industry. As a consequence, the
average American telephone consumer saw their phone bill rise significantly in the first year after the
breakup. At that time many economists stated their preference for using the next policy rather than
creating a series of regional Baby Bells.
Regulate it
If the noncompetitive market offers advantages to consumers such as economies of scale or network
advantage that we do not wish to lose but is abusing their market power or has too much potential to
abuse their market power, we could regulate them. Under this strategy the government would oversee the
industry, setting limits on their actions and prices, but allow the company or companies to continue to
exist as noncompetitive entities.
Electric utilities are a common example of regulated regional monopolies. The economies of scale are
enormous but electricity is such a necessity to households, businesses and communities that, if left alone,
the monopolies would have too much power. As a result, they are regulated. Ideally, the regulatory body
would like to replicate the socially optimal production and price combination that a highly competitive
industry would naturally create. In reality, this is unlikely to happen even if the board is objective and is
honestly trying to find the socially optimal point - no one else in the market wishes them to find it.
In order to prevent excessive profits the regulatory commission or agency could regulate the
noncompetitive industry by setting its price. The problem is that the firm wants the price to be above the
competitive market solution so that it can maximize profits, while the consumers want the price to be
below the competitive market solution so that they save money. Both sides have no interest in aiding the
regulatory board in finding the best long-term solution to price from societys point of view.
If price is set too high, the buyers of this product will have less money for other purchases and activities.
It will represent a needless hardship to buyers with inadequate financial resources. Small businesses may
move or shut down if electric rates are excessive costing the community jobs. Low-income consumers
could lack sufficient heat or cooling because of high electric rates.
If price is set too low, the sellers of this product will not make a normal rate of return on their investment.
They are likely to cut service, quality, maintenance or investment in order to boost their profits back up.
Over time, insufficient maintenance may cause large costs to repair or replace equipment and facilities
at that time the board would have no choice but to raise price to cover necessary expenses. Insufficient
investment may mean that the industry will not be producing all the good or service needed in the future.
This is particularly a problem in industries like electric utilities, where the lead-time on new facilities
takes several years.
A perfectly competitive industry automatically sets price equal to marginal cost this is called marginal
cost pricing. Since the marginal cost is relatively easy to calculate, the government could use this
strategy to set the price for a monopoly. The problem is that the usual reason we are regulating this
industry instead of breaking it up involves large economies of scale. If there are still economies of scale
in the industry, then by definition the average cost of production is falling. If the average cost is falling,
then marginal cost must be below it.
If the average cost of production is falling each
time we get bigger and produce more units, then
the cost of the next unit must be smaller than the
current average. (If your GPA were falling then
your new or marginal grades must be lower than
the previous average.) The marginal cost curve
must be below the average cost curve.
Remember that any average cost curve falls until
it intersects the marginal cost curve.
Economies
of Scale
LRAC
MC
Q
Scale
If we set price by the MC curve while the cost of

production is off the LRAC curve, then this firm
will be making a negative economic profit.
In addition, if the industry is one where the input prices regularly fluctuate as electricity is given the
volatility of oil prices then even if the original approved rate were perfect, it would not long remain so.
The firm lacks the flexibility to raise price when production costs rise and the incentive to lower price
when production costs fall.
The regulatory body could try to limit the power of a noncompetitive industry while avoiding these issues
by regulating the profit rate. This would allow the firm to set price at a level consistent with good service,
maintenance and investment and force them to adjust price as costs change to prevent excessive profit.
Unfortunately, this eliminates the incentive for the firm to keep costs down once the maximum profit
allowed has been achieved. The management of the firm may inflate costs beyond what they would pay
if the money were coming out of their own pockets. Extra money is likely to be spent on fancy offices,
expensive business trips, higher wages than those paid by the unregulated private sector, etc. Decision
makers are maximizing a combination of profit and personal benefit rather than profit alone this is
known as satisficing.
All of the previous discussion assumed that the regulatory body was objective and honestly seeking the
socially optimal price and production combination. What if this were not true? It is possible that
regulatory agencies can be dominated by the interests of one market participant or another a situation
known as capture. A regulatory body is said to be captured when one side or the other has an edge is
able to dominate the process.
Originally, it was thought that capture would always be by the industry if it existed at all. This is very
logical given that we appoint experts on the industry to the regulatory board or commission and most
experts on an industry work in that industry. You are taking people out of the companies being regulated,
putting them in the regulatory process, and when they leave the government position, they usually go
back to the industry that they just finished regulating. It is reasonable to assume a conflict of interest
here. The availability of jobs and the level of salaries could be influenced by how friendly the regulator
was to the industry while in office. We certainly can find industries in which many economists are
convinced the government body has been captured. Many analysts have claimed that the Federal Aviation
Authority has been captured by the airline industry their resistance to changing regulations when new
problems arise has often only been overcome when a major accident or pattern of accidents occurs.
Surprisingly, studies in the late 1970s suggested that sometimes consumers capture a regulatory body.
The difference appears related to how the members of the price board are selected. If the regulators are
directly elected by the public, the group is more likely to be dominated by consumers. This is
understandable, since the number of voters who are consumers far outnumber the voters who work for or
own the industry. The more layers of appointment protecting the price board and the people who select
them from the voter, the more likely the regulatory agency will be dominated by the industry it regulates.
Regulation is the most expensive strategy for the government to pursue. The costs of regulation are high
and continual every year we must pay to keep the regulatory bureaucracy operating. Some conservative
economists and politicians have argued that the costs of regulation coupled with its inexactness result in a
cure that is worse than the disease the regulation was trying to alleviate the lack of competition.
They argue that firms become so inefficient when faced with the rules and charges resulting from
regulation that the prices are higher and the firms less responsive to market conditions than if we left the
noncompetitive industry alone. This claim was heavily advanced during the 1980s and the deregulation
of the Reagan administration. This deregulation appears to have been successful, at least in the short-run
in lowering prices in the airline and trucking industries.
More liberal economists and politicians point to problems in some of the markets that were deregulated as
reasons why the regulations were necessary. So far, attempts to deregulate the electric industry have not
been successful witness the California energy crisis that appears to have been manipulated if not created
by some of the energy companies. Middlemen who move electricity and oil, such as Enron, appear to
have at least taken advantage of the market situation to charge prices far above that of a competitive
market, making enormous profits.
Nationalize it
The last possible strategy the government could use with a noncompetitive industry is to actually take it
over and run the industry itself. This is called nationalizing. If the noncompetitive market offers
advantages to consumers such as economies of scale or network advantage that we do not wish to lose,
but is abusing their market power or has too much potential to abuse their market power, we could take
them over. Under this strategy the industry would be part of government and the employees would be
government employees. There would be no profits being received by owners any money made by the
industry would just be part of government revenue. This alternative has been largely rejected by the
American population and government.
Nationalization is an alternative to regulation. In both cases there are strong reasons not to break the
company up, but the company has too much power to leave alone. There are a several reasons why one
might support nationalizing an industry rather than regulating it. The first is the industry is going
bankrupt this has been the only case where the US took over an industry when passenger rail service
became government run in the 1970s. Even then, Reagan sold some of the Amtrak lines back to the
private sector in the 1980s.
The second reason for nationalization is if people believe the good is so vital to societys well-being that
the government must run it to ensure that enough is made and that it is fairly distributed. This is
particularly important if the good has large external benefit or is largely a public good. The private sector
would underproduce it. Many countries have chosen to nationalize or partially nationalize their health
care sector using this argument. Health care is vital to the well being of individuals and society. There
are large external benefits to having healthy workers and citizens and in a private market system low
income families will be unable to acquire all the necessary basic health care.
The third reason to nationalize rather than regulate is if one believes that the public sector is more
efficient at managing production than the private sector. Again, if the good were very important to
society we might decide that it belongs to the public sector.
In general, Americans do not have great faith in the ability of their government to efficiently run things
and for this reason generally think poorly of attempts to raise government management of industries. In
addition, nationalization has been rejected on ideological grounds as moving toward socialism an
economic system where the government owns and/or controls the factors of production.
Journal Topics: Complete one of the following assignments.
1.
Due to deregulation of the financial sector, banks, insurance companies, brokerages and other
financial companies are able to offer a wider variety of services. They are also able to operate in more
markets and merge more easily than in the past. A number of questions have arisen as a result of these
changes; by the spring of 2002 accusations have been made that financial analysts and brokerage houses
have been recommending stocks to their clients when they knew that the companies had serious
problems. These brokerage firms made millions of dollars in fees for offering financial services to the
companies whose stocks they recommended. Find 3 articles on this and write a 2 page paper
summarizing the situation and giving your reaction.
2.
The Microsoft case is the highest profile antitrust case in the last 20 years. The government
claims that Microsoft is essentially a monopoly that acquired its market dominance through unfair
practices and that they have stifled innovation and competition in the software market. Find at least one
article for and one article against Microsoft and write a 2 page paper summarizing the situation and giving
your reaction. Relate to the potential remedies that the government could use in such a situation.
CHAPTER 14 MARKETS AND GOVERNMENT
The US Economy
Given that markets break down when there is a lack of competition and good information, how well do
markets work in the US? Obviously, this is a normative question and the answers received will vary
greatly depending on the interpretations and priorities of each economist. We can discuss some of the
patterns to competition and information in order to help you come to your own conclusions.
The US has industries in every one of the four market structure in fact, since each market structure is a
broad category with differences in degree from end to end, we have industries across each market
structure. The fewest firms are found at the two extremes.
Very few markets meet the rigorous requirements of perfect competition; generally the market structure is
used to analyze the major agricultural markets and the exchange markets (including in recent years online auctioning). These make up an extremely small percent of the US economy. Given that the free
market model is largely based upon the functioning of perfectly competitive industries, this raises serious
questions about the applicability of the Classical model.
Since markets work the least efficiently in monopolies, aote, government regulation and/or breakup under
antitrust law becomes very important. Today, monopolies are fairly rare in the US because of these
antitrust laws. Many of the monopolies that do exist possess a monopoly status courtesy of the
government. If government licenses only one provider, then we will have a monopolistic market.
Government might only want to deal with one provider or believes that having one firm is more efficient.
Sometimes when large scale physical infrastructure is involved, government wants to minimize disruption
to the community. For example, laying a network of water and sewer pipes, electrical lines, TV. cable,
telephone wires etc. involves tearing up streets or putting poles and wires across neighborhoods. It could
be extremely difficult if multiple companies were all doing this.
Most of the US economy is in monopolistic competition or oligopoly. Industries such as dry cleaning,
restaurants, niche retailing, services, etc. tend to be in monopolistic competition, while almost all heavy
manufacturing and much general retailing tend to be in oligopoly. The industries with more and smaller
companies are generally more responsive to consumers and offer better service; the larger firms offer
more variety and often better prices. Some industries have become more concentrated in the last 20
years, such as hardware stores, bookstores, drugstores, electronic stores. These all used to be dominated
by small, local stores where owners and workers had a closer relationship with customers and were more
directly affected by customer satisfaction. There has been some backlash against the large chain retailer
some communities have attempted to keep the mega chains, such WalMart from entering the market.
Some markets are less competitive than they look. In retailing there may appear to be multiple brands
competing but relatively few companies make those brands. Proctor and Gamble produces Tide, Cheer,
Dreft, Bold and Gain laundry detergents. From the grocery store shelves, one would assume there is a
great deal of competition in laundry detergents, in actuality there is a lot less.
Industries that develop with fewer and larger companies will often have lower prices and may offer more
cutting edge technology. Two economists, Schumpeter, early in the 20 th century, and Galbraith, later in
the 20th century, suggested that a less competitive market structure allowed for greater investment in
research and development (R&D) and greater innovation. Large companies have greater revenue and
therefore budgets for these kinds of activities. This view became known as the Schumpeter/Galbraith
view. Other economists have disagreed with the position saying that large, noncompetitive firms have
little incentive to change the status quo, since there are few or no other companies to innovate, they face
little threat. In part, it probably depends on the importance of patents as a barrier to entry. If the
noncompetitive market is the result of innovation, then continuing to innovate is the best way to defend
that market. Large network advantages may present a greater barrier to innovation, since once a network
platform has been established other companies have grave difficulty offering a different network even if it
is superior. In these circumstances, there would be less incentive to innovate.
Some highly concentrated industries have become more competitive in the last generation with increases
in international trade. The US auto industry by the late 1960s had GM and Ford selling the large majority
of cars sold in America by the 1980s a number of foreign manufacturers were competing for the
American consumers dollar. Many economists do not feel it is coincidence that the quality measures and
consumer satisfaction with American cars is rising in the 1980s this is what one would expect in a
market with greater competition.
Some markets are more competitive than they appear. This may be because other goods are close
substitutes or because there is potential competition. In the 1970s the role of potential rather than actual
competition arose in the study of contestable markets.
Contestable Markets
Contestable markets are those with very low net costs to entry and exit; where the presence of potential
competition causes competitive results even when there are few current producers. The major markets
this model has been applied to all have one thing in common the nature of the good or service being
produced and the resources being used are highly mobile. The airline and trucking industries are the
markets the model grew out of, and some have argued that certain telecommunication services belong
here too.
Suppose that only one airline, for example, Delta, flies out of Kansas City. As a local monopoly one
might expect that they could charge high rates and have poor service. After all, if you want to fly out of
KC there is no choice. But suppose Delta tried to set price high and quality low; Northwest and American
airlines could easily take planes off their Chicago/LA route or New York/LA route and make a stopover in
Kansas City. The airplane and personnel are already mobile so changing the market they operate in has a
low net cost. Since Delta knows this it will not push price up and quality down the entry of potential
competitors would be detrimental to its profit. The same kind of argument was made for the trucking
industry.
Under the model of contestable markets some politicians pushed for these two industries to be
deregulated, claiming that government oversight in fact raised price and reduced quality over what an
open market would produce. The government did deregulate as far as price and competition go but
continues to regulate safety and security. As airlines have gone bankrupt or merged, we now have fewer
airlines to serve as potential competitors. Airlines have also managed to erect a barrier to entry for
potential competitors through the development of hub cities. An airline promises to make an airport its
regional hub the center through which connecting flights come together. In return for this large amount
of guaranteed business the airline receives attractive rates on gates and buys up most of the gates in the
airport. It now becomes very difficult for new airlines to operate because they cant get the gate space to
load and unload airplanes.
As technology continues to improve many telecommunication services could fit the contestable market
model. If movies and other programming could be provided over the Internet, where there are a number
of Internet Service Providers, then cable programming would be under the constraint of potential
competitors. There would be no difference in a cable company in California sending programming to a
customer in San Francisco or New York or Gainesville.
When should government intervene because of poor competition and/or poor information? What about
the other limits of the free market system when and how should government intervene? Government
behavior generally follows the basic decision making pattern that we have talked about with firms and
consumers - maximization of benefit.
Public Choice Theory

Public choice theory is a model that attempts to explain political behavior through the principle of selfinterest that voters, politicians and bureaucrats make decisions based on where they get the most
benefit. Let us apply that concept to anti-trust and regulation to make markets work better given that
voters, politicians and bureaucrats have different goals and power.
Many voters are consumers, in fact, in most markets the number of consumers far outweighs the number
of voters who own or work for an industry. But each voter is considering the fact their vote, by itself, is
unlikely to make a difference in an election. They may choose not to gather adequate information to
make an informed vote or even choose not to vote at all. There decision is that the utility gained from
participation in the democratic process is not sufficient to compensate for the cost in time, energy and
money to fully participate. Since voters are more likely to participate if there is a policy that has a big
impact on them personally, then those strongly affected by a policy will have a disportionate weight in
public decision making.
If, for example, breaking up the local cable monopoly will save each of 50,000 households $3 a month on
its cable bill, ordinary voters are not likely to be sufficiently excited about such a referendum or candidate
to vote in higher numbers than usual. Society, on this local level, will save $1.8 million a year. But if
breaking up the local cable monopoly costs that company $500,000 a year, it and its employees are going
to participate to the full extent of their power. They will have more likelihood of affecting the decision
even though the benefit to those helped outweighs the cost to those hurt.
Firms may participate to generally encourage the most beneficial (to them, of course) government
environment. This is known as rent seeking. In economics the term rent is used to refer to payments
above that necessary to have a good or service provided; a rent-seeking firm is trying to achieve profits
higher than what a competitive market would need. Firms will lobby, make political contributions and
use the voting influence of its workers and owners to obtain legislation that is preferential to their
company at the expense of consumers and/or taxpayers. Since the benefit to firms on an individual level
is much higher than the cost to consumers on an individual level, rent seeking often occurs in markets
with government intervention. Firms wish to minimize regulation and intervention that hurts profit, and
encourage regulation and intervention that helps profit.
Consumers, workers and firms respond to incentives and penalties the government encourages some
behaviors and discourages other behaviors with many of their policies. Sometimes these effects are not
what politicians anticipate. Moral hazard refers to a situation when a contractual agreement between
parties alters the behavior of a participant in ways that shift cost to the other participant or participants.
For example, some economists claim that the presence of FDIC encourages banks to engage in more
aggressive lending and consumers to ignore bank risk in favor of higher interest rates because they know
that the government will cover accounts if the banks fail. The protection provided by the government
encouraged greater risk taking by the other participants in the program that risk taking increased the
cost of the program to the government.
Let us examine some common government intervention programs to see the options available to
government, the new incentives in place and how public choice may play a role.
Safety Nets
The unequal distribution of income can be a serious problem in the economy some individuals will not
have the financial resources needed to buy the necessary goods and services to maintain an acceptable
standard of living. Safety nets refer to government programs to maintain a minimal standard of living for
households. These include Social Security, welfare, unemployment compensation, food stamps and
TANF. Many of these programs have assisted large numbers of Americans and saved them from the
direst of poverty many of these programs have been politically controversial.
The Social Security Act of 1935 put in place a mandatory system where younger workers pay taxes into
the system to support elderly retired workers with the promise that the next generation will pay to support
them. Over the years the nature of Social Security has expanded more people qualify; we now include
dependents of workers and disabled workers and the basic philosophy of Social Security as a supplement
to private savings has shifted to a minimal living income. Social Security taxes are collected both from
current workers and their employers and the percentage taken has had to increase significantly over the
last 25 years as people are living longer and Medicare expenses have risen.
Some conservative economists argue that private savings and pensions have been reduced in
attractiveness by the availability of Social Security. Workers would rather have and use their money
today counting on Social Security to take care of them in retirement. Martin Feldstein, who was the chair
of the Council of Economic Advisors under President Reagan, claimed that Social Security was a major
culprit in the decline of the American savings rate for this reason.
Other conservative economists have argued that private financial investment would on average yield a
better return for the dollar than Social Security. The desire to take care of workers who have not paid
enough into the system to receive the benefits they badly need brings down the return for the average
worker. In response to this, proponents of the system point out that none of us know if we will be one of
those workers who will need more benefits Social Security is a form of disability insurance as well as a
retirement program. By taking care of a dependent after the workers death, Social Security is a form of
life insurance as well. We dont expect to get back what we pay into an insurance program why should
we expect Social Security to be different? In addition, the yield in private financial markets, such as the
stock market, varies enormously from year to year. Look at the number of investors who have lost a large
percent of their retirement portfolios in 2000-2003 of the stock market (including your economics
professor). Social Security is the safe aspect of retirement even if the company misuses your pension
fund, even if your stock portfolio gets hit by an Enron, you still have Social Security.
Social Security is a clear demonstration of public choice. As the number of retirees and people near
retirement has increased, it has become harder and harder to make changes in Social Security that work
against recipients. As a consequence Social Security has been the one transfer program to remain largely
untouched by politicians. Older individuals tend to have a higher than average voting participation rate
and a cut in Social Security benefits or increase in the Medicare co-payment will have a big difference on
their lives, therefore they aggressively lobby. The American Association of Retired Persons, AARP, has
reduced its membership age several times in order to increase its membership and hence political clout.
Clearly, Social Security will not be able to provide the level of benefits to the baby boom generation as to
previous ones there are not as many workers in the next generation relative to the baby boom as the
baby boom were to the generation before them. But, attempts to decrease benefits or slow down the rate
their grow have been hard fought. Politicians are very reluctant to touch Social Security, particularly if
they are from states with a large retired population, such as Florida. Poverty rates among the elderly are
the lowest they have ever been, and many recipients are well off. On the other hand, programs to aid
children, particularly low income children, have been cut or at least eroded by inflation. This is not
surprising in public choice theory, as children do not vote and low-income adults have little money for
lobbying coupled with a lower voting participation. Poverty rates among children are returning back to
the level they were in the early 1960s we have lost almost all the gains made during the 1960s and
1970s. Some liberal economists and politicians have suggested that we are, in effect, transferring income
from the young to the old.
Welfare and Aid to Families with Dependent Children have both been accused of encouraging adults not
to work and not to acquire necessary training and education. Conservative economists and politicians
have claimed that such programs create a permanent dependent underclass; while the first low paying job
may compare poorly to government programs, as someone works and acquires experience their
opportunities and income rise. Since these individuals never put their foot on the first rung of the ladder,
they never climb out of poverty into independence. More liberal economists and politicians point out that
the majority of individuals receiving these entitlement benefits are on them temporarily typically less
than two years. They also argue that climbing ones way out of poverty is a good deal harder than
conservatives claim.
Both these programs have been radically altered in the last ten years. Welfare reform limits the time that
individuals may spend on the program to two years at a time and a maximum of five years over their
lifetime. AFDC has been changed to the Temporary Assistance for Needy Families which requires
participants to work or participate in some kind of job training in order to receive benefits. Some states
are now adjusting entitlement programs to discourage out of wedlock births including counseling on the
importance of marriage or changing benefit levels. It is ironic that in the early days of welfare the
opposite incentive played a role women and their children could not receive benefits if there was an
able-bodied man in the household. The resulting rise of female headed households in the US during that
time period should come as no surprise. Again, as poverty rates have fallen, low income households have
become politically marginalized and policies targeting the poor have generally failed to keep up with
inflation, been cut, or redefined to meet other political/social goals.
Regulation and Externalities.

In a free market system, we will overproduce goods with external cost, such as pollution. Since firms do
not pay the full cost of production, they see this good as more valuable than society does. Government
can intervene to help reduce external cost production with taxes or regulations. Many economists have
suggested that absolute pollution controls or taxes are inefficient. In these plans we would limit the
amount of pollution that firms in an industry can have or tax if they dont reduce pollution by a set
percentage. The problem is that different sources of pollution have different consequences and require a
different level of resources to clean up. For example, it is habitually estimated that 90% of auto emissions
are coming from 10% of the vehicles on the road. A very expensive improvement to the emissions of new
cars will have less impact than a much more modest and less expensive improvement to heavily polluting
older cars and large trucks. Efficient policies will enable us to reduce pollution the most for the least cost.
One possibility is to establish the overall level of pollution we are willing to accept from an industry and
issue each firm permits for a certain share of that total. Firms that pollute less can sell the extra
allowance to other firms. Firms that can more easily and cheaply reduce pollution have an incentive to do
so because they can make money selling the permits. Other firms can save money by buying the
pollution permits and keep production and jobs up. Overall, pollution drops by the desired amount with
the least disruption to production and jobs as well as the least increase to consumer prices. They are also
more acceptable to the industry than more draconian measures. Economists have been very supportive of
this policy but it is often opposed by environmentalists and the general public as a ploy to allow rich firms
to pollute.
In a free market system, we will underproduce goods with external benefit such as education. Since firms
do not receive the full value of production, they see this good as less valuable than society does.
Government can intervene to help increase external benefit production with subsidies or providing these
goods itself. Some economists and politicians have suggested that across the board subsidies or state
provision is not efficient that it is divorced from performance and that not all providers have equal value
to society. The value to society of increasing a group of future workers skill from none to low is greater
than increasing another group from very high to extremely high. Funding of local schools in depressed
economic areas will lag even though society would probably benefit the most from an expansion of
education in those areas. The government is unlikely to make up the difference since an economically
depressed area will have little economic or political clout. Government provided education is more likely
to be responsive to the dictates of the politicians than the desires of employers, students and student
families.
Journal Topics: Complete the following assignment:

1.
Vouchers have been suggested as a way of improving the provision of education. Analyze the
situation from both a pro and con point of view.
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CHAPTER 10 PERFECT COMPETITION

The Perfectly Competitive Model in the Short-run

The Wheat Market

In the graph on the left one can see that the

This producer would want to set

If we added the average cost curve, then we could

Use the following steps to find profit for any price in a

Calculate the production level,

Economic Profit Levels

At $8.50 this firm made a positive

The Perfectly Competitive Long-run Equilibrium

One Corn Farmer

One Soybean Farmer

While the market supply of corn decreases, an

While the market supply of soybeans increases, an

Journal Topics: Complete the following assignment.

CHAPTER 11 MONOPOLISTIC COMPETITION

Perfectly Competitive equilibrium

The non-perfectly competitive firm will still

These non-perfectly competitive markets end up

assumptions of monopolistic competition are:

Short-run equilibrium in Monopolistic Competition

Long-run equilibrium in Monopolistic Competition

The same process works in monopolistic competition

The monopolistically competitive firm on the

This is the trade-off in monopolistic

Journal Topics: Complete the following assignment.

Weak Oligopoly, not strongly concentrated

If this were the situation in the market, it would

In this case the competition decided to match your

Ford's profit $5 million

Only Ford and Honda have

Only Honda has the new,

Ford's profit $3.4 million

The Kinked Demand Curve

Kinked Demand Curve

If firms match a price decrease then the demand

This gives us a demand curve that is bent or

In this situation, the firm is best leaving the price

Its understandable how the corner or kinked price

Anti-trust Law and Collusion

Journal Topics: Complete the following assignment:

If we set price by the MC curve while the cost of

Journal Topics: Complete one of the following assignments.

CHAPTER 14 MARKETS AND GOVERNMENT

Public Choice Theory

Regulation and Externalities.

Journal Topics: Complete the following assignment:

Find and summ

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