Chapter 3

Lesson 1 and 2

Market Structure

Traditionally, when we use the term market, we refer to a place to buy

goods. Filipinos usually call this the wet market or the “palengke”.
However, in economics, market is a specific term. A market is any one of a
variety of different systems, institutions, procedures, social relations and
infrastructures whereby persons trade, and goods and services are
exchanged, forming part of the economy. It is an arrangement that allows
buyers and sellers to exchange things.

Considering this definition, it would mean that when we talk about

market we are not just referring to a venue, but a system, a system that
allows transactions between buyers and sellers to take place. About 20
years ago, transactions were possible only when buyers and sellers meet
eye to eye. A good example would be the Filipino palengke, or the
department store, the mall, a restaurant and so on.

Nowadays, it is already possible for market to exist even without the

personal interaction between the buyers and the sellers. Through
technology, it is possible that trade takes place among buyers and sellers.
In the 1990’s, home TV shopping became very common to the world and
the Philippines. But the greatest development in the market for goods
and services when telecommunications was further updated through the
internet. You can already get hold of a product without living the comfort
of your homes. On line shopping became dominant in the west, and as of
today, Filipinos are also getting their selves familiar with this kind of
system. If in the Unites States, they have e-bay, amazon, and target, in the
Philippines, we have sulit.com and ayosdito.com among many others.

In this chapter, we will be

focusing on the market, its
transactions and the various
market structures. Let’s begin
with a much deeper understanding of the market.

Transactions in the Market

Again, market is a group of buyers and sellers of a particular good or

service. The buyers as a group determine the demand for the product,
and the sellers as a group determine the supply of the product. Markets
take many forms. Sometimes markets are highly organized, such as the
market for agricultural commodities. In these markets, buyers and sellers
meet at a specific time and place, where auctioneer helps set the price
and arrange sales.

Transactions take place in any kind of market. Transactions happen

between buyers and sellers, consumers and producers, households and
firms. In general we have two types of transactions in the market.
Transactions may be either formal or informal. As long as there is an
exchange between any of the two or more members in the economy,
there is a transaction, may it be an exchange of good for another good, a
good for a service, a service or another service, a good in exchange for
money, or even money in exchange for money. The latter, we call as the
market for foreign currency, or the foreign exchange market. Other
specific types of market are the market for health services, market for
automobiles, market for labor, and so on.

Two types of Transactions in the Economy

Formal Transactions

Formal transactions are those which are directly regulated by the

government. These transactions need to be properly documented, and
they usually entail a kind of excise tax, which is commonly known among
Filipinos as the value-added tax. When one gets engaged in a formal
transaction in the market for fast food for example, one is expected to be
handed with a receipt which is the official record of the transaction which
just took place. Examples of formal transactions are when we purchase
goods from the SM Supermarket, ate a burgersteak value meal at Jollibee,
enrolled at a university, or got a spa-massage at Wensha Spa. All of these
are transactions in the formal market.

Informal Transactions

Informal transactions on the other hand are those which are not
regulated and do not pay taxes to the government, they are usually
referred as belonging to the underground economy. There are still two
specific types of informal transactions in the economy; either they belong
to the black market or the gray market.

Transactions in the black market are those which are considered as illegal,
they are not regulated by the government because they are not allowed
by the government. Examples of black market are the market for illegal
drugs, prostitution, and piracy. Considering the laws in the Philippines,
engaging on these kinds of market and their activities are considered as a
criminal act.

Gray market on the other hand are those which are not directly regulated
by the government although they are not considered as illegal
transactions. Actually most of them are arguably very essential for the
economy to function well. There are numerous transactions among
members of the economy within the country that are not regulated and
recorded by the government. For example, the trade that took place
between Mang Pandoy and Mang Kanor when the former ask the latter
who is a plumber to fix his kitchen. Mang Pandoy is not expected to give
Mang Kanor a receipt or any official record of their transaction, yet a
transaction still took place. Other examples of gray market transactions
are those involving street vendors, regular house helpers, sari-sari stores
and karinderia.

Almost all nations has an underground, it just vary from the extent from
one country to another.

Market Structures

Remember that the goal of a company is to maximize its profits.

Remember also that profits are simply the difference between the total
revenues and the total costs of production. We examined the costs of
production first because the principles affecting costs are the same for all
companies regardless of the industry they are in. But this is not true
about the revenues. To analyze the differences in total revenue, we
group industries into four types. They are classified according to the
power a company would have to affect the price of the product.

Perfect Competition
There are four criteria for an industry to
Perfect Competition
be characterized as perfect competition.
Of course, nothing is “perfect”. But, while
 Free entry and exit
no industry will exactly meet the four to industry
criteria of perfect competition, we can  Homogenous
learn much from assuming that such an product – identical
industry does exist. so no consumer
preference
1. There are so many sellers that no  Large number of
one seller can affect the price by buyers and sellers –
himself or herself. no individual seller
can influence price
Think of Mang Pandoy buying gasoline.  Sellers are price
takers – have to
The price says ₱50.00 per liter. Suppose
accept the market
you ask to see the manager and then
price
make an offer: you will buy only if the  Perfect information
price is reduced to ₱20.00 per liter. What available to buyers
will the manager do? The answer is: laugh and sellers
and ask you to leave. The manager will
not take your offer because there are so many others who will pay
₱50.00. These others are your competitors. You don't think of them as
competitors. Indeed, they may even be your friends. You think of them,
like yourself, as subject to impersonal market forces. But nonetheless,
they are your competitors. And because they are there, you have no
influence at all on the price. We say that you are a price taker. If we
switch the example and make you a seller instead of a buyer, we have the
main characteristic of perfect competition. If a seller charged more than
₱50.00 per gallon, no one would buy from him or her. The seller would
never charge less than ₱50.00 because there is no reason to do so.

2. We assume that all buyers and all sellers have perfect

information.

Each knows what the price is, what others are charging, and all relevant
features of the product. No one would ever pay ₱60.00 for a gallon of
gasoline because everyone knows that there are sellers willing to charge
₱50.00.

3. We assume that there is easy entry into and exit from the
industry.

Any company wanting to leave the industry can do so easily. And the are
no barriers preventing entry to any company from coming into the
industry.
 4. We assume that the products of the sellers in the industry are
identical.

One company's product is just the same as another company's product.

Their products are homogeneous or standardized.

Although there are no examples of perfect competition, agriculture is the

closest. We will start our analysis of business behaviors with this market
structure.

Benefits to Society from Perfect Competition

Let us conclude the discussion of perfect competition by summarizing the

benefits to society from it. People believe that competition is good for
the society as a whole. Why is this so? Let us list some of these benefits.

(1) Economic Profit of Zero

As we saw, in perfect competition, companies earn an economic profit of

zero in the long-run. While the long-run is not specified in weeks or
years, we can presume it is a relatively short period. (The long-run is the
time it takes for new companies to enter the industry.) Why is this good
for society? The answer is that, when companies are earning economic
profits above zero, new companies enter the industry. The entry of the
new companies will soon eliminate the economic profits. The only way a
company can earn economic profits for a long time period is to be able to
prevent other companies from producing products that consumers
desire. This clearly is not good for society. For many years, companies
like General Motors, IBM, and CBS earned economic profits that were
well above zero. They were able to maintain these profits only by having
barriers to entry that kept other companies from producing products that
consumers definitely desired.

(2) Productive Efficiency

Productive efficiency involves producing at the lowest possible cost of

production. In our example, the construction company chose to produce
7 homes. Each home cost an average of ₱182,857 (take the total cost of
building 7 homes and divide by 7). We can assume that this is the lowest
possible cost per home of producing 7 homes. Companies in perfect
competition have a financial incentive to produce as efficiently as
possible. Any inefficiency is reflected in reduced profits for the owners of
the companies. Since in the long-run, these profits equal zero,
inefficiencies would cause economic profits to fall below zero.
Companies would either have to find more efficient ways of producing or
be driven out of business.

(3) Improvements over Time

As we have seen with so many products, companies with a large amount

of competition have a strong incentive to find new ways of producing
that will lower production costs. This strong incentive explains why
products that were once very expensive ---computers, televisions,
contact lenses, and so forth --- are now so much cheaper. The incentive is
actually twofold. On the one hand, there is the positive reward of
increased economic profits in the short-run if a company can find a way
of producing at a lower cost. On the other hand, there is the fear that
competitors of the company will find a way of producing at a lower cost
before it does. If they do so, they will be able to charge a lower price.
Our company will not be able to earn satisfactory profits at this lower
price. It risks being forced out of business.

Remember the definition of monopolistic competition. This industry

structure has all of the characteristics of perfect competition except that
the products are differentiated. In that case, we shall see that there are
strong incentives not only to find ways to lower production costs but also
to find ways to "improve" the product. The incentives are the same in
both cases --- the increased economic profits in the short-run and the
fear of a competitor doing so first. What exactly is an "improvement"?
The answer, in a market economy, is that a product has been improved
if consumers desire it more and are more likely to buy it. Consumers
decide when a given change in a product is actually an improvement. The
strong incentives to "improve" products are easily seen in the continual
improving of computer hardware and software, in the competition
between the programs shown on television stations, in competition in
fashion design, in competition between automobile companies, and in
many other examples.

To take just one example for illustration, let us consider the coffee maker.
Prior to 1970, people who drank coffee drank instant coffee, had coffee
brewed in a coffee percolator, or used a pyrex container. The pyrex
container was much cheaper than the percolator. One would heat water
in the container, put the coffee into a filter, put the filter into a plastic
cone, and then pour the boiling water through the cone back into the
container. In the early 1970s, Vince Marotta decided to develop a
product that worked in the same way except that one poured cold water
into a container and a heater boiled the water. The boiling water then
ran through the coffee that had been placed in a plastic cone and into the
pyrex container. He called this invention “Mr. Coffee”. He advertised it
heavily, with Joe DiMaggio as the spokesperson. It was a huge hit and
Marotta was soon making large economic profits.

In a competitive industry, what should happen? Of course, others should

start producing similar products. And so they did. As the supply rose, the
economic profits fell. To maintain them, Marotta changed the design of
the container to allow “Brew for Two”. This too was a huge hit and
economic profits rose. Others, of course, soon copied. Then, Marotta
combined his coffee maker with an alarm clock. Now instead of making a
sound, the alarm would turn on the coffee maker. Another huge hit.
Again it was soon copied.

As time has gone one, we have seen space saver coffee makers, coffee for
one, designer coffee makers, and so on. Some products have been very
successful. Some have not. Since product improvements are easily
copied by other companies, eliminating the economic profits, why bother
developing the improvements at all? The answer, of course, is the
economic profits in the short-run. Even if they don’t last very long, the
huge profits made for a while were enough so that Mr. Marotta need
have no financial worries for the rest of his life.

In summary, in perfect competition in the long-run, companies will earn

zero economic profits, will produce that quantity for which cost per unit
is the lowest possible (productive efficiency), and will have strong
incentives to find ways to lower costs of production and to "improve"
their products. No wonder people believe that a market economy with
perfect competition is so desirable.

Pure Monopoly

Literally, "mono" means one. Therefore, a pure monopoly is an industry

with only one seller. Such a company should have considerable ability to
affect the price that it charges. However, for this to occur, three other
characteristics are necessary. First, there must be high barriers to entry.
If this were not the case, then when the monopoly set a high price and
earned high economic profits, new sellers would enter to compete with
it.
The increased competition would drive down prices, eliminating the
economic profits that were being earned. Second, the demand for the
product needs to be relatively inelastic (that is, has few substitutes). If
this were not the case, then if the monopolistic company raised its price,
buyers would simply shift to other substitute products. This would limit
its ability to raise the price considerably. We will consider pure
monopoly after completing our analysis of perfect competition. And
third, there are high barriers to entry; if economic profits are being
earned, it will be very difficult for new sellers to enter the industry.

There are many reasons for the existence

of high barriers to entry. For example, Monopoly
until a few years ago, it was impossible to
compete with Meralco. DeBeers has  High barriers to
maintained its monopoly on diamond entry
production through control over the  Firm controls price
natural resource. Virtually all of the OR output/supply
diamond in the world has come into the  Abnormal profits in
control of this company, owned by the long run
Oppenheimer family of South Africa. IBM  Possibility of price
discrimination
maintained close to a literal monopoly on
 Consumer choice
mainframe computers through its
limited
copyrighting of computer languages.  Prices in excess of
Xerox and Polaroid maintained near MC
monopolies by patenting their processes.
Automobiles had high barriers to entry because of the very high costs of
capital goods that were necessary.

Some industries had high barriers to entry because of government

regulations. For example, until the early 1980s, the Civil Aeronautics
Board acted to prevent airlines from serving certain markets. And, until
the mid-1970s, the Federal Communications Commission acted to
prevent access to the airwaves to any new television network. In some
industries, economies of scale make it very difficult for new companies to
enter. Because the existing larger companies can produce at a lower cost
per unit, a new company that starts with a small number of buyers would
not be able to compete on the basis of cost. We call these industries
"natural monopolies" and will discuss them in detail later.

In some industries, vertical integration can provide a barrier to entry.

"Vertical integration" means that the same company controls many
phases of the production process. Companies that refine oil into gasoline
also own the oil wells and the tankers. They control the gasoline stations
through a franchise agreement. Any company trying to compete would
have to find its own oil, develop its own tankers for shipping, and create
its own stations to sell the gasoline. General Motors also was vertically
integrated. General Motors owned the companies that made automobile
bodies, batteries and sparkplugs, glass, and so forth. And Microsoft
produces both computer operating systems and software programs. Is it
any wonder that the operating system Windows was made purposely
incompatible with Lotus1-2-3, the most popular spreadsheet in the
world. (Microsoft produces a competing product --- Excel)

Finally, continual innovation can act as a barrier to entry. Both IBM and
AT&T were able to maintain near monopoly positions for many years by
always being first with new ideas. Microsoft has carried on in this
manner. In the early 1980s, IBM lost its barrier to entry. The hierarchical
management of IBM was too slow to keep up with the need for
innovation. Other companies came up with new and better products,
causing IBM to lose almost half of its market share. Something similar
occurred for AT&T.

In the case of the Philippines, the most known monopolist perhaps is

Meralco, which is the biggest company on electricity supply. Back in the
1990’s PLDT was also considered as a monopolist until new players were
able to penetrate the market such as Digitel and Bayantel, as well as the
development of wireless communication.

The Social Problems of Monopoly

Earlier in this chapter, we considered the benefits to society from perfect

competition. We can use these to evaluate why monopoly is bad for
society as a whole. First, in perfect competition, companies could earn
economic profits in the short-run but not in the long-run. In pure
monopoly, because of the high barriers to entry, economic profits can be
earned in the long-run as well.

Indeed, as we will see in a later chapter, much of the wealth of the

superrich has come from owning companies that were able to earn
economic profits for a long time. Second, in perfect competition,
companies would produce the quantity being produced as efficiently as
possible in the short-run. This is also true for a monopoly, as any waste
reduces the company’s profits. However, monopolies do not have as
strong of an incentive to be efficient as there is no competitor who could
drive them out of business. Evidence tends to show that monopolies are
less efficient than companies with considerable competition.

A monopoly company probably will produce at a higher cost per unit than
would be found in a competitive company. Third, in perfect competition,
companies also had incentives to find ways to lower costs over time and
to find ways to “improve” the products they sell. This is also true for
monopolies. Both lower costs and “better” products will increase the
profits of the monopoly.

Monopolistic Competition

If there is one seller but a very elastic

Monopolistic Competition
demand for the product, the industry
is called monopolistic competition.  Many buyers and
The monopoly part results from there sellers
being one seller of the narrowly  Products differentiated
defined product. The competition  Relatively free entry
comes from other products that are and exit
close substitutes.  Each firm may have a
tiny ‘monopoly’
Most real-world competition takes this because of the
form. There is only one Coca-Cola but differentiation of their
product
there are many close substitutes.
 Firm has some control
There is only one MacDonalds but
over price
there are many close substitutes.
There is only one iMac but there are many close substitutes. In each
case, the company can raise its price and not lose all of its sales.
However, an increase in price will cause it to lose a considerable portion
of its sales.

This limits greatly the power of the company to affect the price. The first
three characteristics of perfect competition are similar for monopolistic
competition. There are many sellers. The buyers and sellers have perfect
information. And there are no barriers to entry. The difference is the
fourth characteristic: in perfect competition, the products are identical
whereas in monopolistic competition, the products are differentiated.
Because products are differentiated, monopolistic competition involves
considerable use of advertising. In the Philippines, most grocery items are
in monopolistic competition.

Oligopoly
The final structure of an industry is called oligopoly. "Olig" means "few".
In this industry, there are few sellers. How few is "few"? The answer is
"few enough that each seller has an ability to affect the price". Usually
most oligopolies are dominated by between two and ten companies.
Automobiles, steel, tires, cigarettes,
Oligopoly
accounting firms, and breakfast cereals
are among the many examples.  Industry dominated
Oligopolies are difficult to analyze because by small number of
each firm, in making a decision, must large firms
consider not only the response of the  Many firms may
buyers but also the response of the other make up the
sellers. Should Ford offer a rebate (lower industry
price) on its cars? The answer depends  High barriers to
not only on the way buyers will respond to entry
the rebate but also on Ford's estimate of  Products could be
the response of General Motors, Chrysler, highly differentiated
– branding or
Honda, Toyota, and Nissan.
homogenous
 Non–price
It would be easier to predict the responses competition
of competitors if the competitors met and  Potential for
discussed their decisions. Such a meeting collusion?
of members of an oligopoly to coordinate  Abnormal profits
decisions (especially over the price) is  High degree of
known as a cartel. Cartels are illegal in the interdependence
United States; however, some have between firms
managed to exist. Examples are the
National Collegiate Athletic Association, Major League Baseball, the
National Football League, etc. On a world basis, there have been cartels
in oil, diamonds, and other natural resources.

If we can imagine measuring market power (the ability to affect the price
of the product one sells) on a scale of zero to 100 (with 100 being the
greatest amount of power), the four market structures would be
arranged as follows:

Perfect Monopolistic Pure

Competition Competition Oligopoly Cartel Monopoly
0 ___________25___________50______________75___________ 100

Notice that pure monopoly does not have a market power of 100 on this
imaginary scale. Even if there were only one company, it cannot have
total power over the price. Buyers always have the power to not buy the
product.
 Summary of the Four Market Structures

Table 1. A Comparative Study of the Four Major Market Structures

Summary
Imperfect Markets Perfect Market
 A market is any one of a variety of different systems, institutions,
Monopolistic
Characteristics
procedures, social relations and infrastructuresCompetion
Monopoly Oligopoly Pure Competition
whereby persons
Number of Sellers Single Firm 2-3 major players Large Very large
trade, and goods and services are exchanged, forming part of
Homogeneous
the economy.and It Unique/
is alsoNo defined as a group
Homogeneous or of buyers and sellers Homogeneous
Type of of
Product
a particularclose
good Substitute
or service.Differentiated Differentiated and Standardized
Barriers to entry for
new competitors
Markets allow transaction
Close to Limited
take place
Entry within theEasy
Fairly playersOpen/
in it.Easy Entry
There are two kinds of transactions
Control over the
in the economy:
Controlled but
Formal and
Certain degree of
Price informal transactions.
Price Makers InformalnotTransactions
complete have two subtypes:
inluence Price Takers
the black market and the gray market.
No non-price
price competition
 Market Structure is concerned
but advertise for
with the type of market which
Extensive for
firms operate.public
Non-Price It affects
relation thedifferentiated
degree of power that individual No non-price
Competition
firms have toand information
influence market products
variables such as Extensive
the price of competition
the
Availablity of
product.
Information among limited available limited at a
 Criteria in determining
buyers Very limited the marketinformationstructure includes:
certain degree type
openofinformation
product, control over the price of the product, the number of
Petroleum
Market (Shell, Grocery items Rock Salt,
buyers and sellers in the market,
Electricity Supply
barriers (Shampoo,
Petron, and
to entry, non-price
bath Agricultural
competition, and
Examples: the availability
(Meralco) Caltex)of information
soaps, etc)within theproducts
players in the market.
 There are two major types of market structure: Pure
competition or perfect market and imperfect market.

 There are two critical assumptions of the theory of perfect

competition: the firms are price takers, and the industry displays
freedom of entry and exit.
 Forms of imperfect competition are (1) monopoly, wherein there
is only one major seller of a good or service, (2) oligopoly, where
there are two to three major sellers of a product, and (3)
monopolistic competition, where there are many firms that
make available similar good.