Last week, we wrapped up our primer on microeconomics with a discussion of individual firms. In this post, we enter the world of macroeconomics by taking a step back and looking at the broader picture of how firms compete with each other.
First, a quick definition of macroeconomics from Investopedia:
“The field of economics that studies the behavior of the aggregate economy. Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product, inflation and price levels.”
…Okay, that’s a lot. There are a lot of subjects that fall under the purview of macroeconomics, so let’s start with firms.
In your average capitalist economy, there are three basic forms of market structures in which firms compete. They are:
- Perfect Competition
A scenario of perfect competition has the following features:
- Many firms sell similar products to many buyers.
- None of the firms have any advantage over the others.
- There are no barriers to entry, ie anyone can set up a similar firm.
- Everyone is well informed about the prices for these products.
The scenario where perfect competition would happen is when firms can produce a product at a low cost relative to market demand for that product. In such cases, firms can enter the market with ease. Furthermore, the product has be perceived by buyers as having nothing unique about it, such that these buyers wouldn’t care who they buy it from. Imagine that you’re buying a garden hose – would it really matter whom you bought it from? Firms in situations like these are price takers who cannot influence the price of the product and have to sell at market price. They have zero market power.
One key feature of perfect competition is that in such markets, over the long run, firms earn zero economic profit. This means that total revenue (sales) is offset by total costs, which include opportunity costs and the money earned by the firm’s owner. This is because once a firm is making an economic profit, where revenues exceed total costs, other firms will enter to drive the market price down. They engage in a price war. Eventually, prices will be so low that several firms will leave the market, leaving a situation where the remaining firms make zero economic profit over the long run.
If firms in perfect competition have no market power, than the situation of monopoly is the polar opposite. A monopoly is a firm that has market power but zero competition. This happens when:
- There are no close substitutes to the firm’s product, and
- There are barriers to entry. Such barriers include legal barriers (for example, having a patent or a government license) and natural barriers (where one firm, thanks to economies of scale, can provide the product at the lowest cost – think of electricity distributers).
Monopolies have two price-setting strategies:
- Single price – Each unit of output is sold at the same price. Example: De Beers diamonds
- Price discrimination – The monopoly sells different units of its products at different prices. While it may seem that the monopoly is doing its buyers a favor, it’s actually selling each unit at the highest price possible, depending on the buyer. The classic example is the airline that charges higher ticket prices for business travelers versus and lower prices for vacation travelers.
You could imagine that monopolies can potentially charge customers obscene prices for basic needs. In such cases, these monopolies may be regulated by the government and can only charge an amount that covers its costs.
- Monopolistic Competition and Oligopoly
In between the two extremes of perfect competition and monopoly lie monopolistic competition and oligopoly.
Monopolistic competition is when a large number of firms:
- Compete against each other;
- Produce differentiated products;
- Compete on quality, price, and marketing, and
- They are free to enter/exit the industry (hence, zero economic profit over the long run).
You could think of the fashion retail industry, where branding is a key feature of competition, as having monopolistic competition. Monopolistic competition is very similar to perfect competition with one key difference: firms will produce fewer products, hence not completely realizing economies of scale, but will markup these products to make up for the inefficiency.
An oligopoly is a market structure similar to a monopoly with the difference being that a small number of firms exist, rather than just one. A key consideration when looking at oligopolistic competition is what happens when one player decides to raise or lower prices. What do its competitors do? Another factor to watch out for is collusion, where players form a cartel to raise prices. Iris and Lixue from Ilusion spell out this situation pretty clearly:
And that concludes our brief look at market structure. In our next post, we’ll take a further step back and look at even broader issues like the business cycle and inflation. See you there!
Ramon Rodrigo Cuenca, CFA
Source: CFA Program Curriculum Level I, 2009, volume 2: Economics, pp. 152-153, 166, 180-181, 194, 210-212, 216-217, 223, 226, 232