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Chapter: Civil : Engineering Economics and Cost analysis : Basic Economics

Theories Associated With Different Market Structures

There are four kinds of market organizations: perfect competition, monopolistic competition, oligopoly, and monopoly.


As mentioned earlier, firms' profit maximizing output decisions take into account the market structure under which they are operating. There are four kinds of market organizations: perfect competition, monopolistic competition, oligopoly, and monopoly. PERFECT COMPETITION. Perfect competition is the idealized version of the market structure that provides a foundation for understanding how markets work in a capitalist economy. Three conditions need to be satisfied before a market structure is considered perfectly competitive: homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production. The first condition, the homogeneity of product, requires that the product sold by any one seller is identical with the product sold by any other supplierf products of different sellers are identical, buyers do not care from whom they buy so long as the price charged is also the same. The second condition, existence of many buyers and sellers, also leads to an important outcome: each individual buyer or seller is so small relative to the entire market that he or she does not have any power to influence the price of the product under consideration. Each individual simply decides how much to buy or sell at the given market price. The implication of the third condition is that resources move to the most profitable industry. There is no industry in the world that can be considered perfectly competitive in the strictest sense of the term. However, there are token examples of industries that come quite close to having perfectly competitive markets. Some markets for agricultural commodities, while not meeting all three conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation. As pointed out earlier, in order to maximize profits, a supplier has to look at the cost and revenue sides; a perfectly competitive firm will stop production where marginal revenue equals marginal cost. In the case of a perfectly competitive firm, the market price for the product is also the marginal revenue, as the firm can sell additional units at the going market price. This is not so for a monopolist. A monopolist must reduce price to increase sales. As a result, a monopolist's price is always above the marginal revenue. Thus, even though a monopolist firm also produces the profit maximizing output, where marginal revenue equals marginal cost, it does not produce to the point where price equals marginal cost (as does a perfectly competitive firm). Regarding entry and exit decisions; one can now state that additional firms would enter an industryhenever existing firms are making above normal profits (that is, when the horizontal line is above the average cost at the profit maximizing output). A firm would exit the market if at the profit maximizing point the horizontal line is below the average cost curve; it will actually shut down the production right away if the price is less than the average variable cost. MONOPOLISTIC COMPETITION. Many industries that we often deal with have market structures that are characterized by monopolistic competition or oligopoly. Apparel retail stores (with many stores and differentiated products) provide an example of monopolistic competition. As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers. Usually if an industry has 50 or more firms (producing products that are close substitutes of each other), it is said to have a large number of firms. The sellers under monopolistic competition differentiate their product; unlike under perfect competition, the products are not considered identical. This characteristic is often called product differentiation. In addition, relative ease of entry into the industry is considered another important requirement of a monopolistically competitive market organization. As in the case of perfect competition, a firm under monopolistic competition determines the quantity of the product to produce based on the profit maximization principlet stops production where marginal revenue equals marginal cost of production. There is, however, one very important difference between perfect competition and monopolistic competition. A firm under monopolistic competition has a bit of control over the price it charges, since the firm differentiates its products from those of others. The price associated with the product (at the equilibrium or profit maximizing output) is higher than marginal cost (which equals marginal revenue). Thus, production under monopolistic competition does not take place to the point where price equals marginal cost of production. The net result of the profit maximizing decisions of monopolistically competitive firms is that price charged under monopolistic competition is higher than under perfect competition, and the quantity produced is simultaneously lower. OLIGOPOLY

Oligopoly is a fairly common market organization. In the United States, both the steel and automobile industries (with three or so large firms) provide good examples of oligopolistic market structures. Probably the most important characteristic of an oligopolistic market structure is the interdependence of firms in the industry. The interdependence, actual or perceived, arises from the small number of firms in the industry. Unlike under monopolistic competition, however, if an oligopolistic firm changes its price or output, it has perceptible effects on the sales and profits of its competitors in the industry. Thus, an oligopolist always considers the reactions of its rivals in formulating its pricing or output decisions. There are huge, though not insurmountable, barriers to entry to an oligopolistic market. These barriers can exist because of large financial requirements, availability of raw materials, access to the relevant technology, or simply existence of patent rights with the firms currently in the industry. Several industries in the United States provide good examples of oligopolistic market structures with obvious barriers to entry, such as the automobile industry, where significant financial barriers to entry exist. An oligopolistic industry is also typically characterized by economies of scale. Economies of scale in production implies that as the level of production rises, the cost per unit of product falls from the use of any plant (generally, up to a point). Thus, economies of scale lead to an obvious advantage for a large producer. There is no single theoretical framework that provides answers to output and pricing decisions under an oligopolistic market structure. Analyses exist only for special sets of circumstances. One of these circumstances refers to an oligopoly in which there are asymmetric reactions of its rivals when a particular oligopolist formulates policies. If an oligopolistic firm cuts its price, it is met with price reductions by competing firms; if it raises the price of its product, however, rivals do not match the price increase. For this reason, prices may remain stable in an oligopolistic industry for a prolonged period.


Monopoly can be considered as the polar opposite of perfect competition. It is a market form in which there is only one seller. While, at first glance, a monopolistic form may appear to be rarely found market structure, several industries in the United States have monopolies. Local electricity companies provide an example of a monopolist. There are many factors that give rise to a monopoly. Patents can give rise to a monopoly situation, as can ownership of critical raw materials (to produce a good) by a single firm. A monopoly, however, can also be legally created by a government agency when it sells a market franchise to sell a particular product or to provide a particular service. Often a monopoly so established is also regulated by the appropriate government agency. Provision of local telephone services in the United States provides an example of such a monopoly. Finally, a monopoly may arise due to declining cost of production for a particular product. In such a case the average cost of production keeps falling and reaches a minimum at an output level that is sufficient to satisfy the entire market. In such an industry, rival firms will be eliminated until only the strongest firm (now the monopolist) is left in the market. Such an industry is popularly dubbed as the case of a natural monopoly. A good example of a natural monopoly is the electricity industry, which reaps the benefits of economies of scale and yields decreasing average cost. Natural monopolies are usually regulated by the government. Generally speaking, price and output decisions of a monopolist are similar to a monopolistically competitive firm, with the major distinction that there are a large number of firms under monopolistic competition and only one firm under monopoly. Nevertheless, at any output level, the price charged by a monopolist is higher than the marginal revenue. As a result, a monopolist also does not produce to the point where price equals marginal cost (a condition met under a perfectly competitive market structure).


Managerial decisions both in the short run and in the long run are partly shaped by the market structure relevant to the firm. While the preceding discussion of market structures does not cover the full range of managerial decisions, it nevertheless suggests that managerial decisions are necessarily constrained by the market structure under which a firm operates.


Managerial decision making uses both economic concepts and tools, and techniques of analysis provided by decision sciences. The major categories of these tools and techniques are: optimization, statistical estimation, forecasting, numerical analysis, and game theory. While most of these methodologies are fairly technical, the first three are briefly explained below to illustrate how tools of decision sciences are used in managerial decision making.


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