David St. J.

Clair

Microeconomics for Managers

Chapter 8
Market Structure Analysis
In the last chapter, we looked at the short run costs of the firm and the
profit maximizing rule. In this chapter, we will look at how a profit maximizing firm
will act in different market environments.

Two Different Ways to Classify Market Types

The horizontal environment of the firm depends on the type of market
structure that the firm finds itself in. There are two different ways of classifying
market types or structures: we can classify types according to their descriptive
characteristics or we can classify them as either having - or not having control
over the price of their product. Managers should understand both approaches
because these terms and concepts are used extensively in economics and
business.
We will first present the descriptive classification types and then follow this
with the second type of classification based on pricing power. We will then use
the pricing power approach to compare market outcomes in different market
structures.

Descriptive Market Types

We can define the following four types of market structures based on their
structural characteristics. Each will be described in turn.

Pure or Perfect Competition

Monopolistic Competition

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Oligopoly

Monopoly

Pure or Perfect Competition

Technically, these two terms are not the same; however, the distinction
between the two is not very important for managers. Consequently, we will treat
these terms as being synonymous and use them interchangeably. Pure or
perfect competition is a market type with the following characteristics:

1.

There are many sellers in the market and there are many buyers. If you are
tempted to ask how many is many, you have asked the correct question.
However, hold that question until the end.

2. The firms are all small. Since they are all small, we say that the market is
symmetrical (this simply means that they are all the same size, that is, all
small). But how small is small? If this question has crossed your mind, you
have again asked the correct question. And once again, hold that question
until the end.
3. There are no significant barriers to entry. This is sometimes referred to as
free entry, however, the term free is ambiguous there is no such thing as
zero cost to enter a market free here means that there are no significant
impediments that block firms that want to enter the market from doing so.
4. The product offered in the market is a commodity product. We sometimes
refer to these products as being homogeneous. Commodity and
homogeneous mean the same thing the products offered by each seller are
essentially the same as the products offered by all other sellers. If brand
names and/or product differentiation exist, they are not significant.
5. There is complete (or perfect) information. This is a very awkward phrase
that requires a little translation. You could argue that there is no such thing as
perfect or complete information about anything in this world and you would

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be correct. But this feature is not a philosophical proposition; all it means is

that there are no information restrictions that might create a barrier to entry.
6. All of the buyers and sellers in the market are price takers. Price taking
means that the buyers and the sellers cannot by themselves influence market
price, that is, they can only decide to buy or sell at the market price, but they
cannot change the market price. This is the key feature of pure or perfect
competition. To illustrate why, lets go back to those questions above that we
saved until the end. Points #1 and #2 above used some rather vague terms.
For example, there are many buyers and many sellers, but how many is
many? And they were all small, but how small is small? This need not lead to
a philosophical cat fight we will define many and small in terms of how
they relate to price taking.
Many firms means that there are so many buyers and so many sellers that
no buyer or seller can influence price, that is, there are so many that they are
all price takers. Likewise, purely competitive firms are all so small that they
cannot influence market price on their own; in other words, they are all so
small that they are all price takers. We will take a similar approach to brand
names. If products are brand-named in purely competitive markets, we say
that brand names are insignificant if price taking still prevails. In all cases, the
distinguishing feature of pure or perfect competition is price taking
everything else is simply a description of why price taking occurs.

Monopoly
Monopoly is a market structure with one defining characteristic there is
only one seller in the market. This feature dominates and impacts all other
features. For example, entry in a monopoly is closed; other firms cannot enter
due to formidable barriers to entry. How formidable? The answer is: The barriers
are formidable enough to keep all would-be newcomers out. Likewise, the fact
that there is only one seller precludes any discussion about how a monopolist
interacts with other producers there are no other producers.
We often classify monopolies on the basis of where their barriers to entry
come from. For example, a patent monopoly is a monopoly that uses a
government patent as the barrier that keeps competitors out. A resource
monopoly would be a monopoly that uses its exclusive control of a strategic
resource as a barrier to entry. A natural monopoly is a monopoly in which there
are economies of scale over a range of output that can supply the entire market
in other words, there is only room enough for one efficient firm in the market. A
natural monopoly is protected by a barrier to entry that arises because a new
entrant can never acquire sufficient volume to be cost competitive.

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A monopolist will always be a price searcher or price seeker. That is, a

monopolist has control over the price that it charges (to the extent that it can
choose any price/output on the demand curve). A monopolist cannot, however,
choose to sell more output at a higher price this violates the Law of Demand.
Since there is only one seller in a monopoly, it does not make any sense
talking about product differentiation or size. A monopolist has a size that is equal
to the size of the market and the product that it sells is the only product available
(differentiation simply does not make any sense in this situation). As for
information, information restrictions are often a source of a monopolists barriers
to entry.
Monopoly refers to one seller; the comparable term relating to a market in
which there is only one buyer is monopsony.
Monopolistic Competition
This is a market structure that features all of the structural characteristics
of pure or perfect competition, except one. In monopolistic competition, there are
many small and symmetrical firms that sell a brand-named or differentiated
product. The differentiated product gives these firms a very small amount of
control over the price of their product. This means that they are not price takers,
but they have very limited ability to control their price. Once again, how small and
how limited? The key feature of monopolistic competition (and the feature that
makes it different from differentiated oligopoly) is market power. Monopolistically
competitive firms have too little control over their price to amount to any
significant market power.
Local retailers are often best described as operating in a monopolistically
competitive market. They are all a bit different, but not different enough to confer
any significant market power. Likewise, different brands of popcorn sold in
supermarkets might be another example of monopolistic competition. While
these products have different brand names and are all a bit different, the product
differentiation does not matter much. More to the point, the branded products
found in monopolistic competition are never as important as the brands found in
markets such as soft drink or automobiles. Brands in these markets create
significant barriers to entry and these markets are good examples of
differentiated oligopoly, not monopolistically competitive markets.

Oligopoly
Oligopoly literally means a few sellers. Once again, we are using a term
that is not very precise: How many are a few? Again, lets hold this question
until the end.
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With only a few sellers, it stands to reason that they are big. Big is another
relative term, but we will define it simply as big in relationship to their markets.
While they are usually all big, oligopolies often have asymmetrical size.
That is, some are big while others are giants. For example, in the auto industry,
GM and Toyota are giant firms among a market populated by very large firms. Or
consider the Japanese beer market. The Japanese beer market is dominated by
four large firms, but Kirin Beer is as big as the other three combined.
Oligopolies are commonly described as being pure oligopolies or
differentiated oligopolies. These classifications refer to the nature of the product;
pure oligopolies sell a commodity product while differentiated oligopolies sell
products that are differentiated or brand-named. Steel is an example of a pure
oligopoly while autos and soft drinks are examples of differentiated oligopolies.
The difference between differentiated oligopoly and monopolistic
competition is a matter of market power and pricing power; monopolistically
competitive firms do not have either while differentiated oligopolies usually have
both.
Finally, how few are a few? Again, this is not deep philosophy. A few
means that there are few enough firms to make oligopolists interdependent
rivals. Interdependent means that the actions of each oligopolist have a
meaningful impact on the others. As a consequence, each firm must anticipate
what the others will do. In addition, the success of each firms policies will
depend on how its rivals react. Firms are said to be rivals when they know who
they are competing with. They know each other. For example, the auto
companies know who their rivals are just as Coca Cola knows that its chief rival
is Pepsi Cola.
Notice that rivalry does not exist in pure competition. If you are in this type
of market, you take the price as given. You understand that you are too small to
impact price and market output. In addition, all of the other firms that you know
about are also too small to impact price or the market output. Consequently, they
are irrelevant as rivals. You relate to the market, not to identifiable rivals whose
actions you must react to.
Oligopolists are price searchers in that they have to find the price/output
combination that is best for them. Like monopolists, they are subject to the Law
of Demand. Unlike monopolists, they have to make their price/output decision
within the context of interdependency with their rivals, that is, they have to pick
prices and outputs that are compatible with the reactions of their rivals.

The Two Faces of Oligopoly

In analyzing market structures, pure competition, monopolistic
competition, and monopoly are very straight-forward and unambiguous. This is
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the case because there is no element of gamesmanship or rivalry in these

markets. For example, in pure competition, firms cannot influence the impersonal
market that determines their prices and firms do not directly compete against
other firms instead, they react to the market.
In monopoly, there is no one else in the market whose actions or reactions
need to be considered. In monopolistic competition, firms simply differentiate
their products in an attempt to attract buyers. Whatever gamesmanship there
might be in this is so limited as to be inconsequential.
This is not the case with oligopoly. Oligopolies feature a small number of
large firms who are very aware of each other. They also understand that they are
interdependent. This means that whatever one does will affect the others, and
vice-a-versa. In particular, a price change by one will be a good or bad strategy
depending on whether the others follow. The question is, will the others follow or
will they do the opposite? For example, if I raise my price and you do not follow, I
will lose customers to you. More importantly, if that is your reaction, then I will
probably reverse my price increase to match your price. However, if I raise my
price and you and the others follow, we might all be able to both charge a higher
price and earn more profits (note: inelastic demand is required for this to work).
So which response should we expect? The answer is: We have seen both
types of reactions in the real world. This is why oligopoly has two distinct faces.
On the one hand, oligopolists will try to behave like a group or collective
monopoly if they can forge and maintain an agreement for the group to act in
unison. On the other hand, some of the most intense competition in the business
world occurs in oligopolies where agreements to jointly maximize profits cannot
be reached or maintained.
For example, OPEC is a cartel which acts as a group monopoly. It
operates in the international arena free of U.S. and EU antitrust laws. While it
does not have to worry about antitrust laws, it still has to worry about the
incentive to cheat that is inherent in all group monopolies (in other words, the
best of all possible worlds for a cartel member is always to get others to cut back
on output to create a higher price, but for each cartel member to cheat by
producing more output than the group has allowed).
Cooperative behavior and group monopoly are thus one face of oligopoly.
At the other extreme is intense competition. For example, steel tycoon Andrew
Carnegie complained bitterly about destructive competition among big
oligopolists (see Chapter 13 below). What Carnegie was referring to was brutal
competition that brought misery to giant firms who could not figure out how to
cooperate, but could not drive each other out of business either. According to
Carnegie, this resulted in a perpetual hell. He would have welcomed legalizing
cartels to solve this problem. In the late 1800s, Germany did legalize cartels in an
effort to pave the way for cooperative behavior.
As an example of brutal competition, consider again the case of Intel and
AMD. These two firms have already been featured in many discussions. What is
interesting about them in regard to the current question is the extreme
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competition (and bad blood) that exists between them. This is also a good
example of why this question can never be resolved by simply looking at
structural features. Intel and AMD account for virtually all of the IBM-compatible
microprocessors sold in the world, and the vast majority of microprocessor chips
of any kind sold in the world. With such concentration, one might expect
cooperation between the two. However, we see the exact opposite. A similar
example can be found with Coca Cola and Pepsi. While these two firms
dominate the soft drink market, we usually see intense competition rather than
efforts to create a joint monopoly.
On the other hand, we have seen oligopolies that have managed to
cooperate. Since such cooperation among horizontal competitors is usually
illegal in the U.S., firms have had to devise covert ways of cooperating. For
example, the U.S. automobile industry in the 1950s and 1960s was investigated
by the Justice Department for collusion and price fixing. The Justice Department
was able to document a practice called parallelism in the industry. For example,
each autumn, when the new models came out, either Ford or Chrysler would
take the lead and announce new prices for their new models. If Ford went first,
Chrysler would follow and GM would always weigh in last.
In a typical year, Ford might announce increases in prices of 3%. It would
cite market conditions as its reason for the price increases. Chrysler would then
announce price increases of 4.5%, higher than Fords increase, and again cite
market conditions. General Motors, the largest of the Big Three, would then
announce its price increases of 3.2%, citing market conditions.
Ford would then quickly revise its price increases in light of changing
market conditions and announce price increases of 3.2%. Chrysler would follow
Ford by announcing that it had re-evaluated changing market conditions and
would raise it prices by 3.2%. In the end, all three had increased prices by the
identical 3.2%.
What was going on here? It seemed clear to the Justice Department that
this was a choreographed game designed to allow market cooperation without
the use of overt price fixing or a cartel. However, while parallelism is highly
suspicious and suggestive of a collusive agreement, it takes more than
documenting parallel moves to get a conviction. The Justice Department had to
be content with publishing its findings under the title of Administered Prices, but
it was never able to file charges let alone get a conviction.
So which face of oligopoly will we encounter in any given situation? There
is no way of telling for sure. Much depends on the factors that make it easier or
harder to get and maintain an agreement. We will leave it at that.

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An Important Note regarding the Term Monopoly

Before we continue, we need to clarify the different ways in which the term
monopoly can be used. In formal economics, monopoly means one single
solitary seller. By this strict definition, one can count on one hand the number of
actual monopolies that have existed through history. (I am talking here about
private monopolies, excluding government created or government sanctioned
monopolies.)
However, when the public uses the term monopoly, they are referring to
very large firms that are able to effectively limit or restrict competition in their
industries. This is also how the term is used in antitrust laws (e.g., in the
Sherman Act). The public (and legislative) use of the term monopoly actually
refers to a very strong oligopoly, especially to a colluding oligopoly. It is
unfortunate that we have different meanings attached to the same term, but that
is simply the way it is. The wise thing to do is to make sure of how the term is
being used in any particular discussion.

From Descriptive Market Structures to Analytical Types

We have described four market structures above. We could proceed to
look at each in turn; however, there is a simpler way. Three of these market
structures share a common feature price searching behavior. On the other
hand, pure or perfect competition alone features price taking. We will use this to
simplify the analysis by focusing on price takers versus price searchers. The
following table reiterates this division of descriptive market structures into the
price-taker versus price-searcher format:

Analytical Market Types

1. Price Takers
Pure or Perfect Competition
2. Price Searchers
Monopolistic Competition
Oligopoly
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 Monopoly
We will employ this simplification first in considering the nature of demand
curves and marginal revenue curves in price taker versus price searcher
markets.

Demand and Marginal Revenue Curves

Demand curves and marginal revenue curves are different for price takers
and price searchers:
Price Takers
In a price taker market, the firms marginal revenue is the market price.
This is the case because the firm can sell as much or as little as it wants at the
market price without affecting the price. You encounter price taking everyday in
malls, supermarkets, and in financial markets where your decision to buy, or not
to buy, has no discernible effect on the market price.
The demand curve for a price taker is a horizontal demand curve at the
market price. Again, this simply reflects the fact that the firm can sell as much or
as little as it wants at this price. Such a demand curve has infinite elasticity, that
is, a firm will lose all of its customers if it charges a price greater than the market
price. On the other hand, it can sell as much as it wants at the market price, so
there is no reason to cut its price to attract customers. In price taker markets,
price is not a strategic variable it is market determined.
In price taker markets, MR = AR = P. AR is average revenue.
Price Searchers
In price searcher markets, MR never equals the market price. This is true
because of the Law of Demand. With a downward sloping demand curve (found
in all price searcher markets), one more unit of output offered for sale will reduce
the price that the firm can get for all of its output (lets keep price discrimination
out of this discussion). Consequently, more output depresses price while less
output will allow the firm to get a higher price. What the firm cant get is what it
actually wants most it wants to sell more output at higher prices. That would be

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better, but it is simply not in the cards in the real world due to the Law of
Demand.
In a price searcher market, P = AR, but P > MR. Graphically, the marginal
revenue curve is always half way between the vertical axis and a straight-line
demand curve. (There are many ways to prove this, or you can take my word for
it lets do that.)

What to Expect from Different Market Structures

In this section, we first look at equilibrium in a price taker market, then
equilibrium in a price searcher market. Finally, we compare the two.
Price Taker Markets
Suppose that we have a price taking market that can be represented by
the supply and demand graph shown in Figure 1.
Market competition will move us to the equilibrium shown Figure 1 at P =
$80 and Q = 10,000,000. Supply and demand graphs only depict the relationship
between price and quantities supplied and demanded. All of the other factors that
influence demand and supply are assumed constant. If these change, they will
shift the demand curve and/or the supply curve. The following are factors that
usually influence demand and supply and they are all factors that will shift the
demand curve to the right or left if they change. In a simple supply and demand
curve, they are assumed to be constant ceteris paribus.
Demand = D = f (factors that influence buyers)
D = f ( Price of the Product
Tastes and Preferences
Product Uses (final vs. derived demand)
Product Qualities (real or perceived)
Advertising
Buyer Income
Price of Substitutes
Price of Complements
Time period

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Expectations (i.e., price expectations, product expectations, and

speculation)
Miscellaneous factors (e.g., seasonal factors, fad or fashion, snob
appeal)

Supply = S = g (factors that influence sellers)

S = g ( Price of Product
Input Prices
Other Output Product Prices
Technology and Technological Change
Production Conditions
It is easy to come up with a textbook list of demand and supply factors, but
always keep in mind that the hard part in business is figuring out which factors
matter for your product and how important are they.
Let us further suppose that our price taker market is populated with firms
that all have the costs shown in Figure 2.
In Figure 3, we put the market together with our representative firm. Notice
that our price taking firm cannot influence the market price on its own.
Consequently, it can sell as much or as little as it wants at the market price. The
market price is therefore the firms demand curve. We show this in Figure 3 as a
horizontal demand curve at the market price. Price is also the marginal revenue
for a price taking firm because it can always sell the next unit of output at the
market price. The market price is also the firms average revenue (in fact, it sells
all of its output at the market price).
So, how much will our firm produce? If it wants to maximize its profits (and
we will assume that it does) it will produce 1,000 units of output and charge the
market price of $80. It will have revenues of $80,000 (i.e., $80 times 1,000). It will
incur costs of $37,000 (i.e., $ 37 times 1,000). The unit cost can be read off of
the AC curve at the profit-maximizing output level of 1,000 units.
In market structure analysis, the most important question is always: What
happens next? In this case, we need to ask if the situation that we just described
can last, or will it change? These questions are basically equivalent to asking if
this is equilibrium. Equilibrium is simply a scenario that will not change unless it is
disturbed. If we have equilibrium, nothing else will happen and the answer to the
What happens next? question is: nothing. However, if we do not have
equilibrium, then things will change as a result of competition.

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There are two conditions that must be met to have equilibrium in a price
taker market. First, supply must be equal to demand. If they are not, then market
competition (on one side of the market or the other) will cause the market price to
change. Notice that in Figure 3, supply is equal to demand and we have satisfied
this equilibrium requirement.
The second equilibrium requirement is that economic profits be zero.
Recall from Chapter One that we would include a normal profit in all measures
of economic cost. If a normal profit is included in costs, then positive economic
profits are defined as accounting profits that are above a normal rate of return.
In Figure 3, our firm earns an economic profit of $43,000, that is, $43,000 over
and above a normal profit.
This positive profit will attract new firms to enter the industry. In price taker
markets, there is nothing that will keep them out (i.e., no barriers to entry) so
firms coming into the market will readily increase the supply of goods in the
market. The supply curve will shift to the right and we will have market
competition erupt as suppliers compete with other suppliers to deal with the
market surplus. The market price will fall as a result.
Figure 4 shows the effects of new firms entering the market. It also shows
a new market price of $75 and a new market output of 11 million units. Our firm
reduces its output to 980 units and sells its output at the lower market price of
$75.
Do you think our firm is happy with this development? No, of course not
no one likes a lower price and reduced output. But that is the point. Our firm is a
price taker, like it or not.
Does Figure 4 show equilibrium? Supply is once again equal to demand at
the lower price of $75, but we still have positive economic profits of $38,220, i.e.,
revenues of $73,500 minus costs of $35,280. (AC at 980 units was pegged at
$36, but is not calibrated on the graph). This is therefore not equilibrium; more
firms will enter and the supply curve will shift further to the right. Market
competition among sellers will again reduce price and our firm will produce less
and earn less profits. This will continue until profits are pushed down to zero.
Figure 5 shows equilibrium. Supply is equal to demand at a price of $35
and a market output of 14 million units. Our firm produces 700 units of output and
sells them for $35 each. The firm generates revenues of $24,500 and incurs
costs of $24,500. Since a normal accounting rate of profit is included as a cost,
our firm earns zero economic profits, which corresponds to a normal accounting
profit. This is equilibrium because there is no longer any incentive for firms to
enter (or leave) the industry.
Figure 6 shows the same equilibrium with all of the earlier prices and
outputs removed for clarity. This is what equilibrium in a price taker market looks
like. Hopefully, this is a picture that is worth a million words and is a good way of
summarizing where we end up in these markets. However, if you dont like the
picture, or you dont follow it, you should stop and translate the results into a

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narrative. There is nothing in the picture that cannot be articulated in simple

English. The following is the narrative version:
Market competition will move price until supply is equal to demand. In
addition, firms will enter (or leave) the market until economic profits are zero.
This will occur when the market price is equal to the average cost of producing
the product. At this output, MC = AC, that is, unit costs are at their lowest level.
This is the cost efficiency of price taker markets. Firms in these markets only
earn profits that cover their opportunity costs, that is, they earn normal profits.
There are no excessive profits (or deficient profits).
If you are looking at the graph and are not able to articulate what you are
looking at, you need to stop and look again. (And never try to memorize
something that you do not understand.)

The Response of Price Taker Markets to a Change in Demand

Lets take the analysis one step further and look at how a price taker
market in equilibrium responds to a change in one of the ceteris paribus variables
in the supply function or the demand function. We could do an example for
changes in any of the variables in these functions (shown above), but lets simply
choose one: a change in tastes and preferences that increase the demand for
our product.
Figure 7 shows a price taker market at equilibrium. This equilibrium occurs
at a market price of $100 with 4 million units bought and sold in the market. A
representative firm produces 200 units of output and sells them at the market
price of $100. Supply is equal to demand and economic profits are zero.
Figure 8 shows the change in tastes and preferences as an increase in
demand (i.e., a shift of the demand curve to the right). Supply is no longer equal
to demand at the old market price and market competition increases the price to
$130 as buyers compete with other buyers in the context of a shortage. The
higher price is a signal to producers to produce more. Our representative firm
increases its output to 250 units and sells them for $130 each. Notice that
although unit costs are slightly higher, the higher price more than compensates
and economic profits are positive.
Although supply is equal to demand at $130, positive economic profits will
prompt other firms to enter the market.
Figure 9 shows the entry of new firms and the shift in the supply curve that
entry produces. The supply curve may shift in stages (not shown) but it will
continue shifting until economic profits are zero. Because costs have not
changed, the supply curve shifts to the right until the original price of $100 is
restored. At this price, the firm again produces 200 units of output. We are in
equilibrium because supply is equal to demand and economic profits are zero.
Also note that at the new equilibrium, more output is produced in the market to
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meet the increased demand for the product (i.e., the market has expanded from
4 million units to 6 million units).
Lets take a few steps back and consider these results. People wanted
more of this product and the market responded with increased production. This is
the sign of an efficient economic mechanism. (We might point out that the Soviet
Union never managed to get its socialist economy to accomplish this.) After the
market increases output to satisfy the higher demand, the price returns to a level
that reflects only the costs of production (including a normal profit). Profits are
once again limited to normal accounting profits. Again, firms produce at lowest
unit costs.
As a whole, this is not a bad result. In addition, the example above
illustrates a key feature of price taking markets that all managers need to know
about: the price reversal. When prices rise due to an increase in demand, the
common expectation is for prices to continue going up, or at least to remain high.
This is due to human nature people tend to predict the future by thinking that
tomorrow will be essentially like today, except a little more. In other words, they
assume that todays trends will continue into the future. This is called
extrapolation.
While extrapolation may be the norm, the price reversal shown above
suggests that you should expect the opposite. The price reversal occurs because
of the higher profits and the competition of capitals that it initiates. Higher prices
simply cannot stay at the higher levels unless there is an increase in costs that
keep them there.
This will always occur and managers should anticipate it. However, the
real problem in the world is timing the reversal. Economic theory tells you that the
price reversal will occur, but not when. That is part of the art of business.

Price Searcher Markets

In a price searcher market, a firm has a downward sloping demand curve.
A price searchers demand curve, marginal revenue curve, and cost curves are
shown in Figure 10. The firm must decide how much to produce and what price
to charge. Note that this is not a two-part question once the output level is
chosen, there is one and only one price that will result in that level of sales. The
demand curve shows all of the relevant price-output combinations that the firm
can choose.
Figure 11 shows the profit maximizing output level and the corresponding
price. The firm will produce 10,000 units of output because this is the output level
where MR = MC. The firm will sell its output for $90 each because this is the
price at which buyers will purchase 10,000 units of output. Note that a higher
price will result in fewer sales and less profits.

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The firm has unit costs of $50. This results in $40 economic profit per unit
of output, or total economic profits of $400,000.
What happens next? The answer to this question depends on the
existence and strength of barriers to entry. Barriers to entry are factors that keep
new firms from entering the industry. Very strong barriers to entry might keep all
newcomers out; weaker barriers to entry might keep only some of the
newcomers out, and protect the firm (and its economic profits) from the rest. Very
weak or nonexistent barriers might not keep anyone out.

Strong-Barrier Equilibrium
If barriers to entry are very strong, Figure 11 will be equilibrium. Our firm
will earn $400,000 in economic profits that it will keep because other firms cannot
enter the market, i.e., the competition of capitals is blocked. Certainly a
monopoly, if it is to persist as a monopoly, must have strong barriers to entry.
Figure 11 is equilibrium for a monopoly.

Weak-Barrier Equilibrium
Figure 12 shows the opposite scenario barriers that are so weak as to
offer no protection at all. In this case, firms enter the industry and compete with
our firm. As new firms enter, our demand curve shifts to the left. The MR shifts
with the shifting demand curve. With no barriers at all, we will lose market share
until the demand curve shifts to the point shown in Figure 12.
Notice that the firm in Figure 12 sells less (3,000 units), and it sells its
output at a lower price ($65). In addition, it earns zero economic profit because
unit costs at 3,000 units are $65.
Also note that if newcomers were to continue to enter the market, the firm
would have negative economic profits. Our firm might continue to produce
temporarily in order to minimize its losses (i.e., as long as price remained above
average variable costs), but the firm will not continue to produce in this market on
a long term basis if it cannot cover its opportunity costs (i.e., earn normal profits)
Figure 12 depicts equilibrium in most monopolistically competitive
markets. In these markets, product differentiation gives the firm a downwardsloping demand curve and makes it a price searcher, but product differentiation
provides no meaningful barrier to entry. In some monopolistically competitive
markets with stronger brand name loyalty, the equilibrium might look a bit more

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like oligopoly (to be considered next), but economic profits are likely to be near
zero.

Equilibrium with Strong - but Incomplete - Barriers

Figure 13 shows an equilibrium in a price searcher market where there are
barriers to entry that are strong enough to provide the firm with some protection
from entry - but not strong enough to keep everyone out. This is actually only one
of many different possibilities the demand curve could shift to any position
between the two extremes shown in Figures 11 and 12, depending on the
strength of the barriers.
In Figure 13, newcomers to the market cause the firms demand curve to
shift to the left as shown. Barriers cannot keep them all out, but the barriers are
strong enough to keep the demand curve from shifting as far to the left as shown
in Figure 12. Our firm produces 8,000 units of output and sells each for $80. Its
unit costs are $53 and the firm earns economic profits of $216,000 (i.e., $27
times 8,000). This is equilibrium because the barriers to entry are able to stop the
competition of capitals from further eroding economic profits.
Oligopoly is a market structure that features price searching. We would
expect equilibrium in most oligopolies to look like Figure 13, however, anything is
possible with oligopoly equilibrium could occur anywhere between the two
extremes shown in Figures 11 and 12.
Where we end up in an oligopoly will not only reflect the barriers to entry, it
will also depend on the degree of competition among firms already in the
industry. We have seen oligopolies that have featured cooperative behavior
among oligopolists that amount to a virtual collective monopoly. On the other
hand, we have seen oligopolies with intense cut-throat competition. Cooperative
oligopoly will usually have the equilibrium shown in Figure 11. The cut-throat
oligopolies will usually have equilibrium closer to that shown in Figure 12.

Price Searcher Equilibriums Common Features

Price searcher markets can find equilibrium as shown in Figure 11, Figure
12, or Figure 13. While these are all different, we can distill some common
features. First, prices will reflect not only costs, but also monopoly profits.
Second, economic profits may be zero in some cases i.e., Figure 12, but more
likely to be positive (as shown in Figures 11 and 13). The size of economic profits

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will reflect the strength of barriers to entry as well as the intensity of competition
in the industry.

Price-Taker versus Price-Searcher Equilibriums Compared

The following summarizes the different equilibriums that occur in price
taker versus price searcher markets:

Equilibrium in a Price Taker Market

At equilibrium in a price taker market:
1. MC = AC
This means that producers will operate at lowest unit costs.
2. P = AC
This means prices only reflect the costs of production (including a
normal profit.)
3. P = AC
This means that prices will follow costs, that is, cost reductions will
lead to price reductions.
4. P = AC
This means that profit will be zero. (Accounting profit will be
"normal").
5. New technologies will be quickly disseminated.
This means that firms will be forced to quickly embrace new
technologies that come to the market. Failure to adapt will mean
extinction.

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Equilibrium in a Price Searcher Market

At equilibrium, a Price Searcher will:
1. Not produce at lowest unit costs because MC < AC
2. Usually earn an economic profit because P > AC
3. Usually charge a price that does not reflect only cost because:
Price = cost + economic profit
4. Prices will not necessarily follow costs because lower costs might
simply increase profit margins.
5. Technological Change?
Are oligopolies and/or monopolies more innovative? This is a
difficult issue to come to any firm conclusions on. On the one hand,
price searchers do not usually have the imperative to innovate and
adapt innovations that purely competitive firms have. On the other
hand, big firms (oligopolies) have more resources to devote to
pursuing new technologies. Consequently, while oligopolies are in a
better position to develop new technologies, they may have less
competitive pressure to deploy these innovations. Suffice it here to
note the two opposing forces and recognize that the jury is still out
on this one.
Appendix: Figures 1 13

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