Objectives for Chapter 7

At the end of the Chapter, you will be able to answer the

following:
1. Explain what is meant by "economies of scale" and
why they exist?
2. Explain what is meant by learning by doing or
the learning curve and what is meant by
dynamic increasing returns to scale.
3. Explain what is meant by "diseconomies of scale"
and why they exist.
4. What are the four characteristic of perfect
competition?
5. What are the three characteristics of pure
monopoly?
6. What are the characteristics of monopolistic
competition?
7. What are the characteristics of oligopoly?

Chapter 7
Market Structure

Every gun that is made, every warship launched, every

rocket fire signifies, in the final sense, a theft from
those who hunger and are not fed.
- Pres. Eisenhower

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 1990s, 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. Lets 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 valueadded 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 be characterized as
perfect competition. Of course,
nothing is perfect. But, while no
industry will exactly meet the four
criteria of perfect competition, we
can learn much from assuming
that such an industry does exist.
1. There
are
so
many
sellers that no one seller
can affect the price by
himself or herself.

Perfect Competition

Free entry and

exit to industry
Homogenous
product
identical so no
consumer
preference
Large number of
buyers and
sellers no
individual seller
can influence
price
Sellers are price
takers have to
accept the
market price
Perfect

Think of Mang Pandoy buying

gasoline. The price says 50.00

per liter. Suppose you ask to see
the manager and then make an
offer: you will buy only if the price

is reduced to 20.00 per liter.

What will the manager do? The answer is: laugh 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 dont 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 Monopoly
existence of high barriers to entry.
High barriers to
For example, until a few years
entry
ago, it was impossible to compete
Firm controls
with
Meralco.
DeBeers
has
price OR
maintained its monopoly on
output/supply
diamond
production
through
Abnormal
control over the natural resource.
profits in long
Virtually all of the diamond in the
run
world has come into the control of
Possibility of
this company, owned by the
price
Oppenheimer family of South
discrimination
Africa. IBM maintained close to a
Consumer
literal monopoly on mainframe
choice limited
computers through its copyrighting of computer languages.
Xerox and Polaroid maintained near 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 1990s 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 companys 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 demand for the product,
the
industry
is
called
monopolistic competition. The
monopoly part results from
there being one seller of the
narrowly defined product. The

Monopolistic
Competition

Many buyers and

sellers
Products
differentiated
Relatively free
entry and exit
Each firm may
have a tiny
monopoly
because of the
differentiation of

competition comes from other products that are close

substitutes.
Most real-world competition takes this form. There is only
one Coca-Cola but there are many close substitutes. There
is only one MacDonalds but 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 Oligopoly
dominated by between two and
Industry
ten companies.
Automobiles,
dominated by
steel, tires, cigarettes, accounting
small number of
firms, and breakfast cereals are
large firms
among the many examples.
Many firms may
Oligopolies are difficult to analyze
make up the
because each firm, in making a
industry
decision, must consider not only
High barriers to
the response of the buyers but
entry
also the response of the other
Products could
sellers. Should Ford offer a rebate
be highly
differentiated
(lower price) on its cars? The
branding or
answer depends not only on the
homogenous
way buyers will respond to the

Nonprice
rebate but also on Ford's estimate

competition
Potential for
collusion?
Abnormal
profits
High degree of

of the response of General Motors, Chrysler, Honda, Toyota,

and Nissan.
It would be easier to predict the responses of competitors if
the competitors met and discussed their decisions. Such a
meeting of members of an oligopoly to coordinate
decisions (especially over the price) is known as a cartel.
Cartels are illegal in the United States; however, some
have 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
Summary
Structures

Imperfect
Perfect Market
A market is any one
of Markets
a variety of different
systems, institutions, procedures, Monopolistic
social relationsPure
Characteristics
Monopoly
Oligopoly persons
Competion
and infrastructures
whereby
trade, Competition
and
Number of
2-3 major
goods and Single
services
are exchanged,
forming
partVery
of large
Sellers
Firm
players
Large
the economy.
It
is
also
defined
as
a
group
of
buyers
Homogeneou
andaUnique/
Homogeneou
Homogeneous
and sellerss of
particular
good or service.
No close
s or
Markets allow
transaction
to take place within Standardized
theand
Type of Product
Substitute
Differentiated Differentiated
players
Barriers
to entry in it. There are two kinds of transactions in
for new
Open/ Easy
the economy: Formal and informal transactions.
competitors
Close
Limited Entry
Fairly Easy
Entry
Informal Transactions have two subtypes:
the black
Certain
market
Control
over the and the gray market.
Controlled but
degree of
Price
Price Makers
not complete with
inluence
Market Structure
is concerned
the typePrice
of Takers
No non-price
market whichprice
firms operate. It affects the degree of
power that
individual firms have to influence
competition
but advertise
market variables
such as the price of the product.
for public
Extensive for
Criteria inrelation
determining
the market structure
Non-Price
and
differentiated
No non-price
Competition
information
products
Extensive
includes: type
of product,
control over
the pricecompetition
of
Availablity
of
limited
limited
at
a
the product, the number of buyers and sellers in the
Information
available
certain
open
barriers
to entry,
non-pricedegree
competition,
amongmarket,
buyers
Very limited
information
information
and the availability of information within the 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
Questions for Review and Application:
1. Explain the following benefits to society of a
perfectly competitive industry.
2. What is meant by pure monopoly?

3. What is wrong with the statement: Because a

company is a monopoly, it can charge any price
that it wants.?

Quiz 1. Market Structure

Name:
_______________________________
_________________
Section:
___________
Date:
__________
_________________

Score:
Professor:

Direction: Multiple Choice: Choose the best answer.

_____1. Companies in perfectly competitive industries:
A. make zero economic profits in the long-run
B. achieve productive efficiency
C. have incentives to improve products and produce
more efficiently over time
D. all of the above
______2.
seller is:

For a monopoly, the demand curve facing the

A. perfectly elastic
product
B. the marginal cost curve
revenue curve
______3.
A.
B.
C.
D.
______4.
EXCEPT:

C. the demand for the

D. the marginal

For a monopolist, price is:

greater than marginal revenue
less than marginal revenue
equal to marginal revenue
sometimes greater and sometimes less than
marginal revenue
The following are characteristics of Oligopoly

A. an Industry dominated by small number of large

firms
B. Product are unique and has no close substitute
C. High barriers to entry
D. Products could be highly differentiated branding
or homogenous
E. Nonprice competition

Quiz 2. Market Structure

Name:
_______________________________
_________________
Section:
___________
Date:
__________
_________________

Score:
Professor:

True or False. Write if the statement is true and

if the statement is false. Write your answer at the
left of each number.
1. The term market refers to any instance that allows an
interaction between buyers and sellers.
2. There are two kinds of transactions in the market.
3. Money is required for a transaction to take place
within the market.
4. Monopolists are price takers.
5. Shell, Petron and Caltex are major players in the
petroleum market.
6. Barriers to entry are very difficult to penetrate in a
pure competition.
7. Products in a monopolistic competition are unique and
have no close substitutes.
8. Players in a pure competition are considered as price
takers.
9. Monopolies engage much in non-price competition
through marketing and product innovations.
10. There is only one major seller and many minor
players in a monopolistic competition.
11. Agricultural products are mostly part of pure
competition.
12. Barriers to entry includes high capital requirement
for pure competition.
13. Products in a monopolistic competition are highly
fragmented or differentiated.
14. Credit cards are an example of money
representative.
15. Globe has a certain degree of control in the price of
their products.
16. It is fairly easy to enter as a new competitor against
a monopolist.
17. Monopsony is a market wherein there is only 1 buyer