Market Models: Pure Competition, Monopolistic

Competition, Oligopoly, and Pure Monopoly

A modern economy has many different types of industries. However, an
economic analysis of the different firms or industries within an economy is
simplified by first segregating them into different models based on the amount
of competition within the industry. There are 4 basic market models: pure
competition, monopolistic competition, oligopoly, and pure monopoly. Because
the competition among the last 3 categories is limited, these market models are
often referred to asimperfect competition.
In a purely competitive market, there are large numbers of firms producing
a standardized product. Market prices are determined by consumer demand; no
supplier has any influence over the market price, and thus, the suppliers are
often referred to as price takers. The primary reason why there are many firms
is because there is a low barrier of entry into the business. The best examples
of a purely competitive market are agricultural products, such as corn, wheat,
and soybeans.
Monopolistic competition is much like pure competition in that there are
many suppliers and the barriers to entry are rather low. However, the suppliers
try to achieve some price advantages by differentiating their products from
other similar products. Most consumer goods, such as health and beauty aids,
fall into this category. Suppliers try to differentiate their product as being better
so that they can justify higher prices or to have a larger market share than the
competition. Monopolistic competition is only possible, however, when the
differentiation is significant or if the suppliers are able to convince consumers
that they are significant by using advertising or other methods that would
convince consumers of a product's superiority. For instance, suppliers of
toothpaste may try to convince the public that their product makes teeth whiter
or helps to prevent cavities or periodontal disease.
An oligopoly is a market dominated by a few suppliers. A high barrier to entry
limits the number of suppliers that can compete in the market, so the
oligopolistic firms have considerable influence over the market price of their
product. However, they must always consider the actions of the other firms in
the market when changing prices, because they are certain to respond in a way

to neutralize any changes so that they can maintain their market share. Auto
manufacturers are a good example of an oligopoly, because the fixed costs of
automobile manufacturing are very high, thus limiting the number of firms that
can enter into the market.
A pure monopoly has pricing power within the market. There is only one
supplier who has significant market power and determines the price of its
product. A pure monopoly faces little competition because of high barriers to
entry, such as high initial costs, or because the company has acquired
significant market influence through network effects, for instance.
One of the best examples of a pure monopoly is the production of operating
systems by Microsoft. Because many computer users have standardized on
software products that are compatible with Microsoft's Windows operating
system, most of the market is effectively locked in, because the cost of using a
different operating system, both in terms of acquiring new software that will be
compatible with the new operating system and because the learning curve for
new software is steep, people are willing to pay Microsoft's high prices for
Windows.

Pure Competition
A perfectly competitive market is rare, but the ones that do exist are very large,
such as the markets for agricultural products, stocks, foreign exchange, and
most commodities. Pure competition also offers a simplified economic market
model that yields useful insights into the nature of competition and how it
provides the greatest value to consumers.
Perfectly competitive markets have 4 essential qualities:
1. large number of firms supplying the product,
2. standardized or homogeneous products,
3. low entry and exit costs for firms entering or leaving the industry, and
4. suppliers are price takers in that no individual supplier has any influence on the
market price.

That a large number of firms create a highly competitive market results from
the fact that the product is standardized or homogeneous and that the costs are
low to enter or leave the industry. A high barrier to entry would otherwise limit
the number of suppliers in the market. Hence, there will be many suppliers for
standard products as long as the market price is above the average total cost of
supplying the products.
The suppliers of the competitive market are price takers they have no
influence whatsoever on the market price because each supplier has only a tiny
share of the total market. If some suppliers try to raise their price by even a
few pennies, then consumers will simply buy from other suppliers. On the other
hand, for the individual seller, market demand is completely elastic, so there is
no reason for any supplier to sell even a penny less than the market price, since
they can sell all that they want for the market price.
If the products were differentiated to some degree, then the market would be a
monopolistic competition, by definition, which would allow some suppliers to
charge a slightly higher market price if they can convince consumers, through
advertising or other methods, that their product is worth the higher price.

Economics of a Purely Competitive Seller

Few markets as a whole are perfectly elastic, where consumers would buy
whatever quantity was supplied without affecting the market price. However,
sellers in a purely competitive market see a perfectly elastic demand they
can sell any quantity of the product at the market price. This makes both
the average revenue, which is the average price of all products sold,
andmarginal revenue, which is equal to the price of the last item sold, equal
to the market price.
Average Revenue = Marginal Revenue = Market Price

This, in turn, makes the total revenue of the seller

equal to the market price multiplied by the number of
units sold.
Revenue = Price Quantity

Short-Run Profit Maximization

Since the competitive seller cannot charge anything but the market
price, it can only maximize profits or minimize losses by minimizing
costs. However, in the short run, suppliers can only minimize
variable costs, not fixed costs. There are 2 methods to determine at
what output a seller would maximize his profits or minimize losses:
by comparing total revenue and total costs at each output level or
by increasing output until the marginal revenue equals marginal
cost.

Total Revenue And Total Cost

Under the total-revenuetotal-cost approach, maximum profits occur
when average total cost (ATC) reaches a minimum.
A firm has both fixed and variable costs. If the firm produces only a few units,
then the average total cost will be high because the fixed costs must be covered
by the few units produced. As more units are produced, then the average fixed
costs will decline, which will also decrease the average total cost. Because a
firm has fixed resources in the short run, there will be a point where increasing
the quantity becomes more costly because of the law of diminishing
marginal returns with fixed assets. Hence, at some point average total cost
will start to rise and eventually become greater than the price of the product,
which is the marginal revenue.

Because the average total cost curve includes a

normal profit but not an economic profit, a breakeven point is achieved when the
total cost curve becomes less than total revenue for the first time (#1 in the graph).
There is a 2 breakeven point that occurs as average total cost increases and the
nd

total cost curve again crosses the total revenue line (#2). Between these 2
breakpoints, the difference between total revenue and total cost yields economic
profits (#3) for any quantity of products produced between the 2 breakeven points.

Marginal-RevenueMarginal-Cost Approach
This approach compares how each additional unit of output adds to the total
revenue and total cost. The additional revenue from the unit is the marginal
revenue (MR) and the additional cost is the marginal cost (MC). A firm
maximizes output when marginal revenue equals marginal cost.
MR = MC = Market Price

This results from the fact that as long as the marginal revenue is greater than
the marginal cost, the firm is profiting from producing that unit. Once marginal
revenue equals marginal cost, additional units will incur a marginal cost that is
greater than the marginal revenue for that unit, causing total profits to decline,
which is the result of the diminishing marginal product. This relationship is true
for all firms, whether they are purely competitive, monopolistically competitive,
oligopolistic, or monopolistic. The firm will maximize profit or minimize loss as
long as producing is better than shutting down.
Because, for purely competitive firms, marginal revenue equals price, maximum
revenue is also earned when the marginal cost of producing the last unit is
equal to the market price. This makes sense since if the marginal cost was
greater than the price, then the firm would incur losses for each additional unit.
Note that by producing until marginal cost equals the market price maximizes
total profit but not per unit profit.
If the market price is less than average total cost, then the firm cannot make a
profit, but if it is higher than the minimum average variable cost, then the firm
can at least minimizes losses.
If the price is less than the average minimum average variable cost, then the
firm has reached theshutdown point where it can minimize losses in the short
run by shutting down completely, since then the firm would lose more money if
it produced any output, thereby increasing its losses. Thus, its total loss will be
equal to its total fixed costs.