Tuesday, March 10, 2015

Market Structure



          
Yay "Free" Market!

              A market is a description of the where buyers and sellers of goods and services meet to exchange goods and services. In the olden days, it was a physical place and often set times. The Greeks called their market the agora. It is where the term agoraphobia is derived from. People who do not like being around people were afraid of, at the root, being around people where they congregated the most.
            Thankfully, for the agoraphobic and the buyers and sellers of goods, when the term market structure is brought up, it is not talking about which vendor gets the choice stalls by the entrance. The market is all around us, and it is not just one market. There is an individual market in each good and service that equals the entire market when summed. Instead, when economist talk about market structure, what they are really talking about is the individual power the market sellers have to set their prices and the profits available at in those markets. The market power is a direct relationship with how many sellers of a good there are, and how hard it is for a new seller of the good or service to start selling.
            The best way to think of all the possible market structures is to think of a spectrum. On one end, there is a market with only one seller. This is what is termed a monopoly. On the other end there is a market with an infinite number of sellers, or at least so many that one firm entering or leaving the market makes no effect on the market, because the idea infinite sellers is just a simplification. Two other market structures rest in the middle: Oligopoly and Monopolistic Competition. Monopolistic competition has fewer suppliers than perfect competition, and an oligopoly has fewer still. Each of the four market structures will be dealt with in turn.
            The first kind of market is a market in perfect competition. This is the market that is unaffected by a firm or other seller deciding to sell or stop selling. A firm in a market with perfect competition is one that is a price taker. The market price is the only price they can receive for what they are selling because if they price their goods higher than the market price, then no one will buy what they are selling. No one will buy what they are selling is because a potential consumer can just walk on over to the next person selling what they are selling and buy it at the market price. There is no differentiation this scenario because by definition what firms are selling are all the same. The simplest example of this is agricultural products. If Alpha Corp is selling apples at four bucks and Beta Corp is selling apples at four bucks, then Gamma Corp has to be able to sell at four bucks or else it should not enter the market for apples.
How is this four bucks determined? It does not come from the sky. The crucial part of perfect competition is that there is no economic profit to be made.  Economic profit is often called “rent” the price over and above costs that a firm should make. That is not to say that there is no accounting profit to be made, or else no firms would enter the market. Instead, the price in a perfectly competitive market is one where the price is equal to the marginal cost where it intersects with the average total cost curve. A firm in a competitive market would maximize profit by selling as many apples as it takes until the marginal cost of the last apple sold equals the market price (Besanko et al. p. 173).
Moving down the spectrum is a market structure where there are fewer firms and the products have some sort of differentiation. Instead of looking at apples or oranges, the market could be juice and firms could be selling apple juice or orange juice. In a monopolistic competitive market, there are many sellers. A difference between monopolistic competition and perfect competition is that in a monopolistically competitive market there is a slope to the demand curve. In perfect competition, the slope of the demand curve is zero, meaning it is a flat line at the market price, or perfectly elastic. Any price that is not on the demand curve results in a quantity sold of zero. This is not true in monopolistic competition. The sloping demand curve means that there is some flexibility for a firm to sell on price. They can climb to the top of the tallest tower and scream that their juice is better (vertical differentiation) or they can shout that their juice is closer (horizontal differentiation). The firm can even tout that it has a qualitatively inferior product, but at a lower price. As long as those prices are at or above that magical sport where the marginal cost curve intersects with the average total cost curve, the firm should be in business. That is the quantity they want to make to stay in business. If above, that means it is making an economic profit. That profit means that the market will attract entrants who want a piece of that pie, and it will continue to do so until total economic profit for the market goes to zero (Besanko et al. p. 180). Such is the nature of monopolistic competition. The flip side is also true, though. If there is negative economic profit to be made, the firms with the highest costs will leave the market and equilibrium profit will go back to zero.
A market with even fewer firms is an oligopoly. A defining characteristic of a market that can be called an oligopoly is that the firms within the market are very aware of the actions of the other firms in the market, whereas in the previous markets studied the firms all acted rather independently of each other (Besanko et al. p. 180). One example of a contemporary oligopoly is the large farm equipment market, where two firms, Deere and Caterpillar dominate. In high concentrated markets like the one for large farm equipment, the potential for informal coordination exists so that the participating firms can split the market and reap the rewards of their power. This means that the firms have power to set prices. The firms are no longer price takers, but are price makers up to a point.  Many models exist to describe both a static and a dynamic market that is split between large players. The key takeaway is that the firms will realize the most profit in the sort if they act as if they were a single monopolistic firm, through tit for tat pricing and other ways to coordinate pricing without deliberately forming an illegal cartel. The problem is that as long as there are not significant barriers to entry, other firms will see the profit potential and try to enter that market so that economic profit drops. This is why oligopolistic competition is often seen in industries where there are large capital and regulatory barriers to entry, such as large farm equipment manufacturing or mobile telephony. Other firms maintain their oligopoly through network effects and high switching costs, such as social media and banking.
The final form a market can take is when the bulk of the supplying is done by one firm. This does not mean that other firms cannot exist in a monopolistic market, but that for overall price and quantity produced they more or less do not matter (Besanko et al. p. 176). This is not to say that a monopolist can charge any price for the goods and services it sells. The demand curve is not perfectly inelastic; it is also downward sloping. This means that if a monopoly raises its prices, then it will lose customers. The profit maximizing quantity produced of a monopolist is where the marginal revenue of the last item sold equals the marginal cost of making it. This means there is a limit to how much a monopolist can produce until its profits start decreasing. In this way, the monopolist is the market. It can structure prices in ways to limit entry, but in practice, you see very few monopolies in the real world. Federal regulators for the last 140 years in the United States have been wary about the potential of monopolistic markets driving up the cost of goods and the quality of the goods sold. Market concentration does drive up price, as noted by economist Leonard Weiss (Besanko et al. p. 191), but that does not mean all monopolies are bad. Microsoft was able continue with its dominance over the personal computer operating system market because even though it reaped high profits, the consumers ultimately benefited from the network effects of having industry standard software. Note though that even this monopoly was transient. As the use of computers changed, the stranglehold of Windows and the Office products waned. The lasting monopolies are instead those that are considered natural monopolies, where duplication of services is inefficient. The best example of this is in the distribution of utilities. Laying pipe over the right of ways is most efficient when there is only one entity doing it. It is also easiest when there is state coordination to grant those right of ways or to appropriate them through eminent domain – something that is not within the rights of a private corporation (Kelo v. City of New London excluded). This is why the monopolies that do persist are either highly regulated or have been subsumed into the state apparatus.
In the end, there is no one best market structure. Each market is different based on the goods and the services sold, and the various barriers to entry and exit. The important thing is that for each market and each firm within a market, there is an optimal amount of goods and services that can be provide to maximize. The challenge for each firm is hitting that sweet spot.


References

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New York: Wiley.