Demand & Supply: Market Supply 1

When it comes to the supply, or seller’s side, economic analysis classifies markets into four categories, or structures, according to the degree of competition prevailing in them.

Pure or Perfect Competition

Perfect competition is said to prevail in a market for a given product or service if (1) the number of sellers are very large, (2) the same product produced by different firms is uniform or standardized or homogeneous and (3) entry into and exit from the market by firms is reasonably easy, that is, no important barriers to entry exist.

The first condition ensures that no one seller (or buyer) is large enough to affect the price or the condition of sale by its own actions. The quantity supplied by each firm is a “drop in the bucket” relative to the industry total, so that even if the individual firm withdraws totally, or conversely doubles its supply, the market price does not change. Such a firm is known as a price taker; it takes the market price as given and adjusts its actions to it. The single wheat or milk farmer, one of hundreds of thousands, is a purely competitive firm. It cannot, by its action, affect the market price. The second condition ensures that the individual producer cannot differentiate its product (make it distinguishable) from that of its competitors (for example, by packaging it differently or by introducing a brand name), thereby enabling it to command a higher price. Milk is milk, whether produced by farmer A or farmer B. And the third condition ensures that firms in the industry cannot block entry of other firms: new firms come in readily, if profit opportunities exist, and old firms depart if they sustain losses.

Under perfect competition, one uniform price prevails in the market for each product, and no brand advertising is possible because no brands exist. No firm advertises its milk, wheat, corn or cotton. One may occasionally hear a commercial about milk, but not about a particular brand of milk. Agriculture, the stock market and the markets for foreign currencies are examples of perfectly competitive markets.

Monopolistic Competition

Monopolistic competition is a variant of perfect competition, where conditions 1 and 3 are met but condition 2 is absent. The product of a particular firm is differentiated by packaging, brand name, or some other means, giving the seller some limited control over price, although it faces many competitors. This condition is characteristic of much of the retail trade. Thus, brand-named gasoline can command a somewhat higher price than a non-branded name sold across the street, although the product itself is identical. Advertising and other modes of non-price competition (such as gift coupons) abound, as sellers try to convince buyers of the supposed superiority of their products. Yet the outcome is somewhat similar to that of perfect competition, for the price difference between brands cannot be large. We will combine these two structures under the title: Competitive Markets.

Oligopoly

Oligopoly is said to exist when a few large firms dominate the market for a given product. The automobile industry, consisting of a few firms, is a case in point. Each company has a sizable share of the market; by its very actions, it can affect price and the condition of sale. Such a firm is known as a price maker. It does not merely take the market price for granted; rather, the firm has a certain amount of market power. Since by its action the firm affects the position of its competitors, it can expect them to react. In turn, the anticipation of response places some limit on the firm’s control over its price. Mutual interdependence of firms in the industry is the result.

Products may be standardized (such as raw materials) or differentiated (automobiles, durable goods). In the latter case, advertising is widely used. In part, such advertising is useful in dispensing information, but to some extent, it can be wasteful and even deceptive. Although entry of new firms is possible, the barriers to entry are formidable, for production usually requires large-scale operation, much capital and advanced and often unavailable technology. Most U.S. durable-goods and capital-equipment industries are oligopolistic in structure. In some cases, such as steel, many firms exist; but the industry is dominated by a few large firms that account for a large share of total output. The oligopolistic nature of such a market is determined by the price-leadership role exercised by the large firms; all other firms tend to follow.

Monopoly

A monopoly is a one-firm industry, producing a unique product for which no good substitutes are available. The monopolist is certainly a price maker and has much market power. Barriers to entry are formidable, ranging all the way from advanced technology and patent rights to access to critical materials, and even to legal limitations. Local public utilities (gas and electric companies) are examples of such monopolies.

Monopolistic competition, oligopoly and monopoly are commonly referred to as imperfect competition.

A variety of factors determine the market structure of any particular industry. If large-sized plants are required to produce efficiently and large sums of capital are necessary to form a company (perhaps reinforced by a need to employ advanced technology), an oligopolistic structure is likely to emerge. In the case of public utilities, the law usually mandates a monopoly firm. Gas and electric companies are characterized by huge fixed costs, such as electric lines or gas pipelines, which would be uneconomical to duplicate. Known as natural monopolies, they are accorded a monopoly status by law but are placed under government regulations. In most states, the regulatory agency is the public utilities commission. In the absence of the conditions such as those specified above, competitive markets are likely to emerge.

In the next column, we will develop the supply schedule of a competitive industry using the milk market example that relates to our demand side. Competitive markets are often used because their market outcome is most efficient and can be used to gauge the degree of inefficiency of other structures.

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Mordechai E. Kreinin

Mordechai E. Kreinin

Mordechai Kreinin is a University Distinguished Professor of Economics, emeritus at Michigan State University and past President of the International Trade and Finance Association. He is the author of about 200 articles and books about economics, including the widely used text, International Economics. He can be reached at kreinin@msu.edu or by cell phone at (517) 488-4837

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