ECON 07NA se CH07 CO 8/3/05 11:24 AM Page 150 Market ... CH-7.pdf · ECON_07NA_se_CH07_S1 8/3/05 11:25 AM Page 151. 152 Market Structures Identical Products In a perfectly competitive

Market Structures

II f a single firm produced all computer software,life might be easier because all software would be

compatible. So why has the government tried toprevent one company from dominating thesoftware market? When there are only one or twofirms in a market, consumers have fewer choices,and prices are likely to be higher.

In this chapter you will read about four differenttypes of markets, or market structures. The fourstructures differ mainly in the number of firms thatcompete within them.

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Write down the names of threemajor companies: one with verylittle competition, one with one ortwo important competitors, and one with many competitors. Which situation do you thinkdescribes most markets?

Economics JournalEconomics Journal

ECON_07NA_se_CH07_CO 8/3/05 11:24 AM Page 150

TThe simplest market structure is knownas perfect competition. It is also called

pure competition. A perfectly competitivemarket is one with a large number of firmsall producing essentially the same product.Pure competition assumes that the market isin equilibrium and that all firms sell thesame product for the same price. However,each firm produces so little of the productcompared to the total supply that no singlefirm can hope to influence prices. The onlydecision such producers can make is howmuch to produce, given their productioncosts and the market price.

Four Conditions for Perfect Competition While very few industries meet all of theconditions for perfect competition, somecome close. Examples include the markets formany farm products and the stocks traded onthe New York Stock Exchange. Both of theseexamples fulfill four strict requirements for aperfectly competitive market:

1. Many buyers and sellers participate inthe market.

2. Sellers offer identical products.3. Buyers and sellers are well informed

about products.4. Sellers are able to enter and exit the

market freely.

Many Buyers and SellersPerfectly competitive markets require manyparticipants on both the buying and theselling sides. No individual can be powerfulenough to buy or sell enough goods toinfluence the total market quantity or themarket price. Everyone in the market mustaccept the market price as given.

As we saw in Chapter 6, supply anddemand interact to determine both priceand output. If a market has many indepen-dent buyers and sellers, it is not very likelythat large enough groups of either buyersor sellers will work together to bargain forbetter prices. Instead, the market deter-mines price without any influence fromindividual suppliers or consumers.

perfect competitiona market structure inwhich a large numberof firms all produce thesame product

Perfect CompetitionPreview

Chapter 7 ■ Section 1 151

Section FocusPerfect competition exists when amarket has many buyers and sellersof the same good. Few markets areperfectly competitive becausebarriers keep companies fromentering or leaving the market easily.

ObjectivesAfter studying this section you will be able to:1. Describe the four conditions that are in

place in a perfectly competitive market.2. List two common barriers that prevent

firms from entering a market.3. Describe prices and output in a perfectly

competitive market.

Key Termsperfect competitioncommoditybarrier to entryimperfect competitionstart-up costs

� The market fortomatoes comesclose to perfectcompetition becausea large number offirms sell tomatoes,and one tomato isvery much likeanother.

ECON_07NA_se_CH07_S1 8/3/05 11:25 AM Page 151

152 Market Structures

Identical Products In a perfectly competitive market, there areno differences between the products soldby different suppliers. This is the secondcondition for perfect competition. If arancher needs to buy corn to feed his cattle,he will not care which farmer grew thecorn, as long as every farm is willing todeliver the corn he needs for the same price.If an investor buys a share of a company’sstock, she will not care which particularshare she is buying.

A product that is considered the sameregardless of who makes or sells it is calleda commodity. Examples of commoditiesinclude low-grade gasoline, notebookpaper, and milk. Identical products are keyto perfect competition for one reason: thebuyer will not pay extra for one particular

company’s goods. The buyer will alwayschoose the supplier with the lowest price.

Informed Buyers and SellersThe third condition for a perfectly compet-itive market is that buyers and sellers knowenough about the market to find the bestdeal they can get. Under conditions ofperfect competition, the market providesthe buyer with full information about thefeatures of the product and its price. Forthe market to work effectively, both buyersand sellers have clear incentives to gatheras much information as possible.

In most markets, a buyer’s willingness tofind information about prices and avail-ability represents a trade-off. The time spentgathering information must be worth theamount of money that will be saved. Forexample, most buyers would not search theInternet or visit a dozen convenience storesto save five cents on a pack of chewing gum.

Free Market Entry and Exit The final condition of perfectly competitivemarkets is that firms must be able to enterthem when they can make money and leavethem when they can’t earn enough to stayin business. For example, when the firstpioneering companies began earning a lotof money selling frozen dinners, severalcompetitors jumped into the market with

commodity a productthat is the same nomatter who produces it,such as petroleum,notebook paper, or milk

� A pushcartbusiness is easy andinexpensive to begin,while a steel millrequires a largebuilding and costlymachinery.

Informed Buyers The French government ensures that travelers willhave complete information about the market for hotel rooms and restaurantmeals. While hotels in the United States usually advertise only specialdiscounts, every hotel in France must post in its lobby a list of rates for singleand double rooms, with and without a sink, shower, or full bathroom.Restaurants must go further and post a long list of prices for dozens of items,leaving spaces blank if some common items are not on the menu.

Global Connection


their own products. Later, the firmswithdrew from the market those dinnersthat consumers didn’t buy.

Studies show that markets with morefirms, and thus more competition, havelower prices. When one firm can keepothers out of the market, it can sell itsproduct at a higher price.

Barriers to EntryFactors that make it difficult for new firmsto enter a market are called barriers to entry.Barriers to entry can lead to imperfectcompetition. Common barriers to entryinclude start-up costs and technology.

Start-Up CostsEntrepreneurs need to invest money in anew firm long before they can start earningincome. Before a new sandwich shop canopen, the owner needs to rent a store, buy arefrigerator, freezer, and oven, and printmenus. The expenses that a new businessmust pay before the first product reachesthe customer are called start-up costs.

When the start-up costs in a market arehigh, entrepreneurs are less likely to enterthat market. As a result, markets thatinvolve high start-up costs are less likely tobe perfectly competitive markets. Forexample, the costs of starting up asandwich shop are much lower than thoseinvolved in starting up a lumber mill or agiant supermarket. So, an entrepreneurwith a small income is much more likely totry her luck with a sandwich shop.

Use of the Internet reduced start-up costsin many markets, including books andmusic. However, many entrepreneurs discov-ered that a Web page did not attract andhold customers as easily as a shop window.The high costs of advertising, shipping, anddiscounting goods pushed many out ofbusiness. With a few exceptions, theInternet-based companies that havesucceeded paid substantial start-up costs.

Technology When a school group needs to raisemoney, its members could sell goods like

flowers, cookies, or candy. Some techni-cally skilled students could offer to fix carsor bicycles. Very few student groups wouldbe able to create and sell a new word-processing program.

Some markets require a high degree oftechnological know-how. A carpenter,pharmacist, or electrician can spend yearsin training before he or she has learned allthe important skills. As a result, new entre-preneurs cannot easily enter these marketswithout a lot of preparation and study.Barriers of technology and know-how cankeep a market from becoming perfectlycompetitive.

Price and OutputOne of the primary characteristics ofperfectly competitive markets is that theyare efficient. Competition within thesemarkets keeps both prices and productioncosts low. Firms must use all inputs—land,

barrier to entry anyfactor that makes itdifficult for a new firmto enter a market

imperfect competitiona market structure thatdoes not meet theconditions of perfectcompetition

start-up costs theexpenses a firm mustpay before it can beginto produce and sellgoods

Figure 7.1 Perfect CompetitionFigure 7.1 Perfect Competition

Number of firms: Many

Barriers to entry:None

Control over prices:None

Variety of goods: None

A perfectly competitive market must include a large number of suppliers selling the same good.Competition What prevents any one firm from raising its prices?




labor, organizational skills, machinery andequipment—to their best advantage. As aresult, the prices that consumers pay andthe revenue that suppliers receive accu-rately reflect how much the market valuesthe resources that have gone into theproduct. In a perfectly competitive market,prices correctly represent the opportunitycosts of each product.

Prices in a perfectly competitive marketare the lowest sustainable prices possible.Because many sellers compete to offertheir commodities to buyers, intensecompetition forces prices down to thepoint where the prices just cover the most-efficient sellers’ costs of doing business. Asyou read in Chapter 6, this equilibrium isusually the most efficient state a marketcan achieve.

We saw in Chapter 5 that producersearn their highest profits when theyproduce enough that their cost to produceone more unit exactly equals the marketprice of the unit. Since no supplier caninfluence prices in perfectly competitivemarkets, producers will make their outputdecisions based on their most efficient useof available land, labor, capital, andmanagement skills.

In the long run, output will reach thepoint where each supplying firm just coversall of its costs, including paying the firm’sowners enough to make the businessworthwhile.

Section 1 Assessment

Key Terms and Main Ideas1. Describe characteristics and give examples of perfect

competition (pure competition).

2. How do start-up costs discourage entrepreneurs fromentering a market?

3. What are two examples of barriers to entry in themagazine market?

4. Why must perfectly competitive markets always deal incommodities?

Applying Economic Concepts5. Decision Making Which of these markets come close

to perfect competition? (a) televisions (b) bottled water (c) pizza (d) school buses (e) white socks (f) baseballs (g) paper clips

6. Try This Suppose that you and your friends plan to opena new convenience store. Brainstorm a list of tenexpenses that would be your start-up costs. Next, usethe Sunday newspapers and the Internet to estimatehow much each item on your list will cost. How much doyou estimate you will spend before the store can open?

7. Critical Thinking Other than technology and start-upcosts, what are two specific examples of barriers thatcould prevent a company or individual from entering amarket?

Supply

Demand

EquilibriumPrice

Equi

libri

umQ

uant

ity

Pri

ce

Quantity

Figure 7.2 Market Equilibrium in Perfect CompetitionFigure 7.2 Market Equilibrium in Perfect Competition

In a perfectly competi-tive market, price andoutput reach theirequilibrium levels. Competition Whatfactors allow aperfectly competitivemarket to reach equilibrium?

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1. Identify the symbols in the cartoon.Symbolism plays a major role in helping political cartoons convey theirmessages. For example, Uncle Sam isoften used as a symbol for the federalgovernment of the United States. (a) What company’s symbol is depicted in this cartoon? (b) Who isthe old man?

2. Analyze the meaning of the cartoon.(a) What industry is being representedin this cartoon? (b) Why would theartist use Alexander Graham Bell? (c) What is Mr. Bell reading? Why isthat relevant to this cartoon?

3. Draw conclusions about the cartoonist’sintent. (a) What point is the artisttrying to make about AT&T’s tele-phone rates? (b) Does the artistbelieve the telephone industry hasperfect competition? (c) Are youswayed by the cartoonist’s opinion?

Create your own political cartoonbased on a current economic eventor issue. Include symbolism, humor,and exaggeration in your cartoon.

Additional Practice

Analyzing Political Cartoons

P olitical cartoons express the cartoonist’s opinion on a recent issue or cur-rent event. The artist’s purpose is to sway the opinions of the

reader. To achieve this goal, cartoonists often use humor and exaggeration.When analyzing a political cartoon, be sure to examine all the images andwords to help you fully understand the artist’s intent. Use the following stepsto analyze the cartoon below.

LIFESkills for

155

ECON_05_se_SK_CH07 6/20/05 3:56 PM Page 155

YYou’ve gone to the emergency room witha high fever and a sharp pain in your

leg. The doctor diagnoses a rare infectionand writes a prescription for ten pills of anew medication that the governmentapproved just last year. The doctor tells youthat without this medication, your recoverywill be slow.

At the pharmacy, you find that themedicine costs $97.35, or nearly ten dollarsa pill! The pharmacist tells you that onlyone company has the right to produce themedicine, and it charges a high pricebecause its scientists worked for years to

develop the medication. You feelthat you have no choice, so you

hand over the cash.

The market for prescription medicines isone of many markets in which monopoliescan develop. In this section you will readabout different types of monopolies andhow they form.

Describing MonopolyA monopoly forms when barriers preventfirms from entering a market that has asingle supplier. While a perfectly competi-tive market has many buyers and sellers,monopoly markets have only one seller, butany number of buyers. In fact, barriers toentry are the principal condition thatallows monopolies to exist.

While you can probably think of severalcompanies that look and act like monopo-lies, economists use a strict set of require-ments to define a monopoly. If we definethe good or service provided by a companybroadly enough, we can usually find substi-tute goods from a different source. Forexample, you might think that a conve-nience store on a highway in the middle ofthe desert has a monopoly. However, youcould have carried more water in the car,or, if you had enough money, you mighthave flown across the desert instead ofpaying high prices for food and waterduring the car trip.

monopoly a marketdominated by a singleseller

Monopoly

Section FocusA firm has a monopoly when itcontrols an entire market. Because amonopolist controls the price of itsproduct, a monopoly produces lessand charges higher prices than woulda perfectly competitive firm.

ObjectivesAfter studying this section you will be able to:1. Describe characteristics and give

examples of monopoly.2. Describe how monopolies are formed,

including government monopolies.3. Explain how a firm with a monopoly sets

output and price, and why companiespractice price discrimination.

Key Termsmonopolyeconomies of scalenatural monopolygovernment monopolypatentfranchiselicenseprice discriminationmarket power

Preview

� One company,DeBeers of SouthAfrica, has almosttotal control over theworld’s diamondsupply.




The problem with monopolies is thatthey can take advantage of their marketpower and charge high prices. Given thelaw of demand, this means that thequantity of goods sold is lower than in amarket with more than one seller. For thisreason, the United States has outlawedsome monopolistic practices, as you willread in Section 4.

Forming a MonopolyAll monopolies have one trait in common:a single seller in a market. However,different market conditions can createdifferent types of monopolies.

Economies of ScaleIf a firm’s start-up costs are high, and itsaverage costs fall for each additional unit itproduces, then it enjoys what economistscall economies of scale. Economies of scaleare characteristics that cause a producer’saverage cost to drop as production rises.

The graph on the left in Figure 7.3 aboveshows an average total cost curve for a firmwithout economies of scale. Follow thecurve from left to right. As output increasesfrom zero, the average cost of each gooddrops, and the curve initially slopes

downward. This is because large, initial,fixed costs, like the cost of the factory andmachinery, can be spread out among moreand more goods as production rises. If thefactory cost $1,000 to build and each unitof output costs $10 to make, producingone unit will cost $1,010, but producingtwo units will cost $1,020, or only $510each. However, if the industry has limitedeconomies of scale, output will eventuallyrise to a level at which the limited scaleeconomies are exhausted, and the cost ofmaking each unit will rise. The average costof producing each good increases as outputincreases, and the curve slopes upward tomatch the rising cost per unit.

A factory in an industry with economiesof scale never reaches this second stage ofrising costs per unit. As productionincreases, the firm becomes more efficient,even at a level of output high enough tosupply the entire market. The graph on theright in Figure 7.3 above shows how costand output are related in economies ofscale. Follow the curve from left to right.As output increases, the cost per unit falls,and continues to fall.

A good example is a hydroelectric plant,which generates electricity from a dam on ariver. A large dam is expensive to build.

economies of scalefactors that cause aproducer’s averagecost per unit to fall asoutput rises

Average Total Cost CurveWithout Economies of Scale

Average Total Cost CurveWith Economies of Scale

Figure 7.3 Effect of Economies of ScaleFigure 7.3 Effect of Economies of ScaleC

ost

Average Total Cost

Output

Average Total Cost

Output

Cos

t

With economies of scale, the average cost of production falls when the firm produces more.

The average cost rises when output exceeds a certain level.

With economies of scale, production costs continue to fall as output increases. Markets and Prices Describe the cost curve for a firm without economies of scale.



natural monopoly amarket that runs mostefficiently when onelarge firm supplies allof the output

� Before cellular phones becamepopular, telephone service was anatural monopoly because no onewanted to build more than onenetwork of wires.

However, once the dam is built, the plantcan produce energy at a very low addi-tional cost simply by letting water flowthrough the dam. The average cost of thefirst unit of electricity produced is very highbecause the cost of the dam is so high. Asoutput increases, the fixed costs of the damcan be spread over more units of electricity,so the average cost drops. In a market witheconomies of scale, bigger is better. Anindustry that enjoys economies of scale caneasily become a natural monopoly.

Natural MonopoliesA natural monopoly is a market that runsmost efficiently when one large firmprovides all of the output. If a second firmenters the market, competition will drivedown the market price charged tocustomers and decrease the quantity eachfirm can sell. One or both of the firms willnot be able to cover their costs and will goout of business.

Public water provides a good example ofa natural monopoly. In a competitivemarket, different water companies woulddig reservoirs and set up overlappingnetworks of pipes and pumping stations todeliver water to the same town. Companieswould use more land and water than neces-sary. Each company would have to pay forall of the unneeded pipes and would servecustomers no better than a single network.

In cases like this, the government oftensteps in to allow just one firm in eachgeographic area to provide these necessaryservices. The government action ensuresthat we don’t waste resources building addi-tional plants when only one is needed. Inreturn for monopoly status, a firm with anatural monopoly agrees to let governmentcontrol the prices it can charge and whatservices it must provide.

Technology and ChangeSometimes the development of a new tech-nology can destroy a natural monopoly. Anew innovation can cut fixed costs andmake small companies as efficient as onelarge firm.

Number of firms:One

Barriers to entry:Complete Control over prices:

Complete

Variety of goods:None

Figure 7.4 MonopolyFigure 7.4 Monopoly

In a monopoly, one company controls the market.Markets and Prices Why is public water a monopoly?



When telephone calls werecarried by thick copper wires,local telephone service wasconsidered a natural monopoly.No one wanted to build morethan one network of wires toconnect thousands of homesand businesses. In the 1980sand 1990s, consumers beganusing cellular phones, whichwere portable and could carryphone calls via radio wavesrather than through wires.Cellular technology reducedthe barriers to entry in the localtelephone market. Now that cellular phonecompanies can link to thousands or millionsof customers with a few, well-placedtowers, they don’t need to invest in anexpensive infrastructure of cables and tele-phone poles. Cellular phone companies arebecoming as efficient as traditional wire-based phone services.

Government MonopoliesIn the case of a natural monopoly, thegovernment allows the monopoly to formand then regulates it. In other cases,however, government actions themselvescan create barriers to entry in markets andthereby create monopolies. A governmentmonopoly is a monopoly created by thegovernment.

Technological MonopoliesOne way that the government can give acompany monopoly power is by issuing apatent. A patent gives a company exclusiverights to sell a new good or service for aspecific period of time. Suppose that LelandPharmaceuticals developed a new asthmamedication called BreatheDeep that helpedpeople with asthma develop stronger lungs.If Leland’s researchers could prove to thegovernment that they had inventedBreatheDeep, the Food and DrugAdministration would grant Leland apatent. This patent would give Leland theexclusive right to sell BreatheDeep fortwenty years.

Why would the government want to givea company monopoly power? Patents guar-antee that companies can profit from theirown research without competition. For thisreason, patents encourage firms to researchand develop new products that benefitsociety as a whole, even though the researchand development costs may be very high.The market power that comes with thepatent allows firms to set prices thatmaximize their opportunity to make a profit.

Franchises and LicensesA franchise is a contract issued by a localauthority that gives a single firm the right tosell its goods within an exclusive market.For example, the National Park Servicepicks a single firm to sell food and othergoods at national parks, such asYellowstone, Yosemite, and the Everglades.Your school may have contracted with onesoft-drink company to install and stockvending machines. The franchise mayinclude a condition that noother soft drinks will be soldin the building. Governments,parks, and schools use fran-chises to keep small marketsunder control.

On a larger scale, govern-ments can issue a licensegranting firms the right tooperate a business. Examplesof scarce resources that requirelicensing include radio and tele-vision broadcast frequencies

government monopolya monopoly created bythe government

patent a license thatgives the inventor of anew product theexclusive right to sell itfor a certain period oftime

franchise the right tosell a good or servicewithin an exclusivemarket

license a government-issued right to operatea business

Many villages in India and Bangladesh have never had phone service, even though most of the population lives in the countryside. Stretching a cable to every village was too expensive and inefficient, even for a natural monopoly. Using a cellular network, Grameen Telecom now plans to bring pay phones to 68,000 villages in Bangladesh and serve 100 million new customers.

FAST FACT

� A national parkcan give onecompany a franchisefor, or monopoly over,food service withinthe park.


and land. The Federal CommunicationsCommission issues licenses for individualradio and television stations. Some citiesselect a single firm to own and manage all oftheir public parking lots.

Industrial OrganizationsIn rare cases, the government allows thecompanies in an industry to restrict thenumber of firms in a market. For example,the United States government lets MajorLeague Baseball and other sports leaguesrestrict the number and location of theirteams. The government allows teamowners of the major professional sportsleagues to choose new cities for their teamsand does not charge them with violatingthe laws that prevent competitors fromworking together.

Major League Baseball has an exemptionfrom these laws, which are known asantitrust laws, because they were originallypassed to break up an illegal form of

monopoly known as a trust. Other sportsleagues do not have an official exemption,but the government treats them as it treatsbaseball. The restrictions that the leaguesimpose help keep team play orderly andstable by preventing other cities fromstarting their own major league teams andcrowding the schedule.

The problem with this type of monopolyis that team owners may charge high pricesfor tickets. In addition, if you’re a sports fanin a city without a major league team,you’re out of luck.

Output DecisionsIf you had severe asthma, which can befatal, what would BreatheDeep be worth toyou? You would probably want themedicine no matter how much it cost. SoLeland, the company that invented andpatented the drug, could charge a very highprice for its new medication. In fact, they

BaltimoreIn 1984, Baltimore lost the Colts to Indianapolis. With no help from the NFL in sight, the city lured the Browns from Cleveland via a 30-year, zero-rent lease on a new stadium. Renamed the Ravens, the team won the Super Bowl for Baltimore in 2000 by a score of 34–7.

ClevelandThe owner of the Cleveland Browns took his team to Baltimore in 1995. After Cleveland built a new stadium with help from NFL loans, the NFL approved a new team for Cleveland in 1999.

HoustonThe fourth-largest city in the U.S. lost the Oilers to Tennessee in 1996. An underdog, Houston beat out L.A. for a new team in October 1999 when it promised to build a $310 million stadium and pay the NFL a $700 million fee.

Los AngelesThe second-largest city in the U.S. lost teams to Oakland and St. Louis in 1995. The NFL's 30 team owners voted to give L.A. a new team in March 1999, but withdrew the offer when L.A. could not meet their demands for a new stadium.

Figure 7.5 Monopoly Decisions in the National Football LeagueFigure 7.5 Monopoly Decisions in the National Football League

The owners of professional football teams have a monopoly overmembership in the National Football League. Cities have to apply tothe NFL for a new team or pay top dollar for an existing team.Supply and Demand Why do team owners limit the number of teams?




could charge enough to earn well abovewhat it cost to research and manufacturethe drug. The resulting profits would givethe company a reason, or incentive, forinventing the new medication in the firstplace. But could Leland sell as muchmedication as it wanted to at whateverprice it chose?

Even a monopolist faces a limitedchoice—it can choose either output orprice, but not both. The monopolist looksat the big picture and tries to maximizeprofits. This usually means that, comparedto a perfectly competitive market for thesame good, the monopolist produces fewergoods at a higher price.

The Monopolist’s DilemmaThe law of demand states that buyers willdemand more of a good at lower prices andless at higher prices. Figure 7.6 shows apossible demand curve for BreatheDeep,with prices in dollars on the vertical axisand doses on the horizontal axis. Manypeople with life-threatening asthma will paywhatever the medicine costs. But somepeople with milder asthma will choose acheaper, weaker medicine if the price risestoo high.

Trace the demand curve from left toright. At $12 per dose, consumers mightdemand 8,000 doses of BreatheDeep each

week. But at $9 per dose, as many as11,000 doses will sell. The law of demandmeans that when the monopolist increasesthe price, it will sell less, and when itlowers the price, it will sell more. Anotherway to interpret this graph is that if amonopolist produces more, the price of thegood will fall, and if it produces less, theprice will rise.

Falling Marginal RevenueRemember from Chapter 5 that tomaximize profits, a seller should set itsmarginal revenue, or the amount it earnsfrom the last unit sold, equal to itsmarginal cost, or the extra cost fromproducing that unit. This same rule appliesto a firm with a monopoly. The key differ-ence is that in a perfectly competitivemarket, marginal revenue is always thesame as price, and each firm receives thesame price no matter how much itproduces. Neither assumption is true in amonopoly.

To understand how this happens,consider the demand schedule forBreatheDeep in Figure 7.6. WhenBreatheDeep is sold at $12 a dose,consumers buy 8,000 doses, providing$96,000 in revenue. If Leland lowers theprice to $11 a dose, 9,000 doses will bebought for a total revenue of $99,000. The

Figure 7.6 Demand Schedule for BreatheDeepFigure 7.6 Demand Schedule for BreatheDeep

Price WeeklyDemand

Change in Revenue

Total Revenue

MarginalRevenue

(per dose)

$10 10,000 $100,000 $1,000 $1

$12 8,000 $96,000 — —

$11 9,000 $99,000 $3,000 $3

11,000 $99,000 –$1,000 –$1 $9

12,000 $96,000 –$3,000 –$3 $8

12

11

10

9

8

080 9 10 11 12

Output (in thousands of doses)

Pri

ce (i

n do

llar

s)

When 8,000 doses are made, the market price is $12.

DemandAs production rises to 11,000 doses, the price falls to $9.

By increasing output, a monopolist lowers the price of the good.Above a certain level of output, revenue also begins to decrease. Markets and Prices Why does revenue fall when productionincreases from 10,000 doses to 11,000 doses?



sale of 1,000 more doses brought Leland$3,000 in new revenue.

In Chapter 5, you read that marginalrevenue in most markets is equal to price. Inthis monopoly, the marginal revenue at amarket price of $11 is roughly $3 a dose,far below the price. This is because thelower market price affects both the 1,000new doses sold and the 8,000 doses peoplebuy for $11 each instead of $12.

Now suppose that Leland lowers theprice of BreatheDeep from $11 to $10 adose. 10,000 doses will be bought, giving atotal revenue of $100,000. This time, thesale of 1,000 more doses brought only$1,000 in additional revenue. $10,000 inrevenue from 1,000 new sales barelyexceeds the $9,000 fall in revenue from the9,000 doses which are sold for $10, not$11. The market price is $10 a dose, but themarginal revenue has fallen to a mere $1 foreach dose of BreatheDeep sold.

As you’ve seen, when a firm has somecontrol over price—and can cut the price tosell more—marginal revenue is less thanprice. In contrast, in a perfectly competitivemarket, the price would not drop at all asoutput increased, so marginal revenuewould remain the same as price. The firm’stotal revenue would increase at a steadyrate with production.

The table in Figure 7.6 lists marginalrevenues for several different prices. Notethat marginal revenue actually becomes

negative when the quantity demanded isgreater than 10,000 doses a week.

Setting a PriceLeland will choose a level of output thatyields the highest profits. As you read inChapter 6, this is the point at whichmarginal revenue is equal to marginal cost.

In Figure 7.6 we have plotted the demandfor BreatheDeep at market prices of $8, $9,$10, $11, and $12 a dose. According toFigure 7.6, output at these prices will be12,000, 11,000, 10,000, 9,000, and 8,000doses, respectively. These points form themarket demand curve for BreatheDeepshown in purple.

Then, based on this data, we plottedLeland’s marginal revenue at these levels ofoutput. These points form the marginalrevenue curve shown in blue in Figure 7.7.The marginal revenue curve is at thebottom of the graph because a monopo-list’s marginal revenue is lower than themarket price.

Marginal cost equals marginal revenue atpoint a in Figure 7.7. This is the most prof-itable level of output. The monopolistproduces 9,000 units, the quantity at whichmarginal revenue and marginal cost areboth $3. According to the market demandcurve, the market price is $11 when 9,000units are sold (point b). Therefore, themonopolist will set the price of each dose at$11 or set production at 9,000 units.

Figure 7.7 also shows how price andoutput would be different if dozens of firmssold BreatheDeep and the market wereperfectly competitive. In a perfectly compet-itive market, marginal revenue is alwaysequal to market price, so the marginalrevenue curve would be the same as thepurple demand curve. Firms will set outputwhere marginal revenue is equal tomarginal cost, shown at point c. As you cansee, a perfectly competitive market forBreatheDeep would have more units soldand a lower market price than a monopoly.

ProfitsHow much profit does a monopolist earn?The cost of producing 9,000 doses is $3 per

9,000

Pri

ce

Output(in doses)

b

c

a$3

$11

Figure 7.7 Setting a Price in a MonopolyFigure 7.7 Setting a Price in a Monopoly

Marginal Cost

Market Price

Demand

MarginalRevenue

A monopolist setsoutput at a point (a)where marginalrevenue is equal tomarginal cost.Markets and PricesHow does this affectoutput and pricecompared to aperfectly competitivemarket?



dose. Each dose is sold for $11. Themonopolist will earn $8 of profit per dose.Total profit is $72,000, or $8 per dose for9,000 doses.

Price DiscriminationThe previous example assumed that themonopolist must charge the same price toall consumers. But in some cases, themonopolist may be able to divideconsumers into two or more groups andcharge a different price to each group. Thispractice is known as price discrimination.

Price discrimination is based on the ideathat each customer has his or her ownmaximum price he or she will pay for agood. If a monopolist sets the good’s priceat the highest maximum price of all thebuyers in the market, the monopolist willonly sell to the one customer willing to paythat much. If the monopolist sets a lowprice, the monopolist will gain a lot ofcustomers, but the monopolist will lose theprofits it could have made from thecustomers who bought at the low price butwere willing to pay more.

Although price discrimination is a featureof monopoly, it can be practiced by anycompany with market power. Market poweris the ability to control prices and totalmarket output. As you will read in the nextsection, many companies have some marketpower without having a true monopoly.Market power and price discrimination

may be found in any market structureexcept for perfect competition.

Targeted DiscountsIn the monopolist’s ideal world, the firmcould charge each customer the maximumthat he or she is willing to pay, and no less.However, this is impractical, so companiesdivide consumers into large groups anddesign pricing policies for each group.One common form of price discriminationidentifies some customers who are notwilling to pay the regular price and offersthose customers a discount. Price discrim-ination can also mean that a companyfinds the customers who need the good themost, and charges them more for thatgood. Here are some examples of pricediscrimination.

1. Discounted airline fares Airlines offerdiscounts to travelers who buy ticketsseveral weeks in advance or are willingto spend a Saturday night at their desti-nations. Business travelers would prefernot to stay over on a Saturday night, butthese tickets are appealing to vaca-tioners who wouldn’t otherwise pay tofly and don’t mind the restrictions.

2. Manufacturers’ rebate offers At times,manufacturers of refrigerators, cars,televisions, and other items will refund asmall part of the purchase price tobuyers who fill out a form and mail itback. People who take the time to fulfillthe rebate requirements are likely more

price discriminationdivision of customersinto groups based onhow much they will payfor a good

market power theability of a company tochange prices andoutput like a monopolist

� Pricediscrimination cantake the form ofdiscounts for seniorcitizens, children,and students.




Key Terms and Main Ideas1. What can a firm with market power do?2. Why does government usually approve of natural

monopolies?3. What are three different forms of price discrimination?4. Define the term economies of scale in your own words.

Applying Economic Concepts5. Try This Look through a recent newspaper for adver-

tisements and coupons. List five examples of pricediscrimination.

6. Decision Making Suppose that you are the mayor ofyour town, and a local butcher asks you to franchise his

shop as the only approved butcher shop in town. List areason for and a reason against granting his request.

7. Critical Thinking Do you believe that public educationis a natural monopoly? Why or why not?

price-conscious than those who don't,and may be unwilling to pay full price.

3. Senior citizen or student discountsMany senior citizens or students havelower incomes than people who work fulltime. Zoos, theaters, and restaurantsoften offer discounts to senior citizensand students because they are unlikely tobe able to pay full price for what someconsider luxuries.

4. Children fly or stay free promotionsFamilies with young children spend moreof their income on food, clothing, andschool expenses. As a result, they haveless to spend on vacations. Once again,firms would rather have their businessand earn lower profits than earn noprofits at all, so they offer discounts forfamilies with children.

Limits of Price DiscriminationFor price discrimination to work, a marketmust meet three conditions. Firms that useprice discrimination must have somemarket power, customers must be dividedinto distinct groups, and buyers must not bein a position in which they can easily resellthe good or service.

1. Some market power Price-discrimi-nating firms must have some controlover prices. For this reason, price

discrimination is rare in highly competi-tive markets.

2. Distinct customer groups The price-discriminating firm must be able todivide customers into distinct groupsbased on their sensitivity to price. Inother words, monopolists must be ableto guess the demand curves of differentgroups, one of which is more elastic, orprice-sensitive, than the others.

3. Difficult resale If one set of customerscould buy the product at the lower priceand then resell the product for a profit,the firm could not enforce its pricediscrimination. Because consumer goodslike shoes, groceries, and clothes areeasily resold, price discrimination worksbest in marketing services that areconsumed on the spot. Examples includetheme park admissions and restaurantmeals. Airlines can offer seniordiscounts because the company can askfor identification and proof of age beforeletting the customer board.

Although most forms of price discrimina-tion are perfectly legal, sometimes firms useprice discrimination to drive other firms outof business. This illegal form of the practiceis called predatory pricing, and you willread more about it in Section 4.

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Economist

Entrepreneur

Bill GaBill Gatestes (b. 1955)(b. 1955)

When Bill Gates was 12 years old, the school he attended in Seattle,Washington, bought a computer terminal that was connected to alarge computer at a local company. He immediately became hookedon computers and their potential uses. Today, as the Chief ExecutiveOfficer and Chairman of Microsoft, the world’s largest softwarecompany, Gates says his goal is “to have a computer on every deskand in every home, all running Microsoft software.”

A Young EntrepreneurWhile still a teenager, Gates and somefriends developed a computer program toanalyze and graph traffic data. In marketingthe completed system to city governments,Gates and his friends rang up $20,000 insales before customers realized they weredealing with students. The company soonfolded, but Gates never lost hisentrepreneurial spirit.

Growing a CompanyIn 1975, longtime friend Paul Allen learnedthat a company in New Mexico wasmanufacturing a kit to build a smallcomputer. Allen convinced 19-year-oldGates to leave Harvard University and forma company to produce an operating systemfor this first personal computer, or PC. Theynamed their venture Microsoft.

Five years later, Microsoft landed thecontract to develop the operating system forcomputer giant IBM’s new PCs. By 1983,40 percent of all personal computers wererunning on Microsoft’s operating system.

In the late 1980s, Gates launchedWindows, a new, PC-compatible operatingsystem that used graphics and a mouse toperform computer functions. Microsoft’smarket share for operating systems jumped

to 70 percent. Windows also allowed Gatesto capture the market for software such asword processing programs, becausecompetitors’ products still depended onMicrosoft’s old, less user-friendly operatingsystem. Those competitors began tocomplain that Microsoft had a monopoly.

Defending MicrosoftIn 1997, the U.S. government claimed thatby linking Microsoft’s Internet browser toits operating system, Microsoft was unfairlyusing Windows’ huge market share againstrival browser companies. Gates angrilydenied the charge. “Any operating systemwithout a browser is going to be . . . out ofbusiness,” he said. “Shall we improve ourproduct or go out of business?”

Some former associates have anotherview. “He doesn’t look for win-winsituations with others,” one says, “but forways to make others lose. Success is definedas flattening the competition.” Gates rejectssuch assessments. However, even today,surrounded by the success that being theworld’s richest person represents, hemaintains his competitive edge. Havingsettled Microsoft’s dispute with the federalgovernment, Gates must focus on thechanging technological environment ahead.

1. Source Reading Identify andexplain the steps by which Microsoftused its operating systems to gainwhat critics called a monopoly of theentire computer software industry.

2. Critical Thinking Gates claimsthat his competitive practices improvethe industry. His critics claim that theydamage it. With which side do youagree, and why?

3. Decision Making How importantdo you think competitiveness is inbuilding a successful company? Why?

CHECK FOR UNDERSTANDING

ECONOMIC

165

ECON_05_se_PR_CH07 6/20/05 8:52 AM Page 165

SSo far, you have studied the two extremesof the range of market structures:

perfect competition and monopoly. Veryfew markets fall into either of these cate-gories. Instead, most fall into two addi-tional categories that economists callmonopolistic competition and oligopoly.

Monopolistic CompetitionIn monopolistic competition, many companiescompete in an open market to sell productsthat are similar but not identical. Each firmholds a monopoly over its own particularproduct. You can think of monopolisticcompetition as a modified version of perfect

competition with minor differences inproducts.

The differences between perfect competi-tion and monopolistic competition arisebecause monopolistically competitive firmssell goods that are similar enough to besubstituted for one another but are notidentical. Monopolistic competition doesnot involve identical commodities. Anexample of a monopolistically competitivemarket is the market for jeans. All jeans canbe described as denim pants, but in theshops, buyers can choose from a variety ofcolors, brand names, styles, and sizes.

Unlike perfect competition, monopolisticcompetition is a fact of everyday life. You

monopolisticcompetition a marketstructure in whichmany companies sellproducts that aresimilar but not identical

Monopolistic Competitionand Oligopoly

PreviewSection FocusMonopolistic competition is similar toperfect competition, except thatcompanies sell slightly differentgoods. Oligopoly, which is closer tomonopoly, describes a market withonly a few large producers.

ObjectivesAfter studying this section you will be able to:1. Describe characteristics and give

examples of monopolistic competition.2. Explain how firms compete without

lowering prices.3. Understand how firms in a monopolistically

competitive market set output.4. Describe characteristics and give

examples of oligopoly.

Key Termsmonopolistic

competitiondifferentiationnonprice competitionoligopolyprice warcollusionprice fixingcartel

� The market fordenim jeans ismonopolisticallycompetitive becausejeans can vary by size, color, style, anddesigner.

166


and your friends probably buy frommonopolistically competitive firms severaltimes a week. Common examples includebagel shops, ice cream stands, gas stations,and retail stores.

Four Conditions ofMonopolistic CompetitionMonopolistic competition develops fromfour conditions. As you read about thetypes of markets that favor monopolisticcompetition, note how similar they are tothe rules that define perfect competition.

1. Many firms As a rule, monopolisticallycompetitive markets are not marked byeconomies of scale or high start-up costs.Because firms can start selling goods andearning money after a small initial invest-ment, new firms spring up quickly to jointhe market.

2. Few artificial barriers to entry Firms ina monopolistically competitive marketdo not face the high barriers to entrydiscussed in Section 1. Patents do notprotect anyone from competition, eitherbecause they have expired or becauseeach firm sells a product that is distinctenough to fall outside the zone of patentprotection. Just like a perfectly competi-tive market, a monopolistically competi-tive market includes so many competingfirms that producers cannot worktogether to keep out new competitors.

3. Slight control over price Firms in amonopolistically competitive marketstructure have some freedom to raise orlower their prices because each firm’sgoods are a little different from everyoneelse’s, and some people are willing to paymore for the difference. However, unlikea monopoly, a monopolistically competi-tive firm has only limited control overprice. This is because consumers willsubstitute a rival’s product if the pricerises too high. For example, manycustomers will choose a can of brand-name cola over a generic cola even if itcosts a quarter more per can. If the

brand-name cola cost $5 more per can,however, most people would buy thecheaper cola or drink something else.

4. Differentiated products Firms have somecontrol over their selling price becausethey can differentiate, or distinguish,their goods from the other products inthe market. The main difference betweenperfect competition and monopolisticcompetition is that differentiation enablesa monopolistically competitive seller toprofit from the differences between his orher products and competitors’ products.

Nonprice CompetitionFirms try not to compete on price alone.The alternative is nonprice competition, orcompetition through ways other than lowerprices. Nonprice competition takes severaldifferent forms.

1. Physical characteristics The simplestway for a firm to distinguish its productsis to offer a new size, color, shape,

differentiation makinga product different fromother similar products

nonprice competitiona way to attractcustomers throughstyle, service, orlocation, but not alower price

Number of firms: Many

Barriers to entry:Low

Control over prices:Little

Variety of goods: Some

Figure 7.8 Monopolistic CompetitionFigure 7.8 Monopolistic Competition

Many firms provide a variety of goods in a monopolistically competitive market. Competition Why do firms in monopolistic competition have some control over prices?



texture, or taste. Running shoes, pens,cars, and toothpaste are good examplesof products that can be easily differenti-ated by their physical characteristics. Apen is always a writing tool that uses ink,but many people will pay extra for a penthat looks or writes differently. Similarly,you can probably describe a “car” inonly a few words, but factories aroundthe world manufacture thousands of carmodels to fit a range of personalities,jobs, families, and incomes.

2. Location Real estate agents say that thethree most important factors whenbuying property are “location, location,location.” Some goods can be differenti-ated by where they are sold. Gas stations,movie theaters, and grocery storessucceed or fail based on their locations.A convenience store in the middle of adesert differentiates its product simply byselling it hundreds of miles away fromthe nearest competitor. Such a locationallows the seller to charge a lot more fora quart of water.

3. Service level Some sellers can chargehigher prices because they offer theircustomers a high level of service.Conventional restaurants and fast-foodrestaurants both offer meals tocustomers. However, conventionalrestaurants provide servers who bring thefood to your table, whereas fast-foodrestaurants offer a more barebones, do-it-yourself atmosphere. Conventional

restaurants and fast-food chains sellmany of the same food items, but fast-food chains sell their meals for less.Customers at conventional restaurantspay more for the service and the relaxingatmosphere.

4. Advertising, image, or status Somefirms use advertising to create apparentdifferences between their own offeringsand other products in the marketplace.These product differences are often morea matter of perception than reality. Forexample, a designer can apply his or hername to a plain white T-shirt and chargea higher price, even if the quality of fabricand stitching is no different than whatgeneric T-shirts offer. Customers who payextra for a designer T-shirt do so becausethe image and status that go with thedesigner’s name are worth the extramoney to them.

Price, Output, and Profits When economists look at price, output, andprofits under monopolistic competition,they find the market looks very much as itwould under perfect competition.

PricesPrices under monopolistic competition willbe higher than they would be in perfectcompetition, because firms have somepower to raise prices. However, the numberof firms and ease of entry prevent companies

� A gas station builtin the right locationcan charge more forgasoline.




from raising prices as high as they wouldif they were a true monopoly. As you haveread, if a monopolistically competitivefirm raised prices too high, most customerswould ignore any differences and buy thecheaper product. Because customers canchoose among many substitute products,monopolistically competitive firms facemore elastic demand curves than truemonopolists do.

OutputThe law of demand says that output andprice are negatively related. As one rises, theother falls. Because monopolisticallycompetitive firms sell their products athigher prices than do perfectly competitivefirms, but at lower prices than a monopoly,total output under monopolistic competi-tion falls somewhere between that ofmonopoly and that of perfect competition.

ProfitLike perfectly competitive firms, monopo-listically competitive firms earn just enoughto cover all of their costs, including salariesfor the workers. If a monopolisticallycompetitive firm started to earn profits wellabove its costs, two market trends wouldwork to take those profits away.

First, fierce competition would encouragerivals to think of new ways to differentiatetheir products and lure customers back. Ifone company hires a basketball star topromote its soft drink, a rival might hire apopular singer, while another rival couldinvest in an advertising blitz on television.The rivalries among firms prevent any onefirm from earning excessive profits for long.

Secondly, new firms will enter the marketwith slightly different products that cost alot less than the market leaders. If theoriginal good costs too much, consumerswill switch to these substitutes. You’ve seenthis happen when a brand-name line ofclothing, video games, or stuffed animalsbecomes popular. Competitors quicklyflood the market with cheap imitations forpeople who can’t afford the original ordon’t know or care about the difference.

While monopolistically competitive firmscan earn profits in the short run, they haveto work hard to keep their product distinctto stay ahead of their rivals. Often, theydon’t succeed.

Production Costs and VarietySome economists note that firms in monop-olistic competition may not be able toproduce their goods at the lowest possibleaverage cost. Monopolistically competitivemarkets have many firms, each producingtoo little output to minimize costs and useresources efficiently. On the other hand,consumers in these markets enjoy a widevariety of goods to choose from.

OligopolyOligopoly describes a market dominated by afew large, profitable firms. Oligopoly lookslike an imperfect form of monopoly.Economists usually call an industry anoligopoly if the four largest firms produce atleast 70 to 80 percent of the output.

oligopoly a marketstructure in which afew large firmsdominate a market

Number of firms:A few

Barriers to entry:High

Control over prices:Some

Variety of goods:Some

Figure 7.9 OligopolyFigure 7.9 Oligopoly

In an oligopoly, a few large firms dominate a market. Competition Why are high barriers to entry an important part of oligopoly?


Acting on their own or as a team, thebiggest firms in an oligopoly may well setprices higher and output lower than in aperfectly competitive market. Examples ofoligopolies in the United States include themarkets for air travel, breakfast cereals, andhousehold appliances.

Barriers to EntryAn oligopoly can form when significantbarriers to entry keep new companies fromentering the market to compete withexisting firms. Sometimes these barriers arecreated by a system of government licensesor patents.

In other cases, the economic realities ofthe market lead to an oligopoly. High start-up costs, such as expensive machinery or alarge advertising campaign, can scare firms

away from the market. Manysmall airlines have hadtrouble competing with larger,better-financed rivals becauseairplanes are very expensiveto buy and maintain. Thebiggest airlines compound theproblem because they oftenown the most desirable gatesat the airport, and alreadyenjoy name recognition andthe trust of the consumer. Asanother example, the two bigcola manufacturers haveinvested so much money intheir brand names and sales

networks over the last century that fewcompanies think they can successfully chal-lenge their grip on the market.

Some oligopolies occur because ofeconomies of scale. As you have read, whena firm experiences economies of scale, theaverage cost of production decreases asoutput increases. In a monopoly market,only one company can produce enoughgoods to earn a profit. In an oligopoly,perhaps three or four companies can reacha profitable level of output before themarket becomes too crowded and revenuefalls below costs.

Cooperation and CollusionOligopoly presents a big challenge togovernment, because oligopolistic firmsoften seem to work together to form amonopoly, even when they are notactually doing so. Many government regu-lations try to make oligopolistic firms actmore like competitive firms. When deter-mined oligopolists work together illegallyto set prices and bar competing firms fromthe market, they can become as damagingto the consumer as a monopoly.

The three practices that concern govern-ment the most are price leadership, collusion, and cartels. While these threepractices represent ways that firms in an oligopoly can try to control a market,they don’t always work. Each tacticincludes an incentive for firms to cheatand undo any benefits.

Perfect Competition

Oligopoly MonopolyMonopolisticCompetition

Figure 7.10 Comparison of Market StructuresFigure 7.10 Comparison of Market Structures

Number of firms Many Many A few dominate One

Variety of goods None Some Some None

Control over prices None Little Some Complete

Barriers to entry None Low High Complete

Examples Wheat,shares of stock

Jeans,books

Cars,movie studios

Public water

Markets can begrouped into fourbasic structures:perfect competition,monopolistic competi-tion, oligopoly, andmonopoly.CompetitionHow does a monopo-listic competitiondiffer from monopoly?


In the News Read more about oligopolyin “Bottom of the Food Chain,” an article in The Wall Street Journal Classroom Edition.

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Sometimes the market leader in anoligopoly can start a round of priceincreases and cuts by making itsplans clear to other firms. Priceleaders can set prices and output forentire industries as long as othermember firms go along with theleader’s policy. But disagreementsamong member firms can spark aprice war, when competitors cut theirprices very low to win business. Aprice war is harmful to producers butgood for consumers.

Collusion refers to an agreement amongmembers of an oligopoly to set prices andproduction levels. One outcome of collu-sion is called price fixing, an agreementamong firms to sell at the same or verysimilar prices. Collusive agreements setprices and output at the levels that wouldbe chosen by a monopolist. Collusion isillegal in the United States, but the lure ofmonopolistic profits can tempt businessesto make such agreements despite the ille-gality and risks.

Collusion is not, however, the onlyreason for identical pricing in oligopolisticindustries. Such pricing may actually resultfrom intense competition, especially ifadvertising is vigorous and new lines ofproducts are being introduced.

CartelsStronger than a collusive agreement, a cartelis an agreement by a formal organization ofproducers to coordinate prices and produc-tion. Although other countries and interna-tional organizations permit them, cartels areillegal in the United States. Cartels can onlysurvive if every member keeps to its agreedoutput levels and no more. Otherwise, priceswill fall, and firms will lose profits. However,each member has a strong incentive to cheatand produce more than its quota. If everycartel member cheats, too much productreaches the market, and prices fall. Cartelscan also collapse if some producers are leftout of the group and decide to lower theirprices below the cartel’s levels. Therefore,cartels usually do not last very long.


price war a series ofcompetitive price cutsthat lowers the marketprice below the cost ofproduction

collusion anagreement among firmsto divide the market, setprices, or limitproduction

price fixing anagreement among firmsto charge one price forthe same good

cartel a formalorganization ofproducers that agree tocoordinate prices andproduction


Key Terms and Main Ideas1. What are the four conditions of monopolistic

competition?2. How do economists determine whether a market is an

oligopoly?3. Give three examples of nonprice competition.4. How would price fixing and collusion help producers?

Applying Economic Concepts5. Using the Databank The map on page 545 indicates

which countries are members of OPEC, a cartel made upof oil-exporting countries. In the 1970s, OPEC successfullyraised oil prices by cutting production. Based on whatyou have read in this section, explain how this situationillustrates (a) how cartels operate (b) why cartels canbe dangerous.

6. Decision Making Would you describe the followingmarkets as monopolistic competition or oligopoly? (a) refrigerators (b) video game systems (c) gourmet icecream (d) sunscreen (e) cable sports channels

7. Critical Thinking Which of the four forms of nonpricecompetition described on pp. 167–168 would you empha-size for the following products? Explain your reasoning.(a) a new brand of bottled water (b) in-home computerrepair (c) protein bars

� A computermanufacturer candistinguish itscomputers withbright colors or asleek design.

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II t’s 1946. The soldiers have come homefrom World War II, the cities are

booming, and you’re a city planner whoneeds to get people to work each morning.You can build wide roads and parking lotsand encourage people to buy cars, you caninvest in a fleet of buses, or you can expandthe streetcar lines and train tracks thatalready criss-cross the town center. Ideally,you will choose the most efficient system.

However, you never get to decide. Acompany called National City Lines (NCL)buys your city’s streetcar network anddecides to raise fares and shut down severallines. Service gets so bad that commutersstay away, and NCL soon shuts down thesystem. It’s now 1966, and your streetcarsare gone. Since the roads are too crowdedfor more cars, you must buy buses.

In the newspaper, you read that NationalCity Lines was secretly funded by compa-nies that make tires, automobiles, andgasoline—the same companies that nowoffer to sell you 200 new buses.

This really happened in cities like LosAngeles and Baltimore, where NationalCity Lines turned a mass transit oligopolyinto a monopoly by buying up its rivals.National City Lines then used its monopolyto close down the streetcar lines. Althoughsome experts argue that the streetcarsmight have died out anyway, many criticsblame National City Lines for the endresult. No one can know what might havehappened in a competitive market.

If you think what National City Linesdid was unfair, the federal governmentagrees. In this section, you will read aboutanticompetitive practices and the tools thegovernment uses to stop them.

Market PowerAs you have read, monopoly andoligopoly can sometimes be bad for theconsumer and the economy as a whole.Markets dominated by a few large firmstend to have higher prices and loweroutput than markets with many sellers.Before we look at antitrust policies, let’sthink about how a firm might try toincrease its market power.

Regulation and DeregulationPreview


Section FocusThe federal government sometimessteps into markets to promotecompetition and the lower prices itbrings. In recent years, thegovernment has also deregulatedseveral markets to promotecompetition.

ObjectivesAfter studying this section you will be able to:1. Understand how firms use market power. 2. List three market practices that the

government regulates or bans to protectcompetition.

3. Define deregulation, and list its effects onseveral industries.

Key Termspredatory pricingantitrust lawstrustmergerderegulation

� After World War II,National City Linesused its mass transitmonopoly to shutdown streetcar lines.



To control prices and output like amonopoly, the leading firms in the marketcan form a cartel, merge with one another,or set the market price below their costs forthe short term to drive competitors out ofbusiness. The last practice is known aspredatory pricing. Economists are skepticalabout most claims of predatory pricingbecause the predator loses money each timeit drives an endless series of rivals out ofbusiness.

Government and CompetitionThe federal government has a number ofpolicies that keep firms from controllingthe price and supply of important goods. Ifa firm controls a large share of a market,the Federal Trade Commission and theDepartment of Justice’s Antitrust Divisionwill watch that firm closely to ensure that itdoes not unfairly force out its competitors.These government policies are known asantitrust laws because a trust is a businesscombination similar to a cartel.

In 1890, Congress passed the ShermanAntitrust Act, which outlawed mergers andmonopolies that limit trade between states.This and other laws gave the governmentthe power to regulate industry, to stopfirms from forming cartels or monopolies,and to break up existing monopolies. Overthe years, Congress passed new laws tooutlaw other anticompetitive practices.

Despite the antitrust laws, companieshave used many strategies to gain controlover their markets. Some firms require acustomer who buys one product to buyother products from the same company,whether or not the customer wants them.For example, a tennis shoe manufacturercan demand that a chain buy and resell itsbrand-name shirts, windbreakers, andwatches if it wants to sell its shoes. Anothertactic, the one employed by National CityLines, is to buy out competitors.

Regulating Business Practices The government has the power to regulateall of these practices if they give too muchpower to a company that already has few

competitors. Microsoft sells operatingsystems, software that tells a computer howto run. In 1997, the Department of Justiceaccused Microsoft of using a monopoly inoperating systems to control the market fora program known as a browser. A browserallows people to access Web sites.

Microsoft insisted that computer manu-facturers that sold its operating system alsoinclude its browser. The governmentaccused Microsoft of predatory pricingbecause the company gave away itsbrowser for free, which would ruin theother browser company, Netscape.Microsoft’s power in one market gave it abig—and possibly unfair—advantage inrelated markets.

Microsoft argued that the browser waspart of its operating system and could not besold separately. Microsoft’s defenders saidthat companies do compete with Microsoft,and people buy Microsoft software becausethey like it. In November 1999, a federaljudge ruled against Microsoft. Microsoftappealed, and in 2001, President Bushsettled the case. According to the settle-ment, Microsoft could link its browser toits operating system but could not forcecomputer manufacturers to provide onlyMicrosoft software on new computers.

predatory pricingselling a product belowcost to drive competitorsout of the market

antitrust laws laws thatencourage competitionin the marketplace

trust like a cartel, anillegal grouping ofcompanies thatdiscouragescompetition

� Public outragewith powerful trustsin the late 1800s ledCongress to passantitrust legislation.



Breaking Up MonopoliesThe government used antitrust legislationto break up existing monopolies such as theAmerican Tobacco Company and John D.Rockefeller’s Standard Oil Trust in 1911.In 1982, the government broke AmericanTelephone and Telegraph (AT&T) intoseven regional phone companies, includingBellSouth, USWest, and PacificBell. Becausethe government treated local telephoneservice as a natural monopoly, AT&Tlegally controlled all the cables andnetworks that linked telephones in homesand businesses. The government stepped inonly when AT&T used its legal monopolyin local phone service to take control ofother markets for long-distance phone callsand communications equipment. Today,there are many firms in the market forlong-distance service and the market ismore competitive. Although thousands ofworkers lost their jobs, consumers benefitfrom lower prices and better technology.

Blocking Mergers In addition to breaking up monopolisticcompanies, the government has the powerto prevent the rise of monopolies. Thegovernment does this by blocking companymergers that might reduce competition

and lead to higher prices. A merger occurswhen a company joins with anothercompany or companies to form a singlefirm. Government regulators also followthe effects of past mergers to check thatthey did not lead to unfair market control.You read in Section 1 that prices often fallwhen the number of firms in a marketincreases. The reverse is also true. Pricesoften rise when the number of firms in anindustry falls.

The government tries to predict theeffects of a merger on prices and servicewhen it decides whether or not to approvea merger. Recently, the Department ofJustice has looked at data collected byscanners at supermarket check-out lines tosee how prices vary when two competitorsjoin forces. In 1997, the JusticeDepartment examined the proposedmerger of two companies that sell officesupplies. Their studies showed that onecompany charged less in cities where theother company also had stores. Using thisdata, the Federal Trade Commission (FTC)convinced the courts that the merger wouldhurt competition and force customers topay higher prices. In the end, theDepartment of Justice did not allow thetwo companies to merge.

merger combination oftwo or more companiesinto a single firm

1914Clayton Antitrust Actoutlaws practices thatlimit competition orlead to monopoly

1936Robinson-Patman Act

defines and outlawsseveral forms of price

discrimination

1911Supreme Court breaks up John D. Rockefeller’sStandard Oil Trust

1901 Theodore Rooseveltbecomes President and begins enforcing the 1890Sherman Antitrust Act,which outlaws mergers andmonopolies that restraintrade between states

Figure 7.11 Key Events in Federal Antitrust PolicyFigure 7.11 Key Events in Federal Antitrust Policy

1900 1915 1925 1940

� Over the pastcentury, the federalgovernment has acted often topromote competitionin American industry.


Preserving IncentivesWhile some mergers hurt the consumer byreducing competition, others can actuallyleave the consumer better off. In thesecases, corporate mergers will lower overallaverage costs and lead to lower prices,more reliable products or service, and amore efficient industry. The governmentmust act carefully to make the rightdecision. In 1997, the Justice Departmentand the FTC released new guidelines forproposed mergers. Now, companies thatwant to merge have the chance to provethat the merger would lower costs andconsumer prices or lead to a better product.

DeregulationIn the late 1970s and 1980s, Congresspassed laws to deregulate several industries.Deregulation means that the government nolonger decides what role each company canplay in a market and how much it cancharge its customers. Over several years,the government deregulated the airline,trucking, banking, railroad, natural gas,and television broadcasting industries.Depending on the degree of deregulation,the government’s action allowed—orforced—firms in these industries to

compete more in markets by eliminatingmany entry barriers and price controls.

While deregulation weakens governmentcontrol, antitrust laws strengthen it. Yet thegovernment uses both of these tools, dereg-ulation and antitrust laws, for the samepurpose: to promote competition.

Many critics say that government effortsto regulate industries have created ineffi-ciencies. In some cases, the economic factsthat created the need for regulation in thefirst place have changed. For example, inSection 1 you read how the invention ofcellular phones challenged the naturalmonopoly of local phoneservice and opened themarket to new companies.The trucking industry wasalso regulated as a naturalmonopoly from the early1900s until 1978. By then,many had decided that thegovernment was regulatingindustries that were notnatural monopolies at all.

Judging DeregulationDeregulation has met withmixed success. In most cases,many new firms entered the

deregulation theremoval of somegovernment controlsover a market


1982AT&T agrees to break upits local phone serviceinto several companies

1974 Department ofJustice sues to endAT&T’s monopoly overlocal phone service

2001Department of

Justice settles itslawsuit with

Microsoft

1950 Celler-Kefauver Actallows government to stopmergers that could hurtcompetition

1955 1970 1985 2000

In the News Read more about deregulation in “Wal-Mart Pays at thePump,”an article in The Wall Street Journal Classroom Edition.

The Wall Street JournalClassroom Edition

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deregulated industries right away.Competition certainly increased in theairline, trucking, and banking industries.Typically, years of wild growth werefollowed by the disappearance of somefirms. This weeding out of weaker playersis considered healthy for the economy, butit can be hard on workers in the short term.

In the 1990s, several states deregulatedtheir electricity markets to allow private,competing companies to produce and sell

energy to homeowners. In some markets,energy prices fell, but elsewhere, customerspaid more. California experienced amassive energy crisis in 2000 that forcedthe state government to pay extraordinarilyhigh rates for electricity. Many attributedthis crisis to companies like Enron that mayhave used the state deregulation rules tocreate an electricity shortage.

Airlines: A Complicated DeregulationMany new airlines started operating afterPresident Carter deregulated the industryin 1978, but some eventually failed or wereacquired. Freed from regulatory restriction,many of the large airlines competed aggres-sively for the busiest routes. For most trav-elers, the increased competition createdlower prices. Another result is that manybusy airports now have one dominantairline, and in some cases fares are actuallyhigher than before deregulation.

In the early 2000s, changing conditionstransformed the airlines. Over-expansionand sharply rising labor costs squeezedprofits. The terrorist hijackings onSeptember 11, 2001, followed by aneconomic downturn, caused many peopleto stop flying. Revenues plunged whilecosts of security and insurance rose.Although the federal government providedsome aid, the future of the airline industryis uncertain as several major carriersstruggle against bankruptcy.


Key Terms and Main Ideas1. What is the purpose of antitrust laws?2. Under what conditions will the government approve a

merger?3. How does predatory pricing hurt competition?4. How did deregulation change the banking and air travel

industries?

Applying Economic Concepts5. Decision Making Why did government once regulate

the banking, trucking, and airline industries? 6. Try This Use the library to find an editorial from 1911 in

support of the breakup of Standard Oil, and compare it

to a recent editorial that criticizes Microsoft. Whicharguments are the same? Which are different?

7. Critical Thinking Why does the government believe ithas the right to intervene in markets to promote competi-tion? Is this consistent with the idea of laissez faire andfree markets?

� Many people blamed companies such as Enron for anelectricity shortage that affected California in 2000 afterderegulation. Other states have deregulated their electricitymarkets with no difficulties.

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Regulating Cable TelevisionCable television systems offer more than 100 channels featuring continuous

news, sports, weather, business reports, and coverage of local activities.This growth in popularity, however, has led to aneed for regulation.

The FCC The Federal CommunicationCommission (FCC) oversees the cable industry.During the 1950s, the FCC maintained a “hands-off” policy. In the 1960s, however, the FCCbegan to impose regulations. Responding to com-plaints from over-the-air broadcasters that cablestations were refusing to carry local stations, theFCC ruled that every cable system had to carrythe programs of all local stations as well as thoseof their own.

By the 1970s, the FCC began to impose moreregulations. The agency mandated that cable sys-tems provide at least 20 channels in major mar-kets, provide public access channels, and obtainpublic approval of changes in their rates.

Deregulation In the 1980s, the FCC ruled thatrates for cable services would be deregulated. This led to skyrocketing cablerates and poor service in certain parts of the country. This resulted in a movein the 1990s to regulate the industry once more.

The Cable Television Consumer Protection Act of 1992 allowed competi-tion in the cable industry for the first time. It was hoped that competitionwould cause cable rates to stabilize or even decrease, while service wouldimprove.

Today, cable television has grown so popularthat cable networks now challenge and often sur-pass the popularity of the original broadcastgiants ABC, CBS, and NBC. How much furtherwill cable television grow? No one is sure. Whatseems certain, however, is that with growth willcome further regulation.

Applying Economic Ideas1. Should government regulate the cable television

industry? Why or why not?

2. The table at the right shows the number ofcable subscribers from 1970 to 2000. What doyou think accounts for the increase in sub-scribers in the 1980s and 1990s?

� Many cable channels run specialized pro-gramming, such as all home improvementshows or all sports.

Cable TV Subscribers, 1970–2000

Year Number of Subscribers

1970 4,500,000

1975 9,800,000

1980 16,000,000

1985 32,000,000

1990 50,000,000

1995 58,000,000

2000 70,000,000 (est.)

Source: Statistical Abstract of the United States

177

Government

ECON_07NA_se_CH07_CS 6/20/05 9:22 AM Page 177

178

Chapter SummaryChapter Summary

AA summary of major ideas in Chapter 7 appearsbelow. See also the Guide to the Essentials of

Economics, which provides additional review and testpractice of key concepts in Chapter 7.

Section 1 Perfect Competition (pp. 151–154)Perfect competition describes a market with manywell-informed buyers and sellers, identical goods,and no barriers to entry to stop companies from join-ing the market. Perfect competition is only found inmarkets that deal in commodities, or goods that areidentical no matter who produces or sells them.These markets are efficient at setting output andprices at a level that is beneficial to all.

Section 2 Monopoly (pp. 156–164) A firm is a monopolist when it is the only seller in amarket. A natural monopoly is an industry that worksbest when only one firm serves the entire market.Government can create a monopoly by issuing apatent, franchise, or a license. A monopolist can setprices or output. Firms use price discrimination todivide consumers into groups based on their abilityto pay, and then offer a different price to each group.

Section 3 Monopolistic Competition and Oligopoly (pp. 166–171)

Most markets fall somewhere between perfect com-petition and monopoly. Monopolistic competition issimilar to perfect competition, except that compa-nies sell slightly different goods and have a littlepower to set prices. Closer to monopoly, oligopolydescribes a market dominated by a few large pro-ducers. Firms in an oligopoly can practice collusionor form a cartel to set prices like a monopoly.

Section 4 Regulation and Deregulation (pp. 172–176)Firms in an oligopoly can merge to try to gainmonopoly power. Because monopoly power can leadto inefficient markets, the federal government haspassed laws to promote competition and break upmonopolies. In the late 1970s and 1980s, govern-ment gave up power to regulate several markets.Deregulation has led to lower prices in most deregu-lated markets.

Key TKey TermsermsComplete each sentence by choosing the cor-rect answer from the list of terms below. Youwill not use all of the terms.

1. is when a monopolist divides con-sumers into groups and charges differentprices for the same good.

2. A market with many firms producing thesame good is in .

3. Economists define as a market struc-ture with a few large firms, each of whichhas some market power.

4. are products that are identical nomatter who produces them.

5. A(n) grants the right to sell an inven-tion without competition.

6. A(n) may exist in markets where it ismost efficient for only one large firm toprovide a product.

7. Economists use the term to describeagreements among firms to set prices andproduction levels.

8. Using Graphic OrganizersUsing Graphic OrganizersOn a separate sheet of paper, copy the multi-flow map below. Organize information ongovernment deregulation by completing themap with causes for deregulation on the leftand possible effects on the right. You mayadd more causes or effects.

perfect competitionoligopolypatentcommoditiesprice discrimination

natural monopolyeconomies of scaleprice fixingderegulationcollusion

Government

Deregulation

Prices becomelower for

consumers

Prices lowerwithout

regulation

ECON_07NA_se_CH07_CA 8/3/05 11:39 AM Page 178

179

Reviewing Main IdeasReviewing Main Ideas9. How does the buying and selling of stock fit the

model for perfect competition? 10. Compare and contrast the characteristics of nat-

ural monopolies and monopolies created by gov-ernment.

11. What four conditions are necessary for a marketto be considered monopolistically competitive?

12. How does the United States government inter-vene in the economy in regard to monopolies andcompetition?

Critical ThinkingCritical Thinking13. Making Comparisons How do prices, output, and

profits differ between monopolies and monopo-listically competitive firms? Are there similari-ties?

14. Synthesizing Information What are the trade-offsbetween free enterprise and government inter-vention associated with the United States’antitrust policies?

15. Analyzing Information Using the reference to thehydroelectric plant found in Section 2 as anexample of economies of scale, think of threeexamples of industries that benefit fromeconomies of scale.

Problem-Solving ActivityProblem-Solving Activity16. Assume that you are the owner of the only music

store in town because your town limits the num-ber of shops. The town now wants to repeal thatlaw and allow more music stores to open.Describe what actions you could take as a busi-ness owner once the law is repealed.

Skills for LifeSkills for LifeAnalyzing Political Cartoons Review the stepsshown on page 155; then answer the following ques-tions using the cartoon below.17. Identify the symbols in the cartoon. (a) What is

symbolized by the oil pump? (b) What is symbol-ized by the man’s living room?

18. Analyze the intent of the cartoon. (a) Describe theproposed solution to the energy crisis as illustrat-ed in the cartoon. (b) Describe this solution as itmight be applied to the entire state of California.

19. Draw conclusions about the cartoonist’s intent.(a) Does the artist believe his solution is a goodsolution? (b) Were you swayed or convinced ofthe cartoonist’s opinion in this case?

Brainstorming Reread your Economics Journalentry for Chapter 7. Write a paragraph for each ofthe three companies you listed, explaining whatmarket structure each company competes in andhow you came to this decision.

Economics JournalProgress Monitoring Online

As a final review, take the Economics Chapter 7 Self-Testand receive immediate feedback on your answers. Thetest consists of 20 multiple-choice questions designed totest your understanding of the chapter content.

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Should oil prices beraised to promote energyindependence?

BY ERICH PICA

The price of oil should be increased as part of a priceincrease on all fossil fuels. Our nation has a prob-lem, and it is not simply a dependence on foreign

oil. It is our dependence on oil. The U.S. consumes 25%of the world’s oil supply, and has only 3% of its resources.Unless we fundamentally shift our oil consumption pat-terns, we will remain dependent on foreign oil.

Friends of the Earth, a nonprofit environmentalorganization, believes that the best way to help solve ourdependency problems is with a carbon tax, or a fee on allfossil fuels, including oil. Such a tax would be an effi-cient way to encourage businesses and individuals toconserve fuel and develop nonfossil-fuel energy sources.And a carbon tax would also fix many of the economicdistortions currently not factored into the price of oil.

For example, current oil prices do not reflect theimpact of air pollution from our passenger vehicles,which contributes to unhealthy levels of smog that harmhuman health. And they don’t reflect the environmen-tal impact of oil drilling, which damages public landsand coastal areas. Nor do they reflect the growing mili-tary and foreign-policy costs of defending oil interestsin the Middle East and other turbulent regions.

Using the true cost of oil would raise prices, but itwould provide the incentive for consumers to reduce

consumption and turn to innovative, clean sources ofenergy. Ultimately, using less oil is the only way toreduce our dependence on foreign supplies.

A carbon tax is a potential silver bullet that couldsolve our dependence on oil. Yet, unfortunately, itremains a taboo topic for political leaders. Elected offi-cials and their allies in the oil industry are creatingfalse choices between dependence on foreign oil andreducing the cost of domestic production, knowingthat as long as we consume at current rates, ourdependency will remain.

DEBATING CURRENT ISSUES: Oil and Energy Dependence

180

The U.S. relies on some of the world’s most volatile countries to supply a raw materialthat is critical to its economy and lifestyle. Despite an increasingly energy-efficient econ-omy, the U.S. remains hooked on imported oil.

In this debate from The Wall Street Journal Classroom Edition, Erich Pica, a senior poli-cy analyst with the environmental group Friends of the Earth, and John Felmy andEdward Porter of the American Petroleum Institute present two approaches to reducing oilimports and promoting energy independence in the U.S.◆◆◆

Massive oil rigs extract petroleum from beneath

the ocean floor. Does the market price of gasoline

reflect all the costs of its use?

ECON_05_se_U2_DEB 6/20/05 4:41 PM Page 180

Should oil prices beraised to promote energyindependence?

BY JOHN FELMY AND EDWARD PORTER

The notion that we should raise the price of oil isan old idea that resurfaces frequently, especiallyas the level of U.S. imports increases. But it is an

idea based on incorrect assumptions that oil consump-tion is inherently harmful, its use can be reduced dra-matically without cost to the economy, and that byboosting prices we might enjoy a net gain to the envi-ronment and reduce dependence on foreign supplies.

These notions are simply implausible. Energy is aproductive input into economic activity, and oil is thepre-eminent form used in transportation. If we raiseits price, we reduce its use and lose the added value ofall economic activity associated with that use.Throughout the last century, there are no examples ofsustained growth occurring without increasing energy,and no examples of economic development withoutincreased transportation. Energy, and in particular oil,are essential to sustained economic growth world-wide. And, because of spectacular advances in technol-ogy in the production and use of oil, old trade-offsbetween energy use and the environment often havebeen reduced or eliminated.

The real problem is not the price of oil or the levelof U.S. imports, but the secure supply of energy to agrowing world economy in a manner consistent withthe highest environmental standards. Although over180 billion barrels of oil have been produced in theU.S. since 1859, it is estimated that there are over 140

billion barrels left. But the U.S. is not the main playerin this market, as oil is now produced by about onehundred countries worldwide. In fact, it is competitionamong this diverse group of suppliers that is the mosteffective way to secure both moderate prices and theoil needed to sustain future economic growth.

The policy failures of the past five decades have allshared a common theme—they have sought to defeatthe global market by manipulation of price. All pastattempts to do so have failed. Given the degree ofglobalization in the world economy, they are evenmore likely to fail today. The only effect of raising oilprices in the U.S. today would be to put U.S. firms ata competitive disadvantage in the global market.

What is now needed is responsible development ofour domestic resources along with a vigorous commit-ment to freedom of trade and investment worldwide,not a return to failed policies of the past.

181

1. In addition to the price of oil, what does ErichPica say are the costs of U.S. dependence on oil?

2. According to John Felmy and Edward Porter,why have oil pricing policies failed in the past?

3. Critical Thinking Do you agree that raising oilprices would put U.S. firms at a competitive dis-advantage in the global market?

4. Reading Graphs What share of U.S. oil consump-tion was imported in 1970? What share wasimported in 2000?

DEBATING THE ISSUE

More than half the oil consumed in the U.S. is producedin other countries.

Source: Energy Information Administration

1980 200019901960 1970Impo

rts

(per

cent

age

of to

tal

oil c

onsu

mpt

ion)

0

10

20

30

40

50

60

Year

United States Oil Imports United States Oil Imports

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