Market Structures and Competition

Lesson Purpose:
People sometimes dismiss economics as being “all about” money or business.  While the characterization is misguided, it is true that economics is interested in how people make decisions in the business environment.  This lesson reviews the foundations for choice-making at the margin and connects economic reasoning to the world of business. 

Because of scarcity, all economies must answer the questions of What, How, and For Whom to produce. Businesses play a major role in answering those questions in market economies. Choosing to supply a product necessitates deciding “how much” to produce and “how” to produce it. To make a profit, entrepreneurs must ascertain customer demand and then shape their firms’ abilities to provide products within the constraints of their particular markets.  In all business environments, the profit-maximizing level of production is that at which marginal revenue equals marginal cost, but the structure of individual markets shapes the process by which that profit-maximizing level is identified.  Understanding the dynamics of the market therefore plays a key role in the potential for business success or failure.

This analysis of competition in the market demonstrates how economics education can become an effective vehicle for helping students understand – in their current role as consumers and in preparing for future roles as producers and entrepreneurs – the commercial world they participate in everyday. Consumers and citizens, not just business people, benefit from understanding the dynamics of the different market structures.

Key Terms:

price-takers price-searchers competition market power

perfect competition monopolistic competition oligopoly monopoly

marginal benefit marginal cost firm industry

normal profit economic profit

Content Standards:

Standard 9: Students will understand that:  Competition among sellers lowers costs and prices, and encourages producers to produce more of what consumers are willing and able to buy.  Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most of them.

Benchmarks:
grade 12:

• The level of competition in an industry is affected by the ease with which new producers can enter the industry and by consumers’ information about the availability, price, and quantity of substitute goods and services.
• Collusion among buyers or sellers reduces the level of competition in a market.  Collusion is more difficult in markets with large numbers of buyers and sellers.

Session Objectives:

• Review market dynamics, emphasizing:
• the law of supply and supply shifters;
• business firms face downward sloping demand curves;
• (Clarify the difference between a “firm” and the “industry.”)
• the market, not the producer, sets the price;
• the producer’s only decision is what quantity to supply in order to maximize profit.
• Identify the basic economic questions and how they are answered in market economies.
• Define and illustrate market power and forms of competition.
• Define economic profit.
• Define price-takers and price-searchers.  Compare and contrast their abilities to exercise market power.
• Identify and explain the incentive structure that makes cartels difficult to maintain.
• Identify the four market structures and illustrate how they are similar and different in the context of making business decisions.
• Evaluate the role of advertising as a competitive tool in different market structures.
• Illustrate why equating marginal revenue to marginal cost is the highest total profit- generating level of output.
• Identify the important information business people use to make good business choices regarding how much to produce: fixed cost, average fixed cost, variable cost, marginal cost, average variable cost, and total cost.
• Evaluate market structures in regards to social value and efficiency.
• Discuss the market structures in relation to real businesses and to public perception.

Key Content:

• The level of market power a firm can exercise is a function of the competitive structure of the market in which it operates.
• The level of competition in the market for a particular product is influenced by the number of firms, the ease of entry into and exit from the market, the degree of product differentiation, and consumer access to information about the price and availability of substitutes.
• Market power derives from firms’ ability to influence price by controlling quantity supplied.
• Firms are motivated to produce at the level where MC = MR because it is the point of maximum total profit.
• In the absence of force, it is difficult to sustain collusion in open markets because the profit motive provides incentives for producers that, over time, undermine cartels.

Mythconceptions:

• Buyers and sellers compete against each other in the market.
• All business environments are the same.
• All businesses that follow the MR=MC rule make a profit.
• Few businesses seek to reduce costs.
• Monopolies always make a profit.
• Businesses that don’t make a profit go out of business.
• Price takers don’t make as much profit as price-searchers.
• Big businesses are more likely to be successful.

Frequently Asked Questions:

• Why do so many people dislike monopolies, but everyone seems to want to be one?
• How can businesses stay in business when they don’t earn a profit? 
• Why is it a good idea to make output choices based upon the MR=MC rule rather than just looking at the bottom line?
• If monopolies are socially inefficient why do policy makers actually support having some? (Is there such a thing as a natural monopoly?)
• Why do businesses in markets with monopolistic competition advertise a lot?
• Why is it difficult to form and maintain cartels that fix prices and output levels?

Classroom Activity Options

• Provide students with a list or have them create their own list of businesses whose products they frequently purchase. (Alternately, provide small discussion groups with pictures of common products cut from magazine advertisements.) Without defining the term, ask students to think about the different amounts of “market power” the businesses have.  Assign them the task of sorting the businesses into categories, or ordering them on a continuum in terms of market power. Discuss the results.  Proceed from this activity into definition of market power, and description of the 4 basic market structures.
• Explain the ability of the price taker in a perfectly competitive market structure to continue in business without making an economic profit. 
• Provide practice problems illustrating the advantages of the MR=MC position in producers’ supply decisions.  Include problems showing the case in which costs are so high that there is no profit potential.
• $20-bill Auction:Tell students that you are going to conduct a ballot auction (in which each person submits his/her bid to purchase the $20-bill on a folded piece of paper), and then interrupt yourself as you “remember” that you have to leave the room for a minute to take care of something.  As you leave the room, assure the students that you’ll conduct the auction when you return. (During your absence, students will probably make an agreement - form a cartel - to have everyone bid 0¢ or 1¢, except for one student who bids a cent more – and then shares the $20 with everyone else.) When you return, conduct the auction. Usually, at least one person will break the agreement by bidding higher. Discuss the analogy between the experiment and cartel agreements to restrict production in order to keep prices high. Provide historical examples of the inability of cartels to sustain collusion in the absence of force. (OPEC in the 1970s is a good example.)
• Provide examples illustrating how markets change from one structure to another when technology or other market conditions change.  Reinforce the dynamic nature of markets and the need to commit to life-long learning.
• List students’ favorite advertisements on the board or an overhead transparency.  Challenge students to identify the market structure(s) for the products listed and to explain why advertising is associated with the identified market structure(s). Help students to see the importance of product differentiation and brand loyalty in monopolistic competition.

Handouts and Supplemental Materials

• “Defining Characteristics of  Firm Structures” (pdf)