© 2005 Thomson C hapter 10 Identifying Markets and Market Structures

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles The use of cross elasticity to define markets The relationship between firms, industries, and markets Market structures The characteristics of monopoly

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles The characteristics of monopolistic competition The characteristics of perfect competition The role of advertising

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e Defining the Relevant Market Relevant market The set of goods whose cross elasticities with others in the set are relatively high and whose cross elasticities with goods outside the set are relatively low.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e Defining the Relevant Market The relevant market can be defined narrowly or broadly. What gets included in the relevant market will be determined by this definition.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e Defining the Relevant Market Example: Automobiles and transportation. A relevant market can be narrowly defined as just the automobile industry.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e Defining the Relevant Market Example: Automobiles and transportation. Transportation is a broader definition of the relevant market. It would include the automobile industry as well as all other possible forms of transportation, including taxis, buses, railways and airlines.

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e Defining the Relevant Market 1. What makes up the relevant market for oil? All possible sources of oil, such as Saudi Arabia and the United States.

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e Defining the Relevant Market 2. What makes up the relevant market for energy? Oil, hydroelectric power, coal, wood, solar and nuclear sources.

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e Courts and Markets In many cases the courts are called upon to determine what the market is.

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e Courts and Markets Example: DuPont’s relevant market. In 1953 the government filed suit against DuPont, charging it illegally dominated the cellophane market because it produced over 80 percent of all cellophane.

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e Courts and Markets Example: DuPont’s relevant market. DuPont countered that its relevant market was not cellophane, but the broader market of flexible packaging materials.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e Courts and Markets Example: DuPont’s relevant market. By that definition, DuPont controlled less than 20 percent of the market.

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e Courts and Markets The court decided in favor of DuPont. Example: DuPont’s relevant market.

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e Courts and Markets The decision of the courts is not revealed truth, but rather an impartial judgment concerning the issue of what constitutes a relevant market.

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e Courts and Markets One tool the courts use to identify the relevant market is cross elasticity of demand.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e Cross Elasticity Defines the Market The relevant market can be delineated by comparing the cross elasticities among goods within the set and outside the set.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e Cross Elasticity Defines the Market It has been suggested that when the cross elasticity (e) between two goods is greater than or equal to three, the goods can be regarded as belonging to the same market.

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e EXHIBIT 1DELINEATING THE MARKET

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e Exhibit 1: Delineating the Flower Market Zone A is the Peace rose market. The cross elasticity for goods within the set is infinite – any Peace rose will be a good substitute. The cross elasticity for goods outside the set is zero – nothing but a Peace rose will substitute. In Exhibit 1, what is the market for each zone?

© 2005 Thomson 21 Exhibit 1: Delineating the Flower Market Zone A and B are the rose market. The cross elasticity of goods within the set is relatively high (e = 25)—for most people, any rose will be a good substitute. The cross elasticity of goods outside the set is relatively low—for most people, only a rose will make a good substitute. In Exhibit 1, what is the market for each zone?

© 2005 Thomson 22 Exhibit 1: Delineating the Flower Market Zone A, B and C are the flower market. The cross elasticity of goods within the set is still relatively high (e = 10)—for most people, any kind of flower will be a good substitute. The cross elasticity of goods outside the set is relatively low — for most people, nothing but flowers will make a good substitute. In Exhibit 1, what is the market for each zone?

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e Exhibit 1: Delineating the Flower Market Zone D lies outside these markets. The cross elasticity of goods within the set is zero (e = 0)—fish do not substitute for flowers. In Exhibit 1, what is the market for each zone?

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Markets and Market Structure Market structure A set of market characteristics such as number of firms, ease of firm entry, and substitutability of goods.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e Markets and Market Structure The most important characteristic that distinguishes one market structure from another is the number of producers selling in the market.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Markets and Market Structure The number of producers within a market determines: The control an individual producer has in the market. How producers respond to decisions consumers make.

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Markets and Market Structure The number of producers within a market determines: How producers respond to decisions other producers in their market make. How producers respond to the the market prices they face.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e EXHIBIT 2THE MARKET STRUCTURE SPECTRUM

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e Exhibit 2: The Market Structure Spectrum 1. How is the monopoly market structure characterized? Only one firm is producing goods. The goods have no substitutes. No other firm can enter the market.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e Exhibit 2: The Market Structure Spectrum 2. How is the perfectly competitive market structure characterized? A considerable number of firms are producing goods. The goods are perfect substitutes. Firms can easily enter the market.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e Exhibit 2: The Market Structure Spectrum 3. How is the monopolistic competition market structure characterized? Greater than a few, but fewer than a considerable number of firms are producing goods. Firms can enter the market, but without the ease allowed in perfectly competitive markets.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e Exhibit 2: The Market Structure Spectrum 4. How is the oligopoly market structure characterized? Only a few firms are producing goods. Entry into the market is relatively difficult.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e Markets and Market Structure Mutual interdependence Any price change made by one firm in the oligopoly affects the pricing behavior of all other firms in the oligopoly.

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e The World of Monopoly Monopoly A market structure consisting of one firm producing a good that has no close substitutes. Firm entry is impossible.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e The World of Monopoly Complete this sentence: _____ is the most important characteristic defining a monopoly. i. The size of the firm. ii. Being the only firm.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e The World of Monopoly Complete this sentence: _____ is the most important characteristic defining a monopoly. i. The size of the firm. ii. Being the only firm.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e The World of Monopoly Industry A collection of firms producing the same good.

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e The World of Monopoly If only one firm firm produces a good, then the firm is the industry.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e EXHIBIT 3A MONOPOLY’S DEMAND CURVE

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e Exhibit 3: A Monopoly’s Demand Curve How does the market demand curve compare to the monopoly demand curve? The curves are identical.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e The World of Monopoly In a monopoly market structure, it is impossible for other firms to enter the market. Factors that contribute to impossible entry include the nature of the market, exclusive access to resources, the patent system, and acquisition.

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e The Natural Monopoly Natural monopoly The result of a combination of market demand and firm’s costs such that only one firm is able to produce profitably in a market.

© 2005 Thomson 43 EXHIBIT 4THE NATURAL MONOPOLY

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e Exhibit 4: The Natural Monopoly 1. What happens before the Blues enter the baseball market in Exhibit 4? The Reds charge $7 per person and draw a crowd of 40,000. The ATC is $5. The Reds’ profit = $(7 - 5) × 40,000 = $80,000.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e Exhibit 4: The Natural Monopoly 2. What happens after the Blues enter the baseball market and each team charges $7 per person? Attendance is split between the Blues and Reds. With an attendance of only 20,000, the ATC climbs to $11. Losses for each team = $(7-11) × 20,000 = -$80,000.

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e Exhibit 4: The Natural Monopoly 3. What happens when the Blues and the Reds lower the price per person to $4? At $4 per person, attendance climbs to 35,000 per team. The ATC is $5.50. Losses for each team = $( ) × 35,000 = -$52,500.

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e Exclusive Access to Resources Some firms, by chance or by design, acquire exclusive access to a nonreproducible good. New discoveries of the resource or the creation of alternatives to the resource destroy the monopoly.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Exclusive Access to Resources How might a monopoly on coal power as a source of energy be destroyed? A new producer finds a new source of coal and is able to enter the market. Alternatives to coal, such as solar and wind power, are developed.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e The Patent System Patent A monopoly right on the use of a specific new technology or on the production of a new good. The monopoly right is awarded to and safeguarded by the government to the firm who introduces the new technology or good.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e Acquisition Buying out all of the competition is another way to create a monopoly market structure. Andrew Carnegie, the first U.S. steel mogul, built his empire by consuming the competition.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Monopolistic Competition and Oligopoly Monopolistic competition A market structure consisting of many firms producing goods that are close substitutes. Firm entry is possible but less open and easy than in perfect competition.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e Monopolistic Competition and Oligopoly Oligopoly A market structure consisting of only a few firms producing goods that are close substitutes.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e Monopolistic Competition and Oligopoly The real extent of competition in an oligopoly market must be measured by the number of firms in all the industries producing close substitutes.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e EXHIBIT 5RELATIONSHIP BETWEEN FIRMS, INDUSTRIES, AND MARKETS

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e 1. How many firms are depicted in Exhibit 5? i. 1 ii. 3 iii. 15 Exhibit 5: Relationship Between Firms, Industries, and Markets

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e 1. How many firms are depicted in Exhibit 5? i. 1 ii. 3 iii. 15—Each box represents one firm. Exhibit 5: Relationship Between Firms, Industries, and Markets

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e 2. How many industries are depicted in Exhibit 5? i. 1 ii. 3 iii. 15 Exhibit 5: Relationship Between Firms, Industries, and Markets

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e 2. How many industries are depicted in Exhibit 5? i. 1 ii. 3—The steel industry, the concrete industry and the aluminum industry. iii. 15 Exhibit 5: Relationship Between Firms, Industries, and Markets

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e 3. How many markets are depicted in Exhibit 5? i. 1 ii. 3 iii. 15 Exhibit 5: Relationship Between Firms, Industries, and Markets

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e 3. How many markets are depicted in Exhibit 5? i. 1—All of the firms and all of the industries are part of the construction market. ii. 3 iii. 15 Exhibit 5: Relationship Between Firms, Industries, and Markets

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e Monopolistic Competition and Oligopoly Product differentiation The physical or perceived differences among goods in a market that make them close, but not perfect, substitutes for each other.

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e Monopolistic Competition and Oligopoly As more firms enter a market, firm demand curves become more elastic.

© 2005 Thomson 63 EXHIBIT 6THE DEMAND CURVE FOR COCA-COLA: BEFORE AND AFTER SUBSTITUTES APPEAR ON THE MARKET

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e Exhibit 6: The Demand Curve for Coca- Cola: Before and After Substitutes Appear on the Market 1. How can Coke’s demand curve be described before substitute goods appear on the market? Coke’s demand curve equals the market demand curve.

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e 2. How does Coke’s demand curve change after substitute goods appear on the market? Coke’s demand curve shifts to the left, while the market demand curve remains at D 1. Exhibit 6: The Demand Curve for Coca- Cola: Before and After Substitutes Appear on the Market

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e Brand loyalty The willingness of consumers to continue buying a good at a price higher than the price of its close substitutes. Monopolistic Competition and Oligopoly

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e Firms in both the monopolistic competition and oligopoly market structures have strong incentives to advertise. Advertising is a way to increase market share and make demand more inelastic. Monopolistic Competition and Oligopoly

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e Monopolistic Competition and Oligopoly Market share The percentage of total market sales produced by a particular firm in a market.

© 2005 Thomson 69 EXHIBIT 7THE EFFECT OF ADVERTISING ON THE FIRM’S DEMAND CURVE

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e Exhibit 7: The Effect of Advertising on the Firm’s Demand Curve Complete this sentence: After advertising, Coke’s demand curve shifts to the _____. i. Right ii. Left

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e Exhibit 7: The Effect of Advertising on the Firm’s Demand Curve Complete this sentence: After advertising, Coke’s demand curve shifts to the _____. i. Right ii. Left

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e Perfect Competition Perfect competition A market structure consisting of a large number of firms producing goods that are perfect substitutes. Firm entry is open and easy.

© 2005 Thomson 73 Gottheil - Principles of Economics, 4e Perfect Competition Characteristics of perfect competition: Goods are perfect substitutes. Firms have insignificant market share. Firms have free entry. Firms cannot influence price.

© 2005 Thomson 74 Gottheil - Principles of Economics, 4e EXHIBIT 8MARKET DEMAND CURVE AND THE DEMAND CURVE FACING A FIRM IN PERFECT COMPETITION

© 2005 Thomson 75 Gottheil - Principles of Economics, 4e Exhibit 8: Market Demand Curve and the Demand Curve Facing a Firm in Perfect Competition 1. Why is the demand curve for a perfectly competitive firm horizontal? The perfectly competitive firm cannot influence price. Therefore, it can produce any quantity it desires and price will always remain the same.

© 2005 Thomson 76 Gottheil - Principles of Economics, 4e 2. What would happen if a firm decided to charge $0.66 for potatoes in Exhibit 8? The quantity demanded would fall to zero. Exhibit 8: Market Demand Curve and the Demand Curve Facing a Firm in Perfect Competition

© 2005 Thomson 77 Gottheil - Principles of Economics, 4e EXHIBIT 9SUMMARY SKETCH OF MARKET STRUCTURES

© 2005 Thomson 78 Gottheil - Principles of Economics, 4e Type of Market Number of Firms Type of Products Entry Influence over Price? Perfect Competition ManyIdenticalFullNo Exhibit 9: Summary Sketch of Market Structure

© 2005 Thomson 79 Gottheil - Principles of Economics, 4e Type of Market Number of Firms Type of Products Entry Influence over Price? Monopolistic Competition Many Differentiated Difficult /Easy Yes Exhibit 9: Summary Sketch of Market Structure

© 2005 Thomson 80 Gottheil - Principles of Economics, 4e Type of Market Number of Firms Type of Products Entry Influence over Price? OligopolyFew Usually Differentiated DifficultYes Exhibit 9: Summary Sketch of Market Structure

© 2005 Thomson 81 Gottheil - Principles of Economics, 4e Type of Market Number of Firms Type of Products Entry Influence over Price? MonopolyOne--ImpossibleYes Exhibit 9: Summary Sketch of Market Structure