competition, oligopoly, and monopoly. You need to be able to compare and contrast
these structures in terms of numbers of firms, firm demand elasticity and pricing
power, long-run economic profits, barriers to entry, and the amount of product
differentiation and advertising. Finally, know the two quantitative concentration
measures, their implications for market structure and pricing power, and their
limitations in this regard. We will apply all of these concepts when we analyze industry
competition and pricing power of companies in the Study Session on equity
investments.
LOS 15.a: Describe characteristics of perfect competition, monopolistic competition,
oligopoly, and pure monopoly.
CFA
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Study Session 4
Program Curriculum, Volume 2, page 64
In this topic review, we examine four types of markets, which we will differentiate by
the following:
Number of firms and their relative sizes.
Elasticity of the demand curves they face.
Ways that they compete with other firms for sales.
Ease or difficulty with which firms can enter or exit the market.
At one end of the spectrum is perfect competition, in which many firms produce
identical products, and competition forces them all to sell at the market price. At the
other extreme, we have monopoly, where only one firm is producing the product. In
between are monopolistic competition (many sellers and differentiated products) and
oligopoly (few firms that compete in a variety of ways). Each market structure has its
own characteristics and implications for firm strategy, and we will examine each in
turn.
Perfect competition refers to a market in which many firms produce identical products,
barriers to entry into the market are very low, and firms compete for sales only on the
basis of price. Firms face perfectly elastic (horizontal) demand curves at the price
determined in the market because no firm is large enough to affect the market price.
The market for wheat in a region is a good approximation of such a market. Overall
market supply and demand determine the price of wheat.
Monopolistic competition differs from perfect competition in that products are not
identical. Each firm differentiates its product(s) from those of other firms through
some combination of differences in product quality, product features, and marketing.
The demand curve faced by each firm is downward sloping; while demand is elastic, it
is not perfectly elastic. Prices are not identical because of perceived differences among
competing products, and barriers to entry are low. The market for toothpaste is a good
example of monopolistic competition. Firms differentiate their products through
features and marketing with claims of more attractiveness, whiter teeth, fresher
breath, and even of actually cleaning your teeth and preventing decay. If the price of
your personal favorite increases, you are not likely to immediately switch to another
brand as under perfect competition. Some customers would switch in response to a
10% increase in price and some would not. This is why firm demand is downward
sloping.
The most important characteristic of an oligopoly market is that there are only a few
firms competing. In such a market, each firm must consider the actions and responses
of other firms in setting price and business strategy. We say that such firms are
interdependent. While products are typically good substitutes for each other, they may
be either quite similar or differentiated through features, branding, marketing, and
quality. Barriers to entry are high, often because economies of scale in production or
marketing lead to very large firms. Demand can be more or less elastic than for firms in
monopolistic competition. The automobile market is dominated by a few very large
firms and can be characterized as an oligopoly. The product and pricing decisions of
Toyota certainly affect those of Ford and vice versa. Automobile makers compete
based on price, but also through marketing, product features, and quality, which is
often signaled strongly through brand name. The oil industry also has a few dominant
firms but their products are very good substitutes for each other.
A monopoly market is characterized by a single seller of a product with no close
substitutes. This fact alone means that the firm faces a downward-sloping demand
curve (the market demand curve) and has the power to choose the price at which it
sells its product. High barriers to entry protect a monopoly producer from competition.
One source of monopoly power is the protection offered by copyrights and patents.
Another possible source of monopoly power is control over a resource specifically
needed to produce the product. Most frequently, monopoly power is supported by
government. A natural monopoly refers to a situation where the average cost of
production is falling over the relevant range of consumer demand. In this case, having
two (or more) producers would result in a significantly higher cost of production and
be detrimental to consumers. Examples of natural monopolies include the electric
power and distribution business and other public utilities. When privately owned
companies are granted such monopoly power, the price they charge is often regulated
by government as well.
Sometimes market power is the result of network effects or synergies that make it very
difficult to compete with a company once it has reached a critical level of market
penetration. EBay gained such a large share of the online auction market that its
information on buyers and sellers and the number of buyers who visit eBay essentially
precluded others from establishing competing businesses. While it may have
competition to some degree, its market share is such that it has negatively sloped
demand and a good deal of pricing power. Sometimes we refer to such companies as
having a moat around them that protects them from competition. It is best to
remember, however, that changes in technology and consumer tastes can, and usually
do, reduce market power over time. Polaroid had a monopoly on instant photos for
years, but the introduction of digital photography forced the firm into bankruptcy in
2001.
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