The Science of Everything Podcast - Episode 49: Market Structure

Episode Date: July 20, 2013

A discussion of the effect of market outcomes on firm behavior, consumer welfare, and market outcomes. I examine perfect competition, monopoly, oligopoly, and monopolistic competition, comparing their outcomes and when each type of structure tends to occur. Also includes a discussion of cartels, when they form, and why they tend to fail. Recommended prerequisites are Episode 48: Theory of the Firm, Episode 16: Profits and Competition, and Episode 12: The Price System.

You're listening to The Science of Everything podcast, episode 49. Market structure. I'm your host, James Fodor. In this episode, I'm going to talk about the different types of, well, market structure. That is, the way markets are arranged in terms of the firms that exist and how they compete with each other, and basically take a comparative analysis of the efficiency of these different market structures and how consumer welfare is affected. The four main types of market structure that I'll be analyzing are perfect competition,

where you have lots of buyers and sellers, monopoly, when you only have, one seller. Oligopoly, when there are a few sellers and monopolistic competition, where you have a large or small number of sellers, but they sell differentiated products. Recommended pre-listing for this episode, mostly just listen to episode 48 on The Theory of the Firm, the previous episode, because this episode carries on fairly closely from that one. Also, episode 12 on the price system, episode 16, profits and competition, and episode 5 on corporate conspiracies will also be relevant. Oh, episode 36 on consumer choice theory is somewhat relevant as well, although that's less important.

All right, let's get straight into it. Market structure, first of all, we'll start with looking at perfect competition. But before I get into that, I should say that this episode continues on from the previous episode on Theory of the Firm, in that, if you remember in the previous episode, I talked about how the optimal level of output that the firm selects in order to maximize profits, that optimal level will depend upon how many other firms exist in the market, in that industry. The more other firms, basically the lower the price they'll have to charge. And so in this episode, we're going to look in detail about how that decision of how much output to produce and therefore and what price to charge, how that's affected by the number of other

firms in the industry and how the interactions between the firms play out. So first we'll talk about perfect competition, which is always the baseline case that you always look at in economics. I think I talked about this in perhaps profits and competition or the price system, but we'll recap it because it's important to our understand before we look at the other types of market structure. What does it, what does perfect competition look like? Well, in perfect competition there are many buyers and sellers of a homogenous product. Homogeneous product means that everyone sells exactly the same thing. So the wheat market is like the class example of this. Pick a given strain of wheat. Basically everyone's

exactly the same. No one cares about where the wheat comes from if it's a given strain and quality is high enough and so on. There's never a perfect example of a homogeneous product because there's always some difference you can point to, but some goods are more homogenous than others. And a pretty good example. Most commodities like that, you know, iron and steel and coal and oil and whatever are essentially homogenous. They're all the same. No one really cares where they come from. And you have to have many, many sellers, as I said before. Well, many buyers and sellers, but in this case, we're just focusing on sellers, many firms selling. A consequence of this fact that there are many firms is that no single firm has any ability

to control the market price. Because market price is determined, remember from the price system, it's determined by supply and demand, the total level of supply and the total level of demand. Now, if the total level of supply is very high, because there are lots and lots of firms, then any single firm can't change the supply by any appreciable amount, and therefore, any single firm, the behavior of any single firm does not appreciably affect the market outcome. Now, an analogy you can make here is sort of global warming. Global warming is the product of excessive carbon dioxide emissions, basically, well, and other greenhouse gas like methane, but as a result of humans, of human industrial and agricultural

activities. So every single person, particularly in developed countries, who consumes energy and eats food, is contributing to global warming, is contributing to greenhouse gas emissions. But because the total number of humans is so large, the individual, the effect of any single individual is so tiny that it's effectively zero. I mean, any one person or even any small group of people cannot have any noticeable effect on global warming. Now, I mean, I suppose that's a particularly controversial example, but I don't intend for it to be controversial. I just intend to illustrate the point that if you have many, many people

involved in a particular phenomenon, then the behaviour of any single one person, or any single one firm in this case, doesn't make a difference. Technically, there'll be some tiny marginal effect, but it's so small it can just be ignored. So that's what happens in perfect competition. Any single firm cannot change the market price. They're stuck with the market price as it is, which is sort of a good thing and a bad thing for them.

The good part of it is that the firm can sell as much or as little as they like at the market price. The quantity that they sell is determined by the firm, but the price at which they sell is not. The firm cannot choose their price. They're constrained by the market price. Now, you might think that's a strange way of saying it. Of course people can decide their price. Doesn't the seller decide what sticker to put on the good or the service? Well, in a sense, yes, the seller does determine prices in the direct sense.

but where did they get the number from? They didn't just pull it out of their heads, certainly not if they're existing in a perfectly competitive market. The price came from the price that other people are charging for the same good or a similar good. The firm could charge a higher price if they wanted to, but in a perfectly competitive market, they wouldn't sell anything because everyone would just buy it from someone else. I mean, an example of a perfectly competitive market

that would sort of meet all the criteria is eBay purchases of some really common good that's always exactly the same. So nothing in particular comes to mind. But maybe certain electronic goods, like maybe, well, I was thinking like a USB stick or something like that of a given capacity. But even those, there's some variation. But it would have to be something which lots and lots of people buy and sell, and that there's pretty much no variation in quality. Even their eBay doesn't quite match up. But the advantage of eBay is that there are no transaction costs.

Talked about those in the previous episode. Well, there are transaction costs for eBay. You have to wait for the item to be shipped and so on. But they're very small. It's very easy to log on and just work out what the price is, and you can get all the comparisons listed up right in front of you. there's near perfect information so that everyone knows what everyone else is charging and so on

obviously if one firm's charging a high price but its customers don't know that it's a really high price they think it's a good deal then that's not going to be perfect competition and it needs to be a situation where everyone knows what everyone else is charging and that's called perfect information you have pretty nearly perfect information on eBay where all of the results just come up right in front of you

so imagine if you had that situation on eBay where there's like dozens of people all selling something for $5 and then this is one guy selling it for $6 or 50 or 60 or 500 or 600, it doesn't really matter. Now, who's going to pay the higher price? No one will. If it's exactly the same good, no one is paying the high price. And so that guy can set as higher prices he likes, but he's not selling.

And so he's not going to sell any because no one's going to buy from him. So in practice, in economics, what we say is that the firm is constrained to sell at the market price. Now, of course, they could sell for less on the market price if they wanted to, but then why would they do that? They would be selling at a lower price than they otherwise could. They'd be making less money. Also, a single firm would not be able to sell at less than the market price. Because remember, if they sell it less than the market price, everyone will want to buy from them.

But a single seller, a single firm only has a limited capacity. They might be able to sell twice as many as they currently can, but they're not going to be able to supply the whole market. It's as if one bakery somewhere in the suburbs or some one little corner in the city suddenly had everyone from the entire city coming and wanting to buy bread from them. they wouldn't be able to supply the demand, and so therefore they would not be able to, therefore, you know, they could sell a certain number of units at the low price, but then they'd run out and all the consumers would have to go back to paying the higher price

at everyone else. So in the perfectly competitive market, firms can't sell less than the price and they market price and they can't sell higher than market price. They are constrained to sell that exactly the market price. Now, as I said before, in the real world, there is no such thing as a perfectly competitive market. However, it is a very good approximation for many sectors of the economy, especially service, industries, agricultural markets, I'd say many online markets would fit this category increasingly. So, in fact, information technology in general has made most markets more competitive because of the easier provision of information and reduction in transaction costs and so forth. So perfect competition is a good approximation for many things. It's also a

benchmark by which we can compare other types of market structures to see how they compare, because perfect competition, it turns out, is sort of like optimally efficient. It's like the best possible outcome. And so it's good to be able to compare everything to that. So it's very useful to have this concept of perfect competition, even if nowhere in the real world, it actually exists. And, you know, there are many analogies to this in science. In biology, for instance, you open up a biology textbook and you look at an idealized diagram of a cell that has all the organelles listed, you know, the mitochondria and the nucleus and whatever else. No real cell looks anything like that for most textbooks. They don't use any real cells. It's an idealized version. It illustrates the

important features. And it's the same thing in physics, where we just assume away friction and other complexities that we don't want to worry about at a first blush analysis. It's the same thing in economics. We use models to help simplify the world so that we can identify important features that we want to study. Okay, so what do firms do in a perfectly competitive market? How do they behave now that we know that they have to charge the market price? Well, basically, firms in a perfectly competitive market cannot make a profit in the long run. So a firm in a perfectly competitive market, in a sense, is indifferent between whether it continues to operate or whether it doesn't. Now, when we say that a firm cannot make a profit, what we mean is that they can't make an

economic profit. This is a bit of a different concept to an accounting profit. The firms will always make a profit, because otherwise why would their owners run them? Why would their shareholders own shares? But when we're talking about an economic profit, we mean sort of above-average profits. Higher than you would expect to earn, given the riskiness of your industry that you're in. So if most firms are making 10% return on their assets and this other firm's making 30% return their assets, then that firm is earning a 20% economic return. It's the difference between sort of what everyone else is earning, what the baseline is, and what you're managing to do. In a perfectly competitive market, you cannot earn an economic profit in the long run.

You can't earn above average profit. You can only earn sort of the average going rate of profit. Why is that? Because another important factor of a perfectly competitive market, which I failed to mention, but should have, is that there are no barriers to entry. There is free entry and exit from the market. So at any time, new firms, you, you're a firm. firms can enter and any time firms can exit if they want to leave the market. This means that if, for example, there's an increase in consumer demand, and therefore the price goes up and the output goes up, assuming there's no increase in production costs, which there may be, but let's suppose it's a constant returns to scale industry and there's

no increase in production costs, then the increase in the price in that industry is going to lead to an increase in the profits earned by all the different firms. And then other firms on the outside, or potential new entrants, going to say, oh, the firms in this industry are earning above average profits. We should get into that industry, and therefore they'll start entering the industry, and there'll be high supply, because there are more firms. And what happens when there's high supply? When supply goes up, prices go down again, and prices will come down

until profits go down to the ordinary levels they were before. So this is why, in the long run, in a perfectly competitive market, economic profit will always be zero, because basically the number of firms in the market will always adjust so that this is the case. again in the real world there's going to be noise and complexity so it's not going to be perfect but broadly this is what we would expect to happen and this is what we do see happening you don't see firms in competitive industries earning dramatically above average profits for long periods of time

because more people will enter that industry there's another very important consequence of perfectly competitive markets and that is that price will always be equal to marginal cost that is the price at which firms sell the good and remember all firms have to sell at the same price we established that they sell it for, will always be exactly equal to the cost of producing one additional unit. That's the marginal cost, the cost of producing one more. That's not the same as the average cost, total cost, total cost would be, well, your total cost overall, average cost would be total cost divided by the quantity you're producing. Marginal cost is the cost of producing one more unit of output. And the fact that price is equal to marginal cost is very important, because that's

sort of the definition of the efficient level of production. We want the price to be equal to marginal cost, because that means that we're getting as much benefit as we possibly could out of that type of production. If price is higher than marginal cost, it means we should be producing more because we could be getting extra units for a price that we would be willing to pay. If price is lower than marginal cost, it means that we're actually consuming too much. We should be consuming less and then using our money to buy other things or to produce other things. So again, and I've talked about this in previous episodes, so I won't belabor the point. But basically, in a perfectly competitive market, it will be the case that price is equal to marginal cost at equilibrium,

which means after, you know, the firms have all entered and they've adjusted their levels of output and prices have settled down and all that. So after a certain period of time, price will equal marginal cost. And so you'll be at the efficient level of output, which is what I said before, when I said it turns out that perfectly competitive markets are optimally efficient, because they have this property that the price of the firms in the market

will be equal to marginal cost. And the reason why that's the case, again, it comes out of the behaviour, of the market, because if price was a bit higher than marginal cost, that means that new firms could enter the market and earn an economic profit. They could sell at the, they could sell at just a bit less than the current price and produce it a bit, and produce out the marginal cost, because the marginal cost is how much it costs to produce extra units, and therefore make a profit, that make the profit of the difference between whatever the price they're selling at and whatever

the current marginal cost is, and that's going to be an above, an above average profit, an economic profit. And so firms will keep entering the market to earn that above average profit until the price is driven down. And it will continue to do that until price is driven right down to marginal cost. If prices lower than marginal cost, that means firms are making a loss. The cost of their production is greater than the amount of money that they're getting in terms of by selling the good. So firms will exit the industry in the long run in order to avoid those losses. And as more firms exit the industry, supply goes down and therefore prices increase. And that will continue until you get price equal to marginal cost. So in other case, in a perfectly competitive

market, price equals marginal cost, and the number of firms always adjusts so that that is true in the long run, even if levels of demand change or if input prices change and other things change, number of firms in the industry always adjust so that that stays true, and therefore you will always be in the long run equilibrium at the efficient level of output. So this is a good thing for consumers. It means they get the maximum possible benefit from that type of good, not producing too much not producing too little. So this is why it's the perfectly competitive market serves as our bench line

to which we compare the other types of market structure. So now we'll move on to some of the more interesting cases. And we'll start with the monopoly. Not the board game, the market structure. A monopoly is a situation, you know, coming from the prefix mono, meaning one, where there is only a single seller. Now, when we talk about a single seller,

we're always talking about a single seller of a particular good in a particular market. You can define that now. narrowly or broadly depending on what your interest is. So if you define things broadly enough, like food, you know, no one has a monopoly in food. Food is a really broad category. But if you talked about, well, to take an example I found on Wikipedia,

grapes sold during October 2009 in Moscow versus grapes sold during October 2009 in New York, that's very specific in time and place and type of good. And so in those circumstances, it's going to be relatively easy to find monopolies because you're being really specific about what you define as a market. Obviously, if you've got ridiculously specific, like this type of grapes sold at this particular location in New York and this particular time on this particular date, well, then everyone's going to have a monopoly, but that's just silly. There's no point in having such a narrowly defined market.

There's also no point in having such a broadly defined market as food, because different producers of food don't really compete against each other very much. The relevant question when you're looking at how to define a market is the extent of substitutability between goods. grape sellers in Moscow probably don't compete very much with grape sellers in New York. There might be some degree of competition in terms of able to import to different places around the world. Sorry, export to different places around the world. So if there's much high demand at Moscow, maybe you get more grapes being exported there than in New York. So there's maybe some competition, but I'd say not very much. But if you're talking about oil, for example, well, there's a very great deal of competition all over the world between different oil producers,

because that's really easy to ship, and there's a very liquid market in trading oil. so it's very easy to buy from all over the place very quickly. So it very much depends on the good you're talking about and what type of analysis you're interested in terms of how you define what counts as a market. But however you've defined your market or your particular type of good, if there's only one seller in that market of that particular type of good, then that seller is a monopoly. Also, another sort of messy complexity that there is in the case of monopoly

is that it's very rare that there's literally only exactly one firm producing something. Usually what happens is there's one firm who produces like 90 or 95 percent of the output or earns 90 or 95 percent of the profits. And there's a few other really small firms that no one cares about. So, I mean, some examples of this standard oil, which was a big oil conglomerate back in the late 19th century in the U.S. is famous, probably the most famous monopoly case. But it never had a true literal monopoly, maybe in certain local areas it did, I don't know, but definitely not overall or in any state. It had a very large market share, over 90%, I believe, at one point. But it never had literally 100%. De Beers in South

Africa being another example, the diamond conglomerate, which again at one point owed something like 80 or 90% of the market share in world diamonds, again, it never had 100% of the market. This is almost unheard of to have literally 100% of the market, unless it's a government mandated monopoly, which does happen. The point is, though, often it's a case of, well, it's close enough to a monopoly that we'll call a monopoly, because the other competitors are so small in comparison that it's basically like the only key player. So, real world's messy in terms of how you define one and how you define, you know,

market or good, but when we think about a monopoly, we just sort of think of approximately one seller, one important seller at least, selling, you know, one good in a particular market that we've defined. Oh, sorry, one other point about monopolies. Monoplies don't have to be big businesses. Generally, they are, because they, you know, they serve the entire market, so they have to be big, but sometimes the market could be very small. So you could have a monopoly over, you know, let's say selling a very specific type of, I don't know, jewelry or rare artwork or antiques or something like that, where the market is really, really small. So you might be a very small business, even a sole proprietorship, for example, but you could still be a monopoly.

So you don't have to be large to be monopolies. Just that's often the case. So how do monopolies exist? Generally, remember, we would expect that if one firm is earning above average profits, which is what monopolies generally do, then other firms will enter and start selling goods in that same market, and therefore bid down the price in order to get a share of the profits, and therefore the monopoly is no longer a monopoly because they've got people to compete against. Now, so for a monopoly to be maintained in the long run, sort of in equilibrium,

then there must be what are called barriers to entry. That is, something preventing new firms from entering the market. What are the sources of barriers to entry? There are many different types of barriest entry. One, which we talked a bit about in the previous episode, economy is to scale. If big firms have a large cost advantage over smaller firms owing to technology or capital or something like that, then it's going to be really easy for established large firms to keep new small entrants out of the market. So this is a good example as to why things like national airline manufacturers, for example,

tend to be monopolies or very close to them, like Boeing, for instance, or Airbus in Europe, because it's just so much more efficient and cheaper to have one factory, one firm producing something like that, that's so large and capital intensive and so on, than it is to have many smaller ones doing it. And so if smaller firms tried to enter the market, they'd be pushed out because they wouldn't be able to compete with Boeing's lower costs. And perhaps Walmart might be another example of this. Another reason for monopolies, another cause of barriers to entry in a given market is control over natural resources. So if you have, if you literally own the land on which given scarce resources are located, say, for example, oil, then there's no way that other people can enter the market.

To be as in South Africa, which I mentioned before, a good example of this, where they literally, owned, you know, the few large diamond mines in the world. And so they were able to dominate the world diamond markets for a long time. They're still a powerful player, but not as dominant as they once were, but because they literally owned the land and they therefore had control over the resources. And you can't just make diamonds. Well, I mean, you can, but you can't make naturally occurring diamonds, and you can't make them so that they're quite the same. So there's, again, depends how you define the market here. If you define the market as all diamonds, well, then they didn't have a monopoly. But if you define it as naturally occurring diamonds,

diamonds, then, yeah, they did. And it's very difficult to make that, so to make those. So if you don't have access to the mines, you can't really compete. There's no way you can enter the market. Another cause of barriced entry are network externalities. Now, this is an interesting phenomenon. Network externalities occur when the benefit that you get from using some service, or generally a network, increases as more other people use that same service. So early telephone networks were a good example of this. What's the benefit of buying a telephone if there's no one to call, but as more and more people get telephones, then there's more people to call, and therefore more and more people get telephones. So there tends to be a positive

feedback when there are network externalities. The more people will get it as more people get it. And so when more people get it, more people get it. You sort of see what I mean. Facebook is a great example of this. So Facebook essentially pushed MySpace and some other, some other earlier startups out of that particular style of social network website because of the huge network externalities. The benefit of having or of using a service like this depends on how many people you can be friends with. uses it and then there really isn't any point. And so there tends to be a tendency for people to collect towards only one of these things. In this case, it was Facebook. A final reason for

cause of barriers to entry are legal barriers, and these are quite common. And these are the ones I mentioned before about government restrictions on entry. These are things like licenses, so if you have to have a license to, well, do anything, like be a doctor or a lawyer or operate a truck or whatever, then that's restricting the entry. Patents and copyright laws. restrict entry into markets. So if a company comes up with a new drug and they'd patent it, other people cannot produce the same drug without being taken to court

for a certain period of time, and therefore that company has a monopoly on that drug. And there are many, many, many other legal sources of barriers to entry. Some of them justified, some of them not justified, in my view. Well, many economists views, but whether they're justified or not sort of beside the point. The point is that

the barraised entry, the legal barriers exist, and therefore they can serve to maintain monopolies. And sometimes, particularly more so in the past, there were just government grads monopolies to particular firms. This was especially common in like the 18th centuries and so on, where lots of monarchs would give firms monopolies over like all trade with India or something like that, like the British East India Company. Or more recently, the government might give a particular company monopoly over running the train service or electric power generation in a particular era or something like that. And just no other firms would be allowed to compete. So those are all the various reasons for the barriers to entry existing.

So remember, barriers to entry are essential for maintaining a monopoly, because otherwise you'll have firms entering, diluting the abnormally large profits that the incumbent monopolist is earning, and therefore it's not a monopoly anymore. What's the consequences of monopolies? You probably know they're not good, not for consumers anyway, and I've already said that monopolists tend to earn above-average levels of profit, which they can do because of their barris to entry. But how do they, where do the above-average returns come from?

Basically, what monopolists do is that they charge, a price that's too high by restricting output. Well, they charge a price that's higher than marginal cost, is another way of looking at it. Remember that perfectly competitive markets charge a price that's equal to marginal cost, and therefore the benefit that consumers get from the good, which is the price that they pay, which has to be at least equal to the price they pay, is equal to the cost of that good, which is the marginal cost, and therefore that's the efficient level of output that we would like to achieve, where cost equals the benefit. But monopolists don't produce enough. They always restrict production, cut-back production,

such that the price is higher than the marginal cost. So society could be better off if the monopolist were to increase production and therefore reducing the price and so that people could get more of whatever it is they're producing, but they don't because doing so would earn them lower profits, and I'll explain in a moment exactly why that's the case. But it's very important to understand. I think many people have this idea that a monopolist is...

Monoplies are bad because there's no competition, and therefore the monopolists can do whatever they like. They can just charge really high prices and gouge people and they don't have to innovate or whatever else like that. And that's true to some extent, but it misses the key point about monopolies. Monoplies are not any more or less greedy than other firms, at least from an economic analysis. I don't know if anyone's done sort of a psychological study of the people in monopolies, but I would say there's probably no real difference.

The monopolist is behaving exactly the same as a perfectly competitive firm. It's just that their environment is different. The competitive environment differs, and therefore their optimal behavior differs. So it's all about the market structure that the firm exists in. It's nothing sort of intrinsic to the firm itself. Again, in the real world, there are complexity of organizational culture and so on, but we're just going to abstract away from those at the moment. So why exactly does the firm behave this way then if they're not more greedy or something like that,

or just nasty people? Well, the reason is, as I said before, the monopolist can charge a price that's higher than the martial cost. And the reason they can do that is because they can, well, they can set the price. Monopolis have what is called market power. which means the ability to change the price that they charge. Remember, perfectly competitive firms don't have the ability to change their price. They just have to take their market prices given and charge that. They can't charge higher or lower without either selling everything or selling nothing.

Monopolis can choose whatever price they like as constrained by the demand curve that they face. Because the monopolist can charge any price they like, they have to sort of sit back and think, well, what price should I charge? Well, of course, they'll charge the price that maximizes their profits. because like any business, they're trying to maximize profits. Now, why does that necessarily mean that they charge a higher price? Couldn't it be the case that the profit maximizing price is equal to marginal cost? I mean, that's sort of what happens in a perfectly competitive industry.

So why is it different in a monopoly? Why is their optimum price higher than in a perfect competition? The reason is precisely because monopolists can change their price. If firms in perfectly competitive markets could raise their price, they would as well, but they can't because they would lose all their customers. in monopolists can raise their price. And that means, imagine you're a monopolist and you're deciding, well, should I raise my price? And therefore sell less output, because if I have a higher price, people aren't going to buy as much.

But therefore, I have a higher price. There's a trade-off there. The higher the price that I charge, I get more revenue for each unit I sell, but I also sell less. Remember, monopolists can decide their price, but once they've decided the price, they can't decide how much they sell. that's determined by the demand curve, how much consumers want to buy. Monopolis can't force people to buy their product. They can decide what price is, but they can't force people to buy it. So, Monopolis still don't have complete control.

They only can control price. They can't control price and quantity. If they could, Monopolis would charge a really high price and choose a really high quantity. That would get them the maximum profits possible, but they can't do that. They can't choose both. They choose one or the other. Generally, we just look at them choosing the price, and then demand is quantity that they sell is to determine by the demand curve.

how much people want to buy at that price. So when the firm is, the monopolist is picking their price, they have to decide, they have to work out this trade-off. Should they sell less goods at a higher price, or should they sell more goods at a lower price? So they have to balance out the extra revenue they get from selling more goods versus the revenue they lose from lowering the price, or vice versa if they're thinking about raising the price.

Now, we don't know exactly sort of what that trade-off will be, because it depends on the elasticity of demand and the cost structure and all sorts of things. but as economists, we can say that it will always be higher than the marginal cost. The price will always be set higher than it will at the perfectly competitive market. Why? Because, and this is the key point, in a perfectly competitive market, firms don't have this trade-off decision to make. In a perfectly competitive market, firms don't lose any money when they sell more. When a firm in a perfectly competitive market decides to sell more output, they don't have to lower the price. In fact, they can't lower the price because the price is already as low as it can get.

It's already at the market level. they just sell as much or as little as they like. There's no trade-off there. It's just always more sold means that much more profit for the firm. But in a monopoly, it's not the case. They have to trade off the extra revenue from selling more versus the reduction in price that they have to do in order to get for people to buy the extra goods that they're selling. So this trade-off only exists for monopolists. It does not exist in a perfectly competitive market precisely because perfectly competitive firms can't change their price. It's already at the minimum impossible level. And so all they have to decide is how much to sell at that level of the price.

Monopolis has this extra decision to make, where they trade off price versus quantity. And as a result of that, this extra trade-off, they're always going to choose to produce at least somewhat less, and often a lot less, than a perfectly competitive, than will happen in a perfectly competitive market. So what we say about a monopoly is that they will always produce strictly less, maybe a little bit less, maybe a lot less, but always at least somewhat less than would occur in an equivalently sized perfectly competitive industry. So, you know, obviously a single firm in a perfectly competitive industry is going to produce less a monopoly because it's only one firm among many.

But imagine you add up the production level of all of the firms in a perfectly competitive industry, and then you take the production level of a monopoly and compare them. The monopolist will always be producing at least a little bit, and maybe a lot, less than the total in the perfectly competitive market, because the monopolist is restricting production so that they can charge a higher price and therefore earn larger profits. The perfectly competitive firms don't have this option, and so they can't do that, and so they just all sell as much as they can up until, so that price equals marginal cost. Monopolis doesn't do that, and so for them, price is greater than marginal cost, which means that the monopolist is being inefficient. They're not producing as much as they should. Society's not getting as much benefit from that production as they could, because when benefits maximise, costs should be equal to marginal cost and marginal benefits should be equal.

In other words, price should equal marginal cost. So that is why monopolists are inefficient in the economic. sense. It's not because they're more greedy or they have less incentive or something like that. Those might be true to some extent, but for the most part, or at least at a first order analysis, it's simply because the market situation differs for monopolists and therefore they have this extra trade-off of price versus quantity that perfectly competitive firms don't have. Thus, they decide to charge a higher price and sell a lower quantity. And that's why consumers are worse off because they can't buy as much as they would like to and would be willing to at a

favorable price. Remember, monopolists can only be maintained if they're a barriers to entry, because otherwise firms will come in and offer a lower price than the incumbent monopolist, and consumers will, of course, buy from them because, well, they prefer a lower price, and so the monopolist would go out of business. They can only maintain their privileged position because of the barriers to entry. So basically, it's a good job if you can get it being a monopolist, because you get above average profits. In the rural world, though, it does turn out that monopolies can last for quite a while. The South African example of the diamonds, I mean, that lasted for decades, but it doesn't last forever. No monopoly lasts forever, and many of them

don't last for very long at all, a few years maybe if you're lucky. Now I want to move on from monopolies and talk about oligoplies and cartels. So what's an oligopoly? Well, oligopoly, the prefix means, I think, several or a few. So oligopoly just means a market with a few sellers. It's more than one, but less than a lot. So it could be two or three or maybe a dozen at most, but generally you're thinking an oligopoly is, you know, three or four, something like that. An oligopoly works fairly similarly to a monopoly, they still have, so oligopoly firms have market power, that is they can choose their price, so that's similar to monopolies. However, they do face some competition because there are other firms in the market,

just not as many as in the case of perfect competition. Oligopolis tend to have, firms in an oligopoly, have some market power, but not as much market power as a monopoly does. Monopoly can charge whatever price it likes. oligopolis can't. They can change their price to some degree, but they're still constrained by what other firms in that market are doing. Also, there must be barriers to entry in an oligopoly as well, because, again, otherwise new firms would enter and bid down the level of profits that are being made by the incumbent firms. So in both monopolies and oligoplies, you must have barriest entry. Now, you might be asking if there are barriers to entry, then how come there are three firms,

but not like five or ten? You know, why would there be a few firms, but not more? various reasons for that. One could be regulatory. Maybe there are only a few firms that have the political influence to get the licensing or whatever else to be able to operate. That certainly happens. Another possibility is that these were just like the first three that entered the market

and they got really big, really fast, and therefore they're able to maintain their position by economies of scale or network externalities. Maybe it was just like first in best rest. This is a classic example of this, which I don't know if it's true, but the example people give all the time is VHS versus Betamax, which

of both obsolete now, but for perhaps younger audiences may not even know what I'm talking about, VHS was an old video recording technology where you had a tape that wound around and you put it in the VCR and it played back a movie or whatever. No longer phased down in favor of DVDs about 10 years ago,

but Betamax was a similar format, worked a bit different to VHS, but more or less similar. In the late 70s, early 80s, when these were first coming around, since then, people argued that Betamax was better. It was a better format than VHS. So why did we end up with VHS? Well, because there's a strong network externality for things like videos. When you're deciding whether to buy a VHS player versus a Betamax player, you've got to think, well, how many different movies are being released on VHS versus Betamax, and how easy is it to rent a movie on one versus the other? And so there's a strong negative externality there. And so VHS just got more sort of initial momentum, had more initial users, and so more people went for that over Betamax.

And so Betamax died out, even though it was the better format. That's the story. I don't know if that's true. But if it is or not, it illustrates. the point that early entrants can sometimes have a big advantage in the market. And that's why maybe you'd have only one early entry, but perhaps you'd have a few which gain a sort of dominating share, and then they can prevent other firms from entering. So that's another situation where you can have an oligopoly with a few firms, but barriers preventing any more firms from entering. Anyway, for whatever the reason, an oligopoly exists when you have a few large firms

dominating an industry. Now, so in most senses, oligoplies function quite similarly to monopolies. You know, as I said, firms have market power. they raise their price above marginal cost. By cutting production, consumers are worse off because they could be getting more, they could be consuming more than the firms are allowing them to because the firms are restricting production. Firms are making above average profits, but they're able to do that because of barriers to entry. All those things from monopolies still apply.

It's just to a lesser extent, because now there's not just one firm, there's a few. So firms have less market power. So the price of monopolies tends to be higher than an oligopoly, which in turn tends to be higher than imperfect competition. So it's sort of like a hierarchical thing. Oligopolis are bad for consumers generally, but monopolies are even worse. And oligoplies, there's also degrees of oligoplies. If you have a duopoly, that means two sellers, that's worse than if you had four sellers in an oligopoly, for example. In general, generally speaking, the more competitors there are, the less market power any given firm has.

If you're competing against six other firms, well, that's still an oligopoly, but you're going to have a lot less market power than you feel competing only against one other firm, for example, or if you're competing against no one. However, there's one other very important aspect of monopolies that needs to be mentioned, and this is the idea of strategic interaction. Now, strategic or interdependence, strategic interaction refers to the fact that in an oligopoly, each firm's optimal decision is affected by what every other firm is doing, which in turn is affected by what you're doing. So, in other words, this is a classic case of, well, when I'm deciding, for example, what price to charge as an oligopoly? I've got to think, well, what price is the other guy going to charge? again, I don't have to think about this in a perfectly competitive market, because everyone just sells at the market price. I don't have to think about this in a monopoly either, because I'm the only one around.

But in an oligopoly, I do have to think about this. When I'm setting my price or deciding on other factors, like when to sell or whatever, or quality of good, all sorts of things. I have to think about, well, what's the other guy going to do? And then when I think about what he's going to do, I have to think, well, what he's going to do depends on what he thinks I'm going to do. and then, but what I'm going to do depends on what he's thinking, that I'm thinking that he's thinking that I'm going to do, and so on. And so you sort of get around in this loop. I think I may mention this before on one or more episodes. The study of this sort of strategic interdependence of behaviour is referred to as game theory. Study of how people behave when their decisions

depend upon other people's decisions which depend, which in turn depend on your decisions. Now, we're not going to go through the game theoretic models of oligopolis, because there's more than one of them, they're several, because they're kind of complicated, but they make different predictions about the outcome of oligopoly markets. One such model, the Kourneau model, for those who are interested that spelled C-O-U-R-N-O-T, Kourneau-O-Logopoly, if you want to look that up, that predicts essentially what I was saying before, that an oligopoly will be basically like a monopoly, except there'll be a bit more production and somewhat lower prices, because it's sort of like a less extreme version of a monopoly. But there's another form of a, of a, a, you know, a

an oligopoly model called the Bertrand, B-E-R-T-R-A-N-D, if anyone's interested, Bertrand model of oligopoly, which predicts a completely different outcome. This predicts, in fact, that even with only two firms in a market, you would get the perfectly competitive outcome. That is, the price-judicial cost, and the firms would be producing the efficient level of output. The reason that you get these different outcomes is because the two different models make different assumptions about how firms compete with each other and how they sort of treat this interdependency.

In one model, they compete on quantity, and the other one they compete on price. Again, I won't go into the details of that because it's not too important. I just want to emphasize that when we're modeling situations like this, particularly game theoretic situations, the outcome that we predict often very much is sensitive to the assumptions we make about how, about the behavior of the firms in the markets. And so which one is correct? Well, we have to go and look at the real world and see what happens.

And in fact, we do observe behavior consistent with both of these predictions, both the KORNO and the Bertrand prediction, in different models, in different markets at different time. so it depends on the particular situation. In general, I would say the Kono model is a better approximation. That is, remember, that the oligopoly is a less extreme version of the monopoly. But it certainly can be the case that you can have a very high level of competition, and even essentially efficient, perfectly competitive market prices and levels of output,

even if there are only a couple or a small number of firms in a market. A good example of this case might be if you have price wars between two large, say, supermarkets or other businesses. If they're competing really intensely against each other to have low prices and to attract more consumers, then that's basically what the Bertrand model predicts. And you could have a very efficient outcome then if that happens. There's another thing that I need to talk about in regards to oligoplies, and this is the concept of cartels.

Now, previously when I've been talking about strategic interaction, we've been assuming that the firms are competing against each other, which is generally the case. If one firm sells at a lower price, that means they're going to bid away customers from the other firm. And so they're competing against each other. they're each trying to outdo the other. However, there's another possible outcome for oligopolis, which is the formation of a cartel. A cartel is an agreement between competing firms to act together, to cooperate.

Generally, it takes the form of the producers or the manufacturers meeting together to agree to fixed prices and maybe fixed levels of production and possibly some other common marketing or other quality controls and things like that. In fact, often what cartel, because cartels are illegal precisely because, The purpose of cartilization is so that the firms can get together and agree to restrict production. That is, everyone sells less, and therefore everyone makes higher profits. So that's bad for consumers, and so therefore cartels are generally illegal. And so one way that the cartels try and get around is to sort of disguise what they're doing as, oh, well, this is quality control.

We're all getting together to agree on stands for quality or something like that. In fact, to take a particularly controversial example, professional organizations like medical medical practitioners or of teachers unions or other things like this are at least can be considered to be cartels because they serve to restrict entry into these professions by keeping out people who, or bar associations for lawyers be another example by keeping out people who, well potential entrance basically

and therefore keeping prices and wages higher for these industries in the guise of quality control. Now, whether it is really quality control, maybe it is. That's not really the point that I want to make. The simple point is that by restricting entry, you are cartelizing the industry. Whether that is justified as quality control or not is another question. But cartels are very hard to maintain. Cartels usually fail. They can last for a long time. There's records of cartels lasting for over a century or more, but generally they only last a few years, if at all. And the reason is because every member has an incentive to cheat. Because remember, the way cartels work is everyone agrees. will all produce less so that together we can earn higher profits. And that's true. If everyone can restrict their production, then they can get closer to the monopoly level of output, and therefore every firm makes individually higher profits.

It's sort of like all of the firms are sort of combining together to form one big monopoly, and therefore they're going to restrict their output to the monopolist level of output. The monopolist level of output represents the most profit that can possibly be made in that industry, given the demand curve and production costs and all that sort of stuff. Whereas the perfectly competitive outcome represents the least possible level of profit, which is zero.

Oligopolis will earn somewhere in between, but if they can sort of come together and agree to all restrict production up to the monopoly level, then they can all earn higher profits. You can sort of think of as like match fixing in sports. Each team wants to win, but if your team can win with less effort,

then that's even better. So if the two teams got together beforehand and agreed, well, we'll draw, let's say, or we'll let you win one and we'll win one or whatever. And so we get the same outcome, but we both put in less effort and therefore both better off. That's an imperfect example, but that's kind of like what's happening with cartels. But then each team goes away and what's the incentive?

The incentive is to cheat. The incentive is to say, well, the other guys aren't going to be trying as hard now. So if we try hard, we'll win in both games or we'll win instead of drawing or whatever, depending on what the agreement is. In the case of cartels, they go back home and think, well, everyone else has agreed to cut back their production. So if I now increase my production, I'm going to get all of the business that they used to be taking, and therefore I'm going to make even more profits than if I agree to the cartel. So this is why cartels are really hard to maintain,

because the overwhelming incentive is to cheat, to produce more output, to lower your price, so as to get even more profits. And therefore, if one person starts cheating and everyone starts cheating, because they're like, well, I want to get my share, and then the cartel collapses. This is pretty much exactly what happened with OPEC,

which is the Organization of Petroleum Exporting Countries. It's basically an oil cartel. In the 1970s, they had a great success in, restricting the level of output of oil, therefore dramatically increasing its price. But over the course of the 1980s, as basically the countries all started cheating, they all started producing more and more oil, and squabbling amongst themselves about how much each of them would get to produce. And so, therefore, the price of oil went way down. And you had the what's called the oil glut at the 1980s. And this is related to another point. It's very difficult for

cartel members to agree on quotas for how much each of them is allowed to produce. If all of the firms are exactly the same size, well, then they just agree to split it evenly between them. But that's very seldom the case. Take OPEC as a good example of this. Clearly, Saudi Arabia is not going to agree to produce the same amount of oil as Kuwait, for example, or I don't know, other countries that have much less oil. So some agreement has to be made as to, well, how much do I get to sell versus you? And, you know, they, in OPEC, they have production quotas that are related to the total reserves that each country has. And so the more reserves you have, the more output you're allowed to produce. But if you look at the official statistics of the proven

reserves, what you see is that there are these sudden jumps of like 50% or 100% or, you know, 30% in a given year for no reason at all. And then it stays concert for a few years and then all of a sudden next year it goes up by a huge amount. Sometimes these are because of new discoveries, but in many cases you can't correlate these increases in reserves with any new discovery. So you're like, what happens here? What's going on? Well, we don't really know because the information is not completely made public, but it's suspected that a lot of this is basically cheating, that the countries are just falsifying the amount of reserves they have, or, you know, subtly redefining things or whatever, so that they can get larger reserves than they had before

and therefore produce more output. So this is just a way of cheating, of cartel members cheating, and therefore everyone produces more output, and you get closer to the competitive equilibrium than to the monopolistic equilibrium. Now, I describe this as cheating, and it is from the perspective of the cartel, but for consumers' perspective, this is a really good thing, because when the cartel members cheat, it means they produce more and sell it a lower price. So consumers love it when cartels cheat because it means they're better off. In order to be able to successfully maintain a cartel, you have to have, the firms have to develop some way of detecting cheaters and punishing them in some way. So generally, you have to keep the market relatively small.

You have to have a fairly closely knit group of people, often where the actual managers of the companies know each other personally and sort of friendly with each other. So this is the sort of thing that happened, you know, the late 19th, 30th, 20th century with the Robert Barron's and so on, the sort of really close personal relationships that overlap into the professional sphere. So it's easier to maintain cartels in those circumstances. As companies get bigger and relationships become more distant, it's increasingly difficult to maintain a cartels like that, and they tend to collapse. So, that's all for oligopolis, now we'll look briefly at monopolistic competition. Monopolistic competition is a bit of an interesting one.

Monopolisically competitive industries have no barriers to entry. So that means long-run profits must be driven to zero. Remember, if you don't have any barriers to entry, then firms will just keep entering the market until all the profits have been bit away and you're down to earning your average baseline level of profit. However, unlike perfectly competitive firms, monopolistically competitive firms do have some market power.

So that means they can raise their price. So what's going on there? How can you have market power without having any barriers to entry? Because that's where the market power comes from for oligoplies and for monopolies. It's just from barriers to entry. There's no other reason. In monopolistically competitive firms, though, they get market power from somewhere else.

It's not from Barrier's entry. It's from what's called product differentiation. So this is the essential characteristic of monopolistic competition, and it's what differentiates it from either perfect competition or from oligopolis. Because monopolistic competition, you can have a few firms, or you can have lots of firms. It's not the number that matters. It's just whether there's product differentiation or not. What is product differentiation?

Well, product differentiation occurs when products produced by different firms have real or perceived non-price differences. So if two goods cost a different, you know, have a different price, that's not product differentiation, that's just a different price. But if they differ in any other way, packaging, quality, anything like that, brand name, or even if they're just perceived to differ, even if there is no real difference, if people just perceive as being different because it has a different label on it, then that's a non-price difference and that's referred to as product differentiation. Now remember, for monopolies, for perfectly competitive firms, and for oligopoly, competitive firms, we always assumed that the products were homogenous. They were always the same.

All of the firms sold exactly the same thing. In monopolistically competitive markets, that's no longer the case. Monopolyistically competitive firms sell slightly different goods, and that's where the product differentiation comes in. Obviously, the goods have to be similar, because otherwise they're not competing against each other at all. If it's cars and toasters, those aren't different, that's not product differentiation, that's just different products. But if it's, say, or Burger King versus McDonald's, or Coke versus Pepsi, or Mac versus PC, these are instances of product differentiation, where the products are very similar to have essentially the same purpose, and maybe are indistinguishable on the blind taste tests, as I believe Coke and Pepsi are.

But that doesn't matter. They are perceived to be different by consumers, and therefore people don't treat them as being exactly the same. And that means that you can, as a firm who produces any one of them, you can raise your price a bit above equilibrium levels. So if Coke and Pepsi were perceived by everyone to be exactly the same good, then no one would pay even a cent more for Coke over Pepsi. The prices would have to be the same. But in the real world, they're not the same.

And in fact, the price of Coke and Pepsi are higher than you would pay for a generic cola. Why is that? Well, the reason is because Coke and Pepsi can afford to raise the price above the level of the generic cola because their goods are perceived to be different, specifically perceived to be better. Obviously, if they're perceived to be worse, you wouldn't be able to raise it. price. In fact, if you're perceived to be worse, you'd have to lower the price. But the crucial point is that product differentiation, which makes your good an imperfect substitute for other goods, it's not exactly the same. It might be very similar, but it's not a perfect substitute for the other

good. That allows you to charge an above equilibrium, above perfectly competitive equilibrium price for your product. And therefore, you restrict production and raise price in the same way as an oligopolis or a monopolist does in order to increase your profits. However, remember, we just said that in the long run, monopolistically competitive firms can't earn above average profits. They have to earn zero economic profits. So, sort of why do firms bother? Well, they bother because in the short run, you can earn economic profits in a monopolistically competitive market.

Indeed, you can earn above average profits even in perfectly competitive markets, although it's probably a lot harder to do so. So does that mean that Coke and Pepsi don't earn above average profits? They're just sort of earning the same as the generic coaler produces, even if they might be selling in a higher price? Well, probably not, because there's an element of oligopoly there as well. In the real world, it's often very difficult to distinguish exactly what counts as an oligopoly

and what counts as a monopolistic competition, because they're very similar. There are many comparable attributes. And so how you look at the market will often depend upon what the purpose of your analysis is and what assumptions you make and so on. So in the real world, it's messy. But at least in the idealized realm of theory,

we can say that monopolistically competitive firms will earn zero economic performance, profits in the long run because there are no barriers to entry. So firms can just keep entering and therefore pulling down the price. Monopoly competitive firms can still restrict output and increase prices that they sell their good for because they have a degree of market power owing to product differentiation. Product differentiation and this ability to increase prices explains a great number of otherwise inexplicable behaviors of firms.

Like, for example, advertisements that don't say anything about the quality of the product or anything that they just, I mean, literally are advertising the brand, just making you aware of it, that type of advertisement would be almost impossible to understand, unless it were for the fact that brand name is worth a lot to these companies, precisely because their brand name is what differentiates their products from another firm. So the more conscious people are of their brand name, and therefore the more they're willing to pay for their goods, obviously you have to have a positive association with the brand name, not a negative one, but the more conscious people, just people are, and more positive associations you have with the brand name, the more your product

becomes differentiated from everyone else's, and therefore the high the price you can charge for it. And at least on the short run, the more profits you can earn. Maybe on the long run, there'll be new entrants. But then if you can further differentiate your product or do something else, you can maybe keep earning above average profits. So you're just sort of pushing off the long run situation where eventually competitors will come in. So this is what explains, in my view, at least, and I think in the view of many economists, the dynamism of free markets. It's not sitting around in equilibrium, everyone producing in perfectly competitive markets, that is what makes free markets work so well. It's this constant drive towards always trying to, every firm

try to have an advantage over their competitors by having a better good or a cheaper method of production or a better marketing campaign or whatever it is. Everyone is trying to differentiate their product and make it better or cheaper than everyone else's, and therefore, in the short run, that allows you to earn above average profits. In the long run, new entrants will just come into the market and bid away any advantage you may have had. But then you try some other. innovation and try and make it better and try and improve further. Of course, there are problems with this. There are market failures and there are socially non-optimal ways of trying to

differentiate your product or earn above average profits, which we'll talk about in due course. But that's enough for this episode. It's already gone on a bit too long. So, that's all for this episode. Hopefully you enjoyed it. If so, I'd love it if you would jump onto iTunes and give the podcast a favorable review. Also, you can look us up on Facebook at the Science of Everything podcast and give us a

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don't like any of the ones that I've put up. And I'd really love your feedback, so please do that. ASAP because I'd like to get episode 50 out soon. Thanks again for listening and I'll talk to you next time.