Market Structure

We cover Market Structure in two parts, Part I in Week 5 (read Ch. 8 and 9) and Part II in Week 6 (read Ch. 10 and 11).

Recall that Chapter 7 introduced Market Structure as “The Spectrum of Competition”

Spectrum of Competition

In analyzing market structure, economists use tools like the Concentration Ratio, typically for 4, 5, and 8 firms, and the Herfindahl-Hirschman Index (HHI). Data is also collected and reported by the Federal Trade Commission and the Department of Justice (Antitrust Division). In recent years, regulators typically get involved only in the case of mergers, and especially when a firm in a given industry complains about actual or potential antitrust violations. (A recent antitrust case was when the Staples merger with Office Depot was blocked.)

Perfect Competition exists when there are so many firms that none of them has the market power to affect prices. This situation was much more common 250 years ago when Adam Smith was working on his Wealth of Nations. The pin factory he discussed in Chapter 1 had just 10 workers, and the largest textile factories in Scotland in 1776 might have had at most a few dozen workers. (In comparison, Amoskeag textile mills in Manchester NH had over 17,000 workers during WWI.) An eight firm concentration ratio for a perfectly competitive industry will be less than 50%.

Monopolistic Competition (MC) is characterized by a large number of smaller firms. Back when The Yellow Pages was the standard way of looking for companies, it was easy to find an MC sector, since they usually placed ads in The Yellow Pages. (So restaurants, clothing stores, mechanics, plumbers, roofers, and so on.) In the US, according to the last census, 60% of business have fewer than 5 employees, and it is likely that most of these are MC. Keep in mind that “monopolistic” in this usage just means “has enough market power to influence price.” (I think it was a confusing choice of terms, but nobody asked me.)

Oligopoly can be informally described as an industry where a business can count its competitors on one hand, or perhaps, two hands. For automobile sales in the US, nine firms have market share of 3% or more (GM, Toyota, Ford, Chrysler, Nissan, Honda, Hyundai-Kia, Subaru, and VW.) The top four of these have 60% share and the top eight have 89% share. (Note that a four-firm concentration ratio of 60% is a common sign of an oligopoly.) In an oligopoly, strategic behavior is key. Because there are just a few competitors, firms can craft strategies to gain share and profitability, beating their rivals. Because of this kind of interdependence among firms, Game Theory is used to model firm behavior in oligopolies. (We examine Game Theory in the next unit.) In business strategy, oligopolies are often characterized by The Rule of Three, where these three are the Leader, the Follower, and the Also-Ran, and where this third firm struggles to capture share and achieve profitability. In the 1950s and 1960s, the US automobile industry was led by "The Big Three," GM the Leader, Ford the Follower, and Chrysler, the Also-Ran. Fast-forward to the 21st century, and Chrysler is now a subsidiary of the Italian firm Fiat, which renamed itself Fiat Chrysler Automotive Group.

Monopoly is (theoretically) when one single firm provides the entire market supply, but in practice, a firm with 80% or more market share can often be a de facto monopoly. A natural monopoly occurs when long-term economies of scale lead to ever decreasing average costs. In the US, the Bell System was a natural monopoly, because the analog technology for telecommunications made it less costly to expand and operate the network when centrally managed. But the advent of digital technology began to change the underlying cost structure, so over the last 35 years, we have seen industry splintering, then a re-consolidation. Over the next 5 to 10 years, the advent of 5G cellular service will likely cause more industry reshuffling. The point to keep in mind is that the underlying technology drives a natural monopoly, and changes in technology can also lead to industry changes. There are also government-managed monopolies, like the US Post Office, as well as the New Hampshire Liquor Commission, which operates a monopoly on the sale of hard liquor. The Post Office provides a standard of quality and serves the entire country without respect to differences in cost, and the NH liquor outlets provide funding for the state, as an alternative to general sales taxes.

Monopolies have been, and are still used, to favor this or that firm as part of a political arrangement. Adam Smith wrote against government-backed monopolies in his Wealth of Nations. To add some historical context, Smith was born in 1723, and just 45 years earlier, Great Britain had gone through the Glorious Revolution, where King James was deposed in favor of King William and Queen Mary. (Hence the name for that college in Virginia.) Prior to this establishment of the constitutional monarchy, the king of Great Britain habitually granted monopolies to favorites and members of the aristocracy, and this practice continued in other European countries. Fast forward to the present day, some developing countries face the same problem, the government gives the ruling elite control over various sectors, creating monopolies in various markets, often in transportation and trade. Which is why some (or many) economies around the world are not really free market/capitalist or socialist/marxist, but are based on leveraging the power of monopolies for a ruling elite.