market structure the numberof fms in the market. the ease with wien firms can enter And eave the market, andthe abiltyof fms to Gfrentate thet products ftom those oftheir vals 8.1 Perfect Competition 221 ‘One of the major questions a trucking or other firm faces is “How much should we produce?” To pick a level of output that maximizes its profit, a firm must consider its cost function and how much it can sell at a given price. ‘The amount the firm thinks i ean sell depends in turn on the market demand of consumers and its beliefs about how other firms in the market will behave. The behavior of firms depends on the market structure: the number of firms in the market, the ease with which firms can enter and leave the market, and the ability of firms to differentiate their products from those of their rivals. In this chapter, we look at a competitive market structure, one in which many firms produce identical products and firms can easily enter and exit the market. Because each firm produces a small share of the total market output and its output is identical to that of other firms, each firm is a price taker that cannot raise its price above the market price. If it were to try to do so, this firm would be unable to sell any of its output because consumers would buy the good at a lower price from the other firms in the market. The market price summarizes all a firm needs to know about the demand of consumers and the behavior of its rivals. Thus, a competitive fiem can ignore the specific behavior of individual rivals in deciding how much to produce? In this chapter, we examine four main topics 8.1 1. Perfect Competition. A competiive frm is a price taker, and as such, it faces a horizontal demand curve. 2. Profit Maximization. To maximize profit, any fm must make two decisions: how much to produce and whether to produce at all 3. Competition in the Short Run. Variable costs determine a profit maximizing, competitive firm's supply curve and market supply curve, and with the market demand curve, the ‘competitive equilbrium in the short run, 4. Competition in the Leng Run. Firm supply, market supply, and competitive equitrium are diferent inthe long run than in the short run because firms can vary inputs that were fixed inthe shor run, Perfect Competition Competition is a common market structure that has very desirable properties, 0 itis useful to compare other market structures to competition. In this section, we describe the properties of competitive firms and markets. Price Taking When most people talk about “competitive firms,” they mean firms that are rivals for the same customers. By this interpretation, any market with more than one firm is competitive. However, to an economist, only some of these multifiem markets are competitive. Economists say that a market is competitive if each firm in the market is a price taker: a firm that cannot significantly affect the market price for its output oF the prices at which it buys inputs. Why would a competitive firm be a price taker? 2p contrast, each oligopolistc frm must consider the behavior ofeach ofits small numberof rivals, as we diseuss in Chapter 1.222 CHAPTER 8 Competitive Firms and Markets Because it has no choice. The firm has to be a price taker if it faces a demand curve that is horizontal at the market price. Ifthe demand curve is horizontal at the market price, the firm can sell as much as it wants at that price, so it has no incentive to lower its price. Similarly, the firm cannot increase the price at which it sels by restricting its output because it faces an infinitely clastic demand (see Chapter 3}: A small increase in price results in its demand falling to zero. Why the Firm’s Demand Curve Is Horizontal Perfectly competitive markets have five characteristics that force firms to be price takers: 4. The market consists of many small buyers and sellers. 2. All firms produce identical products. 3. All market participants have full information about price and product characteristics 4. Transaction costs are negligible. 5. Firms can easily enter and exit the market. Large Number of Buyers and Sellers If the sellers in a market are small and numerous, no single firm can raise or lower the market price. The more firms in a market, the less any one firm’s output affects the market output and hence the market price, For example, the 107,000 U.S. soybean farmers are price takers. If a typi- cal grower were to drop out of the market, market supply would fall by only 1/107,000 = 0.00093%, so the market price would not be noticeably affected. Each soybean farm can sell as much output as it can produce at the prevailing market equilibrium price, so each farm faces a demand curve that is a horizontal line at the market price, Similarly, perfect competition requires that buyers be price takers as well. For example, if firms sell to only a single buyer—such as producers of weapons that are allowed to sell to only the government—then the buyer can set the price and the market is not perfectly competitive. Identical Products Firms in a perfectly competitive market sell identical or homo- geneous products. Consumers do not ask which farm grew a Granny Smith apple because they view all Granny Smith apples as essentially identical. If the products of all firms are identical, itis difficult for a single firm to raise its price above the going price charged by other firms. In contrast, in the automobile market—which is not perfectly competitive—the characteristics of a BMW 5 Series and a Honda Civie differ substantially. These products are differentiated or heterogeneous. Competition from Civics would not be very effective in preventing BMW from raising its price. Full Information If buyers know that different firms are producing identical prod- ucts and they know the prices charged by all firms, no single firm can unilaterally raise its price above the market equilibrium price. If it tried to do so, consumers would buy the identical product from another firm. However, if consumers are unaware that products are identical or they don’t know the prices charged by other firms, a single firm may be able to raise its price and still make sales. Negligible Transaction Costs Perfectly competitive markets have very low trans- action costs. Buyers and sellers do not have to spend much time and money finding8.1 Perfect Competition 223 each other or hiring lawyers to write contracts to execute a trade.? If transaction costs are low, itis easy for a customer to buy from a rival firm if the customer's usual supplier raises its price. In contrast, if transaction costs are high, customers might absorb a price increase from a traditional supplier. For example, because some consumers prefer to buy milk at a local convenience store rather than travel several miles to a supermarket, the convenience store ean charge slightly more than the supermarket without losing all its customers. In some perfectly competitive markets, many buyers and sellers are brought together in a single room, so transaction costs are virtually zero. For example, trans- action costs are very low at FloraHolland’s daily flower auctions in the Nether- lands, which attract 7,000 suppliers and 4,500 buyers from around the world. It has 125,000 auction transactions every day, with 12 billion cut flowers and 1.3 billion plants trading in a year. Free Entry and Exit The ability of firms to enter and exit a market freely leads to a large number of firms in a market and promotes price taking. Suppose a firm can raise its price and increase its profit. If other firms are not able to enter the market, the firm will not be a price taker. However, i other firms can quickly and easily enter the market, the higher profit encourages entry by new firms until the price is driven back to the original level. Free exit is also important: If firms can freely enter a market but cannot exit easily if prices decline, they are reluctant to enter the market in response to a possibly temporary profit opportunity.* Perfect Competition in the Chicago Mercantile Exchange The Chicago Mercan- tile Exchange, where buyers and sellers can trade wheat and other commodities, has the various characteristics of perfect competition including thousands of buyers and sellers who are price takers. Anyone can be a buyer or a seller. Indeed, a trader might buy wheat in the morning and sell it in the afternoon. They trade virtually identical products, Buyers and sellers have full information about products and prices, which are posted for everyone to see. Market participants waste no time finding someone who wants to trade and they can easily place buy or sell orders in person, over the telephone, or electronically without paperwork, so transaction costs are negligible. Finally, buyers and sellers can easily enter this market and trade wheat. These char- acteristics lead to an abundance of buyers and sellers and to price-taking behavior by these market participants. Deviations from Perfect Competition Many markets possess some but not al the characteristics of perfect competition, but they are still highly competitive so that buyers and sellers are, for all practical pur- poses, price takers. For example, a government may limit entry into a market, but if the market has many buyers and sellers, they may still be price takers. Many cities use zoning laws to limit che number of certain types of stores or motels, yet these cities still have a large number of these firms. Other cities impose moderately large transac tion costs on entrants by requiring them to buy licenses, post bonds, and deal with SAverage mumber of hours per week that an American and a Chinese person, respectively, spend shopping: 4, 10—Harper’s Indes, 2008, ‘For example, many governments requite that firms give workers six months’ warning before they exit a market or pay them a severance fee224 CHAPTERS Competitive Firms and Markets residual demand cur the markot demand that Is ot met by otter sellers at ‘any given price a slow moving city bureaucracy, yet a significant number of firms enter the market. Similarly, even if only some customers have full information, that may be sufficient to prevent firms from deviating significantly from price taking. For example, tourists do not know the prices at various stores, but locals do and use their knowledge to prevent one store from charging unusually high prices. Economists use the terms competition and competitive more restrictively than do others. To an economist, a competitive firm is a price taker. In contrast, when most people talk about competitive firms, they mean that firms are rivals for che same customers. Even in a market with only a few firms, the firms compete for the same customers so they are competitive in this broader sense. From now on, we will use the terms competition and competitive to refer to all markets in which no buyer or seller can significantly affect the market price—they are price takers—even if the market is not perfectly competitive. Derivation of a Competitive Firm’s Demand Curve Are the demand curves faced by individual competitive firms actually flat? To answer this question, we use a modified supply-and-demand diagram to derive the demand curve for an individual firm. ‘An individual firm faces a residual demand curve: the market demand that is not met by other sellers at any given price. The firm’s residual demand function, D’(p), shows the quantity demanded from the firm at price p. A firm sells only to people who have not already purchased the good from another seller. We can determine how much demand is left for a particular firm at each possible price using the market demand curve and the supply curve for all other firms in the market. The quantity the market demands is a function of the price: Q = Dip). ‘The supply curve of the other firms is S°(p). The residual demand function equals the market demand func- tion, Dip}, minus the supply function of all other firms: Dip) = Dip) — Sep). (8.1) At prices so high that the amount supplied by other firms, S°(p}, is greater than the quantity demanded by the market, Dp), the residual quantity demanded, D’(p), is In Figure 8.1 we derive the residual demand for a Canadian manufacturing firm that produces metal chairs. Panel b shows the market demand curve, D, and the supply of all but one manufacturing firm, $°.5 At p = $66 per chair, the supply of other firms, 500 units {where one unit is 1,000 metal chairs) per year, exactly equals the market demand (panel b), so the residual quantity demanded of the remaining firm {panel a) is zero, ‘At prices below $66, the other chair manufacturers are not willing to supply as much as the market demands. At p = $63, for example, the market demand is 527 units, but other firms want to supply only 434 units, As a result, the resid- ual quantity demanded from the individual firm at p = $63 is 93 (= 527 — 434) units. Thus, the residual demand curve at any given price is the horizontal difference between the market demand curve and the supply curve of the other firms. 5 The figure uses constant elasticity demand and supply curves. The elasticity of supply, = 3.1, is based on the estimated cost function from Robidou and Lester (1988) for Canadian office furni- ture manufacturers, [estimate thatthe elasticity of demand is © = —1.1 using data from Statistics Canada, Office Furniture Manufacturers.8.1 Perfect Competition 225 Figure 8.1. Residual Demand Curve ‘The residual demand curve, I7(p}, that single office fur-_S*ip). The residual demand curve is much flatter chan the pituce manufacturing fiem faces is the market demand, market demand curve Dip}, mious the supply of the other firms in the market, () Fim 100 pS per meta cha (0) Market 1p, 8'per metal chair ae ° “434500 527 49, Thousand metal Thousand metal chairs per year ‘chars per year ‘The residual demand curve the firm faces in panel a is much flatter than the market demand curve in panel b. As a result, the elasticity of the residual demand curve is much higher than the market elasticity If the market has m identical firms, the elasticity of demand, €,, facing Firm iis gS ne — (nny (8.2) where € is the market clasticity of demand (a negative number), is the elasticity of supply of each of the other firms (typically a positive number), and m — 1 is the number of other firms (see Appendix 8A for the derivation} ‘As Equation 8.2 shows, a firm’s residual demand curve is more clastic the more firms, n, are in the market, the more elastic the market demand, e, and the larger the elasticity of supply of the other firms, n,. The residual demand elasticity, ,, must be at least as clastic as ne if the supply curve slopes up so that the second term makes the estimate more elastic. Thus, using ne as an approximation is conservative. For example, even though the estimated market elasticity of demand for soybeans is very inelastic at about € = ~0.2, because n = 107,000, the residual demand facing a single soybean farm must be at least nt = 107,000 X (—0.2) = =21,400, which is extremely elastic, Solved Problem 8.1 ‘The Canadian metal chair manufacturing market has m ~ 78 firms. The estimated clasticity of supply is 1 = 3.1, and the estimated elasticity of demand is € = —1.1. Assuming that the firms are identical, calculate the elasticity of demand facing a single firm. Is its residual demand curve highly elastic?226 CHAPTER 8 Competitive Firms and Markets 8.2 Answer 1. Use Equation 8.2 and the estimated elasticities to calculate the residual demand elasticity facing a firm. Substituting the elasticities into Equation 8.2, we find that ej = ne — (n— 1, [78 x (-1.1)] = (77 x 3.1) 85.8 — 238.7 = ~3245. ‘That is,a typical firm faces a residual demand elasticity of ~324.5. 2. Discuss whether this elasticity is high, The estimated e; is nearly 300 times the marker elasticity of —1.1. If a firm raises its price by one-tenth of a percent, the quantity it can sell falls by nearly one-third. Therefore, the competitive model assumption that this firm faces a horizontal demand curve with an infinite price elasticity is not much of an exaggeration. Why We Study Perfect Competition Perfectly competitive markets are important for two reasons. First, many markets can be reasonably described as competitive. Many agricultural and other commod- ity markets, stock exchanges, retail and wholesale, building construction, and other types of markets have many or all of the properties of a perfectly competitive market, ‘The competitive supply-and-demand model works well enough in these markets that it accurately predicts the effects of changes in taxes, costs, incomes, and other factors on market equilibrium. Second, a perfectly competitive market has many desirable properties (see Chapter 9}. Economists use the perfectly competitive model as the ideal against which real-world markets are compared. Throughout the rest of this book, we consider that society as a whole is worse off if the properties of the perfectly competitive market fail to hold, From this point on, for brevity, we use the phrase competitive market to mean a perfectly competitive market unless we explicitly note an imperfection. Profit Maximization “Too caustic?” To hell with the cost. If it’s a good picture, we'll make it Samuel Goldwyn Economists usually assume that all firms—not just competitive firms—want to maximize their profits. One reason is that many businesspeople say that their objective is to maximize profits. A second reason is that a firm—especially a competitive firm— that does not maximize profit is likely to lose money and be driven out of business. In this section, we examine how any type of firm—not just a competitive firm— maximizes its profit. We then examine how a competitive firm in particular maxi- mizes profit. Profit A firms profit, x, is the difference between a firm’s revenues, R, and its cost, C: n= R-C. If profit is negative, < 0, the firm makes a loss.I I Monopoly Monopoly: one parrot. Challenge Brand-Name and Generic Drugs 344 A firm that cteates a new drug may receive a patent that gives it the right to be the monopoly or sole producer of the drug for up to 20 years. As a result, the firm can charge a price much greater than its marginal cost of production. For example, one of the world’s best-selling drugs, the heart medication Plavix, sold for about $7 per pill though ie costs about 3¢ per pill to produce. Prices for drugs used to treat rare diseases are often very high. Soliris, a drug used to treat a rare blood disorder, costs cover $400,000 per year. Recently, firms have increased their prices substantially for specialty drugs in response to perceived changes in willingness to pay by con- sumers and their insurance companies. Once, H(P. Acthar Gel, an anti-inflammatory, was used to treat relatively common ailments such as gout and sold for $50 a vial. Now it is a crucial anti- seizure drug, which is used to treat children with a rare and severe form of epilepsy. In 2007, its price increased from $1,600 to $23,000 per vial. ‘The price reached $28,000 by 2013. Steve Cartt, an executive at the drug's manufacturer, Quest- cor, said that this price increase was based on a review of the prices of other specialty drugs and estimates of how much of the price insurers and employers would be willing to bear. Two courses of Acthar treatment for a severely ill 3-year-old ail, Reegan Schwartz, cost her father’s health plan about $226,000. Acthar earned $126 million in revenue in the first quarter of 2013, In 2013, 107 US. drug patents expired, including major products such as Cym balta and OxyContin. When a patent for a highly profitable drug expires, many firms enter the market and sell generic (equivalent) versions of the brand-name drug.! Generis account for nearly 70% of all U.S. prescriptions and half of Canadian prescriptions. Under the 1984 Hatch-Waxman Act, the U.S. government allows a firm to sella generic product after a brand-name drug's patent expires ifthe generic drug firm can prove that is product delivers the same amount of active ingredient or drug ro the body inthe same way asthe brand-name prodict. Sometimes the same firm manufactures both a brand name drug and an identical generic drug, so the ‘wo have identical ingredients. Generics produced by other firms usually differ in appearance and name {rom the origina produet and may have diferent nonactive ingeedients but the same active ingredients‘monopoly the ony supplier of good that has no close substitute CHAPTER 11 Monopoly 345 ‘The U.S. Congress, when it originally passed a law permitting generic drugs to quickly enter a market after a patent expires, expected that patent expiration would subsequently lead to sharp declines in drug prices. If consumers view the generic product and the brand-name product as perfect substitutes, both goods will sell for the same price, and entry by many firms will drive the price down to the competitive level. Even if consumers view the goods as imperfect substitutes, one might expect the price of the brand-name drug to fall. ‘However, the prices of many brand-name drugs have increased after their patents expired and generics entered the market. The generic drugs are relatively inexpensive, but the brand-name drugs often continue to enjoy a significant market share and sell for high prices. Regan (2008), who studied the effects of generic entry on post-patent price competition for 18 prescription drugs, found an average 2% increase in brand- name prices. Studies based on older data have found up to a 7% average increase. ‘Why do some brand-name prices rise after the entry of generic drugs? A monopoly is the only supplier of a good that has no close substitute, Monopolies have been common since ancient times. Inthe fifth century 8.c., the Greek philosopher Thales gained control of most of the olive presses during a year of exceptionally pro- ductive harvests. Similarly, the ancient Egyptian pharaohs controlled the sale of food. In England, until Parliament limited the practice in 1624, kings granted monopoly rights called royal charters or patents to court favorites. Today, nearly every country grants a patent—an exclusive right to sell that lasts for a limited period of time—to an Inventor of a new product, process, substance, or design. Until 1999, the U.S. govern- ‘ment gave one company the right to be the sole registrar of Internet domain names. When first introduced, Apple's iPod had a virtual monopoly in the hard-disk, music player market, and Apple's iPad had a near monopoly in the tablet market. ‘A monopoly can set its price—it is not a price taker like a competitive firm. A monopoly’s output is the market output, and the demand curve a monopoly faces is the market demand curve, Because the market demand curve is downward slop- ing, the monopoly (unlike a competitive firm} doesn’t lose all its sales if it raises its price. Asa consequence, the monopoly sets its price above marginal cost to maximize its profit. Consumers buy less at this high monopoly price than they would at the competitive price, which equals marginal cost. In this chapter, we. topies 1. Monopoly Profit Maximization. Like al fms, a monopoly maximizes its profit by setting its price of output so that its marginal revenue equals its marginal cost. 2. Market Power. How much the monopoly's price is above its marginal cost depends on the shape ofthe demand cure it faces. 3, Market Failure Due to Monopoly Pricing. By seting its price above marginal cost, ‘a monopoly creates a deadweight loss. 4. Causes of Monopoly. Two important causes of monopoly are cost factors and ‘government actions that restict entry, such as patonts. 5. Government Actions That Reduce Market Power. The weilare loss of a monopoly can bbe reduced or eliminated ifthe government regulates the price the monopoly charges or allows othor firms to enter the market. 6. Networks, Dynamics, and Behavioral Economies. I! iis curent sales affect a monopo- Iys future demand curve, a monopoly that maximizes its long-run profit may choose not to maximize its short-run protOligopoly and Monopolistic Competition Three can keep a secret, if two of them are dead. —Benjamin Franklin Challenge Government Aircraft Subsidies cligopoly a small gtoup of firs in 8 market with substantial bamiers to ony 424 Aircraft manufacturers lobby their governments for subsidies, which they use to bet- ter compete with rival firms. Airbus SAS, based in Europe, and the Boeing Co., based in the United States, are the only two major manufacturers of large commercial jet aircraft. France, Germany, Spain, and the United Kingdom subsidize Airbus, which competes in the wide-body aircraft market with Boeing. The U.S. government decries the European subsidies to Airbus despite giving lucrative military contracts to Boeing, which the Europeans view as implicit subsidies. This government largess does not magically appear. Managers at both Boeing and Airbus lobby strenuously for this support. For example, in 2012, Bocing spent $15.64 million on lobbying and was represented by 115 lobbyists, including 2 former congressmen. ‘Washington and the European Union have repeatedly charged each other before the World Trade Organization (WTO) with improperly subsidizing their respective air- craft manufacturers, In 2010, the WTO ruled that Airbus received improper subsidies for its A380 superjumbo jet and several other aircraft, hurting Bocing, as the United States charged in 2005. In 2012, the WTO ruled that Boe- ing and Airbus both received improper subsidies. Yet the cycle of subsidies, charges, agreements, and new subsidies continues. .. If only one government subsidizes its firm, how does the firm use the subsidy to gain a competitive advantage? ‘What happens if both governments subsidize their firms? Should Boeing and Airbus lobby for government subsidies that result in a subsidy war? The major airlines within a country compete with relatively few other firms. Conse- quently, each firm’s profit depends on the actions it and its rivals take. Similarly, three firms—Nintendo, Microsoft, and Sony—dominate the video game market, and each fiem’s profit depends on how its price stacks up to those of its rivals and whether its product has better features. The airline and video game markets are each an oligopoly: a market with only a few firms and with substantial barriers to entry. Because relatively few firms compete in such a market, each can influence the price, and hence each affects rival firms The need to consider the behavior of rival firms makes an oligopolistic firm’s profit- maximization decision more difficult than that of a monopoly or a competitive firm.cartel 2 group of fms that explictly agree to coordinate thelr activites monopol competition ‘market structure in whieh fiems have market power butno aaditonal frm can ‘ntor and eam postive profits CHAPTER 13 Oligopoly and Monopolistic Competition 425 A monopoly has no rivals, and a competitive firm ignores the behavior of individual rivals—it considers only the market price and its own costs in choosing its profit- maximizing output. An oligopolistic firm that ignores or inaccurately predicts its rivals’ behavior is likely to suffer a loss of profit. For example, as its rivals produce more cars, the price Ford can get for its cars falls. If Ford underestimates how many cars its rivals will produce, Ford may produce too many automobiles and lose money. Oligopolistic firms may act independently or may coordinate their actions. A group of firms that explicitly agree (collude) to coordinate their activities is called a cartel. These firms may agree on how much each firm will sell or on a common price. By cooperating and behaving like a monopoly, the members of a cartel collectively earn the monopoly profit—the maximum possible profit. In most developed countries, cartels are generally illegal If oligopolistic firms do not collude, they earn lower profits. However, because oligopolies consist of relatively few firms, oligopolistic firms that act independently may earn positive economic profits in the long run, unlike competitive firms. In an oligopolistic market, one or more barriers to entry keep the number of firms smal. In a market with no barriers to entry, firms enter the market until profits are driven to zero. In perfectly competitive markers, enough entry occurs that firms face a horizon- tal demand curve and are price takers. However, in other markets, even after entry has driven profits to zero, each firm faces a downward-sloping demand curve. Because of this slope, the firm can charge a price above its marginal cost, creating a market failure ddue to inefficient (too little) consumption (Chapter 9). Monopolistic competition is a market structure in which firms have market power (the ability to raise price profitably above marginal cost) but no additional firm can enter and earn positive profits. In this chapter, we examine cartelized, oligopolistic, and monopolistically com- petitive markets in which firms set quantities or prices. As noted in Chapter 11, the monopoly equilibrium is the same whether a monopoly sets price or quantity. Simi larly, ifcolluding oligopolies sell identical products, the cartel equilibrium is the same whether they set quantity or price. The oligopolistic and monopolistically competitive equilibria differ, however, if firms set prices instead of quantities. In this chapter, we examine six main topics 1, Market Structures. The number of fms, price, profis, and other properties of markets vary, depending on whether the market is monopolistic, oigopolistie, menopalisticaly compettive, or competitive. 2, Cartels, I firms cuecesstuly coordinate ther actions, they can collectively behave like @ monopoly. 3, Cournot Oligopoly. In a Coumateligapaly, fms choose thelr output levels without colliding and the market output, price, and firms’ profits le between the competitive and monopoly level. 4, Stackelberg Oligopoly. In a Stackelberg oligopoly. in which a leader fim chooses its output lovel before is identical-cos rivals, market output is groator than if all fms choose their output simultaneously, and the leacer makes a higher profit than the other firms. 5, Bertrand Oligopoly. In a Bertrand oligopoly in which fms choose prices, the equilibrium differs from the quantity-setting equllbrium and depends on the degree of product aiferertiation, 6, Monopolistic Competition. When firms can freely enter the market but, in equilibrium, face downward-sloping demand curves, fms charge prices above marginal cost but make no proft.426 CHAPTER 13 Oligopoly and Monopolistic Competition 13.1 Market Structures Markets differ according to the number of firms in the market, the ease with which firms may enter and leave the market, and the ability of firms in a market to differ- entiate their products from those of their rivals, Table 13.1 lists characteristics and properties of the four major market structures: monopoly, oligopoly, monopolistic competition, and perfect competition. In the table, we assume that the firms face many price-taking buyers. ‘The first row describes the number of firms in each market structure. A monopoly isa single (mono) firm in a market. An oligopoly usually has a small number (oligo) of firms. A monopolistically competitive market may have a few or many firms, though typically few. A perfectly competitive market has many firms. ‘The reason why a monopoly and an oligopoly have few firms is because the markets have insurmountable barriers, such as government licenses or patents, that restrict entry (row 2). In contrast, in monopolistically and perfectly competitive mar- kets, entry occurs until no new firm can profitably enter, so that long-run economic profit is zero (row 3). Monopolistic and oligopolistic firms can earn positive long-ran profits Perfectly competitive firms face horizontal demand curves so they are price tak- ers. Monopolistically competitive markets have fewer firms than perfectly competi- tive markets do. Because they have relatively few rivals they are large relative to the market, so each monopolistically competitive firm faces a downward-sloping demand curve as do monopolistic and oligopolistic firms. Thus, noncompetitive firms are price setters (row 4). That is, all but perfectly competitive firms have some degree of market power—the ability to set price above marginal cost—so a market failure occurs in each of these noncompetitive market structures because the price is above marginal cost. Typically, the fewer the firms in a market, the higher is the price (row 5) Oligopolistic and monopolistically competitive firms pay attention to rival firms’ behavior, in contrast to monopolistic or perfectly competitive firms {row 6}. A monopoly has no rivals. A perfectly competitive firm ignores the behavior of Table 13.1 Properties of Monopoly, Oligopoly, Monopolistic Competition, and Perfect Competition ‘Monopolisic Perfect Monopoly Oligopoly Competition Competition 41, Number of firms 1 Few Few or many Many 2. Entry conditions No entry Limited entry Free entry Free entry 3. Long-run profit =o 0 0 ° 4. Ability to set price Price setter Price setter Price steer Price taker 5. Price level Very high High High Low 6, Strategy dependent on individual No (has no Yes Yes [No (cares about rival firms’ behavior rivals) market price only) 7. Products Single product May be May be Undifferentiated differentiated differentiated 8. Example Local natural gas Automobile Plumbersin a Apple farmers utility ‘manufacturers small town13.2 13.2 Cartels 427 individual rivals in choosing its output because the market price tells the firm every thing it needs to know about its competitors. Oligopolistic and monopolistically competitive firms may produce differentiated products (row 7). For example, oligopolistic ear manufacturers produce automobiles that differ in size, weight, and various other dimensions. In contrast, perfectly com: petitive apple farmers sell undifferentiated (homogeneous) products. Cartels People of the same trade seldom meet together, even for merriment and diver- sion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices. —Adam Smith, 1776 Oligopolistic firms have an incentive to form cartels in which they collude in setting prices or quantities so as to increase their profits. The Organization of Petroleum Exporting Countries (OPEC) is a well-known example of an international cartel; however, many cartels operate within a single country Typically, each member of a cartel agrees to produce less output chan it would if i acted independently. As a result, the market price rises and the firms earn higher profits. Ifthe firms reduce market output to the monopoly level, they achieve the highest possible collective profit. Luckily for consumers, cartels often fail because of government policies that forbid cartels or because members of the cartel “cheat” on the agreement. Each member has an incentive to cheat because it can raise its profie if it increases its output while other cartel members stick to the agreement. Why Cartels Form A cartel forms if members of the cartel believe that they can raise their profits by coor dinating their actions. But if a firm maximizes its profit when acting independently, why should joining a cartel increase its profit? The answer involves a subtle argument, ‘When a firm acts independently, it considers how increasing its output affects its own profit only. The firm does not care that when it increases its output, it lowers the profits of other firms. A cartel, in contrast, takes into account how changes in any one firm’s output affect the profits of all members of the cartel. Therefore, the aggregate profit ofa cartel can exceed the combined profits of the same firms acting independently. Although cartels are most common in oligopolistic markets, occasionally we see cartels formed in what would otherwise be highly competitive markets, such as in markets of professionals. Ifa competitive firm lowers its output, it raises the market price very slightly—so slightly that the firm ignores the effect not only on other firms’ profits but also on its own. If ll the identical competitive firms in an industry lower their output by this same amount, however, the market price will change noticeably. Recognizing this effect of collective action, a cartel chooses to produce a smaller market output than is produced by a competitive market, Figure 13.1 illustrates this difference between a competitive market and a cartel. This oligopolistic market has m firms, and no further entry is possible. Panel a shows the marginal and average cost curves of a typical perfectly competitive firm. If all firms are price takers, the market supply curve, S in panel b, is the horizontal sum of the individual marginal cost curves above minimum average cost. At the competitive