Imperfect competition exists in markets that are not perfectly competitive—that is, markets in which some buyer(s) or seller(s) have market power. That market power may derive from a limited number of buyers or sellers or from differentiation between each firm’s products. Although almost every one of the world’s markets falls into this category, we often study the simpler case of perfect competition first, then study monopoly, and follow those benchmarks with more detailed models of imperfect competition.
Perfect competition—that is, identical products sold to many buyers and available from many sellers who may easily enter and exit—may be one of the most unrealistic of market assumptions. Because there are many buyers and sellers, no single market participant can have a significant effect on the market price. As a result both buyers and sellers take the market price as fixed and use it to determine their levels of consumption and production. The market for wheat is an example of perfect competition. There are many buyers, many sellers, and little differentiation among each farmer’s product. Although the theory of perfect competition appears unrealistic, many of its results are similar under other market structures. As Milton Friedman (1953) emphasizes, the usefulness of a theory lies not in its realism but in its ability to predict outcomes. Perfect competition does this well, and we should judge models of imperfect competition not on their realism but on their ability to make useful predictions and provide improved insights into the functioning of markets.
Monopoly falls under the category of limited competition because it assumes that a single producer sells a product with no close substitutes to many buyers and benefits from barriers to entry by other firms. It is the simplest model of limited competition and lies at the opposite end of the spectrum from perfect competition. An example of monopoly in the early twenty-first century is Microsoft Corporation’s operating system Windows (U.S. v. Microsoft, Civil Action No. 98–1232 ). When a seller has market power, the price may remain higher than a competitive market would otherwise.
As in perfect competition, there are few markets that actually satisfy our assumptions, but this simple model of monopoly allows us to understand the basic features of market power. But even in the case of Microsoft, market share does not reach 100 percent.
The market power held by a monopolist can be measured in several ways. The Lerner Index (Lerner 1934) considers the price markup over marginal cost as a fraction of price: (P – MC )/P. It can be shown that this also equals the inverse of the own-price elasticity of demand (technically, its absolute value). Thus the more willing buyers are to do without the monopolist’s product, the smaller the monopolist’s profit-maximizing markup. Measuring marginal cost is difficult in practice (Fisher 1987) because economic cost (rather than accounting cost) is required. Typically neither policymakers nor the courts have good measures of the firm’s true costs; if any measure is available, it is usually average cost rather than marginal cost. Elasticity is easier to measure than marginal cost. In antitrust proceedings, both the own-price elasticity (the reaction of a product’s demand to changes in its own price) and various cross-price elasticities (the reaction of one product’s demand to changes in other products’ prices) are estimated to determine the extent of an alleged monopolist’s market power. The legal definition of monopoly is 80 percent market share of the relevant market, where the markets are often defined using estimates of cross-price elasticities. It is important to note that monopolies are not illegal under U.S. law, but any firm found to have monopoly power is subject to more stringent laws concerning potential abuse of that firm’s market power.
Monopsony is also a model of limited competition that lies at the opposite end of the spectrum from perfect competition; its simplicity is that a single buyer purchases from many sellers. For example, the steel mill in a town without other steel employers can be modeled as a monopsony, and so can the National Football League. In this case, the buyer has market power and may keep the price lower than a competitive market would otherwise. In our two examples, the “price” that is depressed due to market power is workers’ salaries.
One economic cost to monopoly and monopsony (and to market power in general) is due to “allocative inefficiency,” an outcome where marginal benefit (the marginal buyer’s willingness to pay) is not equal to marginal cost (the marginal seller’s willingness to sell). In the case of monopoly, this is because marginal cost is greater than the price charged, whereas in the case of monopsony, marginal benefit is less than the price paid. In both cases, market power causes too few goods to be traded—fewer goods, that is, than would be allocated by a competitive market.
If the number of buyers or sellers is small, they may “collude” to limit competition. This is referred to as a buyer or seller “cartel.” Such behavior is illegal in the United States, but cartels such as the Organization of Petroleum Exporting Countries may operate internationally. Because the largest reward that any single seller or group of sellers can receive from participation in a market is the monopoly profit, we can consider a producers’ cartel to be acting to maximize the members’ joint profits. It is likely that any cartel will have difficulty policing its members’ behavior. Each individual firm has an incentive to deviate from the seller cartel-maximizing price (by selling at a slightly lower price) or quantity (by selling slightly more quantity). A buyer cartel likewise has the incentive to deviate by offering a slightly higher price and buying more quantity than the buyer cartel’s joint-maximizing price and quantity.
With these simpler models described, we now consider firms with market power acting noncooperatively. As mentioned above, product differentiation is one reason market power may arise. This is the model of “monopolistic competition” (Robinson 1934; Chamberlin 1933) or “differentiated products” (Hotelling 1929; Salop 1979; Eaton and Lipsey 1989). Here, as in perfect competition, there are no barriers to entry, and as a result firms receive zero economic profits in the long run. Yet because differentiated products face a downward-sloping demand curve, price is still above marginal cost, and the market is not allocatively efficient. This does not tell us the entire story, however; we cannot ask firms to charge a lower price, as we might imagine asking the monopolist to do. The monopolistically competitive firms expect zero economic profits in the long run already. Instead, we focus on the incentive for firms to enter the market, to find products that differ in some aspect from existing products. This behavior results in “excessive product differentiation” and “excess capacity.” Production costs are higher than they might otherwise be. Due to the many different products produced, firms do not minimize their average costs as perfectly competitive firms would. Just as many “realistic” markets are made up of many firms with differentiated products, this prediction of the models rings true as well. Do we really need so many different kinds of shoes, bicycles, and mystery novels to choose from? Of course in these cases it is also difficult to justify regulation that would lead to an improved outcome. One case in which we may observe market participants’ bargaining to improve the outcome is in the health care industry. For example, Preferred Provider Organizations limit patients’ choices in return for lower fees and physicians’ lower average costs (Arizona v. Maricopa County Medical Society 457 U.S. 332, 334 ; Lynk 1988).
Market power may not only arise from differentiated products; it may also be due to the existence of only a few sellers in the market (oligopoly) or only a few buyers (oligopsony). Oligopolies’ market power can be measured by an average of the firms’ Lerner indices as well as through the firms’ market shares. An industry’s n-firm “concentration ratio” (CRn) is the market share held by the largest n firms. The Department of Justice and the Federal Trade Commission typically use the 4-firm concentration ratio, although in the early twenty-first century cellular phone market 2-firm concentration ratios are reported (because CR4 is often 100 percent), and in other markets the antitrust authorities may report 8-firm concentration ratios. Alternatively market power can be measured by the Herfindahl-Hirschman Index (HHI), which equals the sum of the squared market shares of all firms in the industry. Thus the HHI can vary from a limiting value of zero under perfect competition to (100)2 = 10,000 under monopoly. Most cross-country industry studies measure similar variation for the HHI and CR4.
The study of oligopoly and oligopsony requires the mathematics of game theory because each firm takes into account its rivals’ reactions to and anticipation of its own actions. Such behavior can lead to strategic decisions that are intended solely to constrain the choices of current and potential rivals. For example, an incumbent firm may choose to increase its productive capacity to deter other firms’ future entry (Dixit 1979).
Market power can also explain the level of trade between nations (Helpman and Krugman 1985; Helpman 1988; Baldwin 1992). Two examples illustrate the effect of both sources of market power—product differentiation and few domestic producers—on international trade. Under perfect competition, it is hard to justify why two countries would trade the same product—wheat or potatoes, for example. Each country should focus on the good in which it has a comparative advantage. But when consumers value variety, as in the case of differentiated products such as computers or cars, then two countries can produce more varieties of the good than one country can. Rather than limiting consumers’ choices to the varieties their own country produces, a wider market—an international market—can exist for both countries’ varieties. Market power can even explain the prevalence of cross-border trade with identical products produced in each country if each firm has monopoly power (or equivalently, a cartel) in its domestic market. In this case, each country’s monopolist has an incentive to compete with the other country’s monopolist, as long as transportation costs are not too high, precisely because domestic prices are above marginal cost. Although consumers in both countries benefit because of the effect this international competition has on prices, the fact that both firms incur transportation costs to export from their home country means that the outcome is less efficient than if each firm had just increased its own domestic production.
SEE ALSO Competition; Competition, Managed; Competition, Marxist; Competition, Monopolistic; Competition, Perfect; Consumer Surplus; Discrimination, Price; Game Theory; Monopoly; Monopsony; Producer Surplus; Robinson, Joan
Baldwin, Robert E. 1992. Are Economists’ Traditional Trade Policy Views Still Valid? Journal of Economic Literature 30 (2): 804–829.
Chamberlin, Edward. 1933. The Theory of Monopolistic Competition. Cambridge, MA: Harvard University Press.
Dixit, Avinash. 1979. A Model of Duopoly Suggesting a Theory of Entry Barriers. Bell Journal of Economics 10 (1): 20–32.
Eaton, B. Curtis, and Richard G. Lipsey. 1989. Product Differentiation. In The Handbook of Industrial Organization, ed. Richard Schmalensee and Robert Willig, 723–768. Amsterdam: North-Holland.
Fisher, Franklin M. 1987. On the Misuse of the Profit-Sales Ratio to Infer Monopoly Power. Rand Journal of Economics 18 (Autumn): 384–396.
Friedman, Milton. 1953. The Methodology of Positive Economics. In Essays in Positive Economics, 3–43. Chicago: University of Chicago Press.
Helpman, Elhanan. 1988. Imperfect Competition and International Trade: Evidence from Fourteen Countries. In International Competitiveness, ed. A. Michael Spence and Heather Hazard, 197–220. Cambridge, MA: Ballinger.
Helpman, Elhanan, and Paul Krugman. 1985. Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition, and the International Economy. Cambridge, MA: MIT Press.
Hotelling, Harold. 1929. Stability in Competition. Economic Journal 39 (153): 41–57.
Lerner, Abba P. 1934. The Concept of Monopoly and the Measurement of Monopoly Power. Review of Economic Studies 1 (June): 157–175.
Lynk, William J. 1988. Physician Price Fixing under the Sherman Act: An Indirect Test of the Maricopa Issues. Journal of Health Economics 7 (2): 95–109.
Robinson, Joan. 1934. What Is Perfect Competition? Quarterly Journal of Economics 49 (1): 104–120.
Salop, Steven C. 1979. Monopolistic Competition with Outside Goods. Bell Journal of Economics 10 (1): 141–156.
Christopher S. Ruebeck
Economists have a spectrum of models with which to analyze how competing firms interact. The simplest of these involve situations in which firms can choose quantities and other variables (product quality, and advertising), without having to consider the reaction their choices might generate from other firms. Obviously, when there is a single firm in a market (a monopolist), this occurs by definition, as there are no other firms to do the reacting. However, it is also the key assumption underlying perfect competition, where firms are assumed to take prevailing prices as given. Specifically, firms believe that if they charge a higher price than the market price, they will lose all of their customers. The problem with perfect competition is that, in reality, competing firms have some discretion over the price, and they can therefore raise them without losing all of their sales. In this situation, however, firms might be “small,” and so it might be reasonable to presume that they can be modeled independently of other firms’ potential reactions.
Monopolistic competition is the term given to this “middle ground.” An industry is defined as monopolistically competitive if: (a) there are many producers and consumers in the industry; (b) consumers have preferences that may cause them to favor one specific firm over another; and (c) there are no barriers to entry or exit. Conditions a and c are also features of perfect competition, so the critical distinction comes from condition b, whereby the products sold by firms are not homogeneous (i.e., perfectly substitutable) in the eyes of consumers. Consumers may favor one firm over another because of location, branding issues, knowledge of quality, advertising and marketing appeal, or individual product characteristics.
In many respects, the outcomes from monopolistic competition are similar to those from perfect competition. First, in long-term equilibrium with identical firms, profits are dissipated by competition, and entry occurs at the point where the marginal firm is earning enough to cover fixed or sunk-market entry costs. Second, prices reflect average production costs. However, because the firms have some pricing discretion, they will charge a mark-up over their marginal costs (even in the long-run) and conceptually will be able to recover fixed costs associated with, say, product development. This also means that, compared with perfect competition, prices will be higher and quantity lower in monopolistic competition, leading to a debate as to whether this sacrifice is made up for by product variety.
It is this latter implication that has perhaps proved most significant in giving monopolistic competition greater prominence in economic analysis. Monopolistic competition was independently developed by Edward Chamberlin and Joan Robinson in the early 1930s. Each was motivated by a problem with perfect competition identified by Piero Sraffa, who noted in 1926 that if firms had fixed production costs and falling average costs (i.e., economies of scale), then perfect competition imposed no limit to firm size. This could not be reconciled with the reality of smaller firms even where economies of scale appeared to be present. Chamberlin and Robinson saw the reconciliation of this problem in the notion that competing firms might have downward sloping individual demand curves. Chamberlin assigned this trend to the existence of product differentiation, while Robinson found that it came about because of an imperfect adjustment response from other firms (today termed “residual demand”). This meant that individual firms would be limited in their ability to realize scale economies because of entry by others who could pick up some consumers by supplying a differentiated product.
The marrying of economies of scale and competitive pressures led to important developments in other areas of economics. In 1977, Avinash Dixit and Joseph Stiglitz developed a tractable model of monopolistic competition that allowed for a convenient analysis of product variety (and showed that too few products would be produced relative to the social optimum). This model formed the basis for new trade theory (Krugman 1979), new growth theory (Romer 1987), and new economic geography (Krugman 1991), each of which required a model that enabled firms to have economies of scale, yet also be limited by competitive pressure.
SEE ALSO Competition; Competition, Imperfect; Discrimination, Price; Monopoly; Price Setting and Price Taking; Robinson, Joan
Chamberlin, Edward H. 1933. The Theory of Monopolistic Competition. Cambridge, MA: Harvard University Press.
Dixit, Avinash K., and Joseph E. Stiglitz. 1977. Monopolistic Competition and Optimal Product Diversity. American Economic Review 67 (3): 297–308.
Hotelling, H. 1929. Stability in Competition. Economic Journal 39: 41–57.
Krugman, Paul R. 1979. Increasing Returns, Monopolistic Competition, and International Trade. Journal of International Economics. 9 (4): 469–479.
Krugman, Paul R. 1991. Increasing Returns and Economic Geography. Journal of Political Economy 99 (3): 483–499.
Robinson, Joan. 1933. The Economics of Imperfect Competition. London: Macmillan.
Romer, Paul M. 1987. Growth Based on Increasing Returns Due to Specialization. American Economic Review 77 (2): 56–62.
Sraffa, Piero. 1926. The Law of Returns under Competitive Conditions. Economic Journal 36 (144): 535–560.