The Firm and Market Structures

Every firm operates in one of two revenue environments, and the difference shows up entirely in the slope of the demand curve the firm faces.

A perfectly competitive firm is a price taker. The market sets the price, and the firm can sell as much as it wants at that price but nothing at a higher one. Its demand curve is therefore horizontal (perfectly elastic) at the market price. Because every unit sells for the same price, the price per unit, the revenue per unit, and the revenue from one more unit are all identical. In other words, price equals average revenue equals marginal revenue.

Total revenue is always price times quantity. Under perfect competition the price is fixed by the market, so each extra unit sold adds exactly the price to total revenue. The total revenue curve is a straight line through the origin whose slope is the price per unit.

An imperfectly competitive firm, such as a monopolist, faces a negatively sloped demand curve. To sell one more unit it must lower the price, and the lower price applies to every unit sold, not just the extra one. As a result marginal revenue is less than price.

Here price is a function of quantity, so total revenue is that price function multiplied by quantity. Picture the monopolist lowering price step by step down a linear demand curve. At first the gain from selling more units outweighs the loss from the lower price, so total revenue rises. This is the range where demand is elastic and marginal revenue is positive. Past a certain point the price cut dominates, total revenue falls, demand is inelastic, and marginal revenue turns negative. The monopolist’s total revenue curve therefore rises to a peak and then declines, unlike the straight line of the perfectly competitive firm.

Combining the revenue side with the firm’s short-run cost curves gives the rules for how much to produce, when the firm just covers its costs, and when it should stop producing.

The profit-maximizing rule

A firm maximizes profit at the output where marginal revenue equals marginal cost, provided marginal cost is rising at that point.

The rising-cost condition matters. On a typical cost diagram there can be a second, lower output where price also equals marginal cost, but marginal cost is still falling there. That point is not a profit maximum. For a perfectly competitive firm the rule reduces to producing where price equals rising short-run marginal cost, because price and marginal revenue are the same. For a monopolist the rule is unchanged: find the quantity where marginal revenue equals marginal cost, then read the price the firm can charge for that quantity off its demand curve. The monopolist’s price sits above marginal revenue, and barriers to entry let any positive economic profit persist. In perfect competition, by contrast, positive economic profit in the short run attracts entrants, who expand output and push the market price down toward each firm’s average total cost.

Breakeven and economic versus accounting profit

A firm breaks even when total revenue equals total cost, which is the same as saying price (average revenue) equals average total cost.

Economic cost is broader than accounting cost. It is the sum of accounting costs and the implicit opportunity costs of every factor of production, including capital. A firm whose revenue exactly covers its economic cost is earning what economists call normal profit: a return on capital equal to what investors could earn on an equally risky alternative. Economic profit is then zero, but accounting profit is not, because accounting cost leaves out those implicit opportunity costs.

The shutdown decision

In the long run a firm that cannot earn at least zero economic profit will exit, because it is not covering the opportunity cost of all its factors. In the short run the calculation is different, because some fixed costs are sunk: a lease payment that must be made whether or not the firm operates cannot be avoided, so it should be ignored when deciding whether to keep producing.

What matters in the short run is whether revenue covers variable cost. If price is above average variable cost, the firm covers all of its variable cost and contributes something toward fixed cost, so operating beats closing. If price falls below the minimum of average variable cost, the firm cannot even cover variable cost and should shut down, losing only its fixed cost. Between the minimum of average variable cost and the minimum of average total cost, the firm operates at a loss in the short run but would exit in the long run unless price recovers. Economists call the minimum average variable cost point the shutdown point and the minimum average total cost point the breakeven point.

The short run is the period in which at least one factor of production, such as plant size or physical capital, is fixed. The long run is the period in which all factors are variable and the firm can enter or exit. The long run is often called the planning horizon: the firm always produces in the short run but plans in the long run, choosing the plant size that will minimize cost. How long the long run lasts depends on the industry, from under a year for a small low-capital business to more than a decade for a capital-intensive one.

From plant sizes to the long-run cost curve

Each possible plant size gives its own short-run total cost curve. A larger plant has a higher fixed cost (a higher vertical intercept) but greater capacity, so its cost rises less steeply at high output. For any given level of output the firm would choose the plant size that produces it most cheaply. Joining the lowest short-run cost for every output level traces out the long-run total cost curve, known as the envelope curve because it wraps around all the short-run curves and represents every feasible combination of plant size, technology, and capital.

The same logic applied to average cost gives the long-run average total cost curve (LRAC), the envelope of all the short-run average total cost curves. The shape of the LRAC curve is where economies and diseconomies of scale appear.

Economies and diseconomies of scale

Economies of scale occur when cost per unit falls as the firm increases output, which shows up as a downward-sloping stretch of the LRAC curve. Diseconomies of scale occur when cost per unit rises with output, an upward-sloping stretch. A single LRAC curve can show economies at low output, a flat range, and then diseconomies at high output. Its lowest point is the minimum efficient scale: the least-cost firm size, and the size toward which perfect competition pushes firms in the long run, because the market price settles at that level and a firm that does not operate there is not viable.

Factors that create economies of scale include: increasing returns to scale, where output grows faster than inputs; division of labor and specialization as the workforce grows; the ability to afford more efficient equipment and newer technology; less waste and better quality control, including marketable by-products; better use of market information for management decisions; and discounts from buying inputs in bulk. An electric utility illustrates the first point, since expanding capacity to serve more customers lowers its per-unit cost. Walmart illustrates the last, using bulk purchasing power and point-of-sale data to keep distribution and inventory costs low.

Factors that create diseconomies of scale include: decreasing returns to scale, where output grows slower than inputs; a firm too large to manage well; overlapping and duplicated business functions and product lines; and higher input prices when supply is constrained by very large orders. General Motors before its restructuring is the classic case. It carried overlapping, similar models whose fixed costs were spread thin, ran plants across many countries with the resulting communication and coordination problems, and faced higher labor costs than rivals as the largest producer and a natural target for unions.

Economies and diseconomies can occur together, and the net effect on the LRAC curve depends on which dominates.

Economists sort markets into four structures. Which one a firm sits in shapes its pricing power, its output choices, and how long any profit can last. In the long run a firm’s profitability is set mainly by the forces of its market structure: highly competitive markets compete profits away, while less competitive markets can hold profit even in the long run.

Five factors that determine structure

Five things decide which structure a market falls into: the number and relative size of the firms supplying the product; the degree of product differentiation; the power of the seller over pricing; the strength of the barriers to entry and exit; and the degree of non-price competition such as advertising. Barriers matter a great deal. They can come from large capital requirements (petroleum refining), patents (drug formulas and some electronics), or high exit costs (an aluminium smelting plant is specialized and hard to sell, so exit is costly, which also deters entry). Where production is easy to replicate, as in wheat or corn, barriers are low and the market is highly competitive.

Perfect competition

Many firms sell a homogeneous, standardized product. No single firm can influence the market price, so each is a price taker with no pricing power and no meaningful non-price competition. Barriers to entry are very low. This is not just a textbook ideal: several commodity markets fit it closely. Profits are driven to the normal return needed to attract capital, yet many such businesses do very well.

Monopolistic competition

Also many firms, but each differentiates its product so it appears distinct from close substitutes. That differentiation, often built through advertising and branding, gives a firm some pricing power. Barriers are low, so entry and exit are fairly easy. Brand loyalty toward soft drinks or motorcycles is the classic illustration: customers believe one brand is different from and better than the rest.

Oligopoly

A few firms dominate. Because each is large relative to the market, they are interdependent: every firm must anticipate how rivals will retaliate to a change in price or output. Products may be branded and differentiated (breakfast cereals, bottled beverages) or homogeneous (petroleum, cement). Barriers to entry are high and pricing power ranges from some to considerable. Airline route pricing is a familiar example, where a fare change by one carrier tends to draw a response from the others.

Monopoly

A single seller supplies a unique product with no good substitutes. An unconstrained monopolist has considerable power over price and output, which is why pure monopolies are usually regulated. The common example is the local electricity provider, allowed a normal return with prices set by the regulator.

Owners prefer the structures with the most control over price, since price control can mean large profit; monopoly and oligopoly offer the most, perfect competition the least. Consumers prefer competition, because it generally means lower prices. There is a trade-off, though: some innovation, such as costly drug research, may only be worth undertaking where a firm can expect an attractive return, which is easier under less-than-perfectly-competitive conditions. So consumers can, in some cases, benefit from markets that are not perfectly competitive.

Monopolistic competition is a hybrid: strong competitive forces sit alongside a monopoly-like element, and the distinctive feature is product differentiation. The market has many buyers and sellers, each seller’s product is a close substitute for the others yet made to look different, entry and exit cost little, firms have some pricing power, and differentiation is pursued through advertising and other non-price strategies.

The more successful a firm is at differentiation, the more its position resembles a single-seller market and the more pricing power it gains. But because entry and exit are cheap, competition drives prices and profit down over the long run toward an outcome that resembles perfect competition. The market therefore shows traits of both perfect competition and monopoly.

Demand and the profit-maximizing choice

Because each firm’s product is somewhat different, its demand curve slopes downward: raising price lowers quantity demanded, lowering price raises it, and there are price ranges where demand is elastic and lower ranges where it is inelastic. In the short run the firm produces where marginal revenue equals marginal cost, then charges the price its demand curve allows for that quantity.

At that output, total revenue is price times quantity and total cost is average cost times quantity. The gap between them is economic profit.

No well-defined supply curve

Unlike perfect competition, monopolistic competition has no well-defined supply function. Output is decided from where marginal cost meets marginal revenue, but the price comes from the demand curve, so neither marginal cost nor average cost alone tells you the quantity the firm will supply at each price.

Long-run equilibrium

Economic profit is a signal. Because total cost includes all costs including opportunity cost, positive economic profit attracts new entrants. With low entry costs, entrants lure away customers, demand for each existing firm falls, and economic profit is competed down to zero. At that point output still satisfies marginal revenue equal to marginal cost, and price equals average cost, so total revenue equals total cost.

Two features separate this long-run outcome from perfect competition. First, the equilibrium output sits at a level where average cost has not yet reached its minimum: the firm produces less than the output that would minimize average cost, so it operates with some spare efficiency it never uses. Second, economic cost here includes real spending on differentiation, such as advertising, which does not exist under perfect competition where products are identical. The result is a bit more cost and a bit less output than perfect competition, in exchange for variety.

An oligopoly is a market dominated by a few firms whose decisions are interdependent: each must anticipate how rivals will react to a change in price or output. Products may be branded and differentiated (breakfast cereals, bottled beverages) or homogeneous (petroleum, cement). Entry is difficult and barriers are high, firms usually have substantial pricing power, and because a few firms can earn substantial profit, collusion is tempting. The best-known colluding group is the OPEC oil cartel.

There are three standard ways to analyse oligopoly pricing: pricing interdependence (the kinked demand curve), the Cournot assumption, and the Nash equilibrium.

The kinked demand curve

In markets prone to price wars, the common assumption is that rivals will match a price cut but ignore a price increase. So if the firm raises its price, rivals hold theirs and it loses many customers: demand is elastic above the current price. If it cuts price, rivals match and it gains few customers: demand is inelastic below the current price. The two segments meet at the prevailing price, producing a demand curve with a kink.

The kink leaves a gap in marginal revenue. As long as marginal cost passes somewhere through that gap, the profit-maximizing price and output do not move, so marginal cost can shift over a range without changing the price. This helps explain why oligopoly prices are often stable. The weakness of the model is that it does not explain how the prevailing price was set in the first place, so it is treated as an incomplete theory.

The Cournot assumption

Developed by Augustin Cournot in 1838, this approach has each firm choose its profit-maximizing output while assuming its rival keeps output unchanged. In equilibrium neither firm wants to change output given the other’s, so price and output are stable.

The Nash equilibrium

Named after John Nash, a Nash equilibrium is reached when no firm can raise its own profit by changing strategy alone, given what its rivals do. Firms act non-cooperatively, each doing the best it can given the others.

Collusion and cartels

An open, formal collusive agreement is a cartel. Collusion is unlawful in most countries but attractive because it can raise profit, steady cash flows, and build entry barriers. Six conditions make successful collusion more likely:

1. Number and size of sellers: easier with few firms or one dominant firm; harder as the number grows or shares are similar.
2. Similarity of products: homogeneous products collude more easily.
3. Cost structure: similar costs across firms help.
4. Order size and frequency: frequent, regular, small orders reduce the reward for cheating.
5. Strength of retaliation: a credible, severe threat discourages breaking the agreement.
6. External competition: high profits attract outsiders. In 2016, extraction cost was roughly 9 dollars a barrel in Saudi Arabia, about 23.50 in US shale, and about 27 in Canadian tar sands, so low-cost gulf producers collude more readily, but prices held too low keep higher-cost sources from developing.

Price leadership and the long run

Decisions need not be simultaneous. In the Stackelberg model they are sequential: the leader sets output first and the follower reacts, and the first mover earns more than under Cournot while the follower earns less. Like a monopolistic competitor, an oligopolist has no well-defined supply function: output comes from marginal revenue equal to marginal cost, and price from the demand curve.

Where one firm holds roughly 40 percent or more of the market it can act as price leader, behaving like a monopoly in its segment while smaller firms follow. Followers do not undercut, because the leader is usually the low-cost producer and a price war would threaten them. The leader picks the output where its own marginal revenue meets its marginal cost, charges the price its demand segment supports, and the followers supply the rest of total demand. Over the long run, economic profit is possible but the leader’s share tends to erode as profit draws in entrants: US Steel controlled 66 percent of its market when formed in 1901, 46 percent by 1920, and 42 percent by 1925. Price wars are best avoided, since share gains are temporary; innovation is a costlier but more durable way to hold leadership.

Because market power can be inefficient, since firms with power restrict output to raise prices, many countries use competition law (also called antitrust law) to regulate it. Measuring market power in practice is hard, so analysts and regulators lean on simpler tools. A few historical cases give the flavour: Archer Daniels Midland was prosecuted in the 1990s for fixing the price of lysine and settled for more than 100 million US dollars; US authorities broke up the AT&T local telephone monopoly in the 1970s; and the European Commission has acted against European and non-European firms, including a vitamin price-fixing case and the blocking of the General Electric and Honeywell merger on concentration grounds. An analyst who hears of a proposed merger should always consider whether competition law might block it.

Econometric approaches

In theory, market power is measured by estimating the elasticity of demand and supply: very elastic demand implies a market close to perfect competition, while inelastic demand suggests possible market power. In practice this meets the endogeneity problem: observed price and quantity are joint outcomes of supply and demand, so a two-equation model is needed to separate them. Regression needs many observations, a long time series may straddle structural change, and cross-sectional data is costly to gather and sensitive to how the variables are specified.

The concentration ratio

The concentration ratio adds the market shares of the largest N firms, giving a figure from 0 (perfect competition) to 100 percent (monopoly).

It is easy to compute but has two weaknesses. It does not directly measure market power: a sole incumbent facing low entry barriers may still price competitively, like a lone sugar wholesaler wary of a potential entrant. And it barely moves when two large incumbents merge.

The Herfindahl-Hirschman index

The HHI squares each of the top N firms’ shares, written as decimals, and adds them. A monopoly gives 1, and M equal-sized firms give one divided by M, so an HHI of 0.20 is like five equal firms.

The HHI reacts to mergers among leaders where the concentration ratio does not, which is why regulators prefer it. But like the concentration ratio it ignores the possibility of entry and the elasticity of demand, so it too has limited use for judging profitability.