MARKET STRUCTURE & IMPERFECT COMPETITION

LEARNING OBJECTIVES

After reading and studying this chapter, the reader should be able to:

1. define the different market structures such as Perfect Competition, Monopolistic Competition,
Oligopoly, and Monopoly,

2. discuss the characteristics and descriptions of each market structures

3. define Duopoly;

4. identify important developments of market structures; and

Discussion

Lessons

In this chapter we will introduce the concept of different characteristics of a market through different
market structures in an economy.

As firms maximize profits at the output level where marginal revenue is equal to marginal cost (MR=MC),
the environment where firms operate can have an influence to the behavior of firms. The environment
can have different market conditions which can affect firms in different ways. Through the years,
economists have identified characteristics of firms and categorized them into mainly four structures:
perfect competition, monopolistic completion, oligopoly, and monopoly

Perfect Competition Defined

Many firms sell the same goods or services. See that this free competition forces the firms to produce at
peak efficiency. Perfect competition, as economists wistfully point out, an ideal state of affairs, which,
unfortunately, does not exist in any industry. It is a market structure with many well-informed sellers and
buyers of an identical product and no barriers to entering or leaving the market. But why bother about it?
Perfect competition attains the ideal of always being right. It is held up as what we should strive to
approach, even if we can never hope to attain its state of grace. For these purposes, perfect competition
will be considered as an unattainable standard by which the other forms of competition monopoly,
monopolistic competition, and oligopoly will be judged. Thus, even though it does not exist, perfect
competition has its uses. Let us examine these characteristics one at a time.

Large Number of Small Firms

One of the characteristics of a perfectly competitive market is composed of many firms and buyers, that
is, a large number of independently-acting firms and buyers with each firm and buyer sufficiently small to
be unable to influence the price of product transacted in the market. How many sellers make up a large
number? And, how small is a small firm? Certainly, one, two, ten, fifteen or even one hundred firms in a
market would not be a large number. In fact, under perfect competition, the exact number cannot be
determined,

The condition mentioned earlier is fulfilled only when each firm in a market has no significant share of
total output and therefore, no ability to affect the product's price. Each firm or producer acts
independently rather than coordinating decisions collectively. For instance, there are thousands of
vegetable farmers throughout the Philippines. If any single farmer raises (lowers) the price of vegetables,
the going market price for vegetables in the market will be unaffected.

Homogeneous or Identical Product

In a perfectly competitive market, the products offered by the competing firms are identical not only in
physical attributes but also regarded as identical by buyers who have no preference between the products
of various producers. In other words, all firms produce a standardized or homogenous product. Thus, for
perfect competition to take place, all the firms in the industry must sell an identical of standardized
product. In simpler terms, those who buy the product cannot distinguish what one seller offers from what
another seller offers which, in the buyer's mind, the products are identical hence, the buyer has no reason
to prefer one seller to another.

If this is the case, therefore the rice produced by farmers in Nueva Ecija is similar to the rice produced by
farmers in Bohol. More specifically, Pedro's rice is identical with Juan's rice. This assumption rules out
rivalry among firms in advertising and quality differences.

Very Easy Entry, and Exit

There are no barriers to entry of new sellers or impediments to the exit of existing sellers that is, new
firms face no barriers to entry while existing firms can readily leave the market without difficulty. Barriers
can be in the form of financial, technical, long term contracts, or government-imposed barriers such as
licenses, patents, permits, copyrights, franchises, etc. For example, anyone who wishes to plant tomatoes
or sweet potato need only a plot of land.

Under this condition, firms are free to move wherever there is an opportunity for profits- land, labor, and
capital will move where they can secure the highest possible return. An entrepreneur will give up his or
her business and work for someone else if the wage offered is higher than the firm's profit.

However, no market fits exactly the three assumptions of perfect competition, The perfectly competitive
market structure is only a theoretical or ideal model, but some actual markets do approximate the model
fairly closely. Typical example of this type of market structure is the agriculture sector or farm products
market.

The Perfect Competitor's Demand Curve

The perfect competitor faces a horizontal, or perfectly elastic, demand curve. As we have noted
previously, a firm with a perfectly elastic demand curve has an identical MR curve. This is significant
because the firm can sell as much as it wants to sell at the market price. It is not necessary to lower price
to sell more.
The Perfect Competitor: A Price Taker, Not a Price Maker

If a group of entrepreneurs owns a store, they get to decide how much to charge your customers. But if
they happen to be a perfect competitor, they do not have that privilege; they are price takers, not price
makers. What price do they take? They take the market price.

As one might have already observed, the industry-wide supply and demand determine the market price.
If it feels that price is too low, the only thing that can be done is to close the shop and leave the industry.
Otherwise there is no choice but to charge what everyone else is charging.

Farmers, particularly rice farmers, are about as close to perfect competition. And more likely than not,
they complain about crop prices particularly during bumper harvest. If the price of palay is P3.00 per kilo,
the farmer, as the price taker, has no choice but to sell his entire output at that price. The farmer in this
case is the classic price taker.

Efficiency, Price, and Profit

Efficiency is defined as something cheap. When a firm is an efficient producer, it produces its product at
a relatively low cost. A firm operates at peak efficiency when it produces its product at the lowest possible
cost. That would be at the minimum point of its ATC curve, the break-even point.

For the perfect competitor in the long run, the most profitable output is at the minimum point of its ATC
curve. At any other output, the firm would lose money, just to stay in business; it must operate at peak
efficiency.

Perfect competition is very good for consumers; they can buy at cost, wherein price is equal to ATC.
Remember, there is no economic profit. And consumers have the firm's competitors to thank for such a
low price. Competition will keep business owners honest, that is, if there is enough competition.

Pareto Optimality and Efficiency

When the economy is perfectly competitive, the act of competing means that not everyone can have
everything he desires, as one loses out to the competition. This in effect makes one better off, when
desires are met, and somebody else has been made worse off, as one loses to the other who has gained
in the competition. This has brought some issues about efficient allocation.

The concept of Pareto optimality comes to play to settle this inefficiency. Named after Vilfredo Pareto,
an Italian economist who specialized in resource and income allocation, Pareto Optimality states that an
economy is Pareto optimal or efficient when no further changes in the economy can make one individual
better off without making someone else worse off Pareto optimality is an allocative efficiency which
occurs when the value that consumers place on goods or services equals the cost of the factor resourced
utilized in the production Points lying on the production possibility curve provides for efficient allocations.
Monopolistic Competition

Why do people shop at one drugstore rather than another? Why do people frequent particular
restaurants, beauty parlors, spas, coffee shops, and internet cafes? Do people always buy at stores that
charge the lowest prices?

Most real-world markets lie between the extremes of perfect competition and monopoly. Most firms
possess some power to set their prices as monopolies do, and they face competition from the entry of
new firms as the firms in perfect competition do. This market in which such firms operate is under
monopolistic competition.

Monopolistic Competition Defined

Monopolistic competition is a type of market structure characterized by (1) many small firms, (2)
differentiated products, and (3) easy market entry and exit. While monopolistic competition is formed by
high number of firms producing similar goods that can be seen as unique due to differentiation, this
market structure allows prices to go higher than marginal costs. This means that each producer will be
considered as a monopoly but the whole market is considered competitive because the degree of
differentiation still considers the possibility of having substitution effect. Examine each of the
characteristics that was mentioned

Monopolistically competitive market is comprised of a large number of independently-acting firms and

buyers. However, under monopolistic competition, just like perfect competition, the exact number of
firms cannot be determined. So, how many is many? So many that no firm has any significant influence
on the price. Nevertheless, monopolistic competitors do have some influence over price because their
products are differentiated. But still, it is a 'small' influence.

Therefore, 'many-sellers' condition is met when each firm is so small relative to the total market that its
pricing decisions have a negligible effect on the market price. For instance, Don Pedro owns a seafood
restaurant at the Manila Bay area. He assumes that he can set prices slightly higher or improve services
independently without fear that his competitors will react by also changing their prices or giving better
service. In such case, if any single seafood restaurant raises its prices, the going market price for seafood
dinners increases by a negligible amount

The products offered by competing firms under a monopolistically competitive market are differentiated
from each other in one or more aspects. In fact, this is the key feature of monopolistic competition.
Product differentiation is the process of creating real or apparent differences between goods and
servicessold in the market. A differentiated product has close, but not perfect, substitutes. Although the
products of cach firm are highly similar, the consumer views them as somewhat different or distinct. Some
people will pay more for one variety of the product, so when its price rises, the quantity demand
decreases. Thus although there several seafood restaurants along the Manila Bay area, they are not at all
the same. They differ in location, atmosphere, quality of food, type of menu offered, quality of service,
etc.

Product differentiation can be real or imagined. It does not matter which is true as long as consumers
believe such differences exist. In our previous example, many customers may think that Don Pedro's
seafood restaurant is the best along the Manila Bay area although there are other restaurants that offer
a similar product The importance of this viewpoint, therefore, is that consumers are willing to pay a
slightly high price for Don Pedro's seafood.

This example makes clear that under monopolistic competition rivalry centers on nonprice factors in
addition to price competition. With nonprice competition, a firm under this type of market structure
competes, using marketing strategies like advertising, packaging, product development and innovation,
better quality, and better service, rather than simply lower price. Nonprice is an important characteristic
of monopolistic competition that distinguishes it from perfect competition and monopoly.

Summing it up, product of one firm can be differentiated from that of another, in a monopolistically
competitive market. An efficient producer will use nonprice competitive methods to convince his or her
consumers to pay a higher price for the product. The most common form of nonprice competition is
advertising.

Remember that when an entrepreneur's business is under a monopolistically competitive market

structure, competitor's product is a close substitute. As such, one must maintain relatively high levels of
nonprice competition strategies to keep the customers and thus make the business vibrant.

In a monopolistically competitive market, there are no barriers to entry preventing new firms entering the
market or obstacles in the way of existing firms leaving the market. Thus, unlike a monopoly, firms in a
monopolistically competitive market face low barriers to entry. However, entry into a monopolistically
competitive market is not quite as easy as entry into a perfectly competitive market. Because
monopolistically competitive firms sell differentiated products, it is somewhat difficult for new firms to
become established. For instance, an individual can establish his own seafood restaurant along Manila
Bay since he can easily get a business permit, secure a loan, lease a property, and start serving seafood
without too much trouble. However, his restaurant may have trouble attracting customers because Don
Pedro's seafood restaurant has established a reputation of being the best seafood restaurant in the area.

In such it can be said that in a monopolistically competitive market there are barriers to entry, but these
barriers are relatively small. The number of firms operating in such a market is large, each firm has a small
market share and firms have only limited ability to influence prices.

What is more important however is that a firm in a monopolistically competitive market cannot make an
economic profit in the long run. This is because when firms make economic profits, new firms enter the
industry. Consequently, this entry lowers prices and eventually eliminates economic profits. On the other
hand, when economic losses are incurred, some firms may leave the industry. The exit of these firms
increases prices and profits and eventually eliminates the economic losses. In the long run, equilibrium
firms neither enter nor leave the industry and the firms in the industry make zero economic profit.

Many service providers advertise that their customer service" is much better than their competitors. Some
will capitalize on customer friendly relations where customers' names and preferences are considered
and given priority Some salons offer loyalty programs for customers to enjoy discount perks.

Monopolistically competitive markets can be found in a wide range of industries. One major area is in
garments retailing, and other small businesses. Many service markets are monopolistically competitive;
consider electricians, plumbers, hairdressers, and dress shops.
Arguments for Advertisements

Some of the arguments in favor of advertising are the following:

 advertising is informative;
 advertising increases sales and permits economies of scale;
 advertising increases sales and contributes to economic growth;
 advertising supports the media; and
 advertising increases competition and lowers prices.

New product advertisement is essential: think of a major artistic event that interested viewers would fail
to see because it has not been announced widely enough. But, most of the advertisement (on television
for instance) is for existing, well-established products such as soft drinks or other consumer competitors.
products. Thus, advertisement seeks only to sway customers away from competitors

Arguments against Advertisements

Some of the arguments against advertising are the following:

• advertising is not informative but competitive;

• the economies of scale are illusory;

• advertising raises the cost curve;

• advertisers may use their influence to bias the media;

• advertising is used as an entry barrier, and

• advertising is not a productive activity

Product Differentiation and Demand Elasticity

The demand curve of a firm in a monopolistic competition market structure is downward sloping because
of the preference of customers for the features of the differentiated product. However, because there
are many close (if not perfect) substitutes readily available, the demand is highly elastic. Graphically, this
means that the demand in monopolistic competition is flatter than in monopoly. For example, the demand
of a restaurant is likely to be very elastic because there are many other food outlets available to or
ambiance. customers. But the demand is not perfectly elastic (i.e. horizontal) as in the case of perfect
competition because, each restaurant has something to offer which other restaurants do not for instance,
convenience, location, elaborate menu, or ambiance.

Perfectly competitive firms face a perfectly elastic demand curve for their product because all firms in
their industry produce identical product. In contrast, a monopolistic competitor faces a downward-sloping
firm demand curve. This type of curve is based on the notion that the firm can change its price without
losing all its business because buyers do not see any perfect substitute. Thus, the fewer the substitutes
(ie, the more product differentiation), the less elastic the demand curve will be.
A monopolistic competitor, in the short run, is like a monopolist because it is the only producer of its
unique product. But unlike a monopoly, the monopolistically competitive firm faces competition from
other firms producing good substitutes for its product.

Monopoly

Monopoly refers to a market situation where there is only one seller or producer supplying unique goods
and services (Pindyck & Daniel 2001). It is a single seller that has a complete control over a specific
industry. Thus, there is nobody else selling anything like what the monopolist is producing Thus, there are
no close substitutes. Monopoly comes from the Greek word "mono" which means one and “polise" which
means seller (Samuelson & Nordhaus, 2005).

Under monopoly market, sellers are mostly firms offering water or electricity products and services, or
other public utilities. Monopolies are considered extinct or rare nowadays, some of them exist because
of some governmental regulation and protection, but even then, monopolists should always look over
their shoulders for potential entry of competitor in the industry (Samuelson & Nordhaus, 2005)

Monopoly is the opposite extreme of perfect competition. Under monopoly, the consumer has only two
choices- either buy the monopolist's product or none at all. Monopoly is a market structure characterized
by (1) a single seller or producer, (2) a unique product or service, and (3) impossible entry into the market.
Unlike perfect competition, there are no close substitutes for the monopolist's product

Single Seller or Producer

A monopoly market is comprised of a single supplier selling to a multitude of small, independently-acting

buyers. In other words, a monopoly means a single firm is the industry. That is, one firm provides the total
supply of a product in a given market. Local monopolies are more common in real-world approximations
of the model than national or world market monopolies. For example, MERALCO is a local electric power
provider in Metro Manila and nearby provinces, Manila Water is the distributor of water to the residents
of the eastern zone of Metro Manila. Nationally, the armed forces provide military service to the entire
country.

Unique Product

A unique product means that there are no close substitutes for the monopolist's product. As such, the
monopolist faces little or no competition. In reality, however, there are few, if any, products that have no
close substitutes. For example, buying a generator or using a gas lamp is a substitute for MERALCO.
Similarly, putting a deep well in your backyard or community can be a substitute for Manila Water.
Nevertheless, these may not be good substitutes to the products mentioned previously since putting them
up yourself will be costly and inefficient

Impossible Entry

Barriers to entry are so severe in a monopoly that it is impossible for new firms to enter the market. In
other words, extremely high barriers make it very difficult or impossible for new firms to enter an industry.
Barriers to entry include (1) sole ownership of a vital resource, (2) legal barriers like government franchises
and licenses, and (3) economies of scale.
Other Characteristics of Monopoly Market:

The monopolist definitely makes the price for the products or services. In other words, it is the monopolist
who dictates the price of commodities because the products or services offered are unique and have no
close substitute in the market. As a result, consumers are left with no choice but to follow changes made
by the monopolist regarding the prices of its commodities.

In addition, there is no need for an extensive advertising or sales promotion depending on the goods or
services of the monopolists. There is no need for the monopolist to promote the product, since it is the
only one selling it and offering it to the public. If there are advertisement and promotion of the monopolist
in the market these are just for announcement in regard to the changes in price, warnings, do's and don'ts,
safety tips, etc. (Fajardo 1977).

In the television advertisements of MERALCO of Manila Water, what can be observed? These were all
focused on providing consumer tips, warnings, and measures towards the protection of the environment.

Natural Monopoly and Economies of Scale

A natural monopoly exists when there is great scope for economies of scale to be exploited over a very
large range of output. Indeed, the scale of production that achieves productive efficiency may be a high
percentage of the total market demand for the product in the industry. A natural monopoly therefore is
a situation where economies of scale are so significant that costs are only minimized when the entire
output of an industry is supplied by a single producer, so that supply costs are lower under monopoly than
under conditions of perfect competition and oligopoly

Natural monopolies tend to be associated with industries where there is a high ratio of fixed to variable
costs. For example, the fixed costs of establishing a national distribution network for a product might be
enormous, but the marginal (variable) cost of supplying extra units of output may be very small. In this
case, the average total cost will continue to decline as the scale of production increase, because fixed (or
overhead) costs are spread over higher levels of output.

The telecommunications industry has in the past been considered to be a natural monopoly (especially
during the time when the industry has not yet been deregulated by the Philippine government). Like
railways and water provision, the existence of several companies supplying the same area would result in
an inefficient multiplication of cables, transformers, pipelines, etc. However, the perception of what
constitutes a natural monopoly is now changing because of the impact of new technology in reducing
traditional barriers to entry the market.

Monopoly Seen as Inefficient

Monopolists are price makers, yet they are still subject to the law of demand. Thus, the higher the price
they set on their product, the lower the amount that is bought by consumers.

Economists say that firms will reach a level of production when marginal costs start to rise. As long as
marginal revenue (the extra income generated from extra units of output) is greater than marginal costs,
a firm in a competitive market will continue producing Society will have more to consume. In addition, if
marginal revenue equates with marginal cost, it determines the profit maximizing output of monopolist,
wherein this is the usual practice of general rule of every firm to maximize its profit. On the other hand, if
the marginal revenue is below the marginal cost, monopolist should reduce its production; in return,
decreasing marginal cost increases its marginal revenue. In summary, if MR > MC, the monopolist gains
profit by increasing output and vice versa if MR < MC (Colander, 2010).

In a competitive market, production rises to level where marginal costs equal marginal revenue. In a
monopoly, production rises to a level where profit per unit is maximized. After this point, the monopolist
will make less and less profit per unit. Why work harder, for less?

In a monopoly, the quantity produced of goods is often less than the socially desirable level of production.
There has been a misallocation of resources: not enough resources are being used where they should be,
and other resources are being underutilized. It is for this reason that monopolies are seen as inefficient

Oligopoly

In terms of competitiveness, the spectrum of market structures reaches from pure competition, to
monopolistic competition, to oligopoly, to monopoly.

Oligopoly, a market dominated by a few large producers or sellers of a homogeneous or differentiated

product. Because of their 'fewness', oligopolists have considerable control over their prices, but each must
consider the possible reaction of rivals to its own pricing, output, and advertising decisions.

Oligopoly Defined

Basically, an oligopoly is characterized by (1) few sellers, (2) either a homogeneous or a differentiated
product, and (3) difficult market entry. Oligopoly, just like monopolistic competition, is found in real world
industries. In fact, oligopoly is the prevalent type of industrial competition in most developed countries
like the United States, Japan, and most of Southeast Asian countries.

Under oligopoly, the bulk of market supply is in the hands of a relatively few large firms who sell their
products to many small buyers. Therefore, it can be said that oligopoly is competition among the few'. For
example, the 'Big Three' oil companies (1.e., Petron, Shell, and Chevron) under oligopoly means that these
three firms dominate the oil industry. But what does 'few firms' really mean? As with the other market
structures, there is no specific number of firms which must dominate an industry before it is called an
oligopoly.

Basically, an oligopoly is a consequence of mutual interdependence. It is a condition in which an action of

one firm may cause a reaction from other competing firms in the industry. In other words, a market
structure with a few powerful firms makes it easier for oligopolists to collude. The large number of firms
under perfect competition or monopolistic competition and the absence of other firms in monopoly rule
out mutual interdependence and collusion in these market structures. Hence, 'few-sellers' condition is
met when these firms are relatively large to the total market that they can affect the market price.

Homogeneous or Differentiated Products

In an oligopolistic market, the products offered by suppliers may be identical, or more commonly,
differentiated from each other in one or more respects. These differences may be of a physical nature,
involving functional features, or may be purely fimaginary' in the sense that artificial differences are
created through advertising and sales promotion. For instance, the unleaded gasoline of Pilipinas Shell is
identical with the unleaded gasoline of Petron or Chevron. However, cars produced by the major
automakers, like Toyota, Honda, and Ford, are differentiated products. If such is the case, buyers in an
oligopoly market may or may not be indifferent as to which seller's product they buy. In other words, the
unleaded gasoline that a person buys at a Shell station is no different from that of a Petron or Chevron
station. In other words, that person is indifferent whether he buys gas from the former or the latter.

Difficult Entry

Similar to monopoly, there are formidable barriers that make it very difficult for new firms to enter and
compete in the market. As a matter of fact, the same barriers to entry that create pure monopoly also
contribute to the creation of oligopoly. High barriers to entry in an oligopoly protect firms from new
entrants. These barriers include exclusive financial requirements, control over essential resource, patent
rights, and other legal barriers. But the most significant barriers to enter in an oligopoly market is
economies of scale. Economies of scale are important entry barriers in a number of oligopolistic industries,
such as oil, telecommunication, and airline industries. For example, large oil firms achieve lower average
total costs than those incurred by small oil firms. Thus, it can be seen that even with the deregulation
policy of the government, still the dominant players in the oil industry are the 'Big Three’ firms.

Because of these barriers, competition in an oligopolistic market is intense. Both price and nonprice
methods of competition are used. People have probably seen, read or heard advertisements along these
lines "We will not be beaten on price. If our competitor is selling item X for less, we will match their prices,
whether the item's price has been reduced for a special sale or not.

Moreover, firms in oligopolies compete by offering warranties, "We will replace the item without cost if
it is found to be defective in any way, and through customer service (friendly, helpful staff, and free home
delivery).

Because of stiff competition, firms in oligopolies are said to be mutually interdependent. If one firm
changes its prices, this will have an effect on the sales of all other firms in the market.

An oligopoly therefore usually exhibits the following features:

1. Product Branding: Each firm in the market is selling a branded (differentiated product.

2. Entry Barriers: Significant entry barriers into the market prevent the dilution of competition in the long
run which maintains supernormal profits for the dominant firms. It is perfectly possible for many smaller
firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any
significant effect on market prices and output

3. Interdependent Decision-making: Interdependence means that firms must take into account likely
reactions of their rivals to any change in price, output, or forms of nonprice competition. In perfect
competition and monopoly , the producers did not have to consider a rival's response when choosing
output and price.
4. Nonprice Competition: Nonprice competition is a consistent feature of the competitive strategies of
oligopolistic firms. Examples of nonprice competition include: (a) free deliveries and installation; (b)
extended warranties for consumers and credit facilities; (c) longer opening hours (eg. supermarkets and
petrol stations); (d) branding of products and heavy spending on advertising and marketing (e) extensive
after-sales service; and (1) expanding into new markets plus diversification of the product range.

The Importance of NonPrice Competition under Oligopoly

Nonprice competition assumes increased importance in oligopolistic markets. Nonprice competition

involves advertising and marketing strategies to increase demand and develop brand loyalty among
consumers. Businesses will use other policies to increase market share with the following strategies in
mind:

1. Better quality of service including guaranteed delivery times for consumers and low-cost servicing
agreements;

2. Longer opening hours for retailers, 24-hour telephone and online customer support;

3. Extended warranties on new products;

4. Discounts on product upgrades when they become available in the market; and

5. Contractual relationships with suppliers for example the system of tied houses for pubs and contractual
agreements with franchises (exclusive distribution agreements)

Advertising spending runs in millions of dollars or pesos for many firms, as people see them on their
television sets, or billboards along our highways. Some simply apply a profit maximizing rule to their
marketing strategies. Nonetheless, a promotional campaign is profitable if the marginal benefit (or
revenue) from any extra sales exceeds the cost of the advertising campaign and marginal costs of
producing an extra unit of output. However, it is not always easy to measure accurately the incremental
sales arising from a specific advertising campaign. Other businesses see advertising simply as a way of
increasing sales revenue. If persuasive advertising leads to an outward shift in demand curve of the
product being advertised, this implies that consumers are willing to pay more for each unit consumed.
This increases the potential consumer surplus that a business might extract.

Relatively, high spending on marketing is important for new business startups such as the huge and often
extravagant sums spent on marketing by the emerging dot-coms during the internet mania of the late
1990s and into 2000 and also by firms trying to break into an existing market where there is consumer or
brand loyalty to the existing products in the market. Take note for instance how Sun Cellular undertook
massive promotional activities and advertising campaigns when it started its business in late 1990s so as
to penetrate the market and thus compete with the two giant telecommunications companies, Smart and
Globe.

Price Leadership - Tacit Collusion

As discussed, oligopoly is a market structure with only a few firms dominating the industry. Since the
market is shared by few firms, market becomes highly concentrated
Another type of oligopolistic behavior is price leadership. This is when one firm has a clear dominant
position in the market and the firms with lower market shares follow the pricing changes prompted by
the dominant firm. Examples of this are the major telecommunication and airline firms where smaller
firms follow the pricing strategies of leading firms. If most of the leading firms in a market are moving
prices in the same direction, it can take some time for relative price differences to emerge which might
cause consumers to switch their demand.

Firms who market to consumers that they are "never knowingly undersold" or who claim to be monitoring
and matching the cheapest price in a given geographical area are essentially engaged in tacit collusion.
Does the consumer really benefit from this?

Tacit Collusion occurs when firms undertake actions that are likely to minimize a competitive response,
e.g. avoiding price cutting or not attacking each other's market

Price Fixing

Collusion is often explained by a desire to achieve joint-profit maximization within a market or prevent
price and revenue instability in an industry, Price fixing represents an attempt by suppliers to control
supply and fix price at a level close to the level we would expect from a monopoly. When price fixing
happens, producers or suppliers tend to control supply and fix price at a level somewhat close to the price
in the monopoly market. To collude on price, producers must exert control over market supply.

To fix prices, the producers in the market must be able to exert control over market supply. The
distribution of the cartel output may be allocated on the basis of an output quota system or another
process of negotiation.

Although the cartel as a whole is maximizing profits, the individual firm's output quota is unlikely to be at
their profit maximizing point. For any one firm within the cartel, expanding output and selling at a pnce
that slightly undercuts the cartel price can achieve extra profits. Unfortunately, if one firm does this, it is
in each firms interests to do exactly the same. If all firms break the terms of their cartel agreement, the
result will be an excess supply in the market and a sharp fall in the price. Under these circumstances, a
cartel agreement might break down.

Forms of Collusive Arrangements

Having exclusive dealings and tring contracts are illegal to the extent that perfect competition is being
restricted. Exclusive dealing is a contractual agreement between two firms that limits outside firms to
participate or engage in.

Collusion in a market or industry is easier to achieve when (1) there are only a small number of firms in
the industry and barriers to entry protect the monopoly power of existing firms in the long run; (2) market
demand is not too variable: (3) demand is fairly inclastic with respect to price so that a higher cartel price
increases the total revenue to suppliers in the market; and (d) each firm's output can be easily monitored-
this enables the cartel more easily to control total supply and identify firms who are cheating on output
quotas.
Possible Breakdown of Cartels

Most cartel arrangements experience difficulties and tensions, and some producer of cartels collapse
completely. Several factors can create problems within a collusive agreement between suppliers. These
include:

1. Enforcement problems: The cartel aims to restrict total production to maximize total profits of
members. But each individual member of the cartel finds it profitable to raise its own production. It may
become difficult for the cartel to enforce its output quotas. There may be disputes about how to share
out the profits. Other firms, not members of the cartel, may opt to take a free ride by producing close to
but just under the cartel price.

2. Falling market demand during a slowdown or recession creates excess capacity in the industry and puts
pressure on individual firms to cut prices to maintain their revenue. There are good recent examples of
this international commodity markets including the collapse the coffee export cartel and some of the
problems that have confronted OPEC in recent years.

3. The successful entry of non-cartel firms into the industry undermines a cartel's control of the market,
e.g. the emergence of online retailers in the book industry in the mid1990s

Size of an Oligopoly and the Market Outcome

Generally, the more companies in the industry, the harder it is to form a cartel and to enforce it. As the
number of companies increases, the more the industry resembles a competitive outcome, since each
company has a smaller effect on the outcome. The mentality where each company tends to think only of
its own profit and strategic behavior is reduced. Each company will increase production as long as price is
greater than marginal cost. As the number of companies increases, the market or the industry tends to
move towards a perfectly competitive outcome.

Duopoly

Duopoly is another form of oligopoly wherein two corporations produce similar goods or services which
are almost identical. In a duopoly, only two companies have the entire control of the market and the firms'
interactions with one another shape of the market. Examples of duopolistic markets are Airbus and
Boeing, Bloomberg and Reuters.

In a duopoly, the set-up forces each producer to consider the rival firm's actions to certain business
decisions. When there's a duopoly in the market, the consumers may tend to benefit from the actions of
the two firms when they compete on price since firms will drive the price down in order to keep up in the
competition with each other. However, since there are only two firms sharing in the market, this condition
gives the duopolists an opportunity to agree and charge a monopolistic price in order to gain profit.

There are two types of duopoly. The Cournot duopoly and the Bertrand Duopoly named after French
mathematician Antoine Augustin Cournot and French economist, Joseph Betrand.

The Cournot Duopoly

The competition between two companies is based on the quantity of products supplied, saying that it is
the quantity which shapes the competition between two firms. The Cournot model believes that each
company receives price values on the availability of goods and services. So, the price each company
receives for the product is based on the numerical count or quantity of the produced goods. Equilibrium
is achieved when the two companies react to the changes in production of each other.

The Bertrand Duopoly

While the Cournot duopoly focused more on quantity, the Bertrand duopoly focused on the price since
this is what drives competition in the market etween two companies. When given a choice between two
goods and services which tend to be equal or similar, consumers will go for the firm that will offer the best
price.

Monopsony

Monopsony is similar to the concept of monopoly that has one seller and many buyers. For monopsony,
there is only one buyer but many sellers. The buyer is called the monopsomist.

Monopsony occurs when there is a market power exercised by a firm when cmploying factors of
production, giving the monopsonist the control when negotiating prices.

One example of monopsony is the case of one employer and many workers seeking employment. Since
there is only one employer, the market power in setting wages and the number of how many will be given
employment, rest mainly on the command of this one major employer.

One example of monopsony is the supermarket industry which source their food and agricultural supplies
from the farmers. If there are no products to sell to supermarkets, it would be hard to look for alternatives
farm products. Another example is the industry of coal mining in one province wherein employment in
this industry becomes the primary or the only source of employment in that specific town.

Market Structure and Innovation

For many years, the question which market conditions are optimal for effective and sustained innovation
to occur has always been an interesting concept for economists and business academics. High levels of
research and development spending are frequently observed in oligopolistic markets, although this does
not always translate itself into a fast pace of innovation

The work of William Banmol (2002) provides support for oligopoly as market structure best suited for
innovative behavior. Innovation is perceived as being "mandatory" for businesses that need to establish
a cost-advantage or a significant leadership in product quality over their rivals.

"As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price
variable is ousted from its dominant position... But in capitalist reality as distinguished from its textbook
picture, it is not that kind of competition which counts but the competition which commands a decisive
cost or quality advantage and which strikes not at the margins of profits and the outputs of the existing
firms but at their foundations and their very lives. This kind of competition is as much more effective than
the other as a bombardment is in comparison with forcing a door." (Baumol 2002).
Supernormal profits persist in the long-run in an oligopoly and these can be used to finance R&D

Important Developments of Market Structures

The fast changing business environment during the past decades has brought about important
developments in market structures. We can cite some of these important developments as follows:

1. Increasingly most innovation is done by smaller firms. Indeed multinational corporations are now
outsourcing their research and development spending to small businesses at home and overseas, much
is being shifted to cheaper locations "offshore"— in India and Russia and recently China.

2. Innovation is now a continuous process, in part because the length of the product cycle is getting
shorter as innovations are rapidly copied by competitors, pushing down profit margins and according to
a recent article in The Economist) "Transforming today's consumer sensation into tomorrow's
commonplace commodity". A good example of this is the introduction of two major competitors to the
anti-impotence drug Viagra. However, this is more evident in the IT industry as well as the tech gadgets
market.

3. Innovation is not something left to chance. The most successful firms are those that pursue innovation
in a systematic fashion. One very good example is the continuous innovations of Microsoft Corporation,
which make the company the leader in the software business.

4. Demand innovation is becoming more important. In many markets, demand is either stable or in long-
run decline. The response is to go for "demand innovation"- discovering new forms of demand from
consumers and adapting an existing product to meet them. The toy industry is a classic example of this.

5. Globalization is driving innovation and not just in manufactured goods but across a vast range of
household and business services and in particular in high-value knowledge industries.

Classic examples of innovation first achieved by smaller firms:

• Air-conditioning

• Hydraulic brakes

• Digital X-Rays

• Digital cameras

• Soft contact lenses

• Quick frozen food

• Zip fastener