<p>This course is part of the Economics section of the study material for CFA Level I Exam. </p>

The Firm and Market Structures

There are four basic market structures: perfect competition, monopoly, monopolistic competition and oligopoly.

In a <strong>perfect competition</strong> market structure several firms are present who all produce identical products and are all sold at market price. The entry barriers to this market are low and the only factor determining sales is price. Since no one producer can affect prices, the demand curve for such a market is horizontal i.e. perfectly elastic. An example of this could be onions produced from a certain region.

On the other end of the spectrum is the <strong>monopoly</strong> market structure. In such a market there is usually just one seller. The entry barrier is very high to this kind of market. The cost of investment, copyright or holds over resources are some examples of high entry barrier. The railway network of any country is an example of a monopoly.

When it makes natural sense to have one firm produce a product it is called a natural monopoly. Public utilities, electronic defense equipment are government sponsored natural monopolies.

Covering the middle ground of market structure in one form is <strong>monopolistic competition</strong>. In this scenario firms do not produce identical products. There exist in the products difference in features, price, branding and so on. The shampoo market demonstrates this. Despite the same end use, i.e., cleaning hair and scalp, the firms producing them market their differences. Removal of dandruff, stopping hair fall, more luster are some of the differentiators they advertise. Consumers are loath to shift unless there is a very high (&gt;10%) increase in price.

In an <strong>oligopoly market</strong> there are a few players who need to keep an eye on each other’s strategy. The cement industry or airline manufacturing industry are good examples. In both these industries the economies of scale are very high making entry barriers in these segments high. The different firms differentiate on the basis of some features, their offerings being good substitutes to each other. In this market structure demand elasticity is more than that of a monopoly.

The following table highlights and compares the features of these four types of market structures.
<table class="mytable">
<tbody>
<tr>
<th valign="top" width="104" scope="colspan"></th>
<th valign="top" width="67" scope="colspan">Perfect Competition</th>
<th valign="top" width="91" scope="colspan">Monopolistic Competition</th>
<th valign="top" width="117" scope="colspan">Oligopoly</th>
<th valign="top" width="95" scope="colspan">Monopoly</th>
</tr>
<tr>
<td valign="top" width="104">Number of Sellers</td>
<td valign="top" width="67">Many</td>
<td valign="top" width="91">Many</td>
<td valign="top" width="117">Few</td>
<td valign="top" width="95">One</td>
</tr>
<tr>
<td valign="top" width="104">Barriers to Entry</td>
<td valign="top" width="67">Very Low</td>
<td valign="top" width="91">Low</td>
<td valign="top" width="117">High</td>
<td valign="top" width="95">Very High</td>
</tr>
<tr>
<td valign="top" width="104">Type of Substitute Products</td>
<td valign="top" width="67">Very good</td>
<td valign="top" width="91">Good substitutes but differentiated</td>
<td valign="top" width="117">Very good differentiated substitutes</td>
<td valign="top" width="95">No good substitutes</td>
</tr>
<tr>
<td valign="top" width="104">Nature of competition</td>
<td valign="top" width="67">Price only</td>
<td valign="top" width="91">Marketing, features and price</td>
<td valign="top" width="117">Marketing, features and price</td>
<td valign="top" width="95">Advertising</td>
</tr>
<tr>
<td valign="top" width="104">Pricing Power</td>
<td valign="top" width="67">None</td>
<td valign="top" width="91">Little</td>
<td valign="top" width="117">Little to significant</td>
<td valign="top" width="95">Significant</td>
</tr>
</tbody>
</table>

Types of Market Structures

<h5>Elasticity</h5>



<p>The firms in perfect competition are price takers. They have no influence on the price of the product. The price is determined by the supply and demand forces.</p>



<p>In perfect competition, each firm faces a perfectly elastic demand curve as shown below. However, the industry will have downward sloping demand curve.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/pc-1.png" alt="" class="wp-image-28193" width="327" height="345"/></figure></div>



<h5>Optimum Price and Output</h5>



<p>The output price and output is calculated by equating the demand and supply function.</p>



<p>The goal of the firm is to maximize profits. A firm maximizes profit when marginal cost (MC) equals marginal revenue (MR), i.e., MC = MR. Till the marginal cost becomes equal to marginal revenue the firm will continue to increase its output. Since each firm is a price taker, marginal revenue is equal to the price of the product (MR = P). So, the marginal revenue curve is the demand curve.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/pc-2-1024x118.png" alt="" class="wp-image-28194" width="583" height="67"/></figure></div>



<p>The marginal cost first decreases and then increases. The firm will produce quantity Q where marginal cost equals marginal revenue.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/pc-3.png" alt="" class="wp-image-28195" width="370" height="298"/></figure></div>



<p>In the short run, a firm maximizes its economic profit at the quantity where MC = MR. Alternatively, we can say that the profit is maximized at the point where Total revenue – Total cost is maximum.</p>



<p>In the long run, economic profits go to zero because the entry of new firms increases market supply and lowers prices.</p>



<h3>Review of Important Definitions</h3>



<p><strong>Total revenue</strong> is sales price times quantity sold.</p>



<p><strong>Total costs</strong> equal average total costs (ATC) times output level.</p>



<p><strong>Marginal revenue (MR)</strong> is the revenue received from an additional unit of output, or the change in total revenue divided by the change in output.</p>



<p><strong>Marginal cost (MC)</strong> is the cost of producing an additional unit of output.</p>



<p><strong>Price Elasticity of Demand</strong> is the % change in quantity demanded divided by % change in price. Demand can be elastic (E&gt;1), inelastic (E&lt;1), or unitary elastic (E=1). Price elasticity depends on availability of substitutes, how much income consumers spend on the product, and the time period considered.</p>

What is Perfect Competition?

<h3>Elasticity</h3>



<p>Firms in monopolistic competition are price searchers. The products of firms under monopolistic competition have a downward sloping demand. The quantity the company can sell is inversely related to the price charged. The quantity sold depends on the price the firm chooses to charge. Elasticity is greater than 1, i.e., relatively elastic but not perfectly elastic. Small changes in price will have relatively large changes in quantity demanded.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/mc-1.png" alt="" class="wp-image-28198" width="391" height="70"/></figure></div>



<h3>Optimum Price and Output</h3>



<p>The firms in price searcher markets face dual competition, i.e., from the existing firms as well as potential new entrants. There are lower barriers to entry. In the short run, if there are economic profits to be made, new rivals will enter the market until all profits have been eroded by firm entry. In the short run, firms in monopolistic competition act like monopolies. As long as MR &gt; MC, firms will make economic profits. To maximize profits, firms will produce until MR = MC. When MC = MR, we get the profit maximizing output.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/mc-2-1024x113.png" alt="" class="wp-image-28199" width="573" height="62"/></figure></div>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/mc-3.png" alt="" class="wp-image-28200" width="577" height="374"/></figure></div>



<p>In the long run, companies making losses will exit and new firms will enter profitable businesses. This will shift the demand curve downwards. This will happen until price is equal to average total cost. The economic profit for all firms reduces to zero.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/mc-4.png" alt="" class="wp-image-28201" width="507" height="362"/></figure></div>



<p>The differences between Perfect Competition and Monopolistic Competition are highlighted below:</p>



<figure class="wp-block-table"><table><tbody><tr><td><strong>&nbsp;</strong></td><td><strong>Perfect Competition</strong></td><td><strong>Monopolistic Competition</strong></td></tr><tr><td><strong>Excess Capacity</strong></td><td>The firm produces at its maximum capacity (Average Total Cost (ATC) is lowest). &nbsp;</td><td>Firm has excess capacity. The firm can sell more by reducing prices, however, to do so, they will produce at a level where cost &gt; revenue. &nbsp;</td></tr><tr><td><strong>Profit mark-up</strong></td><td>Price = Marginal Cost</td><td>Price &gt; Marginal Cost Mark-up is due to price discrimination as consumers get variety. Variety also increases cost.</td></tr></tbody></table></figure>



<p>The quantity produces in monopolistic competition is less than efficient however the variety is valued by the consumers.</p>

What is Monopolistic Competition

<p>In an oligopoly, there are even fewer firms compared to monopolistic competition, and there are higher barriers to entry. The&nbsp;players need to keep an eye on each other’s strategy. If one firm changes its prices, you can expect the same move from other firms as well. The firms are interdependent and one firm’s actions will have an impact on the other firm’s demand curve as well. The oligopolies can be described using the following models:</p>



<ol type="1"><li>Kinked Demand Curve Model</li><li>Cournot Duopoly Model</li><li>Nash Equilibrium Model</li><li>Stackelberg Dominant Firm Model</li></ol>



<h3>Kinked Demand Curve Model</h3>



<p>According to this model, each firm in the oligopoly believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow. The following graph shows the kinked demand curve model. According to each firm, the demand for its product has a kink at the current price (P) and quantity (Q).</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/kinked-1.png" alt="" class="wp-image-28444" width="507" height="367"/></figure></div>



<p>If prices are greater than P, then increasing the price by a small amount leads to a large decrease in quantity sold. If price is less than P, large price cuts lead to low increases in the quantity sold. If competitors also lower prices, then there is no advantage to cutting prices.</p>



<p>Demand is relatively elastic above the kink. This is because the prices of all other firms remain unchanged.</p>



<p>Demand is relatively inelastic below the kink because if the firm shown in the figure changes its prices, all other firms’ prices will also change.</p>



<p>Firms produce at the point where MR = MC. This model states that price and quantity are not very sensitive to small cost changes.</p>



<p>The kink in the demand curve means that the <em>MR</em> curve is discontinuous at the current quantity. This is shown by gap in the figure below.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/kinked-2.png" alt="" class="wp-image-28445" width="473" height="334"/></figure></div>



<p>The main drawback of this model is the assumption that the other firms will not raise prices when one firm does and other firms will cut prices if one firm does. This assumption may not be correct and what determines the market price at which the kink occurs is not explained by the model.</p>



<h3>Cournot Duopoly Model</h3>



<p>Cournot duopoly model is another model used to describe the prices and outputs of firms in an oligopoly. The model assumes that there are only two firms in the oligopoly (it’s a duopoly).&nbsp;</p>



<p>The key assumption of the Cournot model is that each ﬁrm assumes the other ﬁrm’s output is given and ﬁxed, and maximizes its own proﬁt based on that assumption. When ﬁrm 1 chooses its output y1 to maximize its proﬁt, it takes ﬁrm 2’s output y2 as given and ﬁxed; and, similarly, when ﬁrm 2 chooses its output y2 to maximize its proﬁt, it takes ﬁrm 1’s output y1 as given and ﬁxed.</p>



<p>When each firm chooses to produce the same quantity, they cannot make additional profits by changing quantities and we have equilibrium. The market price as a result of this will be less than the profit maximizing price as would be charged by a monopolist; however, it will be higher than the marginal cost, i.e., the price that would be charged by a firm in perfect competition.</p>



<p>Further, as new firms enter the oligopoly, the equilibrium market price will fall till price equals marginal cost.</p>



<h3>Nash Equilibrium (Prisoner’s Dilemma)</h3>



<p>Game theory is the study of strategic behavior that takes into account how others are expected to behave, and the mutual recognition of interdependence. Game theory can be used to study oligopolies.&nbsp;</p>



<p>The prisoners’ dilemma game has the following four characteristics:&nbsp;</p>



<ul><li>Rules&nbsp;</li><li>Strategies</li><li>Outcomes</li><li>Payoffs</li></ul>



<p>A good Web version of the game can be found on a site operated by a group called Serendip at Bryn Mawr College in Pennsylvania. The URL (also on your Economics Place Web site) is&nbsp;<a href="http://serendip.brynmawr.edu/playground/pd.html">http://serendip.brynmawr.edu/playground/pd.html</a></p>



<p><strong>Rules</strong></p>



<p>The rules describe the setting of the game, the actions the players may take, and the consequences of those actions.&nbsp;</p>



<p>In the prisoners’ dilemma game, two prisoners (A and B) have been caught committing a petty crime. Each is held in a separate cell and cannot communicate with each other.</p>



<p>Each is told that both are suspected of committing a more serious crime.</p>



<p>If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice get a 10-year sentence for both crimes.</p>



<p>If both confess to the more serious crime, each receives 3 years in jail for both crimes.</p>



<p>If neither confesses, each receives a 2-year sentence for the minor crime only.<strong></strong></p>



<p><strong>Strategies</strong></p>



<p>Strategies&nbsp;are all the possible actions of each player.&nbsp;</p>



<p>A and B each have two possible actions:</p>



<p>1. Confess to the larger crime.</p>



<p>2. Deny having committed the larger crime.</p>



<p>With two players and two actions for each player, there are four possible outcomes:</p>



<p>1. Both confess.</p>



<p>2. Both deny.&nbsp;</p>



<p>3. A confesses and B denies.</p>



<p>4. B confesses and A denies.</p>



<p><strong>Payoffs</strong></p>



<p>Each prisoner can work out what happens to him—can work out his payoff—in each of the four possible outcomes.</p>



<figure class="wp-block-table"><table><tbody><tr><td><strong>&nbsp;</strong></td><td><strong>&nbsp;</strong></td><td><strong>Art’s Strategy</strong></td></tr><tr><td><strong>&nbsp;</strong></td><td><strong>&nbsp;</strong></td><td><strong>Confess</strong></td><td><strong>Deny</strong></td></tr><tr><td><strong>Bob’s Strategy</strong></td><td><strong>Confess</strong></td><td>Both get 3 years.</td><td>Art gets 10 years and Bob gets 1 year.</td></tr><tr><td><strong>Deny</strong></td><td>Art gets 1 year and Bob gets 10 years.</td><td>Both get 2 years.</td></tr></tbody></table></figure>



<p><strong>Outcome</strong></p>



<p>Nash equilibrium (developed by John Nash) happens when player one makes the best decision, given player two’s actions and vice versa. For example, if A confesses, then it is in the best interest of B to also confess to avoid the very long prison sentence. The same is true for A if B confesses. In this case, it is in the best interest of both prisoners to confess. But this is not the best outcome for both prisoners. It would be better if neither of them confessed, then neither would be convicted of the serious crime. There is no way to avoid the bad outcome from confessing because the prisoners cannot communicate with each other.</p>



<h5>Game Theory in Oligopolies</h5>



<p>Firms in an oligopoly can decide to collude with each other or not. For an oligopolistic firm, the key factor in determining the demand is the pricing strategy of other firms in the oligopoly. So, it’s important for the firm to predict how other firms will react if they adjust their own prices. While we may not be able to determine the exact price and output, we can analyze two extreme cases. In reality, however, firms operate somewhere in between these two extremes.</p>



<p><strong>Collusion</strong></p>



<p>Under collusion, firms agree to avoid various competitive practices, specifically price reductions. A collusive agreement is an agreement between two (or more) firms to restrict output, raise the price, and increase profits. The oligopolistic firms restrict their output to the monopoly level, i.e., to the point where MR = MC. The market price of the products is set at the monopoly price, and all firms earn monopoly profits. An example of a collusive agreement is a cartel. Sellers coordinate supply decisions so that the joint profits of members will be maximized.</p>



<p><strong>No Collusion</strong></p>



<p>Under no collusion or non-cooperation, all oligopolistic firms set their price independently. In this case, the market price is driven to the competitive price since all firms will lower their price as much as possible in order to attract customers. Any firm with a price above the competitive level will have zero demand. The zero profit rule applies when oligopolists do not collude.</p>



<p>There is an incentive to cheat among oligopolists. If there is an undetected price cut, the firm cutting prices will attract more customers, both those who would not purchase the good at the higher price, and customers of competing firms. The demand curve for an individual firm in the oligopoly will be more elastic than the overall market demand curve. The price that maximizes prices for the whole industry is higher than the price that is best for an individual firm which charges a lower price than the remaining firms in the oligopoly. Like the prisoners’ dilemma, each firm in the oligopoly faces a conflict: cooperate with competitors to maximize joint profits or secretly cheat on the agreement to maximize its share of the joint profits. A firm does not benefit from cooperating if the other firms cheat.</p>



<p>In this case, there may be a Nash equilibrium in which the best outcome (all firms cooperating) is not in the best self interest of each individual firm. An equilibrium in which the best strategy is to cheat, no matter what the strategy of the other firms, is called&nbsp;<strong>dominant strategy equilibrium</strong>. If such an equilibrium doesn’t exist, the firms may be playing a game of chicken, where the first player to flinch loses. If one firm improves its products, it knows its research will be copied, and it will lose the benefits from innovating. It hopes its rival firm will innovate instead, so it can copy that research. If neither firm innovates, then no firm gains. Equilibrium only exists if one firm innovates and the other copies.</p>



<p>Many games are repeated.&nbsp;<strong>Cooperative equilibrium</strong>&nbsp;exists when firms make and share monopoly profits. This occurs if cheating is punished. In a “tit for tat” strategy, the firms take turns cheating, and therefore share monopoly profits. In a&nbsp;<strong>“trigger strategy,”</strong>&nbsp;if one firm cheats, the others also cheat, reducing economic profits to zero in the long run. This can result in price wars among oligopolistic firms.</p>



<h3>Dominant Firm Model</h3>



<p>This model states that the dominant firm has a large cost advantage over competing firms in the oligopoly. The dominant firm sets prices for the remaining firms. The dominant firm behaves as a monopoly and the remaining firms are price takers, behaving like firms in perfect competition.</p>



<p>The dominant firm sets the price where MR = MC. The smaller firms accept the price set by the dominant firm.</p>

Oligopoly or Oligopolistic Market

<p>Monopoly is a market where there is an exclusive seller of a product for which there are no good substitutes, and there are high entry barriers for that product.&nbsp;</p>



<p>A monopoly faces a downward sloping demand curve and this firm may choose to produce at any point on the market demand curve.</p>



<p>To maximize profits, a monopolist will choose to produce the output level for which marginal revenue is equal to marginal cost (MR = MC). For the monopoly firm, the price is higher than the marginal revenue due to the downward sloping demand curve. Since MR = MC at the profit-maximizing output and P > MR for a monopolist, the monopolist will set a price greater than marginal cost.</p>



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/monopoly-1.png" alt="" class="wp-image-28448"/></figure></div>



<p>Monopoly profits will be positive as long as the market price exceeds average cost. Profit represents the difference between price and ATC times the number of units of output sold. If the ATC curve of a monopolist is above its demand curve (i.e., demand for the product is not high enough), economic losses will result. Therefore, the profitability of a monopolist is limited by the demand for its product. The monopolist, however, has considerable pricing power and can charge a higher price for its unique product. Monopoly profits can continue into the long run because entry is not possible some economists refer to the profits that monopolies earn in the long run as&nbsp;<strong>monopoly rents</strong>&nbsp;the return to the factor that forms the basis of the monopoly.</p>



<p>A monopoly is inefficient. It restricts output and sells for a price higher than the equilibrium price, creating a deadweight loss. Consumer surplus decreases because consumers must pay more for the goods and because they are getting less of the good than demanded. Producers gain from higher prices, but lose because they are producing less than the equilibrium quantity. Monopolies produce less at a higher cost and increase price at a level greater than the increased cost of production. Monopolies also redistribute surpluses. Some of the lost consumer surplus goes to the monopoly producer. When there is perfect competition, the firm has no pricing ability and must accept the market price.</p>



<p>Another cost of a monopoly is rent seeking, working to take part of a consumer or producer surplus or economic profit. For example, a part of a monopoly’s economic profit comes from taking part of the consumer surplus for itself. Rent seekers may either buy or create a monopoly to obtain excess profits. An example of rent seeking behavior is expending resources to get Congress to pass protections like quotas and tariffs that will benefit a limited group of producers. Rent seeking behavior can reach equilibrium, so only a normal profit and not a monopoly profit is made. For example, suppose there are a limited number of seats on the New York Stock Exchange (whose members can make profits because of their greater knowledge about trading in their securities). In equilibrium, the price of a seat on the exchange will be bid up to the point where only normal profits, not monopolistic profits, can be made.</p>



<p><strong>Price Discrimination</strong></p>



<p><strong>Price discrimination</strong>&nbsp;is when a seller charges different prices for the same product or service.</p>



<p>In order to gain from price discrimination, price-searchers must be able to:</p>



<ol type="1"><li>Recognize and separate at least two groups with varying elasticities of demand</li><li>Ensure that those who buy at low prices do not resell to customers who are charged higher prices</li></ol>



<p>Under price discrimination, groups with the most inelastic demand are charged high prices and groups with more elastic demand are charged low prices. Therefore, under price discrimination, inelastic consumers are worse off while elastic consumers are better off. Allocative efficiency is enhanced under price discrimination because more output is produced overall. If the firm can divide its customers into groups with differing demand elasticities, and it can control reselling, the firm may be able to gain from price discrimination by charging higher prices to inelastic demand groups and lower prices to elastic demand customers. It can also increase total gains from trade and allow production where otherwise there would be no production. Generally, producer surplus is increased, while total consumer surplus is decreased.</p>



<p><strong>Perfect price discrimination</strong>&nbsp;occurs when a producer can sell its output for the highest prices that anyone will pay. In this case, the monopolist captures all of the consumer surplus. Here, the market demand curve and marginal revenue curves are the same. It is to the producers’ advantage to lower the price, say through advertised specials, and sell additional units (still keeping the higher price for those willing to pay it). The producer will sell until MR = MC. This is efficient, but instead of consumers and producers sharing the surplus, the producer captures all of it.</p>



<h3>Natural Monopoly</h3>



<p>A natural monopoly is a situation in which one firm can produce the total output of the market at lower cost than several firms could.Believing that they are natural monopolies, governments frequently grant monopoly rights to public utilities to provide essential goods or services such as water, gas, electric power, or mail delivery.</p>

Monopoly

<h3>Perfect Competition</h3>



<p>In perfect competition, the supply curve of an individual firm is positively sloped. The industry supply curve is also positively sloped, i.e., as the prices increase, the quantity supplied increases.</p>



<p>A firm’s&nbsp;<strong>short-run supply curve</strong>&nbsp;is the portion of the firm’s short-run marginal cost curve above average variable cost. This is because in the short-run, in order to be able to operate, the firm should recover its variable cost.</p>



<p>Remember that average variable cost curve is U-shaped. The average total cost curve is also U-shaped. The marginal cost curve is a J-shaped curve. In the graph below, the blue line from the point above AVC represents the short-run supply curve.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/pc-1-1.png" alt="" class="wp-image-28451" width="608" height="347"/></figure></div>



<p>The long-run market supply curve indicates the minimum price at which firms will supply various market output levels, given sufficient time both to adjust plant size and to enter or exit the industry In the long-run, it doesn’t make sense for the firm to operate below average total cost (ATC). Therefore, in the long run, the supply curve of a firm is the portion of the firm’s long-run marginal cost curve above average total cost.</p>



<h3>Monopolistic Competition</h3>



<p>In a monopolistic market, there are instances where changes in demand curves do not produce a change in both price and quantity (P and Q). With a change in demand curve, a monopolist can either produce the same quantity but charge a different price or charge the same price but produce at a different quantity. Therefore, there is no one-to-one relationship between quantity and price—a monopolistic market has no supply curve.</p>



<h3>Oligopoly&nbsp;</h3>



<p>An oligopoly firm also does not have a supply curve.</p>



<h3>Monopoly</h3>



<p>Even&nbsp;a monopoly does not have a supply curve.&nbsp;A given quantity can correspond to more than one monopoly-optimal price. A shift in the demand curve may cause the monopoly optimal price to stay constant and the quantity to change or both price and quantity to change.</p>

Supply Curve in Various Market Structures

<p>Economists can use the concentration measures to measure the market power. Market concentration is a function of the number of firms and their respective shares of the total production in a market.</p>



<p>There are two popular concentration measures, namely, N-firm concentration ratio and Herfindahl-Hirschman Index (HHI).</p>



<h3>N-firm Concentration Ratio</h3>



<p>N-firm concentration is the sales of top n firms divided by the total sales in the industry, i.e., the percentage of sales held by the n largest firms in an industry. For example, 4-firm concentration ratio will be the percentage of sales held by the four largest firms in an industry.</p>



<p>In a market with perfect competition, this ratio would be zero. It will be 100 in a highly concentrated market. In general, a ratio of more than 60% is indicative of a high degree of concentration (oligopoly), and less than 40% indicates a competitive market.</p>



<h3>Herfindahl-Hirschman Index (HHI)</h3>



<p>HHI measures market concentration and is a metric used by government oversight bodies in the U.S. to determine if a merger should be allowed or blocked.</p>



<p>HHI calculates the sum of squared market shares for competing companies.</p>



<figure class="wp-block-image size-large"><img src="https://financetrain.com/wp-content/uploads/hhi-1.png" alt="" class="wp-image-28454"/></figure>



<p>For an individual firm, HHI is calculated once; for a merger of two companies the HHI of the combined entity will be the sum of their individual market share HHI values.</p>



<p>This number is small in competitive markets. When HHI crosses a certain threshold, the government may legally challenge the proposed merger. An HHI greater than 1,800 indicates an uncompetitive market, and mergers which result in HHIs greater than 1,800 are more likely to be challenged by the Justice Department antitrust division.</p>



<figure class="wp-block-table"><table><tbody><tr><td><strong>Combined Entity HHI</strong></td><td><strong>HHI Change</strong></td><td><strong>Government Response</strong></td></tr><tr><td><strong>&lt; 1,000</strong></td><td>Irrelevant</td><td>None.</td></tr><tr><td><strong>1,000 – 1,800</strong></td><td>≥ 100</td><td>Potential legal challenge to merger.</td></tr><tr><td><strong>1,800+</strong></td><td>≥ 50</td><td>Definite government challenge to merger.</td></tr></tbody></table></figure>



<p>Note that a small change to HHI in a heavily concentrated industry may be more scrutinized than a large change to HHI in a highly competitive industry. In the U.S., the Justice Department will consider other factors than just the HHI, when determining whether or not to attempt to block a merger.</p>



<p>Suppose there are five firms in a market, with the following market shares:</p>



<p>Firm 1: 30%, Firms 2, 3, and 4: 20% each, Firm 5: 10%. The HHI for this industry is 30<sup>2</sup>&nbsp;+ 20<sup>2</sup>&nbsp;+ 20<sup>2</sup>&nbsp;+ 20<sup>2</sup>&nbsp;+ 10<sup>2</sup>&nbsp;= 2,200. A market with an HHI this high is considered to be uncompetitive.</p>



<p>In addition to the above concentration measures, concentration can be gauged by:</p>



<ul><li><strong>Barriers to entry -</strong>&nbsp;Low barriers to entry, even in concentrated industries can lead to greater competition in the future.</li><li><strong>Number of firms in the industry</strong></li><li><strong>Product type -</strong>&nbsp;Is the product a commodity or can it be easily differentiated?</li><li><strong>Price control -</strong>&nbsp;Does the firm control price? Is price subject to regulation or market forces beyond the control of the firm?</li></ul>



<p><strong>Limitations of concentration measures include:</strong></p>



<ul><li><strong>Scope of the market -</strong>&nbsp;Is there a small, domestic market for a product or is there a global market? For example, there is limited worldwide demand for a local newspaper, but there is a wider market for clothing, worldwide.</li><li><strong>Entry barriers -</strong>&nbsp;Do firms enter and exit the industry easily or often?</li><li><strong>Market and industry definitions -</strong>&nbsp;Markets and industries may not correspond. Companies may compete in multiple product markets, some competitive and others less competitive. Companies may also switch from industry to industry depending on market demands. There may be smaller, sub-markets within an industry that are more or less competitive than the overall market.</li></ul>



<p>Most U.S. markets are competitive. In addition to domestic competition, U.S. companies face competition from international companies as well.</p>

Concentration Measures in Economics

This quiz is a part of the CFA Level 1 reading 'The Firm and Market Structures'. 

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