Chapter 10: Identifying Markets

and Market Structures

Chapter Outline

Defining the Relevant Market

Is a Rose Is a Rose Is a Rose?
Movies and Entertainment
Automobiles and Transportation
Courts and Markets
Cross Elasticity Defines the Market
Cross Elasticities in the Flower Market
How High Is a High Cross Elasticity?
Markets and Market Structures
The World of Monopoly
Size Is Not Important
The Firm Is the Industry
No Easy Entry
The Natural Monopoly
Exclusive Access to Resources
The Patent System
Acquisition, Acquisition, and More Acquisition
The World of Monopolistic Competition and Oligopoly
No Easy Entry, But Entry
Close Substitutes
As Firms Enter, Demand Curve Becomes More Elastic
The Role of Advertising
Increasing Market Share
Making Demand More Inelastic

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The World of Perfect Competition

Perfect Substitutes
Insignificant Market Share
Free Entry
Firms Cannot Influence Price
Putting Together a Scorecard on Market Structures

What the Chapter’s About

This chapter describes how economists identify markets and analyzes the distinguishing
features of the four principal market structures: monopoly, monopolistic competition, oli-
gopoly, and perfect competition. Price, output, and profit determination are not discussed
here. Think of this chapter as the first in a series of three. The second examines price,
output, and profit determination under conditions of monopoly, monopolistic competition,
and perfect competition. The third considers price, output, and profit determination under
conditions of oligopoly.
Why this three-chapter sequence, and why do this and the following chapter begin
with monopoly, move on to monopolistic competition, and finally end up with an analysis
of perfect competition? Because this flow of discussion capitalizes on what students al-
ready know.
After all, up to this point in the course, students were taught (and hopefully under-
stand) that the individual and market demand curves are downward sloping. So let’s be-
gin with that! Reinforce what they already know. By the time we get to the horizontal
demand curve at the end of the chapter, they will have a fair idea of why it should be ho-
rizontal.
Another reason why we should start our analysis of market structures with monopoly
is because monopoly is an excellent point of departure: It’s what each firm wishes it
were. Firms that are not monopolies are not monopolies because of circumstances
beyond their control. They would like to be the only firm in their industry, but they can’t
prevent market entry. That’s what we ought to stress. Differentiations among market
structures have much to do with a firm’s ability or inability to control entry.
But let’s first address the critical issue of market identification before we plunge into
market structures. What is a market? Are salmon sold in a salmon market or in a fish
market? Are roses sold in a rose market or a flower market? The chapter links the idea
of which specific goods belong to which specific market to the idea of substitutability
among goods. Cross elasticity makes the connection.
Classroom discussion can work well with this idea. Ask the students to name goods
that are good substitutes for jeans, polo shirts, earrings, ballpoint pens, telephones,
flashlights, forks, Coca-Cola, frozen yogurt, and broccoli, and to describe the markets
they belong to. You should get some disagreements. In each case, ask them to guess
the cross elasticity (high, very high, or extraordinarily high, to get them familiar with the
relationship between cross elasticity and market identification).
Let’s start with the exhibit that shows the spectrum of market structures from mono-
poly to perfect competition. The chapter lists and discusses the set of features that de-

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scribes each. The key to monopoly, of course, is the barriers to firm entry. But why can’t
firms get in? That’s the focus of the discussion. If firms can’t enter, then the firm already
in ends up in a unique situation: It is the industry. Don’t worry about price, output, and
profit just yet. No need to discuss marginal revenue. Get them first to see that the mono-
poly’s demand curve is the demand curve for the industry.
To get students talking about this unique situation, ask them to name markets that
are monopolies. If my students are typical, they will immediately think of public utilities
without much prompting, and you can show that in most cases, substitutes exist. For ex-
ample, is the postal service a monopoly? How about Federal Express, the telephone, the
fax, and e-mail as substitute services? Is the power company a monopoly? Is the bus
company a monopoly? This is a good place to discuss the features of natural monopo-
lies.
When we get to monopolistic competition, we can play off the monopoly discussion.
Each of its features can be regarded as a modification of the monopolies. For example,
entry. It’s a key issue. Play on it. The ability of firms to enter the industry breaks the mo-
nopoly. The students can visualize the monopoly crumbling. What happens to the firm’s
demand curve when entry occurs? Each firm’s demand curve becomes only a piece of
the industry’s demand curve. And because it’s only a piece, it lies to the left of the indus-
try’s demand curve and is more elastic.
Let’s talk about how they enter. Each entering firm needs something to differentiate
itself from the others. That’s why product differentiation is a feature of the monopolistical-
ly competitive market, and why the more firms in the industry, the more elastic is each
firm’s demand curve.
Ask students how they could, if they were a firm in a monopolistically competitive in-
dustry, improve their market position. Shifting their demand curve to the right—taking
higher market share—and making their demand curve more inelastic are what firms in
monopolistic competition strive for, and advertising can help them accomplish these
goals. Discuss the significance of brand loyalty. Coke and Pepsi are always good illu-
strations.
Ask students to read advertisements carefully. Pick out the way firms distinguish
their products (and often go head-to-head, knocking competitors). Ask students to watch
television commercials (they do it anyway). Get them to discuss how these commercials
can shift a firm’s demand curve and affect its price elasticity of demand. To get them ex-
cited (they do get excited!), ask them to differentiate between Coke and 7-Up. Here’s a
tidbit of information that will grab their attention. Tell them that in a blind test, after drink-
ing a little of either, they can’t tell the difference between classic Coke and regular 7-Up!
(Actually, some can, but many can’t.) Once any soft-drink’s carbonation gets into the
mouth, it interferes with the ability to differentiate taste.
Now, let’s switch to a different set of goods. Can your students differentiate between
one Idaho potato and another? Can they differentiate between one bag of crushed ice and
another? Can they differentiate between one salmon and another? Can they differentiate
between one egg and another? We are now talking about perfectly substitutable goods, a
distinguishing feature of the perfectly competitive market structure. Now suppose that any
firm willing to enter this market to produce these kinds of goods can do so (free entry is a
distinguishing characteristic of perfect competition). And let’s also suppose that a consi-
derable number of firms do (another distinguishing characteristic of perfect competition).
Then what would each firm’s demand curve look like?
First of all, we can see why each firm’s market share would be insignificant, only a
minute piece of the industry’s total. Although the figures for the firm and the industry are

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approximately the same size in the text, draw students’ attention to the numbers on the
horizontal axis of each. On your chalkboard, draw the firm’s demand curve on the indus-
try’s demand curve figure, showing it to be an almost invisible horizontal dash of a line.
Then show them that this tiny dash of a curve is blown up (like an enlarged photo) in the
other figure to distinguish its features. Second, because all goods are perfect substi-
tutes, the firm loses the option of choosing its price. If it raises price, no one buys. There
is no reason to lower price because the firm can sell all it wants at the market price.
Then translate this feature into the language of infinite elasticity.

Basic Economic Concepts

This chapter introduces a large set of key terms. Students learn to identify a relevant
market, and to understand what a perfectly contained market is. They are able to dif-
ferentiate between an industry and a market. They distinguish among market struc-
tures: monopoly (and natural monopoly), monopolistic competition, oligopoly, and
perfect competition. They know why we created the patent, and what roles product
differentiation, brand loyalty, market share, and mutual independence play in the
different market structures.

Using the Economic Consultants Feature

You can turn this Economic Consultants feature into an assigned project for the class.
Each student can prepare a report on patents, or specific segments of the topic can be
assigned to a student or group of students to create a collective project for the class. For
example, students can write reports on specific patents for goods that are commonplace
in their lives, such as the pull-up tab on soft-drink aluminum cans. They can write reports
on the copyrighting of books and music. Another topic is copyright and patent infringe-
ment and what countries are trying to do about it. They can report on universities and
colleges that license their logos.

Answers to Text Questions

1. Because the monopoly is the only firm in the industry, it is the industry and the in-
dustry’s downward-sloping demand curve is precisely the demand curve that the
monopoly faces. The monopoly can pick any price and quantity combination that
the demand curve allows. That’s why the monopoly is described as a “price maker.”
That option is not afforded to a firm in perfect competition. Because very many firms
produce identical goods in the perfectly competitive industry, no firm can raise its
price without suffering total loss of sales. And since each firm has insignificant mar-
ket share, each can sell any quantity it wants at the industry’s market price; so it
has no need to lower price to sell more. It can’t raise price and need not lower it,
which is why the competitive firm is described as a “price taker.”

2. Barriers to entry determine whether a firm is a monopoly or not. Imagine a new fruit
that is as big as a plum, has the color and texture of a plum, but tastes like a cherry.
Call it cherrum. Suppose one hi-tech agri-firm developed the cherrum. Nobody else

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knows how to produce it. That’s a barrier to entry that cannot be overcome. That
barrier makes the firm a monopoly. Once the cherrum secret is known, other firms
can produce their own varieties. Some bigger, some sweeter, some of different col-
ors, and so on. Barriers to entry fall, although not everybody joins the cherrum in-
dustry. That market is now monopolistically competitive.

3. Cross elasticity measures the percentage change in quantity demand of one good
that is generated by a percentage change in the price of another. It records how
people view the relationship between the two goods: Are they good substitutes or
not? A high cross elasticity indicates that people are readily willing to switch (substi-
tute) from one good to another when the price of one changes so that both goods
belong to the same market. A lower cross elasticity of demand among two goods
indicates that people are less willing to switch when the price of one changes so
that the goods do not belong to the same market. A market, then, consists of a set
of goods whose cross elasticities among any two in the set are relatively high and
whose cross elasticities with goods outside the set are relatively low.

4. A market structure is defined by its set of market characteristics, such as number of

firms, ease or difficulty of entry, and degree of substitutability of goods.

5. A natural monopoly is defined by the relationship between market demand and its
cost structure. Total fixed cost dominates total cost throughout the production range
so that average total cost is downward sloping. That cost characteristic generates
an outcome in which only one firm is able to produce profitably. Public utilities are
good examples of natural monopolies. So too are the cable television companies in
most towns. Because total fixed cost associated with cable television is relatively
high, a second cable company would split the cable-viewing market, making it un-
profitable for both to operate. Consider many garbage-collecting firms servicing the
same street. It may be less efficient than one firm servicing the street, but if more
than one can survive and make profit, it is a clear indication that the industry is not
a natural monopoly.

6. Why would any firm create new technology—innovate—if it could not profit by it? It
wouldn’t, and that’s the circumstance in perfect competition. Competitive firms that
innovate discover very quickly that as soon as they apply that innovation to produc-
tion, other firms in the industry copy the innovation, undermining the innovating
firm’s profit. The ability of competitive firms to imitate the new technology makes all
competitive firms reluctant to create new technology. The patent system is de-
signed to correct this flawed feature of the competitive system. The government, by
issuing patents, gives the innovating firm exclusive rights to the new technology it
creates. In this way, the innovating firm has a government-protected monopoly on
that patented technology. Any competitive firm that infringes on the innovating firm’s
monopoly is subject to criminal prosecution. Patents serve as an incentive to inno-
vate.

7. Market structures are distinguished by the number of firms in the industry, the ability
of firms to entry the industry, the differentiation and degree of substitutability among
the goods produced by the firms, the firm’s influence over price, and how firms re-
spond to competition.

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8. A zoologist is more likely to classify horses, cows, and automobiles according to

whether they are living or inanimate objects. As a result, horses and cows would
compose one set while automobiles would compose the other. An economist, on
the other hand, is more likely to classify horses, cows, and automobiles according
to their cross elasticities. The cross elasticity between horses and automobiles—as
means of transportation—is higher than the cross elasticity between horses and
cows (except, perhaps, among the French who eat horsemeat). For economists,
then, horses and automobiles would compose one set, while cows would compose
the other.

9. We typically think of monopolies as large firms, like the electric company. But size
does not matter. The local dentist, if she is the only one in the community, is a mo-
nopoly. The local lawn-care service, if it’s the only one in the community, is a mo-
nopoly. What counts in identifying a monopoly is its oneness.

10. Most soft drinks are good substitutes for each other. When you choose courses for
next semester, many are taught by more than one professor and most are good
substitutes for each other. When you think about having fun tonight, there is more
than one alternative competing for your time and money. But some goods have
very few substitutes, and others have close to none. Consider, for example, the ex-
treme and unpleasant case where a person’s heart is defective and failing. What
substitute is there other than a heart replacement? None. But the replacement can
be a transplant or an artificial heart. These are substitutes, albeit not very good
ones. If there is only one railway serving the community, it still has to compete with
road transportation, a fairly good substitute. If the one dentist in town is too expen-
sive, the alternative is to find someone in town willing to perform dental surgery,
perhaps a veterinarian (would you try it?), or take the train to the next town. This is
an inconvenient substitute, but a substitute nonetheless.

11. An industry is a collection of firms producing the same good. A market is a collec-
tion of goods, many from different industries, that have relatively high cross elastici-
ties.

12. Because each monopolistically competitive firm in the industry produces a good
that is not a perfect substitute, such a firm can raise its price without losing all of its
sales to competitors and can lower its price expecting to gain some sales, but not
all, from competitors. Such a condition traces out a downward-sloping demand
curve for each of the firms in the industry.

13. In an industry composed of only a few firms, each knows each other, constantly ob-
serve what others do, and react to what they do. After all, if one lowers price, it may
affect the quantity demanded of every other firm. Knowing that, every firm may be
dissuaded from lowering price believing that other firms would cut price as well to
keep customers from switching, thus negating the effect the first firm expected to
make from the initial price cut. Knowing that others respond to whatever any does is
what is meant by mutual interdependence.

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Answers to Practice Problems

1. Firm A is the natural monopoly because average total cost continues to decline as
quantity increases.

2. Todd Fletcher’s T-Shirt Company is not a monopoly (it would be, if column 2 were
the only demand curve it faced) nor is it a firm in perfect competition (because the
demand curves are all downward sloping). It could be an oligopoly, but with 20
competitors (column 4), it is most likely in monopolistic competition. At a price of $9,
its market share is 100 percent, 73 percent, and 18 percent with 0, 10, and 20 com-
petitors, and at a price of $6, its market share is 100 percent, 64 percent, and 35
percent with 0, 10, and 20 competitors.

3. Firm A is a monopoly. The firm’s demand curve is the market demand. Firm C is in
perfect competition. The market price is $3, and at any higher price, the quantity
demanded of the firm’s good is 0. Firm B is either in oligopoly or monopolistic com-
petition. Its demand curve is downward sloping, so it is not in perfect competition
and because it has less than 100 percent market share, it is not a monopoly.

4.

Quantity De- Quantity Demanded Quantity Demanded

Price manded with No with Most Effective with Moderately Effec-
Advertising Advertising tive Advertising

$4.50 100 350 200

4.00 150 375 250

3.50 200 400 300

3.00 250 425 350

2.50 300 450 400

2.00 350 475 450

Most effective advertising generates a substantial increase in market share (3 ½-

fold increase at a price of $4.50) and only a moderate increase in quantity de-
manded as price falls (25 units with each price change) so that the demand curve
for the good is less price elastic. The moderately effective advertising increases
market share (doubles quantity demanded at $4.50), and generates a 50-unit in-
crease with every price reduction. The demand curve is only slightly less inelastic.

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5.

Quantity Demanded Quantity Demanded Quantity Demanded

Price with No Wendy’s with Most Effective with Moderately Effec-
Advertising Wendy’s Advertising tive Wendy’s Advertising

$4.50 100 50 75

4.00 150 75 125

3.50 200 100 175

3.00 250 125 225

2.50 300 150 275

2.00 350 175 325

The demand for Taco Bell’s burrito suffers substantially when Wendy’s advertising
is most effective. After all, Wendy’s produces substitute goods. At $4.50, quantity
demanded is cut in half and only increases by 25 units with each price cut. The
moderately effective advertising still hurts Taco Bell, but it only cuts quantity de-
manded by 25 units and every price cut still generates an increase of 50 units, as it
did before Wendy’s advertising.

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