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7.2: Considerations in Classifying a Market

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    How do you know whether a market is a monopoly, an oligopoly, monopolistically competitive, or perfectly competitive? To answer this question, it is useful to clarify the boundaries of the market you are considering. There are three dimensions of a market. These are the product, the time, and the place. You should think about market boundaries in terms of each of these three dimensions. In the product dimension, clarify how narrowly you are defining the product. For instance, are you interested in the market for herbicides broadly, or are you interested in the market for herbicides designed to control a specific weed or class of weeds? Once you have specified the product boundaries, you can then identify competitors that are operating in the market. The next dimension is time. Agricultural products are sometimes sourced from different locations at different times of the year. Because of this, the set of sellers who comprise the market could be different at different points in time. Finally, the place dimension is important because agricultural products are bulky and transportation costs are often an important consideration. Thus, sellers in one geographic area may be different than sellers in another. Moreover, there may be more sellers in one geographic area than another depending on demand conditions in the respective geographic areas. Having defined the boundaries of a market along these three dimensions (product, time, and place), you can use several characteristics of the market to classify its structure.

    The first, and probably most obvious, characteristic is the number of firms that comprise the market. The number of firms is central to the definitions of market structures above. In a monopoly, the market is comprised of one firm. In an oligopoly there are a few firms. If there are many firms, the market is either monopolistically or perfectly competitive, depending on the nature of the product.

    Another issue of specific importance is whether the product of one seller is different from the product of another in the minds of consumers. If so, the products are differentiated. If not, the products are homogeneous. If products are differentiated, it is useful to distinguish between two different types of product differentiation:

    1. A product is vertically differentiated if there are clear quality differences that can be measured objectively. All buyers can agree upon the presence or absence of the quality attribute, regardless of whether the buyer actually places a value on the attribute in question. For example, in lumber, there are vertical differences between oak and pine. Buyers are knowledgeable about these differences and situations wherein one type of lumber is better suited than the other. Usually there are vertical differences among agricultural products. In many cases, grades and standards are used to convey information about these vertical quality differences.
    2. Products are horizontally differentiated if there are less tangible quality differences among products that are nonetheless important to the consumer or some segments of consumers. Horizontal differences usually come down to a matter of taste. Most horizontal differences are conveyed through brand image. For example, if you were to compare the ingredient lists on two different brands of cola, you would see that they were nearly identical. It is hard to make the case that one brand is truly better than another for its intended purpose. However, some consumers are probably quite loyal to one of the brands and may even dislike the other.

    If horizontal product differences exist, then brands can play a role in conveying these differences, and an industry comprised of many competitors will be monopolistically competitive, as opposed to being perfectly competitive. Vertical product difference can exist in either perfect or monopolistic competition. In a perfectly competitive market, the market price is augmented by a series of market-determined discounts or premiums to account for the vertical quality differences.

    Finally, the ease with which new firms can enter the market is important to market structure and market outcomes. Entrants are latent or potential competitors. As you learned in Chapter 2, if an outside firm finds a market to be attractive, it will come into the market, cause supply to shift outwards and depress prices. Outcomes of some of the market structures depend on entry being difficult in one way or another. Entry can be difficult for several reasons:

    1. Economies of scale are large compared to the size of the market. In some cases, production technology is such that a firm must produce a very large number of units in order to cover fixed costs. If demand is limited, there may only be room for one or two firms to operate at an efficient scale within a given market. This could foreclose entry because outside firms will not be able to achieve an efficient scale if the market is entered.
    2. Access to raw materials, technology, or distribution channels. The inability to access key sources of raw materials, technology, or distribution channels can prevent entry, even if the production process is well understood and economies of scale are inconsequential. In some cases, access is limited by patents or other legal restrictions. This is common with some plant materials, seed varieties, and crop protectants.
    3. Network externalities. A network externality exists if there are benefits when multiple consumers use the same platform. A livestock auction provides a good example. Buyers benefit when there are more sellers participating in the auction. Similarly, sellers benefit when there are more buyers participating in the auction. Software, such as a word processing package, provides another example of a network externality. You have an incentive to use the package that is most commonly used by other users. This way, if a colleague sends you a document, you will likely be able to open and edit it without problems. Once established, the existence of network externalities in a market can make entry difficult.

    Usually, entry is impossible in a market that is a monopoly. The inability to enter the market is presumably why the market can remain a monopoly. There is one exception, however. This is the case of a contestable monopoly (Baumol, Panzar, and Willig 1982). A contestable monopoly exists in cases where the market can be served by one seller, but if this seller attempts to exploit its monopoly position by charging a high price, the market will be attacked by entrants who will cause the price to fall. If entrants can get in and out of the market easily, the monopolist will be attacked by entry whenever the monopolist attempts to raise its price. A contestable monopoly can exist if the fixed costs of entry can be recovered upon exit. An argument could be made that some food brands have characteristics of contestable monopolies.

    Table \(\PageIndex{1}\). Summary of Industry Characteristics and Market Structures
    Structure Number of Firms Horizontal Differences Vertical Differences Entry
    Monopoly One Not Applicable Possible, by product line Difficult*
    Oligopoly Few Possible Possible Difficult
    Monopolistic Comp. Many Yes Possible Easy
    Perfect Comp. Many No Possible Easy

    * The exception is a contestable monopoly

    This page titled 7.2: Considerations in Classifying a Market is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Michael R. Thomsen via source content that was edited to the style and standards of the LibreTexts platform; a detailed edit history is available upon request.