Market Consists of All Firms

¶ … market consists of all firms and individuals who are willing and able to buy or sell a particular product. These parties include those currently engaged in buying and selling the product, as well as potential entrants. Market structure refers to the basic character-istics of the market environment, including (1) the number and size of buyers, sellers, and potential entrants; (2) the degree of product differentiation; (3) the amount and cost of information about product price and quality; and (4) the conditions for entry and exit.

Competitive markets are characterized by four basic conditions: A large number of potential buyers and sellers; product homogeneity; rapid, low-cost dissemination of information; and free entry into and exit from the market. In competitive markets, individual buyers and sellers take the market price of the product as given: They have no control over price. Firms thus view their demand curves as horizontal. The firm's short-run supply curve is that portion of its short-run marginal cost curve above short-run average variable cost. The long-run supply curve is that portion of its long-run marginal cost curve above long-run average cost. In a competitive equilibrium, firms make no economic profits. Production is efficient in that firms produce at their minimum long-run average cost. Firms in competitive industries must move rapidly to take advantage of transitory opportunities. They also must strive for efficient production in order to survive. Some firms in the industry can employ resources that give them a competitive advantage (for example, an extremely talented manager). Yet in such cases, any excess returns often go to the factor of production responsible for the particular advantage, rather than to the firm's owners.

Although the competitive model provides a useful description of the interaction be-tween buyers and sellers for many industries, there are others where firms have substan-tial market power -- prices are affected materially by the output decisions of individual firms. Market power can exist when there are substantial barriers to entry into the indus-try. Expectations about incumbent reactions, incumbent advantages, and exit costs all can serve as entry barriers.

The extreme case of a firm with market power is monopoly, where the industry con-sists of only one firm. Here, industry and firm demand curves are one and the same. In contrast to competitive markets, consumers pay more than marginal cost and the firm earns economic profits. Output is restricted from competitive levels. With a monopoly, not all the potential gains from trade are exhausted.

Monopolistic competition is a hybrid between competition and monopoly. It is like mo-nopoly in that firms under both market structures face downward-sloping demand curves. Market power comes from differentiated products. Examples include the toothpaste, golf ball, tennis racket, and shampoo markets. The analyses of output and pricing policies are similar in the two cases. The difference between monopoly and monopolistic competition is that in monopolistic competition, economic profits invite entry that limits profits.