Spectrum of Competition

Industries in the economy can involve one of four types of competition, which can be set along a spectrum from perfect competition, to monopolistic competition, to oligopoly, to monopoly.

Perfect Competition

• Perfect competition is the highest level of competition, in which many producers of goods compete to sell at the lowest price.

• The definition of perfect competition emphasizes small firms (relative to the size of the market) selling identical products.

• Some key characteristics of perfectly competitive firms are that they are price-takers, entry and exit are easy, profits are low, and prices closely reflect costs of production.

• In a perfectly competitive market, with many firms and identical products, each firm is a price-taker that must accept the market price and sell at the market price.

• With many small firms and a product that many firms can make, it is easy for existing perfectly competitive firms to expand production or reduce it.

• With easy entry and exit and firms all charging the same price, firms in a perfectly competitive industry will earn low profits.

• Price will closely reflect cost of production, because profits are low and all firms are charging the same price.

• Perfect competition is rarely as “perfect” as the definition literally implies, but when firms face many competitors and are forced to act as price-takers, the industry is close to perfect competition.

Monopolies 

• Monopoly is the opposite extreme from perfect competition, because it is the case of little or no competition.

• Monopoly occurs when a single seller has all or most of the sales in a given market.

• For a monopoly to last over time, it requires a barrier to entry by other firms.

• A patent for an invention can be a barrier to entry of other firms.

• Some monopolies are created by law, such as the U.S. Postal Service or the firms that pick up garbage in many cities.

• Monopoly can arise if large firms merge together or if they agree to act together in their pricing and output decisions.

• A natural monopoly arises when production of the good has economies of scale relative to the size of market demand, giving the large, established firm an advantage over any new entrants.

• Monopolies have some power to set prices and to earn consistently above-average profits.

• A monopoly will set its price according to the elasticity of demand for its product, with the price being higher the more inelastic the demand.

• Because a monopoly can charge a higher price and not fear entry from other firms, it can earn consistently above-average profits.

Monopolistic Competition

• On the spectrum of competition, monopolistic competition is closer to perfect competition than to monopoly.

• Monopolistic competition occurs when many small firms compete by selling differentiated products.

• A monopolistically competitive firm has some power to choose its price, but because entry and exit are possible, it cannot earn above-average profits in the long run.

• Like a monopoly, a monopolistically competitive firm will have some power to choose its price, based on elasticity of demand. But it will have less power to raise price than an actual monopoly.

• Monopolistically competitive firms are in industries that do not face substantial barriers to entry.

• In the long run, new firms will enter a market if profits are exceptionally high and existing firms will exit a market if profits are exceptionally low. Because of this entry and exit, monopolistically competitive firms can make higher-than-normal profits in the short run but not in the long run.

• Monopolistic competition gives a strong incentive for spotting trends, trying to make lots of innovations, and offering different styles, looks, and features. The major social question is whether these gains from variety exceed the costs of higher prices to consumers.

Oligopoly

• An oligopoly is closer to monopoly than to perfect competition, but in some cases, oligopolists may compete in tough ways against each other.

• Oligopoly exists when a small number of large firms have most or all of the sales in a given market.

• Firms in an oligopoly may compete against each other in a tough way, in which case, they may act like perfect competitors and have low profits, or they may seek to act together as if they were a monopoly and earn higher-than-normal profits.