Both buyers and sellers are price takers.

Legal barriers to entry.

Legal barriers: legal franchise, license, patent or copyrights granted by government that prohibits other firms or individuals from producing particular products or entering particular occupations or industries.

The whole idea is for the government to allow just one firm or a group of individuals to do business.

First, it may be necessary to obtain a public franchise to operate in an industry. As we noted in the Focus essay, the monarch granted a franchise determining who could sell Asian goods in England in the seventeenth and eighteenth centuries. In modern times, franchises are granted by government for a variety of undertakings.

Example: The U.S. Postal Service has an exclusive franchise to deliver first-class mail. Many universities offer exclusive franchises to firms that provide food service on campus. Similar arrangements for food and gas service are made along toll roads such as the New Jersey Turnpike. The essence of an exclusive public franchise is that a monopoly is created; competitors are legally prohibited from entering franchised markets.

Public franchise: A right granted to a firm or industry allowing it to provide a good or service and excluding competitors from providing that good or service.

Second, in many industries and occupations a government license is required to operate.

Example: In most states a license is required to enter occupations such as architecture, dentistry, embalming, law, professional nursing, pharmacy, school teaching, medical practice, and veterinary practice. At the federal level, an operating license is required from the Federal Communications Commission to open a radio or television station. If you want to operate a trucking firm that carries goods across state lines, you must obtain a license from the Interstate Commerce Commission. Licensing therefore creates a type of monopoly right by restricting the ability of firms to enter certain industries and occupations.

Government license: A right granted by state or federal government to enter certain occupations or industries.

The patent prohibits others from producing the patented product and thereby confers a limited-term monopoly on the inventor. The purpose of a patent is to encourage innovation by allowing inventors to reap the exclusive fruits of their inventions for a period of time. Yet a patent also establishes a legal monopoly right. In effect, the social benefit of innovation is traded off against the possible social costs of monopoly.

Some barriers to entry are the result of government policies that grant single-seller status to firms.

Patents and copyrights are another government-supported barrier to entry.

A patent is a legal protection of a technical innovation that gives the person holding the patent a monopoly on using that innovation.

They give creators of new products and works of literature, art, and music exclusive rights to sell or license the use of their inventions and creations.Patents and copyrights provide monopoly protection for only a specified number of years. After the patent expires, the barrier to entry is removed.

The idea behind patents and copyrights is to encourage firms and individuals to innovate and produce new products by guaranteeing exclusive rights to the profits through monopoly supply for limited periods.

 

2. Perfect Competition

The concept, competition, is used in two ways in economics. One way is as a state, or type of market structure. The other way is as a process. As a process, competition is prevalent throughout our economy.

Competition as a process is a rivalry among firms. It involves one firm trying to figure out how to take away market share from another firm.

Competition as a state, or market structure, is the end result of the competitive process under certain conditions.

A perfectly competitive market is a market in which economic forces operate absolutely. For a market to be called perfectly competitive, it must meet some stringent conditions:

1. Buyers and sellers are price takers.

2. No influence.

3. The number of firms is large.

4. There are no barriers to entry.

5. Firms' products are homogeneous (identical).

6. Exit and entry are instantaneous and costless.

7. There is complete information.

8. Selling firms are profit-maximizing entrepreneurial firms.

These conditions are needed to ensure that economic forces operate instantaneously and are unlimited by other invisible or visible forces.

To give you a sense of these conditions, let's consider them a bit more carefully.

No influence.

- If any action taken by the firm has any effect on price, that's influence.

- If a firm, by withholding half its output from the market was able to push up price, that would be influence.

- If a firm doubled its output and forced down price, that too would be influence.

- If a firm left the industry, which would make price go up, that would be influence on price.

No barriers to entry.

Barriers to entry are any things that prevent other firms from entering a market. They might be legal barriers such as exist when firms acquire a patent to produce a certain product. Barriers might be technological, such as when the minimum efficient scale of production allows only one firm to produce at the lowest average total cost. Or barriers might be created by social forces, such as when bankers will lend only to certain types of people and not to other types. Perfect competition can have no barriers to entry.

Homogeneous product.

A homogeneous product is a product such that each firm's output is indistinguishable from any other firm's output.

This means that advertising does not exist in apurely competitive market. Why would one firm want to advertise the advantages of its product if it is perfectly substitutable for the product of competitors? That is, those who buy the product cannot distinguish between what one seller and another sells. So, in the buyer's mind, the product is identical. The buyer has no reason to prefer one seller to another.

Aperfectly competitive industry has many firms selling an identical product. How many is many? So many that no one firm can influence price. What is identical? A product that is identical in the minds of buyers so that they have no reason to prefer one seller to another.

Corn bought by the bushel is relatively homogeneous. One kernel is indistinguishable from every other kernel. On the other hand, you can buy 30 different brands of many goods—soft drinks, for instance: Pepsi, Coke, 7-Up, and so on. Each is slightly different from the other and thus not homogeneous.

Complete information.

In a perfectly competitive market, not only would the store open up immediately; you'd also know about it instantaneously. So would other firms. Similarly, if any firm experienced a technological breakthrough, all firms would know about it and would be able to use the same technology instantaneously.

A perfectly competitive market also offers perfect information to buyers and sellers. Everybody in the market has equal, free access to information about the location and price of the product.

Perfect information: A condition in which information about prices and products is free to market participants; combined with conditions for pure perfect competition, perfect information leads to perfect competition.

Agriculture, particularly wheat growing, has been held up as an example of perfect or near-perfect competition. The rise of the giant corporate farm has made this example somewhat obsolete, but we haven't been able to come up with any other examples of perfect competition.

Imperfect Competition

Imperfect competition exists when more than one seller competes for sales with other sellers of similar products, each of whom has some control over price. Individual sellers in such markets have a degree of monopoly power, which means they can influence on the price of their product by controlling its availability to buyers. Firms can control prices by differentiating their products either by quality or by brand.

For example, loyal buyers of Coca-Cola, Bayer aspirin gladly pay higher prices for these products than they would for generic ones. In other markets, firms control price by gaming large market shares. We will first discuss imperfectly competitive markets in which sellers gain monopoly power by differentiating their products from those of their competitors.

Monopolistic Competition

Monopolistic competition exists when many sellers compete to sell a differentiated product in a market into which the entry of new sellers is possible. In a monopolistically competitive market:

1. There are relatively large numbers of firms, each satisfying a small, but not microscopic, share of the market demand for a similar, but not identical product. The market share of each rival firm is generally larger than it would have under perfect competition, but it's unlikely that any one firm satisfies not more than 10 percent of market demand.

2. The product of each firm is not a perfect substitute for the products of competing firms. Each seller's product has unique qualities or characteristics that cause some buyers to prefer it to products of competing firms. The product is therefore differentiated from any other product.

For example, people who believe that Reeboks are more comfortable than other sports shoes will pay higher prices for Reeboks than for another shoes. Similarly, people who like the cut or fabrics of Calvin Klein's clothes will pay more for them. Although each seller's product is unique, there's enough similarity among particular kinds of products to group sellers into broad categories. A product group represents several closely related, but not identical, items that serve the same general purpose for consumers. The sellers in each product group can be considered competing firms within an industry.

Arbitrary decisions are necessary to define a product group. Is the footwear industry, for example, to include all types of footwear including men’s shoes, women’s shoes, children's shoes, boots, athletic shoes, and rubber overshoes? Are the providers of fast-food services like McDonald's to be considered members of the restaurant-services product group? The answer isn't clear. Many buyers don't think the meals served by these firms are good substitutes for meals in a full service-restaurant.

3. Firms in an industry don't consider the reaction of their rivals when choosing their product prices or annual sales targets. Because there are a relatively large number of firms in a monopolistically competitive industry, a firm's managers believe that their actions can't significantly reduce the market share of their rivals.

If a single firm cuts the price of its shoes by 20 percent to gain more sales, other firms may experience only a small decrease in sales and are therefore unlikely to react by cutting their prices also. The managers of the first firm know this, so they don't bother to consider any possible reaction from competitors.

4. Relative freedom of entry and exit by new firms exists in monopolistically competitive markets. It's easy to set up new firms in monopolistically competitive markets. Entry may not be quite as easy as it is in perfect competition because new firm with new brands or product features may initially have difficulty establishing their reputations. Existing firms with established brands and reputations for service are likely to hold some competitive edge over new entrants.

Free entry means that profitable conditions in the industry are likely to attract new sellers. In the long run the magnet of profits will serve to increase supplies of the product sold by the industry. This in turn will put downward pressure on both price and profits.

5. Neither the opportunity nor the incentive exists for firms in the industry to cooperate in ways that decrease competition. The firms in a monopolistically competitive market don't cooperate to fix prices in order to increase their group profits. They can't effectively prevent new entrants from responding to profit opportunities by opening rival enterprises.

Product Differentiation

Product differentiation is crucial to monopolistic competition. In fact, product differentiation is really what stands between perfect competition and the real world. People differentiate among many similar products.

What makes one good or service differ from another? We need only for the buyer to believe it's different, because product differentiation takes place in the buyer's mind. In the real world, however, buyers generally do differentiate. We're always differentiating, and it doesn't have to be based on taste, smell, size, or even any physical differences among the products.

Example: Two record shops might carry the same poor excuse that passes for music these days — it can only be played loud, so those young people suffering from hearing loss can still pick up some of the sounds. Both shops charge exactly the same prices. Both shops are conveniently located. But one is always crowded and the other is always empty.

Perhaps one place lets you play a CD before you buy it. Perhaps one place will take special orders for you. Perhaps the sales clerks and owner is nice, helpful people, while in the other store, they're all grouches.

Now we're dealing with a differentiated product. The CDs are the same. The prices are the same. But one store's got ambience up to here, and the other has to send out for it. The buyer prefers Mr. Nice Guy's store over the grouch's store, so we have a differentiated product.

When sellers try to get buyers to differentiate between their products and those of competitors, the sellers do so based on not just physical differences between their product and those of the competitors. Also used are convenience, ambience, reputation of the seller, and appeals to your vanity, unconscious fears, and desires, as well as snob appeal.

Price Discrimination

Price discrimination occurs when a seller charges two or more prices for the same good or service.

Examples:

1. Doctors often charge rich patients 10 times as much for the same service as poor patients.

2. Airlines sometimes allow riders under 16 years of age to fly at half-fare ("youthfare").

3. The most notorious example of price discrimination was probably that of A&P during the 1940s. A&P had three grades of canned goods: A, B, and C. Grade A was presumably of the highest quality, B was fairly good, and C was— well, C was edible. My mother told me that she always bought grade A, even though it was the most expensive. Nothing but the best for our family. Our family was friendly with another family in the neighborhood. The husband, a man in his early 50s, found out he had stomach cancer. "Aha!" exclaimed my mother, "Mrs. S. always bought grade C!"

A few years later the Federal Trade Commission (FTC) prohibited A&P from selling grades A, B, and C. The FTC didn't do that because of Mr. S.'s stomach cancer, but because there was absolutely no difference among the grades.

Why had A&P concocted this elaborate subterfuge? Because it was worth tens of millions of dollars in profits! Take a can of green peas that had a demand schedule like the one in Table 1.

To keep things simple, suppose A&P had a constant ATC of 20 cents a can. How much should it charge? To figure this out, add a total cost column to Table 1 and then a total profits column. Now figure out the total profits at prices of 50 cents, 40 cents, and 30 cents, respectively.

In Table 2, these calculations are all worked out. If A&P could charge only one price, it would be 50 cents; total profit would be $30. Now let's see how much profit would be if A&P were able to charge three different prices.

Table 1

Hypothetical Demand Schedule for Canned Peas

Price	Quantity Demanded	Total Revenue
$ 0.50	100	$50
0.40	140	56
0.30	170	51

At 50 cents, A&P would be able to sell 100 cans. These are sold to the people who won't buy anything if it isn't grade A. Then there are those who would like to buy grade A but just can't afford it. These people buy 40 cans of grade B. Finally, we have the poor, who can afford only grade C; they buy 30 cans.

Table 2

Hypothetical Demand Schedule for Canned Peas

Price	Total Revenue	Total Cost	Total Profit
$ 0.50	$50	$20	$30
0.40	56	28	28
0.30	51	34	17

All this is worked out in Table 3. Total revenue now is $75 for the 170 cans sold, and total cost of 170 cans remains $34. This gives A&P a total profit of $41.

Table 3

Hypothetical Demand Schedule for Canned Peas, by Grades

Grade	Price	Quantity Demanded	Total Revenue	Total Costs	Total Profit
A	$ 0.50	100	$50	$20	$30
B	0.40	40	16	8	28
C	0.30	30	9	6	17
Sum			$75	$34	$41

 

Why is total profit so much greater under price discrimination ($41) than it is under a single price ($30)? Total profit would be $30 at 50 cents; it would be $28 at 40 cents; it would be $17 at 30cents. People are willing to buy only 100 cans at 50 cents, 40 more at 40 cents, and another 30 at 30 cents. But the people who buy only grade A will buy all their cans of green peas at that price, while those buying grade B will buy all their peas at 40 cents and grade C buyers will buy all their peas at 30 cents. By keeping its markets separate rather than charging a single price, A&P had been able to make much larger profits.

The firm that practices price discrimination needs to be able to distinguish between two or more separate groups of buyers.

In addition to distinguishing among separate groups of buyers, the price discriminator must be able to prevent buyers from reselling the product (i.e., stop those who buy at a low price from selling to those who would otherwise buy at a higher price).

If the 15-and-a-half-year-old buys an airline ticket at half-fare and resells it to someone 35 years old, the airline loses money. Most 15-and-a-half-year-olds don't have too much money, so that's a way of filling an otherwise empty seat; but when the 35-year-old flies half-fare and would have been willing to pay full fare, the airline loses money. In the case of A&P. there was no problem preventing the grade C customers from reselling their food to the grade A customers because these people voluntarily separated themselves into these markets.

Price discrimination is woven into our economic fabric, and in most cases it is basically a mechanism for rationing scarce goods and services. For example, since nearly everyone seems to want to go to the movies at 8:00 on Saturday night, the theaters encourage moviegoers to see films at other times by charging considerably less. But the main motivation for price discrimination is, of course, to raise profits. If price discrimination were carried to its logical conclusion, we would have perfect price discrimination.

Oligopoly

Unlike a monopolistically competitive market, oligopoly is a market structure in which a few sellers dominate in sales of a product and where entry of new sellers is difficult or impossible. The product can be either differentiated or standardized.

An oligopoly is an industry with just a few sellers. How few? So few that at least one firm is large enough to influence price.

Is the product identical or differentiated? It doesn't matter. In the case of the steel, copper, and aluminum industries, the product happens to be identical; but in most other cases, the product is differentiated.

The crucial factor under oligopoly is the small number of firms in the industry. Because there are so few firms, every competitor must think continually about the actions of his rivals, since what each does could make or break him. Thus there is a kind of interdependence among oligopolists.

For example, in market sales in the United States for a standardized product, aluminum, are dominated ALCOA, Reynolds, and Kaiser. Automobiles, cigarettes, beer, and chewing gum are examples of differentiated goods whose market structures are oligopolistic.

Oligopolistic markets are characterized by high market concentration. Usually the four largest producers of a good account for over half the domestic shipments.

Concentration ratios

One way of measuring how concentrated an industry is, is to look at the percentage share of sales of the leading firms. This is called the industry's concentration ratio.

Economists use concentration ratios as a quantitative measure of oligopoly.

The total percentage share of industry sales of the four leading firms is the industry concentration ratio. Industries with high ratios are very oligopolistic.

Two key shortcomings of concentration ratios should be noted.

1. Don't include imports. For example, in the auto industry, foreign cars account for about one third of the American market. Although Honda is listed among the top four American automakers, we have not taken into account the 2 million Japanese imports, not to mention the hundreds of thousands of Volkswagens, Saabs, BMWs, Audis, Jaguars, Porsches, and Rolls Royces we also import.

Concentration ratios have become less meaningful as foreign imports have increased. For instance, we get 75 percent of our consumer electronics and 50 percent of our oil from abroad, so concentration ratios in these industries are meaningless. Perhaps in a world with unrestricted international trade, which would make our world a veritable global village, we could replace national concentration ratios with international concentration ratios.

2. The concentration ratios tell us nothing about the competitive structure of the rest of the industry. Are the remaining firms all relatively large, as in the cigarette industry, which has a total of just 13 firms, or are they small, as in the aircraft and engine parts industry, which totals about 190 firms? This distinction is important because when the remaining firms are large, they are not as easily dominated by the top four as are dozens of relatively small firms.

The American automobile industry, which had long been a classic example of an oligopoly, has been changing drastically in recent years. Not only have imports had a substantial impact, but now seven Japanese carmakers have set up operations in thiscountry. The imports have made the automobile industry's concentration ratio much less relevant, while the transplants have been reducing that ratio. But these developments have been an unmitigated boon to the car buyer, who is reaping the benefits of lower prices and much higher quality.

A second way is to calculate the Herfindahl-Hirschman index, which, it turns out, is a lot easier to do than to say.

The Herfindahl-Hirschman Index (HHI). The Herfindahl-Hirschman index (HHI) is the sum of the squares of the market shares of each firm in the industry.

We'll start with a monopoly. One firm has all the sales, or 100 percent of the market share. So, its HHI would be 100², or 100 x 100 = 10,000.

Find the HHI of an industry with just two firms, both of which have 50 percent market shares. Work it out right here:

50² + 50² = 2,500 + 2,500 = 5,000

Find the HHI of an industry that has four firms, each with a 25 percent market share:

25² + 25² + 25² + 25² = 625 + 625 + 625 + 625 = 2,500

The less concentrated an industry, the lower its HHI. And here's one last question. Imagine an industry with 100 firms, each with an equal market share. Without going through all the work, see if you can figure out the HHI.

It would come to 100: 1² + 1² + 1²  ... + 1² = 100.

The Competitive Spectrum

No single general model of oligopoly behavior exists. The reason is that an oligopolist can decide on pricing and output strategy in many possible ways, and there are no compelling grounds to characterize any of them as the oligopoly strategy. Although there are five or six formal models, we'll focus on two informal models of oligopoly behavior that give you insight into real-world problems rather than exercise your reasoning and modeling abilities as my earlier discussion did.

The reason lies in the interdependence of oligopolists. Since thereare so few competitors, what one firm does, so specifically influences what other firms do, so an oligopolist's plan must always be a contingency or strategic plan. If my competitors act one way, I’ll do X, but if they act another way, I'll do Y. Strategic interactions have a varietyof potential outcomes rather than a single outcome such as shown in the formal models we discussed. An oligopolist spends enormous amounts of time guessing what its competitors will do, and it develops a strategy of how it will act, depending on what its competitors do.

The disastrous effect of price wars on profits of firms in oligopolistic markets provides an incentive for sellers to collude to keep profits up. Such collusion is illegal in most nations, and governments may prosecute firms that collude to fix prices at high levels or at temporarily low levels to force competitors out of business.

In this section we shall consider the possible degrees of competition from cartels and open collusion down through cutthroat competition.

Cartel

An extreme case of oligopoly is a cartel, where the firms behave as a monopoly in a manner similar to that of the Organization of Petroleum Exporting Countries (OPEC) in the world oil market.

A cartel is a group of firms acting together to coordinate output decisions and control prices as if they were a single monopoly. Cartels are illegal. International cartels, however, do exist. Perhaps the best known is OPEC: Organization of Petroleum Exporting Countries (most of which are Middle Eastern nations). It seeks to regulate its members' output of crude oil with the goal of controlling price to maximize group profits.

Implicit Price Collusion

In other cases the various firms meet, sometimes only by happenstance, at the golf course or at a trade association gathering, and arrive at a collective decision. In yet other cases the firms engage in implicit collusion —multiple firms make the same pricing decisions even though they have not explicitly consulted with one another.

Implicit price collusion, in which firms just happen to charge the same price but didn't meet to discuss price strategy, isn't against the law. Oligopolies often operate as close to the fine edge of the law as they can. For example, many oligopolistic industries allow a price leader to set the price, and then the others follow suit. The airline and steel industries take that route. Firms just happen to charge the same price or very close to the same price.

It isn't only in major industries that you see such implicit collusion. In small towns, you'll notice that most independent carpenters charge the same price. There’s no explicit collusion, but were a carpenter to offer to work for less than the others, she would feel unwelcome at the local breakfast restaurant. She would feel the pressure of the invisible handshake (social pressure).

Price war

A price war is a bout of continual price cutting by rival firms in a market. It's one of many possible consequences of oligopolistic rivalry. Price wars are great for consumers but bad for the profits of sellers.

Other Oligopoly Models

Behavior in oligopolistic markets is very difficult to analyze. The difficulty seems from the fact that the way firms behave depends crucially on how they think their rivals will respond to their pricing policies. The way firms compete in a market also depends on how they think their rivals will react to changes in advertising policies or to the introduction of new products.

In the preceding analysis of oligopoly we considered only the possibility of price wars and the tendency of firms to collude to maximize group profits. There are many other possible outcomes in oligopolistic markets. Each outcome depends on how firms regard their rivals, on their willingness to collude with their rivals, and on the penalties they may pay for illegal collusion. Each oligopolistic market must be examined by itself to determine what is going on.

Price leadership

In some oligopolistic markets, one dominant firm in the industry sets its price to maximize its own profits; other firms simply follow its lead by setting exactly the same price. The dominant firm is called the price leader. There's no collusion or quota setting. For example, in banking markets one or two large banks typically set the prime rate, which is the interest on loans to large corporations. Other banks quickly follow the large banks' lead and adjust their own interest rates.

Entry-Limit Pricing

Firms in an oligopolistic market may set prices in order to make it unprofitable for potential new entrants into the market to actually begin selling. To accomplish this objective, firms in the market do not necessarily set a price that maximizes their current profits. Instead, they are forward looking enough to forgo current profits in order to keep new entrants from entering the market and putting downward pressure on future profits.

Firms either collude or follow the lead of another firm in setting prices to achieve the objective of discouraging entry. To achieve this objective, they estimate the minimum possible long-run average cost of any potential entrants in the market. They also presume that any potential entrant will take the price set by existing firms is one that will be maintained.

Entry-limit pricing shows how the fear of new entrants into the market can provide profit-maximizing sellers currently in the market with the incentive not to exercise their monopoly power.

Advertising under Oligopoly

In oligopolistic markets, individual firms consider the reactions of their rivals before engaging in advertising and other promotional expenses. An oligopolistic firm can substantially increase its market share by advertising only if rival firms do not retaliate with advertising campaigns of their own.

There is some evidence that advertising in oligopolistic industries is carried beyond the point that would be justified by profit maximization. Advertising in oligopolistic industries apparently tends to raise costs without significantly increasing any one firm's market share. Rival firms merely cancel out the effect of each other's advertising.

There is also evidence that advertising in the soap and detergent industry does little more than cancel out the effect of rival firms' promotional messages. It is possible that such firms prefer nonprice competition to the alternative of a price war. They may believe that promotional efforts can provide them with temporary increases in profits if rivals lag in reacting.

Other studies have found that advertising does contribute to profits. Such studies indicate that the higher the ratio of advertising expenditures to sales in an industry the higher the industry profit rates. Insofar as higher profits indicate monopoly power, this implies that advertising leads to more monopoly control over price. It is unclear, however, whether increased advertising causes higher profits or higher profits cause more advertising.

Legal barriers to entry.

Legal barriers: legal franchise, license, patent or copyrights granted by government that prohibits other firms or individuals from producing particular products or entering particular occupations or industries.

The whole idea is for the government to allow just one firm or a group of individuals to do business.

First, it may be necessary to obtain a public franchise to operate in an industry. As we noted in the Focus essay, the monarch granted a franchise determining who could sell Asian goods in England in the seventeenth and eighteenth centuries. In modern times, franchises are granted by government for a variety of undertakings.

Example: The U.S. Postal Service has an exclusive franchise to deliver first-class mail. Many universities offer exclusive franchises to firms that provide food service on campus. Similar arrangements for food and gas service are made along toll roads such as the New Jersey Turnpike. The essence of an exclusive public franchise is that a monopoly is created; competitors are legally prohibited from entering franchised markets.

Public franchise: A right granted to a firm or industry allowing it to provide a good or service and excluding competitors from providing that good or service.

Second, in many industries and occupations a government license is required to operate.

Example: In most states a license is required to enter occupations such as architecture, dentistry, embalming, law, professional nursing, pharmacy, school teaching, medical practice, and veterinary practice. At the federal level, an operating license is required from the Federal Communications Commission to open a radio or television station. If you want to operate a trucking firm that carries goods across state lines, you must obtain a license from the Interstate Commerce Commission. Licensing therefore creates a type of monopoly right by restricting the ability of firms to enter certain industries and occupations.

Government license: A right granted by state or federal government to enter certain occupations or industries.

The patent prohibits others from producing the patented product and thereby confers a limited-term monopoly on the inventor. The purpose of a patent is to encourage innovation by allowing inventors to reap the exclusive fruits of their inventions for a period of time. Yet a patent also establishes a legal monopoly right. In effect, the social benefit of innovation is traded off against the possible social costs of monopoly.

Some barriers to entry are the result of government policies that grant single-seller status to firms.

Patents and copyrights are another government-supported barrier to entry.

A patent is a legal protection of a technical innovation that gives the person holding the patent a monopoly on using that innovation.

They give creators of new products and works of literature, art, and music exclusive rights to sell or license the use of their inventions and creations.Patents and copyrights provide monopoly protection for only a specified number of years. After the patent expires, the barrier to entry is removed.

The idea behind patents and copyrights is to encourage firms and individuals to innovate and produce new products by guaranteeing exclusive rights to the profits through monopoly supply for limited periods.

 

2. Perfect Competition

The concept, competition, is used in two ways in economics. One way is as a state, or type of market structure. The other way is as a process. As a process, competition is prevalent throughout our economy.

Competition as a process is a rivalry among firms. It involves one firm trying to figure out how to take away market share from another firm.

Competition as a state, or market structure, is the end result of the competitive process under certain conditions.

A perfectly competitive market is a market in which economic forces operate absolutely. For a market to be called perfectly competitive, it must meet some stringent conditions:

1. Buyers and sellers are price takers.

2. No influence.

3. The number of firms is large.

4. There are no barriers to entry.

5. Firms' products are homogeneous (identical).

6. Exit and entry are instantaneous and costless.

7. There is complete information.

8. Selling firms are profit-maximizing entrepreneurial firms.

These conditions are needed to ensure that economic forces operate instantaneously and are unlimited by other invisible or visible forces.

To give you a sense of these conditions, let's consider them a bit more carefully.

Both buyers and sellers are price takers.

A price taker is a firm or individual who takes the market price determined by market supply and demand as given.

When you buy, say, toothpaste, you go to the store and find that the price of toothpaste is, say $1.38 for the medium-size tube: you're a price taker. The firm, however, is a price maker since it set the price at $1.38. So even though the toothpaste industry is highly competitive, it's not a perfectly competitive market. In a perfectly competitive market, market supply and demand determine the price; both firms and consumers take the market price as given.

No influence.

- If any action taken by the firm has any effect on price, that's influence.

- If a firm, by withholding half its output from the market was able to push up price, that would be influence.

- If a firm doubled its output and forced down price, that too would be influence.

- If a firm left the industry, which would make price go up, that would be influence on price.