Joseph Schumpeter, as mentioned in class two, essentially viewed business cycles as
being driven by entrepreneurs. Schumpeter was writing his book on "Capitalism,
Socialism and Democracy" and his two-volume "Business Cycles" in the 1930s and
reflecting on the past. He observed the roaring 1920s - a period of rapid
technological change and economic growth accompanied by low inflation. That was
followed by a period of major economic contraction and economic stagnation. He
was not pessimistic about the future during the 1930s, as he didn't believe capitalism
could destroy itself by creating economic problems. Instead Schumpeter thought
capitalism might be destroyed by its successes.
Schumpeter viewed entrepreneurs and their innovating activity as the source of
profit. Entrepreneurs were not normal business people following established routines
but were people that introduced change and competition into the economic system
" … competition of the kind we now have in mind acts not only when in being but
also when it is merely an ever-present threat. It disciplines before it attacks. The
businessman feels himself to be in a competitive situation even if he is alone in his
field or if, though not alone, he holds a position such investigating government
experts fail to see any effective competition between him and any other firms in the
same or a neighboring field and in consequence conclude that his talk, under
examination, about his competitive sorrows is all make-believe."
Microsoft is essentially alone in its field; it created a monopoly and monopoly
profits. Microsoft probably felt pressures of changing technologies in competing
industries closing in on their software business. Microsoft made a natural business
response - transformation, using its monopoly position in the operating system field,
to also emerge as a player in the Internet business.
Competitors saw, heard and felt the competitive pressures of a giant business in
transformation. Competitors cried uncle and ran to bureaucrats for protection.
Bureaucrats responded. Microsoft behavior is what one expects when a monopoly
player, in this case Microsoft, feels its traditional business lines threatened. They use
their monopoly power both to protect their existing business and to transform
themselves into a new business.
Mr. Gates knows that competition from within his industry is not important since he
is a monopolist. Instead it is technology changes and competition in other industries
that would, in the end, destroy his business unless Microsoft took action.
Suppose that in the future, the bulk of memory and software that currently is on
personal computers will be held at central locations until needed by the user. At that
time, it will be pointless to have sophisticated PCs loaded with software sitting
around either individually or hooked to each other.
Microsoft may be attempting to position itself for and compete with companies
already engaged in this business. Microsoft, ideally, might like a large piece of the
storage, software and personalized database market of the corporate and consumer
markets in order to capture flows of monthly fees -- similar to monthly fees that
phone companies capture. Microsoft has the ability to position itself for that.
The Internet constitutes a major technological change in the economic system that
creates and delivers goods and services from business to business, business to
consumers as well as the government-taxpayer relationship. Microsoft no doubt
would like to be a part of the value-added business to business and business to
Microsoft is a classic case of a business attempting to reposition itself. Microsoft
probably would like to maintain its monopoly position in the software and operating
system business and develop a strong Internet position -- the classic textbook
monopoly model in one business and a major player in an oligopoly model in
another. Two business market models Microsoft doesn't want to be in are perfect
competition and monopolistic competition as they are characterized by smaller and
more numerous competitors.
Market Structures and Characteristics
A key theme of economics is scarcity. Consumers have unlimited needs and wants
but resources to achieve those needs are scarce. In market economies, suppliers
provide the types of products and services customers want and can afford. The
market environment differs for various suppliers.
There are four types of market structures -- perfect competition (also referred to as
pure competition), monopoly, monopolistic competition, and oligopoly. Producers in
these markets sell product and services.
There are not necessarily clear "break points" between different market structures, as
in some cases hybrid types of market structures evolve.
Characteristics of perfect competition include:
1. Large number of buyers and sellers
2. Buyers and sellers have perfect information on prices and products
3. Homogeneous, non-differentiable products (i.e. commodities)
4. Low barriers to entry and exit
5. Price-taking firms
Agricultural commodity markets are a good example of perfect competition. There
are hundreds of thousands of farmers that sell their products to thousands of grain
elevators. Buyers and sellers know prices, product, and quality issues associated with
various agricultural commodities, such as corn, soybeans, and wheat.
Products are largely homogeneous -- commodities, with adjustments for factors such
as moisture content. This makes it very difficult to differentiate the product.
There are low barriers to entry. Farmers can move in and out of markets quickly, by
planting a different type of crop or no crop at all. Finally suppliers are "price-takers"
as they take the price determined by global industry demand and supply. No
producer has any influence on selling price but they do on their costs.
Demand Curve under Perfect Competition
The industry market conditions under perfect competition are typical of other
markets in that they have a normal upward sloping supply curve and downward
sloping demand curve. This is shown below. However, the individual producer in
perfect competition faces a horizontal demand curve, or a perfectly elastic demand
curve, relative to the x-axis. Click on this graph and understand the why the
industry has a downward sloping demand curve while the firm in perfect
competition faces a horizontal demand curve.
Click here to see Graph 1.
The key to the demand curve under perfect competition is that there is only one price
in the market. Attempts by a single supplier or group to influence prices are futile.
Raising prices under such a scenario immediately results in a zero demand for the
product. In perfect competition one is a price taker.
Short Run Profit Maximization - Perfect Competition
Profit maximization is selling price equals marginal cost equal to or above average
variable cost in the short run. In perfect competition the market price to the firm is
equal to its marginal revenue. Price is not equal to marginal revenue in other market
models as the demand curve slopes down.
Under perfect competition the shutdown rule states that a firm should continue to
operate in the short run as long as variable costs are being recovered. Fixed costs
accrue whether production occurs or not. Only variable costs must be recovered in
the short run, and as long as that is achieved, a firm should not shut down. Over the
long run, all costs, fixed and variable, must be recovered.
Shut-Down Rule (Short Run)
The Profit-Maximization rule states that firms operating in all types of market
environments, including monopoly, oligopoly, and monopolistic competition
produce at the point where marginal cost equals marginal revenue when at or above
minimum average variable cost - covering variable costs.
If firms can't cover variable cost such as labor and material costs, they shut down.
Companies with money in the bank such as .com companies can burn cash to pay
variable costs. The IPO and secondary offerings put cash in the bank. A company
could continue to operate in the shut down position as long as cash is present to
cover variable costs.
Marginal cost is the increase in total cost or variable cost associated with production
of an additional unit of output. For some .com companies (ones that give their
product away) the marginal cost of an additional user is zero. Marginal revenue is
the increase in total revenue associated with the sale of an additional unit of output.
For perfect competition and its horizontal demand curve, marginal revenue is the
same from the first to the last unit of sale and is the market price. In perfect
competition, a profit-maximizing firm should operate at a production level where
marginal cost equals price, or where the marginal cost curve intersects the perfectly
elastic, horizontal demand curve. Note the following graph:
In a perfectly competitive environment, the marginal cost curve also becomes the
supply curve. How is that? Remember the intent is to produce where marginal cost
equals price. Thus no matter where price settles, the profit-maximizing firm would
want to be at point MC=MR=price as long as it covers variable cost.
The firm's marginal cost curve intersects both the average variable and average total
cost curves at their minimum. If the marginal is below the average, the average is
going down. If the marginal is above the average, the average is increasing. The
marginal must therefore equal the average at its minimum.
A monopoly exists when there is a single supplier of a product or service with no
close substitutes. Closely associated with the concept of a single supplier are barriers
to entry that restrict new entry.
Examples of regulated monopolies are electric and water companies. Electric utilities
are slowly being deregulated however.
Characteristics of Monopoly
The characteristic that distinguishes monopoly from other market structures is that
the firm's demand curve is the market demand curve plus its ability to restrict entry
of new producers. The following are examples of methods that can be used to block
entry of new firms.
1. Economies of Scale
2. Technology, Response Time, Innovation
3. Patents, Trademarks, Licensing, quotas, tariffs or other governmental powers
4. Distribution, shelf space, franchises
5. Control or ownership of raw materials
A monopoly produces either commodity or differentiated products, faces a
downward sloping demand and a marginal revenue curve that slopes down at 2X the
rate of the demand curve. Marginal revenue is positive when price elasticity of
demand is elastic, equal to zero when MR is -1 and negative when demand is
The firm produces at MR=MC as long as price is greater than AVC in the short run.
The selling price corresponding to MR=MC is given by drawing a line from
MR=MC up to the demand curve. The output is obtained by extending a line from
MR=MC down to the X-axis. A normal profit for the monopolist occurs at P=ATC.
Economic profit is when P>ATC.
Maximum profit occurs where MR=MC and the firm is producing in the elastic
region of its market demand curve. A firm is producing at less than maximum profit
if production is in the inelastic portion. MR and MC are negative for a downward
sloping demand curve and MC for a firm cannot be negative. Maximum total
revenue occurs where price elasticity is equal to -1.
Firms continually restructure to lower cost curves in order to lose less or earn more.
Another point is substitutability. There are few substitutes for electricity, water, and
other utilities but different producers provide those products. Competition among
producers, if allowed by regulatory authorities, usually results in lower prices for
consumers. Customers decide what company to purchase an auto from. Why not the
same for electricity? It is moving that way.
Customers purchase a college and MBA education from the school they want to
attend. Why not the same for grade and high school education?
Certain airline hubs are close to fitting a monopoly model. American (directly and
indirectly through Ft. Worth) fights the opening of Love Field in the Metroplex. For
Metroplex consumers the opening of Love Field to all flights would result in lower
airfares at both airports - a major plus for consumers. An open Love would provide
for choice and lower fares - a competitive market and would end American's near
monopoly at DFW.
Stockholders of American would suffer however with an open Love. So American
management should fight to restrict flights out of Love in the interest of its
stockholders. Consumers and businesses with an interest in Love Field are doing
what they should -- fight to open Love - as it would mean more choice and lower
fares to customers in the Metroplex.
The Monopolist - A Price Searcher
The monopolist is a price- searcher -- a firm that exhibits some degree of power or
control over market prices as it faces a downward sloping demand curve. If the
perfect competitor wants to increase the firm's revenue, it simply sells more at the
same market price. The monopolist, however, may be required to lower its prices if
it intends to sell more and gain market share if that is the objective.
A monopolist that wants to maximize profitability will produce in the price elastic
region of the market demand curve. Price-searching or price-maker firms are not
necessarily limited to monopolists. The demand curve for the monopolist is
The monopolist is earning an economic profit when the selling price is above
average cost of production. But when selling price is equal to average cost the
monopolist earns a normal profit. A less than normal profit occurs when the average
cost of production is greater than the selling price. The latter case suggests a massive
employee termination program and restructuring effort is on the way. The following
links show each of the respective cases. Be sure to go through each of these to see
how the average cost curve shifts for the different cases.
Click here to see Graph 3.
Click here to see Graph 4.
Click here to see Graph 5.
Monopolistic competition is a market structure in which the premise is that a
differentiated product or service is produced. The monopolistic competitor attempts
to create a sense of superiority of the firm's products or services (actual or perceived)
in the minds of the customer.
There are four characteristics of a monopolistic competitive segment including
1. Relatively large number of sellers
2. Differentiated products or services
3. Relatively free entry to and exit from markets
4. Sellers attempt to be price searchers
Examples of business segments fitting this model include downstream game
software, educational software and neighborhood restaurants.
The bottom end of the fast food hamburger market is monopolistic competition
while the franchised top end that includes McDonald's is an oligopoly segment. The
number of McDonald's outlets, brand name and market share put it into an oligopoly
for that segment of the fast food. One needs to define the business segment and close
competitors in order to decide which market model fits.
At times business segments represent a combination of models. Residential real
estate is an example. There are many residential realtors and residential firms that
sell houses. Entry and exit barriers are relatively low. That segment is monopolistic
competition. But this segment has a monopoly characteristic -- the six-percent
commission. Internet competition may alter that six-percent fee.
The Demand Curve for the monopolistic competitive firm is downward sloping.
Profit can be normal, above or less than normal as in monopoly.
Oligopoly is the remaining structure. Oligopoly is a market structure in which there
are usually a few large competitors operating within a uniquely dependent
framework. Characteristics include:
1. A visible sense of mutual interdependence among suppliers
2. High barriers to entry
3. Price searching firms
4. Sometimes the presence of a "price leading" firm
5. A relatively small number of generally large producers in the industry
6. Commodity or differentiated products and services
Examples of oligopoly segments -- soft drinks, beer, cigarettes, toothpaste and credit
cards - a few producers in each of segments dominate. Producers have differentiated
some of these products in the minds of the consumer. Many of the consumer product
segments have oligopoly producers. This does not mean that competition is not
intense in these segments. It means that the potential for collusion is greater when
there are a small number of firms than in the case of many smaller producers.
Oligopolies usually consist of large firms with long-established names and product
lines with which consumers can easily identify. But oligopolies do not necessarily
involve large firms. Isolated smaller towns may have oligopolies or a monopoly in
the form of small businesses.
The "Kinked" Demand Curve Under Oligopoly
In certain oligopolies, for example the airline industry, there are no distinct price
leaders nation-wide but there may be on certain routes. Different participants in this
industry attempt to effect price changes, both increases and decreases. One of the
firm's costs may change, enticing it to change prices accordingly. Or it could simply
test the market.
Usually other firms will follow a price decrease by one firm. If they don't, the price
leader will gain market share. All firms decreasing price together means the demand
curve they move along is the industry demand curve.
Should one airline increase price, however, other firms may not follow because the
price leader in this case will lose market share to those that don't increase prices. In
effect, an oligopoly firm in this situation faces what is called a "kinked" demand
curve, in that it is more elastic than the industry demand for price increases as close
competitors do not follow.
Firms face the industry demand curve for price decreases as all firms move together.
When firms don't follow on the upside the price leader faces a very elastic demand
curve - the product line demand curve.
In such cases, initial price increases may not "stick" resulting in the initiating firm
dropping its price to be in line with other close competitors. This gives a "kinked"
Perfect Competition in the Long Run
The long run is the time frame in which all inputs are variable so that the firm can
change its plant size. Should above normal profits exist in the short run, existing
firms are motivated to expand plant size and/or new firms are motivated to enter the
industry segment. Likewise, the reverse process occurs if there are below normal
Result - in the long run the average firm in the industry approaches normal profit.
All firms in the industry segment face the same selling price by definition of being a
price taker. Textbooks assume that the minimum of the LRAC curve is the same for
all firms in that segment and includes implicit costs. Realistically this is not the case
and the textbook LRAC curve is a composite curve with firms having cost curves
above and below.
Increasing, Decreasing and Constant Cost Industries
Constant Cost Industry
Industry segments that expand through expansion by existing firms or entry of new
firms in response to a higher selling price without increasing input costs have a
horizontal long-run supply curve.
Increasing Cost Industry
Other industry segments can't expand production in response to a higher selling price
(either from within or with new entrants) without the price of inputs increasing as
their use increases. Cost of inputs increase and the marginal cost curve of each firm
shifts left and, in turn, tends to shift the industry supply curve to the left. But more
firms enter or existing firms expand so that by assumption the industry supply curve
Result - a positively sloping long-run supply curve.
Decreasing Cost Industry
The industry segment is in balance, selling price increases and existing firms either
increase production or there are new entrants. When this occurs, competitors use
more inputs and they find that their cost of inputs decreases. A decrease in cost of
inputs shifts the MC and industry supply curve to the right.
Result - a negatively sloped long-run supply curve. The concept of decreasing cost
industry segments is typical, in particular in technology segments. Computer box
makers are an example as Dell has lower costs, in part, because cost of inputs that go
inside the box have fallen.
Technology spending increased rapidly during the 1990s and this technology
allowed many companies to produce more at decreased per unit costs. Cost
reductions occur as the industry expands. This may be due to technology
improvements occurring in one sector and implementing those in another.
Improvements and innovation in chip manufacturing result in lower per unit costs
and quality improvements in chip production but also for downstream users.
Other Market Models
The long run in other models of monopolistic competition, oligopoly and monopoly
resemble those in the short run. Most textbooks assume monopolistic competition
will operate at normal profits in the longer run but there is no reason this needs to
Oligopoly and monopoly models in the long run may or may not continue to operate
at normal, above or below normal profits. Much depends on whether technology
helps or hurt that company or industry segment and shifts in its cost and demand