Behavior and Choice: EC 102

A market is a collection of buyers and sellers of a particular good or service. In previous sections, we have separately examined the behavior of buyers (consumer theory) and the behavior of sellers (firm theory). In this next section, we will examine a) how buyers’ and sellers’ behavior comes together to generate transactions in markets; and b) how buyers’ and sellers’ behavior is influenced by different market structures.

Markets can take many different forms, like the market for flights from Seattle to New York; the market for a college education; the market for limes; the market for local internet service; and, the market for streaming video services. While each of these market loosely consists of groups of buyers and sellers who each make decisions to exchange a good or service, these markets vary significantly in several ways. We will use the phrase market structure to describe a market that has a particular set of characteristics. In this way, we will try to group markets with similar characteristics together so we can better study them.

The first question addresses whether firms sell identical products or differentiated products. In the market for smartphones, for example, an iPhone and a Samsung Galaxy are decidedly differentiated products: the products have vastly different features, including operating systems, functionality, and available apps. Products can differ in lots of different and important ways, too. The location of the seller can matter to grocery store customers, who generally tend to shop at stores closest to home, and drivers buying gasoline, who often have a preference for gas stations in more convenient locations. In the market for airline tickets, however, a coach seat on a direct flight from Seattle to New York may be essentially the same on United Airlines as it is on Delta Airlines. This would make tickets sold from the two sellers identical products.

There is clearly some grey area here. One could argue that because there are differences in the amenities on the airlines, like legroom, movie selection, or customer service, that the products are technically different. In practice, there is a spectrum of how differentiated products are. How can we deal with the nuance in degrees of product differentiation? Primarily, we will use this admittedly imperfect question to categorize markets: do consumers perceive the products to be essentially identical?

If a consumer considers buying limes from two different grocery stores, they might come from different suppliers who source their limes from different countries, making the products literally differentiated. But perhaps this difference is not perceptible or relevant to the consumer, and therefore, the consumer considers the two sellers’ limes as essentially identical - even if the products themselves are not.

One way to test this comparison is to ask: if the two products were priced identically, would the consumer have any reason to prefer one to the other? Suppose a consumer attempts to book that flight from Seattle to New York. Direct flight, coach class seat. If the flight is for sale at a price of $750 on both Delta and United, would there be any reason to select one over the other? If the consumer’s answer is yes, say, because she prefers the customer service when she flies United, or because Delta’s planes have more comfy seats, then the products are clearly not identical. If, however, neither airline has any advantage and the consumer is indifferent between the two airlines when tickets are offered at the same price, then the products are essentially identical.

In essence, in the presence of differentiated products, consumer preferences allow for a consumer to be willing to pay more for one firm’s product than another firm’s product. If a consumer is willing to pay $800 for the United flight instead of $750 for the Delta flight, then clearly the products are different. (Why pay an extra $50 for something identical?) Moreover, the willingness to pay more for the United flight must be driven by some preference for what United offers, like better customer service. Product differentiation creates markets where differences in preferences gives consumers different WTP for goods from different sellers in the same market.

The second question focuses on the number of sellers in the market.¹ Instead of identifying an exact number of sellers in a given market, though, market structure categorization will rely on whether markets have many sellers, few sellers, or one seller. Despite how imprecise these terms seem, they provide us with more than enough information for us to apply the relevant market structure model in our analysis.

So, how many is “many”? Or “few”? The number of sellers that exist in a given market is determined by how easily new firms can enter the market. Barriers to entry are conditions which would prevent at least some firms from entering a particular market. While some barriers to entry can be strategic - the result of specific actions taken by a firm already in the market to keep other firms out of the market - we will focus on structural barriers to entry. These are conditions inherent in the nature of the particular market that can make it difficult or impossible for new firms to enter that market.²

Cost is an interesting one to consider. There are certain markets where the cost of entering the market is so wildly high that no firm would find it rational to enter. These markets are known as natural monopolies, where due to the excessively high cost, the market logically has just one seller. The most common example would be a public utility, such as public water. In most cities, water is provided by the city government. But imagine how a firm would go about entering the market: it would need rights to a very large source of water, and would need to dig up the entire city, lay its own pipes everywhere, and connect them to every home and business. Incredibly disruptive and incredibly expensive!^4  5

In other industries, the cost to entering may be very high, but not technically so high that firms would never reasonably enter. In markets like these, high costs serve as a kind of soft barrier to entry: it serves to deter much entry, but is not an absolute dealbreaker. Consider the automotive industry. Is it very high cost to start a car manufacturing company? Without a doubt. Is it impossible to do? Not necessarily. While some manufacturers have existed for nearly 100 years, others - such as Tesla, which was founded in 2003 - have been able to make the large investment to start a new one.

The presence of barriers to entry is closely related to the number of sellers in a given market. Markets with strict barriers to entry, such as natural monopolies or markets where production is protected by a patent, are likely to have just one seller. Markets with soft barriers to entry, like high-but-not-excessively-high costs, will likely have a small number of firms: the barriers will not keep out all entrants, but it will deter entry enough to keep the number of sellers low. A market with few significant barriers to entry, or no barriers to entry at all, is likely to be a market with many sellers. The market for coffee shops, for example, may have some small regulations that need to be met (such as meeting public health codes), but these are not likely to deter an entrepreneur from entering the market.

Based on these two factors - number of sellers and degree of differentiated products - the grid below categorizes four crticial market structures. Along the top of the grid, market structures are characterized by the number of firms and, consequently, the barriers to entry. Along the left side, the grid plots identical versus differentiated products. While these four market structures do not encompass all markets, they serve both as important descriptive models of the world and as helpful benchmarks for markets which do not fit squarely into the grid.

Common market structures⁶.

Perfect competition is a market structure with many sellers and many buyers, all of whom can freely enter and exit the market. Sellers in perfectly competitive markets sell identical products. Markets for agricultural products, like the market for blueberries, are common examples of perfectly competitive markets: there are no barriers to entry in the market for blueberries, and while berries grown by different farms may differ in subtle ways, most consumers do not distinguish between products.

Monopolistic competition is a market structure with many sellers and buyers and no barriers to entry; however, in monopolistically competitive markets, products are differentiated. Markets for groceries, coffee shops, and fast food restaurants are good examples of these markets. There are no barriers to entry for opening a coffee shop, and in most places, there are many sellers; but, each coffee shop is likely to sell a product that is differentiated in ways that matter to consumers. Since many consumers have strong preferences for coffee drinks from their favorite place, similar products are less substitutable and consumers are likely to be willing to pay a little extra to buy what they prefer!

On the other end of the spectrum, a monopoly is a market structure with exactly one seller, due to a restrictive barrier to entry like a patent, copyright, or exclusive access to an essential input. The University of Puget Sound, for example, has a monopoly on selling University of Puget Sound swag, while musical artists (often in conjunction their recording studios) with legal protections are the sole sellers of their music.

Markets with a small number of sellers are oligopolies. In these markets, products may be identical or differentiated, but importantly, there are soft barriers to entry significant enough to keep the number of sellers low. The markets for aircraft manufacturers, cell phone carriers, and video game consoles are all oligopolies. In fact, the market for aircraft manufacturing is essentially a duopoly: a market with exactly two sellers (Airbus and Boeing). Importantly, in oligopolistically competitive markets, the small number of competing sellers allows firms to act with direct consideration of competitors’ actions. Therefore, this is the primary market structure where game theory, the study of strategic decision making, is used.

The ensuing sections tackle these four market structures, stressing the differences in firm behavior and market outcomes (how do consumers fare? which structures are more efficient?) in each structure. The deepest concept which highlights the distinction between structures, however, is the concept of market power. Which firms have it, and how much they’ve got, is critical to developing our understanding of how different markets operate.

So, what is market power?