Microeconomics - Types of Markets & Concentration Measures

Price Taker Markets
A purely competitive (price taker) market exists when the following conditions occur:

· Low entry and exit barriers - there are no restraints on firms entering or exiting the market
·Homogeneity of products - buyers can purchase the good from any seller and receive the same good
·Perfect knowledge about product quality, price and cost
·No single buyer or seller is large enough to influence the market price

Sellers must take the existing market price and they will adjust the quantity of their products so as to maximize profit at the market price. Because sellers must take the current market price, a purely competitive market also is called a "price takers" market.

Price-Searcher Markets
Price-searcher markets are characterized by:

1.Barriers to Entry
2.Firms in the Markets that have Downward-Sloping Demand Curves

While perfectly competitive markets have a homogeneity of goods, price-searcher markets have a differentiation of goods. The differentiation could be in the form of location, taste, packaging, design, quality and many other factors. Some textbooks use the phrase "monopolistic competition" to describe markets where each firm has something unique about its product while facing significant competition. A good example would be a gas station. Although there are many competing gas stations, an individual gas station is the only one at its particular location and, therefore, to some degree it has a monopoly or is a sole seller. The CFA text prefers the term "competitive price searcher".

Firms in a price-searcher market with low barriers to entry have some flexibility to raise prices, as they will not lose all their customers if they do so. For example, if Valvoline raises the price of its motor oil, some people will be willing to pay the price for the motor oil they prefer. However, rival firms such as Pennzoil or Castrol also provide similar motor oils. As Valvoline raises its prices, many customers will switch to rival suppliers. The demand curve faced by firms in competitive price search markets, such as motor oil, will be highly elastic.

Firms in price-searcher markets with low barriers to entry face competition from existing suppliers and potential new entrants. If economic profits are being made in the market, then more firms will be expected to enter the market. Price searchers can set their prices, but the actual quantities sold will depend upon market forces.

Monopoly refers to a "single seller". The single seller will have a market with no well-defined substitute. The monopolist does not need to worry about the reactions of other firms. Utility companies are often monopolists in particular markets.

within an industry refers to the degree to which a small number of firms provide a major portion of the industry's total production. If concentration is low, then the industry is considered to be competitive. If the concentration is high, then the industry will be viewed as oligopolistic or monopolistic. Government agencies such as the U.S. Department of Justice examine concentration within an industry when deciding to approve potential mergers between industry firms.

The most common measure of concentration is the four-firm concentration ratio, which is defined as the percentage of the industry's output sold by the four largest firms. An industry with a four-firm concentration ratio of forty percent is generally considered to be competitive.

he Herfindahl-Hirschman Index (HHI) calculates concentration ratios by squaring the market share of the fifty largest firms in an industry. The formula can be expressed as follows:

Formula 3.4

HHI = s12 + s22 + s32 + ... + sn2

(where sn is the market share of the ith firm).

A monopoly would have the largest possible value - 1002 = 10000. The HHI for a highly fragmented industry would be close to zero. The Justice Department generally considers an industry with an HHI above 1800 to be highly concentrated.

Limitations of Concentration Measures
Concentration ratios have some of the following limitations:

· Foreign production – concentration ratios often fail to fully incorporate the revenue from foreign companies, thus overestimating the concentration of a domestic industry and underestimating the impact of foreign goods on competition.

· Ease of entry – an industry may have relatively few participants, but low barriers to entry. In such cases, a concentration ratio will overstate the power of current suppliers.

· Elasticity of demand – concentration ratios do not factor in the elasticity of demand and the availability of substitutes. Many highly-concentrated industries (metals, airlines, et al) are constrained by the availability and cost of substitute products and services.

· Imprecise definitions – a narrowly-defined industry will appear to be more concentrated than a more broadly-defined industry. Suppose we were looking at concentration within the shoe industry. Should the market be simply "shoes", or do we break that down further into "athletic shoes", "men's shoes", "children's shoes", etc.?

Coordinating Economic Activity
Economic activity can be coordinated by markets or by individual firms. A firm organizes input production factors so as to produce and market goods and/or services.

Auto manufacturers are actually assemblers of cars - most the parts in a car are produced by hundreds of component suppliers. This is an example of market coordination. If General Motors decides to coordinate all activities associated with brake components, then the coordination is being done by that firm. A firm will decide to coordinate a particular type of economic activity when it can do so more efficiently than what is provided by the market.

Firms can be more efficient than markets due to:

· Economies of scope - this applies when a firm hires specialized resources that can produce a broad range of goods and services. For example, a person with a difficult to diagnose medical condition would probably be sent to a hospital, which will have a broad range of medical specialists and diagnostic equipment.

· Economies of scale - for many types of goods, per unit production costs decline as larger volumes of output are produced by an individual firm.

· Team production can often lower production costs.

· Transaction costs are often reduced when economic activity is coordinated by a firm. Suppose you want to perform a major remodeling of your house. If you decide to coordinate the work yourself, you will have significant transaction costs associated with hiring qualified personnel such as plumbers and carpenters, monitoring their work, negotiating contracts with them, finding suitable building materials, arranging for delivery of materials and coordinating work schedules of the various subcontractors. If you hire a building firm or general contractor to coordinate the work, they probably will have lower transaction costs because they already will have knowledge of suitable subcontractors in the area and how best to get building materials. By hiring a general contractor, you will reduce your transaction costs by only having to negotiate one contract.

Modifying Output
Related Articles
  1. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  2. Investing

    Asset Manager Ethics: Investment Process and Actions

    Managers, in developing their investment process, need to determine some “general rules” that make it meaningful. We offer six.
  3. Professionals

    Career Advice: Financial Analyst Vs. Investment Banker

    Read an in-depth comparison about working as a Financial Analyst vs. working as an Investment Banker, two highly prestigious business careers.
  4. Professionals

    Advisors: Which Certifications Are Essential?

    The right advisor credentials can make all the difference, but wading through some 100 certifications can be a challenge. Here's some help.
  5. Investing Basics

    Asset Manager Ethics: Valuation Is A Tricky Business

    Asset managers must accurately represent all of a clients assets in the client portfolio. This can be tricky for unique and hard-to-value assets.
  6. Personal Finance

    Top 10 Most Valuable Sports Teams in 2015

    Cleats, pads and profits: we take a look at the top 10 most valuable sports teams in the world.
  7. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  8. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  9. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  10. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. Security Analyst

    A financial professional who studies various industries and companies, ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. CFA Institute

    Formerly known as the Association for Investment Management and ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  3. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!