The Science of Economics

Fred Foldvary


Industrial Organization

1. How markets work

In order to understand the concept of a market, it is helpful to look at its evolution.

Trade may have begun with informal agreements among neighbours, such as the basket-weaver offering his handiwork to the farmer next door, in exchange for some of the farmer's fresh vegetables. But, in time, trade became carried out on a more community-wide basis - in particular gathering spots called markets. Today, we use the term "market economy" to refer to a society where people meet their needs through voluntary agreements of exchange. A "market" is not a particular place or group of people, but the process of voluntary production, exchange, distribution, and consumption.

Initially, trade was carried on through barter - the

direct exchange of one good for another. However, for

large-scale trading, barter is a cumbersome business: any

farmer, for example, who wants to swap his vegetables for some

tools, needs not only to find someone willing to trade in tools,

but to trade tools specifically for vegetables. Trade through

barter requires what is called "a double coincidence of wants".

The story of how traders solved this problem has been

related by many authors, Menger (1871, p. 258) being the first

to analyze it in detail. As related by Menger, although barter

limited the exchanges of traders "there were elements in their

situation that everywhere led men inevitably, without the need

for a special agreement or even government compulsion, to a

state of affairs in which this difficulty was completely

overcome. Traders realized that they could exchange their

specialized products for commodities which had a greater

marketability, which they could then trade for what they wanted

to consume." Cattle, for example, were readily saleable in many


And so, in any particular market area, certain goods,

such as cattle, cocoa beans, gold, or wampum, became

intermediate goods with exchange value, and the use of such

goods for payments became a social custom. Menger emphasizes

the importance of custom, since "the actual performance of

exchange operations of this kind presupposes a knowledge of

their interest on the part of economizing individuals" (p. 261).

Money eliminated the need for the more cumbersome system

of bartering, but whether one is trading with money or through

barter, the act of voluntary exchange is what creates a market.

As set forth in Chapter 1, a "market" is the totality of

voluntary economic acts in some context. The term market

denotes anything from an exchange between two individuals on a

street corner, to the more elaborate trading on Wall Street. A

market process cannot be perceived as detached from the people

who create it.

Classical economists noted that a free market will

allocate scarce resources effectively without the need for any

central direction. The output produced is generally the amount

that people wanted to buy, without severe shortages or

surpluses. How is it that production manages to adjust to the

continually changing wants of consumers?

Markets are able to allocate resources through the price

system. Prices serve as a signal to a consumer about the

relative costs of goods, which they compare to their subjective

valuations of these goods. Prices also indicate the costs and

revenues to producers. Consumers and producers react to prices

in their buying and selling decisions, determining the types and

quantities of products.

If more of one item - a hammer for instance - is

demanded, hammers become sold out. There is a temporary

shortage. This will cause the price of a hammer to rise,

eliminating the shortage. But then since producers are making a

greater profit, this stimulates them to produce more hammers.

As more hammers are supplied, the price of hammers will go down

again, though perhaps not to the previous level, since it may

costs more to draw resources from other uses in order to make

more hammers. And so the market ends up with more hammers,

perhaps at a bit higher price, equilibrating the desires of

consumers with the costs of producers.

Similarly, imagine that too much of a certain commodity,

such as coffee, has been supplied. Through competition among

sellers to get rid of their coffee, the price will be pushed

down. But at the lower price there is less profit, so producers

will reduce their supply, thereby reducing the glut of coffee.

So we can see that through an enormous system of trial

and error the price system will ultimately balance supply with

demand - fluctuating prices will ensure that a glut or shortage

of an item or service does not persist.

Adam Smith, in his classic text The Wealth of Nations,

praised the workings of the price system. He demonstrated how

through the price system, the an individual's pursuit of his own

interest contributes to the well-being of others. Thus, from

the pursuit of individual interest, society is led, by an

invisible hand, to the common good.

Smith showed that "self-interest" in the course of

history had led to the specialization and division of labour.

The exchange - through trade in markets - which naturally

followed specialization, was responsible for the world's

progress. As such it should be allowed to progress unhindered

by government intervention.

2. Competition

The achievement of community welfare through the pursuit of individual interest presumes a freely competitive market. The term "competition" has two meanings. One is rivalry among producers and consumers, bidding against one another for goods or sales. It is only through

competition that more producers enter a market when profits are high, increasing supply and reducing the price. As such, the economic society envisaged by Smith was to be devoid of both

economic privileges and monopolies, which hinder competition.

Rivalrous competition is criticized as being chaotic, but it is in

fact an orderly process, a spontaneous rather than planned order

that follows ethical rules, namely that of not harming others.

Far from being destructive, rivalrous firms competing for scarce

resources determine the best use of the resources by their

bidding for them. Without this competition, we could not

perform economic calculations, because in a complex economy

there would be no way of knowing the relative scarcity of

resources relative to consumer demand.

If competition is prevented from operating in any way,

whether by organised groups, criminals, or legislation, the

result is usually higher prices or a lower quality of goods and

services, as well as the social waste of inefficiency.

Competition tends to eliminate profits other than normal

returns to the factors of production. The firms that maintain

the lowest costs of production will earn a greater share of

profits. In an effort to keep costs of production down to a

minimum every avenue of innovation will be explored. Indeed,

the process of competition is essential to efficiency - it

provides for cost saving innovations and induces firms to adapt

to change.

The second meaning of "competition" is an absence of monopoly power.

One obvious barrier to rivalrous competition is tariffs and quotas

imposed at national borders will be discussed in Part II. The

main point, for now, is that trade barriers reduce competition

and increase the cost of the goods in the affected industries.

Another barrier is a government-granted monopoly, the

privilege of being the sole supplier in an industry ( eg..

British Rail).

Licenses restrict entry into an industry to certain

specified persons. The alleged reason is to assure some

standard of competency, but the result is often restricted entry

even for qualified practitioners.

Marketing boards - such as the Potato Marketing Board in

the U.K. controls the size of the potatoes coming on to the

market as a means of restricting the supply and thereby

controlling the price.

Other restrictions on competition will be discussed in

Chapter 9, on the role of government.

3. Market structure

The market structure of an industry consists of the

number of firms and their relative size. Different market

structures induce different types of competition.

The degree of industry concentration can be

measured using the Herfindahl index. You first calculate the

fraction of the industry that each firm has. Then square this

fraction. Finally, add up the squares. The result is a

concentration index between zero and 1, 1 being an absolute

monopoly and a number close to zero being atomistic.

atomistic competition

The more concentrated an industry is in terms of fewer number of firms and more inequality of size, the greater monopoly power the firms have, and thus the less competition there is in the sense of absence of monopoly pwer. The least monopolistic structure, then, is that in which there are many, thousands and millions, of firms, none of which is large enough to affect the price of the product, and in which there are no barriers to the entry and exit of firms into that industry. This structure is called "atomistic" competition, and also confusingly called "perfect"

competition. The latter term implies that other structures are imperfect, which is misleading, since if the most effective forms of structure for some industry is not atomistic, it is not imperfect.

In atomistic competition, a firm is so small relative to

the rest of the industry that it must sell its output at the

price set by industry supply and demand. This implies that the

product of that industry is homogenous or uniform, so that if

one firm tried to sell at a price a bit above the market, no one

would buy its product, since others are selling the same stuff

for less. As noted above, atomistic competition also has

complete freedom of entry and exit. Any firm can set up

production within the industry and any firm can quit.

If firms in atomistic competition make economic profits

(as discussed in Chapter 7), then new firms will enter the

industry to obtain some profits. As the industry expands, the

industry supply curve shifts out and hence price will be driven

down the demand curve. Economic profits are therefore a

short-run situation; in atomistic competition, economic profit

tends to be zero, and the firms only make normal accounting

profits that provide normal returns to the factors of


But wait a minute, you say. What if, for example, one

farm has superior land than another. Wheat farming may be an

industry with atomistic competition, but the farms with better

land will have more profit!

Yes, they will have higher accounting profits, but the

better land has a higher rent, so after subtracting out the rent

from the accounting profit, the net economic profit is still

zero. The producer surplus goes to rent.

But wait another minute! Something seems goofy here.

Each firm in atomistic competition has no control over the

price, yet the industry price can move up and down as industry

supply and demand curves shift. So how can industry prices

change if no one firm can change the price?

Here's how it works. Suppose we have a million wheat

farmers. One farmer wants to sell his wheat. He calls a

wholesale dealer. The wholesale dealer might be overstocked

with wheat, so he calls his broker at the commodity exchange,

where the wholesaler can buy or sell all he wants at the quoted

price. In the commodity market, there are thousands of buy and

sell bids being entered every minute. The price is set

second-by-second by the brokers who match the buy and sell bids.

No single bidder can dictate a price, but each bidder has a

small influence by increasing the bid in one or the other

direction. So the price is set in auction markets, with each

bidder having a tiny influence but none being able to dictate a


In atomistic competition, firms produce at the lowest

possible cost, which is the industry's minimum average cost. If

any one firm could produce at a lower cost, it would do so to

get an enormous competitive advantage, selling at a bit lower

price than the others, so the other firms would copy the first

one's production function and also produce at lowest possible


Atomistic competition has the happy result that

production takes place in the most efficient way, not only for

the firms, but also for society, since the price of the product

is just equal to the marginal cost of producing it. As you may

recall from Chapter 7, the marginal cost crosses the average

cost line at the bottom of average cost. Atomistic competition

is socially efficient because the marginal revenue of a firm

equals the price of the good, so that if any more were sold, the

social costs would be higher than the price, and if any less

were sold, the cost of one more unit would be less than what

people would be willing to pay. When price equals marginal

cost, social benefits from the good just match the social cost

of the resources.


The other extreme of market structure is monopoly. A

monopoly exists either when there is only a single seller of a

particular good or service, or as a different type of monopoly,

when there is no entry into the industry for the expansion of

product. We can call the first type an absolute monopoly and the

second an entry-monopoly. Economists today usually mean absolute

monopoly when they use the term "monopoly," although classical

economists also referred to entry-monopoly.

If there is only one firm in an industry, the firm's

demand curve is that of the industry, so it has the ability to

set either the price or quantity of output. Note that in a

market economically it cannot do both, since if it sets a price,

market demand will determine the output sold at that price. A

government monopoly, operating outside a market, can of course

dictate both price and quantity, forcing people to consume and

pay a price.

A profit-maximizing number-monopoly will set its price

at the level where its marginal cost equals its marginal

revenue. Since its demand curve slopes down, its marginal

revenue curve slopes down too, and even steeper. This is

because each extra unit of output is not only sold at a lower

price, but all previous units area also sold at that lower

price. So where the two curves intersect, the marginal revenue

is less than the demand curve, where the price is, and the

difference is an economic profit (since the marginal cost curve

also includes all implicit costs). This is not an

entrepreneurial profit, but a monopoly profit, since it is not

due to the uncertainty of the market, but on the contrary, to

assured profits due to the lack of competition.

An absolute monopoly, secure in the fact that it is the

only producer of a good, can limit supply so as to maintain a

higher price. Consumers could be made better off if production

were expanded production, lowering the price (the monopoly owner

could even be compensated for his loss of profit and society

would still be better off).

A monopoly can also practice price discrimination, the

practice of charging different prices to different types of

users. Firms price discriminate when they have discounts to

older people or children. In Eastern Europe, some expensive

restaurants charge a higher price to tourists than to the

locals. Price discrimination increases sales by adjusting the

price to the elasticity of demand, with the demand of wealthier

customers more inelastic, or less responsive to price increases,

i.e. they continue to buy even at the higher price.

A monopoly having no current competition may face

potential competition if its economic profits are consistently

high (such as from abroad), so it may be induced to keep its

price below the short-run profit-maximizing level.

In entry-monopoly, even where there are many firms, they

can earn economic profits, since other firms cannot enter to

expand the output. An example of entry monopoly is taxi cabs in

New York City; one needs a government permit to enter the field,

but the number of permits is fixed, so to enter, one needs to

buy a permit from a previous owner. Land, being fixed in

supply, works the same way.

The four types of absolute monopoly are locational

monopoly, natural monopoly, new-product monopoly, and

government-protected monopoly.

A locational monopoly is the only firm in some immediate

market area, such as the only drug store in a small town. Such

firms can have monopolistic profits, but these profits are

limited by competition from farther-away firms and from

non-market factors, such as the personal relationships that may

develop in a small town.

A natural monopoly occurs when there are economies of

scale and, since the supply for a firm curve slopes down, the

first firm to achieve a big size has a competitive economy,

driving the smaller ones out of business. Examples include

municipal utilities such as piped water; a second firm would

duplicate the pipes of the first, and bringing in water by truck

is much more expensive.

A new-product monopoly is a temporary

restriction against competition for creators of new literature

(copyrights) and for new inventions (patents).

A government-protected monopoly is a legal barrier to entry not

warranted by new products.

Patents are a controversial form of monopoly. Some argue

that patents are necessary to protect the investment in research

of the inventor and stimulate new inventions; others that they

give the inventor too much of a monopolistic privilege.

Actually, patents are simply a method of economizing on

contracts. It would be costly for the maker of a new firm to

make a contract with each buyer not to copy the item, especially

to enforce such a contract. Patents, like copyrights, simplify

the contract with a notice on the product that it is patented

and a conventional number of years that the contract applies

for. Patents also enable the inventor to register his invention

and check to see that it is really new. No one is coerced into

buying the product, so the patent facilitates the market by

simplifying property rights rather than being a privilege or


Hence, new-product monopolies may charge higher prices

than they would in a competitive market structure, but these new

products might not be brought to market otherwise, so the net

result is usually beneficial. This is not so for

government-protected monopolies. Here, the public pays a higher

price and gets less output for no good economic reason.

Government-protected monopolies are an intervention, and do not

exist in a pure market economy.

That leaves us with natural monopolies, a difficult

problem for economics as well as politics. One way government

has dealt with them is to set a price, usually at the average

cost (including some margin of accounting profit). A problem

with this method is that the firm has little incentive to

control costs, other than from government oversight and

hearings, which may not be effective in controlling costs. The

commissioners regulating a monopoly may have come from that

industry and may in fact be working to benefit its owners rather

than the public.

In many cases, the government runs the industry

directly. In some cases, government enterprises such as trains

and subways provide good service, though often not, but it is

again difficult to control the costs, and the incentive of the

government agents may be to increase their own benefits and

power, which increases costs.

A third option is to periodically open control of the

firm to a competitive bid. The industry itself is a monopoly,

but bidding to own it for a while can be highly competitive.

The highest bidder then runs the outfit for a certain period of

time, charging what it pleases. But the government keeps the

fee paid by the bidder. If the bidding is competitive, this fee

represents the monopoly profit, which is now paid to the

government. The company then has the incentive to minimize

costs during its operations. This option is also not perfect,

because the firm still charges the public a monopoly price, but

it avoids the social waste of artificially high costs that may

compensate for that.

A fourth option exists when the firm cannot make a

profit only from the user charges, but when the service is a

territorial collective good that increases rents. Suppose there

is a subway in a city, which is a natural monopoly. Even

maximizing profits, the revenues would not cover the costs. But

there is a second profit in the increased land value and rent,

which when added to the fares would make the operation

profitable. The service can therefore be funded by a

combination of rent and user charges, especially when the

charges are based on the congestion of the service, charging

more when it is crowded to compensate society for the crowding

the users impose and to even out the usage.

Monopolistic Competition

Whereas with atomistic competition, there is a uniform

product, with monopolistic competition, there are many firms,

but there is product differentiation: each firm produces a

different version of the product, such as a different style,

brand, or location. There is competition, but each firm also

has a mild monopoly on its variant, the products being close

substitutes. There are also no barriers to the entry of new

firms and increased production. Examples of product

differentiation include different brands and types of

toothpaste, and different locations of retail stores.

Because of this mild monopoly, each firm faces a

downward-sloping demand curve, and has some control over price.

These firms will then set prices where marginal costs equal

marginal revenues. But over the long run, because of

competition, there will tend to be no economic profits, firms

operating where the price equals the average cost. But since

this cost curve is tangent to the demand curve (coming down to

touch it and then bouncing off), the firms are not operating at

the minimum possible average cost. Critics call this type of

market structure "imperfect competition," saying that there are

too many firms, and also too many artificial varieties of

products. But product variety is valued by many people.

Critics also say there is too much advertising, but again, given

different varieties, it is natural to want to draw customers to

your brand, and advertising helps pay for newspapers, magazines,

radio, and television.

It is unrealistic to expect markets where products are

or can be differentiated to behave like those where they are

uniform. The market has in fact produced generic brands as well

that have less fancy labels for lower prices. Firms try to

influence consumers, but in the end, consumers choices are

voluntary. There is nothing imperfect about an outcome that is

the best one can have given the conditions of the products.


An oligopoly, an industry with few sellers, includes

both a "pure oligopoly" with a homogenous product and a

"differentiated oligopoly," with product differentiation. There

are often few firms in an industry due to economies of scale,

which induce firms to become large. A firm in an oligopoly is

very much affected by the action of any of its competitors, but

exactly how it responds depends on circumstances. A type of

game can be played by one firm lowering price and the others

responding, and like chess, the oligopoly game has no one exact

sequence of plays.

Oligopolists can collude to create an industry monopoly

among them, either secretly or openly as a cartel. But there

will be a great temptation to cheat on the agreement, since a

firm that lowers its price just a bit will be able to sell much

more product. If one or more of the firms sell below the cartel

price, then eventually that price cannot be maintained, and the

oligopoly will fall apart. Also, new firms may enter the

industry to take advantage of the cartel price, and as the

supply curve shifts outward, the increased product must be sold

at a lower price. The cartel must either lower its price or

fall apart.

4. Government and competition

Governments have reacted to oligopolies and collusion

with anti-trust laws, breaking large firms into small ones. But

the success of this policy has been questioned, since large firm

size or high concentration does not necessarily imply that the

market can be improved by intervention. Some firms become large

because they provide superior goods and services - breaking them

up would punish market success. Large firms can also capture

the benefits of research, and focusing only on industry within a

country overlooks the fact that we live in a global economy, and

in a market economy, there can be plenty of competition.

Moreover, government agents do not have the knowledge needed to

know just how much competition is optimal, and they are unable

to know the unintended consequences of meddling in the market.

While trying to break up some industry oligopolies,

governments sometimes deliberately create them with price

controls and restrictions on entry. For example, some city

governments limit the number of taxi cab firms and cars. Before

1978, the airline industry in the U.S. was prevented from

competing in prices, and the entry of new firms was restricted.

The industry therefore engaged in non-price competition, such as

offering more luxurious service or more frequent flights on

half-empty airplanes. Many consumers prefer lower prices to

such high-cost services.

As noted, competition is not just the existence of many

firms, but of rivalry among them. In a free market, rivalry for

the consumer's marginal dollar or pound will ultimately win out

against inefficiencies, since in a global economy any excess

profits or costs are like bait to the hungry wolves stalking the

woods for profit opportunities. The best that government can

normally do is to take down the barriers but prevent the

consumer sheep from being fleeced, with stiff laws against

fraud, and easy access to the courts, making the loser of a

lawsuit pay all legal costs.

Though competition is rivalrous, at the same time, firms

have an incentive to cooperate where their interests are mutual.

Firms create industry associations to provide them with

research, information, and cameraderie. Hence, competition and

cooperation are complements rather than opposites in a market


The best policy for government with respect to

competition is normally to let the market process do its work,

avoid imposing restrictions and costs, and concentrate on

protecting property rights and the resolution of disputes

brought before its courts. It is difficult enough to provide a

sound legal basis for market processes without trying to improve

outcomes when the cure may well be worse than the alleged


The next chapter will take a closer look at the outcomes

of our current economies and analyze them to see whether it is

indeed the market or intervention that is the foundational