Lecture 8: Market Structures¹

How Substitutability Determines Market Power

Learning Objectives

Explain how substitutability determines market power
Describe the four main market structures: perfect competition, monopolistic competition, oligopoly, and monopoly
Analyze the efficiency of each market structure
Discuss the role of market power in pricing decisions
Evaluate the impact of market power on consumer welfare

Two Ways to Use Economics

Positive economics: what does happen (testable predictions)

Normative economics: what should happen (policy advice)

$MR = MC$ works both ways:

	Example
Normative	“A firm should produce where $MR = MC$ to maximize profit”
Positive	“A new technology lowers $MC$ at all quantities $\Rightarrow$ the firm produces more $\Rightarrow$ price falls”

The positive prediction maps directly to a supply shift: lower costs $\rightarrow$ more output $\rightarrow$ lower prices. Today we use both lenses.

Review: The Competitive Benchmark

In perfect competition, firms are price takers:

$P = MC$ — price equals marginal cost
Zero economic profit in the long run
Allocatively efficient: every mutually beneficial trade occurs

This is our benchmark. Everything today is a deviation from it.

What Happens When Quantity Is Inefficient?

Figure 1: When quantity falls below the competitive equilibrium, surplus is destroyed

Why Does Quantity Fall Below Equilibrium?

Many forces can push $Q$ below the efficient level:

Cause	Mechanism
Market power	Firm restricts output to raise price
Taxes	Wedge between buyer and seller price
Price floors	Minimum price above equilibrium (e.g. minimum wage)
Price ceilings	Maximum price below equilibrium (e.g. rent control)
Externalities	Private costs $\neq$ social costs

Today’s focus: market power — firms deliberately restricting $Q$ because they face downward-sloping demand.

Key Question

What gives a firm the power to charge $P > MC$?

The answer: how few substitutes exist for its product.

More substitutes $\rightarrow$ more competition $\rightarrow$ less pricing power
Fewer substitutes $\rightarrow$ less competition $\rightarrow$ more pricing power

Substitutes and Complements: Definitions

Substitutes: goods that can replace each other

If the price of Coke rises, demand for Pepsi increases
Cross-price effect is positive: $\frac{\Delta Q_B}{\Delta P_A} > 0$

Complements: goods used together

If the price of printers rises, demand for ink falls
Cross-price effect is negative: $\frac{\Delta Q_B}{\Delta P_A} < 0$

The Substitutability Spectrum

Figure 2: The substitutability spectrum determines market power

Why Substitutability Matters for Firms

The number and closeness of substitutes determines:

Demand elasticity — more substitutes $\rightarrow$ more elastic demand
Pricing power — elastic demand $\rightarrow$ can’t raise price much
Long-run profits — easy substitution $\rightarrow$ entry erodes profits

\[|\varepsilon_d| \uparrow \quad \Rightarrow \quad \text{markup} \downarrow \quad \Rightarrow \quad P \rightarrow MC\]

Cross-Price Elasticity

Formally, the cross-price elasticity of demand:

\[\varepsilon_{AB} = \frac{\%\Delta Q_B}{\%\Delta P_A}\]

Sign	Relationship	Example
$\varepsilon_{AB} > 0$	Substitutes	Coke & Pepsi
$\varepsilon_{AB} < 0$	Complements	Printers & ink
$\varepsilon_{AB} \approx 0$	Unrelated	Pizza & lawnmowers

Perfect Competition: perfect substitutes, free entry

When products are perfect substitutes, no firm has pricing power:

Any firm that raises $P$ above market price loses all customers
$P = MC$ is the only sustainable outcome
Demand curve facing each firm is perfectly elastic (horizontal)
Short run: firms may earn profits or losses
Long run: profits attract entry:
1. New firms enter (entry is easy because products are perfect substitutes)
2. Supply increases $\rightarrow$ price falls
3. Continues until $P = ATC$ $\rightarrow$ zero economic profit

If your product is identical to everyone else’s, you’re a price taker. Entry erodes profits because perfect substitutability means new entrants are just as good as incumbents.

Market Structures: Overview

Feature	Perfect Competition	Monopolistic Comp.	Oligopoly	Monopoly
# of firms	Many	Many	Few	One
Product	Identical	Similar	Differentiated	Unique
Substitutability	Perfect	Close	Partial	None
Barriers to entry	None	Low	High	Very high
Pricing power	None	Some	Moderate	High
$P$ vs $MC$	$P = MC$	$P > MC$	$P > MC$	$P > MC$

Recall: Perfect competition gives us Pareto efficiency per the first welfare theorem.

Case Study: Why Was Cable TV a Monopoly?

In the 1990s, most towns had exactly one cable provider. Why?

Huge fixed cost — laying cable infrastructure
Very low marginal cost per additional viewer
ATC falls over a large range $\rightarrow$ one firm serves cheaply

If we allowed 5 companies to each lay their own cables, what would happen to costs? To prices?

How Does a Cable Monopolist Set Price?

You’re the only cable provider. How do you choose your price?

“Raise it!” — Okay, raise it until when?

Until $MR = MC$.

But why not even higher?

Raising price $\rightarrow$ some customers cancel
Revenue lost on those customers > revenue gained from higher price
Cost of providing to these customers increasing
That’s the elasticity logic: $MR < MC$ means you’ve gone too far

Why is monopoly quantity smaller than competitive quantity? Don’t look ahead — reason it out.

Who Loses Under Cable Monopoly?

After the monopolist restricts output and charges $P > MC$:

Does the monopolist lose? No — they earn profit.

Do consumers lose? Yes — higher price, fewer subscribers.

Does society lose? Yes — the deadweight loss.

Is the DWL transferred to someone?

No — it disappears. Trades that would create surplus simply don’t happen. That’s what makes it inefficiency, not just redistribution.

Streaming Enters: What Happens to Cable?

Netflix launches. What happens to cable’s demand curve?

Shifts left — some customers switch
Becomes more elastic — cable now has a substitute

Does cable still have market power?

Yes — but less. Cable and Netflix aren’t identical (live sports vs. on-demand). They’re imperfect substitutes.

We’ve moved from monopoly toward monopolistic competition.

Why Doesn’t Streaming Become Perfect Competition?

Today: Netflix, Hulu, Disney+, Prime, Apple TV+, Max, Peacock…

Why don’t prices fall to $MC$?

Each service has exclusive content (differentiation)
Switching costs (learning a new interface, watchlists)
Not perfect substitutes — Stranger Things is only on Netflix

Many firms + free entry + differentiated products = monopolistic competition

Each firm has some market power, but entry keeps driving profits toward zero.

In-Class Game: “The Restricted Seller”

Game Setup (~2 min)

Roles:

Buyers (half the class) — each gets a private WTP slip
Sellers (2–3 students) — marginal cost = $4 per unit
Everyone else observes

Buyer WTP values: $20, $18, $16, $14, $12, $10, $8, $6

Seller cost: $4 per unit (unlimited capacity)

Rules: one unit per buyer, announce trades publicly, record prices on the board.

Round 1: Competitive Market (~5 min)

All sellers can trade. Free bargaining.

Let it run. Record each trade on the board.

What should happen:

Prices cluster near $P \approx 8\text{--}12$
Almost all buyers with WTP $> 4$ trade
~6–7 trades

Quick sketch on the board: where is equilibrium? How much total surplus?

Round 2: Monopoly (~5 min)

Now: only ONE seller.

Before trading, ask the monopolist:

“How many units will you sell, and at what price?”

They must commit to a quantity and set one price.

Watch what happens:

Monopolist likely sells ~3–4 units at $P \approx 14\text{--}16$
Fewer trades than Round 1

Debrief: Who Lost?

Who was willing to pay more than $4 but didn’t get to buy?

Those are the unrealized trades.

Did the monopolist lose? No — they earned more profit.
Did those excluded buyers lose? Yes — they didn’t get to buy the good they wanted.
Did society lose? Yes — the deadweight loss.

Where did that lost value go?

It disappeared. That’s deadweight loss. You didn’t draw it — you just lived it.

From Game to Graph

Figure 3: The game you just played, drawn as supply and demand

Monopoly: No Close Substitutes

One firm, no close substitutes, high barriers

Sources of monopoly power:

Legal barriers — patents, licenses, regulations
Natural monopoly — economies of scale so large one firm serves market cheapest
Network effects — value increases with users (e.g., social media platforms)
Control of key resources — De Beers diamonds (historically)

A monopolist has market power because there is nothing else consumers can buy instead.

Monopoly: The Graph

Figure 4: The monopolist restricts output and charges P > MC, creating deadweight loss

Why Monopoly Is Inefficient

The monopolist produces where $MR = MC$, but charges $P > MC$:

Consumers who value the good between $MC$ and $P_m$ don’t get it
These are mutually beneficial trades that don’t happen
The lost surplus is the deadweight loss (DWL)

\[\text{DWL} = \frac{1}{2}(P_m - MC)(Q_c - Q_m)\]

Monopolistic Competition: Imperfect Near Substitutes

Key features:

Many firms, free entry and exit
Products are close but imperfect substitutes
Each firm has a tiny bit of market power

Examples: restaurants, coffee shops, clothing brands, craft breweries

Every restaurant is slightly different — that differentiation gives each one a small downward-sloping demand curve.

Example: The Restaurant Market

Why can your favorite restaurant charge a little more than the competition?

Location — convenience matters
Cuisine — not all food is the same
Atmosphere — ambiance, service, brand
Quality — some restaurants are just better

Each of these creates differentiation — making the restaurant an imperfect substitute for its competitors.

Monopolistic Competition: Short Run

Figure 5: Short run: the firm earns positive economic profit

Monopolistic Competition: Long Run Entry

Profits attract entry of close substitutes:

New firms enter with similar (but differentiated) products
Customers spread across more firms
Each firm’s demand shifts left (and becomes more elastic)
Entry continues until $P = ATC$ $\rightarrow$ zero economic profit

Entry works because new firms offer close substitutes — they steal customers even though products aren’t identical.

Monopolistic Competition: Long Run Equilibrium

Figure 6: Entry shifts demand left until P = ATC — zero economic profit

The Variety Tradeoff

Even in the long run, monopolistic competition has two “inefficiencies”:

Markup: $P > MC$ — allocative inefficiency
Excess capacity: firms produce left of minimum ATC

But is this really bad?

Consumers get variety — different restaurants, styles, brands
The “cost” is slightly higher prices than perfect competition

The markup is the price we pay for choice.

Oligopoly: Few Firms, Partial Substitutes

Key features:

Few firms dominate the market
Products are partial substitutes (similar but not identical)
High barriers to entry
Firms are strategically aware of each other

Examples: airlines, smartphone OS (iOS/Android), OPEC, auto manufacturers

Oligopoly: The Cartel Temptation

Oligopolists face a prisoner’s dilemma:

	Firm B: High Price	Firm B: Low Price
Firm A: High Price	Both profit	A loses, B gains
Firm A: Low Price	A gains, B loses	Both low profit

Collude (both high price) $\rightarrow$ maximize joint profit
Cheat (undercut) $\rightarrow$ steal customers because products are substitutes
Nash equilibrium $\rightarrow$ both cheat, both worse off

Oligopoly: Real-World Examples

Airlines:

Few carriers on most routes (partial substitutes)
Frequent price matching, occasional price wars

OPEC:

Agreement to restrict oil output
Members constantly tempted to cheat

Smartphones:

iOS and Android — only two real options
Network effects raise barriers to entry

Game 1: Price War (Prisoner’s Dilemma)

You and one other firm each pick a price simultaneously
- High price = collude (maximize joint profit)
- Low price = undercut (steal customers)
No communication allowed

Your goal: maximize your own profit.

Key ideas: - “High” = cartel price; “Low” = cheating - What you choose depends on expectations about the rival

Payoff Matrix

Both pick High: both earn high profit
One picks Low, one High: low-price firm gains, high-price firm loses
Both pick Low: profits shrink (“price war”)
Firm B: High Price Firm B: Low Price

Firm A: High Price A: 1, B: 1 A: 0, B: 2

Firm A: Low Price A: 2, B: 0 A: 0.5, B: 0.5

	Firm B: High Price	Firm B: Low Price
Firm A: High Price	A: 1, B: 1	A: 0, B: 2
Firm A: Low Price	A: 2, B: 0	A: 0.5, B: 0.5

Prediction: Even though (High, High) is best together, (Low, Low) is the one-shot equilibrium (“dominant strategy”: Low protects you no matter what).

How We’ll Play

Log in to the app
Pick High or Low
Submit (choices hidden)
I’ll close the round and reveal the results
You receive flex passes equal to the profit you earned

We’ll repeat across multiple rounds—watch for how strategies evolve.

What to Observe

Can we sustain collusion (High/High) for more than one round?
What happens after a “cheat”?
Do players retaliate (“punish”)?
Does trust rebuild?

Debrief: Why Cartels Collapse

Group vs self-interest: individual incentives undercut the collective
Trust is fragile: one defection unravels cooperation
Hard to monitor: hard to punish cheaters if you can’t observe them
Repeated interaction: only hope for sustaining collusion is the threat of future punishment

This sets up the move to theory: Nash equilibrium, repeated games, and antitrust policy.

Comparison: All Four Market Structures

Feature	Perfect Comp.	Monopolistic Comp.	Oligopoly	Monopoly
Substitutability	Perfect	Close	Partial	None
$P$ vs $MC$	$P = MC$	$P > MC$	$P > MC$	$P > MC$
Long-run profit	Zero	Zero	Positive	Positive
Efficient?	Yes	No	No	No
Entry	Free	Free	Restricted	Blocked
Variety	None	High	Some	None

The common thread: less substitutability $\rightarrow$ more market power $\rightarrow$ greater departure from efficiency.

Closing Question

Is some inefficiency worth it if consumers value variety?

Would you prefer:

One identical restaurant at $P = MC$ pricing?
Many differentiated restaurants at markup pricing?

Think about this as we move to price discrimination and antitrust policy next.