Thursday, July 26, 2012

Four Types of Industry Structure

If you're an aspiring business person, the level of competition is one of the most important things that you should look at in choosing a business or market since more intense competition among players in an industry typically results in lower profit margins; the reason why astute business persons like MVP aggressively seek dominant market positions and less competition is to be able to have greater control over pricing and profits. 

Industry or market structure is primarily defined by the number of competing firms or sellers, and to a lesser degree, the types of products offered by the firms. In this post, I will discuss four main types of market structure; hopefully, this post will be able to help you better evaluate businesses that you are thinking of pursuing in the future.

Number of firms
Type of product
Identical products
Differentiated products
One firm
Few firms
Many firms
Perfect competition
Monopolistic competition

1. Perfect competition

A perfectly competitive market has the following characteristics:
  • There are many buyers and sellers (i.e., firms) in the market
  • The goods offered by the various sellers are largely the same
  • Firms can freely enter or exit the market
Because of these characteristics, the actions of any one buyer or seller in the market would have very little impact on the market price and firms just take price as given. Also, in perfectly competitive markets prices and margins tend to be low since, in theory, the only way for a seller to attract more buyers and generate more sales is to reduce prices (particularly if there's no effective way of using marketing strategies to differentiate the product).

2. Monopoly

A firm is considered a monopoly if
  • It is the sole seller of its product
  • Its product does not have close substitutes
The fundamental cause of a monopoly is barriers to entry. Barriers to entry have three primary sources:
  • Ownership of a key resource. Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.
  • The government gives a single firm the exclusive right to produce some good (or render a service). Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.
  • Costs of production make a single producer more efficient than a large number of producers. An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output.
The most important advantage of being a monopolist is that it can set prices without regard to how other firms respond. Thus, while a perfectly competitive firm is a price taker, a monopoly firm is a price maker

3. Monopolistic competition 

Monopolistic competition is a market structure where many firms are selling products that are similar but not identical. monopolistically competitive firm’s products may be differentiated due to factors like geography (when consumers prefer stores that are convenient to reach) or the idiosyncratic preferences of buyers (that is, if tastes differ markedly from one person to the next). These slight differences enable firms to charge higher prices and still attract buyers. This opportunity to profit in the short run encourages new firms to enter monopolistically competitive markets, which may eventually lower profits and move the industry closer to perfect competition.
4. Oligopoly 
An oligopoly market is characterized by few sellers offering similar or identical products. While it's possible for competition to be intense even when there are only a few or a couple of players, which places the industry closer to perfect competition (think the local telco industry prior to PLDT's acquisition of Digitel), sometimes firms realize that it's in their best interest to cooperate, and even collude when the law explicitly requires them to compete. When sellers in an oligopoly act in concert, the market becomes a quasi-monopoly since firms are able to set higher prices for greater profitability.

So, given these types of industry structure, as a prospective (or already practicing) entrepreneur these are some things that you have to keep in mind:
  • Choose monopolistic or oligopolistic businesses for greater profitability. You do not have to have MVP's resources to achieve this--just remember Porter's Five Forces and choose industries with high barriers to entry (for other entrants) and a low threat of substitute. 
  • While it's easier said than done, the best way to achieve monopoly profits is to innovate and create a business that can't easily be emulated. While intellectual property laws in the Philippines may still be limited (or maybe just the enforcement of these laws?), still always try to use them to protect your business.
  • Or if you're already in a particularly competitive industry, try to differentiate your product and not just compete based on price. Enter unexplored geographic markets or be a niche player and change the product enough to suit particular tastes.
  • If you think it's easy to copy your business but no one is doing it yet, you can enjoy "first mover" advantages and command higher margins for a while. But be ready for an exit strategy and execute this as soon as the market becomes saturated (innovating/improving your product may be considered one such strategy)
  • Avoid perfectly competitive markets at all costs! Ask yourself this question: Why would a customer buy this product from me? If the only answer you can think of is "because my price is lower," then in all probability you'll just be wasting your capital, effort, and time if you start this business.
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