Firms should always know their competition. Not only is competitive information important strategically, the concentration of competitors, and their conduct in the marketplace, are determinants of market structure.
The first step in analyzing competition is to identify your firm’s competitors. A simple rule of thumb to follow is that a competitor is any firm that offers a product which is a substitute for that offered by your firm. Any two sellers in an output market are competitors if their products are close substitutes – that is, customers could use either product in place of the other.
Price elasticities of demand are useful for determining whether a product has close substitutes. Where demand is more elastic, the availability of substitutes will be greater.
Market structures vary acccording to the number of competitors and how they operate. Markets with many sellers offering similar products are more likely to feature competitive pricing. In contrast, markets with few sellers and differentiated products are likely to feature divergences in pricing.
A market with a single seller is a monopoly. Monopolists have the bulk of the market share and they ignore the pricing and production decisions of fringe firms. A monopolist has great market power and may set prices well above marginal cost without losing much, if any, business.
Monopolistically competitive markets have many sellers, each with a loyal customer base. Pricing is determined by the willingness of customers to switch from one seller to another. If customer loyalty is not strong, sellers may lower prices in an effort to attract customers away from rivals and industry profitability may be lowered by new entrants.
Oligopolies have market share concentrated among a few leading firms. Because each firm’s pricing and production decisions affects the market price, market prices can be either well above marginal costs or driven down to that level. Much depends on the degree of product differentiation and the competitive interaction between the firms that make up the oligopoly.
Prices are strongly correlated to market structure. As competition increases, price-cost margins tend to decrease. Knowing your firm’s competition and market structure is critical to formulating a sound competitive strategy.