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Teaching notes for chapter 6

One may think of the spectrum of possible market structures as a segment with two extremes: monopoly and perfect competition. Both of these extremes are ideal situations that do not exist exactly in reality. In particular, there is no real-world industry that satisfies all of the assumptions of the perfect competition model. How useful is the model, then?

To address this question, this chapter presents two models that relax some of the rather extreme assumptions of the perfect competition model: the models of competitive selection and monopolistic competition. Of these two models, the first one is a bit of a novelty in IO textbooks. The reason for its introduction is fourfold. First, the theoretical developments around this model have been one of the important developments in the field during the 1980s and 90s, though this fact is not always duly appreciated. Second, the advent of powerful computers and rich datasets has created a wealth of well documented stylized facts regarding the process of firm entry, growth and exit, among others. Third, the theoretical models seem to fit the facts fairly well (actually, the models are a great help in understanding the facts). Fourth, there are still a large number of theoretical points to be studied and facts to be investigated; that is, this is important area in terms of future research.

This chapter, together with the previous one (Monopoly and regulation), is supposed to set the stage for the rest of the book. Together, these chapters make the point that the extreme models are a good approximation to situations that are close to the ends of the spectrum. So, a dominant firm (close to a monopolist, but not quite) behaves in a way similar to a monopolist; a firm in a competitive selection or monopolistic competition context (close to perfect competition, but not quite) behaves in a way similar to a firm under perfect competition. This leaves a host of other possible intermediate market structures, those with more than one firm but less than the "large number" assumed by perfect competition. This is where oligopoly analysis enters: Chapter 7 and the following chapters.

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