market structures

Market Structures

• An industry consists of all firms making similar or identical products.

• An industry’s market structure depends on the number of firms in the industry and how they compete.

• Here are the four basic market structures:1. Perfect competition2. Monopoly3. Oligopoly4. Monopolistic competition

Perfect competition

• Perfect competition happens when numerous small firms compete against each other.

• Firms in a competitive industry produce the socially optimal output level at the minimum possible cost per unit.

Key characteristicsPerfectly competitive markets exhibit the following characteristics:• There is perfect knowledge/Information• There are no barriers to entry into or exit out of the

market.• Firms produce homogeneous, identical, units of output

that are not branded.• Each unit of input, such as units of labour, are also

homogeneous.• No single firm can influence the market price, or

market conditions. • There are a very large numbers of firms in the market. • There is no need for government regulation, except to

make markets more competitive.

The firm as price taker• The single firm takes its price from the industry, and is,

consequently, referred to as a price taker. • The industry is composed of all firms in the industry

and the market price is where market demand is equal to market supply.

• Each single firm must charge this price and cannot diverge from it.

Monopoly• A monopoly is a firm that has no competitors in its

industry. • It reduces output to drive up prices and increase

profits. • By doing so, it produces less than the socially optimal

output level and produces at higher costs than competitive firms.

• A pure monopoly is a single supplier in a market. • For the purposes of regulation, monopoly power exists

when a single firm controls 25% or more of a particular market.

Formation of monopoliesMonopolies can form for a variety of reasons, including the following:1. If a firm has exclusive ownership of a scarce resource2. Governments may grant a firm monopoly status3. Producers may have patents over designs, or copyright

over ideas, characters, images, sounds or names • A monopoly could be created following the merger of

two or more firms. • Given that this will reduce competition, such mergers

are subject to close regulation and may be prevented if the two firms gain a combined market share of 25% or more.

Advantages of monopolies• They can benefit from economies of scale, and may be

‘natural’ monopolies• Domestic monopolies can become dominant in their

own territory and then penetrate overseas markets, earning a country valuable export revenues. This is certainly the case with Microsoft

Disadvantages of monopoly• Restrict output onto the market.• Charge a higher price than in a more competitive

market.• Reduce consumer surplus and economic welfare.• Restrict choice for consumers.• Reduce consumer sovereignty.

Oligopoly• An oligopoly is an industry with only a few firms. • If they collude, they reduce output and drive up profits

the way a monopoly does. • However, because of strong incentives to cheat on

collusive agreements, oligopoly firms often end up competing against each other.

• Although only a few firms dominate, it is possible that many small firms may also operate in the market.

• For example, major airlines like British Airways (BA) and Air France operate their routes with only a few close competitors, but there are also many small airlines catering for the holidaymaker or offering specialist services.

Concentration ratios• Oligopolies may be identified using concentration

ratios, which measure the proportion of total market share controlled by a given number of firms.

• When there is a high concentration ratio in an industry, economists tend to identify the industry as an oligopoly.

Example of a hypothetical concentration ratioThe following are the annual sales, in £m, of the six firms in a hypothetical market:A = 56B = 43C = 22D = 12E = 3F = 1In this hypothetical case, the 3-firm concentration ratio is 88.3%, that is 121/137 x 100.

Key characteristics• Interdependence• Strategy• Barriers to entry• Economies of large scale production• Ownership or control of a key scarce resource• High set-up costs• High R&D costs

The disadvantages of oligopolies• High concentration reduces consumer choice.• Cartel-like behaviour reduces competition and can

lead to higher prices and reduced output.• Firms can be prevented from entering a market

because of deliberate barriers to entry.• There is a potential loss of economic welfare.• Oligopolists may be allocatively and productively

inefficient

The advantages of oligopolies• Oligopolies may adopt a highly competitive strategy, in

which case they can generate similar benefits to more competitive market structures, such as lower prices

• Oligopolists may be dynamically efficient in terms of innovation and new product and process development

• Price stability may bring advantages to consumers and the macro-economy because it helps consumers plan ahead and stabilises their expenditure, which may help stabilise the trade cycle.

Monopolistic competition• In monopolistic competition, an industry contains

many competing firms, each of which has a similar but at least slightly different product.

• Restaurants, for example, all serve food but of different types and in different locations.

• Production costs are above what could be achieved if all the firms sold identical products, but consumers benefit from the variety.

Characteristics• Each firm makes independent decisions about price

and output, based on its product, its market, and its costs of production

• Knowledge is widely spread between participants, but it is unlikely to be perfect.

• The entrepreneur has a more significant role than in firms that are perfectly competitive because of the increased risks associated with decision making

• There is freedom to enter or leave the market, as there are no major barriers to entry or exit.

• Firms are price makers and are faced with a downward sloping demand curve

Examples of monopolistic competition• The restaurant business• Hotels and pubs• General specialist retailing• Consumer services, such as hairdressing

The advantages of monopolistic competition• There are no significant barriers to entry; therefore

markets are relatively contestable.• Differentiation creates diversity, choice and utility. • The market is more efficient than monopoly but less

efficient than perfect competition

The disadvantages of monopolistic competition• Some differentiation does not create utility but

generates unnecessary waste, such as excess packaging. Advertising may also be considered wasteful, though most is informative rather than persuasive.

• There is allocative inefficiency in both the long and short run.