Economics: Understanding Market Structures

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In this lesson, we will look at different types of market structure. You want to know how to compete in your industry, and that's going to depend on the structure of the market. The structure of the market is related to our earlier discussion of market power. Can you affect the price of your product? It's also related to how much profit you can expect to earn in the long run. We have already considered one kind of market structure: that is perfect competition. In the perfectly competitive market, you have a large number of small firms producing identical products. Because you have a large number of small firms producing an identical product, each firm in this market has no market power. That is, they are driven by their rivals to a common price, and that will be the equilibrium price in the market. If you are an individual firm in this market, your individual demand curve looks like this. It's a horizontal line at the equilibrium market price. That is, if you raise the price you are charging, you are going to lose all of your customers, and you would never lower the price, because you can't serve the whole market. Why not charge the higher price for the customers you can serve? This is what the demand curve looks like in a perfectly competitive market.
There is one other important thing to consider in a perfectly competitive market. We assume that there are no barriers to entry. That is, any firm can enter or exit at will and, as a result, you can expect that there will be new entrants into this industry as long as any one is making a positive economic profit. Entry will continue until economic profit is driven to zero. That's one extreme. At the other extreme, we have a market structure that we call monopoly. The monopolized market is one in which you have a single large producer serving the entire market. This monopolist is able to set any price that they want according to the demand curve. For the monopolist, the firm's demand curve is equal to the market's demand curve, because it is a sole supplier to this market. How do you get to be a monopolist? Well you've got to have very good barriers to entry. Perhaps they come from patents or copyrights, perhaps they come from sole ownership of some strategic resource. Because you are the only supplier in this market, you have the power then to choose any price along this demand curve. You can set a high price and serve a small number of customers or a lower price and serve more of the market.
All of the other market structures that we would consider, fall somewhere on the continuum between perfect competition and monopoly. Let's look at two other possibilities. Let's consider monopolistic competition, a hybrid of monopoly and competition. In this particular case, we have got a large number of firms, so in that way monopolistic competition is like the competitive market. However, the firms are producing individualized products--differentiated products--and therefore, each firm has its own little version of a monopoly. An example would be fast food. There are several firms serving the fast food market. However, they are all producing subtly different versions of that same fast food product: Hamburgers that are flame broiled, hamburgers that are ready in one minute or less, hamburgers that taste like this or that. In this particular industry structure, you've got a large number of firms competing, but they are differentiating their products, one from another, and each one of them has created its own little version of a monopoly. If we took the individual demand curves and added them up together, we would get the market demand curve for fast food. But along the individual demand curve, each firm gets to exploit the trade-off between price and quantity. Each firm gets to exercise a little bit of market power. Now, in monopolistic competition, there are no barriers to entry. That is, any new fast food chain that wants can enter the fray of this market. They just got to come up with a convincing way to differentiate their offering from those of their rivals.
A final form of market that we will consider is oligopoly. The key here is that whether they are producing a product that's identical or differentiated, they are all keeping a close eye on each other. That is, they are watching what their rivals are doing, particularly how they are pricing their products and how much they are producing. In the oligopoly market structure, we have to have barriers to entry to keep out newcomers. In that way, it's similar to a monopoly. However, the interaction with each other, the competition, the eye on the rival, is more like the competitive market. What does the demand curve look like for an oligopoly? Well, economists don't really agree on that matter. In fact, there is a whole sub-discipline in economics devoted to studying how a small number of firms strategically interact with each other. But here is a famous version of what an oligopoly demand curve might look like. It's called the Kinked Demand Curve. And we imagine, for the sake of the story we are going to tell with this picture, that the firm starts with an oligopoly price at the elbow of this individual demand curve. The story goes that if you raise your price, you can expect your rivals will sit tight with their lower prices and steal market share from you. That's why the curve is relatively elastic above the bend. If, however, you were to lower your price, you could expect aggressive competition. Your rivals would follow you down the demand curve, and therefore you wouldn't increase your own market share significantly. The whole idea with oligopoly is firms keeping an eye on each other; a small number of firms protected by barriers to entry, perhaps even producing identical products, strategically interacting, each seeking maximum profit.
We can summarize this discussion about market structure in the following table. The columns indicate the important questions in determining market structure: the number of firms, the type of products sold, and the existence of barriers to entry. Consider first the case of perfect competition; here we have many firms producing identical products with no barriers to entry. Monopolistic competition is like perfect competition in that there are many firms and no barriers to entry. However, it's distinguished by the fact that the firms are producing differentiated products. Oligopoly now has few firms and some barriers to entry. It's defined by strategic interaction among firms and it doesn't really matter whether the firms are producing identical products or differentiated ones. Finally, in the extreme case of monopoly, we have one firm and many barriers to entry. And we might say that the type of product sold is unique; the monopolist is producing something for which there simply is no good substitute.
Once you know where your firm fits in this taxonomy of market structures, you know how it is going to be interacting with its rivals and what your prospects are for profits in the long run and market power in the short run.
Perfect Competition
The Basic Assumptions of Competitive Markets
Understanding Market Structures [1 of 2]