Market structure is best defined as the organisational and other characteristics of a market which determine the performance of the firm in that market. There are four main types of market structures:
- Perfect Competition
- Monopolistic Competition
Main Characteristics of Market Structures
The main criteria by which one can distinguish between different market structures are
- The number of sellers - there may be many, one or a few,
- The type of product sold - some firms sell identical (homogenous) products while others sell different brands (heterogeneous),
- Barriers to entry into and/or exit out of the market - these include factors such as high cost of production, specialised technology, licenses and control over natural resources,
- The level of knowledge - in some markets, firms may have perfect knowledge about other competitors in terms of profitability and production techniques while in other markets, firms may have imperfect knowledge;
- Control over price - in some markets, firms are price setters which means that they have total control over the price set in the market. In other markets, firms are price takers and cannot set their own price but depend on the price set by the market.
Types of Market Structures
- Perfect Competition – in this market structure, there are many buyers and sellers. The product being sold is very similar or homogeneous. It will be expected that price elasticity of demand will be very high in this type of market structure (perfectly elastic demand). In this case, price increases will lead to decreases in total revenues and profits because buyers will go to other sellers because of the now increased price. For the seller to be profitable in this market structure, price must be decreased so that he can take away customers from his competitors.
- Monopoly – this is where there is only one seller of a product or service. Monopsony is when there is only one buyer in a market.
- Monopolistic competition – this is a market structure that falls between perfect competition and monopoly. In this market structure, there are many independent firms which have a very small proportion of the market share. The product can be differentiated – advertising plays a huge role in this type of structure.
- Oligopoly – in this market structure, the market is dominated by a small number of firms which own more than 40 percent of the market share.
Profit Maximization of the Perfect Competitor in both the Short and Long Run
Short-run profit maximization is achieved at the output level where marginal revenue equals marginal cost (MR=MC) as can be seen in the following graph. In this type of market structure, MR is equal to the demand curve or average revenue curve or price. It must be remembered that the demand curve for the perfect competitor is horizontal. The reason for this is that there are many sellers and buyers in the industry. At the point where MR=MC, this MR must be greater than the average cost and the average variable cost. Profits are shown by the shaded area (MRABC) where price is greater than average cost. These profits are equal to total revenue (MRCOQ0) minus total cost (AB0Q0). Note that if average costs were greater than price, the seller can still operate as long as price is greater than average variable cost; at least he will be covering his variable costs. Only where price is less than average variable cost will the seller shut down. Therefore, P=AVC is the shutdown point.
However, in the long period, because of the large short run profits, new firms will enter the market and these large profits will be eroded due to the high level of competition. The result will be normal profits where price will equal average costs as in the graph below. Therefore, unlike the short run where the competitive firm will be making large and abnormal profits, in the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point.
Profit Maximization for the Monopolist in the Short and Long Run
As stated above, a monopoly is a market structure where only one firm is the sole supplier of a particular product or service. The firm has full control over setting its price and there are significant barriers to entering such an industry.
Monopoly power is the control over price that a pure monopoly holds. The demand curve facing the firm is therefore downward sloping. When a monopolist faces the market demand curve as its own demand curve, its marginal revenue will be less than price. Profit maximization requires that output be Q1 which is where marginal revenue (MR) curve intersects the marginal cost (MC) curve from below. Price is determined from the demand curve at point “a” as can be seen in the following graph. So price is P1 which is greater than the average total and average variable costs. This gives a profit equal to the area of P1abd.
As in every other market, the presence of economic profit is a signal to investors that entry into this market provides an opportunity to make abnormal profits. Thus, this is where the issue of barriers to entry, that is, the ability to preserve its monopoly, becomes critical to the firm. It is therefore possible that a monopoly will make abnormal profit in the long run as well as the short run. Therefore, unlike the other types of market structures, the same profit position in the short run holds for the long run with the monopoly – large and abnormal profits.
Profit Maximization of the Monopolistic Competitor in both the Short and Long
A monopolistic competitive market structure is one in which there are a large number of sellers or suppliers whose products can be differentiated where there are low barriers to entry. Good examples of such companies are restaurants, clothing and shoe companies. Monopolistic competition differs from perfect competition only in one main aspect in that the products from different sellers have distinct traits which differentiate the goods of one seller from those of another seller. Additionally, the firm has full control over setting the price in the market, hence a downward sloping average and marginal revenue curve. All other characteristics are the same as perfect competition.
Profit maximization occurs where marginal revenue equals marginal cost with output Q0, and the firm charges what the market will sustain, P0 according to the demand curve. In this case, average cost is C0, and the firm is making an abnormal profit equal to the rectangle P0abC0 as can be seen in the graph below.
Profit plays the same role in monopolistic competition as it does in perfect competition - it is a signal to entrepreneurs to enter or exit a market. As in perfect competition, in the long run the incentives drive profit to zero. Additionally, the market demand must be divided among more firms now, giving each a smaller share and profits in the long run will tend to zero as can be seen in the graph below. At the output Qe the firm charges Pe, which just equals both the short run average cost and long run average cost.
Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the few firms that make up the industry may employ restrictive trade practices such as collusion and market sharing to raise prices and restrict production in much the same way as a monopoly. In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. A good example of an oligopolistic company is that of the airline industry that comprises of a few companies.
Demand Curve of an Oligopolist
The demand curve for the oligopolist has a kink at point E as seen in the graph below and thus, the demand curve has an elastic and an inelastic portion. Above the kink, demand is relatively elastic because all other firms’ prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point and the kink point.
The motivation behind this kink is the idea that in an oligopolistic competitive market, firms will not raise their prices because even a small price increase will result in them losing many customers. This is because competitors will generally ignore price increases with the hope of gaining a larger market share as a result of them now having comparatively lower prices. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less price-elastic for price decreases.