In AS Economics we learned about market failure – describing situations when free markets where not performing at their most efficient level. One reason for this was termed ‘imperfect competition’. It was argued that, if a firm could achieve a position of market dominance, they may distort the pattern of resource allocation.
The fact that a firm attempts to profit maxmise is not in itself bad for society.The structure of the market has a strong influence on how well a market performs. ‘Structure’ here is seen in relation to a number of different dimensions, but in particular the number of firms that are operating in the market and the way they interact.
Firms cannot take decisions without some awareness of the market in which they are operating. In some markets, firms find themselves to be such a small player that they cannot influence the price at which they sell. In others, a firm may find itself as the only firm, which clearly gives it much more discretion in devising a price and output strategy. There may be some intermediate situations where the firm has some control over price, but needs to be aware of the rivals in the market.
Economists have devised a range of models that allow such different market structures to be analysed. Before looking carefully at the different types of market structure, the key characteristics will be introduced. The main models are summarised in the table below. In may ways, we can regard these as a spectrum of markets with different characteristics.
|Perfect Competition||Monopolistic Competition||Oligopoly||Monopoly|
|Number of firms||Many||Many||Few||One|
|Freedom of entry||Not restricted||Not restricted||Some barriers to entry||High barriers to entry|
|Firm’s influence over price||None||Some||Some||Price maker, subject to demand curve|
|Nature of product||Homogeneous||Differentiated||Varied||No close substitutes|
|PC operating systems
Local water supply
At one extreme is perfect competition. This is a market in which an individual firm is a price taker. This mean that there is no individual firm that is large enough to be able to influence the price, which is set by the market as a whole. This situation would arise when there are many firms operating in a market, producing a product that is much the same whatever firm produces it. You might think of it as the market for a particular sort of vegetable, for example. One cauliflower is very much like another, and it would not be possible for a particular cauliflower to set a premium price for their product.
Such markets are also typified by their freedom of entry and exit. In other words, it is relatively easy for new firms to enter the market, or for existing firms to leave it to produce something else. The market price in such a market will be driven down to that at which a typical firm in the market just makes enough profit to stay in business in the long run – covering their normal profit. If firms make more than this, other firms will be attracted in, and this abnormal profits will be competed away. If some firms in the market do not make sufficient profit to remain in the market, they will exit, allowing price to drfit up again until again the typical firm makes enough to stay in business.
At the other extreme of the spectrum of market structures is monopoly. This is a market where there is only one firm in operation. Such as firm has some influence over the price, and can choose the combination of price and output in order to maximise profits. The monopolist is not entirely free to set any price it wants, as it must remain aware of the demand curve for its product. Nonetheless, it has the freedom to choose a point along its demand curve.
The nature of a monopolist’s product is that it has no close substitutes – either actual or potential – so faces no competition. An example might be Microsoft, which for a long time held a global monopoly for operating systems for PCs. At the time of the famous trial in 1998, Microsoft was said to supply the operating system for 95% of the world’s PCs.
Another condition of a monopoly market is that there are barriers to entry for new firms. This means that the firm is able to set its price such as to make profits which are above the minimum needed to keep the firm in business, without attracting new rivals to the market.
Between the two extreme forms of market structure are many intermediate situations in which firms have some influence over the selling price, but still have to take into account of the fact that there are other firms in the market. One such market is known as monopolistic competition. This is a market in which there are many firms operating and competing, each producing similar but not identical products, so there is some scope for influencing price, perhaps because of brand loyalty. However, firms in such a market are likely to be relatively small. Such firms may find it profitable to make sure that their product is differentiated from other goods, and may advertise in order to convince potential customers that this is the case. For example, small-scale local restaurants may offer different styles of cooking.
Another intermediate structure is oligopoly, which literally means ‘few sellers’. This is a market in which there are just a few firms that supply the market. Each firm will take decisions in close awareness of how the other firms in the market may react to their actions. In some cases, they may be intense rivals, which will tend to result in abnormal profits being competed away. In other cases the firms may try to collude – to work together to behave as if they were a monopolist – in order to make higher supernormal profits. The question of whether firms in an oligopoly collude or compete has a substantial impact on how the overall market performs in terms of resource allocation, an whether consumers will be disadvantaged as a result of the actions of the firms in the market.
Barriers to entry
It has been argued that if firms in a market are able to make abnormal profits then this will act as an inducement for new firms to try and gain entry into a market in order to share in those profits. A barrier to entry is a characteristic of a market that prevents new firms from joining the market. The existence of such barriers is thus of great importance in influencing the market structure.
For example, if a firm holds a patent on a particular good, this means that no other firm is permitted to produce the good by law, and the patent-holding firm has a monopoly. The firm may then be able to set price such as to make abnormal profits without fear of rival firms competing away these profits. On the other hand, if there are no barriers to entry in a market, and if the existing firms set price to make abnormal profits, new firms will join the market, and the increase in market supply will push price down until no abnormal profits are being made.