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MARKET STRUCTURES IN AN ECONOMY

1st June, 2021 Prelims

Introduction

Market structure, in economics, refers to how different industries are classified and differentiated based on their degree and nature of competition for goods and services. It is based on the characteristics that influence the behavior and outcomes of companies working in a specific market.

Some of the factors that determine a market structure include the number of buyers and sellers, ability to negotiate, degree of concentration, degree of differentiation of products, and the ease or difficulty of entering and exiting the market.

Perfect competition

Perfect competition is a market structure where many firms offer a homogeneous product. Because there is freedom of entry and exit and perfect information, firms will make normal profits and prices will be kept low by competitive pressures.

Features of perfect competition

  • Many firms.
  • Freedom of entry and exit; this will require low sunk costs.
  • All firms produce an identical or homogeneous product.
  • All firms are price takers, therefore the firm’s demand curve is perfectly elastic.
  • There is perfect information and knowledge.

 

Monopoly

A pure monopoly is defined as a single seller of a product, i.e. 100% of market share.

When we speak of monopolies, the following conclusions are made:

  • The monopolist maximizes benefit,
  • The price may be fixed,
  • Strong hurdles to entry and exit,
  • Only one business controls the whole industry.

Oligopoly

An oligopoly is an industry dominated by a few large firms. For example, an industry with a five-firm concentration ratio of greater than 50% is considered an oligopoly.

The market framework of the oligopoly is based on the following assumptions:

  • All companies optimize profit;
  • Pricing of oligopolies;
  • Entrance and exit obstacles exist in the industry;
  • Homogeneous or distinct goods
  • The sector is regulated only by few firms. Sadly, what a "few corporations" specifically entails is not well described.

Collusive behavior

  • Collusion occurs when rival firms agree to work together – e.g. setting higher prices in order to make greater profits.
  • Collusion is a way for firms to make higher profits at the expense of consumers and reduces the competitiveness of the market.

Monopolistic competition

Monopolistic competition is a market structure which combines elements of monopoly and competitive markets. Essentially a monopolistic competitive market is one with freedom of entry and exit, but firms can differentiate their products. Therefore, they have an inelastic demand curve and so they can set prices. However, because there is freedom of entry, supernormal profits will encourage more firms to enter the market leading to normal profits in the long term.

A monopolistic competitive industry has the following features:

  • Many firms.
  • Freedom of entry and exit.
  • Firms produce differentiated products.
  • Firms have price inelastic demand; they are price makers because the good is highly differentiated
  • Firms make normal profits in the long run but could make supernormal profits in the short term
  • Firms are productively inefficient.

Contestable markets

An industry with freedom of entry and exit, low sunk costs. The theory of contestability suggests the number of firms is not so important, but the threat of competition.

In a nutshell,

  • A contestable market occurs when there is freedom of entry and exit into the market.
  • In a contestable market, there will be low sunk costs. (Costs which can’t be recovered when leaving the market)
  • Due to freedom of entry and exit – existing firms always face the threat of new firms entering the market.
  • This threat of entry is sufficient to keep prices close to a competitive equilibrium and profits low – otherwise, new firms enter.
  • In a contestable market, it is not the number of firms that is important, but the ease by which new firms can enter the market.

Duopoly

A duopoly falls between a monopoly and oligopoly. A duopoly is a market structure dominated by two     firms. For example, Android vs Apple.

A pure duopoly is a market where there are just two firms. But, in reality, most duopolies are markets where the two biggest firms control over 70% of the market share.

Characteristics of duopoly

  • Strong barriers to entry in the market, e.g. brand loyalty (Coca-cola and Pepsi).
  • Significant economies of scale which suit a small number of firms (e.g. Airbus and Boeing – airline manufacture)