Competition and Market Structures (Industrial Organization)

An Economics Topics Detail

By Arnold S. Kling

What Are Market Structures?

Market structures, or industrial organization, describe the extent to which markets are competitive. At one extreme, pure monopoly means that there is only one firm in an industry. At the other extreme, economists describe a theoretical possibility termed perfect competition. In between are the market structures found most often in the real world, which are oligopoly and monopolistic competition.

What Is a Monopolist?

A pure monopolist is a hypothetical market structure in which a firm faces no competition and is able to earn a significant economic profit. If other firms could enter the market, then they would do so, attracted by the profit opportunity. Therefore, a profitable monopoly could only exist if there were barriers to entry. For example, a patent can give the patent owner a legal monopoly on the production of the patented product.

One barrier to entry is high fixed costs. If it takes a large investment to enter a market, new firms may be deterred from making the attempt. High fixed costs thus can create a natural monopoly.

The monopolist faces the entire demand curve. To sell an additional unit of output, the monopolist must lower its price. It would prefer to lower its price only to the next customer, keeping its price high for existing customers. If it can price discriminate in this way, it earns a higher profit. Oddly enough, this would enhance economic efficiency, by increasing output to the point where price is equal to marginal cost.

If the monopolist is unable to price discriminate, then it will hesitate to try to get an existing customer by lowering its price. That is because it would lower its revenue from existing customers by giving them the lower price. Without price discrimination, the monopolist will restrict output. Relative to the efficient outcome, the monopolist will produce too little and charge too much.

What Is Perfect Competition?

Perfect competition is a hypothetical market structure in which there are very many firms, each of which represents an infinitesimal share of the market. In a perfectly competitive market, if any firm is able to earn an economic profit, other firms will immediately enter the market, driving economic profit to zero.

In a perfectly competitive market, each firm is a price taker, meaning that it has no control over the price. If it tries to raise its price, it loses all its consumers to other firms. If it lowers its price, it can sell as much as it wishes to, but it does not cover its costs. In a perfectly competitive market, price is driven to the point where it is equal to the marginal cost where marginal cost meets average cost. If the firm produces less output, then its average cost goes up. If it produces more output, then its average cost goes up. Thus, it produces at the point of minimum average cost.

What Are Oligopoly and Monopolistic Competition?

In the real world, pure monopoly is rare and perfectly competitive markets are almost nonexistent. The most common types of market structures are oligopoly and monopolistic competition.

In an oligopoly, there are a few firms, and each one knows who its rivals are. Examples of oligopolistic industries include airlines and automobile manufacturers.

When choosing a strategy, an oligopolist must anticipate the response of its rivals. If it raises its price and its rivals do not follow, it may lose a lot of customers. If it lowers its price in order to gain market share, perhaps its rivals will also lower their prices, foiling the attempt. Economists often use simple game theory to describe how oligopolists might arrive at their decisions. But in contrast to the other market structures, there is no precise mathematical solution to the problem of how much output to produce and what price to charge.

In monopolistic competition, there are many firms, each selling slightly differentiated products that are not perfect substitutes for one another. One difference might be location—the drug store that is five blocks away from you is not a perfect substitute for the drug store that is ten miles down the road.

Unlike a perfectly competitive firm, a monopolistically competitive firm can raise its price without driving away every customer. But unlike a monopolist, it does not benefit from barriers to entry. Because other firms can come into the market, profits are limited.

Restaurants are a good example of monopolistic competition. They do not sell identical products. They are free to try to raise and lower prices. But they rarely earn spectacular profits, because it is relatively easy for competitors to swoop in if there seem to be profit opportunities.