Market Structure

Market structure refers to structural variables such as number of firms, barriers to entry and exit, product differentiation, etc. which determine the level of competition in a market. Basic market structures are monopoly, oligopoly, monopolistic competition and perfect competition.

There are a number of factors which affect demand curves and cost curves of a market and ultimately determines whether firms in that market earn any positive economic profit in the short-run and/or in the long-run and whether they have market power. Such key variables include number of firms, degree of market concentration, nature of product, barriers to entry, cost structure, minimum efficient scale, regulation, etc.

Characteristics

Following are important determinants of market structure:

Number of Firms

The number of firms competing in a market is arguably the single-most important determinant of profitability of each firm in the market. If there is only one firm, it is in a better position to set its price such as each positive economic profit. However, if there are many firms, competition makes each firm a price-taker i.e. it must sell at the prevailing market price or else sell nothing which forces the market towards zero economic profit.

Monopoly has only one firm, duopoly only two, oligopoly is characterized by a few firms, monopolistic competition has significant number of firms and perfect competition has the largest number of firms each of which is so small that it can’t affect the market in any way.

Degree of Concentration

Degree of concentration refers to the extent of the market share held by top firms. There are a number of measures such as Herfindahl-Hirschman Index, Rothchild Index and four-firm concentration ratio, used to assess degree of concentration of a market.

A monopoly has highest degree of concentration, followed by an oligopoly. Monopolistic competition and perfect competition both have low degree of concentration but in perfect competition, a single firm's market share is negligible.

Nature of Product and its Substitutes

Whether a firm sells a differentiated product is very important in determining the firm’s ability to charge a price higher than the market price. If the product is standardized, it has multiple substitutes which eliminates a firm’s ability to charge premium for it. However, if the product is differentiated i.e. there is something such as brand value, features, advertising, etc. to which the consumers attach some additional value, the firm may be able to charge a little more for it.

Firms in perfect competition have completely standardized product with multiple substitutes, a firm which has a monopoly has a product with few substitutes but firms in oligopoly and monopolistic competition are characterized by differentiated products.

Entry and Exit Barriers

The extent to which existing firms in a market can restrict new firms from entering the market is an indicator of market power. The barriers to entry may arise either from patents, copyrights, economies of scale, etc.

The entry barriers are the highest in case of a monopoly and to some extent in oligopoly. Monopolistic competition and perfect competition, on the other hand, have very low barriers to entry.

Demand Curves

One of the most important factor affecting market power of a firm is the elasticity of demand of its product and the nature of its demand curve.

A firm which has a monopoly in a product faces a down-ward sloping demand curve and the product typically has very low elasticity of demand. In case of an oligopoly, even though the industry demand curve slopes downward and the market elasticity of demand is low, each individual firm has a demand curve and elasticity of demand which are less steep than the overall market. Firms in perfect competition, on the other hand, face a horizontal demand curve and hence theoretically infinite price elasticity of demand.

Cost Curves

The existence of economies of scale and increasing returns to scale gravitate a market towards monopoly and/or oligopoly. It is because when average cost of production is low, larger firms are able to produce a product at a lower price which give them considerable advantage in pricing smaller firms out of the market.

When the minimum efficient scale, the minimum output level at which average total cost is minimum, is high, barriers to entry are also high because each entrant must bring heavy investment to install the feasible capacity.

Comparison

The following table summarizes key characteristics of the popular types of market structure:

Characteristic Monopoly Oligopoly Monopolistic Competition Perfect competition
Number of firms One Few Large Very large
Typical firm size Very large Large Medium Small
Four-firm concentration ratio 1 Close to 1 Low Near zero or very low
Demand curve Steep downward-sloping Downward-sloping Downward-sloping Horizontal
Elasticity of demand Very low Low Low High
Nature of product No substitutes Differentiated Differentiated Standardized
Barriers to entry Very high Very high Low Nonexistent
Minimum efficient scale Very high Very high Medium Low
Positive economic profit Both in short-run and long-rum Both in short-run and long-run Only in short-run Only in short-run
Deadweight loss High High Low No

by Irfanullah Jan, ACCA and last modified on

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