Unit 6: Market Structure

Market structure describes the organisational and competitive features of a market that determine how firms behave and how price and output are settled. It ranges along a spectrum from many small sellers of identical goods (perfect competition) to a single seller (monopoly), with monopolistic competition and oligopoly lying between. The structure a firm operates in fixes its degree of price-making power and the shape of the demand curve it faces.

Dimensions that classify a market:

• Number of sellers: many (competition), one (monopoly), few (oligopoly), or many with differentiation (monopolistic competition).
• Nature of product: homogeneous (identical, perfect substitutes) versus differentiated (real or perceived differences).
• Entry and exit conditions: free entry drives long-run profit to zero; barriers (patents, scale, licences) protect abnormal profit.
• Knowledge: perfect information versus imperfect information about prices and quality.
• Price control: the firm is a price taker (accepts market price) or a price maker (chooses price along its demand curve).

Common equilibrium rule for every structure:

Profit is maximised where MR = MC, with MC cutting MR from below
MR = marginal revenue (change in total revenue per extra unit)
MC = marginal cost (change in total cost per extra unit)

II. Perfect Competition

The benchmark of price-taking behaviour

A. Defining assumptions

A market of so many buyers and sellers that no single agent influences price; the firm accepts the ruling price as given.

• Large numbers: each firm supplies a negligible share of total output.
• Homogeneous product: buyers have no reason to prefer one seller, so a single price prevails.
• Free entry and exit: no barriers, allowing long-run adjustment.
• Perfect knowledge and mobility: factors and information move freely.
• Firm's demand curve: horizontal (perfectly elastic) at the market price P, so P = AR = MR.

B. Price and output determination under perfect competition

Market price is set by the intersection of industry demand and supply; the individual firm then chooses the output that maximises profit at that price.

• Industry level: price P is where market demand = market supply. This P is the horizontal line each firm faces.
• Firm's output rule: produce where MR = MC = P, since MR equals price.
• Short-run outcomes depend on where price sits relative to average cost:
  • Supernormal profit: if P > ATC, profit per unit = P − ATC.
  • Normal profit: if P = ATC (minimum), only opportunity cost is covered.
  • Loss but continue: if AVC < P < ATC, the firm covers variable cost and stays open.
  • Shut-down point: if P < AVC, close down; the firm cannot cover variable cost.
• Long-run equilibrium: free entry competes profit away until P = MR = MC = minimum ATC. Every firm earns only normal profit and operates at the lowest point of its ATC curve (productive efficiency).
• Worked example:
  
  TEXT

    Market price P* = 10
    Firm cost: TC = 100 + 2Q + 0.5Q^2  →  MC = 2 + Q
    Profit-max: P = MC → 10 = 2 + Q → Q = 8 units
    TR = 10 × 8 = 80 ; TC = 100 + 16 + 32 = 148 → loss of 68 in short run

  
  Here price exceeds AVC (which is 2 + 0.5Q), so the firm keeps producing 8 units and minimises its loss rather than shutting down.

C. Significance and limitations

• Efficiency claim: yields both allocative efficiency (P = MC, price equals the cost of the last unit) and productive efficiency (output at minimum ATC).
• Limitation: the strict assumptions (identical goods, perfect knowledge, zero barriers) rarely hold, so it serves as a theoretical yardstick rather than a common reality.

III. Monopoly

A single seller facing the whole market demand

A. Definition and features

One firm is the entire industry, producing a good with no close substitutes and protected by barriers to entry.

• Sole seller: the firm's demand curve is the market demand curve, sloping downward.
• Barriers to entry: patents, exclusive resource ownership, legal franchise, or large economies of scale (natural monopoly).
• Price maker: the firm chooses price or quantity, but not both, along the demand curve.
• MR below AR: to sell more it must cut price on all units, so MR < AR (price) at every output.

B. Price and output determination under monopoly

The monopolist selects the output where MR = MC, then reads the price off the demand curve above that output.

• Output rule: produce Q where MR = MC.
• Price rule: charge the highest price the demand curve permits for that Q, so P > MR.
• Revenue link (linear demand):
  
  TEXT

    Demand: P = a − bQ
    TR = P·Q = aQ − bQ^2  →  MR = a − 2bQ
    MR curve is twice as steep as the demand curve

• Profit: supernormal profit (P > ATC) can persist even in the long run because barriers block entry.
• Worked example:
  
  TEXT

    Demand: P = 100 − 2Q  →  MR = 100 − 4Q
    MC = 20 (constant)
    MR = MC → 100 − 4Q = 20 → Q = 20 units
    Price: P = 100 − 2(20) = 60 per unit

  
  The monopolist sells 20 units at 60, above marginal cost of 20.

C. Price discrimination, welfare and limitations

• Price discrimination: charging different prices to different buyers for the same good to capture more consumer surplus.
  • First degree: a separate price for each unit at each buyer's maximum willingness to pay.
  • Third degree: different prices to separable groups (student vs adult fares), charging more where demand is less elastic.
• Welfare cost: because P > MC, output is restricted below the competitive level, creating a deadweight loss and allocative inefficiency.
• Limitation: absence of a unique supply curve; output depends jointly on demand elasticity and cost, not on price alone.

IV. Monopolistic Competition

Many sellers of differentiated but close substitutes

A. Defining features

Many firms compete by differentiating their products, so each has limited price-setting power within a crowded market.

• Many sellers: enough that each ignores rivals' reactions, unlike oligopoly.
• Product differentiation: branding, quality, packaging or location make goods close but imperfect substitutes (toothpaste, restaurants, salons).
• Free entry and exit: in the long run this erodes abnormal profit.
• Downward-sloping, elastic demand: each firm faces a gently falling demand curve because substitutes limit its pricing freedom, giving it a small degree of monopoly power.
• Non-price competition: advertising and product variation are central selling tools.

B. Price and output determination under monopolistic competition

Each firm behaves like a mini-monopolist over its own brand, applying MR = MC, but entry drives long-run profit to zero.

• Short-run rule: produce Q where MR = MC and set price from the firm's own demand curve, P > MR.
• Short-run profit: supernormal profit is possible if P > ATC, just as in monopoly.
• Long-run adjustment: attracted by profit, new differentiated brands enter, shifting each firm's demand curve leftward until it is tangent to the ATC curve.
• Long-run equilibrium condition:
  
  TEXT

    P = ATC   (only normal profit)
    MR = MC   (profit maximised)
    Tangency occurs on the falling part of ATC, so P > minimum ATC

• Comparison with the benchmarks:
  1. Versus perfect competition: equilibrium is on the downward-sloping stretch of ATC, not its minimum, so the firm carries excess capacity and P > MC (mild allocative inefficiency).
  2. Versus monopoly: long-run profit is competed away to normal profit because entry is free, unlike the protected monopolist.

C. Excess capacity and limitations

• Excess capacity: the gap between the firm's actual output and the minimum-ATC output; the market carries too many firms each producing below efficient scale.
• Selling costs: heavy advertising raises average cost and may add little social value where it only reshuffles market shares.
• Consumer offset: product variety and choice partly compensate for the higher price and unused capacity.
• Limitation: the "many firms acting independently" assumption blurs the boundary with oligopoly, where firms are few and interdependent.

V. Comparing the Three Structures

How power, price and efficiency change across the spectrum

• Price versus marginal cost:
  • Perfect competition: P = MC — allocatively efficient.
  • Monopoly and monopolistic competition: P > MC — output restricted below the efficient level.
• Long-run profit:
  • Perfect and monopolistic competition: normal profit only, as free entry removes surplus.
  • Monopoly: supernormal profit persists behind entry barriers.
• Firm's demand curve:
  • Perfect competition: horizontal (P = AR = MR).
  • Monopolistic competition: downward-sloping and highly elastic.
  • Monopoly: downward-sloping and less elastic (few substitutes).
• Capacity use:
  • Perfect competition: produces at minimum ATC (full efficiency).
  • Monopolistic competition: operates with excess capacity.
• Basis of competition: price alone under perfect competition; price plus differentiation and advertising under monopolistic competition; no direct rivalry under monopoly.