Understanding Market Structures | CFA Level I Economics

In this lesson, we’ll explore the characteristics of the four types of market structures: perfect competition, monopolistic competition, oligopoly, and monopoly.

Market Structure Spectrum

Market structure is a spectrum. At one extreme, we have perfect competition, in which many firms produce identical products and competition forces them all to sell at the market price. At the other extreme is monopoly, where only one firm is producing the product. In between are monopolistic competition, where there are many sellers and differentiated products, and oligopoly, where a few firms compete in a variety of ways.

To determine where an industry falls along this spectrum, we need to examine five characteristics:

• The number of sellers and their relative sizes
• Barriers to entry or exit from the industry
• The degree to which firms differentiate their products
• The nature of competition
• The pricing power of the firms

Now, let’s take a closer look at each of these market structures and their implications for firm strategy.

Perfect Competition

Perfect competition is a market in which many firms produce identical products, barriers to entry are very low, and firms compete for sales only based on price. Firms face perfectly elastic demand curves at the price determined in the market because no firm is large enough to affect the market price. While perfect competition is just a theoretical concept, some industries come close to it, such as wheat production in a region.

Monopolistic Competition

In monopolistic competition, we also have many competing firms and low barriers to entry. However, the products are differentiated in terms of quality, features, and marketing. The firms compete not just in price, but also in product differentiation. The demand curve faced by each firm is elastic, but downward-sloping, giving them limited pricing power.

An example of monopolistic competition is the shampoo market, where firms differentiate their products through features and marketing, like anti-dandruff or anti-hair loss properties.

Oligopoly

The most important characteristic of an oligopoly market is that there are only a few firms competing. Barriers to entry are high, often due to economies of scale in production or marketing. Products can be either quite similar or differentiated through features, branding, marketing, and quality.

In an oligopoly, firms are interdependent, meaning they must consider the strategies and actions of other firms when setting their own price and differentiation strategy. Demand is also downward-sloping, but can vary in elasticity.

Examples of oligopolies include the telecommunications industry and the automobile market.

Monopoly

A monopoly market is characterized by a single seller of a product with no close substitutes, resulting in little competition. The firm faces a downward-sloping demand curve, which is the market demand curve, and has the power to choose the price at which it sells its product.

Monopolies can arise due to high barriers to entry, copyrights and patents, control over a specific resource needed for production, or government support. In some cases, the price charged by a monopoly is regulated by the government to protect consumers.

A common example of a regulated monopoly is the local electrical power provider, which is typically allowed to earn a normal return on its investment, with prices set by the regulatory authority.

Summary of Market Structures

As an analyst, you can use these general characteristics to help you determine the type of market structure within which a firm or industry is operating. The number of firms in the industry can be a good starting point. Another distinguishing characteristic is the presence of significant pricing and output decisions in an oligopoly.

And there you have it – an introduction to the types of market structures. In the following lessons, we’ll delve deeper into each of them and explore how firms should determine optimal pricing and output.