Different market structures

Perfect competition

Perfect competition is a benchmark rather than a description of anywhere. Its assumptions are many buyers and sellers each too small to affect price, a homogeneous product, perfect information, free entry and exit, and no transport costs. Together these make each firm a price taker facing a horizontal demand curve at the market price, so average revenue and marginal revenue coincide. The value of the model is not realism but that it yields the efficiency outcomes against which every other structure is judged.

In the short run a perfectly competitive firm produces where MC equals MR, which is where MC equals price, and may earn supernormal profit or make a loss depending on where average cost sits. In the long run neither survives. Supernormal profit attracts entry, market supply rises, price falls, and entry continues until only normal profit remains. Losses cause exit, supply falls, price rises, and exit continues until the remaining firms break even. Long-run equilibrium therefore has price equal to minimum average cost, with each firm earning normal profit only.

That outcome is efficient in both senses, which is why it is the benchmark. Productive efficiency holds because each firm produces at the minimum of its average cost curve, so no output is being produced at avoidable cost. Allocative efficiency holds because price equals marginal cost, meaning the value consumers place on the last unit exactly equals the cost of producing it, so no reallocation of resources could make anyone better off without making someone worse off. Neither condition holds in any other structure.

The same diagram tells a loss-making firm whether to keep producing. In the short run its fixed costs must be paid whether it produces or not, so the question is only whether producing covers its variable costs. If price is at or above average variable cost, each unit sold covers its own variable cost and contributes something towards the fixed costs, so producing loses less than closing. If price falls below the minimum of average variable cost, every unit adds to the loss, and the firm should shut down. That price, the minimum point of AVC, is the short-run shutdown price. In the long run there are no fixed costs, so a firm that cannot cover average total cost at the minimum of ATC leaves the industry: the minimum of ATC is the long-run shutdown, or exit, price.

This is also where the perfectly competitive firm's supply curve comes from. At any market price the firm produces where price equals marginal cost, so the MC curve tells you how much it supplies at each price. Below the minimum of AVC it supplies nothing. The firm's short-run supply curve is therefore the section of its marginal cost curve above average variable cost, and the industry supply curve is the sum of these across all firms. A monopolist has no supply curve in this sense, because the output it chooses depends on the shape of the demand curve it faces, not on price alone.

Monopoly

A monopolist is the industry, so it faces the downward-sloping market demand curve as its own average revenue curve, with marginal revenue below it and twice as steep. It maximises profit where MC equals MR and then charges the price the demand curve permits at that output, which lies above marginal cost. Because barriers to entry prevent the entry that would compete profits away, supernormal profit persists into the long run. Output is lower and price higher than the competitive outcome, and the area between the demand curve and marginal cost over the units not produced is the deadweight welfare loss.

The case against monopoly is not the whole story and A Level answers are expected to say so. Economies of scale may allow a monopolist to produce at lower average cost than many small firms, and if the cost saving is large enough its price may be below the competitive industry's despite the mark-up. Supernormal profit funds research and development that firms earning only normal profit could not finance, which is the explicit rationale for the patent system. Natural monopoly makes competition actively wasteful, since duplicating a water network raises costs without benefit. And a monopolist may face potential competition even without actual rivals, which constrains it if entry is credible.

A further cost of monopoly is X-inefficiency, which is different from both productive and allocative inefficiency. A firm is X-inefficient when it produces at a higher cost than it needs to for its output, so it operates above its average cost curve rather than on it. The cause is lack of pressure: a firm protected from competition can tolerate overstaffing, weak management and waste, because the costs are covered by its market power rather than punished by rivals. The same argument is made about state-owned firms without a profit motive. It is the reason competition and contestability matter even where they would not change the textbook price and output: they force firms onto their cost curves.

Price discrimination is charging different prices to different consumers for the same good where the difference does not reflect cost. It requires market power, the ability to separate consumers into groups with different price elasticities, and the ability to prevent resale between them. The firm charges more where demand is inelastic and less where it is elastic, converting consumer surplus into profit. The welfare assessment is genuinely ambiguous: total output usually rises and some consumers gain access at prices they could not otherwise afford, while others pay more than they would under a single price.

Monopolistic competition and oligopoly

Monopolistic competition has many firms and free entry, as in perfect competition, but differentiated products. Differentiation gives each firm a downward-sloping demand curve and therefore some price-setting power, but it is a weak power because close substitutes exist. In the short run supernormal profit is possible; in the long run entry erodes it, and equilibrium occurs where the demand curve is tangential to the average cost curve. The firm earns normal profit but produces below minimum average cost, so it carries excess capacity and is neither productively nor allocatively efficient. Whether that inefficiency is a genuine cost depends on how much consumers value the variety that differentiation provides.

Oligopoly is a market dominated by a few interdependent firms, and interdependence is the defining feature. Each firm's best action depends on what its rivals do, so behaviour cannot be predicted from cost and revenue curves alone. This produces two opposite tendencies. Firms may collude, formally through a cartel setting price and output jointly, or tacitly through price leadership, achieving something close to the monopoly outcome. Or they may compete, and because price cuts are easily matched and destroy profits for everyone, competition typically takes non-price forms: advertising, product development, loyalty schemes and service quality. The kinked demand curve model rationalises observed price stickiness by assuming rivals match price cuts but not price rises, though it explains rigidity rather than how the price got there.

Contestability cuts across the whole classification and is often the most useful idea in an evaluation. A market is contestable when entry and exit are cheap, in particular when costs are not sunk and can be recovered on exit. In a perfectly contestable market the threat of hit-and-run entry disciplines incumbents even if none actually enter, so a monopolist may price close to average cost to deter entry. The implication is that the number of firms is a poor guide to behaviour: a monopoly in a contestable market may behave competitively, while an oligopoly protected by heavy sunk costs may not.

Game theory, collusion and cartels

Because oligopolists are interdependent, economists use game theory to analyse them: the study of decisions where each player's best choice depends on what the others do. A pay-off matrix sets out the result for each player of every combination of choices. A dominant strategy is one that is best for a player whatever the other player does. An equilibrium in which neither player can do better by changing only their own choice is called a Nash equilibrium. The most important result for oligopoly is that this equilibrium can be worse for both players than an outcome they could reach by cooperating.

A cartel is most likely to hold when there are few firms, so cheating is easy to spot; when their costs and products are similar, so they can agree on a price; when barriers to entry keep new firms out; when demand is stable, so a fall in sales can be blamed on cheating rather than on the market; and when members can punish those who break the agreement. The consequences for consumers are those of monopoly: higher prices, lower output, a deadweight welfare loss and the risk of X-inefficiency. This is why cartels are illegal in most countries, and why competition authorities offer reduced penalties to the first member that reports one, which deliberately turns the cartel into a prisoner's dilemma of its own. OPEC is the best known cartel between governments rather than firms; its members agree production quotas, and its history of members producing above them illustrates the incentive to cheat.