The spectrum of market structures

Market structures are distinguished by four things: the number of firms, whether products are homogeneous or differentiated, the height of barriers to entry, and how good information is.

• Perfect competition — very many firms, identical products, free entry, perfect information, price takers.
• Monopolistic competition — many firms, differentiated products, low barriers. Some price-setting power (hairdressers, cafés, plumbers).
• Oligopoly — a few dominant, interdependent firms, high barriers (supermarkets, banks, energy).
• Monopoly — pure monopoly is one seller; in UK competition law a firm with ≥ 25% market share is deemed to have monopoly power.
• Monopsony — a single dominant buyer (see 4.1.6).

The framework examiners reward: structure → conduct → performance. Structure (how many firms, what barriers) shapes conduct (pricing, advertising, collusion), which determines performance (price, output, efficiency, profit). Use it to organise any market-structure essay.

Perfect competition: short run and long run

Assumptions: many buyers and sellers, homogeneous product, perfect information, no barriers to entry or exit, firms are profit maximisers and price takers.

Because the firm is a price taker, its demand curve is horizontal at the market price: AR = MR = P. It maximises profit where MC = MR.

• Short run: supernormal profit is possible if P > ATC at the profit-maximising output. Losses are possible too.
• Long run: supernormal profit attracts entry (no barriers). Market supply shifts right, price falls, and entry stops only when profit is normal again. If firms were making losses, exit raises price back up. So in long-run equilibrium: P = MC = AR = MR = minimum ATC, and only normal profit is earned.

Why it is the benchmark: P = MC gives allocative efficiency and production at min AC gives productive efficiency. But it is a theoretical yardstick — the assumptions (perfect information, identical products, zero barriers) are met almost nowhere. Its real value is as the standard against which we measure the cost of monopoly.

The four efficiency concepts

• Allocative efficiency — resources go where consumers want them. Condition: P = MC. (Price measures the marginal benefit to the consumer; MC measures the marginal cost to society. Equalise them and you cannot make anyone better off without making someone worse off — Pareto optimality.)
• Productive efficiency — output produced at the minimum of average cost; no waste. On a PPF, any point on the frontier.
• Dynamic efficiency — efficiency over time: investment, R&D, innovation and new products that shift cost curves downwards. This needs retained supernormal profit — which is exactly what monopolists have and perfectly competitive firms do not (Schumpeter's creative destruction).
• X-inefficiency (Leibenstein) — costs are above the minimum possible because a firm without competitive pressure becomes complacent: overstaffing, gold-plated offices, slack. It is drawn as an AC curve higher than it needs to be.

The key evaluation tension: monopoly is statically inefficient (P > MC, output restricted, possible X-inefficiency) but may be dynamically efficient (profits fund R&D — pharmaceuticals are the classic case). Which effect dominates is an empirical question, and saying so is worth marks.

Why no supernormal profit in the long run?

Monopoly, barriers to entry and the welfare loss

A monopolist faces the whole market demand curve, so AR slopes down and MR < AR. Profit maximising at MC = MR means it sets a price above MC and restricts output below the competitive level.

Barriers to entry — legal (patents, licences), technical (huge MES / natural monopoly), sunk costs, brand loyalty and advertising, control of an essential input, and strategic barriers (limit pricing, predatory pricing).

Costs of monopoly: higher price, lower output, allocative inefficiency (P > MC), productive inefficiency (not at min AC), possible X-inefficiency, a transfer of consumer surplus to producer surplus, plus a deadweight welfare loss — the triangle of surplus that simply disappears because units worth more to consumers than they cost to make are never produced.

Benefits of monopoly: economies of scale can make the monopolist's costs so much lower that price ends up below the competitive price (crucial for a natural monopoly such as the water network, where duplicating pipes would be absurd); dynamic efficiency from R&D; and the ability to cross-subsidise or compete internationally as a national champion.

Natural monopoly: MES is so large relative to demand that LRAC is still falling at the level of total market demand — one firm can always supply more cheaply than two. The answer is not to break it up but to regulate it (RPI − X price caps, as with Ofwat and Ofgem).

Your turn — profit-maximising price

Price discrimination

Price discrimination is charging different prices to different consumers for the same good, where the price difference is not justified by a cost difference.

Three conditions must all hold:

• The firm must have price-setting power (it cannot be a price taker).
• Consumers must have different PEDs, and the firm must be able to identify and separate them.
• Resale (arbitrage) must be prevented — otherwise the low-price group buys and resells to the high-price group.

Degrees: first degree — each consumer pays exactly their maximum willingness to pay, so all consumer surplus is captured (haggling, personalised online pricing). Second degree — price varies by quantity or time (bulk discounts, last-minute airline seats). Third degree — different prices to identifiable groups (student and OAP rail fares, peak vs off-peak).

Evaluate: it looks purely exploitative — consumer surplus is transferred to the producer, and inelastic-demand consumers pay more. But it also raises total output (some consumers priced out under a single price now get served), can fund cross-subsidy of loss-making routes, and the extra profit may fund investment. Cinemas and railways would run fewer services without it.

Conditions for price discrimination

Monopolistic competition and oligopoly

Monopolistic competition: many firms, differentiated products (branding, location, quality), low barriers. Each firm has a slightly downward-sloping demand curve, so it can raise price a little without losing all customers. Short run: supernormal profit possible. Long run: entry competes it away — the firm ends at normal profit but produces where AR is tangent to a falling AC curve, so it has excess capacity and is neither allocatively nor productively efficient. The compensation is choice and variety.

Oligopoly: defined not by number but by interdependence — each firm's best move depends on what rivals do. Measured by the n-firm concentration ratio: the combined market share of the largest n firms.

• Non-price competition dominates (advertising, loyalty cards, quality, product placement) because a price cut is easily and instantly matched.
• Collusion — overt (an illegal cartel, e.g. OPEC) or tacit (price leadership). Collusion turns the industry into a joint monopolist: higher price, restricted output. It is illegal in the UK under the Competition Act 1998, and the CMA runs a leniency programme for whistleblowers precisely to make cartels unstable.
• Kinked demand curve — a stylised explanation of price rigidity: rivals match a price cut (so demand below the current price is inelastic — you gain little) but ignore a price rise (so demand above it is elastic — you lose a lot). Hence firms leave price alone.

Your turn — concentration ratio

Game theory and the prisoners dilemma

Because oligopolists are interdependent, we model them with game theory. Read a payoff matrix by asking, for each firm: whatever my rival does, what is my best move?

• Firm A's reasoning: if B does not advertise, A gets 12 by advertising vs 10 by not → advertise. If B does advertise, A gets 6 by advertising vs 4 by not → advertise. Advertising is A's dominant strategy. By symmetry it is B's too.
• Nash equilibrium = both advertise, earning £6m each — a position where neither firm can improve by unilaterally changing strategy.
• Yet if they colluded and neither advertised, each would earn £10m. Collusion is jointly better but individually unstable: each has a private incentive to cheat and grab the 12.

Why this matters for policy: the prisoners dilemma explains why cartels break down, why price wars start, and why a CMA leniency programme (immunity for the first firm to confess) is such a powerful weapon — it strengthens the incentive to defect. It also explains wasteful advertising arms races.

Your turn — the gains from collusion

Which market structure?

Tap a feature, then tap the market structure it best describes.

Contestable markets

Baumol's theory of contestable markets says what matters is not the number of firms but the threat of entry. A market is perfectly contestable when entry and exit are costless — no sunk costs.

In a contestable market, even a single incumbent must keep price close to average cost and stay efficient, because supernormal profit would invite hit-and-run entry: a rival enters, undercuts, takes the profit, and exits before the incumbent can respond.

• Sunk costs are the key barrier — costs that cannot be recovered on exit (specialised machinery, brand advertising, R&D). High sunk costs make a market non-contestable.
• Incumbents fight contestability with limit pricing (setting price below the profit-maximising level to deter entry) and predatory pricing (pricing below cost to drive out an entrant — illegal, but hard to prove).

Policy implication: if contestability is what disciplines firms, competition policy should focus on removing barriers to entry (deregulation, easy switching, open access to networks) rather than obsessing over concentration ratios. Airline deregulation is the standard example — and the standard counter-example, since sunk costs in slots and fleets turned out to be higher than Baumol assumed.

Match the efficiency concept

Tap a description on the left, then the concept it defines.

Contestability in action

The case for monopoly

The big ideas to know

You have covered the key ideas in AQA 4.1.5. Press Finish to see your score.