Market structures – in theory and practice - Business Environment

Perfect competition
This is the most competitive market structure. A number of conditions need to be fulfilled before perfect competition is said to exist. These conditions are as follows:

  • There are so many buyers and sellers in the market that no one of them can influence price through its activities.
  • The good being sold in the market is homogeneous (i.e. all units of the good are identical).
  • Perfect knowledgeexists in the market. This means that producers have perfect knowledge of prices and costs of other producers and that consumers know the prices charged by all firms.
  • There exists perfect mobility of both the factors of production and consumers. This means that people, machines and land can be used for any purpose, and that consumers are free to purchase the good from any of the producers.
  • There are no barriers to entry or exit in the industry. There is nothing to prevent a new firm setting up production in the industry. Naturally, this is a highly theoretical model and these conditions are unlikely to be all met in reality, but if they did, and the theory is followed through, the conclusion is that there will only be one price in the market for the good being sold. For example, if one firm is charging a higher price for the good than other firms, everyone in the market will know (because of perfect knowledge), and because the good is homogeneous and because of perfect mobility on the part of consumers, consumers will simply purchase the good from another firm. The firm that was charging a higher price will be forced to reduce the price of the good in order to sell it, or face mounting stocks of the good. There is therefore only one price for the good and this will be determined by market demand and supply that is, total demand and total supply, no one consumer or producer having enough market power to influence the price. Accordingly, the firm is said to be a ‘price taker’.

Price determination in perfect competition
Firms need to cover costs of production and to earn a certain level of profits in order to stay in business. This minimum level of profits is called ‘normal profit’,and profits over and above this level are called ‘abnormal profits’. If the firm is trying to maximize its profits it will decide what level of output to produce by setting the cost of producing the last unit of the good equal to the revenue gained from selling the last unit: in economic terminology, where marginal cost equals marginal revenue. Included in cost would be elements of wages, rent, rates, interest, raw materials and normal profits. If these costs are not being covered the firm will be making a loss.As there is only one price in perfect competition, the revenue derived from selling the last unit must be equal to its price. Therefore, the price of the good depends on the level of marginal cost.In the short run, individual firms can earn abnormal profits, but these are not sustainable in the longer term. If one firm is earning abnormal profits, given the assumption of perfect knowledge, everyone will know and, since freedom of entry exists, other firms will enter the market in order to earn abnormal profits. This means that there is an increase in market supply and price will fall back to a level where abnormal profits have been competed away. Similarly when losses are being made, freedom of exit means that supply will be reduced and price will rise again until normal profits have been regained.The implications of perfect competition for market behaviour and performance are summarized in Table. Perfect competition involves very restrictive assumptions, which will rarely be fulfilled in the real world. The usefulness of the model lies in its role as an ideal market in which competition is at a maximum, rather than in its applicability to the real world.

An example of perfect competition?

The nearest example to perfect competition is probably the fruit and vegetable market in the center of a large town. The goods will be fairly homogeneous, with perhaps slight variation in the quality. Knowledge will be almost perfect with respect to prices charged, as consumers could quickly walk around the market and ascertain the price of tomatoes, for example. Mobility of consumers is also high because the sellers are located in the same place. Thus the conditions for perfect competition nearly hold. The prediction is that there will be only one price for a particular good. Again this prediction is nearly fulfilled; the price of tomatoes tends to be rather similar across such a market, and when one trader reduces the price towards the end of the day, others tend to follow suit. Another market which is said to be close to perfect competition is the stock exchange, although with the increasing use of computers this is less likely to be true in the future.

Monopoly lies at the opposite end of the spectrum to competition. In its purest form a monopolistic market is one in which there is no competition at all; there is a single producer supplying the whole market. The monopolist has considerable market power and can determine price or quantity sold, but not both because he or she cannot control demand. The power of the monopolist depends on the availability of substitutes, and on the existence and height of barriers to entry. If there are no close substitutes for the good being produced, or if there are high barriers to entry, the power of the monopolist will be high and abnormal profits can be earned in the long run.
A monopolist could also be a group of producers acting together to control supply to the market: for example, a cartel such as OPEC (Organisation of Petroleum Exporting Countries). In monopolistic markets the producer might be able to charge different prices for the same good: for example, on an aeroplane it is quite likely that there will be passengers sitting in the same class of seat having paid very different prices, depending upon where and when the tickets were bought. Essentially they are paying different prices for the same service, and the producer is said to be exercising price discrimination.
Why is this possible? There are certain conditions that must hold for this type of price discrimination to occur. First, the market must be monopolistic and the producer must be able to control supply. Second, there must be groups of consumers with different demand conditions. For example, the demand for train travel by the commuter who works in London will be more in elastic than the demand of a student going to London for the day, who could use alternative forms of transport or even not go. This means that the willingness to pay among consumers will vary.
The final condition necessary is that it must be possible to separate these groups in some way. For example, telephone companies are able to separate markets by time so that it is cheaper to phone after a certain time; British Rail used to separate groups by age for certain of its rail cards.The monopolist will maximize its profits by charging different prices in different markets. Price discrimination is often thought of as a bad thing as the monopolist is exploiting the consumer by charging different prices for the same good. But there are some advantages, in that it makes for better use of resources if cheap airline tickets are offered to fill an aeroplane which would otherwise have flown half-full.It can also lead to a more equitable solution in that higher-income users pay a higher price than lower-income users. The main problems with the notion of price discrimination is not that it is always a bad thing, but that it is the monopolist who has the power to decide who is charged what price.Again the effects of monopoly on the behaviour and performance of the firm can be predicted. Like perfect competition, this is a highly theoretical model and is mainly used as a comparison with perfect competition to show the effects of the lack of competition.

A comparison of perfect competition and monopoly

  • It would be expected that price would be higher under monopoly than under perfect competition because of the absence of competition in the monopolistic market. It is argued, for example, that the large telephone companies (including BT) are overcharging the consumer. The benefits of the considerable technological advances that have been made in this area have not been passed on fully to the consumer. This can only be sustained by virtue of the monopolistic power of the companies. But, to counter this it could be argued that a monopolist is in a better position to reap the benefits of economies of scale, therefore it is possible that price might be lower.
  • There might be less choice under monopoly since firms do not have to continually update their products in order to stay in business. But, it is also possible to think of examples where monopolies provide greater choice (e.g. in the case of radio stations), where under perfect competition all radio stations would cater for the biggest market, which would be for pop music. A monopolist, however, would be able to cover all tastes with a variety of stations.

There is less incentive to innovate under monopoly, since the monopolist is subject to less competition. But, equally, a monopolist might have more incentive to innovate as it can reap the benefits in terms of higher profits. It may also have more resources to devote to innovation.

As can be seen there is not a clear set of arguments that imply that perfect competition is better than monopoly, this is taken into account in UK competition policy.

An example of monopoly?
Although it is easy to think of examples of industries where the dominant firm has a great deal of monopoly power, there is no such thing as a pure monopoly, as substitutes exist for most goods. For example, British Rail used to have monopoly power in the market for rail travel, but there are many alternative forms of travel.
This point highlights the difficulties of defining markets and industries discussed. The nearest examples of monopolies are the old public utilities, like gas, electricity, water and so on, many of which have been privatized.

The government, in determining whether monopoly power exists in a market, has a working definition of what constitutes a monopoly. It is when 25 per cent of the market is accounted for by one firm or firms acting together. This would form grounds for investigation by the Competition Commission. The process of UK competition policy is discussed in Chapter in more detail. The sources of monopoly power are the existence of barriers to entry and exit and the availability of substitutes(these will be discussed later in this chapter).

In both perfect competition and monopoly firms make independent decisions. In the case of monopoly there are no other firms in the industry to consider; in the case of perfect competition the firm has no power to affect the market at all. So for different reasons they act as though they have no rivals. This is not true in the case of oligopoly. Oligopoly is where a small number of producers supply a market in which the product is differentiated in some way. The characteristics of oligopoly are:

  • A great deal of interdependence between the firms; each firm has to consider the likely actions of other firms when making its decisions.
  • A lack of price competition in the market; firms are reluctant to increase their prices in case their competitors do not and they might lose market share. Firms are also reluctant to reduce their prices, in case other firms do the same and a price war results which reduces prices but leaves market share unchanged and so everyone is left worse off.
  • The lack of price competition means that different forms of non-price competitiontake place, such as branding or advertising. Oligopolists will sell their products not by reducing the price but through heavy advertising, brand names or special offers. The Premier points scheme was a good example of such non-price competition. The purchase of petrol from certain outlets gave the customer points which were accumulated on their Premier points card and then redeemed for money-off vouchers to be spent at Argos. Table shows the implications of oligopoly for conduct and performance of firms in an industry. The way in which price is determined in an oligopolistic market is through eitherprice leadership or some sort of collusion. Price leadership is where one firm takes the lead in setting prices and the others follow suit. The price leader is not necessarily the firm with the lowest cost, as it depends upon the power of the firm. So price could be set at a higher level than in a competitive market. Collusion is an explicit or implicit agreement between firms on price, which serves to reduce the amount of competition between firms. Collusion is illegal in most countries as it is seen as a form of restrictive practice, but this does not mean that collusion does not take place. A cartel is a form of collusion where firms come together to exercise joint market power. Cartels are now illegal in most countries, but the most famous of all is OPEC which has had a dramatic effect on the oil industry over the last 30 years.
    Collusive agreements, as well as possibly being harmful to the consumer, tend to be unstable as there is great temptation on the part of individual firms/countries to cheat. What is clear in the case of oligopoly is that once price is set there is a reluctance to change it. Therefore price competition is replaced by non-price competition of the sort mentioned above. The most often quoted examples of oligopoly are the market for tobacco and the market for soap powder. Both of these markets are dominated by a very small number of producers and both exhibit the predicted characteristics. There is little price competition and price is fairly uniform in both markets. There is a high degree of non-price competition in both markets high advertising, strong brand names and images, and the use of special offers or gifts at times in order to sell the goods.


Compared with monopoly and perfect competition, oligopoly is a much more realistic market structure, with many markets exhibiting the characteristics stated above.

The-top-firms share of the market in the uk

Monopolistic competition
A market structure of monopolistic competition exists when all of the conditions for perfect competition are met except for the existence of a homogeneous good, so that each firm has a monopoly over its own good but there is a great deal of competition in the market from other suppliers producing very similar products. In monopolistic competition the good is slightly differentiated in some way, either by advertising and branding or by local production. There does not have to be a technical difference between the two goods, which could be identical in composition, but there must be an ‘economic difference’ that is, a difference in the way the goods are perceived by consumers. There is also some degree of consumer loyalty, so that if one firm reduces price, consumers might not necessarily move to that firm if they believe that the difference between the brands justifies the higher price.

Implication-of-monopolistic competetion
Abnormal profits can exist in the short run but cannot persist since new firms are free to enter the industry and compete away abnormal profit.An example of monopolistic competition?

There are many examples of this type of industry: for example, the paint industry where ICI is the only producer of Dulux but there are many other types of paint on the market.

How accurate is the theory?
The implications of the theory of market structures for the behaviour and performance of firms are summarized in Table. As argued above, both perfect competition and pure monopoly tend to be based on assumptions that are somewhat unrealistic and should be regarded as ‘ideal types’ of market structure, in the sense that they establish the boundaries within which true markets exist and operate, and against which they can be analysed. In contrast, oligopoly and monopolistic competition are much nearer to the types of market structure which can be found in the real world, and economic theory does appear to explain and predict behaviour in these markets to a certain extent. In oligopolistic markets, for example, price tends to be ‘sticky’ and much of the competition between firms occurs in non-price ways, particularly branding, advertising and sales promotion. Occasionally, however, price wars do occur as in the petrol market in the 1980s and more recently between the four biggest supermarkets.

Implimentation-of-theory for behaiviour of firms
Table shows the top advertisers in the United Kingdom ranked for 2003; their ranks in 1995 are also given. The names in the list are familiar and largely expected from the predictions: for example, Procter & Gamble is one of the twocompanies which together with Unilever account for around 90 per cent of the market for washing powder. It is much more difficult to judge how accurate the behavioural implications are,

Top-advertisers in the Uk

Lack of data is one problem, as is the fact that only one structural characteristic has been considered here the level of competition between producers. The other structural factors listed in Table will also have an effect, like the level of demand, the degree of competition between the buyers and the degree of potential competition. Profitability, price and advertising, for instance, will be affected by the level of demand in the market.

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