There are quite a few different market structures that can characterize an economy. However, if you are just getting started with this topic, you may want to look at the four basic types of market structures first. Namely perfect competition, monopolistic competition, oligopoly, and monopoly. Each of them has their own set of characteristics and assumptions, which in turn affect the decision making of firms and the profits they can make.
It is important to note that not all of these market structures actually exist in reality, some of them are just theoretical constructs. Nevertheless, they are of critical importance, because they can illustrate relevant aspects of competition firms’ decision making. Hence, they will help you to understand the underlying economic principles. With that being said, let’s look at them in more detail.
Perfect competition describes a market structure, where a large number of small firms compete against each other. In this scenario, a single firm does not have any significant market power. As a result, the industry as a whole produces the socially optimal level of output, because none of the firms have the ability to influence market prices.
The idea of perfect competition builds on a number of assumptions: (1) all firms maximize profits (2) there is free entry and exit to the market, (3) all firms sell completely identical (i.e. homogenous) goods, (4) there are no consumer preferences. By looking at those assumptions it becomes quite obvious, that we will hardly ever find perfect competition in reality. This is an important aspect, because it is the only market structure that can (theoretically) result in a socially optimal level of output.
Probably the best example of a market with almost perfect competition we can find in reality is the stock market. If you are looking for more information on perfect competition, you can also check our post on perfect competition vs imperfect competition.
Monopolistic competition also refers to a market structure, where a large number of small firms compete against each other. However, unlike in perfect competition, the firms in monopolistic competition sell similar, but slightly differentiated products. This gives them a certain degree of market power which allows them to charge higher prices within a certain range.
Monopolistic competition builds on the following assumptions: (1) all firms maximize profits (2) there is free entry and exit to the market, (3) firms sell differentiated products (4) consumers may prefer one product over the other. Now, those assumptions are a bit closer to reality than the ones we looked at in perfect competition. However, this market structure will no longer result in a socially optimal level of output, because the firms have more power and can influence market prices to a certain degree.
An example of monopolistic competition is the market for cereals. There is a huge number of different brands (e.g. Cap’n Crunch, Lucky Charms, Froot Loops, Apple Jacks). Most of them probably taste slightly different, but at the end of the day, they are all breakfast cereals.
An oligopoly describes a market structure which is dominated by only a small number firms. This results in a state of limited competition. The firms can either compete against each other or collaborate. By doing so they can use their collective market power to drive up prices and earn more profit.
The oligopolistic market structure builds on the following assumptions: (1) all firms maximize profits, (2) oligopolies can set prices, (3) there are barriers to entry and exit in the market, (4) products may be homogenous or differentiated, and (5) there is only a few firms that dominate the market. Unfortunately, it is not clearly defined what a «few» firms means exactly. As a rule of thumb, we say that an oligopoly typically consists of about 3-5 dominant firms.
To give an example of an oligopoly, let’s look at the market for gaming consoles. This market is dominated by three powerful companies: Microsoft, Sony, and Nintendo. This leaves all of them with a significant amount of market power.
A monopoly refers to a market structure where a single firm controls the entire market. In this scenario, the firm has the highest level of market power, as consumers do not have any alternatives. As a result, monopilists often reduce output to increase prices and earn more profit.
The following assumptions are made when we talk about monopolies: (1) the monopolist maximizes profit, (2) it can set the price, (3) there are high barriers to entry and exit, (4) there is only one firm that dominates the entire market.
From the perspective of society, most monopolies are usually not desirable, because they result in lower outputs and higher prices compared to competitive markets. Therefore, they are often regulated by the government. An example of a real life monopoly could be Monsanto. About 80% of all corn harvested in the US is trademarked by this company. That gives Monsanto an extremely high level of market power. You can find additional information about monopolies our post on monopoly power.
In a Nutshell
There are four basic types of market structures: perfect competition, imperfect competition, oligopoly, and monopoly. Perfect competition describes a market structure, where a large number of small firms compete against each other with homogenous products. Meanwhile, monopolistic competition refers to a market structure, where a large number of small firms compete against each other with differentiated products. An Oligopoly describes a market structure where a small number of firms compete against each other. And last but not least a monopoly refers to a market structure where a single firm controls the entire market.