Different market structures

Economics A2 · The price system and the microeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Market structures differ in the number of firms, how different their products are, how easy entry is and how much firms know. Perfect competition has many small firms, identical products, free entry and perfect information, so each firm is a price taker. A monopoly is a single seller protected by barriers to entry. Monopolistic competition has many firms with differentiated products. An oligopoly has a few large, interdependent firms.

Every profit-maximising firm produces where MC = MR. With free entry, supernormal profit attracts new firms, so only normal profit is left in the long run. With barriers, supernormal profit can last.

A contestable market has no entry or exit costs, so even one firm must behave competitively.

Rules to remember

Perfect competition: P = AR = MR (horizontal demand). In the long run P = MC = lowest ATC: normal profit, allocative and productive efficiency.
Monopoly: AR slopes down and MR lies below it. Output is lower and price higher than in perfect competition, with P above MC. X-inefficiency: costs above the lowest possible level.
Monopolistic competition in the long run: AR touches ATC (normal profit), but P is above MC and there is excess capacity.
Shutdown: in the short run if price is below AVC. In the long run if price is below ATC.
A perfectly competitive firm’s short-run supply curve is its MC curve above AVC.
Natural monopoly: economies of scale are so large that one firm can supply the whole market at the lowest average cost.
n-firm concentration ratio = total market share of the n largest firms (%).

Common mistake

Students say a loss-making firm must close at once. In the short run it should keep producing if price covers average variable cost, because the loss is then smaller than its fixed costs.

Worked example

The market price in a perfectly competitive industry is $12. A firm maximises profit at 200 units, where its average total cost is $9. What profit does it make now, and what happens in the long run?

Supernormal profit per unit = AR − ATC = 12 − 9 = $3.
Total supernormal profit = 3 × 200 = $600.
There are no barriers to entry, so new firms enter. Market supply shifts to the right and the price falls.
Entry stops when price equals the lowest average total cost and only normal profit is earned.

Answer: The firm earns $600 supernormal profit in the short run and only normal profit in the long run.

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