Lesson 6 - Market Structures

It is typical in economics to divide markets into categories according to the degree of competition
that exists between the firms within the industry. There are four such categories.

On one end there is perfect competition, where there are very many firms competing. Each firm
is so small relative to the whole industry that it has no power to influence the price. In other
words, it is a price taker. At the other extreme is monopoly, where there is just one firm in the
industry and therefore no competition from within the industry. In the middle comes
monopolistic competition, where there are quite a lot of firms competing and where there is
freedom for new firms to enter the market, and oligopoly, where there are only a few firms and
where entry of new firms is restricted.

The market structure under which a firm operates will determine its behaviour. This behaviour
(conduct) will in turn affect the firm’s performance: its price levels, profits, efficiency etc. In some
cases, it will also affect other firm’s performance.

Structure Conduct Performance

To distinguish more precisely between these four categories the following must be considered:

i. The freedom with which firms can enter the market

Definition: Market – The Interaction between buyers and sellers.

Perfect Competition

This model is built on four underlying assumptions/characteristics:

▪ Firms are price takers: Given that there are very many suppliers (and buyers) in the
market, each one produces an insignificantly small portion of the total industry supply. In
this regard, no firm whatsoever has the power to single handily influence the market
price of the product. In a nutshell, each firm in a perfect competitive structure is a price
taker.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
 ▪ There is complete freedom of entry of new firms into the industry. Existing firms are
unable to stop new firms from joining the market. Setting up a business will however take
time and therefore freedom of entry is essentially a long run reality.

▪ All firms produce a homogenous (identical) product – there is no branding and

▪ Both producers and consumers in the market have perfect knowledge and information
about the market. Producers – fully aware of prices, costs & market opportunities.
Consumers – fully aware of prices, quality and availability of product.

These assumptions are very strict and few, if any, industries in the reality meet these conditions.
Certain agricultural markets are perhaps closest to perfect competition. Nonetheless, despite the
lack of real-world cases, the model of perfect competition plays a crucial role in economic
analysis and policy. Its major relevance is as an ‘ideal type’. Many on the political right argue that
perfect competition brings a number of important advantages and therefore the model can be
used as a standard against which to judge the shortcomings of real world industries. Additionally
it can help governments formulate policies towards this model.

Why is perfect competition so rare in the real world – if it even exists at all? One important
reason for this has to do with economies of scale.

In many industries, firms have to be quite large if they are to experience the full potential
economies of scale. But perfect competition requires there to be many firms. Firms must
therefore be small under perfect competition: too small in most cases for economies of scale.

Once a firm expands sufficiently to achieve economies of scale, it will usually gain market power.
Consequently, it will be able to undercut prices of smaller firms, which will thus be driven out of
business. Perfect competition is destroyed. To this effect, perfect competition could only exist in
an industry if there were no economies of scale.

Advantages of Perfect Competition

▪ Efficiency: to remain competitive, in the long-run firms produce at their lowest cost possible.

▪ Low Prices: competition will push prices down. In the long run firms only enjoy normal profits.

▪ Consumer Sovereignty: consumers in a perfect competitive scenario heavily control the

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
Monopoly

In economics, a monopoly exists when there is only one firm in the industry. But whether an
industry can be classed as a monopoly is not always clear. What is more important for a firm is
the amount of monopoly power it enjoys, and that in turn depends on the closeness of
substitutes produced by rival industries. For example there is only one public transport operator
in Malta and that can be deemed to be a monopoly, but in truth it faces competition from other
modes of transport; cabs, bolt etc.

Provided there is, by definition, only one firm in the industry, the firm’s demand curve is also the
industry’s demand curve. Demand under monopoly will be relatively inelastic to each price.
Consumers in this structure cannot influence the market since there is only one source to choose
from and therefore, they will either pay the higher price or go without the good altogether.

Unlike firms under a perfect competitive scenario, the monopoly firm is a ‘price maker’; it can
choose what price to charge given it has no competition.

How/Why does a monopoly retain its monopoly power/situation?

In order for a firm to maintain its monopoly power, there must be barriers to entry of new firms.
In essence barriers can be of various forms.

▪ Economies of Scale: if a firm experiences substantial economies of scale, the industry may not
be able to support more than one producer. This case is typical of a natural monopoly and is
particularly likely if the market is small. The average costs per unit would be lower if an
industry were under monopoly than if it were shared between two or more producers.
Imagine two water services corporations – it would be unprofitable to serve the Maltese
people, each adopting their water systems. Imagine the expense (inefficient allocation of
limited resources which could have been used elsewhere) and hassle each company would
have to go through in order to enter the industry. On the other hand, one company with a
monopoly of water services could make profit since all the country would request water from
one corporation.

Even if a market could support more than one firm, a new entrant is unlikely to start up on a
very large scale. In this case the monopolist which is already enjoying economies of scale can
charge a price below the cost of a new entrant and drive it out of business. These tactics are
commonly referred to as price wars. Other aggressive tactics to continue enjoy market power
include massive advertisement campaigns, attractive after sale services and so on.

▪ Legal Protection: The firm’s monopoly position may be protected by patents on essential
processes, licensing and copyrights.

▪ Ownership of and control over retail outlets: if a firm controls the outlets through which the
product must be sold, it may prevent new rivals from gaining access to consumers.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
▪ Brand Loyalty & Product differentiation: if a firm produces a clearly differentiated product,
where the consumer associates the product with the brand, it will be very difficult for a new
firm to break into that market. When buying a Cola most automatically ask for a Coke; biro (is
a brand) – Hoover is a brand; when people want to buy such products they refer to them as
to their brand names.

▪ Ownership/ control of factors of production/ raw materials

▪ Lower costs for established firms: An established firm is likely to have developed specialised
production and marketing skills, have access to cheaper finance and so on. New firms would
therefore find it hard to compete and likely to lose any price war.

▪ Intimidation: The monopolist may resort to various forms of harassment, legal or illegal to
force competing firms out of the market.

Advantages & Disadvantages Monopoly

▪ Disadvantages

Monopolies are not as efficient as perfectly competitive firms. Firms in a monopoly do not
produce at their lowest cost since absence of competition will not incentivise efficiency as the
firm will continue enjoying supernormal profits in the long run. With competition, firms generally
have to reduce prices if they want to dominate a higher market share. However, profitability
levels may generally suffer unless maintained through lower costs brought about by higher
efficiency. But in a monopolistic scenario, the lack of competition will reinforce inefficiencies and
increase the possibility of higher costs.

Unequal distribution of income: The high profits of monopolists may be considered as unfair,
especially by competitive firms, or any one on low incomes for that matter.

In addition to these disadvantages, monopolies may lack the incentive to be produce new
products and come up with new ideas.

Large monopolies may exert political influence in return for favourable treatment from
governments.

▪ Advantages

Despite the above arguments, monopolies can have some advantages which will benefit society
at large.

Economies of Scale: The monopoly firm may be able to achieve substantial economies of scale
due to large plant, centralised administration and the avoidance of unnecessary duplication (e.g.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
a monopoly water company would eliminate the need for several systems of rival water mains
under each street). This can result in the production of higher output at a lower price.

Research and Development: Although the monopolist’s survival does not depend on its finding
ever more efficient methods of production, it can use part of its supernormal profits for research
& development and investment. It thus has a greater ability to become efficient and operate at
lower costs than have the small firms with limited funds. In essence, R&D is very costly and
expensive to conduct and therefore small firms in a perfect competition are hampered by this
fact.

Innovation & New Products: This may be seen by the monopoly as a barrier to entry in itself as no
firm may compete against the monopoly on the basis of new ideas and products. New products
will give the consumer a greater choice. In a perfect competition, on the other hand, it is difficult
to have innovation as this is generally expensive and will be adopted by the other competing
firms provided there is perfect information and knowledge.

Imperfect Competition

Monopolistic Oligopoly
Competition

Monopolistic Competition

▪ Developed in the 1930s

▪ A situation where there are a lot of firms competing, but where each firm has some
degree of market power especially in terms of service, quality, location etc. Moreover
each firm has some discretion as to what price to charge for its products.

▪ Examples: Restaurants, hairdressers, petrol stations

This model is built on three underlying characteristics:

▪ There are quite a large number of firms. Consequently, each firm has an insignificantly
small share of the market and any actions or decisions are unlikely to affect its rivals.
Similarly, this model assumes that each firm in making its decisions does have to worry
how its rivals will react. This means that what its rivals choose to do will not be influenced
by what it does. This is known as the assumption of independence.

▪ Product Differentiation – Each firm produces a product or service in some way different
from its competitors due to level of service, location, quality etc. Consequently, the price

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
 for the same product or service may vary from one firm to the other because the
customer will be paying for the added ‘experience’.

▪ Relative freedom of entry – any new firm is free to set up business.

Theoretically, if firms under this model enjoy supernormal profits, then new firms will enter the
industry in the long run. Consequently, the demand for the existing firms will fall as the new
entrants will take some of the customers away. This will continue to happen so as long as
supernormal profits remain and thus new firms are attracted to join the industry. In due course,
long run equilibrium will be attained when only normal profits remain and hence there is no
more incentive for further firms to enter.

In reality, however, some firms may still continue to enjoy supernormal profits in the long run.
Assume a hairdresser in a small village, if no other salon opens in the village or the vicinity, then
the existing hairdresser is most likely to benefit from ‘monopoly power’ in that village and still
enjoy supernormal profit. This exception will bring us to next debate relating to limitations about
the model.

Problems with the model

▪ Since information is not perfect, new firms will not enter the industry if they are unaware of
supernormal profits.

▪ The fact that products are differentiated implies that it is difficult to derive a demand curve
for the whole industry and therefore the analysis has to be confined to the level of the firm.

▪ In reality firms are likely to differ from each other not only in terms of the product they
produce but also in their size and cost structure.

▪ Entry may not be completely free e.g. two petrol stations could not set up in exactly the same
spot; on a busy cross road. Therefore, while typically, firms in the long run will only have
normal profits other firms may be able to earn long run supernormal profits because they
may have some cost advantage or produce a product or offer a service which is impossible to
duplicate perfectly.

▪ Non-Price Competition – advertising & product development makes it more difficult for new
firms to enter the market and compete with the established rivals.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
 Monopolistic Competition & the Public Interest

Comparison with perfect competition

▪ One of the advantages of monopolistic competition over perfect competition is that the
consumer, given that there is product differentiation, benefits from a greater variety of
products to choose from. In other words the consumer has more choice.

▪ On the other hand, it is often argued that monopolistic competition leads to a less efficient
allocation of resources than perfect competition. Given this assumption, monopolistic
competition has the following disadvantages:

▪ Less will be sold and at a higher price than under a perfect competitive structure
▪ Firms will not be producing at the least-cost point

In this sense, there seems to be a trade-off between variety/choice and prices. Sometimes
choice does come with a higher price.

Comparison with Monopoly

▪ Freedom of entry for new firms and hence the lack of supernormal profits under
monopolistic competition are likely to help keep prices down for consumers and encourage
cost savings. But again the limitations to this model may challenge this argument.

▪ Monopolies are likely to achieve greater economies of scale and have more funds for
investment and R&D.

Oligopoly

An Oligopoly is a market structure where just a few firms between them share a large proportion
of the industry. A situation where there are only two firms is referred to as a duopoly.

There are significant differences in the structure of industries under oligopoly and similarly
significant differences in the behaviour of firms. The firms may produce a virtually identical
product (e.g. chemicals, petrol, telephony, banking, insurance). Most oligopolists, however,
produce differentiated products. Much of the competition between such oligopolists is in terms
of the marketing of their particular brand e.g. Android & Apple

Despite the differences between oligopolies, there are two crucial features that distinguish
oligopoly from other market structures.

i. Barriers to Entry: similar to those under monopoly although the size of the barriers will vary
from industry to industry and in some cases entry is relatively easy while in others it is
virtually impossible.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
ii. Interdependence of the firms: Since there are a few firms under oligopoly, each firm will have
to take account of the others. Firms are mutually dependent / interdependent. Each firm is
affected by its rivals’ actions. If a firm changes the price or specification of its product or the
amount of advertising or some other factor the sales of its rivals will be affected. The rivals
may then respond by changing their price, specification or other. No firm can afford to ignore
the actions and reactions of other firms in the industry. We see this very often with our
mobile telephony companies, banks etc.

➢ Keep in mind that under monopolist competition firms are independent and have relative
freedom to entry. Thus the underlying difference between these two structures under the
umbrella of imperfect competition becomes now even more evident.

Due to barriers of entry oligopolistic firms will enjoy supernormal profits in both the short run
and the long run.

Oligopoly Behaviour

Oligopolists can behave in two different ways:

▪ The interdependence of firms may make them wish to collude with each other. If they could
club together and act as if they were a monopoly then they could jointly maximise industry
profits.

▪ Conversely, they may be tempted to compete with their rivals to gain a bigger share of
industry profits for themselves.

Collusive Behaviour

When firms under an oligopoly engage in collusion, they may agree on prices, market share,
advertising etc. Such collusion will reduce the uncertainty they face and the fear of engaging in
competitive price cutting or retaliatory advertising, both of which could reduce total industry
profits.

Open Collusion/Cartel

A formal collusive agreement is called a cartel. This situation, which is illegal in most countries as
it goes against the competition act, exists when firms openly agree on the level of quantity to be
produced to protect themselves & gain a larger market share. Put it differently, a cartel operates
with a quota*, whereby each firm has a regulated quantity it must produce. This limited amount
produced will in turn increase prices and simultaneously improve industry profits. With open
collusion, firms act like monopolies since they have control of the industry. The only difference
may be that since oligopolies are generally smaller than monopolies they may fail to reap the
benefits of economies of scale.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
This scenario is very similar to OPEC (Organisation of the Petroleum Exporting Countries),
whereby 13 countries extracting and producing oil are united under this organisation, which in
turn imposes quotas on the amount each country can produce every year. The main objective
behind this cartel is to pursue ways and means of ensuring the stabilization of prices in
international oil markets with a view to eliminating harmful and unnecessary fluctuations; giving
due regard at all times to the interests of the producing nations and to the necessity of securing a
steady income to the producing countries.

* the output that a given member of cartel is allowed to produce or sell.

Tacit Collusion

Despite the fact that open collusion is illegal, firms still wanting to collude may simply break the
law or get round it. Alternatively, firms may stay within the law, but still tacitly collude by
watching each other’s prices and keeping theirs similar. In this sense, firms may tacitly agree to
avoid price wars or aggressive advertising campaigns.

Tacit collusion is an unofficial agreement without any formal meetings or communication. This
behaviour is not due to any prior agreements but because it is in the interest of oligopolies to do
so. Instead of waging price wars with each other, oligopolies may resort to non-price competition
like advertising, improved services etc.

One form of tacit collusion is where firms set the same price as an established leader. The leader
may be the largest firm that dominates the industry. This is known as dominant firm price
leadership. Alternatively, the price leader may simply be the one that emerged over time as the
most reliable one to follow: the one that is the best barometer of market conditions. This is
known as barometric firm price leadership.

Conclusively when there is a price leader there is a greater chance of having tacit collusion.

Conditions that favour collusion

Collusion between firms, be it formal or tacit, is more likely to happen when firms can clearly
identify with each other or some leader and when they trust each other not to break
agreements. Furthermore the following conditions are necessary to have successful collusion:

• There are few firms in the industry that know each other well
• Costs and production methods are well known
• There is a price leader
• Similar products such that agreement on price is easily reached
• Heavy barriers to entry so that no new firms will disrupt the collusive environment
• The market is stable – if industry demand or production costs fluctuate wildly, it would be
difficult to make agreements as it would be difficult to predict and keep consistent

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
• No government rules against collusion

Non-Collusive Behaviour

In some oligopolies, there may only be a few, if any, conditions that would favour collusion. In
such cases the likelihood of price competition is greater. The behaviour of a firm under non-
collusive oligopoly will depend on how it thinks its rivals will react to its policies. Economists use
game theory to examine the best strategy a firm can adopt for each assumption about its rivals’
behaviour.

Consider two firms with identical costs, products and demand. Additionally, assume they will
both have to choose between two alternative prices. The diagram below shows this set up and
the typical profits they could each earn.

Firm A
€3 €2

€ € 3 mln (B)
€ 6 mln each
3 Total € 12 mln € 8 mln (A)
Firm B

Total € 11 mln

€ € 8 mln (B)
€ 4 mln each
2 € 3 mln (A) Total € 8 mln
Total € 11 mln

Let’s start by assuming that both firms (A & B) are charging a price of €3 and that each are
making a profit of €6 million, giving a total industry profit of €12 million. Now, assume that both
firms are independently considering reducing the price to €2. In making this decision they would
have to take account what their rival might do and how it will in turn affect them. To solve this
dilemma two approaches are generally used.

Maximin Strategy: the cautious and prudent approach, i.e. choosing the policy whose worst
possible outcome is the least bad.

Firm A has the following alternatives:

Price €2 – Profit €8m / €4m

Firm A would choose €2 selling price as a maximin minded firm, since the worst possible
consequence will guarantee a profit of €4m, which is better than the worst situation if the firm
had to charge €3. In this case, firm A is choosing the policy whose worst possible outcome is the
least unfavourable.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
Maximax Strategy: the optimistic & ambitious approach, i.e. choosing the policy which has he
best outcome.

Firm A has the following alternatives:

Price €2 – Profit €8m / €4m

Firm A would choose €2 selling price as a maximax minded firm, since the best possible outcome
is better at €2 (€8m) than at €3 (€6m).

The same logic will be followed by Firm B.

Given that in this game both approaches, lead to the same strategy (namely cutting prices) this is
known as a dominant strategy game. The equilibrium outcome of a game where there is no
collusion between the players is known as a Nash equilibrium. But given that both firms will be
tempted to lower prices, they will both end up earning a lower profit (€4m each). Thus collusion,
rather than a price war, would have benefitted both and yet both would be tempted to ‘cheat’
and cut prices. This is known as the prisoners’ dilemma – where two or more firms by attempting
independently to choose the best strategy for whatever the other is likely to do end up in a
worse position than if they had cooperated in the first place.

Mark
Do not admit Admit
Do not admit

0 years (Mark)
0 years each
10 years (Robert)
Robert

0 years (Robert)
6 years each
10 years (Mark)
Admit

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)