👋 Welcome to Market Structures and Contestability!

Hi there! This chapter is all about understanding how businesses behave depending on the type of market they operate in. Think of it like this: A corner shop competes differently than a massive tech company. Why? Because the rules, rivals, and barriers are different.

Learning these structures—from Perfect Competition to Monopoly—is crucial because they explain everything from the price you pay for bread to the innovation breakthroughs in medicine. Don't worry if the graphs seem tricky at first; we will focus on the economic reasoning behind them. Let's get started!

1. Understanding Business Objectives and Profit

Before diving into market types, we need to know what firms are trying to achieve. Economists generally assume firms aim for one main goal: Profit Maximisation.

1.1 The Profit Maximisation Rule

A firm maximises profit when the extra revenue gained from selling one more unit (Marginal Revenue, MR) equals the extra cost of producing that unit (Marginal Cost, MC).

The Golden Rule:
MR = MC

Analogy: Imagine you run a bakery. You should keep baking loaves of bread as long as the money you get for the next loaf (MR) is greater than the cost of the ingredients and electricity for that next loaf (MC). The moment the cost equals or exceeds the revenue, you stop!

Quick Definitions:

  • Total Profit (TP): Total Revenue (TR) minus Total Cost (TC). \(TP = TR - TC\)
  • Normal Profit: The minimum profit required to keep the factors of production (like the entrepreneur) in their current use. It’s counted as a cost. Occurs when \(TR = TC\) or \(AR = AC\).
  • Abnormal (Supernormal) Profit: Profit earned above and beyond normal profit. Occurs when \(TR > TC\) or \(AR > AC\).
  • Subnormal Profit (Loss): Occurs when \(TR < TC\) or \(AR < AC\).

1.2 Other Business Objectives

While profit maximisation is the core assumption, firms (especially larger ones with different managers and owners) might pursue other goals:

  • Revenue Maximisation: Maximising total sales value. Occurs where MR = 0.
  • Sales/Output Maximisation: Sometimes defined as maximising the volume of output subject to making normal profit (where AR = AC).
  • Satisficing: Making "just enough" profit to keep shareholders happy, allowing managers to pursue other goals (like higher salaries or less stress).
🔑 Key Takeaway for Objectives

Always remember MR = MC. This is the foundation of firm behaviour across all market structures.

2. The Extremes of Market Structure: Perfect Competition (PC)

Perfect Competition is a theoretical market structure used as a benchmark for maximum efficiency. It rarely exists perfectly in the real world.

2.1 Characteristics of Perfect Competition

PC requires strict conditions:

  1. Many Buyers and Sellers: So many that no single firm can influence the market price.
  2. Homogeneous (Identical) Products: Consumers see all products as perfect substitutes (e.g., pure unbranded gold, basic stocks).
  3. Perfect Knowledge: Buyers and sellers know all prices and costs instantly.
  4. Freedom of Entry and Exit: No barriers to new firms joining or existing firms leaving the market.

Memory Aid: Think of PC firms as Price Takers. They must accept the price set by the market demand and supply.

2.2 Short Run vs. Long Run in PC

Because PC firms are price takers, their demand curve (D) is perfectly elastic (horizontal).
D = AR = MR

  • Short Run: A firm can temporarily earn abnormal profits or suffer losses.
  • Long Run: If abnormal profits are made, new firms enter (due to no barriers). This increases market supply, pushing the market price down until all firms only earn Normal Profit (\(AR = AC\)). If firms make losses, they exit, reducing supply and pushing the price back up to normal profit level.

2.3 Efficiency in Perfect Competition

PC achieves maximum efficiency in the long run:

  • Productive Efficiency: Output is produced at the lowest possible average cost (\(P = Minimum AC\)).
  • Allocative Efficiency: Price equals Marginal Cost (\(P = MC\)). This means the resources allocated to this good exactly match what consumers are willing to pay for the last unit. This is socially optimum.
🧠 Quick Review: PC

Key Feature: Price Taker.
Long Run Result: Normal Profit only.
Efficiency: Maximum (P=MC and P=min AC).

3. Monopoly and Monopoly Power

A monopoly is the opposite extreme of Perfect Competition.

3.1 Defining Monopoly

A pure monopoly means only one firm exists in the market. However, regulators often define a working monopoly as a firm controlling 25% or more of the market share (e.g., in the UK).

3.2 Characteristics of Monopoly

The defining feature of a monopoly is High Barriers to Entry. These protect the firm from competition and allow it to earn abnormal profits indefinitely.

Examples of Barriers:

  • Legal Barriers: Patents, licenses, government franchises (e.g., utility companies).
  • Control of Key Resources: Owning the only source of a vital input.
  • Economies of Scale (Natural Monopoly): Costs are so low at high output levels that no new small firm could ever compete on price (e.g., railway networks, water infrastructure).
  • Intimidation/Predatory Pricing: Setting prices below cost to drive out competitors.

3.3 Monopoly Behaviour (The Price Maker)

A monopolist faces the entire market demand curve, which slopes downwards.

  • To sell more, they must lower the price on all units.
  • Therefore, MR is always less than AR (Price), and the MR curve lies below the AR curve.

The monopolist maximises profit where MR = MC, resulting in lower output and higher prices compared to PC. They earn Abnormal Profit in both the short run and the long run.

3.4 Costs and Benefits of Monopoly

Monopolies are often seen negatively, but they have potential advantages:

Costs (Inefficiencies):
  1. Allocative Inefficiency: \(P > MC\). Consumers pay more than the cost of the last unit produced, leading to deadweight welfare loss.
  2. Productive Inefficiency: Output is usually not at the lowest point on the AC curve.
  3. X-Inefficiency: Due to lack of competition, firms may become lazy, costs may rise unnecessarily (e.g., lavish offices).
Benefits (Potential Efficiencies):
  1. Economies of Scale: If they are very large, they can produce at lower average costs than smaller firms, potentially passing some savings onto consumers.
  2. Dynamic Efficiency: Abnormal profits can be reinvested into Research & Development (R&D), leading to innovation and better quality products over time.
💡 Did You Know?

A natural monopoly occurs when one firm can supply the entire market output at a lower cost than two or more firms. It often happens in industries with huge fixed costs, like infrastructure.

4. Monopolistic Competition (MC)

Monopolistic Competition blends elements of monopoly and perfect competition. This market structure describes most high streets (e.g., cafes, hairdressers, small clothing brands).

4.1 Characteristics of Monopolistic Competition

  1. Many Firms: Plenty of competitors.
  2. Low Barriers to Entry/Exit: Relatively easy to start or stop a business.
  3. Product Differentiation: This is the key! Products are similar but slightly different (heterogeneous). Firms use branding, location, quality, or customer service to distinguish themselves.

Because of Product Differentiation, the firm has a slight downward sloping demand curve—it is a mini price maker for its specific brand (e.g., a specific brand of artisan coffee).

4.2 Short Run vs. Long Run in MC

  • Short Run: Due to differentiation, the firm has some control over price and can earn Abnormal Profits.
  • Long Run: Since there are low barriers, new competitors enter the market, attracted by the profits. These new firms "steal" some demand from existing firms, shifting the existing firm’s demand curve left until it is just tangent to the AC curve. Result: Only Normal Profit (\(AR = AC\)).

4.3 Efficiency in MC

Monopolistic competition is generally inefficient compared to PC:

  • No Productive Efficiency: Firms do not produce at the lowest point on the AC curve.
  • No Allocative Efficiency: \(P > MC\).

However, MC offers consumer choice and variety, which PC does not. The "inefficiency" is often viewed as the necessary cost for having varied products like different flavours of crisps or styles of jeans.

5. Oligopoly and Strategic Interdependence

An oligopoly is dominated by a few large firms (e.g., supermarkets, phone networks, car manufacturers).

5.1 Characteristics of Oligopoly

  1. Few Firms: A small number of dominant firms control most of the market share (high concentration ratio).
  2. High Barriers to Entry: Similar to monopoly, preventing new rivals from challenging the established firms.
  3. Product Differentiation: Products may be differentiated (cars) or homogeneous (oil).
  4. Interdependence: Crucial feature! The actions of one firm directly affect the others. This leads to strategic decision-making.

Analogy: Oligopoly is like playing Chess. Every move you make depends on anticipating how your opponent will react.

5.2 Strategic Behaviour: Collusion vs. Competition

Due to interdependence, firms have two main choices:

A. Collusion (Cooperation)

Firms work together to limit competition, often illegally, to increase joint profits.

  • Overt Collusion (Cartel): Formal, secret agreements on price setting or output quotas (e.g., OPEC). This behaves like a monopoly.
  • Tacit Collusion: Informal understanding without explicit agreement (e.g., Price Leadership, where one dominant firm changes price and others follow).
B. Non-Collusive Competition

Firms compete fiercely. This is often analysed using the concept of the Kinked Demand Curve.

  • The Kink: It is assumed rivals will match a price cut (to protect their market share) but will ignore a price rise (to gain market share).
  • Result: The firm faces a demand curve that is highly elastic above the current price and inelastic below it. This creates a "kink" and suggests price stability in oligopolies.

5.3 Non-Price Competition

Because prices are often rigid or firms avoid price wars (which hurt everyone), oligopolies focus heavily on competing in other areas:

  • Advertising and Branding
  • Product Development and Innovation
  • Customer Service and Loyalty Schemes

6. Contestable Markets

This is a modern and very important concept. Contestability focuses not on the current number of firms, but the potential for competition.

6.1 Defining Contestability

A market is perfectly contestable if there are zero barriers to entry and exit.

6.2 The Key Barrier: Sunk Costs

The primary factor determining contestability is the level of Sunk Costs.

  • Sunk Cost: A cost that cannot be recovered when a firm leaves the market (e.g., advertising campaigns, highly specialised machinery).
  • High Sunk Costs = Low Contestability.
  • Low Sunk Costs = High Contestability (e.g., online retail or pop-up shops where equipment can be resold or reused).

If sunk costs are low, firms can engage in Hit-and-Run Competition: they enter the market, make abnormal profits quickly, and exit before the established firms can react.

6.3 Implications of Contestability

The *threat* of hit-and-run competition forces existing firms—even a monopolist—to behave as if they were in a competitive market.

  • Firms keep prices low (close to AC or P=MC) to deter entry.
  • They operate efficiently (minimising costs) to protect their profits.

Outcome: Contestability can deliver the efficiency benefits of Perfect Competition even when the market structure itself looks like a monopoly or oligopoly.

📝 Common Mistake to Avoid

Don't confuse the number of firms with contestability. A market with one firm (a monopoly) can still be highly contestable if barriers (sunk costs) are low!

7. Summary of Efficiency Across Structures

Understanding efficiency helps you compare the performance of different markets:

Structure Allocative Efficiency (P=MC) Productive Efficiency (P=min AC) Dynamic Efficiency
Perfect Competition YES (Long Run) YES (Long Run) NO (No abnormal profit for R&D)
Monopoly NO NO YES (High potential due to large profit)
Monopolistic Competition NO NO Limited (Only normal profit long run)
Contestable Markets YES (Potential, due to threat of entry) YES (Potential, due to threat of entry) Possible

You made it! Understanding these structures allows you to critically analyse business behaviour and market outcomes. Now, go review your key terms!