Perfect Competition 
        The Basic Assumptions of Competitive Markets 
           Understanding Market Structures        Page 1 of 2 
       
       
      In this lesson, we look at different types of market structure.  You want to know how to compete in 
      your industry, and that’s going to depend on the structure of the market.  The structure of the 
      market is related to our earlier discussion of market power.  Can you affect the price of your 
      product?  It’s also related to how much profit you can expect to earn in the long-run.  We’ve already 
      considered one kind of market structure, that is, perfect competition.  In the perfectly competitive 
      market you have a large number of small firms producing identical products.  Because you have a 
      large number of small firms producing an identical product, each firm in this market has no market 
      power, that is, they are driven by their rivals to a common price and that will be the equilibrium 
      price in the market.  If you’re an individual firm in this market your individual demand curve looks 
      like this.  It’s a horizontal line at the equilibrium market price, that is, if you raise the price you’re 
      charging you’re going to lose all of your customers and you’d never lower the price because you 
      can’t serve the whole market.  Why not charge the higher price for the customers you can serve.  
      This is what the demand curve looks like in a perfectly competitive market.  There’s one other 
      important thing to consider in a perfectly competitive market.  We assume that there are no barriers 
      to entry, that is, any firm can enter or exit at will, and as a result you can expect that there will be 
      new entrance into this industry as long as anyone is making a positive economic profit.  Entry will 
      continue until economic profit is driven to zero.  That’s one extreme. 
       
      At the other extreme, we have a market structure that we call monopoly.  The monopolized market 
      is one in which you have a single large producer serving the entire market.  This monopolist is able 
      to set any price that they want according to the demand curve.  For the monopolist, the firm’s 
      demand curve is equal to the market’s demand curve because it is a sole supplier to this market.  
      How do you get to be a monopolist?  Well, you’ve got to have very good barriers to entry.  Perhaps 
      they come from patents or copyrights.  Perhaps they come from sole ownership of some strategic 
      resource.  Because you’re the only supplier in this market you have the power then to choose any 
      price along this demand curve.  You can set a high price and serve a small number of customers or 
      a lower price and serve more of the market.  All of the other market structures that we would 
      consider fall somewhere on a continuum between perfect competition and monopoly.  Let’s look at 
      two other possibilities.   
       
      Let’s consider monopolistic competition, a hybrid of monopoly and competition.  In this particular 
      case, we have got a large number of firms, so in that way monopolistic competition is like the 
      competitive market.  However, the firms are producing individualized products, differentiated 
      products, and therefore each firm has its own little version of a monopoly.  An example would be 
      fast food.  There’s several firms serving the fast food market; however, they’re all producing subtly 
      different versions of that same fast food product, hamburgers that are flame-broiled, hamburgers 
      that are ready in one minute or less, hamburgers that taste like this or that.  In this particular 
      industry structure, you’ve got a large number of firms competing but they are differentiating their 
      products one from another, and each one of them has created its own little version of a monopoly.  
      If we took the individual demand curves and added them up together, we would get the market 
      demand curve for fast food.  But along the individual demand curve each firm gets to exploit the 
      trade-off between price and quantity.  Each firm gets to exercise a little bit of market power.  Now, 
      in monopolistic competition there are no barriers to entry.  That is, any new fast food chain that 
      wants can enter the fray of this market; they’ve just got to come up with a convincing way to 
      differentiate their offering from those of their rivals.  
       
                                                                
      Perfect Competition 
        The Basic Assumptions of Competitive Markets 
           Understanding Market Structures        Page 2 of 2 
       
       
      A final form of market that we’ll consider is the oligopoly.  The key here is that whether they are 
      producing a product that’s identical or differentiated they’re all keeping a close eye on each other.  
      That is, they are watching what their rivals are doing, particularly how they’re pricing their products 
      and how much they’re producing.  In the oligopoly market structure, we have to have barriers to 
      entry to keep out newcomers.  In that way it’s similar to a monopoly.  However, the interaction with 
      each other, the competition, the eye on the rival is more like the competitive market.  What does 
      the demand curve look like for an oligopoly?  Well, economists don’t really agree on that matter.  In 
      fact, there’s a whole sub discipline in economics devoted to studying how a small number of firms 
      strategically interacts with each other.  But here’s a famous version of what an oligopoly demand 
      curve might look like.  It’s called the kinked demand curve, and we imagine for the sake of the story 
      we’re going to tell with this picture that the firm starts with an oligopoly price at the elbow of this 
      individual demand curve.  The story goes that if you raise your price you can expect your rivals will 
      sit tight with their lower prices and steal market share from you.  That’s why the curve is relatively 
      elastic above the bend.  If, however, you were to lower your price, you could expect aggressive 
      competition.  Your rivals would follow you down the demand curve, and therefore you wouldn’t 
      increase your own market share significantly.  The whole idea with oligopoly is firms keeping an eye 
      on each other.  A small number of firms protected by barriers to entry, perhaps even producing 
      identical products, strategically interacting, each seeking maximum profit.   
       
      We can summarize this discussion about market structure in the following table.  The columns 
      indicate the important questions in determining market structure, the number of firms, the type of 
      products sold, and the existence of barriers to entry.  Consider first the case of perfect competition.  
      Here we have many firms producing identical products with no barriers to entry.  Monopolistic 
      competition is like perfect competition in that there are many firms and no barriers to entry.  
      However, it’s distinguished by the fact that the firms are producing differentiated products.  
      Oligopoly now has few firms and some barriers to entry.  It’s defined by strategic interaction among 
      firms and it doesn’t really matter whether the firms are producing identical products or differentiated 
      ones.  
       
      Finally, in the extreme case of monopoly, we have one firm and many barriers to entry, and we 
      might say that the type of product sold is unique.  The monopolist is producing something for which 
      there simply is no good substitute.  Once you know where your firm fits in this taxonomy of market 
      structures, you know how it’s going to be interacting with its rivals and what your prospects are for 
      profits in the long-run and market power in the short-run.