A market structure is defined as the layout in which a market is organized, structured, and characterized. For many years, the study of market structure has taken centre stage in the business as well as the academic field. The studies focused on identifying various characteristics as well as the nature of pricing and competition in the market. Traditionally, the study of market structure focused on identifying and classifying various features of the market such as the number of firms, the market share, the nature of costs, the extent of product differentiation, as well as the structure and turnover of customers among others. This paper aims to extend the knowledge of market structure by describing each type of market structure using real-life examples. IN addition, this study explores how firms’ long-term profitability, their likelihood to survive, cost-effectiveness, and entrepreneurs’ incentives to develop substitutes are affected by barriers to entry. The paper concludes by describing the preferred market for selling and buying products respectively.
Types of Market Structures
There are four types of market structures, namely; perfect competition, monopolistic competition, oligopoly, and monopoly as described in the following sections.
The main characteristic of this type of market structure is the availability of numerous small firms that are constantly competing against each other. As a result, a single firm in a perfect competition market does not have any market power. Since none of the firms can significantly influence the market prices, the industry produces at a socially optimal level. In this market, there lacks artificial restrictions imposed on buyers or sellers. Furthermore, according to Etro (2009), this type of market is characterized by the absence of rivalry, whereby all firms are price-takers. In a perfect competition, it is assumed that all firms maximize profits, sell homogenous goods, there is free entry and exit in the market, and that there is no consumer preference. Consequently, it is not likely to find a perfect competition market in reality. A real-life example that is almost close to a perfect competition is the stock market. Another close example is the forex market. In the forex market, there is no firm rivalry; This is because numerous firms participate in the buying and selling of homogenous products.
New firms can enter the market whenever the industry is earning excess profits because entry and exit within a perfect competition market are not limited. However, when the industry is earning losses, many firms will be willing to exit the market. In perfect competition, there are no barriers to entry that influence the long-term profitability of firms, cost-efficiency, incentive of entrepreneurship to develop a substitute for products, as well as the likelihood of inefficient firms surviving in the market. As a result, a perfect competition is characterized by a lack of incentive to develop substitute products. In addition, the long-term profitability of each firm depends only on its internal factors without the influence of other firms in the industry. Finally, due to the lack of entry barriers, this market is free of competitive pressures.
Change in prices is a common phenomenon in a perfect competition. Because firms in this market are price takers, they respond to changes in prices by taking them without any alteration. This is because the number of buyers and sellers expands to the extent that no individual firm can influence the market prices of products and services. Because firms in perfect competition market are unable to influence prices, they can only adjust their prices to match the market prices. Moreover, in this market, firms are selling inelastic products. This is because there exist a few substitutes in the market. In addition, the quantity demanded is not affected by changes in prices. Also, all the firms are selling homogenous products. Since the market sells inelastic products, the market price charged will remain relatively unchanged. Finally, in this market, it is assumed that there is no government intervention. This is because any form of government intervention would lead to imbalances in the perfect competition market. However, the government plays a significant role in establishing price controls that would ensure that consumers are not exploited. Under a perfect competition market structure, the international trade increases competition, which further ensures that prices are fair. It also ensures that consumers have access to a wide variety of products to choose from.
A large number of small firms that are actively competing against each other which is characteristic of this type of market structure. However, despite that monopolistic competition sell similar products, they are slightly differentiated. The differentiation of products thus gives firms in this market structure a certain degree of market power allowing them to charge slightly higher prices (Stackelberg et al., 2011). A monopolistic competition market is based on four major assumptions. These include; free entry into and exit from the market, differentiation of products, all firms maximize profits, and lastly, consumer preference of certain products. Unlike perfect competition, monopolistic competition market does not result in socially optimal outputs. In addition, firms have more market power and hence can easily influence prices in the market in order to take advantage. A real-life example of monopolistic competition includes the market for cereal products. A huge number of similar but differentiated brands such as Apple Jack, Lucky Charms, as well as Froot Loops among others characterize the cereal market. Though these products are breakfast cereals, they taste slightly different. Despite the concentrated competition in this market, it is not a perfect one because many firms make similar products. As a result, no firm in a monopolistic competition can have a perceptible influence on the market prices and other output policies. Another important feature of a monopolistic competition is that all firms enjoy freedom in entry into and exit out of the market. Firms can leave or enter the market at any time because they are small in size and are capable of producing similar substitute products. Changes in prices occur in this market due to the internal competition caused by the high level of product differentiation. Firms, therefore, respond to price changes by altering their prices although some have small levels of market power. Furthermore, firms in this market structure do not respond to price changes by a cut in prices but rather through an increase in sales. Because no single firm controls the market, a reduction in prices in one product will increase its sales but have little effect on the market prices and outs.
In monopolistic competition, all firms sell elastic products; however, the products are not perfectly elastic. This is because all firms are selling similar but differentiated products, which can act as substitutes to one another. This affects the market price changes since firms do not respond to an increase in the price of other products by raising theirs. Just like in the perfect competition market, the government plays a significant role in establishing price controls that would ensure that consumers are not exploited. International trade also affects the monopolistic competition. Under this market structure, the international trade ensures the production of high quality differentiated products. This also plays significant roles in the establishing of fair prices of the differentiated products.
This type of market structure is characterized by the presence of only a small number of firms. Due to the small number of firms, there is limited competition in the oligopoly market. However, the few firms can either collaborate or compete against each other. Furthermore, they have collective market power, which they can use to drive up prices in order to earn more profits. Because there are only a few firms, the action of one is likely to affect the other. There is interdependence amongst firms in the oligopoly market. Hence, the action of one firm may prompt the others to take countermeasures. For example, if one firm reduces their prices, the others might follow suit. Another characteristic of oligopoly is that there is a high level of competition (Kamien & Schwartz, 2014).
The oligopoly market is based on the assumption that oligopolies can set prices, all firms maximize profits, products are homogenous or differentiated, no barrier to entry or exit, and only a few firms dominate the market. Based on these assumptions and other market characteristics, a perfect real-life example of oligopoly is the gaming consoles market. In this market, only three firms dominate the market: Sony, Microsoft, and Nintendo. Each of these has a significant market power to set prices and dominate the market.
In an oligopoly market, there are high levels of entry barriers into the market because the few existing firms enjoy large economies of scales, control essential inputs, and have exclusive patents and licenses among other factors. This tends to improve the long-term profitability of the few firms because they control the market and have few competitors. However, the likelihood that some inefficient firms will survive in the oligopoly market is minimal because they face stiff competition from the few already established firms. The incentive of entrepreneurs to develop substitutes for the products supplied by the firms is also high because the few firms are engaged in a constant struggle to control the market. Moreover, in the oligopoly market, firms understand that changes in their prices affect their competitors hence creating countermoves. Therefore, each firm in this market responds to price changes by creating countermoves to neutralize actions by their rivals.
In the oligopoly market, firms sell elastic products because substitutes are available. However, the products are not perfectly elastic because there lacks adequate substitutes due to the presence of only a few firms. Because firms are selling elastic products, the market price charge tends to converge at the equilibrium. In addition, government control and intervention is granted. Government regulation is essential in oligopoly as it prevents the firms from engaging in collusion to control the market. In this market structure, the role of the government is to ensure that oligopolists do not charge exploitative prices. For instance, the government might put price floors and price ceilings to control how oligopolists price their products. International trade opens new avenues thereby directly affecting this type of market. Under oligopoly, international trade creates measures such as competition that ensures prices are cheaper.
In a monopoly market structure, a single firm controls the entire market. In this case, single firm has huge market power as the consumers do not have an alternative. As a result,, monopolists tend to reduce output in order to maximize their profits and increase prices. Monopolies are not desirable in the society because they result in higher prices and lower outputs. As a result, monopolies are highly regulated by governments. There are four major assumptions under monopoly. These include that monopolies can set prices, maximize profits, only one firm dominates the market, and there exist a high barriers to entry and exit. Based on these assumptions and characteristics, a real-life example of a monopoly market is Monsanto. This firm operates in the United States, and controls more than 80% of all corn harvested and traded in the economy. As a result, Monsanto has a high level of market power and lacks a competitor firm.
In monopoly markets, firms sell perfectly inelastic products. This is because there is no substitute in the market as there lacks other firms to provide alternative goods and services. Because firms are selling perfectly inelastic products, an increase in the price does not affect demand. However, a decrease in price is likely to increase demand. Therefore, in a monopoly market, firms respond to changes in market prices by being price takers because there are no alternative products and services (Baldwin & Scott, 2013). In a monopoly market, therefore, the government plays a very important role as a price watchdog. The government does this to ensure that consumers are protected from exploitative monopolists. This can be achieved through introducing a price ceiling that protects consumers from exorbitant prices. Finally, under this market structure, international trade plays an important role by eliminating exploitative prices. This is possible through allowing international firms with a huge capital base to invest in the industry.
Preferred Market Structure for Selling Products
The most preferred market for selling products is a monopoly. This is because it has the highest barriers to entry. In addition, the competition is very low. These two factors empower the firm to have absolute control over the price of the goods sold in the market. As a result, the firm can charge different prices for its products and earn abnormal profits.
Preferred Market Structure for Buying Products
The most preferred market to buy products is perfect competition. This is because there are numerous small firms competing against each other. Hence, the quality of products and services sold are improved, and the market prices are not exorbitant. Furthermore, perfect competition is the most preferred market because firms produce socially optimal outputs.
High Entry Barriers in the Market
Some industries in the market are easy to enter and start doing business, unlike others. The former has a low barrier to entry while the latter have high barriers to entry. For instance, the restaurant industry has a low barrier to entry due to low operational costs and training requirements. The high entry barriers into the market influence Firms’ long-term profitability is affected by barriers to entry, survival likelihood of some inefficient firms, cost-efficiency in the industry, and the entrepreneurs’ ability to develop substitutes.
There exist various barriers to entry in the market and they determine the long-term profitability of a firm in different ways. First, resource ownership, which is a fundamental barrier to entry, makes it very costly for new firms to possess input. Due to resource ownership, the existing firms are able to control prices thereby making high profits in the long-term. The large resource ownership by the existing firms will ensure they continue earning high profits in the long-run because they can produce at low costs. It will also reduce their cost efficiency as well as the likelihood that inefficient firms will survive in the industry in the long-term. Secondly, when investors require high capital, it becomes very costly for firms to enter new markets. As explained by Feenstra (2004), new firms require a high amount of capital to enter monopoly markets. Since most new firms are unable to raise huge capital requirements, existing monopolists still continue charging high prices and earning abnormal profits in the long-run. In addition, the existing firms continue enjoying their large economies of scale which enables them to earn more profits in the long-run. These aspects are irrespective of barriers to entry.
The existence of strict copyrights and patent rights also act as a barrier to entry by protecting the existing firms. This results in a reduced competition from firms willing to join the market. As a result, only a few firms operate in the market with the freedom and power to control prices to realize abnormal profits in the long-term. Consequently, this limits the possibility of small, start-up firms surviving in the industry in the long-run. However, this provides huge entrepreneurial incentives for developing substitute products.
Competitive Pressures Present
Various competitive pressures are also present in markets that have high barriers to entry. Most established firms in these markets are large and are producing large quantities of goods and services. New, start-up entrants cannot match the foromer’s production levels. In addition, most firms in these markets have gained substantial customer loyalty through advertisement and brand differentiation. This makes it difficult for new firms to enter the market and compete with them effectively. Most firms operating in markets with a high barrier to entry have controls over the logical channels of distributions, which gives them a competitive advantage. In addition, they have built a long relationship with their distributors, something that new firms are missing. Therefore, it would not be easy for new firms to access and establish new distribution channels to compete with the existing ones effectively.
Government policies also create competitive pressures in markets with a high barrier to entry. Some government policies may prevent as well as limit the possibility of new entrants into the market. This happens when a government policy limits the access to raw materials, withholds issuing license, as well as limits production tests to new entrants. Such actions by the government provide opportunities for the existing firms to continue controlling the market by gaining a competitive advantage. The existence of huge switching costs is another competitive pressure existing in markets with high barriers to entry. This is because it is costly for buyers to switch from a firm to another. As a result, most buyers in these markets prefer to be served by the existing firms rather than switch to new ones because they are not ready to incur the switching costs. This competitive pressure discourages new firms from entering markets with high barriers to entry (Rios, McConnel, & Brue, 2013).
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Feenstra, R. C. (2004). Advanced international trade: Theory and evidence. Princeton, N.J: Princeton University Press.
Kamien, M. I., & Schwartz, N. L. (2014). Market structure and innovation. Cambridge: Cambridge University Press.
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