Market Structures: Free Markets, Competition, and Alternative Economic Systems

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Market Structures: Free Markets, Competition, and Alternative Economic Systems

Business Essentials · Chapter 2: Economic Systems and IndicatorsSection 2.2 · lesson 10 of 10516 min · free with a free account

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In this lesson

How the shape of a market decides a firm's options.

  • Describe the four market structures
  • Identify the structure an industry operates in
  • Name the core U.S. competition statutes
  • Compare market, command, and mixed systems

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Everything said in the video, section by section (2,236 words). Read along, or search it.

Economic Systems and Indicators

Market Structures, Competition, and Economic Systems

Two businesses can sell almost the same thing, and still face completely different strategic choices. A tomato stall can't raise its price. A water utility can, and it's regulated for exactly that reason. The difference lies in the structure of the market each one sells into. In this section we'll define the four market structures, and learn to read which one an industry is in. We'll name the core federal competition laws, and the agencies that enforce them. Then we'll step back to whole economies, and compare market, command, and mixed systems, each at its strongest. And we'll close with a salon owner who can't win a price war, and has to find another way.

Market Structure

Four Variables Define a Market

A market structure is the set of characteristics that determines how sellers behave, toward one another, and toward buyers. Four variables generate the categories. The first is the number of sellers, which ranges from many down to one. The second is the nature of the product. Are different sellers' goods interchangeable, or differentiated? The third is barriers to entry, the obstacles that make it costly or slow for a new firm to start selling. The fourth is price-setting power. Can a single seller raise its price without losing all of its customers? A firm with no such power is a price taker. It must accept whatever price the market sets. A firm with some power is a price maker. Combine the four variables, and you get four standard structures. Why should a manager care about a classification? Because the structure a business faces determines which strategies are actually open to it.

Many Sellers

Perfect and Monopolistic Competition

Start at the competitive extreme. Perfect competition has many small sellers, an identical product, and free entry and exit. Each seller is so small that it can sell all it wants at the going price, and nothing at a higher one. That's a price taker. Free entry keeps everyone in line. Profits above the normal return attract new sellers, which raises supply and pushes the price down. Losses drive sellers out, and push the price back up. Very few real markets meet every requirement, so treat perfect competition as a benchmark. It shows how prices behave when rivalry is at its most intense. Basic agricultural commodities, with many producers selling nearly identical products, come close. Monopolistic competition is where most consumer businesses actually live. Restaurants, hair salons, clothing shops, independent retailers. There are many sellers, entry is relatively easy, and each firm sells something slightly different, in quality, style, location, service, or reputation. That gives it a little price-setting power over its own customers, who'd need a reason to switch. But the substitutes are close, so that power is limited, and any profit tends to attract imitators. The strategic consequence is differentiation. Make the product distinct enough that price isn't the only basis for choosing. Branding and positioning, the methods of differentiation, come in chapter twelve.

Oligopoly

A Few Sellers Watching Each Other

Oligopoly is a market dominated by a few sellers, protected by significant barriers to entry. The products may be identical, or differentiated. What really distinguishes oligopoly is interdependence. With only a few firms, each one's decisions on price, output, or advertising visibly affect the others. So each must anticipate how its rivals will respond, before it acts. Think through a price cut. Rivals may match it, and then every firm ends up worse off. Now a price increase. If the others don't follow, the firm that raised its price loses customers. The result is characteristic behavior. Prices tend to move together, and firms prefer to compete through advertising, features, and service. Here's an important caution. Parallel movement in prices is not, on its own, evidence of any agreement. It can come from each firm independently reading the same conditions. Whether a particular pattern of conduct is lawful is a question for legal counsel. Industries with very large capital requirements, like commercial aircraft manufacture, tend toward oligopoly.

Monopoly

One Seller, No Close Substitute

At the far end sits monopoly. A single seller, a product with no close substitute, and barriers so high no other firm can enter. A monopolist is a price maker. But even its power has limits. Raise the price, and some customers stop buying. And there may be regulation. Barriers can come from control of an essential resource, or from a legal grant such as a patent. Or they can come from the costs of production themselves. That case is called a natural monopoly. In a natural monopoly, the cost of serving the whole market is lowest when a single firm does it, usually because fixed costs are very large. A local water system is the standard example. Laying a second set of pipes beside the first would duplicate a large expense, without adding any value. So where a natural monopoly exists, competition isn't a workable option. The usual response is regulation. In the United States, local services are generally overseen by a state public utility commission. It reviews the rates the monopolist may charge, in return for its exclusive position.

Table 2.2.1

The Four Structures Compared

Here are the four structures side by side. Read down the rows, and the number of sellers falls, from very many, to many, to few, to one. Barriers to entry rise in step, from almost none, to low, to high, to very high or absolute. And price-setting power grows. None at all for the farm commodity seller. A small amount for the neighborhood restaurant. Considerable power for the aircraft maker, though constrained by rivals' responses. And a large amount for the water utility, limited by demand and by regulation. The practical payoff is this. A firm's row tells its manager where the main competitive lever lies. In perfect competition, it's cost. In monopolistic competition, it's differentiation. In oligopoly, it's reacting to rivals. And for a monopoly, it's the regulator.

Competition Law

Three Federal Statutes

Where competition is limited, the law sets boundaries on how firms may behave. Three federal statutes form the core of United States competition law. The Sherman Act, passed in eighteen ninety, prohibits agreements and combinations in restraint of trade. It also prohibits monopolization, and attempts to monopolize. The Clayton Act, from nineteen fourteen, addresses specific practices. It also covers mergers and acquisitions whose effect may be substantially to lessen competition. The Federal Trade Commission Act, also from nineteen fourteen, prohibits unfair methods of competition, and unfair or deceptive acts or practices. Two federal agencies enforce these statutes. The Antitrust Division of the Department of Justice, and the Federal Trade Commission. States have their own competition laws, enforced by their attorneys general. And harmed private parties can bring suit as well. We're describing these laws only at the level of what they govern. Applying them to particular conduct is complex and fact-specific. So a business considering a merger, a joint arrangement with a competitor, or exclusive dealing needs legal counsel.

Figure 2.2.1

A Spectrum, Not Three Boxes

Now step back from single markets to whole economies. Every economy must decide what to produce, how, and for whom. An economic system is the set of institutions and rules a society uses to answer those questions. Three types are distinguished by how they allocate resources, and who owns them. A market system allocates through prices, set by voluntary exchange between buyers and sellers. Resources are mostly privately owned. A command system allocates through central planning. A public authority decides what is produced, and at what price. There, resources are mostly publicly owned. A mixed system combines market allocation with a significant role for government. Here's the key point. Every actual economy is mixed, to some degree. So it's more useful to picture a spectrum than three boxes. Four fictional economies can be placed along it, from one with only narrow public provision, to one with central planning of most output. They differ in how much government allocates. They also differ in which domains it allocates. So the useful question isn't which system a country has. It's how much allocation government does, and where. That's why an argument about the market, or the state, usually turns out to be about one particular domain.

Strongest Cases

Arguments For and Against Each System

These are among the most contested subjects in public life. So here is each position at its strongest, with no verdict, and none attributed to this course. The case for markets is about information and incentives. Prices carry information about scarcity and preferences that no central body could ever gather in full. They reward better methods and penalize waste, so innovation and efficiency happen without anyone directing them. Voluntary exchange also respects choice, and disperses economic power. The objection is that markets don't handle everything well on their own. They may leave large inequalities, under-produce goods everyone benefits from, ignore harms to third parties, and be distorted by market power. The case for command is about coordination and priority. A central authority can direct resources to collective goals, like rapid industrialization. It can avoid duplication and instability, and distribute output by need, rather than by purchasing power. The objection is about knowledge and incentives. A planner can't know local conditions as prices reveal them, and producers lack a reason to economize or innovate. And concentrating economic and political authority in one body removes a check on its errors. Mixed systems claim the strengths of both. The objection is that they can bring the weaknesses of both, through political influence and unintended effects. Keep two kinds of question apart. Empirical questions, about what happens, can be investigated, though the evidence is often contested. Normative questions, about how to weigh equality, liberty, security, and efficiency, can't be settled by evidence. Two people who accept the same facts can still disagree, because they weigh the values differently.

Role of Government

What Markets Do Not Do Unaided

Even in systems that rely mainly on markets, government performs functions that markets don't perform unaided. Describing those functions is separate from arguing about how far each should go. First, public goods. No one can be excluded from using them, and one person's use doesn't reduce another's. Think of national defense, or street lighting. Because non-payers can't be excluded, private firms struggle to charge for them. Everyone has an incentive to be a free rider, enjoying the benefit without paying. Second, externalities. These are costs or benefits that fall on people who aren't party to a transaction. A factory whose emissions harm its neighbors imposes a negative externality. The price it charges doesn't include the harm. A business whose training program improves the local workforce's skills creates a positive externality. Markets tend to under-supply those. Third, government enforces contracts and competition, through the courts and the rules we just covered. Fourth, it redistributes income and resources, through taxes and transfers. Public goods and externalities are the standard reasons markets handle some allocations poorly. How much government action they justify is a normative question, and reasonable people answer it differently.

Worked Application

Reading a Structure From the Variables

The four variables give you a method for classifying any market. Let's apply it. Forty stalls at a weekly market sell similar tomatoes. Many sellers, a nearly identical product, and easy entry. No stall can charge more without losing customers. That approximates perfect competition. A stall's only real levers are cost, and the quality of its service. Next, three firms supply nearly all the cement in a region. A plant costs an enormous sum, and hauling cement long distances is uneconomic. Few sellers, high barriers, and each firm watches the others' prices. That's oligopoly. So its managers should ask how rivals will react, and whether competing on service is safer than competing on price. Last, a small island served by a single ferry operator. One seller, no close substitute, very high barriers. Its price power is limited only by demand, and it's likely to face rate regulation, as a natural monopoly would. The method also shows why one firm can sit in more than one category, depending on how the market is drawn. A restaurant is one of many, if the market is meals in the town. But the only one open after midnight in a district may hold some monopoly-like power for a few hours. So don't memorize a label for each industry. Ask the four questions, about the market as the customer sees it.

Case Vignette

Unable to Win on Price

Our closing case is a composite, built for instruction. Ines owns a neighborhood hair salon that has served the same district for nine years. A discount salon chain opens two streets away, advertising basic cuts well below her price. She runs the numbers. With her rent, trained stylists, and product, matching that price would lose money on every appointment. So she starts from the structure of her market. Many sellers, differentiated services, low barriers to entry. That's monopolistic competition. Her salon isn't identical to the discounter's, so she has some power over her own customers. But close substitutes limit it. A price cut would be a losing contest against a rival with lower costs. The option her structure leaves open is differentiation, giving customers a reason to pay more. She concentrates on coloring, and on longer, booked appointments. She drops the walk-in cuts the discounter now offers more cheaply. The trade-off is real. She gives up some volume, and depends on a smaller group who value the difference. And differentiation only works if customers can see it. Notice how the reasoning runs. The market isn't perfectly competitive, so she isn't obliged to accept the discounter's price. And it isn't a monopoly, so she can't ignore it either. Next, we move from the structure of markets to measuring the economy as a whole, starting with gross domestic product.

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FAQ

Questions students ask us

About Market Structures: Free Markets, Competition, and Alternative Economic Systems

What are the four types of market structure?
The four market structures are perfect competition, monopolistic competition, oligopoly, and monopoly. They differ in the number of sellers, whether products are identical or differentiated, barriers to entry, and price-setting power. Perfect competition has many sellers of an identical product and no price power, monopolistic competition has many differentiated sellers, oligopoly has a few interdependent sellers behind high barriers, and monopoly has one seller with no close substitute.
Why do prices in an oligopoly tend to move together?
Prices in an oligopoly often move together because each of the few firms must anticipate how rivals will react. A price cut may be matched, leaving every firm worse off, while a price increase that rivals do not follow loses customers. So firms tend to compete through advertising, features, and service instead. Parallel pricing alone is not evidence of an agreement, since each firm may be reading the same conditions independently.
What is the difference between market, command, and mixed economies?
A market economy allocates resources through prices set by voluntary exchange, with mostly private ownership, while a command economy allocates through central planning, with mostly public ownership. A mixed economy combines market allocation with a significant role for government. Every actual economy is mixed to some degree, so the more useful question is how much allocation government does and in which domains, rather than which label a country carries.
What are the main U.S. antitrust laws?
The core U.S. antitrust laws are the Sherman Act of 1890, the Clayton Act of 1914, and the Federal Trade Commission Act of 1914. The Sherman Act bans agreements in restraint of trade and monopolization, the Clayton Act targets specific practices and mergers that may substantially lessen competition, and the FTC Act bans unfair methods of competition and deceptive practices. The Justice Department's Antitrust Division and the FTC enforce them.

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