Revise Market analysis for Cambridge 2281 (3.9)

Market structure refers to the organisational and other characteristics of a market, which influence the behaviour of firms within it. Economists classify markets along a spectrum of competition, from perfect competition at one extreme to pure monopoly at the other. The classification depends on several key characteristics: the number of firms in the market, the ease of entry and exit (barriers to entry), the degree of product differentiation, and the availability of information. Understanding these characteristics allows us to predict a firm's pricing and output decisions, its potential for long-run profitability, and the overall efficiency of the market. Monopolistic competition and oligopoly represent the more complex and common 'imperfectly competitive' structures that lie between the two extremes.

Perfect competition is a theoretical benchmark with strict assumptions: a very large number of small firms, a homogenous (identical) product, no barriers to entry or exit, and perfect information for all buyers and sellers. The crucial outcome of these conditions is that each individual firm is a 'price taker'. It has no market power and must accept the market price determined by the industry's supply and demand. The firm's demand curve is therefore perfectly elastic (horizontal), where Average Revenue (AR) equals Marginal Revenue (MR). In the long run, freedom of entry and exit ensures that firms can only make normal profit. Any supernormal profit attracts new firms, increasing industry supply and driving the price down until only normal profit remains.

A pure monopoly exists when a single firm is the sole supplier in a market with very high barriers to entry. These barriers, such as patents, control over resources, or significant economies of scale (creating a natural monopoly), prevent competition. As the sole supplier, the monopolist faces the entire downward-sloping market demand curve. This means it is a 'price maker' but is still constrained by demand; to sell more, it must lower its price. Consequently, its Marginal Revenue (MR) curve lies below its Average Revenue (AR) curve. A profit-maximising monopolist will produce where MC=MR, enabling it to earn sustained supernormal profits in the long run. This typically results in allocative inefficiency (P>MC) and productive inefficiency.

Monopolistic competition describes a market with many firms and low barriers to entry, much like perfect competition. However, its defining feature is product differentiation. Firms compete by making their products distinct through branding, quality, design, or location (e.g., restaurants, hairdressers). This differentiation gives each firm a small degree of monopoly power, resulting in a downward-sloping, but relatively elastic, demand curve. In the short run, a firm can make supernormal profits. However, because barriers to entry are low, these profits attract new competitors, which erodes the original firm's demand until, in the long run, only normal profit is made. The long-run equilibrium is not productively or allocatively efficient.

Oligopoly is a market structure dominated by a few large firms, where high barriers to entry exist. The defining characteristic is interdependence: each firm's actions (on price, output, or advertising) directly affect its rivals, who will then react. This creates strategic behaviour. Firms may choose to collude (formally as a cartel, or tacitly) to act like a monopoly, restricting output and raising prices to maximise joint profits. Alternatively, they may compete aggressively, leading to price wars. This strategic uncertainty is often explained by the kinked demand curve model, which suggests price stability (rigidity) in oligopolistic markets. Consequently, non-price competition, such as branding, loyalty schemes, and advertising, is a prevalent feature.

The individual firm faces a horizontal demand curve at market price (P = MR = AR). It is a price taker.

Short run: firm may earn supernormal profit (AR > AC), normal profit (AR = AC), or loss (AR < AC).

Long run: free entry/exit drives profit to normal — AR = AC at minimum AC. Also P = MC → allocative and productive efficiency.

A monopolist faces the market demand curve (downward sloping). MR lies below AR because lowering price to sell more reduces revenue on inframarginal units.

Profit max: MC = MR. Price is read from the demand curve at this output — P > MC.

Allocative inefficiency: output is less than the competitive level. DWL exists. However, monopolist may achieve productive efficiency if it produces at min AC (natural monopoly argument).