Market Structures: Monopoly and Competition
Types of Market Structure
Economists have developed four basic models of market structure: perfect competition, monopoly, oligopoly, and monopolistic competition. This system is based on two characteristics:
- The number of producers in the market (one, few, or many).
- Whether the goods offered are identical or differentiated (differentiated goods are goods that consumers consider different but substitutes to some extent; for example, Coca-Cola and Pepsi).
In a monopoly, a single producer sells a single, undifferentiated good. Under an oligopoly, a few producers sell products that can be identical or differentiated. In monopolistic competition, there are many producers, and each one sells a differentiated product. In perfect competition, many producers sell an identical product.
The Meaning of Monopoly
A monopoly is a company that is the only producer of a good that has no close substitutes. An industry controlled by a monopolist is called a monopoly. In practice, real monopolies are hard to find in modern economies, partly because of existing legal barriers. However, monopolies play an important role in some sectors of the economy, such as the pharmaceutical industry.
In a monopoly, the monopolist moves upward along the demand curve, reducing supply to a point where the output is lower and the price is higher than in perfect competition. The ability of a monopolist to raise its price above the competitive level by reducing the production volume is known as market power. The monopoly, therefore, has market power and, as a result, will set higher prices and offer a smaller amount of product than a competitive industry. This generates profits for the monopolist in the short and long term. The monopolist reduces its output and raises price levels compared to a perfectly competitive industry to increase its profit.
Maintaining Long-Term Benefits in a Monopoly
To maintain long-term benefits, a monopolist should be protected by a barrier to entry, which prevents other firms from entering the industry. There are four main types of barriers to entry:
- Control of resources or scarce factors of production: A monopolist who controls a resource or production factor crucial for an industry can prevent other firms from entering the market.
- Economies of scale: A natural monopoly occurs when economies of scale provide a cost advantage to a situation where all production is supplied by a single company. These economies of scale mean that larger producers have lower average total costs. The average total cost curve of the natural monopolist decreases with the level of output for the interval at which the price is greater than or equal to the average total cost. Therefore, the natural monopolist has economies of scale over the entire range of production volume for which a company is willing to stay in the market: the production interval for which the company would at least have no long-term losses. The necessary condition for this to happen is that fixed costs are high: when high fixed costs are required, a given output level is obtained with a lower average total cost if a single large firm produces it than if two or more smaller companies do. A monopoly is established with a lower average total cost than any smaller company.
- Technological superiority: A company that maintains a constant technological advantage over potential competitors can establish itself as a monopoly. However, technological superiority is normally a barrier to entry only in the short term: over time, competitors will invest in improving their technology to match the technological leader.
It should be noted that in certain high-tech industries, technological superiority is no guarantee of success against competition. Some high-tech industries are characterized by network externalities, a condition that arises when a good’s value to consumers increases as the number of people also using that good increases.