Understanding Market Structures: Competition Types Explained
Market Competition Fundamentals
Competition is a rivalry between several companies aiming to sell the same kind of goods or services to customers in a specific market.
Perfect Competition Explained
Perfect competition describes a market type where:
- There are many small firms.
- Firms produce a single, undifferentiated product.
- No single producer can influence the market price (firms are price takers).
The long-term equilibrium in a perfectly competitive market occurs at a price where producers cover all their costs but earn no extraordinary profit. This represents the lowest sustainable price, benefiting consumers with the best possible price and quantity. In the long term, prices in perfectly competitive markets tend to decrease.
Imperfect Competition Types
Imperfect competition covers market structures that deviate from perfect competition.
Monopolistic Competition
Key features include:
- Low barriers to entry and exit.
- A large number of producers.
- Products exchanged are differentiated.
- Producers have some power to set prices, though this power is limited.
Consumers typically face higher prices than in a perfectly competitive market.
Oligopoly
Key features include:
- A small number of firms dominate the market.
- These firms are typically large, each holding a significant market share.
- The decisions of one firm significantly influence the others due to the small number of players. Companies must consider competitors’ potential reactions before making any strategic decisions.
Oligopolistic firms often strive to differentiate their products to convince consumers theirs are superior. Advertising plays a crucial role. When only two firms exist, it’s called a duopoly.
A cartel is a formal agreement between several companies in an oligopolistic market to coordinate actions (like setting prices or output), although such agreements are typically banned by competition legislation.
Game Theory in Economics
Game theory studies the behavior of economic agents in situations of interdependence. It attempts to explain how a firm’s success depends not only on its own actions but also on those of its competitors.
Competitor behaviors can be:
- Cooperative: Bidders agree on strategies, potentially leading to mutual gain (often illegal, like cartels).
- Non-cooperative (Nash Equilibrium): Each firm follows the dominant strategy (the best strategy regardless of what others do), which might lead to a suboptimal outcome for the group.
- Unfair/Betrayal: After reaching an agreement, any undertaking breaks it for short-term gain.
To overcome suboptimal non-cooperative equilibria, firms might signal intentions (e.g., producing less), expecting the competitor to do the same, because they know if the other takes the same position, both gain in the long term.
Monopoly Market Structure
A monopoly exists when a single company controls all or most of the supply of a product. Significant barriers to entry prevent other firms from competing.
Circumstances leading to monopolies:
- Control of Resources: A company controls all the resources needed to produce a good (e.g., historically, De Beers).
- Technological Superiority: A company holds sufficient technological control (e.g., patents) to provide a unique product (e.g., Microsoft).
- Legal Monopoly: A state allows only one company to offer a certain product (e.g., historically, CAMPSA). This often comes from patents that prevent any other company from copying and producing what another has patented.
- Natural Monopoly: Occurs when there are high fixed costs and very reduced variable costs, making it most efficient for one firm to supply the entire market (e.g., water supply).
Consequences of monopolies generally include a price that is always greater than when there is competition, and the quantity produced is lower.