Market structures
Markets differ in how many sellers there are and how much power they have over price:
- Perfect competition: many sellers, identical product, price takers.
- Monopolistic competition: many sellers, differentiated products (restaurants, clothing), free entry.
- Oligopoly: a few large sellers who watch each other closely (airlines, mobile networks).
- Monopoly: one seller, barriers to entry, no close substitutes.
Barriers to entry include legal protection (patents, licences), control of a key resource, and economies of scale so large that a single firm serves the market most cheaply (a natural monopoly, as with a local water network).
Monopoly pricing
A monopolist faces the whole market demand curve, so to sell more it must lower the price on every unit. This makes marginal revenue lower than price. It still maximises profit where MR = MC, but then reads the price from the demand curve.
Worked example
Demand is P = 20 − Q, and marginal cost is a constant 4.
- Total revenue = P × Q = 20Q − Q², so MR = 20 − 2Q.
- Set MR = MC: 20 − 2Q = 4, so Q = 8.
- Price from demand: P = 20 − 8 = 12.
- Profit = (12 − 4) × 8 = 64.
A competitive market would set P = MC = 4, giving Q = 16. The monopoly produces less (8 instead of 16) at a higher price. The lost trades, where buyers value the good above its cost but do not buy, create a deadweight loss = ½ × (12 − 4) × (16 − 8) = 32.
Regulation
Governments respond with antitrust law, regulation of price in natural monopolies, or by allowing entry. Setting a price cap at marginal cost can restore efficiency, but a natural monopoly may then lose money.
Concentration
The Herfindahl-Hirschman Index (HHI) adds the squares of the market shares (in percent). Four firms with 40, 30, 20 and 10 percent give 1,600 + 900 + 400 + 100 = 3,000, a highly concentrated market. A monopoly has HHI = 10,000.
Oligopoly and strategy
In an oligopoly, each firm's best choice depends on rivals' choices, which game theory analyses. The prisoners' dilemma shows why firms in a cartel are tempted to cheat on an agreement to hold prices high, and why such cartels are unstable and, in most countries, illegal.