What defines a market structure

Overview

Assumptions of perfect competition, pure monopoly and assumptions of monopolistic competition.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What characteristics are used to place a market into one structure rather than another?

   Model answer

   Five characteristics do the work: the number of firms and how concentrated sales are among them; whether the product is identical across sellers or differentiated; how easily new firms can enter and existing firms leave; how good the information available to buyers and sellers is; and whether firms are interdependent, meaning each one must anticipate rivals' reactions. Together these determine how much power a single firm has over its own price.

2. 2

   Set out the assumptions of perfect competition.

   Model answer

   There are very many buyers and sellers, each too small to affect the market price. The product is homogeneous, so buyers are indifferent between suppliers. There is freedom of entry and exit in the long run, with no barriers and no sunk costs. Buyers and sellers have perfect information about prices and technology. Firms are profit maximisers and factors of production are perfectly mobile. No individual firm is large enough to be interdependent with any other.

3. 3

   Why is a firm in perfect competition a price taker rather than a price maker?

   Model answer

   It supplies a negligible share of total output and its product is identical to everyone else's, so if it raised its price above the ruling market price every buyer would switch to a rival with no loss of satisfaction. It has no reason to cut price either, because it can already sell as much as it wants at the going price. Its own demand curve is therefore horizontal at the market price, and it can only accept that price and choose its output.

4. 4

   For a firm facing a horizontal demand curve, what is the relationship between average revenue and marginal revenue, and why?

   Model answer

   They are equal, and both equal the market price. Because the firm can sell any quantity without cutting its price, each extra unit adds exactly the price to total revenue, so marginal revenue equals price. Average revenue is total revenue divided by output, which is also the price. The firm's demand curve, average revenue curve and marginal revenue curve are therefore a single horizontal line drawn at the market price, with quantity on the horizontal axis and price, cost and revenue in pounds on the vertical axis.

5. 5

   What is a pure monopoly, and how does it differ from a firm that merely has monopoly power?

   Model answer

   A pure monopoly is a market with a single seller and no close substitutes, so the firm's own demand curve is the whole market demand curve. Monopoly power is the weaker and much more common condition of being able to set price above marginal cost because rivals' products are imperfect substitutes; a firm with a large share of a market can hold considerable monopoly power without being the only seller. Pure monopoly is best treated as the limiting case at one end of a spectrum of market power.

6. 6

   Set out the assumptions of monopolistic competition.

   Model answer

   There are many small firms, each with a small market share and none large enough to worry about rivals' reactions. Products are differentiated by brand, quality, location or service, so each firm faces its own downward-sloping demand curve and has a little price-setting power. Entry and exit are free in the long run, so supernormal profit cannot persist. Information is good but not perfect, and firms compete on non-price grounds such as advertising and product design as well as on price.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.