Market Structure Revision

Market Structures

	Barriers to Entry and Exit	Degree of Competition	Number of Firms	Profit	X-Efficient?	Allocatively Efficient?	Productively Efficient?
Perfect Competition	None	High	A lot	SR: Supernormal LR: Normal	✓	SR: ✓ LR: ✓	SR: X LR: ✓
Monopolistic Competition	Low barriers to entry; high sunk costs	High	A lot	SR: Supernormal LR: Normal	✓	SR: X LR: X	SR: X LR: X
Oligopoly	Varies	Varies	A few	UNKNOWN	UNKNOWN	UNKNOWN	UNKNOWN
Monopoly	High	Low	One or very few	Supernormal profit	X	X	X
Contestable Markets	Low; no sunk costs	The threat results in high competition	Varies	Normal	✓	SR: X LR: ✓	SR: X LR: ✓

NB: Markets which are stated to be productively and allocatively inefficient may be effecient inadvertently; but this would only happen coincidentally, and isn't a given.

Perfect Competition

Conditions:

Firms profit maximise (set prices equal to MR=MC).
There are many buyers and sellers in a market and none have much market power. Firms are therefore price takers.
The product is homogenous (identical).
There are no barriers to entry or exit.
There is perfect knowledge of market conditions.
There are no externalities.

Short Run

Perfectly elastic demand curve (horizontal) as firms are price takers.
As the firm is profit maximising (MR=MC) it will make a supernormal profit (highlighted).
The firms' supply curve is the marginal cost curve above the point where it intersects the average variable cost curve.
Allocative efficiency is achieved in the short run but productive efficiency isn't.

Long Run

New firms will enter the market if it is profitable to take some of this profit. This will result in a fall in price due to the increase in supply. This will occur until firms are only making a normal profit.
If firms are making a supernormal loss then firms will exit the market, supply will shift leftwards causing prices to rise, this will occur until only a normal profit is made.
Hence no supernormal profits are made
In the long run productive and allocative efficiency is achieved.

Evaluation: Hayek argued that perfect competition isn't the ideal market structure as there are no supernormal profits and hence firms won't invest or innovate. This isn't ideal for the economy as innovation is beneficial to society and can result in new merit goods.

Monopolistic Competition

Conditions

Products are differentiated.
There is freedom of entry to the market (but not necessarily exit due to high sunk costs).
There are many firms operating in the market and hence concentration is low.

Firms will face downward sloping demand curves due to the differentiated products, despite the large number of competitor firms.

Short Run

Firms can make supernormal profits in the short run.
Firms are allocatively inefficient and only productively efficient by chance.

Long Run

Because there is free entry into the market supernormal profits will attract new firms with differentiated products into the market.
Customers may purchase these other products and so demand shifts left and becomes more elastic as there are more substitute goods.
This process will continue until profits are eliminated.
Firms may attempt to keep their demand curves elastic by advertising, this will result in higher average costs, diminishing profits more quickly.
In the long run there are too many firms in the market producing externalities.
Advertising results in higher costs and hence higher prices.
False brand loyalty may be detrimental.
If there were fewer firms in the market then incumbents may be able to produce at a higher output and hence operate at the minimum point on the average cost curve.

Oligopoly

Conditions

There are a few firms
Similar products; but not necessarily identical
There are modest economies of scale

Firms are interdependent; their strategy is based on the firms assumptions of what competition will do (how much they will spend on advertising, what price they will set etc).

Monopoly

Conditions

There are no substitutes for the good.

There are very few firms in the market.

There are high barriers to entry into the market.

The firm is profit maximising.

The firm is a price maker and has a downward sloping demand curve.
Monopolies can make supernormal profits in the short run which can persist into the long run.
Monopolies can make supernormal profits in the short run which can persist into the long run.
Monopolies can make abnormal losses if average costs are greater than average revenue at the MR=MC point.
They can arise:

From patents giving exclusive rights to one firm
Natural monopolies: a firm which has significant economies of scale due to high fixed costs but comparatively low variable costs.

Monopolies are neither allocatively efficient nor productively efficient (unless by coincidence).

Contestable Markets

Conditions:

No barriers to entry or exit (specifically no sunk costs).
Access to the same level of technology between incumbents and new entries.
Entry can take place rapidly (to permit hit and run tactics).

Incumbent firms act competitively due to the threat of new entries.
In the long run firms in contestable markets will only make normal profit.
Firms can make a supernormal profit in the short run however this attracts new entrants to the market. Therefore firms may opt to only make a normal profit in the short run to prevent new entries.
Because of the low sunk costs firms may enter a market to make a quick profit and then leave the market when the incumbent firm reduces it prices (hit and run tactics) or it could remain in the market and compete with the incumbent.
Due to this incumbent firms are likely to set prices at AR=AC (sales maximisation) in order not to attract new entrants.
To make markets more contestable the government could deregulate in order to reduce the barriers to entry; new technology could be made available (although not patented as this is a barrier to entry); or new business models could be developed (for example the business model adopted by low-cost airlines).
Efficiency: A contestable market will be productively and allocatively efficient in the long run (in a perfectly contestable market), the firm has to be operating at the lowest point on the LRAC curve. If this is the case the it will be productively and allocatively efficient. In the short run it may be productively and allocatively inefficient.
Intervention by regulatory authorities is usually unnecessary in contestable markets due to the threat of competition.
Evaluation: markets usually have some sunk costs (advertising) and incumbent firms may have advantages of asymmetric information which act as a barrier to entry to the new firms.