What’s it: Imperfect competition is a market structure in which sellers or buyers have market power over prices, which prevents the market from operating under perfect competition. Because they have market power, market participants are often in a position to abuse their power, raise prices, and manipulate the market to secure higher profits.
Examples of imperfect competition are monopolistic competition, oligopoly, and monopoly. In this case, producers (sellers) can influence prices and act as a price maker. To make high profits, they set prices above marginal cost.
Other imperfect competition examples are oligopsony and monopsony. Both are the opposite of oligopoly and monopoly. Consumers (buyers) have the power to influence prices because they dominate market demand. They have the power to bid lower prices and higher quality.
Characteristics of imperfect competition
Most markets operate under imperfect competition. They may be a monopoly, oligopoly, or monopolistic competition. On the other hand, a perfectly competitive market cannot exist in the real world and is only an economics theory.
The characteristics of imperfect competition vary between types of market structures. In this case, I exclude monopsony and oligopsony markets.
Sellers have market power and some control over prices, ranging from some power (monopolistic competition) to absolute (monopoly). Sources of market power can come from a firm’s ability to differentiate between supply (product differentiation) or influence supply.
Number of sellers
In a monopolistic competitive market, the market consists of many sellers (producers). They have a small and uniform output size relative to market supply.
The number of sellers is getting fewer when it comes to oligopoly. The fewer the number, the greater their power to influence market supply. Producer size usually varies, with several firms dominating the market supply. Apart from changing output, they also have market power through differentiation.
In an oligopoly market, the market usually creates collusive behavior. Players work together to increase profits. If it occurs formally, we will call it a cartel.
Furthermore, under a monopoly, the market consists of only one producer. Hence, the firm’s output represents the market supply. Monopolists can increase its profits by exercising price discrimination, reducing output and product quality.
Market entry and exit barriers
Entry and exit barriers are low in monopolistic competitive markets. It increases when the market operates under oligopoly and monopoly.
Barriers to entry prevent the market from becoming highly competitive, thereby reducing market profits. Conversely, when the barriers to entry are low new players can easily enter. New players bring additional supply to the market, pushing prices down.
Under imperfect competition, there is no full disclosure of information about prices and products. Information asymmetry is present in the market. Few companies are better informed than their customers or competitors. They can use such information to pursue their own advantage.
Competing manufacturers offer heterogeneous products. They act as close substitutes rather than perfect substitutes. Each product has slightly (or even wholly) different features and qualities, allowing buyers to prefer products from one company over another.
Because they have price power, producers act as price makers. They can charge a price that is higher than the marginal cost. The more significant the difference between the two, the higher their profit.
On the other hand, under perfect competition, they can only set the selling price equal to marginal cost. They use the market price as the selling price of the product, making them the price taker.
Types of imperfect competition
As long as perfect competition conditions are not met, the market operates on the imperfect competition. This market can take a variety of types, including:
- Monopoly. The market consists of one producer (seller or supplier) and has many buyers (consumers).
- Oligopoly. The market consists of several players and serves many buyers. The fewer the number of players, the greater the market power. If the market consists of two producers, we call this a duopoly.
- Monopolistic competition. This market structure is similar to perfect competition in that it consists of many players and many buyers.
- Monopsony. Many producers operate in the market, and they serve one buyer. This is the opposite of a monopoly.
- Oligopsony. This market structure is the opposite of oligopoly. The market is made up of many producers serving few buyers.
- Bilateral monopoly. It is a combination of monopoly and monopsony because it consists of only one seller and one buyer.
Market consists of only one company. Other characteristics of the monopoly market are:
- Monopolist determines the output, price, and quality of market products.
- Market has no substitutes, leaving consumers unable to switch.
- Barriers to entry are high, so the threat of additional supplies from new entrants is minimal.
Because of these characteristics, the monopolist can maintain market power over time. To maximize profits, the monopolist can supply fewer goods and charge a higher price. Of course, it is detrimental to consumer welfare. Therefore, the monopoly is usually under government supervision.
Furthermore, monopoly is an exception in several sectors, such as public utilities (water, electricity). In these sectors, the proportion of fixed costs is highly significant. Thus, to lower costs and prices, the market requires significant economies of scale to lower average costs. As a consequence, the market requires only a few producers, even one producer, to operate. This is what we call a natural monopoly.
In this market, several players serve many buyers. The number of firms is more than one firm but less than the number of players in the monopolistic competition market. Some producers usually dominate and control a higher market share compared to other players.
To influence prices, dominant firms can change their output. Alternatively, they can also do it with a differentiation strategy, enabling them to charge a premium.
Furthermore, under oligopoly, companies have strategic dependence. When a dominant firm changes the production quantity or price, it will affect other players and the overall market conditions. Strategic dependence is higher if the number of firms is smaller, for example, in the case of a duopoly.
Another feature of oligopoly markets is the emergence of coordination between firms to maintain high market profits. It may take place in tacitly (collusion) or formally (cartel).
Monopolistic competition is similar to perfect competition. The market comprises many producers, each of which is similar in size and relatively small. Therefore, they cannot influence prices by changing output. Entry and exit barriers are also low.
In this case, differentiation is the factor that differentiates monopolistic and perfectly competitive markets. The product on the market acts as a close substitute. Producers will differentiate their offerings, making consumers prefer products from one producer over other products. That allows them to charge a price that is higher than the marginal cost.
On the other hand, under perfect competition, the product is homogeneous and acts as a perfect substitute. There is no reason for consumers to prefer one product to another. As a result, producers act only as price takers and set prices at the marginal cost.
Under monopsony, many sellers serve a single buyer. In other words, the demand from one buyer represents market demand.
As a consequence, buyers have significant bargaining power over sellers. They will bid a lower price than what happens in a competitive market. Or, they will ask for a higher quality product, increasing the costs of the sellers.
An example of a monopsony is a tobacco farmer in the vicinity of a cigarette factory. When they can only sell tobacco to the cigarette factory, the market leads to monopsony. The factory sets the purchase price, and the farmers have a weak bargaining position to negotiate higher prices.
In this market structure, many sellers serve a few buyers. Therefore, buyers have high bargaining power over sellers, although not as high as in the case of monopsony. Buyers can take advantage of their power to negotiate lower prices and higher quality.
The agricultural sector in developing countries is a comparative example of an oligopsony. The market consists of many farmers who supply various agricultural commodities such as corn, rice, and vegetables, to only a few middlemen or companies.
Another example is the labor market in the manufacturing sector. The number of manufacturers is far less than the number of workers. Therefore, individuals have weak power in negotiating wages. To strengthen their bargaining position, they form a trade union.