Market structure refers to the characteristics of market organizations that determine the behavior of companies in an industry. It determines the nature of competition and price and has implications for the market share and profits that companies get.
Market structure is important since it affects market results, especially in terms of profits. It affects the opportunities, motivations, and strategic decisions of economic actors participating in the market. The company analyzes it to explain and predict market results, mainly profits. For the government, it tells them how to regulate the market, to ensure fair competition, and reduce the adverse effects of unfair competition for the economy such as cartels.
Classification and their characteristics
The four types of market structure are:
- Perfect competition
- Monopolistic competition
For a narrower classification, the four are combined to become perfect and imperfect competitions. The imperfect competition constitutes monopolistic, oligopolistic, and monopolistic competition.
The four markets have different characteristics in several issues, namely the number of sellers, types of products, barriers to entry and exit, and pricing.
The perfect competition market consists of a large number of buyers and sellers. The size of sellers is relatively small and equal, so that they have no influence on the market. They offer a homogeneous product and perfectly substitute each other. They are also easy in and out of the industry in response to industry profits.
Sellers in perfectly competitive markets have no pricing power, so there is no non-price competition in the market. They accept the market price as the selling price of their products (price takers). A close example of perfect competition is the foreign exchange market.
Monopolistic competition markets are similar to perfect competition. The market comprises a large number of sellers and buyers.
Barriers to entry and exit exist but are low. What distinguishes the perfect competition from the monopolistic competition is the type of product offered. In monopolistic competition, each seller provides a product that is similar, but not identical. Companies try to differentiate their products from competitors through non-price strategies such as advertising. Therefore, products in this market function as close substitutes for each other, but not as perfect substitutes as in perfect competition. For these reasons, companies have some degree of price power and are not price takers.
In the oligopoly, a small number of sellers operate in the market. They vary in size and might offer differentiated products (eg, Apple and Samsung) or homogeneous (like petroleum). Typically, companies differentiate their products based on quality, features, marketing, and other non-price strategies.
Barriers to entry are high, thus protecting the market from competitive pressure. Sellers also enjoy market power over their price as a result of the few sellers and high entry barriers.
Finally, the monopoly market consists of one seller and several to many buyers. If there are one seller and one buyer, we call it a bilateral monopoly and have different characteristics from the monopoly.
A monopolist has substantial price power because of having no close substitutes and high entry barriers. The company also determines the quantity of output, price, and quality of goods on the market.
Which is the best market structure
Theoretically, the perfect competition market is the most ideal. That’s because only this market structure allows us to achieve an efficient economic allocation. The market allocates resources efficiently. All producers and consumers have full and symmetrical information. They trade without cost.
However, it is difficult to find a market that genuinely competes perfectly.
Conversely, a monopoly is considered the least socially ideal market, but in some cases, it is needed. Because of having substantial market power, the rational monopolist will maximize its profit. It can charge high prices and offering low-quality products (thus saving on production costs).
However, monopoly is needed in some markets, such as electricity and utility. Very high fixed costs require huge outputs so that average costs fall and reach economies of scale. That, of course, is more suitable for one producer than several producers. In a market like this, the government usually intervenes and regulates it, so as not to harm consumers and producers. We call this legal monopoly as a natural monopoly.
How do we determine the market structure
We need to consider several variables to distinguish the characteristics of the four market structures, including:
- Number of buyers and sellers
- Product type (homogeneous vs. differentiable)
- Product substitution rate
- Barriers to entering and leaving the market
Observing the market of a product with those variables helps us determine the market structure. Other tools to identify markets are with statistics:
- N-firms concentration ratio
- Herfindahl – Hirschman Index
We calculate the concentration ratio of N-companies by adding up the market share of the largest N companies in the industry. A concentration ratio of 0% means perfect competition, and 100% indicates a monopoly (because there is only one company). A value of 0% is impossible; therefore, perfect competition is unlikely in the real world.
The concentration ratio has a disadvantage because it does not take into account the barriers of entry. It is also not affected by mergers at the top level.
To overcome the weakness of the merger effect, we can use the Herfindahl-Hirschman Index (HHI). We calculate the HHI by adding the square of the market share of each company in the market. HHI is equal to 1 for a monopoly. Like the concentration ratio, HHI has a weakness because it does not take into account barriers to entry and does not consider the elasticity of demand.
For example, there are five companies in an industry, each with a market share of 30%, 25%, 20%, 15%, and 10%. Then the 4-company concentration ratio is 90% = 30% + 25% + 20% + 15%. Meanwhile, HHI is 2250 or 22.5% = 30%2 + 25%2 + 20%2 + 15%2 + 10%2.