How does competition shape firm behaviour?
Compare market structures from perfect competition to monopoly and explain their effects on price, output and efficiency.
Market structures range from perfect competition through monopolistic competition and oligopoly to monopoly. The number of firms, barriers to entry and product differentiation determine pricing power, output and efficiency.
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What this dot point is asking
You need to compare the main market structures, explain what distinguishes them, and assess their effects on price, output, efficiency and consumer welfare.
What defines a market structure
A market structure is described by four key features:
- Number and size of firms in the market.
- Barriers to entry - how easy it is for new firms to enter.
- Product differentiation - whether goods are identical or differentiated.
- Degree of price-making power - whether firms are price takers or price makers.
These features place a market somewhere on a spectrum from perfect competition to monopoly.
Perfect competition
Perfect competition is a theoretical benchmark with many small firms, an identical (homogeneous) product, no barriers to entry, and perfect information. No single firm can influence the market price, so each is a price taker. Firms can earn only normal profit in the long run, because any abnormal profit attracts new entrants who compete it away.
Monopolistic competition
Monopolistic competition has many firms selling differentiated products, such as cafes, hairdressers or clothing brands. Differentiation (through branding, quality or location) gives each firm a little pricing power, so the demand curve slopes downward. Barriers to entry are low, so long-run profits are competed away to normal profit, but the variety of products is a benefit to consumers.
Oligopoly
An oligopoly is dominated by a few large firms, such as supermarkets, banks or petrol retailers in Australia. High barriers to entry and interdependence are the key features - each firm must consider how rivals will react. This leads to non-price competition (advertising, loyalty programs) and sometimes price stickiness. Firms may collude (which is illegal in Australia) or engage in price wars.
Monopoly
A monopoly is a market with a single seller and no close substitutes, protected by high barriers to entry. The monopolist is a price maker and can restrict output to raise price above the competitive level, earning long-run abnormal profit. Examples include some utilities and patent-protected medicines.
Monopolies are often allocatively and productively inefficient because they produce less and charge more than a competitive market would. However, a natural monopoly (where one large firm can supply the whole market at lower cost than several smaller firms, such as water pipes or electricity transmission) can be efficient, which is why such industries are often regulated rather than broken up.
Comparing the structures
| Feature | Perfect competition | Monopolistic competition | Oligopoly | Monopoly |
|---|---|---|---|---|
| Number of firms | Very many | Many | Few | One |
| Barriers to entry | None | Low | High | Very high |
| Product | Identical | Differentiated | Identical or differentiated | Unique |
| Price power | None (price taker) | Some | Considerable | Substantial (price maker) |
Why this matters
Understanding market structures explains why prices and choice differ across industries, and why governments regulate some markets. In Australia, the Australian Competition and Consumer Commission (ACCC) enforces competition law to prevent the abuse of market power, block anti-competitive mergers and stop collusion - all of which protect consumers from the costs of weak competition.
Exam-style practice questions
Practice questions written in the style of SACE Board exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
2020 SACE Stage 22 marksThe chicken-meat production industry in Country X is dominated by two large producers who supply 70% of the chicken, with a few medium-sized firms supplying 22% and the rest by small producers. Identify the likely market structure of the chicken-meat production industry in Country X. Justify your answer.Show worked answer →
Two marks: name the structure and justify using its defining features.
Identification (1 mark). The industry is an oligopoly, dominated by a few large firms.
Justification (1 mark). A small number of large firms control the bulk of the market (two firms supply 70%), so there is a high concentration ratio. This indicates significant market power and interdependence between the dominant firms, which is the hallmark of oligopoly rather than perfect competition or monopoly. Barriers to entry (such as the scale needed to compete with the dominant producers) also support this classification.
2023 SACE Stage 22 marksThere are two main types of potatoes in Country A and production is affected by weather. Explain why the structure of the potato market cannot be classified as perfect competition. In your answer, refer to one of the characteristics that distinguish market structures.Show worked answer →
Two marks: name a feature of perfect competition that the potato market fails to meet, and explain why.
Perfect competition requires features such as a homogeneous (identical) product, many buyers and sellers, free entry and exit, and perfect information. The potato market fails at least one of these.
For example, the products are not homogeneous: processing potatoes (for frozen fries) and table potatoes serve different purposes and are not perfect substitutes for one another. Because the products are differentiated, buyers cannot treat all potatoes as identical, so the market cannot be perfectly competitive. (An alternative accepted answer is product differentiation giving some firms a degree of price-setting power, unlike the price-taker firms of perfect competition.)
2022 SACE Stage 23 marksTwo firms (A and B) producing specialised mask fabric each choose to maintain or increase R&D spending. Payoffs ($million): both maintain = 20,20; A maintain, B increase = A 24, B 14; A increase, B maintain = A 14, B 24; both increase = 16,16. Using data from the payoff matrix, explain why the Nash equilibrium is reached when both firms increase spending on R&D.Show worked answer →
Three marks: show that increasing R&D is each firm's dominant strategy and conclude with the Nash equilibrium.
Firm A's best response. If Firm B maintains, A earns 24 by increasing vs 20 by maintaining, so A increases. If B increases, A earns 16 by increasing vs 14 by maintaining, so A still increases. Increasing R&D is A's dominant strategy.
Firm B's best response. By the symmetry of the payoffs, the same logic applies to B: B earns more by increasing whatever A does, so increasing is also B's dominant strategy.
Nash equilibrium. Because each firm is choosing its best response given the other's choice, neither can improve by unilaterally changing. The outcome where both increase R&D (16, 16) is the Nash equilibrium, even though both would be better off (20, 20) if they could both agree to maintain.