All business firms operate in a market. When we talk about a market, most people consider it a place where goods and services are sold and purchased. However, the definition of a market is different in economics. In economics, the market is not only a place where buyers and sellers meet to exchange goods and services. It also considers types of goods and services, number of buyers and sellers (competition) and information flow. Because of this complexity, market structures have also emerged and are being studied.
Firms in a marketplace need to know their market structure to make the right decisions. Market structure is a way to understand the degree of competition in an industry. There are generally two types of market structures: perfect market structure and imperfect market structure.
Now, the question is, what determines a market structure? If you want to be a financial analyst and are interested in enrolling in a CFA course, you should be able to identify which market structure a company falls in.
Market Structures - Chief Considerations
While competition is one of the main factors determining a market structure, that is not all. Economists combine several market elements together to put together a market structure. A firm analyses its position in the market based on the following determinants and, thereby, defines within which market structure it falls:
- Entry and Exit Barrier - One of the determinants is not based on existing competition but rather on how easy it is for new competitors to enter the market. The barrier of entry is a primary factor that can define whether a market is highly competitive or has the potential to become highly competitive.
- Product Differentiation - The nature of the product also determines market structure. Are the products sold by all competitors homogeneous or identical, or are they slightly different?
- Price differentiation - Products with different pricing can also contribute to placing firms in different market structures. For example, your product pricing can place you within a luxury product range or a general product range and as a result, you may be in a different competitive landscape.
- Consumers - Another consideration is the number of consumers of the product or service. This puts you either in the mass market or niche market and thereby, creates the market structure you would be in.
- Finally, Competition - One of the primary factors is the number of companies in the marketplace. This is your primary competition and defines the market structure you are in.
Based on the following factors, there are four types of market structures that economists have narrowed down on:
- Perfect Competition
- Monopolistic Competition
- Oligopoly
- Monopoly
Types of Market Structures
Perfect Competition
Perfect competition is a very idealistic market structure, and it rarely exists. In this structure, many companies sell identical products, and there is a minimal entry barrier (low startup cost and wide resource availability). While economists do not mention how many companies function in perfect competition, it is large enough that no single company can influence the market.
Since all companies sell the same product, price fluctuation is not possible. If one company increases its price, consumers will choose another company selling the same product at a lower price. Companies cannot lower their prices as they won’t be making enough profits.
Now, why is this market structure improbable? Most companies will introduce some product differentiation to change prices. There are also entry barriers to most markets.
Monopolistic Competition
In this market structure, several players sell similar products but with slight differentiation. Because of this differentiation, products can gain a slight competitive advantage, and as a result, some firms can gain a little market power. They can also change prices based on the added features. If a product’s price is too high, consumers can shift to similar alternatives or give up on specific features.
While the barrier of entry may not be very high, even then, in monopolistic competition, only a few firms can enter the market space due to differentiation. A firm must also meet initial startup costs to match the existing competition. Most businesses operate in a monopolistic competition setup.
Oligopoly
In an oligopoly market, a few sellers sell to many buyers. These sellers may sell identical products or slightly differentiated products, but they have enough market influence to affect competition if they opt for any change. For example, if one firm lowers the price, other competitors have to lower prices to stay relevant. As a result, in this market structure, the sellers generally follow a consistent pricing model.
Sellers often collaborate rather than compete against each other. Also, the barrier to entry is very high due to high startup costs. An example of such a model is the beverage industry—Coca-Cola and Pepsi are both competitors running an almost oligopoly.
Monopoly
If you are looking to take a CFA course, it’s important not to be confused with the Monopoly vs. Oligopoly similarity. Both are very different, though they may share minor similarities, especially with high entry barriers.
Monopoly is a situation where one company offers products to a large market. In such a situation, this firm has the sole dominant influence on the market, and hence, the barrier to entry is very high. The product is unique, and maybe with the use of patents, it cannot be duplicated.
Because a single firm offers this product, buyers are also willing to pay high prices for the goods or services. Generally, governments try to crack down on pure monopolies, as such companies can take advantage of customers and often influence market spaces negatively. Pure monopolies are difficult to find, but similar real examples could be the railway companies.
Conclusion
Measuring a firm’s market power based on its market structure isn’t easy. While it is possible to marginally place a firm within the defined market structure, most firms are a mix of monopolistic competition and perfect competition. However, a financial analyst needs to identify the characteristics of each market structure, place the firm in the right market, and forecast future profit streams for the firm.
If you want to be a solid analyst and figure out ways to determine the company profits in their market spaces, you should enrol in Chartered Financial Analyst (CFA) offered by Imarticus for a guided learning opportunity.
Frequently Asked Questions
Are firms in perfect competition profitable?
Firms in perfect competition cannot be economically profitable. Since they do not have power over pricing, these firms will not have margins as their profits would be spent on rentals and other overheads.
What kind of industry is the telecom industry?
The telecom industry is an oligopoly with a few players like Vodafone, Jio and Airtel providing similar services.
How can you identify market structures?
Market structures can be identified by figuring out the relative size of the firms, the degree of competition, the product differentiation and the pricing power of the firms.
How can market structures help?
Market structure can help financial analysts find out the future profit streams of a company. Based on this, firms can also set prices or make new product introductions in the market to improve their market differentiation.
