Market Structures

In economics, the behaviour of firms cannot be analysed in isolation from the environment in which they operate. This environment is called the market structure. Market structure refers to the number of firms in a market, the nature of the products they sell, and the degree of control each firm has over price and output. The market structure defines the conditions of competition, and these conditions influence efficiency, profits, and the welfare of consumers.

Economists classify markets into broad structures based on observable features. At one end of the spectrum lies perfect competition, where many small firms produce a homogeneous product and no firm has influence over price. At the other extreme is monopoly, where a single producer dominates the market and can exert significant influence over output and price. Between these extremes lie monopolistic competition and oligopoly, both of which exhibit intermediate degrees of competition and market power.

The comparison of different market structures allows economists to examine how resource allocation, efficiency, and profits vary across markets. For example, a market with many firms producing a standardised product may allocate resources differently from one dominated by a few powerful firms producing differentiated goods. The implications are significant because market structure influences whether consumers obtain goods at the lowest possible cost, whether firms make supernormal profits, and whether resources are used productively.

Perfect Competition

Perfect competition represents one extreme form of market structure. It is largely a theoretical idea, because very few real-world markets meet all its conditions. However, it serves as a benchmark model that enables economists to understand how markets would function if certain strict assumptions were fulfilled.

In perfect competition, the defining feature is that each individual firm is a price taker. This means that no single firm can set its own price, nor can it raise or lower the market price. The price is determined entirely by market demand and market supply for the industry as a whole. Each firm in this environment can sell as much output as it wishes at the current market price, but it cannot influence that price.

To illustrate, imagine a market for a basic agricultural product such as wheat. If there are thousands of farmers producing wheat, and the wheat is homogeneous across sellers, the market price is set collectively. If one farmer tried to charge a higher price, buyers would simply purchase wheat from other suppliers at the going price. Conversely, a single farmer cannot force the price up by restricting their own supply, because their share of the total market is so small that it has no measurable impact on the overall balance of supply and demand.

In this way, perfect competition ensures that each firm accepts the market price and produces output based on its costs of production. The firm’s ability to earn profits or incur losses depends not on its power to manipulate price, but on its cost structure relative to the prevailing price.

The Assumptions of Perfect Competition

The model of perfect competition is built on several assumptions that define the conditions under which it operates. These assumptions make the model distinct and allow economists to analyse efficiency outcomes in both the short run and the long run.

Profit maximisation is the firm’s objective. It is assumed that all firms act with the intention of maximising profits. Profit is defined as the difference between total revenue and total cost. Total revenue equals price multiplied by output, while total cost includes both fixed costs and variable costs. Firms will choose the level of output where marginal revenue, which is the additional revenue from selling one more unit, equals marginal cost, which is the additional cost of producing one more unit. This profit-maximising rule ensures that the firm neither produces too little nor too much relative to its cost and revenue conditions.

Large numbers of buyers and sellers, none of which is dominant. In perfect competition, there are many participants in the market, both on the demand side and on the supply side. No individual buyer or seller is large enough to influence the market price. This condition guarantees that the price is determined by the market as a whole, through the interaction of demand and supply. Each firm faces a perfectly elastic demand curve, meaning it can sell any quantity at the prevailing market price but cannot sell at a higher price.

Homogeneous product. Every firm in a perfectly competitive market sells an identical product. There is no branding, no differentiation, and no perception of quality differences. Buyers view each unit of the product as a perfect substitute for one another. Because of this homogeneity, there is no scope for firms to charge different prices or to gain market share by advertising. The product is standardised, and consumers are indifferent to the identity of the producer.

Freedom of entry and exit. There are no barriers preventing new firms from entering the industry when profits are being made, and there are no restrictions preventing existing firms from leaving if they are making losses. This condition ensures that in the long run, supernormal profits are eroded as new firms enter, increasing supply and driving down price. Similarly, persistent losses drive firms out, reducing supply and raising price until only normal profit is made. This freedom of entry and exit guarantees that resources are allocated efficiently in the long run.

Perfect knowledge. Both buyers and sellers have complete information about prices, product quality, and production methods. Buyers are fully aware of the prices being charged by all firms, and sellers are fully informed about the cost conditions and technology of production. This assumption prevents any firm from gaining advantage by charging higher prices or withholding information. It also means consumers always buy at the lowest available price, and firms cannot survive if they are inefficient relative to competitors.

These assumptions together produce a market environment in which firms are highly constrained. Each firm must operate as efficiently as possible, because it cannot increase revenue by raising prices. The only path to profit is minimising costs. In the short run, firms may earn supernormal profits, normal profits, or losses depending on the relationship between the market price and their cost structure. In the long run, however, the condition of free entry and exit ensures that only normal profits prevail.

From the perspective of efficiency, perfect competition has two critical implications. First, in the short run, the equilibrium outcome ensures allocative efficiency, because the market price equals marginal cost. Consumers are therefore paying a price equal to the additional cost of producing the last unit, which means resources are being allocated to produce the goods most valued by society. Second, in the long run, productive efficiency is achieved because firms operate at the minimum point of their average cost curve.

Short-Run Equilibrium in Perfect Competition

In the short run, some factors of production are fixed while others are variable. Land and large items of capital may be fixed in quantity, while labour and raw materials may be varied more easily. Because of this, each firm in perfect competition operates within a framework of short-run cost curves, including average total cost, average variable cost, and marginal cost. The firm remains a price taker and must accept the market price, but its profits or losses depend on how that price compares with its cost structure.

The condition for profit maximisation is that the firm chooses the output level where marginal revenue equals marginal cost. In perfect competition, marginal revenue is identical to price, because the firm can sell each additional unit at the going market price. Therefore, the firm maximises profit by producing the quantity at which price equals marginal cost. At this point, it cannot increase profit by expanding or reducing output.

Once output is chosen, the relationship between the price line and the average total cost curve determines whether the firm earns supernormal profit, normal profit, or makes a loss.

Supernormal Profit in the Short Run

If the market price is greater than the average total cost at the profit-maximising output, the firm makes supernormal profit. Supernormal profit refers to profit over and above normal profit. Normal profit is the return necessary to keep the entrepreneur and the firm’s resources in their current use; it is the opportunity cost of production. Anything above this is considered supernormal.

Imagine a diagram where the horizontal axis measures output and the vertical axis measures price and cost. The firm’s demand curve, which is also its average revenue curve, is a horizontal line at the market price. Marginal revenue is the same horizontal line, since price is constant for each unit sold. The firm’s marginal cost curve slopes upward in the usual way, and it intersects the marginal revenue line at the chosen output. At that output, the average total cost curve lies entirely below the price line.

In this case, the firm covers all its costs, including the opportunity cost of capital and enterprise, and still has surplus revenue left. That surplus is the supernormal profit. Other firms in the market, seeing that supernormal profits are possible, will be attracted to enter the industry in the long run, since there are no barriers to entry.

Normal Profit in the Short Run

If the market price is exactly equal to average total cost at the profit-maximising output, the firm earns normal profit. Here the price line touches the average total cost curve at its minimum point. Marginal cost still equals marginal revenue at the chosen output, but average total cost is equal to price.

In this situation, the firm is covering all its costs, including the opportunity cost of the entrepreneur’s time and capital, but is not making any surplus beyond that. From the perspective of the economist, this is not a failure, because the firm is still earning enough to remain in the market. From the perspective of competition, this is the long-run expected outcome, since entry and exit drive profits to this normal level.

Loss in the Short Run

If the market price falls below the average total cost at the profit-maximising output, the firm incurs a loss. However, whether the firm continues to produce depends on whether the price is above or below average variable cost.

In the diagram, the AR = MR line lies below the ATC curve at the equilibrium output. The marginal cost curve still cuts MR at the point of profit maximisation. The rectangle representing the difference between price and average cost is now negative, showing a loss.

If the price is above average variable cost, the firm will continue to produce in the short run, because it is covering variable costs and contributing something towards fixed costs. Shutting down would mean losing the entirety of fixed costs, whereas continuing reduces losses.

If the price falls below the average variable cost, the firm will shut down in the short run. At that point, it cannot even cover its variable costs, and producing more output only increases its loss. The shutdown point, therefore, occurs where price equals the minimum of average variable cost.

Key Points for Short-Run Equilibrium

1. The profit-maximising condition is always MR = MC, which in perfect competition is the same as P = MC.

2. Whether the firm earns supernormal profit, normal profit, or a loss depends on the relationship between price and average total cost.

3. If P > ATC, the firm makes supernormal profit.

4. If P = ATC, the firm makes normal profit.

5. If P < ATC but P > AVC, the firm makes a loss but continues to produce.

6. If P < AVC, the firm shuts down in the short run.

These outcomes illustrate the responsiveness of perfectly competitive firms to cost and price conditions. Because no firm has influence over the market price, they are entirely at the mercy of cost conditions and demand in the market as a whole.

Industry Equilibrium in the Short Run

So far, the analysis has focused on an individual firm in perfect competition, which faces a perfectly elastic demand curve at the market price. That analysis explains how the firm chooses its profit-maximising output where marginal cost equals marginal revenue, and how the relationship between price and average cost determines whether the firm earns supernormal profit, normal profit, or a loss.

However, the price itself is not determined by a single firm. Instead, it is determined at the industry level, where the total demand for the product meets the total supply from all firms combined. In this way, the price is established by the intersection of the market demand curve and the market supply curve.

Each firm takes that price as given, but the industry outcome depends on how many firms are producing and what their cost structures are. In the short run, the number of firms in the industry is fixed, because entry and exit are constrained by the immobility of fixed factors. Therefore, industry supply in the short run is simply the horizontal summation of the supply curves of all firms currently in the market.

Short-Run Industry Supply Curve

The individual firm’s supply curve in perfect competition is the portion of its marginal cost curve that lies above the minimum point of average variable cost. Below that point, the firm would shut down, because it could not cover variable costs. Therefore, the short-run supply curve for the firm begins at the shutdown point and follows the upward-sloping marginal cost curve beyond it.

To derive the industry supply curve, we sum the supply curves of all the firms in the market. This is done horizontally, meaning that at each possible price we add up the quantities that individual firms are willing to supply. The result is an upward-sloping industry supply curve.

This diagram represents the market as a whole. The equilibrium price is determined where market demand equals market supply. At this price, the industry supplies output Q, and each firm produces its own share of that output, given its cost conditions.

Linking Industry Price to the Firm

Once the industry equilibrium price is established, each firm accepts it as given. The firm then faces a perfectly elastic demand curve at that price. Its output decision follows the usual rule: produce where marginal revenue equals marginal cost, which in perfect competition is where price equals marginal cost.

If the equilibrium price in the industry is above the average cost of the firm, the firm makes supernormal profit. If the equilibrium price is equal to average cost, the firm makes normal profit. If the equilibrium price is below average cost but above average variable cost, the firm incurs a loss but continues to produce in the short run.

In this way, it can be seen that the market equilibrium sets the individual firms' demand curve. The left-hand diagram shows how price is established by market demand and supply, while the right-hand diagram shows how the firm reacts to that price in its own cost conditions.

Adjustments in the Short Run

In the short run, the number of firms is fixed, so the only adjustment that can take place in response to changes in demand is a movement along the industry supply curve.

For example, if market demand increases, the demand curve shifts to the right. The new equilibrium price rises. Each firm now faces a higher price line and produces a larger output, as long as marginal cost rises with output. The higher price may move firms from making losses into normal profit, or from normal profit into supernormal profit.

If market demand falls, the opposite happens. The price falls, firms reduce output, and many may now make losses if the price falls below average cost. In the short run, they may continue to produce as long as price covers average variable cost, but they cannot escape losses entirely.

Short-Run Industry Equilibrium as a Temporary Position

The short-run equilibrium of the industry is therefore a temporary position. It shows how price and output are determined given a fixed number of firms. However, it does not allow for entry or exit. That adjustment occurs in the long run, where supernormal profits attract new entrants and losses drive firms out.

The importance of the short-run analysis is that it explains how firms respond immediately to price signals in the market. Even though entry and exit are not possible in the short run, existing firms adjust their output to match changes in demand. The price ensures that demand and supply balance, but it does not guarantee that firms are making normal profit.

Key Points for Industry Equilibrium in the Short Run

1. The short-run supply curve of the firm is the part of the marginal cost curve above average variable cost.

2. The industry supply curve is derived by summing all firms’ short-run supply curves horizontally.

3. Industry equilibrium is determined by the intersection of market demand and industry supply.

4. Each firm then takes the equilibrium price as given and produces at the point where marginal cost equals marginal revenue.

5. The short-run equilibrium may involve firms making supernormal profit, normal profit, or losses, depending on the relationship between price and average cost.

6. The short run is a temporary position; entry and exit will change the number of firms in the long run.

Dynamics of Short-Run Equilibrium

In the earlier short-run analysis, it was established that firms may make supernormal profit, normal profit, or losses depending on the relationship between the market price and the firm’s average total cost. Each firm produces where marginal cost equals marginal revenue, which in perfect competition is where marginal cost equals price. However, the industry as a whole is not static. When firms are consistently earning supernormal profits, or when they are incurring losses, there is pressure for change.

The key to understanding these pressures is the assumption of freedom of entry and exit. Although the number of firms is fixed in the short run, over time firms can enter the industry if profits are attractive, and they can leave the industry if losses are persistent. Therefore, the short-run equilibrium must be seen as only a temporary position, setting the stage for longer-term adjustment.

Suppose that in the short run the equilibrium price is high enough that the typical firm makes supernormal profit. In a diagram for the firm, the horizontal average revenue line lies above the average total cost curve at the output where marginal cost equals marginal revenue. The shaded rectangle between the price and the average total cost curve represents the amount of supernormal profit per unit multiplied by total output.

This outcome is attractive to other firms outside the industry. Because entry is not restricted, new firms are incentivised to enter. When new firms enter, the industry supply curve shifts to the right. In the industry diagram, this means that for the same level of demand, the equilibrium price falls.

The fall in price continues until the supernormal profits of existing firms are eroded. As the number of firms grows, industry output expands, price falls, and the shaded profit rectangles shrink until they disappear. The entry process continues until the price is driven down to equal average cost, at which point all firms earn only normal profit.

The reverse applies when firms make losses in the short run. Suppose the equilibrium price is below the average cost curve but above the average variable cost. Firms continue producing, but they are losing money. The losses encourage firms to exit the industry if they can redeploy their resources more profitably elsewhere. When firms exit, the industry supply curve shifts left. As supply contracts, the equilibrium price rises. This rise continues until the price is restored to a level equal to the average cost, where firms make a normal profit.

Thus, the short-run equilibrium revisited shows that the forces of entry and exit ensure that supernormal profits and persistent losses cannot last in the long run. The long-run equilibrium is characterised by normal profit for all firms in the industry.

Long-Run Equilibrium under Perfect Competition

In the long run, all factors of production are variable, and the number of firms in the industry can adjust freely. Entry occurs if firms are making supernormal profits, and exit occurs if firms are making losses. Therefore, in the long run, equilibrium is achieved when firms are earning normal profit and there is no incentive for new firms to enter or for existing firms to leave.

For an individual firm, the long-run equilibrium is reached when the following conditions are met:

Price equals marginal cost. The firm is producing at the point where profit is maximised.

Price equals average total cost. The firm covers all its costs, including opportunity costs, so it makes only normal profit.

Marginal cost equals average cost at its minimum point. The firm is operating at the lowest point of the average cost curve, which means productive efficiency is achieved.

From the industry perspective, the long-run equilibrium is reached when the industry supply curve intersects with market demand at the price where firms make normal profit. The supply curve is perfectly elastic in the long run if all firms have identical cost conditions. At that price, any level of demand can be met by adjusting the number of firms in the industry.

This horizontal industry supply curve represents the idea that in the long run, firms can enter or exit until the price is exactly equal to the long-run average cost. If demand increases, new firms enter, keeping the price constant at this minimum-cost level. If demand falls, firms exit, again keeping price constant.

Efficiency in Long-Run Equilibrium

The long-run equilibrium of perfect competition has two important efficiency properties.

Allocative efficiency is achieved because price equals marginal cost. Consumers pay a price equal to the additional cost of producing the last unit, which means resources are allocated to produce goods valued most highly by society. No reallocation of resources could improve consumer satisfaction without making others worse off.

Productive efficiency is achieved because firms produce at the minimum point of their average cost curve. Resources are used with maximum efficiency, and no unit could be produced at lower average cost.

These two properties make perfect competition the only market structure that achieves both allocative and productive efficiency in the long run.

The Role of Entry and Exit

The mechanism of entry and exit is central to the adjustment process. Supernormal profit acts as a signal to potential entrants that there are profitable opportunities in the industry. Entry increases supply, drives down price, and eliminates the profit. Losses act as a signal that resources are misallocated. Exit reduces supply, raises price, and eliminates the loss.

This self-correcting mechanism ensures that the long-run equilibrium under perfect competition is stable. Firms earn just enough to remain in the industry, but not enough to attract unlimited entry. Resources flow to where they are most valued, as indicated by consumer demand and the costs of production.

Key Results of Long-Run Equilibrium

Firms make normal profit only, with price equal to average cost.

Allocative efficiency is achieved, because P = MC.

Productive efficiency is achieved, because production takes place at the minimum point of AC.

The industry supply curve in the long run is perfectly elastic if firms have identical cost structures, meaning output can expand or contract at the same price.

The Long-Run Supply Curve in Perfect Competition

The long-run supply curve of an industry shows the relationship between the price of a good and the quantity supplied, when all firms can freely enter and exit the industry and when all factors of production are variable. It differs from the short-run supply curve, which reflects the output decisions of a fixed number of firms with some inputs held constant.

In the long run, new firms can enter if profits are available, and existing firms can exit if losses persist. The long-run supply curve, therefore, embodies the adjustment process by which the industry responds to changes in demand. The exact shape of this curve depends on what happens to costs as the industry expands or contracts.

Constant-Cost Industry

In the simplest case, the industry is a constant-cost industry. This means that as the industry expands, the entry of new firms does not change the input prices faced by all firms. The cost curves of individual firms remain unchanged. For example, if the demand for wheat rises and new farmers enter the industry, the expansion does not bid up the prices of land, labour, or machinery. Each farmer’s costs remain the same as before.

In this situation, the long-run industry supply curve is perfectly elastic, meaning it is a horizontal line at the level of minimum average cost. If demand increases, the demand curve shifts right, and output expands because new firms enter. However, the equilibrium price remains constant at the level where firms make only normal profit.

This diagram shows that in a constant-cost industry, price does not change with demand in the long run. Instead, adjustments occur entirely through changes in output and the number of firms.

Increasing-Cost Industry

In some industries, expansion pushes up input prices. For instance, if the demand for skilled labour rises sharply as more firms enter, wages may increase. If the industry depends on scarce resources, such as specific types of land, expansion may bid up the price of that land. When input prices rise as the industry grows, cost curves shift upward.

As a result, the long-run supply curve slopes upward. A higher equilibrium price is necessary to cover the increased average costs of production. This means that, in the long run, greater quantities are supplied only at higher prices.

Decreasing-Cost Industry

The opposite situation can also occur: expansion of the industry may reduce input prices or create external economies of scale. For example, if a new high-tech industry grows in a particular region, suppliers of components, skilled labour, and specialist services may cluster there, lowering costs for all firms. Similarly, improvements in infrastructure, such as transport or communications, may reduce costs as the industry expands.

In this case, the long-run supply curve slopes downward. As demand increases and more firms enter, costs fall, and the equilibrium price declines. Consumers benefit from lower prices, while firms continue to earn only normal profit at the new lower cost level.

Efficiency Implications

Regardless of whether the long-run supply curve is flat, upward-sloping, or downward-sloping, the efficiency results of perfect competition remain. Firms still produce at the point where price equals marginal cost, ensuring allocative efficiency, and they still produce at the minimum point of their average cost curve, ensuring productive efficiency.

The main difference is in how the industry adjusts to changes in demand. In a constant-cost industry, only output changes. In an increasing-cost industry, both output and price increase. In a decreasing-cost industry, output increases while price falls.

Evaluation of Perfect Competition

Pros of Perfect Competition

The model of perfect competition has several advantages that make it a valuable benchmark in economic analysis.

First, it provides a clear demonstration of allocative efficiency because the price in long-run equilibrium equals marginal cost, resources are allocated to produce the goods and services that consumers value most. Each unit is produced up to the point where the value consumers place on it, as measured by their willingness to pay, equals the cost of the resources used to produce it. No resources are wasted producing goods that are worth less than their cost, and no opportunities are missed to produce goods that are valued more than their cost.

Second, perfect competition also ensures productive efficiency. Firms produce at the minimum point of their average cost curve in the long run. This means that goods are produced at the lowest possible cost per unit, and no resources are wasted through inefficiency. Consumers therefore benefit from the lowest sustainable prices.

Third, the model encourages dynamic adjustment through entry and exit. If firms earn supernormal profits, new firms enter, increasing supply and driving down price until only normal profit is left. If firms incur losses, some exit, reducing supply and raising price until losses are eliminated. This entry–exit mechanism ensures that the industry self-corrects, directing resources to their most valued uses.

Fourth, the model assumes perfect knowledge, which means consumers are fully informed about prices and firms cannot exploit ignorance. Combined with homogeneous products, this condition means firms must compete on efficiency rather than branding or advertising. The pressure of competition drives out inefficiency, reinforcing the achievement of productive efficiency.

Weaknesses of Perfect Competition

Despite these strengths, perfect competition has important weaknesses that limit its realism.

The first problem is that the assumptions are very restrictive and rarely met in practice. Very few markets contain the very large number of firms required for no single one to have influence over price. In most markets, firms produce differentiated products and attempt to build brand loyalty, rather than producing a homogeneous output. Perfect knowledge is also unrealistic, because consumers often do not know all prices available, and firms may have private information about costs and technology.

The second weakness is that the model largely ignores dynamic efficiency. While firms are productively and allocatively efficient in the long run, they earn only normal profit. With no supernormal profit to fund research and development, firms in perfect competition may lack incentives to innovate, invest in new technology, or develop new products. In contrast, firms in imperfect competition, such as monopolies or oligopolies, may be able to finance innovation precisely because they can sustain supernormal profits.

A third limitation is that the model does not account for the role of economies of scale beyond the individual firm. In industries where economies of scale are extensive, it may not be efficient to have many small firms. A natural monopoly may, in some cases, provide goods at a lower cost than a perfectly competitive industry could, because a single large firm can exploit economies of scale more fully.