Market Structures

Lessons

Senior 5 · Economics

Market Structures

5 lessons

Lesson 1 of 5

Market structures and the perfectly competitive firm

40 min

A potato grower and a phone company

At a Saturday market in Musanze, dozens of farmers sell Irish potatoes that look the same. If one farmer asks Frw 50 a kilogram more than the others, buyers simply walk to the next stall and she sells nothing. A few kilometres away, a mobile network raises the price of a data bundle. Some customers grumble and a few switch, but most keep buying, because there are only two mobile networks in Rwanda to choose from and switching takes effort.

The farmer has no power over her price; the network has a great deal. The difference is not about how clever their managers are. It comes from the structure of the market each one sells in: how many sellers there are, whether their products differ, and how easily a newcomer can join. In Senior 4 you met perfect competition and monopoly briefly. This unit studies all four main structures in depth, with the cost and revenue curves an examiner expects you to draw.

Definition

Market structure: the features of a market that shape how firms in it behave, above all the number and size of sellers, how alike their products are, how easily firms can enter or leave, and how much information buyers and sellers have.

Firm: a single business unit that produces and sells, such as one potato farm. Industry: all the firms producing the same or similar product, such as all potato growers supplying a market.

The features that set one structure apart from another

Feature	Perfect competition	Monopolistic competition	Oligopoly	Monopoly
Number of sellers	Very many, each tiny	Many	A few large firms	One
Product	Identical (homogeneous)	Slightly different (differentiated)	Identical or differentiated	Unique, no close substitute
Entry and exit	Free	Fairly free	Difficult: high barriers	Blocked
Control over price	None: a price taker	Some	Considerable, but rivals react	Great: a price maker
Rwandan illustration	Irish potato growers at a rural market (close to it)	Hair salons, tailors and restaurants in a town	Mobile telephone networks; beer brewing	The national electricity grid; piped water in most towns

The four are not separate boxes so much as points along a line. As you move from left to right, the number of firms falls, barriers to entry rise and each firm gains more control over its price.

Definition

Imperfect competition: any market structure between the two extremes, in which at least some firms can influence the price they charge. Monopolistic competition, oligopoly and monopoly are all forms of it.

Two other structures are named by the buyer's side. Monopsony: a market with a single buyer, for example a coffee washing station that is the only buyer allowed to collect cherries in its zone. Duopoly: an oligopoly with exactly two sellers.

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Perfect competition: the assumptions

Perfect competition is a model. No real market meets every condition, but some come close, and the model gives a yardstick against which the others are judged.

Many buyers and many sellers, each so small that none can change the market price by changing how much it buys or sells.
A homogeneous product: every seller's output is identical, so buyers have no reason to prefer one seller.
Free entry and exit: no legal, financial or technical barrier stops a firm joining or leaving the industry in the long run.
Perfect knowledge: buyers and sellers know every price and every production method.
Perfect mobility of factors: labour and capital move freely to wherever they earn most.
No transport costs between sellers, and no government interference such as price controls, taxes or subsidies.

Together these make every firm a price taker. The price is set by the industry's demand and supply, and each firm must accept it. That is why the firm's demand curve is a horizontal line at the market price: it can sell all it wants at that price, and nothing at all above it.

Definition

Price taker: a firm that cannot influence the market price and must accept the price set by industry demand and supply. Its demand curve is perfectly elastic (horizontal).

Example: one potato grower among hundreds supplying Musanze market.

Revenue curves of a price taker

Three revenue measures matter for every firm:

\text{TR} = P \times q, \qquad \text{AR} = \frac{\text{TR}}{q}, \qquad \text{MR} = \frac{\Delta \text{TR}}{\Delta q}

For a price taker $P$ is constant, so $\text{AR} = \frac{P \times q}{q} = P$ , and every extra unit sold adds exactly $P$ to revenue, so $\text{MR} = P$ too. The firm's demand curve, its AR curve and its MR curve are the same horizontal line, and its TR curve is a straight line through the origin with slope $P$ .

Worked example 1: the revenue schedule of a price taker

The market price of Irish potatoes is Frw 400 per kg (illustrative). Build the revenue schedule for 0 to 4 sacks of 100 kg.

Sacks sold (q)	TR (Frw)	AR (Frw per sack)	MR (Frw)
0	0	–	–
1	40,000	40,000	40,000
2	80,000	40,000	40,000
3	120,000	40,000	40,000
4	160,000	40,000	40,000

One sack is 100 kg, so its price is $100 \times 400 = 40\,000$ Frw. TR rises by the same Frw 40,000 with each sack, so MR is constant and equal to AR and to the price per sack. Conclusion: for a price taker, $P = \text{AR} = \text{MR}$ .

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The short-run cost curves, revisited

In Senior 4 you split total cost into fixed and variable cost. At A-level you must draw the per-unit curves accurately, because the equilibrium diagrams in this unit are built on them:

\text{AFC} = \frac{\text{TFC}}{q}, \quad \text{AVC} = \frac{\text{TVC}}{q}, \quad \text{ATC} = \text{AFC} + \text{AVC}, \quad \text{MC} = \frac{\Delta \text{TC}}{\Delta q}

Three facts about the drawing are tested again and again:

MC cuts AVC and ATC at their lowest points. This follows from the arithmetic of averages: if the next unit costs less than the average, it pulls the average down; if it costs more, it pulls the average up. So the average stops falling, and is at its minimum, exactly where marginal equals average.
The gap between ATC and AVC is AFC, which shrinks as output rises because the same fixed cost is spread over more units. The two curves get closer but never meet.
The curves are U-shaped because of the law of diminishing returns: as more of a variable factor is added to a fixed factor, extra output first rises and then falls, so the cost of each extra unit first falls and then rises.

Definition

Profit-maximising rule: a firm maximises profit (or minimises loss) at the output where $\text{MR} = \text{MC}$ and MC is rising (cutting MR from below). Below that output, an extra unit adds more to revenue than to cost; above it, an extra unit adds more to cost than to revenue.

Worked example 2: finding the best output from a table

A small vegetable farm sells cabbages at a market price of Frw 300 thousand per tonne. Its total costs (illustrative, in Frw thousand) are shown. How many tonnes should it produce, and what is its profit?

q (tonnes)	TC	MC	TR	Profit
0	200	–	0	−200
1	420	220	300	−120
2	580	160	600	20
3	720	140	900	180
4	880	160	1,200	320
5	1,080	200	1,500	420
6	1,340	260	1,800	460
7	1,680	340	2,100	420

Step 1 MR is the price, 300, for every tonne. Step 2. Compare MC with MR. The 6th tonne adds 260 to cost and 300 to revenue, so it raises profit by 40. The 7th adds 340 to cost but only 300 to revenue, so it lowers profit by 40. Step 3. Produce 6 tonnes. Profit $= 1\,800 - 1\,340 = 460$ thousand Frw, the largest figure in the last column.

Note that at q = 1 MC (220) is also below MR, and at q = 2 and 3 MC is falling: the rule needs MC to be rising through MR, which is why we look at the upper crossing.

Warning

Common mistakes in the diagrams. (1) Drawing MC so that it cuts ATC or AVC away from their lowest points: an examiner treats this as a wrong diagram. (2) Drawing the firm's demand curve sloping down: under perfect competition the industry demand curve slopes down, but the firm's is horizontal. (3) Putting the price on the firm's graph at a different height from the industry graph: the firm takes exactly the industry's price.

Tip

Remember "P = AR = MR = d". Under perfect competition the four labels sit on one horizontal line. In every other structure the demand curve slopes down and MR lies below AR, which is where the rest of this unit begins.

Think Econ, "What Are the FOUR Market Structures in Economics?" (about 7 minutes). As you watch, add one more example of your own, from Rwanda, to each column of the comparison table above.

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Practice

Define market structure and name four features used to tell one structure from another.
Distinguish between a firm and an industry, using a Rwandan example.
List five assumptions of perfect competition.
Explain why a perfectly competitive firm's demand curve is horizontal even though the industry's demand curve slopes downward.
Tomatoes sell at Frw 600 per kg (illustrative). Find TR, AR and MR when a farmer sells 50 kg, and when she sells 51 kg.
Explain, using the relationship between marginal and average, why the MC curve passes through the lowest point of the ATC curve.
Using the table in worked example 2, find the profit-maximising output if the market price falls to Frw 200 thousand per tonne, and the profit or loss at that output.
"No market in Rwanda is perfectly competitive, so the model is useless." Evaluate this statement.

Show answersHide answers

Market structure is the set of features of a market that shape how its firms behave. Features: number and size of sellers; nature of the product (identical or differentiated); barriers to entry and exit; degree of control over price (and the information available).
A firm is one producing unit, such as one tea factory; an industry is all firms making the same product, such as all tea factories in Rwanda.
Any five of: many buyers and sellers; homogeneous product; free entry and exit; perfect knowledge; perfect factor mobility; no transport costs; no government interference.
Each firm is too small to affect the market price. If it charged more, buyers would go to identical sellers, so it sells nothing; it can sell any amount at the market price, so it has no reason to charge less. The industry demand curve slopes down because, for the market as a whole, a lower price brings more buyers.
At 50 kg: TR = 50 × 600 = Frw 30,000, AR = Frw 600. At 51 kg: TR = Frw 30,600, AR = Frw 600. MR of the 51st kg = 30,600 − 30,000 = Frw 600. P = AR = MR.
When MC is below ATC, each extra unit costs less than the average, pulling ATC down; when MC is above ATC, it pulls ATC up. ATC therefore stops falling and starts rising exactly where MC = ATC, so MC cuts ATC at its minimum.
With MR = 200: the 5th tonne has MC 200 = MR, the 6th has MC 260 > 200. Produce 5 tonnes (4 gives the same profit, since the 5th tonne adds exactly as much revenue as cost). TR = 5 × 200 = 1,000; TC = 1,080; loss = 80 thousand Frw. (At 4 tonnes: 800 − 880 = −80, the same.)
Answers should argue both ways. For: real markets have branding, transport costs and imperfect information, so predictions such as zero long-run profit rarely hold exactly. Against: some markets (farm produce at rural markets) come close; the model is a benchmark that shows what efficiency looks like, so we can measure how far other markets fall short and design policy. A good conclusion: useful as a benchmark, not as a description.

Sources and credits

Video: What Are the FOUR Market Structures in Economics? [WITH EXAMPLES], Think Econ, embedded from YouTube.

Written by Ganzaa: the text, the three diagrams (cost curves computed from a cubic cost function), the tables, the worked examples and the practice items. All prices and costs in the examples are illustrative.

1A potato grower and a phone company

2The features that set one structure apart from another

3Perfect competition: the assumptions

4Revenue curves of a price taker

5The short-run cost curves, revisited

A potato grower and a phone company

The features that set one structure apart from another

Perfect competition: the assumptions

Revenue curves of a price taker

The short-run cost curves, revisited