Market Structures, Concentration Ratios, and Efficiency

1. Market Structures

Market structure refers to the characteristics and organization of a market that affect the nature of
competition and pricing. Key elements include the number of firms, the type of products, barriers to
entry, pricing power, and the level of competition.

The four major types of market structures are:

2. The Four Types of Market Structures

a) Perfect Competition

 Definition: A market where a large number of small firms produce identical products and no
single firm can influence the market price.

 Characteristics:

o Many buyers and sellers.

o Homogeneous (identical) products.

o No barriers to entry and exit.

o Perfect information (buyers and sellers have full knowledge).

o Firms are price takers (they accept the market price).

o No individual firm can influence output or price.

 Examples: Agricultural commodities (e.g., wheat, rice).

 Outcomes:

o In the short run, firms can earn abnormal profits or losses.

o In the long run, only normal profit is earned as new firms enter or exit the market.

b) Monopolistic Competition

 Definition: A market where many firms sell similar but slightly differentiated products.

 Characteristics:

o Many sellers.

o Products are differentiated (through branding, quality, services).

o Few barriers to entry and exit.

o Some degree of price-setting power due to product differentiation.

o Advertising and brand loyalty are important.

  Examples: Restaurants, clothing brands, salons.

 Outcomes:

o In the short run, firms can earn supernormal profits or losses.

o In the long run, only normal profit due to easy entry and imitation by new firms.

c) Oligopoly

 Definition: A market dominated by a small number of large firms, leading to mutual

interdependence.

 Characteristics:

o Few dominant firms.

o Products may be homogeneous (oil, steel) or differentiated (cars, smartphones).

o Significant barriers to entry (costs, technology, brand loyalty).

o Firms are interdependent: the actions of one affect the others (e.g., pricing
strategies).

o Potential for collusion or price wars.

 Examples: Airline industry, automobile industry, mobile networks.

 Outcomes:

o Firms can earn long-term supernormal profits.

o Efficiency depends on the degree of competition and collusion.

d) Monopoly

 Definition: A market with only one firm supplying a unique product without close
substitutes.

 Characteristics:

o Single seller.

o No close substitutes.

o Very high barriers to entry (legal, technological, ownership of resources).

o Firm is a price maker (controls price and output).

 Examples: Local water supply companies, patented pharmaceuticals.

 Outcomes:

o In both short and long run, monopolies can earn supernormal profits.

o Risk of inefficiency and consumer exploitation without regulation.

3. Concentration Ratios

Concentration ratios measure the degree of market dominance by the largest firms in the industry.

 Definition: The percentage of total market output produced by a specific number

(commonly four) of the largest firms.

 Common Ratios:

o CR4: Four-firm concentration ratio.

o CR5: Five-firm concentration ratio.

 Interpretation:

o CR4 > 60%: Highly concentrated (few firms dominate).

o CR4 between 40%-60%: Moderately concentrated.

o CR4 < 40%: Low concentration (more competitive).

 Significance:

o High concentration can signal less competition, potential collusion, and higher
prices.

o Low concentration suggests a competitive market with benefits for consumers.

4. Types of Efficiency

Efficiency measures how well a market allocates resources and minimizes waste. There are several
types:

a) Allocative Efficiency

 Resources are distributed according to consumer preferences.

 Achieved when Price = Marginal Cost (P = MC).

 Consumer and producer surplus are maximized.

 No deadweight loss.

b) Productive Efficiency

 Firms produce goods at the lowest possible cost.

 Achieved when production occurs at the minimum point of the Average Total Cost (ATC)
curve.

c) Dynamic Efficiency

 Improvement in productive and allocative efficiency over time through innovation and
investment.

 Associated with technological progress and better products.

d) X-Inefficiency

 Occurs when a firm’s actual costs are higher than the lowest possible costs, often due to lack
of competition or poor management.

5. Efficiency in Market Structures: Short Run vs Long Run

Market
Short Run Efficiency Long Run Efficiency
Structure

- Productive and allocative efficiency - Both allocative (P = MC) and productive

Perfect
may not be achieved if firms are efficiency achieved as only normal profit is
Competition
making abnormal profits or losses. made and firms operate at minimum ATC.

- Neither productive nor allocative - Firms still have excess capacity; not
Monopolistic
efficiency; firms have market power productively or allocatively efficient, but
Competition
and excess capacity. competition limits inefficiency.

- Firms can be dynamically efficient

- Efficiency depends: competition
(innovation and R&D); productive and
Oligopoly leads to better efficiency; collusion
allocative efficiency may not always be
reduces efficiency.
achieved.

- Productive and allocative efficiency - Possible dynamic efficiency through R&D

Monopoly not achieved; firms restrict output investment; X-inefficiency risk if monopoly
and raise prices (P > MC). is protected without competition.

Summary Points

 Perfect competition offers the highest efficiency in the long run.

 Monopolistic competition achieves innovation but not full efficiency.

 Oligopolies can be dynamically efficient but prone to inefficiency if collusion happens.

 Monopolies are generally allocatively and productively inefficient but may drive dynamic
efficiency through innovation.