Level 1 CFA® Exam:
Market Structures
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| Type of Market Structure | Perfect Competition | Monopolistic Competition | Oligopoly | Monopoly |
|---|---|---|---|---|
| Number of Firms in a Market | many firms with a small market share | many firms | a few firms | one firm |
| Barriers to Entry and Exit | very low | low | high | very high |
| Product | homogeneous | differentiated | usually homogeneous / sometimes differentiated | unique |
| Marketing (non-price competition) | low | high expenditure on advertising and promotion | high expenditure on advertising and promotion (especially in the case of a differentiated product) | high expenditure on advertising and promotion |
| Pricing Power of the Firm | none | some | considerable | high |
The features that we will take into consideration when describing different types of market structures are:
- number of firms in a market,
- barriers to entry and exit,
- type of product,
- marketing and, and
- pricing power.
Perfect competition is characterized by quite a big number of firms with a small market share. The barriers to entry and exit in perfect competition are very low and the product may be described as homogeneous, which means that every company produces exactly the same product. In perfect competition, companies have no marketing nor pricing power.
In monopolistic competition, there are many firms, the barriers are low and the product is differentiated (thus, certain substitutes may exist). The expenditures on marketing are rather high and pricing power is present to some extent.
As far as oligopoly is concerned, a few firms enter this market structure, as the barriers to entry are high. The product is either homogeneous or differentiated and in the case of the latter, the expenditures on marketing are rather high. Pricing power is present and it may be sometimes described even as considerable.
Monopoly means that only one firm is present in the market. Barriers to entry and exit are very high and the product offered by the firm is unique. The firm makes great expenditures on adverting and promotion and has considerable pricing power.
Equilibrium Conditions
Marginal revenue is an increase in total revenue resulting from the sale of an additional unit of product. The calculation of marginal revenue depends on whether we are dealing with perfect competition or some other market structure. Only under perfect competition the price is fixed and doesn’t depend on the quantity sold. Under other market structures, price is related to quantity.
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Own-Price Elasticity of Demand
Equilibrium conditions under perfect competition in the short-run:
- P = MR = MC,
- demand is perfectly elastic,
- economic profit for an individual company is possible if the average price is higher than the minimum average cost. However, if an economic profit is possible in the short-run, new companies will enter the perfectly competitive market.
Equilibrium conditions under perfect competition in the long-run:
- P = MR = MC,
- demand is perfectly elastic,
- no long-run economic profit.
Important: Even though each company in perfect competition faces the horizontal demand line, the demand function for the whole market is downward sloping.
Under monopolistic competition, a large number of firms deliver differentiated products to the market. Because the products are close substitutes but are differentiated, the demand function for each company is downward slopping. There is no well-defined supply schedule.
Equilibrium conditions under monopolistic competition:
- P > MR = MC,
- depending on the point on the demand curve, the demand can be elastic or inelastic,
- short-run economic profit for an individual company is possible if the average price is higher than the minimum average cost. However, if an economic profit is possible in the short-run, new companies will enter the market and drive long-run economic profit to zero.
- In comparison with perfect competition, the level of output and the price are higher (above the minimum average cost).
Oligopoly is characterized by:
- only a few companies present,
- the complex pricing strategy, because companies' decisions depend on their competitors' reactions and the optimal price and output are associated with cost structures in other companies and their reactions to price changes made by competitors.
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Nash equilibrium
The company expects retaliation from the competitors after changing the output, so when changing the output in order to maximize profit, it takes possible reactions of the competitors into account. When all the firms in the oligopoly market take the actions of all the competitors into account (both “in response” and independent actions), the Nash equilibrium is reached.
To sum up, equilibrium conditions under oligopoly:
- P > MR = MC,
- a positive long-run economic profit is possible.
Equilibrium conditions under monopoly:
- P > MR = MC,
- no long-run economic profit.
First-degree price discrimination is when the monopolist takes all consumer surplus, i.e. it’s able to charge each consumer the max price the consumer is ready to pay for the product.
Second-degree price discrimination is when the product is offered in different versions (differences in quality and quantity), so the customer can choose + the “better” version costs more.
Third-degree price discrimination is when consumers are segregated by demographic, geographic, or other dimensions.
Optimal Price & Pricing Strategy Summarized for Level 1 CFA Candidates
star content check off when doneUnder all market structures, an increase in demand translates into an increase in short-run economic profit. Consequently, positive economic profits attract other firms to enter the market, of course, if we assume that barriers to entry are relatively low. When new companies enter the market, we observe an increase in market supply, which results in lower prices and higher market output.
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Insufficient information and changes in elasticity of demand over time make it difficult to measure market power. That's why analysts try to use relatively simpler measures. They can use for example:
- the concentration ratio for N firms, or
- the Herfindahl-Hirschman index.
The concentration ratio for N firms is calculated as the sum of the market shares of the largest N firms. It's easy to compute, but it does not directly quantify market power or elasticity of demand.
The Herfindahl-Hirschman index (HHI) is an index where the market shares of the top N companies are first squared and then added. Thanks to its composition, this index is sensitive to changes in the market such as mergers and takeovers.
- Types of market structure: perfect competition, monopolistic competition, oligopoly, and monopoly.
- Perfect competition is characterized by quite a big number of firms with a small market share. The barriers to entry and exit in perfect competition are very low and the product may be described as homogeneous.
- In monopolistic competition, there are many firms, the barriers are low and the product is differentiated.
- As far as oligopoly is concerned, a few firms enter this market structure, as the barriers to entry are high. The product is either homogeneous or differentiated.
- Monopoly means that only one firm is present in the market. Barriers to entry and exit are very high and the product offered by the firm is unique.
- In equilibrium, marginal revenue is equal to marginal cost. Only in the case of perfect competition marginal revenue is equal to price. Under other market structures price is higher than marginal revenue.
- In perfect competition, firms realize no economic profit.
- In oligopoly, collusion occurs when producers agree to have market shares divided among them in order to maximize total profit in the industry.
- In oligopoly, a dominant firm model is observed when one firm has a dominant position in the market and maximizes its profits at a particular price. Other companies are price takers.
- According to Cournot assumption each company assumes that its competitors will not change the output if the company changes its output.
- In monopoly, first-degree price discrimination* is when the monopolist takes all consumer surplus.
- In monopoly, second-degree price discrimination is when the product is offered in different versions.
- In monopoly, third-degree price discrimination* is when consumers are segregated by demographic, geographic, or other dimensions.
- The Herfindahl-Hirschman index (HHI) is an index where the market shares of the top N companies are first squared and then added.