Source: Microeconomic Theory, Texas A&M University
Tags: market structures, perfect competition, monopoly, oligopoly, monopolistic competition, imperfect competition, concentration ratio, HHI, Herfindahl-Hirschman Index, price taker, price setter, market power, barriers to entry
Market structures range from perfect competition (many firms, no market power) to monopoly (one firm, full market power). Most real industries sit between these extremes in what economists call imperfect competition, which includes monopolistic competition and oligopoly. Concentration ratios and the HHI are the standard tools for measuring how concentrated a market is.
Perfect competition
A market with many buyers and sellers of an identical product, where every participant has perfect information. Each firm is a price taker with zero market power.
Monopoly
A market with a single seller of a product that has no close substitutes. The firm is a price setter with full market power.
Oligopoly
A market dominated by a small number of large firms whose decisions are interdependent. Each firm must consider how rivals will respond to its pricing and output choices.
Monopolistic competition
A market with many firms selling differentiated (but substitutable) products, with relatively free entry and exit.
Imperfect competition
Any market structure between perfect competition and monopoly. Covers both oligopoly and monopolistic competition.
Market power
The ability of a firm to influence the price of its product. A firm with market power faces a downward-sloping demand curve rather than a horizontal one.
Price taker
A firm that has no influence over the market price and must accept whatever price the market dictates. Characteristic of perfect competition.
Price setter
A firm that can choose its own price because it faces a downward-sloping demand curve. Characteristic of monopoly and, to varying degrees, oligopoly and monopolistic competition.
Concentration ratio (4-firm, 8-firm)
The percentage of total market output (or revenue) produced by the top four or eight firms. Higher ratios signal greater market concentration.
Herfindahl-Hirschman Index (HHI)
The sum of the squared market shares of all firms in an industry. Ranges from close to 0 (highly competitive) to 10,000 (pure monopoly). The US Department of Justice uses HHI thresholds to evaluate mergers.
Barriers to entry
Anything that makes it difficult for new firms to enter a market, such as patents, large capital requirements, or economies of scale. Present in monopoly and oligopoly; largely absent in perfect competition and monopolistic competition.
The four main structures sit on a continuum defined by the number of firms, product differentiation, and barriers to entry:
Perfect competition sits at one end: many firms, identical products, perfect information, no barriers, zero long-run economic profit.
Monopoly sits at the other: one firm, unique product, high barriers, positive long-run economic profit.
Monopolistic competition and oligopoly fill the space between these two poles.
The key insight is that most real-world markets are imperfectly competitive.
Demand curve: horizontal for a perfectly competitive firm (price taker), downward-sloping for a monopolist (price setter).
Long-run profit: normal (zero economic) profit in perfect competition because entry erodes any short-run gains; positive economic profit in monopoly because barriers keep entrants out.
Market power: none under perfect competition; full under monopoly.
Two standard tools appear in this chapter:
Concentration ratios give a quick snapshot. A 4-firm ratio above 60% typically signals an oligopolistic market.
HHI is more sensitive to the distribution of market shares. An industry where four firms each hold 25% has an HHI of 2,500, whereas one where a single firm holds 97% and three hold 1% each has an HHI near 9,412, even though the 4-firm ratio is 100% in both cases.
Beer: 373 firms, 4-firm ratio 89.6, HHI > 2,000 – highly concentrated despite a large total number of firms.
Breakfast cereals: 35 firms, 4-firm ratio 85.0, HHI 2,909.
Household furniture: 15,898 firms, 4-firm ratio 16.7, HHI 94 – close to the competitive end.
Hospitals: 6,505 firms, 4-firm ratio 7.4 – very low concentration.
The takeaway: a high number of firms does not guarantee low concentration. What matters is how market share is distributed.
In an oligopoly, each firm's demand curve depends on how rivals react to its pricing decisions. The Apple/Amazon song-pricing example in the chapter illustrates three scenarios when Apple raises its price from $0.99 to $1.29:
If Amazon holds its price steady, Apple's sales drop significantly (movement along demand curve D₁, from point A to point B).
If Amazon matches the price increase, Apple's demand curve shifts right to D₂, and the sales drop is smaller (point A to point B').
If Amazon cuts its price in response, Apple's demand curve shifts left to D₃, and the sales drop is much larger (point A to point B'').
This interdependence is the defining feature of oligopoly and the reason game theory becomes essential for analysing it.
The LRATC (long-run average total cost) curve helps explain why some industries are oligopolies. If minimum efficient scale is large relative to total market demand, only a few firms can operate profitably, which naturally produces an oligopolistic structure.
In the chapter's example, if minimum LRATC is reached at 240 units and total market demand is 480, the market can only support about two efficient firms.
⚠️ Know the difference between concentration ratios and HHI, and when each is more informative. HHI captures the distribution of shares; concentration ratios do not.
⚠️ Be able to explain why a firm's demand curve is uncertain in oligopoly but not in perfect competition or monopoly.
⚠️ Understand that "imperfect competition" is the umbrella term for everything between the two extremes, not a synonym for monopolistic competition alone.
⚠️ The number of firms in a market does not by itself determine how competitive the market is. Distribution of market share matters more.
Q: What is the key difference between how a perfectly competitive firm and a monopolist face demand?
A: A perfectly competitive firm faces a perfectly horizontal (elastic) demand curve and takes the market price as given. A monopolist faces the entire downward-sloping market demand curve and can set its own price.
Q: Why does an oligopolist face an uncertain demand curve?
A: Because the quantity demanded at any price the oligopolist sets depends on how its rivals respond. Different rival responses shift the firm's demand curve to different positions.
Q: Two industries both have a 4-firm concentration ratio of 80%. Industry A has an HHI of 1,700 and Industry B has an HHI of 3,200. What does this tell you?
A: Industry B's market share is more unevenly distributed among its top firms (one or two firms dominate), even though the top four control the same percentage in both. HHI is more sensitive to this uneven distribution than concentration ratios.
Q: Why might economies of scale lead to oligopoly?
A: If minimum efficient scale is large relative to total market demand, only a small number of firms can produce at low enough average costs to be profitable. This naturally limits the number of viable competitors.
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