Market Structures & Contestability

The heart of Unit 3. The number and size of firms in a market shapes how they price, compete and perform. We move from the most competitive structure (perfect competition) to the least (monopoly), drawing each one.

Learning objectives — by the end of 3.3 you can…

- define the four types of efficiency and calculate concentration ratios; - draw and analyse perfect competition, monopolistic competition, oligopoly and monopoly; - use game theory and explain collusion, price and non-price competition; - explain monopsony, contestability and the role of sunk costs.

Efficiency & concentration ratios

Spec: 3.3.1

Concentration ratios

The n-firm concentration ratio is the combined market share of the largest n firms. A high ratio signals a concentrated market (oligopoly or monopoly).

Example: if the top four firms hold 30%, 25%, 20% and 10%, the 4-firm concentration ratio = 85% — a highly concentrated market.

Perfect competition

Spec: 3.3.2

Assumptions: many buyers and sellers; identical (homogeneous) products; freedom of entry and exit; perfect information. Firms are therefore price takers facing a horizontal demand curve where AR = MR = price. They profit-maximise at MC = MR.

In the short run a firm can earn supernormal profit. But freedom of entry means new firms are attracted in, driving the price down until — in the long run — only normal profit remains (price = minimum AC).

Monopolistic competition

Spec: 3.3.3

Assumptions: many firms, low barriers to entry and exit, and slightly differentiated products — so each firm has a little price-setting power and faces a downward-sloping demand curve. Differentiation can be physical (features), marketing (advertising, packaging) or distribution (shop, online, phone). Think restaurants, hairdressers and plumbers.

The short run can bring supernormal profit, but low barriers mean entry erodes it. In the long run the demand curve (AR) is pushed back until it is just tangent to AC — leaving only normal profit:

Oligopoly

Spec: 3.3.4

Assumptions: a few large firms dominate the market (high concentration ratio); high barriers to entry and exit; and crucially, interdependence — each firm must anticipate how rivals will react. Barriers include economies of scale, limit pricing, patents, branding, sunk costs and legal barriers.

The kinked demand curve explains why oligopoly prices are often "sticky". At the current price, demand is elastic above (raise price and rivals don't follow — you lose lots of sales) but inelastic below (cut price and rivals match you — you gain little). This creates a gap in the MR curve, so costs can change without changing the price:

Game theory models this interdependence. In a simple two-firm game, each firm chooses a high or low price, and the payoff (profit) depends on what the other firm does:

A two-firm pricing game (profits in $m)

| | Firm B: High price | Firm B: Low price | | --- | --- | --- | | Firm A: High price | A: 80 \| B: 80 | A: 40 \| B: 100 | | Firm A: Low price | A: 100 \| B: 40 | A: 60 \| B: 60 |

Whatever the rival does, each firm is tempted to choose low price — so both end up at (60, 60), worse than the (80, 80) they'd get by both pricing high. This is the prisoner's dilemma: a powerful incentive to collude, but an equally powerful incentive to cheat.

Collusion & competition

- Collusion: firms agree to fix prices or output (a cartel) to act like a monopoly. Price leadership is a tacit version. Collusion is usually illegal; it raises producer profits but harms consumers through higher prices and less choice. - Price competition: price wars, predatory pricing (pricing below cost to drive rivals out) and limit pricing (pricing low to deter entry). - Non-price competition: advertising and branding, quality, endorsements, product placement and after-sales service.

Evaluation — is oligopoly good or bad for consumers?

It depends. Collusion and high barriers can mean high prices and little choice. But fierce non-price competition and the supernormal profits that fund innovation (dynamic efficiency) can benefit consumers — think smartphones or supermarkets. The outcome hinges on how contestable the market is.

Monopoly & price discrimination

Spec: 3.3.5

Assumptions: a single dominant seller (pure monopoly = one firm; in practice, significant market power) protected by high barriers to entry. The monopolist is a price maker, profit-maximising where MC = MR and charging the price the demand curve will bear — which gives supernormal profit that persists because barriers keep rivals out.

Natural monopoly

A natural monopoly exists where economies of scale are so large (high fixed/infrastructure costs) that one firm can supply the whole market more cheaply than several — LRAC is still falling at the market's output. Competition would wastefully duplicate infrastructure. Examples: water, gas pipelines and rail networks. These are usually regulated.

Third-degree price discrimination

Charging different prices to different groups for the same product. It requires three conditions:

- the firm has price-setting power; - it can separate consumers into groups with different PEDs; - it can prevent resale between groups.

Examples: peak vs off-peak rail fares, student vs adult tickets. The firm captures more consumer surplus (higher profit); inelastic customers pay more, elastic customers less; output can rise.

Monopsony

Spec: 3.3.6

A monopsony is a single or dominant buyer in a market — for example a dominant employer in a town, or a large supermarket buying from farmers. Its buying power lets it drive down the price it pays.

Contestable markets

Spec: 3.3.7

A market is contestable when barriers to entry and exit are low, so the threat of new entry disciplines existing firms even if there are only a few of them. In a perfectly contestable market, the mere possibility of "hit-and-run" entry forces incumbents to keep prices and profits low.

Implications & the role of sunk costs

- Incumbents hold prices and profits down (toward normal profit) and may use limit pricing to deter entry — so behaviour matters more than the number of firms. - Sunk costs are costs that cannot be recovered on exit (specialised equipment, advertising). High sunk costs reduce contestability (they deter entry); low sunk costs raise it.

Exam Tip

Contestability is the great evaluation lever in 3.3. Even a monopoly may behave well if its market is contestable — so when judging market power, always ask: how easy is it for new firms to enter and exit?

3.3 Recap — nail these

Efficiency: allocative (P=MC), productive (min AC), dynamic, X-inefficiency; concentration ratios measure dominance.
Perfect competition: price taker; SR supernormal → LR normal profit; efficient.
Monopolistic competition: differentiated; LR normal profit; excess capacity.
Oligopoly: interdependence, kinked demand, game theory, collusion, price & non-price competition.
Monopoly: price maker; supernormal profit; allocatively inefficient; natural monopoly; price discrimination.
Monopsony = dominant buyer; contestability & sunk costs discipline behaviour.