Market Models: Pure Competition, Monopolistic Competition, Oligopoly, and Pure Monopoly

A modern economy has many different types of industries. However, an economic analysis of the different firms or industries within an economy is simplified by first segregating them into different models based on the amount of competition within the industry. There are 4 basic market models: pure competition, monopolistic competition, oligopoly, and pure monopoly. Because the competition among the last 3 categories is limited, these market models are often referred to as imperfect competition.

In a purely competitive market, there are large numbers of firms producing a standardized product. Market prices are determined by consumer demand; no supplier has any influence over the market price, and thus, the suppliers are often referred to as price takers. The primary reason why there are many firms is because there is a low barrier of entry into the business. The best examples of a purely competitive market are agricultural products, such as corn, wheat, and soybeans.

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Monopolistic competition is much like pure competition in that there are many suppliers and the barriers to entry are low. However, the suppliers try to achieve some price advantages by differentiating their products from other similar products. Most consumer goods, such as health and beauty aids, fall into this category. Suppliers try to differentiate their product as being better so that they can justify higher prices or to increase market share. Monopolistic competition is only possible, however, when the differentiation is significant or if the suppliers are able to convince consumers that they are significant by using advertising or other methods that would convince consumers of a product's superiority. For instance, suppliers of toothpaste may try to convince the public that their product makes teeth whiter or helps to prevent cavities or periodontal disease.

An oligopoly is a market dominated by a few suppliers. Although supply and demand influences all markets, prices and output by an oligopoly are also based on strategic decisions: the expected response of other members of the oligopoly to changes in price and output by any 1 member. A high barrier to entry limits the number of suppliers that can compete in the market, so the oligopolistic firms have considerable influence over the market price of their product. However, they must always consider the actions of the other firms in the market when changing prices, because they are certain to respond in a way to neutralize any changes so that they can maintain their market share. Auto manufacturers are a good example of an oligopoly, because the fixed costs of automobile manufacturing are very high, thus limiting the number of firms that can enter into the market.

A pure monopoly has pricing power within the market. There is only one supplier who has significant market power and determines the price of its product. A pure monopoly faces little competition because of high barriers to entry, such as high initial costs, or because the company has acquired significant market influence through network effects, such as Facebook, for instance.

One of the best examples of a pure monopoly is the production of operating systems by Microsoft. Because many computer users have standardized on software products that are compatible with Microsoft's Windows operating system, most of the market is effectively locked in, because the cost of using a different operating system, both in terms of acquiring new software that will be compatible with the new operating system and because the learning curve for new software is steep, people are willing to pay Microsoft's high prices for Windows.

The 1st diagram shows consumer and producer surplus under pure competition. An oligopoly or monopoly can increase profits (Pe to Pm) by reducing supplies (Qe to Qm), which increases prices. This is reflected as an additional producer surplus, which comes at the expense of lower consumer surplus for the buyers of the product. Additionally, some consumers will not buy the product because of the higher price, which is the area #1 in the diagram. Additionally, some producer surplus is lost because there are fewer suppliers. The producer surplus that would've been earned by the suppliers in the market if it were a competitive market is shown as area #2 in the diagram. The combined areas of losses equal the deadweight loss to the economy, the reduction in total surplus, that results from the oligopoly or monopoly restricting supply, so as to raise prices.

Note that, in the above schematic diagrams, consumer and producer surplus may not be equal in a competitive market, since that will depend on the relative elasticities of supply and demand, but total surplus will be maximized in a competitive market and reduced in an imperfectly competitive market; this reduction is the deadweight loss of imperfect competition.

Pure Competition Is Best for the Consumer

From the consumer point of view, pure competition is the best type of market, because it gives consumers the greatest consumer surplus and maximizes total surplus for the economy. From an economic standpoint, pure competition is also the easiest model to analyze, so this is the first market model that will be covered in depth.