Market structure is determined by the number and size distribution of firms in a market, entry conditions, and the extent of product differentiation. The major types of market structure include the following:
- Monopoly: An industry structure where a single firm produces a product for which there are no close substitutes. Monopolists are price makers. Barriers to entry and exit exist, and, in order to ensure profits, a monopoly will attempt to maintain them.
- Monopolistic competition: A market structure in which there is a large number of firms, each having a small portion of the market share and slightly differentiated products. There are close substitutes for the product of any given firm, so competitors have slight control over price. There are relatively insignificant barriers to entry or exit, and success invites new competitors into the industry.
- Oligopoly: An industry structure in which there are a few firms producing products that range from slightly differentiated to highly differentiated. Each firm is large enough to influence the industry. Barriers to entry exist.
- Perfect competition: An industry structure in which there are many firms, none large enough to influence the industry, producing homogeneous products. Firms are price takers. There are no barriers to entry. Agriculture comes close to being perfectly competitive.
Perfect competition leads to the Pareto-efficient allocation of economic resources. Because of this it serves as a natural benchmark against which to contrast other market structures. However, in practice, very few industries can be described as perfectly competitive. Nevertheless, it is used because it provides important insights.
A perfectly competitive market has several important characteristics:
- All producers contribute insignificantly to the market. Their own production levels do not change the supply curve.
- All producers are price takers. They cannot influence the market. If a firm tries to raise its price consumers would buy from a competitor with a lower price instead.
- Products are homogeneous. The characteristics of a good or service do not vary between suppliers.
- Producers enter and exit the market freely.
- Both buyers and sellers have perfect information about the price, utility, quality, and production methods of products.
- There are no transaction costs. Buyers and sellers do not incur costs in making an exchange of goods in a perfectly competitive market.
- Producers earn zero economic profits in the long run.