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Market structures

How much power a firm has over its price depends on how many competitors it faces and how different its product is. Market structure is the name for that spectrum, from perfect competition to monopoly.

Perfect competition

Many small firms sell an identical product, so each is a price taker: its demand curve is flat at the market price and P = MR. It maximizes profit where MR = MC, so P = MC. Economic profit is (P − ATC) × Q.

Profit attracts entrants, market supply rises and the price falls. Losses push firms out, supply falls and the price rises. The long-run treadmill stops where price equals the minimum of ATC: zero economic profit, and nobody has a reason to move.

Monopolistic competition

Many firms sell differentiated products, such as restaurants or clothing brands. Each faces a downward-sloping demand curve, so MR is below price and the firm charges more than marginal cost. Profits attract entry, which shifts each firm's demand left until economic profit is zero. The firm ends up producing less than the output that would minimize ATC (excess capacity) and still charging a price above MC.

Monopoly

A single seller faces the whole market's downward-sloping demand, so MR lies below the demand curve. It produces where MR = MC and charges the price on the demand curve at that quantity, which is above MC. Compared with competition, output is lower, the price is higher and there is a deadweight loss. Barriers to entry let profit survive in the long run.

Regulating a natural monopoly

When large fixed costs and a low marginal cost make one firm the cheapest way to serve a market (utilities, rail), regulators pick a pricing rule:

• Unregulated: the monopoly price. Big profit, low output.
• Average-cost pricing (P = ATC): zero economic profit and the firm survives, though some deadweight loss remains.
• Marginal-cost pricing (P = MC): the efficient quantity, but because MC is below ATC the firm makes a loss and needs a subsidy.

Common exam traps

• Reading the monopoly price off the MR = MC point. Find the quantity there, then go up to the demand curve for the price.
• Treating zero economic profit as zero accounting profit. Economic profit already counts the owner's opportunity cost.
• Forgetting that marginal-cost pricing leaves a natural monopoly with a loss.

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