Microeconomics studies the behavior of individuals and firms in making decisions regarding the distribution of scarce resources and the relations among these individuals and firms. Microeconomics examines the market mechanisms that establish relative prices among goods and services and allot limited resources among alternate uses. Microeconomics shows conditions under which free markets lead to desirable allocations. It also studies market failure, where markets fail to produce effective results.
There are different types of markets depending on the number of firms in the market, the ease of entering the market and the degree to which products sold are similar. There are four main basic types of market structure in economics. Each of them has their own set of characteristics and assumptions, which affects the decision-making of firms and the profits they can reap. However, not all of these structures of microeconomic markets really exist in actuality, some of them are just theoretic concepts. Nonetheless, they are of vital significance because they can explain applicable characteristics of competition firms’ decision-making.
Perfect competition describes a market structure, where a large number of small firms compete against each other. In this situation, a single firm does not have any major market power. As a result, the industry as a whole produces the socially optimal level of output, because none of the firms have the ability to influence market prices.
The idea of perfect competition builds on a number of assumptions: (1) all firms maximize profits (2) there is free entry and exit to the market, (3) all firms sell completely identical (i.e. homogeneous) goods, (4) there are no consumer preferences. By looking at those assumptions it becomes quite obvious, that we will hardly ever find perfect competition in reality.
Monopolistic competition also refers to a market structure, where a large number of small firms compete against each other. However, unlike in perfect competition, the firms in monopolistic competition sell similar, but slightly differentiated products. This gives them a certain degree of market power which allows them to charge higher prices within a certain range.
Monopolistic competition builds on the following assumptions: (1) all firms maximize profits (2) there is free entry and exit to the market; (3) firms sell differentiated products (4) consumers may prefer one product over the other. These assumptions are a little nearer to reality than the ones we looked at in perfect competition. However, this market structure will no longer result in a socially optimal level of output, because the firms have more power and can impact market prices to a certain degree.
An oligopoly describes a market structure which is dominated by only a small number of firms. This results in a state of limited competition. The firms can either compete against each other or collaborate. By doing so they can use their collective market power to drive up prices and earn more profit.
The oligopolistic market structure builds on the following assumptions: (1) all firms maximize profits, (2) oligopolies can set prices, (3) there are difficulties to entry and exit in the market, (4) products may be homogeneous or differentiated, and (5) there are only a few firms that control the market.
A monopoly refers to a market structure where a single firm controls the entire market. In this scenario, the firm has the highest level of market power, as consumers do not have any alternatives. Monopolists often reduce output to increase prices and earn more profit.
The following assumptions are made about monopolies: (1) the monopolist maximizes profit, (2) it can set the price, (3) there are high barriers to entry and exit, (4) there is only one firm that dominates the entire market.