Market structure | IGCSE Class 10 Economics Notes

This note covers what a competitive market is, how a large number of firms affects price, product quality, consumer choice and firm profit, what a monopoly market is, the characteristics of a monopoly, and the advantages and disadvantages of monopoly for consumers, firms and the economy.

What is a competitive market?

Defining features

A competitive market is one in which a large number of independent firms sell to a large number of buyers, so that no single firm or buyer is big enough to control the market price.

Such a market typically has four defining features: a large number of buyers and sellers, a product that buyers see as broadly similar across firms, freedom for new firms to enter and for existing firms to leave, and buyers who are well informed about prices and quality on offer.

Free entry and exit are essential to keeping a market competitive. If entry is easy, new firms are attracted into the market whenever existing firms are earning unusually high profits, and this flow of new firms is what keeps the number of sellers large and keeps any one firm from gaining power over price.

Price-taking behaviour

Because no individual seller is large relative to the whole market, each firm is, in effect, a price taker: it cannot charge more than the going market price without losing its customers to rivals, since buyers can simply switch to another firm selling an almost identical product.

At the same time, a firm does not need to charge less than the market price, because at that price it can already sell as much as it is able to produce.

This price-taking behaviour is the single most important feature that distinguishes a highly competitive market from one dominated by a few large firms.

How does a large number of firms affect price?

Why firms cannot raise price

When many firms compete to sell a similar product, each firm must set its price close to what every other firm is charging.

A firm that tried to charge a noticeably higher price would find buyers switching to the many other sellers offering the same thing more cheaply, and since there are so many alternative sellers, buyers can switch without difficulty.

A firm therefore has very little market power to raise price above the level set by the market as a whole.

The entry and exit mechanism

This downward pressure on price is strengthened by free entry. If firms already in the market are earning high profits at the prevailing price, new firms are attracted in by the chance of sharing those profits.

As more firms enter and compete for the same buyers, the market price is pushed down further, towards the level that just covers the cost of production.

The result, over time, is that prices in a highly competitive market tend to be lower, and closer to the cost of supplying the good, than they would be if only a few firms controlled the market.

The reverse process also matters. If too many firms enter and the market price falls below what some of them need to cover their costs, the least efficient firms tend to exit the market, which removes some sellers and allows price to recover slightly, so that over time price settles at a level that keeps a large, but not unlimited, number of firms in business.

Draw the number of firms competing in a market on the horizontal axis and the market price on the vertical axis. Sketch a downward-sloping curve that starts high when there are very few firms and flattens out close to the cost of supply once the number of firms becomes very large, showing that extra competition has a smaller and smaller effect on price once a market is already highly competitive.

How does a large number of firms affect quality and choice?

Pressure on quality

With many sellers offering buyers a choice, each firm has an incentive to attract and keep customers by improving the features, reliability or service that accompany its product, since a buyer who is dissatisfied with one firm can readily take their business elsewhere.

This pressure to satisfy customers, so as not to lose them to a rival, tends to keep quality higher than it would be if buyers had nowhere else to go.

A firm whose quality falls below what buyers expect risks losing sales quickly in a market with many sellers, because dissatisfied buyers do not have to tolerate poor quality; they simply buy from a rival firm instead.

Range of choice

A large number of firms also means buyers have a wide range of sellers, and often of slightly different versions of the product, to choose from.

A buyer who prefers a particular feature, location or level of service can seek out the firm that best meets their needs, rather than having to accept whatever a single supplier provides.

Greater consumer choice is therefore closely linked to having many competing sellers in a market, and perfect information about prices and quality helps buyers to make the comparisons on which this choice depends.

In this way, the large number of firms acts almost like a constant check on every individual seller, rewarding those that keep their product reliable and well suited to what buyers want, and taking custom away from those that do not.

What is the effect of a large number of firms on profit?

Why high profit cannot persist

In a market with many firms and free entry, profit above what is needed to keep a firm in business cannot usually persist for long.

If firms are earning more than this minimum, the prospect of similar profits draws in new firms; as these new entrants compete for the same customers, the market price is driven down and existing firms' profits fall back towards the level needed just to keep them operating, no more.

A firm that manages to produce at lower cost than its rivals can still earn somewhat higher profit for a time, but as other firms copy its methods or as new firms enter hoping to share in that advantage, this extra profit tends to be squeezed down again.

Why losses cannot persist

Equally, if firms in the market were making losses, free exit allows some of them to leave, which reduces the number of sellers and allows prices, and therefore profits for the remaining firms, to recover.

This two-way movement of firms in and out of the market is what tends to hold profit at a normal level over time in a genuinely competitive market, in contrast with a market that only one or a few firms can enter.

This constant pressure towards a normal profit level is one reason competitive markets are generally seen as working well for consumers: it stops any single firm from keeping unusually high profit for very long at the expense of buyers.

What is a monopoly market?

Definition: Monopoly. A monopoly is a market structure in which a single firm is the only seller of a good or service that has no close substitutes, so that the firm faces no direct competition from rival sellers.

A single seller

A monopoly sits at the opposite end of the scale from a competitive market. Instead of many firms each with very little power over price, a monopoly has one firm that supplies the whole market.

Because buyers have no alternative seller to turn to for that particular good or service, the monopolist is described as a price maker rather than a price taker: it can choose the price at which it sells, within the limits set by how much buyers are willing and able to pay at different prices.

Barriers to entry

Monopolies arise and persist because of barriers to entry, obstacles that stop other firms from entering the market and competing away the monopolist's position.

These barriers can take several forms, including a sole legal right to supply a service, ownership or control of an essential resource, or a market that is only large enough to support one efficient supplier, such as the single network needed to deliver electricity, water or rail transport to an area.

What are the characteristics of a monopoly?

Key characteristics

A monopoly market can be recognised by a small number of linked characteristics that together set it apart from a competitive market.

• A single seller supplies the entire market for the good or service, so there is no rival firm offering the same product to the same buyers.
• The product has no close substitutes, meaning buyers cannot easily turn to a different good to meet the same need.
• Barriers to entry prevent other firms from entering the market, so the monopolist's position is protected rather than being open to challenge.
• The firm is a price maker, able to set its own price rather than having the price determined for it by the actions of many competing sellers.
• Buyers generally have limited choice, since they must either buy from the monopolist on the terms it offers or go without the product altogether.

How the characteristics interact

These characteristics tend to reinforce one another. Because there is only one seller and no close substitute, buyers have no practical way of disciplining the firm by switching elsewhere, which is exactly what gives the monopolist its power to act as a price maker rather than a price taker.

It is the combination of a single seller, no close substitutes and barriers to entry, rather than any one feature alone, that makes a market a monopoly in the way economists use the term.

What are the advantages of monopoly?

Economies of scale and investment

A monopoly is not always harmful, and in certain circumstances a single large supplier can bring real benefits that a market of many small firms could not easily provide.

• A monopolist that produces on a very large scale can often benefit from economies of scale, spreading fixed costs, such as those of a national pipeline or electricity grid, over a very large output and so lowering the average cost of each unit supplied.
• A monopoly protected from competition, for example by a patent, may have both the funds and the certainty of keeping the reward from its own effort that are needed to invest heavily in research and development, which smaller rival firms competing on thin profit margins might not be able to afford.

Avoiding duplication and ensuring consistency

• Where a good or service is naturally supplied more efficiently by one firm than by several, such as a water or rail network, a monopoly avoids the costly duplication of having several competing firms each build their own separate network.
• A single supplier can offer a more consistent and standardised product or service across the whole market, which can be useful where uniformity, such as a single national postage rate, is itself valuable to users.

What are the limitations of monopoly?

Effects on price, output and efficiency

Alongside these possible benefits, a monopoly carries limitations that explain why most governments keep a close watch on monopolies and sometimes act to control them.

• Because the monopolist faces no rival sellers, it can set a higher price and supply a lower output than would be the case in a competitive market, so that buyers generally pay more and obtain less of the good than they otherwise would.
• With no competitor to lose customers to, a monopolist has less pressure to keep its costs down or to innovate, which can lead to complacency and a less efficient use of resources than in a market with many rival firms.

Effects on choice and exploitation of consumers

• Buyers face limited choice, since there is only one seller to deal with, and no alternative supplier whose price, quality or service they can compare it against.
• A monopolist's market power creates the possibility of exploiting consumers, for example by charging a price well above the cost of supply, because buyers who need the good have nowhere else to turn.

Draw output on the horizontal axis and price on the vertical axis. Mark a higher price and a lower level of output for the single firm in a monopoly, and a lower price with a higher level of output for the many firms together in a competitive market, to show how buyers generally pay more and receive less when one firm controls the whole market.

These limitations are the main reason some monopolies are regulated rather than simply left to charge whatever price they choose, especially where the good or service, such as water or electricity, is one that households cannot easily do without.

How do competitive markets and monopoly markets compare?

Summary table

A competitive market and a monopoly market sit at opposite ends of the same spectrum of market structures, differing mainly in how many firms supply the market and how much power any one firm has over price.

The table below summarises the main differences between the two market structures described in this unit.

Markets in between

Most real markets fall somewhere between these two extremes, with more than one seller but fewer than the very large numbers assumed in a fully competitive market, so the features in the table are best treated as the two ends of a range rather than the only two possibilities.

What matters for buyers, in either case, is how much market power the firm or firms have over price, how easily new sellers can enter if existing firms raise prices too far, and how much consumer choice is actually available when a buyer is dissatisfied with what one seller offers.

Going beyond the syllabus

A government that is concerned about a harmful monopoly does not have to leave it unchecked.

Some governments regulate the prices a monopoly may charge, especially for an essential service such as water or electricity supplied over a single network; others require a dominant firm to allow rival firms access to its network on fair terms, or break up a monopoly into separate competing firms where this is practical.

The choice between these approaches generally depends on whether the monopoly's size brings genuine economies of scale worth keeping, or whether it mainly allows the firm to charge consumers more than is justified.

A government can also choose simply to monitor a monopoly without regulating it directly, requiring the firm to publish information on its prices, costs and profits so that excessive charges become visible and can be challenged, rather than imposing a price limit from the outset.

In practice, a market structure is rarely a fixed label for life: a market that is highly competitive today can become dominated by one or two large firms over time if some firms grow much larger or merge together, and a market once protected by a barrier to entry can become more competitive if that barrier, such as a patent, expires or a new technology makes the old barrier less effective.

Glossary

• Competitive market — a market with a large number of independent buyers and sellers, so that no single firm controls the price.
• Price taker — a firm that must accept the market price because it is too small, relative to the whole market, to influence it.
• Price maker — a firm with enough market power to choose the price at which it sells, rather than having to accept a price set by competition.
• Homogeneous product — a good that buyers see as essentially identical however and by whomever it is produced.
• Free entry and exit — the freedom of new firms to enter a market, and of existing firms to leave it, without unusual obstacles.
• Perfect information — a situation in which buyers and sellers are fully aware of the prices and quality on offer across the market.
• Monopoly — a market with a single seller of a good or service that has no close substitutes.
• Barriers to entry — legal, physical or economic obstacles that stop new firms from entering a market and competing with an established firm.
• Economies of scale — reductions in the average cost of production that come from producing on a larger scale.
• Consumer choice — the range of different sellers or product variants available to a buyer in a market.
• Normal profit — the minimum level of profit needed to keep a firm in its current line of business.
• Natural monopoly — a market that is most efficiently supplied by a single large firm because of the scale of the network or infrastructure involved.

Common errors and misconceptions

• Misconception: a monopoly always charges whatever price it likes with no limit. Correct: a monopolist is still limited by how much buyers are willing and able to pay; charging too high a price can reduce the quantity bought.
• Misconception: a competitive market always means dozens of tiny identical firms with no differences at all. Correct: what matters is that no single firm is large enough to control the price and that entry is free, not that firms are literally identical in every respect.
• Misconception: monopoly is always bad for consumers. Correct: a monopoly can sometimes bring lower costs through economies of scale or fund research that a competitive market could not support, alongside its usual drawbacks.
• Misconception: barriers to entry only mean legal restrictions, such as a licence. Correct: barriers to entry can also be economic, such as the very large scale needed to supply a network efficiently, or control of an essential resource.
• Misconception: in a competitive market, firms earn no profit at all. Correct: firms in a competitive market can still earn normal profit, which is enough to keep them in business; it is unusually high profit above this that tends to be competed away.
• Misconception: a monopolist has no reason ever to innovate. Correct: a monopolist protected by patents may have both the funds and the security to invest heavily in research, even though it also faces less pressure to do so than a firm under competition.
• Misconception: more firms in a market always means higher quality for buyers. Correct: more firms give buyers more choice and put pressure on firms to satisfy customers, but quality still depends on what buyers actually value and reward with their custom.

Exam-style questions with model answers

Q1. Define a monopoly market. [2 marks]

1. A monopoly is a market structure in which a single firm is the only seller of a good or service that has no close substitutes, so buyers have no alternative supplier to turn to.

Q2. State two characteristics of a highly competitive market. [2 marks]

1. A large number of independent buyers and sellers, none of whom is big enough to control the market price.
2. Freedom for new firms to enter the market and for existing firms to leave it.

Q3. A market for a basic foodstuff has 200 small firms, each selling an almost identical product, with no restrictions on new firms joining. Explain two effects this large number of firms is likely to have on price and on consumer choice. [4 marks]

1. Price: because buyers can easily switch between the many sellers offering the same product, no single firm can charge noticeably more than the others without losing customers, so prices across the market are pushed down towards the cost of supply.
2. Choice: with 200 sellers to pick from, buyers are not dependent on any one firm and can seek out whichever seller offers the terms, location or service that suits them best, giving buyers much greater choice than a market with few sellers.

Q4. Explain two advantages a monopoly supplying a national water network might bring. [4 marks]

1. Economies of scale: spreading the very high fixed cost of building and maintaining a single national network over a large output can lower the average cost of supplying each household, a saving that might not be available if several firms each built their own separate network.
2. Avoiding duplication: having one firm supply the whole network avoids the wasteful cost of several competing firms each digging up roads and laying parallel pipes to reach the same households.

Q5. State one reason why a firm in a highly competitive market is described as a price taker. [2 marks]

1. Because there are so many other firms selling an almost identical product, a firm that set its price above the market price would lose its customers to rivals, so it must accept the price set by the market as a whole.

Q6. In a market with a single national electricity supplier protected by law from competition, explain why the firm is described as a price maker rather than a price taker. [3 marks]

1. Because it is the only seller, buyers have no alternative firm to switch to if the price rises.
2. The legal protection from competition acts as a barrier to entry, stopping rival firms from entering and undercutting its price.
3. As a result, the firm itself can choose the price it charges, within the limits of what buyers are able and willing to pay, rather than having the price forced on it by competing sellers.

Q7. A country is deciding whether to allow a single firm to remain the only supplier of its railway network, rather than opening the network to several competing firms. Discuss whether the government should keep the network as a monopoly. [6 marks]

1. In favour of keeping the monopoly: a single national network can benefit from economies of scale, spreading the very high fixed cost of track and signalling over the whole country's traffic, which may lower the average cost per journey.
2. In favour of keeping the monopoly: one firm avoids the wasteful duplication of several competitors each trying to build parallel track along the same routes.
3. Against keeping the monopoly: with no rival firm to lose passengers to, the single supplier faces less pressure to keep fares low, improve punctuality or raise service quality.
4. Against keeping the monopoly: passengers have no alternative railway firm to choose if they are dissatisfied, unlike in a market with several competing sellers.
5. Overall judgement: the case for keeping it as a monopoly is stronger where the economies of scale from a single network are large, but is weaker if there is clear evidence the firm is charging high fares or providing poor service because it faces no competition; a government might instead regulate the monopoly's prices rather than force full competition.

Key takeaways

• A competitive market has a large number of firms, a broadly similar product, free entry and exit, and well-informed buyers, which together make each firm a price taker.
• A large number of competing firms tends to push prices down towards the cost of supply, since no single firm can charge much more than its rivals without losing customers.
• Many sellers competing for the same buyers give consumers a wide choice and put pressure on firms to maintain quality.
• Free entry and exit tend to pull profit in a competitive market towards the normal level needed to keep firms in business.
• A monopoly is a market with a single seller of a good or service that has no close substitutes, protected by barriers to entry.
• A monopoly is a price maker, able to set its own price, unlike the price-taking firms of a competitive market.
• Monopoly can bring economies of scale, funds for research, and the avoidance of wasteful duplication of networks.
• Monopoly can also mean higher prices, lower output, limited consumer choice and less pressure on the firm to be efficient.

Test yourself

Why is a firm in a competitive market called a price taker?

Because there are so many rival sellers of an almost identical product that a firm cannot charge more than the market price without losing its customers to those rivals.

What tends to happen to profit in a competitive market if existing firms are earning unusually high profits?

New firms are attracted into the market by those high profits; as they enter and compete for customers, prices and profits are pushed back down towards the normal level.

Name two features that make a market highly competitive.

A large number of buyers and sellers, and free entry and exit for firms, are two of the main defining features.

What is a barrier to entry?

An obstacle, such as a legal restriction, control of an essential resource, or the very large scale needed, that stops new firms from entering a market.

Why can a monopolist choose its own price, unlike a firm in a competitive market?

Because it is the only seller of a good with no close substitutes, so buyers have no alternative firm to switch to if the price rises.

Give one advantage and one disadvantage of a monopoly.

Advantage: it may achieve economies of scale that lower average costs. Disadvantage: it can charge a higher price and supply less, with buyers having no alternative seller.

Why might a monopoly avoid wasteful duplication?

Because only one firm builds and operates the network, such as a railway or pipeline, rather than several competing firms each building their own parallel version.