180

21 Market
Structures
What types of market structure are identified by neoclassical theory?
Are competitive markets ideal?
What policies are necessary for imperfectly competitive markets?

Consumer behaviour and business behaviour cannot be understood independently of each

other. Consumers buy from businesses, and firms must have customers for their products. How
best to understand those interactions? The neoclassical economic stance is distinctive, using
models of different market structures to analyse the interconnections of demand and supply.
Particular emphasis is placed on how competitive markets differ from less competitive ones.
Four categories of market structure are distinguished: perfect competition, monopolistic
competition, oligopoly, and monopoly. Almost without exception, neoclassical economics
textbooks contain a chapter on each, describing their characteristics in detail and adapting
the analysis introduced in the preceding chapter of this book to examine the different
equilibrium conditions. We can do that more summarily here, revealing the distinctive
character of these neoclassical concerns, examining the implications for public policy, and
teasing out the underlying assumptions about the nature of competition and economic power.
In this way, a political economic perspective on the neoclassical theory of market structures
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can be developed.

Perfect competition
Table 21.1 shows the three bases on which the four types of market structure are defined: the
number of sellers, the nature of the products supplied, and the entry conditions.
Perfect competition is the usual starting point. This theoretical model is at the heart
of neoclassical economics. It is the extreme case, where the number of firms is so large and
the product each makes so uniform that no single firm can affect the price of its products.
Consumers cannot distinguish between the products made by the different producers. As a
result, each firm has to accept the prevailing market price and simply decide how much to

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produce and sell at that price. Since there are no barriers to the entry of new firms, the existing
firms cannot make profits over and above the bare minimum needed to maintain the existence
of the industry in the long run.

Table 21.1 A general classification of market structures

Type of market Number of sellers and

situation importance of each
Perfect A large number of sellers,
competition each accounting for a very
small proportion of the total
output of the industry
Monopolistic Normally fewer sellers than
competition under perfect competition,
but the proportion of output
supplied by each is still
relatively small
Oligopoly A few important sellers
accounting for a large
proportion of the total output
Perfect One seller
monopoly
Nature of products supplied Entry conditions
Homogeneous (i.e., perfectly No restriction on entry
substitutable products supplied of new firms
by each firm)
Although broadly substitutable, Usually no restriction
the products are differentiated on entry
from one another
The products are normally Usually some restriction
differentiated (e.g., according to on entry
brand names)
No directly competitive product Some restriction
(otherwise the
monopoly will only be
temporary)

Is perfect competition an ideal market structure? It is certainly not ideal from the
viewpoint of the firms themselves. They must strive continuously to minimise their costs for
fear of being driven out of business by more efficient rivals. They have no customers on whose
loyalty they can rely. Even if they do stay in business, in the long run their profits will be
minimal. This is a business nightmare. On the other hand, from the consumers’ point of view
it seems to be a very attractive scenario. Consumers are well served by a multitude of firms
who compete with one another for market share and keep product prices at the lowest possible
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level, given the current state of technology and the costs of the factors of production.
How is that market price for the product determined? The neoclassical answer is simple:
by the principle of demand and supply. As noted in Chapter 18, this is the ubiquitous principle
said to be continuously reconciling the interests of buyers and sellers in the marketplace. The
aggregate (industry) demand curve is derived as the sum of all individual consumer demand
curves for the product in question. It shows how much the consumers as a whole are willing
to buy at different market prices for the product. The aggregate supply curve is derived, by
similar reasoning, from the sum of individual producers’ marginal cost curves. It shows how
much will be on the market at various market prices. Putting the aggregate demand and supply
curves together enables us to identify the market-clearing price. This price continually adjusts
to changes in demand and supply, restoring equilibrium.

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Perfect competition is seldom found in the real world, however. Some markets for
agricultural products, where a large number of small farmers produce an identical crop and
where there are low barriers to entry (for example, just the initial cost of acquiring the
necessary land and tools), may approximate it. Some financial markets, where numerous buyers
and sellers are each too small to influence market prices, may have some of these competitive
characteristics, too. But these are exceptional instances.
The centrality of perfect competition theory in neoclassical economics has less to do
with its practical relevance than with its analytical elegance and its posited ideal normative
properties. Perfectly competitive markets are held to be ideal because they ensure maximum
efficiency in the use of factors of production, continuous adjustment of market prices to
changes in the conditions of demand and supply, and the elimination of any excess profits that
would result from the exercise of monopoly power. Perfect competition is not a common market
structure in practice because it is normally in the interest of firms to try to deviate from this
ideal. They differentiate their products, seek to establish customer loyalty, and erect barriers
to the entry of potential competitors. Such business behaviour tends to result in monopolistic
competition, oligopoly, or monopoly.

Monopolistic competition
The smallest deviation from the perfectly competitive extreme takes us into the realm of
monopolistic competition. In this market situation there is still a large number of firms, but
there is some degree of product differentiation. In monopolistic competition, the consumers
can tell the difference between the products of the various firms in the industry, although they
are usually broadly substitutable in practice. All petrol stations sell essentially the same fuel,
but they may be differentiated in the eyes of consumers according to the convenience of their
location or the friendliness of their staff. Similarly, all chemist shops sell essentially the same
pharmaceutical products, but may differ in the perceived attractiveness of their premises, the
helpfulness of the resident pharmacist, or—again—their location.
Location is perhaps the most pervasive form of product differentiation leading to
monopolistic competition. If convenience of access is relevant to consumer choice (as it usually
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is), a situation that might otherwise tend towards perfect competition almost invariably
becomes monopolistic competition in practice. Indeed, one may reasonably conclude that,
because a spatial dimension exists in virtually all economic behaviour in the real world,
perfect competition is a logical impossibility. Even the development of modern information
technologies and increasingly rapid means of transport does not wholly eradicate the tyranny
of distance. Goods purchased on the internet still have to be physically transported to the
consumer. In practice, monopolistic competition is about as competitive as markets usually get.
The possibility of persistent economic inefficiency exists in such a market structure,
for product differentiation may cause duplication and waste of resources. Do we need petrol
stations on each corner at major road intersections? Do we want chemist shops clustered in
the high street, while outlying areas are less well served? Are economic resources wasted on
product differentiation that is sometimes of a spurious nature? Such deviations from the norm

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of perfect competition are commonly regarded as drawbacks of monopolistic competition,

although neoclassical economists usually regard them as relatively unimportant so long as the
barriers to entry of new firms are low. It is the latter aspect—competition from potential new
entrants to the industry—that is said to keep existing firms on their toes and to inhibit the
tendency to excessive waste.

Oligopoly
Oligopoly involves a more major departure from the perfectly competitive norm. This is
a market structure in which there are relatively few firms in an industry, and each usually
produces differentiated (brand-named) goods or services, the prices of which are directly
under the control of the firms themselves. New firms have difficulty coming into the industry,
either because of the inherent difficulties of establishing sufficiently large productive
capacity or because the collusive practices of existing firms (sometimes involving government
cooperation) impose substantial barriers to entry. This is the world of big business, as perceived
by neoclassical economists.
Commonly cited examples of industries with these general oligopolistic characteristics
are oil production and distribution, steel and aluminium production, car production, the
manufacture of computers, food processing, the manufacture of laundry detergents, aircraft
production, and airline travel. Oligopoly can also exist in service industries. Some would
say that universities—large institutions vigorously competing for students, research funds,
and sponsors—now have the characteristics of oligopolistic industries, too. A cynic would
add political parties, the biggest of which compete with one another for market share,
differentiating their offerings to the extent necessary to secure a strategic competitive
advantage. In all these cases, the dominant feature is competition among the few. There may
be a number of smaller players alongside the bigger ones, but it is the behaviour of the latter
that determines how the industry functions.
Such behaviour is shaped by the perceived interdependence of the major players. Each
seller in an oligopolistic industry recognises that any change in its policies (regarding
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production technologies, production locations, the range of product lines, prices, and
commercial advertising strategies, for instance) is likely to precipitate changes in its rivals’
policies.
This perceived interdependence gives rise to distinctive patterns of behaviour. Price
rigidity is a predictable outcome. It is a common consequence of interdependent behaviour
under conditions of oligopoly, even without explicit collusion. Prices tend to be sticky,
remaining fixed for quite long periods of time, despite fluctuations in demand and supply
conditions that would cause price fluctuations in more competitive markets.1 Periodic bouts of
vigorous price competition may occur, especially when a new entrant threatens to invade the
market territories of existing firms.2 Typically though, non-price competition prevails. Rivalry
over market shares, focusing on commercial advertising, may be intense, but it is a very long
way from the business behaviour required in the realm of perfect competition.

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Collusion is a strong tendency under conditions of oligopoly. It can take many forms.
Firms in an oligopoly may, for example, agree to a territorial division of the market. A mutual
interest in the avoidance of beggar-thy-neighbour competition may also lead firms to collude
in pricing their products. They recognise that one firm seeking to increase its market share by
lowering its prices is likely to trigger a price war, which would eventually cause each firm to
suffer reduced profits. Better not let the process start. So, a system of tacit price leadership,
whereby one firm in the industry (not necessarily the biggest) sets the general industry
standard and the others follow suit, is commonly adopted. In effect, collusive oligopoly
converges on monopoly.

Box 21.1 Game theory

Many economic decisions involve strategic choices. When setting the prices of their
products, for example, individual firms, particularly in oligopolistic market situations, have
to try to anticipate the impact of their decision on the pricing policy of their rivals. They
weigh up the anticipated advantages and disadvantages of competitive and cooperative
strategies, taking into account the likelihood of any cooperative agreement being
maintained in practice and the possible consequences of its being dishonoured.
The term ‘game theory’ implies a sporting analogy. Indeed, the complex and shifting
relationship between cooperation and competition is one of the more intriguing aspects of
sporting endeavours. Warfare is the yet more obvious arena in which strategic choices are
important. The development of mathematical models to help decision-making processes
was, in fact, stimulated by the Second World War and the subsequent Cold War. Its
application to economics followed quickly. John Nash, the mathematics professor on
whose remarkable life the Hollywood movie A Beautiful Mind was based, was a particularly
significant contributor to its development. The Nash equilibrium is a central concept in game
theory. Essentially, this is the situation created when the set of strategies that individuals
willingly choose as the best response to the predicted strategies of other players produces
strategically stable or self-enforcing outcomes in which no single player wants to deviate
from his or her predicted strategy.
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Applying game theory to the study of economic behaviour has been a focal point in the
further development of mathematical economic theory. It has also produced some more
down-to-earth experimental studies that involve putting real people in simulated strategic-
choice situations and monitoring their behaviour. Is this merely fun and games? On the
one hand, game theory has demonstrated that the mainstream microeconomic theory of
individually rational decision-makers is internally inconsistent and descriptively inaccurate.
As such, it has strengthened the critique of conventional neoclassical theory. On the other
hand, it has difficulty producing alternative, well-defined predictions of economic behaviour
and therefore remains constrained by a choice-theoretic methodology, even while trying to
push against the boundaries of orthodox economics.

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Perfect monopoly
As global media magnate Rupert Murdoch once said, ‘Monopoly is a terrible thing until you
have it.’3 Strictly defined, perfect monopoly is the polar extreme of perfect competition. This
is where there is only one firm supplying the product in question: the firm is the industry. It
usually maintains its monopoly position by imposing barriers to the entry of new firms. It also
takes advantage of its monopoly position by restricting output and raising prices in order to
generate maximum profits. So, the prevailing market price will be higher than that under perfect
competition—assuming that production costs are the same in either case. That is the basis for
neoclassical economists’ antipathy towards monopoly. It fits with the popular presumption that
monopolists tend to exploit their economic power by charging higher prices for their products.
Whether markets that are more competitive do actually generate lower prices depends
crucially on the level of production costs. The foregoing case against monopoly rests on the
assumption that an industry’s production costs would be the same irrespective of whether
it is organised as a monopoly or as perfect competition. This is not necessarily the case. A
monopolist lacks the imperative to minimise costs that firms have in perfectly competitive
market situations. However, a monopolist usually has more resources at its disposal to invest
in new technologies, and product innovations, if it so wishes. Because the costs of production
may be either higher or lower for the monopoly in practice, we cannot know for certain how
the prevailing price level compares with the perfectly competitive norm. All we can say with
confidence is that, whatever the costs of production may be, monopolists have the capacity,
unless constrained by government regulations or faced with a highly elastic demand for their
products, to seek higher profits by raising prices.
This illustrates a general feature of the neoclassical theory of market structures. Only in
the perfectly competitive case does the market structure actually determine the conduct and
performance of the firms. The further one deviates from this norm, the greater the scope for
firms to engage in strategic action, which, by its very nature, is harder to model and predict.
This is particularly so for oligopoly, where the uncertainties associated with the perceived
interdependence of firms are most striking. Neoclassical economists have sought to apply
game theory in this context in order to graft on some models of strategic behaviour.4 This helps
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to inject some realism into the analysis of business behaviour, but at the price of producing
more uncertainty about the predicted outcomes. The general problem remains: the greater
the departure from the perfectly competitive ideal and the closer the approximation to real-
world market situations, the less effective is neoclassical theory as a means of explaining and
predicting market behaviour.
In discussing the features of different market structures, the term ‘monopoly’ is often
used interchangeably with ‘imperfect competition’.5 In other words, it is used to refer to any
market situation in which firms have the capacity to differentiate their products, command
some degree of brand loyalty among their customers, impede the entry of new firms, or
otherwise mould the operations of the market to their own interests. This is a much broader use
of the term than that of ‘pure’ or ‘perfect’ monopoly, where only one seller exists. It is a use of

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the term associated with the concern to understand business behaviour in all contexts—other
than the idealised perfect competition—and to decide what to do about it.

Structure, conduct, performance

The mainstream economic approach assumes that the structure of a market shapes the
conduct and performance of firms operating within it. In a perfectly competitive structure,
firms’ conduct is necessarily that of the price taker; therefore, their performance depends
on efficient cost minimisation, and their capacity to make profits is always constrained by
the actual or potential entry of new firms into the industry. The structure of monopolistic
competition, on the other hand, allows for more competitive conduct through price and
product differentiation—although firms’ ability to generate high levels of profit is still
constrained by the relative ease of entry. In oligopoly, the structure makes strategic conduct a
business imperative, and successful performance in these strategic games is usually rewarded
with substantial profits. In conditions of pure monopoly, the structure imposes no requirement
on the firm to act efficiently, other than in securing its own monopoly position, and its profit
performance can be enhanced by monopoly pricing (subject to the constraint imposed by the
elasticity of demand).
This structure–conduct–performance approach to understanding business behaviour
embodies a distinctive interpretation of what competition means.6 It treats competition as
an end state, as a consequence of market structure rather than a process. A contrast may
be made with Adam Smith’s conception of competition as a process of rivalry, such as that
between producers in different locations. This alternative, more dynamic view of competition
has strong echoes in Marx, Marshall, and the Austrian tradition of economic analysis, from
Menger through to Schumpeter and Hayek. It puts more emphasis on entrepreneurship as an
active element in business behaviour. Entrepreneurship is the process by which firms create
business opportunities. It is a means by which firms pursue rivalrous business behaviour. It
has no equivalent place in the standard neoclassical approach, notwithstanding the common
(and confusing) reference to the firm as the ‘entrepreneur’. Rather, in neoclassical theory, the
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extent of competition is understood to be determined by the industry structure, particularly

the number of firms in the industry in question.
The concept of efficiency in neoclassical theory is largely restricted to considerations of
resource allocation. The typical concern is with how resources are being allocated between
industries, given the prevailing state of technology and pattern of consumer demand. Questions
about resource creation are paid significantly less attention. Yet the issue of whether competitive
or oligopolistic industries are more likely to generate technological progress over time (or to
improve the quality of human capital) may be much more important than the question of which
market structure is more conducive to allocative efficiency at any given point in time.
A restricted view of economic power is also evident in the neoclassical theory. Economic
power is only market power. The power of oligopolists or monopolists is their ability to charge

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higher prices than would prevail under perfectly competitive conditions (assuming similar
production costs). Firms may also have power to reduce the costs of factors of production—
because of their monopolistic position as buyers of labour, for example. However, their power
to shape the broader economic environment is not usually considered. Yet therein may lie the
major consequences of the transition from competitive to monopoly capitalism. Insofar as
giant businesses in the modern economy can influence government policies (on taxes, tariffs,
industry subsidies, and other forms of ‘corporate welfare’), or play off national governments
against one another through the international movement of capital, they have far greater
power than these models of imperfect competition imply. To the extent that their activities
foster consumerist behaviour and/or deplete natural resources, the social and environmental
consequences of their activities are far-reaching.

Taming the tigers?

The neoclassical theory of market structures, based on these distinctive views of competition,
efficiency, and market power, could be expected to generate clear guidelines for public policy.
It categorises types of market structure according to their presumed deviation from the
competitive ideal.7 Its process of formal modelling emphasises key economic variables, setting
aside other complexities. It should have something to say about policies towards markets in
practice. Indeed, this is a significant focus of the theory as it is presented in the mainstream
economics textbooks. In line with the structure–conduct–performance continuum, three
policy approaches may be discerned.
First is the emphasis on policies to influence market structure. If perfect competition is
an ideal in the normative sense, then, presumably, public policy should seek to achieve it in
practice, or at least to approximate it. A case is thereby made for breaking up large firms into
smaller ones, or preventing smaller ones from combining into larger ones through mergers
and takeovers. This is the characteristic anti-monopoly stance of neoclassical economics.
Historically, it has been influential in a number of countries, including the USA. It was the
rationale for the decision by the US Supreme Court in 1911 to break up Standard Oil into
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34 smaller companies. It implicitly underlay the US District Court ruling in 2000 that giant
software company Microsoft be divided in two (still giant) companies.8 It is an approach to
economic policy that seems to prioritise consumers’ interests relative to those of business
(although it should be noted that, in practice, many of the consumers of big businesses are
other businesses, big and small). As a general policy approach, it is bedevilled by the tension
between the concern to prevent monopoly pricing and the desire to reap the economies of
large-scale production. Moreover, especially for governments of smaller nations, it now sits
uncomfortably with the strategy of promoting big firms as ‘national champions’ capable of
competing effectively in world markets.
A second approach, focusing on firms’ conduct, emphasises the case for the regulation
of business behaviour. Restrictions on monopoly pricing, collusive activities, and other

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restrictive trade practices are implied. Box 21.2 gives some examples of what has come to be
generally known as competition policy. It has been a major feature of public policy in practice
in many countries, such as the USA, the UK, and Australia, and is supported by neoclassical
economic reasoning emphasising the perfectly competitive ideal. It requires a regulatory role
for government that sits uncomfortably with the more purist strain of economic liberalism that
harbours deep distrust of government intervention of any sort.

Box 21.2 Competition policy

How much competition among firms supplying goods and services is necessary, desirable,
or possible? How concerned should governments be about enforcing competition? Herein lie
major dilemmas. The case for a capitalist market economy relies on the posited link between
competition, efficient resource allocation, and consumer welfare. Yet, ever since Adam
Smith, it has been recognised that the forces of competition are continually confronted,
even thwarted, by the forces of monopolisation. Governments have sought to deal with
these tensions by having national competition policies.
Legislative restrictions and regulations have generally sought to preclude business
practices such as:
ĩĩ anti-competitive agreements and exclusionary provisions, including primary and
secondary boycotts
ĩĩ misuse of market power, such as charging excessively high prices
ĩĩ exclusive dealing, such as when a large firm insists that its suppliers do not deal with
other firms
ĩĩ resale price maintenance, whereby manufacturers insist on the price at which retailers
sell their products
ĩĩ mergers that have the likely effect of substantially lessening market competition.
In the last two decades, governments have extended national competition policies
to previously exempt areas such as public utilities. In effect, competition policy thereby
becomes linked to the push for privatisation, either directly transferring public enterprises
into private hands through the sale of their assets, or requiring public enterprises to act
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more like private-sector enterprises. Insisting on ‘contestable markets’ for the provision of all
services is a recurrent theme, with the declared aim of enforcing efficiency on the providers
of public services. In practice, it usually results in services previously provided by public
enterprises (such as electricity and gas suppliers) being contracted out to private-sector
firms, and the relinquishment of community service obligations that previously guided the
behaviour of the public enterprises.
The Organization for Economic Cooperation and Development (OECD) has been trying
to promote convergence of national competition policies in different nations. It stresses the
need for competition laws to be applied uniformly with a minimum of exceptions. This has
the appeal of creating a so-called level playing field for business, but in practice it can mean
a level playing field on which transnational corporations can extend their domination.

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A third type of policy dealing with market structures focuses on performance. ‘Let the
structures of imperfect competition remain; let firms decide what strategic business behaviour
and pricing policies are best for them; just focus on dealing with the outcomes’, this argument
runs. Profit outcomes are a particular focus. If oligopoly or monopoly generate excessive levels
of profit (however that be defined), then business taxation can cream off whatever portion
is necessary in order to finance government expenditures. This deals with the consequences
rather than the causes of monopoly power. However, it offers a potentially appealing way of
dealing with the lack of adequate competition in industry—appealing to citizens, not to big
business, of course.
Note, though, that the victims of monopoly pricing, for example, are not necessarily the
same people as the beneficiaries of the government spending financed by taxes on monopoly
profits. So complex redistributions between losers and winners may ensue. Yet more troubling
is the evident aversion by most governments nowadays to imposing substantial business
taxation. In a world of increasingly mobile capital, there is the frequent fear that such taxes
may precipitate ‘capital flight’ to other nations where tax rates are lower. Faced with this
threat, real or imagined, the prevailing tendency is to shy away from tackling the power of big
business.
So, governments, faced with practical decisions about coping with big business and
restrictive trade practices, tend to take a more pragmatic approach, seeking ‘workable
competition’ rather than perfect competition. It seems that the closer one gets to matters of
practical judgment, the cloudier the issues become and the less relevant the principles derived
from the neoclassical theory appear. ‘Workable competition’, in one wry opinion, is ‘a vague
term meaning simply the degree of competition considered acceptable by the economist
calling it workable’.9

Conclusion
The neoclassical theory of market structures is superficially attractive: it recognises a spectrum
from perfect competition to perfect monopoly. However, closer investigation indicates some
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fundamental problems with this body of analysis.

It quickly becomes open-ended in what it says about expected business behaviour as
soon as the perfect competition model is set aside. The result is that the precision sought by
neoclassical theorists cannot be achieved, except by making some truly heroic assumptions
(such as costs of production being independent of market structure).
These difficulties also limit the use of the theory of market structures in the formulation
of public policies. How best to promote business competition and limit monopoly power? No
clear policy prescriptions emerge, despite the strong commitment to the perfectly competitive
ideal. Competition policies in practice oscillate between attempts to influence structure,
conduct, and performance. The tension between the principle of competition and the practice
of capitalism remains.

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In the end, one has to wonder what the point of the theory is. Is its purpose to describe
(or at least approximate) real-world market structures? Is it meant to provide a normative ideal
that can be used as a basis for policy formulation? Or is there a yet more contentious purpose:
to provide an ideology that diverts attention from the actual structures of economic power,
thereby serving as a legitimising device for capitalist interests? These three possibilities apply
not only to the theory of market structures, but also to neoclassical economics as a whole,
including what it has to say about the distribution of income between land, labour, and capital.

Key points

ĩĩ Neoclassical economists distinguish between perfect competition, monopolistic

competition, oligopoly, and monopoly as the principal market structures.
ĩĩ Because perfect competition is held to be the normative ideal, more common market
structures in modern capitalism may be targets for government policies intended to affect
industry structure, business conduct, and performance.
ĩĩ Critics of neoclassical theory emphasise that this idealised view of market structures
neglects many aspects of actual business behaviour that involve the use of economic
power.
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