Market structure refers to the relative size of the businesses that make up an industry, and this has a direct effect on the amount of products they are willing to flood the market with. This is due to the fact that the less that is produced, the more the price goes up, and the fewer business in the market, the less they need to produce to stay competitive. That is, the more businesses in an industry, the more competition there is and the more they have to produce to compete, thus driving down price. Based on this simple idea, four market structures can be identified, along with how it affects supply.
Perfect competition exists when the market consists of many small businesses that are allowed to compete against each other. That is, no business has a disproportionate share of the market and cannot influence the amount of supply significantly. This competition leads to each business fighting over customers and market share, forcing them to produce as much as possible, thus lowering the price per unit. This is good for consumers, as businesses need to optimize their price and increase their quality to attract what little market share they can. Overall, in this type of market, these businesses reach the optimal output level at the lowest cost per unit that is possible.
In this type of market one business controls the market, as they are the only one doing business. In this case, the monopoly can increase its profits by driving up prices by lowering the amount of units that customers can buy. Because only one business controls the entire market, and because they are trying to maximize their profits, they will decrease their production, making their product or service rarer, thus driving up the price. In other words, “A monopoly maximizes profit by producing output when MR = MC and by charging maximum price that consumers are willing to pay for that output” (Market Structures, 2014). This means that the marginal cost equals the marginal revenue, which results in the higher price per unit. Furthermore, a monopoly actively tries to keep other firms out of the market so they can continue to control the amount of supply and the cost per unit. Overall, this results in a less than optimal social output and makes the cost per unit much higher.
An oligopoly exists when a handful of large businesses control the market. That is, two, three, four, etc. businesses have enough market share to dictate the market flows. However, the effect this has on supply depends on how these businesses operate with each other, as they may be adversarial towards each other or they may try to collude to control the market. If these business work together, then they can act as a monopoly. However, the tendency is for them to compete against each other. If they work together, then they will decrease the amount of production so that the amount per unit will increase. If they compete, then this could drop the price per unit, but not nearly as much as a perfect competition market structure. Therefore, the amount of supply depends on how the large businesses work together.
Monopolistic competition is when the market consists of many businesses that provide a similar product or service but not necessarily the same. “Similar to a perfect competition, monopolistic competition has many buyers and sellers in the market. Each seller has a relatively small market share” (Bernell, 2016). For example, the food service industry is composed many varieties of restaurants, and, while these are in competition with in each other, they are not in direct competition, as if they sold the exact type of food. Rather, they compete for restaurant customers, but each type of restaurant attracts a different type of customer, of course, with some overlap. That is, the amount of supply is depends on how each type of business can service its niche market along with the overlap into others. For the most part, this is close to perfect competition, meaning supply is relatively high in this type of market structure. Overall, the cost of production is more than in perfect competition but certainly less than a monopoly or oligopoly, leading to less supply than perfect competition and more supply than a monopoly or oligopoly.
The amount of supply is directly dependent on the amount of business in the market place. That is, the fewer businesses, the less supply, and the more businesses, the more supply. This is due to the amount of competition each business faces, meaning to compete a business is incentivized to increase their production to increase their market share. However, in a market place with few businesses, there is less competition and businesses can reduce production to make their price per unit higher, thus increasing profits. Overall, the market structure that has the highest amount of supply is perfect competition; second would be monopolist competition; third is an oligopoly; and last is, of course, a monopoly. Understanding the difference between these types has powerful ramifications not only for the market place, but for legislation, policy, etc. “Understanding the relationship between market structure and performance is critical for determining effective economic policy governing anti-trust, intellectual property, industry regulation, and international trade” (Ellickson, n.d.).