AQA Specification focus:
‘Factors such as the number of firms, the degree of product differentiation and ease of entry are used to distinguish between different market structures.’
Introduction
Market structures in economics differ primarily by the number of competing firms, the uniqueness of products, and the ability of new businesses to enter or exit markets.
Market Structure Criteria
The criteria used to distinguish between perfect competition, monopolistic competition, oligopoly, and monopoly are essential for analysing firm behaviour and industry performance.
Number of Firms
The number of firms in a market directly affects the level of competition, pricing power, and consumer choice.
Number of Firms: The quantity of independent producers supplying goods or services within a specific market.
Perfect competition: Very large number of firms, each too small to influence market price.
Monopolistic competition: Many firms, but each with some degree of market influence due to product differentiation.
Oligopoly: Few large firms dominate the market, creating significant interdependence.
Monopoly: A single firm controls the market and sets prices without direct competition.
The distribution of firms along this spectrum of competition determines how prices and outputs are established.
Product Differentiation
The degree of product differentiation plays a key role in shaping firm strategy and consumer choice.
Product Differentiation: The extent to which goods or services are perceived as distinct from those of competitors, whether by design, branding, quality, or features.
In perfect competition, products are homogeneous (identical), making firms price takers.
In monopolistic competition, products are similar but differentiated through branding, quality, or marketing.
In oligopoly, firms may use both price and non-price competition (advertising, innovation) to gain market share.
In monopoly, the product has no close substitutes, giving the firm significant control over pricing.
Differentiation affects price elasticity of demand:
Higher differentiation → more inelastic demand → greater pricing power.
Lower differentiation → more elastic demand → limited pricing power.
Ease of Entry and Exit
Barriers to entry and exit shape the competitive environment and the sustainability of firm profits.
Product Differentiation: The extent to which goods or services are perceived as distinct from those of competitors, whether by design, branding, quality, or features.
Perfect competition: Free entry and exit; abnormal profits attract new entrants, while losses lead to exits.
Monopolistic competition: Relatively easy entry, though branding and advertising can create modest barriers.
Oligopoly: High barriers to entry, including sunk costs, economies of scale, and strategic behaviour by incumbents.
Monopoly: Extremely high or insurmountable barriers (legal protections, patents, natural monopoly conditions).
Barriers influence long-run profits:
Low barriers → profits competed away.
High barriers → sustained supernormal profits.
Linking the Criteria
The three main criteria — number of firms, product differentiation, and ease of entry — are interrelated and collectively determine the market power of firms.
Number of firms affects the level of competition and pricing behaviour.
Product differentiation alters consumer loyalty and demand elasticity.
Ease of entry determines whether profits are temporary or sustainable.
For example:
A monopoly has one firm, no substitutes, and very high barriers to entry.
Perfect competition features many firms, identical products, and no entry restrictions.
Oligopoly lies between these extremes, with few firms, differentiated products, and high barriers.
Application in Economic Analysis
When comparing industries, these criteria help economists and policymakers assess efficiency, consumer welfare, and the potential for market failure.
Markets with many firms, low barriers, and homogeneous products are generally efficient and competitive.
Markets with few firms, strong differentiation, and high barriers may lead to higher prices, reduced consumer surplus, and possible inefficiency.
Understanding these structural differences is crucial for analysing outcomes such as:
Pricing power and strategies (price-making vs price-taking).
Efficiency conditions (allocative and productive efficiency).
Long-run market dynamics (entry, exit, and innovation).
FAQ
Consumer knowledge affects how easily buyers can compare products and prices.
In perfectly competitive markets, perfect knowledge means consumers know all prices and qualities, preventing firms from charging higher prices.
In monopolistic or oligopolistic markets, imperfect knowledge allows firms to use advertising and branding to influence consumer decisions, making product differentiation more powerful.
The number of firms determines whether a firm is a price maker or price taker.
Many firms: Each firm is too small to influence price, leading to price-taking behaviour.
Few firms: Firms become interdependent and may influence prices strategically.
One firm: A monopoly has full control over price.
Thus, the fewer the firms, the greater the pricing power.
Product differentiation builds loyalty by making consumers perceive one firm’s product as superior or unique.
Branding, design, and advertising create identity beyond price.
Higher loyalty makes demand less price elastic, enabling firms to sustain higher prices.
In monopolistic competition, differentiation is key to retaining market share in otherwise competitive markets.
Yes, barriers to entry can evolve.
Technological advances may lower costs, reducing barriers.
Regulations or patents can increase barriers suddenly.
Economies of scale often strengthen as industries mature, making entry harder for small firms.
Thus, an industry’s competitive landscape can shift significantly over time.
Regulators use these criteria to decide whether markets need intervention.
High concentration and strong barriers may prompt investigation for anti-competitive behaviour.
Lack of differentiation in highly concentrated markets may signal collusion risks.
Easy entry usually reduces the need for intervention, as new firms can discipline incumbents.
These criteria form the foundation of competition law assessments.
Practice Questions
State two factors used to distinguish between different market structures. (2 marks)
1 mark for correctly identifying each factor (maximum 2 marks).
Possible answers:
Number of firms in the market (1 mark)
Degree of product differentiation (1 mark)
Ease of entry into and exit from the market (1 mark)
Explain how barriers to entry influence the level of competition in different market structures. (6 marks)
Knowledge (up to 2 marks):
Clear understanding of barriers to entry, e.g. “Barriers to entry are obstacles that prevent new firms from entering a market.” (1 mark)
Recognition that barriers affect the extent to which abnormal profits can be sustained. (1 mark)
Application (up to 2 marks):
Reference to different market structures, e.g. “In perfect competition, there are no barriers to entry so firms can enter freely.” (1 mark)
“In monopoly, barriers to entry are very high, which allows the firm to retain market power.” (1 mark)
Analysis (up to 2 marks):
Explanation of the impact on competition, e.g. “High barriers reduce competition, leading to sustained supernormal profits.” (1 mark)
“Low barriers encourage competition, as profits are eroded by new entrants, which makes markets more efficient.” (1 mark)
Maximum 6 marks.
