We know that all firms will maximize profits at the output level where MR=MC. In the real world, firms operate in a large variety of environments. These different environments, based on different market conditions, influence the behavior of different firms in different ways.
In order to analyze this real life behavior, economists have identified characteristics that make some firms similar to one another and other firms different from one another. This has led to the study of firms based on four categories of market structure: perfect competition, monopolistic competition, oligopoly, and monopoly.
The characteristics of each market structure relate to differences in the demand curves faced by firms in each category.
The identifying characteristics for each type of market structure include the number of firms in the industry, whether the products are identical (homogeneous), ease of entry for new firms in the industry, and the power that the firm has to influence the price of its products.
The following table summarizes the characteristics of the four types of market structure:
Perfect competition and monopoly are extremes at the opposite ends of the competitive spectrum.
Most real world firms have characteristics that more closely resemble the monopolistic competition and oligopoly models.
For each of these four models of market structure, I have included a section which explains some of the details that distinguish one market structure from the rest. You can jump to each of these sections by clicking on the corresponding link. These sections assume some knowledge of information included in the Basics, Supply & Demand , and Elasticity sections of this website.
Besides the above table, which identifies the characteristics of each market structure, the following summary of conclusions from the details of each section should be helpful:
Perfect competitionis the market structure that maximizes efficiency, as determined by total surplus. Perfect competition gives consumers more total output at a lower price than other market structures. Firms produce where P=MR=MC, which is at minimum average cost. Advertising is non-existent, since products are identical in the minds of consumers. The only competition is price competition, yet each firm is a price taker. Ease of entry and exit means that all firms will earn normal, not economic, profits in the long run.
Monopolistic competition: differentiated products allow for more consumer choices than perfect competition. Higher prices and lower total output result in less efficiency than perfect competition. Firms do not produce at minimum average total cost. However, this lower efficiency results from consumer preference for more choices, not from economic profits. In the long run, economic profits do not exist. Advertising is an important part of product differentiation.
Oligopoly: more than one model is needed to explain the behavior of firms in an oligopoly market structure. Non-price competition can be fiercer than any other market structure; on the other hand, anti-competitive cooperation may exist. Advertising is an important part of competition. So is research and development. Oligopoly is the market structure most responsible for technological advances. Price is above mc, and long run economic profits are possible as long as entry is restricted.
Monopoly: with only one firm in the market, consumers are not given a choice of products. A monopolist has market power, and will set its output at the quantity where MR=MC, which is a lower quantity than the quantity under perfect competition, where MR=demand. At the same time, a monopolist will set its price where the MR=MC quantity equals demand, which is a higher price than perfect competition, where P=MC. With monopoly, advertising and innovation are unnecessary. Long run economic profits are possible.