Economists identify four types of market structures: perfect competition, monopolistic competition, oligopoly, and monopoly.
This classification depends on:
- Number of relative size of firms in a market (more firms means greater competition),
- Degree of product differentiation (how consumers perceive one company’s product to be different from others),
- Pricing power,
- Strength of entry and exit barriers (high investment requirements, patents), and
- Degree of non-price competition (such as advertising).
In perfect competition, there are a large number of firms offering an undifferentiated product (such as commodities), such that neither of them has pricing power (all are price-takers, i.e. they must accept the market price or else lose all their sales) and there are no barriers to entry or exit.
In monopolistic competition, there are features of both perfect competition and monopoly. The existence of a large number of firms and low barriers to entry are pure-competition-like features while monopoly-like features include product differentiation and some pricing power resulting from non-price competition such as advertising.
In an oligopoly, there are a few firms selling standardized products in an environment in which there are high barriers to entry and exist and significant non-price competition. There exists a considerable amount of interdependence between oligopoly firms because each firm wields a certain level of pricing power and the relationship might be complex (existence of collusion, price leadership by dominant firms, etc.).
In a monopoly, there is a single firm yielding significant pricing power because there are no substitutes for the product that they offer and very high barriers to entry or exit.
Owners of a firm would want the most restrictive market structure (a monopoly) while consumers want the perfect competition. But there is a trade-off: we cannot conclude that perfect competition is best, because the existence of monopoly profits and pricing power results in innovation that would not be possible in perfect competition.