Key Concepts of Market Structures

Why This Matters

Market structures are the backbone of AP Microeconomics—they determine how firms make decisions about pricing, output, and competition. You're being tested on your ability to compare efficiency outcomes, profit-maximizing behavior, and welfare effects across different market types. The exam loves asking why a monopolist produces less than a perfectly competitive market, or how free entry drives long-run profits to zero in monopolistic competition.

Don't just memorize the characteristics of each structure. Know what each one illustrates about market power, barriers to entry, and allocative efficiency. When you see an FRQ asking about deadweight loss or consumer surplus, you need to instantly connect the market structure to its welfare implications. Master the underlying mechanisms, and you'll be ready for any question they throw at you.

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Competitive Markets: The Efficiency Benchmark

Perfect competition serves as the baseline for evaluating all other market structures. When no single firm has market power, prices reflect true marginal costs, and resources flow to their highest-valued uses.

Perfect Competition

• Price-taking behavior—firms accept the market price because no individual seller is large enough to influence it, making the firm's demand curve perfectly elastic (horizontal)
• Allocative efficiency occurs because $P = MC$ at equilibrium, meaning the last unit produced provides exactly as much value to consumers as it costs to produce
• Zero economic profit in the long run results from free entry and exit—when profits attract new firms, supply increases until $P = ATC$ at the minimum point

Perfectly Competitive Factor Markets

• Derived demand for labor means firms hire workers based on how much revenue each additional worker generates, not just their productivity alone
• Profit-maximizing hiring rule is $MRP = W$, where marginal revenue product equals the wage; firms hire until the last worker's contribution to revenue equals their cost
• Wage-taking behavior mirrors product market price-taking—in competitive labor markets, firms face a horizontal labor supply curve at the market wage

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Single-Seller Markets: Maximum Market Power

When one firm controls the entire market, it gains the ability to restrict output and raise prices. The key inefficiency: monopolists produce where $MR = MC$ but charge a price on the demand curve, creating a wedge between price and marginal cost.

Monopoly

• Price-making power allows the monopolist to choose any point on the market demand curve; to sell more, it must lower the price on all units, making $MR < P$
• Deadweight loss emerges because output is restricted below the socially optimal level where $P = MC$—the DWL triangle represents lost consumer and producer surplus
• Barriers to entry (patents, exclusive resources, government franchises) protect long-run economic profits, unlike in competitive markets

Natural Monopoly

• Declining long-run average costs mean one firm can serve the entire market more cheaply than multiple firms—economies of scale are so large that competition is inefficient
• Average-cost pricing regulation sets $P = ATC$ to eliminate economic profit while keeping the firm viable; marginal-cost pricing ($P = MC$) requires a government subsidy
• Infrastructure industries like utilities exemplify this structure—high fixed costs (power plants, water pipes) spread over many units create the declining cost curve

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Imperfect Competition: Between the Extremes

Most real-world markets fall between perfect competition and monopoly. These structures feature some market power but also some competitive pressure, leading to intermediate efficiency outcomes.

Monopolistic Competition

• Product differentiation gives each firm a downward-sloping demand curve—brands, advertising, and quality variations create perceived differences even when products are similar
• Long-run zero economic profit occurs because free entry drives demand curves leftward until $P = ATC$ at the tangency point, not at minimum ATC
• Excess capacity means firms produce below the efficient scale; the gap between actual output and minimum-ATC output represents productive inefficiency

Oligopoly

• Strategic interdependence defines oligopoly behavior—each firm's optimal choice depends on what rivals do, requiring game-theoretic analysis rather than simple optimization
• Mutual interdependence can lead to collusion (acting like a monopoly) or competition (approaching competitive outcomes), making predictions difficult without knowing firm strategies
• High barriers to entry from economies of scale, brand loyalty, or strategic behavior protect above-normal profits even in the long run

Duopoly

• Two-firm strategic interaction is the simplest oligopoly case and the foundation for game theory models like Cournot (quantity competition) and Bertrand (price competition)
• Collusion incentives are strong because coordinating with one rival is easier than with many, but each firm also has incentives to cheat on agreements
• Output and price typically fall between monopoly and competitive levels—more competition than monopoly, but strategic behavior prevents full efficiency

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Buyer-Side Market Power

Market power isn't limited to sellers. When a single buyer dominates, the same logic applies in reverse—the buyer restricts purchases to drive down prices, creating inefficiency.

Monopsony

• Single buyer faces an upward-sloping supply curve and must raise the price to attract more sellers, making marginal factor cost ($MFC$) exceed the supply price
• Profit-maximizing hiring occurs where $MRP = MFC$, but the wage paid is read off the supply curve—resulting in lower wages and fewer workers hired than in competitive markets
• Minimum wage policy can actually increase employment in a monopsony labor market by forcing the wage closer to the competitive level—a key exception to the standard minimum wage analysis

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Quick Reference Table

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Self-Check Questions

1. Which two market structures feature zero economic profit in the long run, and what mechanism drives this result in each case?

2. A firm faces a horizontal demand curve at the market price. What market structure is this, and what profit-maximizing condition applies?

3. Compare and contrast the sources of deadweight loss in monopoly versus monopsony. How do the graphs differ, and what policy interventions might address each?

4. Why does monopolistic competition result in excess capacity while perfect competition does not? Connect your answer to the long-run equilibrium condition in each structure.

5. An FRQ presents a natural monopoly and asks you to evaluate average-cost pricing versus marginal-cost pricing. What are the efficiency and profitability tradeoffs of each approach?