Chapter 6: Differentiate market structures

Market structures form the foundation for understanding how businesses operate within different competitive environments. For business management professionals in Kenya, distinguishing between various market structures is essential to designing effective strategies, pricing products, and navigating competition. This chapter explores the determination of market structures and the implications for market output, providing insights relevant to sectors such as banking, retail, and manufacturing.

6.1 Market structures determination

A market structure is the way a market is organised: how many firms sell in it, how alike their products are, how easily new firms can enter and how much say each firm has over price. A business manager who can place the firm's market on this scale can predict how rivals will react, how freely prices can be set and how hard it will be for newcomers to take customers away. Determining the structure is therefore the first step before pricing, output and entry decisions are made. The five structures studied here run from one seller with no rivals (monopoly) to many sellers with no power over price (perfect competition), with monopolistic competition, oligopoly and duopoly between them.

Characteristics used to determine market structure

Five questions are asked of any market, and the answers decide which structure it fits.

• Number of firms: A market with hundreds of small sellers, such as the traders in an open-air produce market, behaves very differently from one supplied by two or three large firms. The more firms there are, the smaller the share of each and the weaker its power over the market price.
• Product differentiation: Products are homogeneous when buyers see no difference between sellers, as with loose maize or tomatoes of the same grade. They are differentiated when brand, design, quality, packaging or service set one seller apart, as with tailoring shops or bakeries.
• Barriers to entry and exit: Barriers are the costs and rules that keep new firms out: heavy capital, licences, patents, control of a key input or the size of existing firms. Where barriers are low, firms enter when profits are high and leave when they are low.
• Control over price: A price taker must accept the market price. A price maker can raise or lower its own price and still keep some customers. The more control a firm has, the further the market is from perfect competition.
• Market information: Where buyers and sellers know prices, quality and alternatives, rivals are easy to compare and prices stay close together. Where information is hard to get, a firm can charge more without losing customers at once.

Factors that shape market structure in Kenya

• Level of economic development: A developing economy such as Kenya's holds many small informal traders alongside a smaller number of large formal firms, so some markets are close to perfect competition while others are dominated by a few.
• Regulation: Licensing rules and competition law decide who may enter and how firms may behave. The Competition Act, 2010 prohibits agreements between rivals that fix prices and the abuse of a dominant position, and the Competition Authority of Kenya enforces it.
• Technology: Mobile payments and online selling lower the cost of reaching customers, so a small business can enter a market that once needed a shop in every town.
• Consumer preferences: Buyers who want variety and style push sellers to differentiate, which moves a market towards monopolistic competition.
• Access to capital: Industries that need factories, fleets or networks keep out firms that cannot raise large sums, which leaves only a few sellers.

Comparison of the five structures

How market structure shapes business decisions

• Pricing: A firm in a crowded market watches the going price; a firm with few rivals watches what those rivals will do before it changes its own.
• Product development: Where products can be told apart, a firm invests in design, quality and branding to hold its customers.
• Entry and expansion: High barriers lead a business to look for a niche, a partnership or a supplier role instead of a head-on entry.
• Compliance: A firm with a large share of its market must take care that its pricing and dealings with rivals stay within competition law.

6.1.1 Monopoly

A monopoly is a market with a single seller of a product that has no close substitute. Because buyers have nowhere else to go, the monopolist is a price maker and chooses the price and output that give it the greatest profit, usually a higher price and a smaller output than a competitive market would give. Example: a water company that owns the only piped network in a town is the sole supplier to every household and business on that network.

Features of a monopoly

• Single seller: The firm is the industry, so the market demand curve is the firm's own demand curve.
• No close substitutes: Buyers cannot switch to a similar product, so demand is relatively inelastic.
• Barriers to entry: New firms are shut out by a legal licence, a patent, ownership of a key resource or the huge cost of building a rival network.
• Price making: The firm sets the price and accepts the loss of some buyers when it raises it.
• Possible price discrimination: A monopolist can charge different groups different prices for the same product where it can keep the groups apart.

Sources of monopoly power

• Legal monopoly: The state gives one firm the sole right to supply a service, such as a licence for a toll road or a rail line.
• Natural monopoly: The cost of building a second network is so high that one firm serves the market at the lowest unit cost, as with piped water or electricity lines.
• Control of a raw material: A firm that owns the only source of an input can refuse to supply rivals.
• Patents and copyright: The law protects an invention or creation for a period so that only its owner may sell it.

A monopoly does not stay free of control: regulators set tariffs for natural monopolies, and competition law forbids a dominant firm from abusing its position.

6.1.2 Perfect competition

Perfect competition is a market with so many buyers and sellers that no single one can influence the price. Each firm sells an identical product at the price the market sets and can sell as much as it wishes at that price but nothing at a higher one. It is a model against which real markets are measured, and no real market meets every condition. Example: sellers of loose tomatoes of the same grade in a produce market come close, because buyers compare prices stall by stall.

Conditions of perfect competition

• Very many buyers and sellers: Each trader is too small to change the market price.
• Homogeneous product: Buyers see no difference between one seller's product and another's.
• Free entry and exit: Any firm can join or leave the market without legal or cost barriers.
• Perfect information: Buyers and sellers know the prices and quality on offer.
• Perfect mobility of factors: Labour, capital and materials move freely to where they earn most.

Price taker behaviour

The firm's demand curve is a horizontal line at the market price, so one more unit always sells at that same price. If a stall owner raises the price above the market level, buyers go to the next stall. The firm can only decide how much to supply, and in the long run, with free entry, firms earn only normal profit.

6.1.3 Monopolistic competition

Monopolistic competition combines many sellers, as in perfect competition, with differentiated products, as in monopoly. Each firm is the only seller of its own version of the product, so it has some control over price, but close substitutes from rivals limit how far it can raise it. Example: tailoring shops, barbershops and bakeries in a town each offer a similar service or product but compete on style, quality, location and customer care.

Features of monopolistic competition

• Many sellers: Each firm has a small share of the market and acts without watching any one rival closely.
• Product differentiation: Branding, design, packaging, quality, location and after-sales service make each product a little different.
• Free or easy entry and exit: New firms can set up with modest capital, so high profits attract competitors.
• Some control over price: A firm with loyal customers can charge a little more than rivals.
• Non-price competition: Advertising, promotions, packaging and service are used to build loyalty, because price cuts are easily copied.

In the long run, new entrants share out the customers and the typical firm earns only normal profit, so a firm must keep differentiating to keep its edge.

6.1.4 Oligopoly

An oligopoly is a market dominated by a few large firms, each big enough that its actions change the sales of the others. The firms are interdependent: before changing a price, launching a product or starting an advertising campaign, each must predict how rivals will respond. Example: a market in which three large producers of bottled water supply most of the demand, and a price cut by one is copied by the others within days.

Features of oligopoly

• Few large firms: A small number of sellers hold most of the market.
• Interdependence: Each firm's decisions depend on its guess about its rivals' reactions.
• High barriers to entry: Large capital needs, established brands, distribution networks and economies of scale protect existing firms.
• Price rigidity: Prices tend to stay stable, because a firm that raises its price may be left alone while one that cuts it is followed.
• Heavy non-price competition: Branding, advertising, product design and service are used in place of price cuts.

Collusion and cartels

Oligopolists may agree among themselves to fix prices or share out markets, which makes them act like a single monopolist. Such agreements are unstable because each member gains by cheating on the agreement, and in Kenya price fixing between rivals is prohibited by the Competition Act, 2010.

6.1.5 Duopoly

A duopoly is the special case of oligopoly in which only two firms supply the whole market. Each knows that the other is its only rival, so every decision on price or output is made with the other firm's likely response in mind. Example: two companies that operate the only scheduled bus services between two towns must each think about the other's fares and departure times.

Features of duopoly

• Two sellers: The market is shared between two firms of similar size or one large and one smaller.
• Strong interdependence: A fare cut by one firm quickly pulls customers from the other, which usually answers by cutting its own.
• High barriers to entry: A third firm would need the same licences, vehicles and terminals, which keeps the market at two.
• Possible outcomes: The two firms may compete fiercely, follow the price set by the stronger firm (price leadership), or agree to share the market, which competition law forbids.

When the two firms compete on price, the lower prices benefit buyers. When they collude, buyers pay more and the market behaves as a monopoly.

Chapter Summary

This chapter explored the various market structures that determine how firms compete and operate within an economy. It examined monopoly, perfect competition, monopolistic competition, oligopoly, and duopoly, explaining their defining features and market dynamics. The discussion then shifted to how these market structures influence the quantity of output produced, highlighting differences in production levels across the structures. Following this, the chapter analyzed market prices, showing how price determination varies depending on the degree of competition and market power. Finally, it focused on how different market structures are selected based on factors such as barriers to entry, product differentiation, and the number of sellers. The chapter concluded by considering the implications of each market structure on efficiency, consumer choice, and overall market performance.