## **Learning Outcomes**

This article explains how the main microeconomic market structures—perfect competition, monopolistic competition, oligopoly, and monopoly—shape firms’ pricing power, revenue behaviour, and ability to earn long‑run economic profit. It clarifies how the number and relative size of firms, the degree of product differentiation, and the strength of entry and exit barriers determine whether a firm is a price taker or price setter, and how closely price will track marginal cost. The article explains why perfectly competitive firms face horizontal demand, why monopolists and many oligopolists confront downward‑sloping demand with marginal revenue below price, and how these features translate into different optimal output and price choices under the MR = MC rule. It highlights the conditions under which economic profits are competed away versus sustained, linking those outcomes directly to the structure of the industry. The discussion also prepares you to interpret common CFA Level 1 item sets by training you to identify the implied market structure from short scenarios, recognise typical exam distractors—such as confusing monopolistic competition with monopoly—and evaluate how changes in barriers to entry, market concentration, or differentiation are likely to affect competitive intensity, pricing flexibility, and the sustainability of above‑normal returns.

## **CFA Level 1 Syllabus**

For the CFA Level 1 exam, you are expected to understand fundamental market structures and how they impact pricing and profitability, with a focus on the following syllabus points:

- Identify features of perfect competition, monopolistic competition, oligopoly, and monopoly
- Explain how market structures determine pricing power and long-run profitability
- Assess the impact of product differentiation and barriers to entry on market power
- Analyse optimal price and output choice under different market structures

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which market structure offers zero pricing power to individual firms in the long run?
2. What is the relationship between marginal revenue (MR) and price (P) for a monopolist?
3. How do barriers to entry affect long-run profits in different market structures?
4. Which structure best describes many firms with differentiated but similar products?

## **Introduction**

Microeconomic market structures are a fundamental part of CFA exam content. Market structure classifies industries by the number of sellers, product type, pricing ability, and barriers to entry. Understanding these distinctions is fundamental for interpreting competition, setting expectations for profitability, and determining the sustainability of excess returns.

## Types of Market Structure and Pricing Power

Most markets fall into one of four main categories: perfect competition, monopolistic competition, oligopoly, and monopoly. Each structure has unique implications for pricing power and the ability to earn long-run economic profits.

> **Key Term: market structure**
> The classification of a market according to the number of firms, product type (homogeneous or differentiated), pricing power, and entry/exit barriers.
>
> **Key Term: pricing power**
> The ability of a firm to influence the market price of its product, rather than taking the price set by supply and demand.

### Perfect Competition

A perfectly competitive market contains a large number of firms selling identical products. There are no barriers to entry or exit, and each firm is a price taker—no single firm can influence the overall price.

Firms in perfect competition face a horizontal demand curve at the market price. Thus, price equals marginal revenue (P = MR). In the long run, economic profits are driven to zero as new entrants erode any positive profit. Examples include some commodity and agricultural markets.

> **Key Term: price taker**
> A firm that must accept the prevailing market price because its individual output is too small to affect market price.

### Monopolistic Competition

Monopolistic competition features many sellers offering products that are similar but not identical. Firms differentiate their products via branding, quality, features, or service. There are low barriers to entry, and firms possess some pricing power due to product differentiation.

The demand curve facing an individual firm is downward sloping but relatively elastic. Firms can set prices above marginal cost in the short run, but any economic profits attract new entrants, eroding profits over time. Long-run profits converge to zero, but price remains above marginal cost—indicating some inefficiency.

### Oligopoly

Oligopoly describes a market dominated by a small number of large firms. Products may be homogeneous (e.g., steel) or differentiated (e.g., automobiles). Barriers to entry are high, often due to scale economies, control of key resources, or regulation.

Each firm has significant pricing power, but strategic interdependence shapes pricing decisions. Firms must consider competitors’ anticipated responses—leading to a variety of outcomes (e.g., price wars, collusion, or non-price competition). Long-run economic profits are possible, but competition among oligopolists limits excessive profits.

### Monopoly

A pure monopoly consists of a single seller offering a unique product with no close substitutes. Barriers to entry are very high or absolute—such as legal protection (patents), control of strategic resources, or economies of scale.

The monopolist faces the entire market demand curve, which is downward sloping. Marginal revenue lies below price, and profit maximization occurs where MR = MC, at a price higher than perfect or monopolistic competition. Monopolies can sustain long-run economic profits, constrained only by regulation or potential entry.

> **Key Term: economic profit**
> The difference between total revenue and total economic costs (including opportunity costs), indicating whether a firm is earning above-normal returns.

## Components Influencing Market Structure

Several factors define and distinguish these market structures:

- **Number and size of sellers:** Many small firms (perfect, monopolistic competition); few large firms (oligopoly); or one firm (monopoly).
- **Product differentiation:** Homogeneous products (perfect competition, some oligopolies); differentiated products (monopolistic competition and many oligopolies).
- **Barriers to entry and exit:** Low or none (perfect, monopolistic competition); high (oligopoly, monopoly).
- **Non-price competition:** Product differentiation, advertising, and service are key in monopolistic competition and some oligopolies.

## Profit Maximization: Output and Price Choice

Firms in all market structures maximize profit by producing where marginal revenue equals marginal cost (MR = MC). However, the demand curve’s elasticity and a firm's position on it determine how much pricing power the firm actually has.

### **Worked Example 1.1**

Suppose a bakery operates in a market with many other bakeries selling identical bread. What can it charge for a loaf of bread if the market price is £2 and what happens if it tries to raise prices?

> **Answer:**
> In perfect competition, the bakery is a price taker. It must charge £2 per loaf because consumers can easily switch to competitors. If the bakery raises its price above £2, it will sell nothing.

### **Worked Example 1.2**

An airline industry is dominated by four major firms. When one airline cuts prices, the others follow quickly. What type of market structure is this, and what is the impact on pricing power?

> **Answer:**
> This is an oligopoly. Firms have some pricing power but are constrained by rivals’ actions. Price competition can lead to lower prices and lower profits if airlines “match” cuts in fares.

### **Worked Example 1.3**

A pharmaceutical company holds a patent for a new drug. What does the patent provide in terms of pricing and profits?

> **Answer:**
> The patent creates a monopoly. The company can charge above marginal cost and sustain economic profits in the long run as long as the patent and barriers to entry are maintained.

### **Exam Warning**

> Watch for the common exam error of confusing product differentiation (monopolistic competition) with monopoly power. Monopolistic competitors have limited pricing power due to entry, while monopolists can block entry entirely.

### Determining Long-Run Profitability

The ability to sustain economic profits depends primarily on barriers to entry:

- **No/low barriers:** Profits competed away (perfect, monopolistic competition).
- **High barriers:** Profits maintained (oligopoly, monopoly).

### Revision Tip

> Focus your revision on linking market structure to pricing power and long-term profit. Always identify product differentiation, the number of firms, and barriers to entry in any scenario.

## **Summary**

Market structure underpins pricing power and profit potential. Key distinctions: perfect competition (no pricing power or profit), monopolistic competition (limited pricing power, zero long-run profit), oligopoly (substantial pricing power, some profit), and monopoly (highest pricing power and long-run profit). Always link barriers to entry and product differentiation to sustainability of profit for the CFA exam.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Distinguish between perfect competition, monopolistic competition, oligopoly, and monopoly
- Explain how each market structure impacts firms’ pricing power and long-term profit
- Describe the importance of barriers to entry and product differentiation for competition
- Apply profit maximization (MR = MC) across market structures in pricing decisions

## **Key Terms and Concepts**

- market structure
- pricing power
- price taker
- economic profit

Microeconomic foundations - Market structures and pricing power