Market structures

Barriers to entry are obstacles that make it difficult for new firms to enter a market (1) — for example high start-up costs, patents, strong brand loyalty, control of an essential resource, or government regulation — which protect existing firms from competition (1).

A price taker (2 marks) is a firm that must accept the market price and cannot influence it, because it is one of many small firms selling an identical product (as in perfect competition) — if it charged more, it would lose all its customers. A price maker (2 marks) is a firm with market power that can set its own price, because it has few or no competitors and faces barriers to entry (as a monopoly does) — though raising its price will still reduce the quantity it sells. So a price taker accepts the price; a price maker chooses it.

Competitive markets — with many firms, easy entry and consumers having alternatives — have both advantages and disadvantages for society. Advantages: competition drives prices down towards costs, benefiting consumers; firms must offer good quality, choice and service to win customers; and the pressure to survive forces firms to be efficient and to innovate with better products. These raise consumer welfare and the efficient use of resources. Disadvantages: firms with thin profit margins may struggle to fund long-term research and development, so some big innovations may be under-provided; intense competition can cause a 'race to the bottom', where firms cut wages, safety standards or environmental protection (e.g. pollution) to undercut rivals — harming workers and sustainability; and many small competing firms may fail to achieve economies of scale, keeping costs higher than necessary. In summary, competitive markets usually deliver lower prices, choice and innovation, but without regulation they can lead to weak R&D and harmful cost-cutting on labour and the environment — so the advantages tend to outweigh the disadvantages when the market is well regulated.

Barriers to entry are obstacles that stop new firms entering a market, and they are what allow a monopoly to sustain high prices. Normally, if a firm charges a high price and earns large profits, this attracts new firms into the market; their extra supply and competition then drive the price back down. Barriers to entry block this process. For example, high start-up costs (huge factories or networks), patents (legal protection of a product), control of an essential resource, strong brand loyalty, or government licences make it too difficult or expensive for new firms to enter. Because rivals cannot enter, the monopolist faces no competitive pressure, so it can keep its price above the competitive level and earn super-normal profit year after year without being undercut. The stronger the barriers, the more secure the monopoly's high prices. So barriers to entry protect a monopoly by preventing the new competition that would otherwise compete its high prices and profits away.

A natural monopoly exists where economies of scale are so large that one firm can supply the whole market more cheaply than several — water, electricity grids and rail networks are examples — and whether the government should own it is debatable. Arguments for government ownership: a single network avoids wasteful duplication (we don't want several sets of water pipes), and as a private monopoly it could exploit consumers with high prices and poor service since they have no alternative; government ownership can keep prices fair and affordable, guarantee universal access to an essential service, and pursue the public interest rather than profit. Arguments against (for private ownership, regulated): government-run firms can be inefficient, with weak incentives to cut costs or innovate and a burden on taxpayers; a privately owned but regulated monopoly (with a price cap set by a regulator) might combine private-sector efficiency with protection for consumers. Judgement: because a natural monopoly supplies an essential service with no competition, it must not be left as an unregulated private monopoly. Whether it is best government-owned or privately owned but tightly regulated depends on which delivers efficiency and fair prices in that country — a well-run public utility can serve the public interest, while elsewhere a regulated private firm may be more efficient. So the key requirement is public ownership or strong regulation, and which is best depends on circumstances.

A monopoly earns large, sustained (super-normal) profits because barriers to entry keep competitors out, and whether this benefits society is debatable. Why the profit can benefit society: the profit can be reinvested in research and development, funding innovation and new products that consumers eventually benefit from — costly research (e.g. new medicines) may need such profits to be viable; profits also fund investment in better technology and capacity, can support economies of scale that lower costs, and are taxed, providing government revenue. Why it may not benefit society: the profit often comes from charging consumers high prices and restricting output, so it represents a transfer from consumers to the firm's owners rather than a gain to society; there is no guarantee the profit is reinvested — it may simply enrich shareholders; and without competition the monopolist has little incentive to innovate or pass on cost savings. Judgement: a monopoly's profit benefits society if it is reinvested in innovation, better products and lower costs that reach consumers. But it harms society if it is merely a result of overcharging consumers and is paid out to owners with no wider benefit. So whether the profit benefits society depends on how it is used — which is why governments regulate monopolies to ensure consumers are protected and, ideally, that profits fund genuine improvements.