Economists can predict and describe the nature of a firm based upon its existing size, structure, behaviour and relationship to other firms (market power). This is known as theory of the firm. Two possible market structures that a firm may belong to are perfect competition and monopolistic competition (there are also oligopolies and monopolies).
Perfect competition exists when an industry consists of an infinite amount (in reality a very large number) of firms. There are a number of assumptions that accompany a perfectly competitive market:
1) Each individual firm has no market power
- Firms are too small, relative to the whole industry, to have a noticeable effect on the output of the whole industry by altering its own output.
- The firm cannot affect the supply curve of the industry so it can’t affect the price of the product
2) The firm is a price-taker
- Meaning, the firm has to sell at whatever price is set by the demand and supply in the industry as a whole
3) Firms produce homogenous goods (identical).
- Not possible to distinguish between goods produced by different firms
ie. No brand names or marketing
4) There are no barriers to entry/exit.
- Firms are completely free to enter or leave the industry as they wish
ie. No costs or legal barriers
5) All producers/ consumers possess perfect knowledge of the market
ie. Prices, costs, quality of products, availability, etc.
In real life, the closest industry to representing perfect competition is the agricultural market.
ie. Wheat production in Europe
Monopolistic competition exists if an industry has a fairly large number of firms present (albeit, fewer firms than in perfect competition). The assumptions that underlie a market in monopolistic competition are:
1) The firm has some price-setting ability
- Firms are still relatively small compared to the industry, so actions of one firm are unlikely to have a great effect on its competitors.
- Firms act independently of each other
2) It is possible to slightly differentiate between products.
- Firms produce slightly different products from each other, so the consumer has choice.
3) There are no barriers to entry/exit
-Firms are free to enter or leave the industry
4) Producers/consumers have almost perfect knowledge of the industry
There exist a number of real life examples of markets in monopolistic competition, for example: nail salons, restaurants, car mechanics, etc.
There are additionally similarities and differences in the profit abilities and efficiency of each market type:
In both perfect competition and monopolistic competition, firms in the industry are profit maximisers. A firm is only able to make normal (zero economic) profits in the long run, but can make short-run abnormal profits or losses.
In perfect competition, a firm achieves both allocative and productive efficiency in the long run. Consumers pay lower prices than in monopolistic competition, as they are only able to purchase homogenous products.
In monopolistic competition, a firm never achieves allocative or productive efficiency as consumers are willing to pay a slightly higher price in order to have differentiated products (choice).