You can no more build a successful portfolio without the right mixture of stocks any more than you can construct a skyscraper in Tornado Alley without the right mixture of building materials.
If you want to invest in a way that keeps your savings safe in the storm of changing economic environments, you have to start with a sound structural foundation. That begins with understanding how companies and markets work, how they compete and how they respond to changes.
Understanding the four market structures provides a starting point for judging industry and market news, policy changes and legislation and how it shapes your investing decisions.
So what kind of structures and materials define companies and markets?
Generally, there are several basic defining characteristics of a market structure:
- The commodity or item that is sold and level of differentiation between them.
- The number of companies in the market, the ease or difficulty of entering the market and the distribution of market share of the largest firms.
- The number of buyers and how they work with or against sellers to influence price and quantity.
- The relationship between producers or sellers.
We can use these characteristics to guide our discussion of the four types of market structures.
1. Perfect Competition Market Structure
In a perfectly competitive market, the forces of supply and demand determine the amount of goods and services produced as well as market prices set by the companies in the market.
Perfect competition assumes the environment or climate cooperates with the buildings within it.
The perfectly competitive market structure is a theoretically ideal market; there is free entry and exit, so many companies move into the market and easily exit when it’s not profitable. With so many competitors, the influence of one company or buyer is relatively small and does not affect the market as a whole.
Buyers and sellers are referred to as price takers rather than price influencers.
The products within the market are seen as homogenous, there is little difference between them. Not only are the products identical, information regarding product quality and price is perfectly and openly given to the public. The model assumes each producer is operating at the lowest possible cost to achieve the greatest possible output.
The perfect competition model is difficult to find in operation. There are few agricultural and craft markets that may fit the theory. This model is primarily a reference point from which economists compare the other market structures.
2. Monopolistic Competition Market Structure
Unlike perfect competition, monopolistic competition does not assume lowest possible cost production.
That slight difference in definition leaves room for huge differences in how the companies operate in the market.
Companies in a monopolistic competition structure sell very similar products with small differences they use as the basis of their marketing and advertising.
This is completely different from the perfectly competitive market structure which excludes advertising. Consider bath soap — they are all pretty much the same as far as what makes it soap and its use, but small differences like fragrance, shape, added oils or color are used in advertising and in setting price.
In monopolistic competition producers are price maximizers.
When the profits are attractive, producers freely enter the market. The slight differences between the products also creates imperfect information regarding quality and price.
Monopolistic competition markets are a hybrid of two extremes, the perfectly competitive market and monopoly.
Examples of monopolistic competition markets are:
- service and repair markets like HVAC repair companies.
- beauty salons and spas.
- and tutoring companies.
3. Monopoly Market Structure
Monopolies and perfectly competitive markets sit at either end of market structure extremes. However, both minimize cost and maximize profit. Where there are many competitors in a perfect competition, in monopolistic markets there’s just one supplier.
High barriers to entry into this market leave a “mono-” or lone company standing so there is no price competition. The supplier is the price-maker, setting a price that maximizes profits.
There are naturally occurring monopolies and those created through legislation, such as state-legislated liquor stores. However, several companies have been criticized as breaking antitrust laws including:
4. Oligopoly Market Structure
Not all companies aim to sit as the sole building in a city. Oligopolies have companies that collude, or work together, to limit competition and dominate a market or industry. The companies in these market structures can be large or small, however, the most powerful firms often have patents, finance, physical resources and control over raw materials that create barriers to entry for new firms.
Since this market structure discourages true competition, the producers are able to set prices, but the market is price sensitive. If the prices are too high, buyers will migrate to the market’s product substitutes.
- There are pure oligopolies with homogenous products, like the gasoline industry.
- Some firms function in differentiated oligopolies; selling products with small differences, like fast food or air transportation.
Understanding the definition of market structure and the differences within these four types allows you to be understand the context under which a company in question functions.
The dynamic relationships among and between sellers and buyers changes pricing, profits and production levels. Trading and investing requires researching how firms react to those relationships and changes and forecasting how their reactions will change their bottom lines, and yours.