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CFA® Level I · Economics · free lesson
The Firm and Market Structures
Market structure decides whether a company can defend its margins or will see them competed away, which makes it a starting point for any industry analysis. This module shows how economists classify markets, how firms in each structure choose price and output, when a loss-making firm should keep producing, how economies of scale shape the number of firms, how oligopolists interact, and how analysts and regulators measure concentration.
What you will learn
1. Describe and compare the defining features of perfect competition, monopolistic competition, oligopoly and monopoly, and explain how they determine a firm's pricing power.
- Classify markets by number of sellers, product differentiation, entry barriers, pricing power and non-price competition.
- A perfectly competitive firm is a price taker facing a horizontal (perfectly elastic) demand curve.
- Monopolistic competition: many sellers of differentiated products; low barriers erode economic profit over time.
- Oligopoly is defined by interdependence: each firm's best choice depends on rivals' choices.
- Monopoly power rests on barriers to entry such as patents, licences, key resources, network effects or scale.
2. Explain how price elasticity of demand links price and marginal revenue, and determine the profit-maximizing output and price for a perfectly competitive firm and a monopolist.
- Profit is maximized where MR = MC in every market structure.
- Perfect competition: P = MR, so the firm produces where P = MC.
- MR = P(1 - 1/|E|): MR > 0 when demand is elastic, 0 at unit elasticity, < 0 when inelastic.
- A monopolist sets MR = MC, reads the price off the demand curve, and charges P > MC, creating a deadweight loss.
- Price discrimination lets a firm with pricing power capture more consumer surplus.
3. Calculate and interpret the breakeven and shutdown points, and distinguish a firm's short-run operating decision from its long-run decision to stay in or exit an industry.
- Breakeven: TR = TC, or P = ATC; economic profit is zero and the firm earns a normal profit.
- Short run: operate if TR ≥ TVC (P ≥ AVC) even at a loss; fixed costs are paid either way.
- Shutdown point: price equal to minimum AVC; below it, stop producing immediately.
- Long run: all costs are variable; exit if TR cannot cover TC.
- The loss from shutting down equals total fixed cost.
4. Explain economies and diseconomies of scale, interpret the long-run average cost curve and minimum efficient scale, and relate them to long-run equilibrium in each market structure.
- LRAC is the envelope of short-run ATC curves; all inputs are variable in the long run.
- Economies of scale: specialization, spreading fixed costs, bulk buying. Diseconomies: bureaucracy, coordination problems, duplication.
- Minimum efficient scale is the lowest output at which LRAC reaches its minimum.
- Large MES relative to demand leads to oligopoly or natural monopoly.
- Long run: perfect competition has P = MC = min ATC; monopolistic competition has zero profit but excess capacity.
5. Describe the main models of oligopoly behaviour, including kinked demand, Cournot, Stackelberg, dominant-firm and game-theoretic (Nash) approaches, and explain why cartels tend to be unstable.
- Kinked demand: price cuts are matched, increases are not; the MR gap makes prices sticky.
- Cournot: simultaneous quantity choices; output between monopoly and competition, approaching competition as firms are added.
- Stackelberg: the first mover produces more and earns more than the follower.
- Dominant firm: the leader sets price; the competitive fringe takes it as given.
- Nash equilibrium need not maximize joint profit; the incentive to cheat makes cartels unstable.
6. Identify a market's structure using concentration measures such as the N-firm concentration ratio and the Herfindahl-Hirschman Index, and explain the limitations of these measures.
- CR_N = sum of the market shares of the N largest firms.
- HHI = sum of squared percentage shares of all firms; 10,000 for a monopoly, 10,000/N for N equal firms.
- A merger of firms with shares s1 and s2 raises HHI by 2 x s1 x s2.
- Concentration measures ignore entry barriers and contestability.
- Results depend heavily on how the product and geographic market are defined.
Module at a glance
- Classify markets by sellers, differentiation, entry barriers, pricing power and non-price competition.
- All firms maximize profit where MR = MC; a price taker produces where P = MC, a firm with pricing power charges P > MC.
- MR = P(1 - 1/|E|): a monopolist with positive costs operates only on the elastic part of its demand curve.
- Short run: operate if TR covers TVC; long run: stay only if TR covers TC.
- Minimum efficient scale relative to market demand determines how many firms can produce efficiently.
- Oligopoly outcomes depend on assumed rival reactions: kinked demand, Cournot, Stackelberg, dominant firm, Nash equilibrium.
- Cartels are unstable because each member gains by cheating on its quota.
- HHI = sum of squared shares; a merger adds 2 x s1 x s2; concentration measures ignore entry and depend on market definition.
This free module has 6 lessons, 14 practice questions with full explanations.