Notes · EconomicsUK · A-Levels

Perfect competition, imperfectly competitive markets and monopoly

This chapter analyses how firms behave in different market structures. It sets out the objectives of firms and the profit-maximising rule, then works through the spectrum of competition - perfect competition, monopolistic competition, oligopoly and monopoly - examining pricing, profit and efficiency in each, price discrimination, and the theory of contestable markets.

4 sections~18 min reading time4 competenciesLevel Standard 1 · Advanced 3

T·0555 / 14

Exam profile

AO1 · State the assumptions and outcomes of each market structure and the MC = MR profit-maximising ruleAO2 · Apply the models to real industries and interpret concentration ratios and profit dataAO3 · Analyse the profit-maximising equilibrium and the efficiency of each structure using diagramsAO4 · Evaluate the costs and benefits of monopoly and the usefulness of the perfect-competition model

Operators:defineexplainanalysecalculateevaluateassessdraw a diagram to show

basic level

AS-Level introduces competitive markets, the profit-maximising rule and monopoly; the full theory of market structures is A2.

higher level

The full A-Level requires diagrammatic analysis of all four structures, price discrimination, efficiency comparison and contestable-market theory.

Depth

Text

Contents · 4 sections

Perfect competition, imperfectly competitive markets and monopoly

Market structures, firm objectives and profit maximisation#

StandardAQA 7136 4.1.5DfE GCE Economics - market structures and firm objectives

The spectrum of market structures

Fig. 1Market structures differ in the number of firms, barriers to entry and product differentiation, which shape conduct and performance.

Market structure describes the characteristics of a market that determine how firms in it behave: the number and size of firms, the freedom of entry and exit (barriers to entry), the degree of product differentiation, and the availability of information. These characteristics place a market somewhere on a spectrum running from perfect competition (very many small firms, identical products, free entry, perfect information) through monopolistic competition and oligopoly to pure monopoly (a single firm, high barriers). Where a market sits on this spectrum shapes its price, output, profit and efficiency, which is why market structure is the organising idea of the theory of the firm.

The standard assumption is that firms aim to maximise profit, and profit is maximised at the output where marginal cost equals marginal revenue (MC = MR). The logic is marginal: while MR exceeds MC, producing one more unit adds more to revenue than to cost and so raises profit; while MC exceeds MR, the last unit costs more than it earns and cutting output raises profit; profit is therefore greatest where the two are equal (and MC is rising through MR). This single rule applies in every market structure - what differs between structures is the shape of the revenue curves the firm faces.

Firms may, however, pursue objectives other than profit maximisation, and awareness of these earns evaluation marks. Because of the divorce of ownership from control in large firms (shareholders own, managers control), managers may pursue their own goals - revenue maximisation (MR = 0, to boost their status or sales-linked pay), sales maximisation (the largest output that still earns normal profit, to gain market share), or 'satisficing' (earning enough profit to keep shareholders content while pursuing other aims). Firms may also pursue survival, social or environmental objectives, or profit satisficing under the principal-agent problem.

These alternative objectives matter because they change the predicted price and output: a revenue maximiser produces more, and charges less, than a profit maximiser, while a sales maximiser produces still more. In practice, imperfect information means firms may not know their exact cost and revenue curves, so profit maximisation is better seen as a tendency than a precise calculation. For A-Level answers, use MC = MR as the workhorse assumption but be ready to evaluate how alternative objectives, or the difficulty of identifying the curves, qualify it.

\text{Profit is maximised where } MC = MR

The profit-maximising rule

While MR > MC an extra unit adds to profit; while MC > MR cutting output adds to profit; so profit peaks where MC = MR (with MC rising through MR). This holds in every market structure.

Worked example

Finding the profit-maximising output

A firm's marginal revenue is MR = 20 - 2Q and its marginal cost is MC = 2 + Q. Find the profit-maximising output.

Apply the rule
Profit is maximised where MC = MR: set 2 + Q = 20 - 2Q.
Solve for Q
2 + Q = 20 - 2Q gives 3Q = 18, so Q = 6.
Interpret
At Q = 6, MR = 20 - 12 = 8 and MC = 2 + 6 = 8, confirming MC = MR. Producing more would cost more than it earns; producing less would forgo profitable units.

Result: The profit-maximising output is Q = 6, where MC = MR = 8.

Typical mistakes

Saying profit is maximised where total revenue is greatest - that is REVENUE maximisation (MR = 0), which produces more than the profit-maximising output.
Confusing the number of firms with the intensity of competition - a contestable market with few firms can still behave competitively.

Active revision

Explain why a profit-maximising firm produces where MC = MR, and analyse how its output would differ if it were a revenue maximiser instead.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Perfect competition: short-run and long-run equilibrium#

AdvancedAQA 7136 4.1.5DfE GCE Economics - perfect competition

Perfect competition: short-run supernormal profit

Fig. 2The price-taking firm produces where MC = MR (= price). Because price (6) exceeds ATC (5) at that output, it earns supernormal profit, the shaded rectangle.

Perfect competition is a theoretical benchmark defined by strict assumptions: a very large number of buyers and sellers, so each is too small to affect the price; a homogeneous (identical) product; freedom of entry and exit in the long run; and perfect information. The key consequence is that each firm is a price taker - it must accept the market price set by industry demand and supply, and can sell any quantity at that price but nothing above it. The individual firm's demand curve is therefore perfectly elastic (horizontal) at the market price, which means its average revenue and marginal revenue are equal and constant: AR = MR = price.

In the short run a perfectly competitive firm maximises profit where MC = MR, and because MR equals the market price, this is where MC equals price. It may earn supernormal profit if the price exceeds average total cost at that output, break even (normal profit) if price equals ATC, or make a loss if price is below ATC - a loss it will continue to bear in the short run as long as price covers average variable cost (the shut-down rule: produce if P is at least AVC, since any excess over variable cost covers some fixed cost). The diagram shows the horizontal AR = MR line, the profit-maximising output where it cuts MC, and the profit or loss as the rectangle between price and ATC.

The long run is where the model's distinctive result emerges, driven by free entry and exit. If firms are earning supernormal profit, new firms are attracted into the industry; this increases market supply, shifting the industry supply curve right and lowering the market price, until the supernormal profit is competed away. If firms are making losses, some exit, supply falls, and the price rises until the remaining firms break even. The process stops only when firms earn exactly normal profit, so in long-run equilibrium price equals the minimum of average total cost, and price = MR = MC = minimum ATC. No supernormal profit persists.

This long-run outcome is why perfect competition is held up as an efficiency ideal. It is productively efficient because each firm produces at the minimum of its ATC (lowest possible average cost), and allocatively efficient because price (which reflects the marginal benefit to consumers) equals marginal cost, so the value society places on the last unit equals the cost of producing it. But the model is an abstraction - perfect information and homogeneous products are rare, and its very efficiency leaves no supernormal profit to fund research and development, which is a serious limitation. Its main value at A-Level is as the benchmark against which the inefficiencies of monopoly and oligopoly are measured.

\text{Firm's demand: } AR = MR = P \quad (\text{price taker})

The price taker

A perfectly competitive firm faces a perfectly elastic (horizontal) demand curve at the market price, so average and marginal revenue both equal the price.

Perfect competition: long-run equilibrium

Fig. 3Free entry competes away supernormal profit: in the long run price equals the minimum of ATC, so AR = MR = MC = minimum ATC and only normal profit is earned.

Worked example

Short-run profit for a price taker

The market price is 6 pounds. A price-taking firm has MC = Q and, at its profit-maximising output, its ATC is 5 pounds. Find the profit-maximising output and the supernormal profit.

Set MC = MR
For a price taker MR = price = 6, so MC = MR means Q = 6. The firm produces 6 units.
Compare price with ATC
At Q = 6, price is 6 and ATC is 5, so the firm earns supernormal profit of (6 - 5) = 1 pound per unit.
Total supernormal profit
Supernormal profit = (P - ATC) x Q = (6 - 5) x 6 = 6 pounds. In the long run, entry would erode this until P = minimum ATC.

Result: The firm produces 6 units and earns 6 pounds of supernormal profit in the short run, which long-run entry would compete away.

Typical mistakes

Drawing an upward-sloping demand curve for the firm - the individual firm's demand is horizontal (it is a price taker), even though the INDUSTRY demand slopes down.
Forgetting the shut-down rule - in the short run a firm keeps producing as long as price covers average variable cost.

Active revision

Using diagrams, explain how supernormal profit earned by a perfectly competitive firm in the short run is eliminated in the long run.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Monopolistic competition and oligopoly#

AdvancedAQA 7136 4.1.5DfE GCE Economics - monopolistic competition and oligopoly

The prisoner's dilemma in oligopoly

Fig. 4Each firm's dominant strategy is to cut price (fearing being undercut), so both reach the low-price outcome - worse for them than colluding, illustrating why cartels are unstable.

Monopolistic competition describes markets with many firms selling differentiated (but close-substitute) products, with low barriers to entry - hairdressers, restaurants, plumbers. Each firm has a little market power from its differentiation, so it faces a downward-sloping (but highly elastic) demand curve and can set its price. In the short run a firm may earn supernormal profit; but because entry is easy, new firms attracted by that profit enter and take market share, shifting each existing firm's demand curve left until, in the long run, firms earn only normal profit (demand is tangent to ATC). The outcome is neither productively nor allocatively efficient (price exceeds MC and output is below minimum ATC), but the inefficiency is modest and consumers gain from variety and choice.

Oligopoly is the most realistic and important structure: a market dominated by a few large, interdependent firms - supermarkets, banks, energy, mobile networks. The defining feature is interdependence: because each firm is large, its decisions on price, output and marketing noticeably affect its rivals, who will react, so each firm must anticipate rivals' reactions when it acts. Oligopolies have high barriers to entry and typically a high concentration ratio - the share of the market held by the largest few firms (a five-firm concentration ratio of 80% means the top five firms supply 80% of the market). Products may be homogeneous or differentiated.

Interdependence produces two contrasting tendencies. On the one hand, firms have a strong incentive to collude - to act together like a monopoly, fixing prices or output to raise joint profits (a cartel, such as OPEC). Collusion may be overt (formal agreement, illegal in the UK) or tacit (an unspoken understanding, often via price leadership, where firms follow a dominant firm's price). On the other hand, the temptation to cheat on a collusive agreement, and the risk of price wars, mean cooperation is fragile. Game theory, illustrated by the prisoner's dilemma, formalises this: two firms choosing prices independently may both end up in a worse (low-price) outcome than if they had cooperated, because each fears being undercut.

Where firms compete rather than collude, the kinked demand curve model offers one explanation of the price stability often observed in oligopoly: each firm believes rivals will match a price cut (so demand is inelastic below the current price - cutting price gains little) but will not match a price rise (so demand is elastic above it - raising price loses many customers). The kink creates a discontinuity in marginal revenue, so costs can change within a range without altering the profit-maximising price, giving 'sticky' prices. Because price competition is risky, oligopolists often compete on non-price grounds instead - advertising, branding, product quality, loyalty schemes and innovation - which can benefit consumers but also raises barriers to entry. Evaluation turns on whether a given oligopoly behaves collusively (bad for consumers, high prices) or competitively (lower prices, more innovation).

\text{n-firm concentration ratio} = \text{combined market share of the largest } n \text{ firms}

Concentration ratio

Measures the degree of market dominance. A high ratio (e.g. a five-firm ratio above 60%) indicates an oligopoly.

Worked example

Interpreting a concentration ratio

In a market, the five largest firms have market shares of 30%, 22%, 18%, 8% and 6%. Calculate the five-firm concentration ratio and comment on the market structure.

Sum the shares
The five-firm concentration ratio adds the shares of the five largest firms: 30 + 22 + 18 + 8 + 6 = 84%.
Interpret
The top five firms supply 84% of the market, a high concentration ratio, so the market is a tight oligopoly.
Draw the implication
With so much of the market in a few hands, the firms are interdependent and there is a real risk of collusion or tacit price leadership, which regulators would monitor.

Result: The five-firm concentration ratio is 84%, indicating a highly concentrated oligopoly with interdependent firms.

Typical mistakes

Assuming all oligopolies collude and charge high prices - many compete fiercely on price and non-price factors.
Confusing monopolistic competition (many firms, easy entry, normal profit in the long run) with monopoly or oligopoly.

Active revision

Using game theory, explain why two petrol retailers might both end up charging low prices even though both would earn more by keeping prices high.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Monopoly, price discrimination and efficiency comparison#

AdvancedAQA 7136 4.1.5DfE GCE Economics - monopoly and monopoly power

Monopoly equilibrium and supernormal profit

Fig. 5The monopolist produces where MC = MR (Q = 4), charges the price consumers will pay on the AR curve (P = 8), and earns supernormal profit (the shaded rectangle) because price exceeds ATC.

A pure monopoly is a single seller supplying the whole market; in law and practice, a firm with a dominant market share (25% or more in UK competition law) is said to have monopoly power. Monopoly is protected by high barriers to entry - legal barriers (patents, licences), natural barriers (economies of scale so large that one firm supplies the whole market at lowest cost - a natural monopoly), control of an essential resource, brand loyalty and predatory or limit pricing. Because it faces the entire market demand curve, a monopolist is a price maker: it faces a downward-sloping AR (demand) curve, with MR below it, and it profit-maximises where MC = MR, then charges the price consumers will pay for that output (read off the AR curve above the MC = MR output).

The result is the central criticism of monopoly: compared with a competitive market, the monopolist restricts output and charges a higher price. Because high barriers block entry, supernormal profit is not competed away and can persist in the long run, shown as the rectangle between price and ATC at the profit-maximising output. Monopoly is allocatively inefficient because price exceeds marginal cost (P > MC: consumers value the last unit more than it costs to produce, so too little is produced), and it need not be productively efficient because it does not produce at the minimum of ATC. The loss of consumer surplus, part of which becomes producer surplus and part of which is lost altogether (the deadweight welfare loss), is the standard case against monopoly.

A monopolist with market power may practise price discrimination - charging different prices to different consumers for the same good, for reasons not based on differences in cost. This requires the firm to have market power, to be able to separate consumers into groups with different price elasticities of demand, and to prevent resale between them. Examples include peak and off-peak rail fares, student and adult tickets, and airline pricing. Price discrimination raises the firm's profit by capturing more consumer surplus (charging inelastic-demand groups more), and can, controversially, allow output to expand and some consumers to be served who otherwise would not be - so its welfare effects are genuinely mixed.

The evaluation of monopoly is therefore balanced, not one-sided, which is what separates top answers. Against monopoly: higher prices, restricted output, allocative and productive inefficiency, and possible X-inefficiency (slack from lack of competition). In favour: economies of scale may make a large firm's costs (and so potentially its prices) lower than many small firms' - decisive for a natural monopoly; supernormal profit can fund research and development and innovation (dynamic efficiency), which competitive firms cannot afford; and the theory of contestable markets (Baumol) argues that what disciplines a firm is not the number of rivals but the threat of entry - if entry and exit are costless (no sunk costs), even a monopolist must keep prices near the competitive level for fear of 'hit-and-run' entry. The judgement depends on the height of the barriers, the size of the economies of scale, whether profits fund innovation, and how contestable the market is.

\text{Monopoly: profit-max } MC = MR, \ \text{ then } P \ \text{read off } AR > MC

Monopoly pricing

The monopolist sets output where MC = MR, then charges the highest price consumers will pay for that output (from the AR curve). Because P > MC, monopoly is allocatively inefficient.

Worked example

Solving a monopoly for price, output and profit

A monopolist faces demand P = 12 - Q (so MR = 12 - 2Q) and has MC = Q. At the profit-maximising output its ATC is 5 pounds. Find the output, price and supernormal profit.

Set MC = MR
12 - 2Q = Q gives 12 = 3Q, so Q = 4. This is the profit-maximising output.
Find the price from AR
Read the price off the demand curve at Q = 4: P = 12 - 4 = 8 pounds. (Note P = 8 exceeds MC = 4, so the market is allocatively inefficient.)
Compute supernormal profit
Supernormal profit = (P - ATC) x Q = (8 - 5) x 4 = 12 pounds, which persists because barriers block entry.

Result: The monopolist produces 4 units, charges 8 pounds and earns 12 pounds of supernormal profit; because P = 8 > MC = 4, output is allocatively inefficient.

Typical mistakes

Reading the monopoly price off the MC = MR point rather than up on the AR (demand) curve - the price is always on the demand curve.
Presenting monopoly as wholly bad - top answers weigh economies of scale, innovation and contestable-market theory.

Active revision

Evaluate the view that a monopoly always harms consumers. Use a monopoly diagram to support your answer.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

References & sources

Sources

Department for Education

GCE AS and A level subject content for economics

AQA

AQA A-level Economics 7136 specification

Perfect competition, imperfectly competitive markets and monopoly

4 sections~18 min reading time4 competenciesLevel Standard 1 · Advanced 3

Perfect competition, imperfectly competitive markets and monopoly

Key points

Finding the profit-maximising output

Key points

Short-run profit for a price taker

Key points

Interpreting a concentration ratio

Key points

Solving a monopoly for price, output and profit

Sources

Perfect competition, imperfectly competitive markets and monopoly

Key points

Finding the profit-maximising output

Key points

Short-run profit for a price taker

Key points

Interpreting a concentration ratio

Key points

Solving a monopoly for price, output and profit

Sources