1.5 Perfect competition, imperfectly competitive markets, and monopoly Flashcards
Price taker
a firm which accepts the ruling market price set by market conditions
Price maker
a firm possessing the power to set the price within the market
Characteristics of perfect competition (6)
• a large number of buyers and sellers
• all buyers and sellers possesses perfect market information
• buyers/sellers can buy/sell as much as they wish at the market price
• any single buyer or seller is unable to influence the market price
• the goods being sold are homogeneous
• no barriers to entry or exit
Homogeneous goods
goods which are identical
Barriers to entry
factors that prevent or discourage new firms from entering a market, helping existing firms maintain market power.
Consumer surplus
the difference between the amount the consumer is willing to pay for a product and the price they have actually paid
The area between the horizontal equilibrium price line and the demand curve represents the consumer surplus in the market (ABPe)
The consumer surplus lies underneath the demand curve
Producer surplus
the difference between the amount that the producer is willing to sell a product for and the price they actually receive
The area between the horizontal equilibrium price line and the supply curve represents the producer surplus in the market (CBPe)
Producer surplus lies above the supply curve
Deadweight loss
Deadweight loss is the loss of economic efficiency that occurs when the allocative optimum (where MSB = MSC) is not achieved, leading to a reduction in total welfare.
Allocative efficiency
when resources are allocated in a way that maximizes societal welfare, meaning:
Marginal Social Benefit (MSB) = Marginal Social Cost (MSC)
or P=MC
SR perfect competition
- firms can be making abnormal profit
- new firms cannot enter the market due to there being at least one fixed factor of production
Existing firms can adjust variable inputs (e.g., hire more workers), but cannot instantly expand capacity.
New firms cannot enter because they need time to acquire/build fixed assets.
Describe perfect competition in the long run
- new firms enter the market
new firms can enter by building factories, buying machines, etc. - the equilibrium price in the market falls, just until firms are making normal profit
Monopoly power
power to set prices and other aspects of the market such as differentiation. Firms in market structures other than perfect competition possess a degree of monopoly power
Monopoly
a market structure with only firm in the market
total costs under supernormal prof
Natural monopoly
when there is only room in a market for one firm benefiting from economies of scale to the fullest
Differentiated goods
goods which are different from other goods
Market failure
when the market mechanism leads to a misallocation of resources in an economy, either completely failing to provide a good or service or providing the wrong quantity
P does not = MC
Oligopoly
a market structure where there are a small number of interdependent firms
Top 3-5 firms control ≥60-70% of the market
if costs changes in the vertical gap a profit maximizing oligopolist will always charge price p1
Collusion def + pros & cons
agreements between firms to restrict competition
Pros of Collusion (advantages for firms):
-Higher Profits
Firms act like a monopoly, reducing output and raising prices (P > MC).
Example: OPEC oil cartel limits supply to boost prices.
-Price Stability
Avoids price wars, which can erode profits (e.g., airline industry).
-Reduced Uncertainty
Firms can coordinate production without fear of being undercut.
-Cost Savings
No need for aggressive advertising or R&D spending if competition is suppressed.
Cons of Collusion :(Disadvantages for Economy & Consumers)
Higher Prices & Allocative Inefficiency
Consumers pay more → deadweight loss (MSB > MSC).
Reduced Consumer Choice
Colluding firms may standardise products (e.g., fewer innovations in smartphones).
Barriers to Entry
New firms struggle to compete (e.g., cartels dominate raw material supplies).
Risk of Detection & Penalties
Illegal in most countries (e.g., UK Competition and Markets Authority fines).
Example: 2015 Truck Cartel fined €2.9bn for price-fixing.
Unstable Agreements
Incentive to cheat (e.g., one firm undercuts others secretly → prisoner’s dilemma).
How does monopoly power lead to market failure? (4 point analysis)
- redistributes welfare away from consumers to producers
- consumers are exploited as they pay a price above the marginal cost of production leading reduced consumer surplus and increase producer surplus
- reduces total welfare
- producers’ net gain is smaller than the loss inflicted on consumers
Barriers to entry in a monopoly (9)
- patents + trademarks
- limit pricing
- advertising + marketing
- control over outlets
- control over suppliers
- reaction of existing firms
- legislation
- cost-advantage
- differentiation
Legislation
government may restrict the ability of firms to compete in the market. e.g. for 350 years Royal Mail was the only firm allowed to deliver letters in the UK
Differentiation
making a good different from the competition through marketing and branding can prevent a new firm from being able to enter a market and gain market share
Ways to differentiate a product (8)
- improved product
- wider product range
- nicer packaging
- compatibility with complements
- better quality of service
- advertising
- easier to use products
- production methods
Brand loyalty
when consumers repeat purchase from the same firm, instead of swapping and switching between firms. It can be expensive for new firms to develop a brand image to break existing loyalties within the market
Control over outlets
if a firm controls the place where a product is sold it means their competitors may not be able to sell their products
Patents and trademarks
legal protection which prevents other firms from imitating existing ideas
Control over suppliers
if a firm controls the materials needed to make a good it means potential new firms may not be able to produce their goods
Cost advantage
if a firm has achieved a lower average cost because of the economies of scale, this means potential competitors may not be able to compete as they cannot produce as cheaply
Reaction of existing firms
new firms may not enter a market if they think it will trigger a price war
Limit pricing
prices set low enough to make it unprofitable for new firms to enter a market
Divorce of ownership from control
the owners and those who manage the firm are different groups with different objectives
Principle-Agent Problem
When the agent (worker or manager) doesn’t act in the best interest of the principle (owner).
solutions to principal-agent problem (3)
-Performance-Related Pay (Incentive Alignment)
Example: Bonuses, profit-sharing, stock options.
How it works: Ties agent rewards to firm performance (e.g., CEO stock options).
Evaluation:
✅ Encourages effort.
❌ May encourage short-term risk-taking
Contract Design
Example: Long-term employment contracts with clawback clauses.
How it works: Penalises poor performance (e.g., fired for missing targets).
Evaluation:
✅ Aligns long-term goals.
❌ Inflexible in dynamic markets.
Revenue maximisation occurs at
MR = 0
Profit maximisation occurs at
MC = MR
Sales maximisation
occurs when revenue is maximised (while still generating normal profit); AR=ATC or ac
Market share maximisation
occurs when a firm maximises its percentage share of the market in which it sells its product
Economic surplus maximisation
- occurs where a firm maximises the size of the consumer and producer surplus, achieving allocative efficiency
- occurs where MC=AR
Survival
occurs where a firm avoids making or reduces the size of subnormal profit, or potential subnormal profit
Quality maximisation
occurs where a firm maximises the quality of the goods that they are selling
Growth maximisation
The objective of increasing the size of the firm as much as possible (e.g. could be measured through no. of employees, market capitalisation)
Stakeholders
People with an interest in an organisation
Shareholders
owners of shares in a company
Satisficing
achieving a satisfactory outcome rather than the best possible outcome
Profit satisficing
Making enough profit to satisfy the needs of the firm’s owner(s)
Productively efficient
the level of output at which average costs are minimised
X-inefficiency
X-inefficiency occurs when a firm fails to minimise its production costs due to a lack of competitive pressure, resulting in higher average costs
Dynamic efficiency
Dynamic efficiency occurs when firms improve quality, innovation, and production techniques over time, leading to:
Lower long-run average costs (LRAC)
Better products/services
Sustained economic growth
Concentration ratio
the total market share of a number of leading firms in a market, or the output of these firms as a percentage of total market output
Real-World Example (AQA Context)
UK Grocery Market (2023):
Tesco (27%), Sainsbury’s (15%), Asda (14%), Morrisons (10%) → CR4 = 66% (Oligopoly).
Advantages of monopoly (3)
Economies of Scale (3.6.3)
Lower LRAC: Mass production reduces costs (e.g., National Grid’s infrastructure).
Diagram: Downward-sloping LRAC curve.
AQA Context: Natural monopolies (water, railways) benefit most.
Innovation (Dynamic Efficiency)
Supernormal profits fund R&D (e.g., Pfizer’s COVID vaccine).
Stable Prices
Avoids price wars
Disadvantages of monopoly (3)
Allocative Inefficiency
Mechanism: Monopolies set P > MC (profit-maximising at MR=MC).
Effect:
Higher prices
Lower output leading to deadweight loss
Productive Inefficiency (X-Inefficiency)
No pressure to minimise costs: Lack of competition → waste (e.g., overstaffing).
Reduced Consumer Choice
Single supplier → less variety
Higher Prices & Regressive Impact
Disproportionately harms low-income households (e.g., energy bills).
Market share formula
Firm’s sales/Total Market Sales X 100
Cartel
a group of firms who collude with each other
Price fixing
agreeing prices with your competitors, or agreeing to offer discounts at the same time, or agreeing to raise prices at the same time
Market sharing
dividing a market (e.g. by region or customer type), and agreeing not to sell to each other’s customers
Consumer inertia
the tendency of consumers to buy or continue buying a good, even when superior options exist
Price war
occurs when rival firms continuously lower prices to undercut each other with the aim to gain or defend market share
Impact of sub-normal profit under perfect competition
- sub-normal profit in the short run means firms leave the market
- price then returns to equilibrium in long run
impact of abnormal profit under perfect competition
- abnormal profit in the short run attracts firms to the market
- price and quantity then return to equilibrium in long run
impact of perfect competition on economic welfare
- leads to allocative efficiency
- maximum possible mutually beneficial transactions take place
- absence of deadweight loss
How is productive efficiency shown on a cost/revenue diagram?
AC minimised (where MC=AC) or atc
How is allocative efficiency shown on a cost/revenue diagram?
P=MC
resource misallocation
when resources are allocated in a way which does not maximise economic welfare
P doesn’t =MC
MSC does not = MSB
Conditions of monopoly (6)
- only one firm in the market
- there may be imperfect information
- the firm has a trade-off between price and quantity due to having a downward-sloping demand curve
- the firm is a price setter
- the goods in the market are differentiated
- there are barriers into the market
Shutdown point
the level of output (in the short-run) where a firm has no economic benefit of producing; occurs where AR=AVC
shutdown price
the minimum price a firm needs to charge to justify remaining in the market in the short run
Characteristics of monopolistic competition (6)
- if a firm raises its price, it does not lose all of its customers
- large number of firms in the market
- no barriers to entry or exit in the long-run
- Goods produced by various firms are partial but not perfect substitutes.
- the entry of new firms, attracted by short-run abnormal profits, brings down price until only normal profits can be made in the long-run
- each firm’s MR curve is below its AR curve
How efficient is monopolistic competition?
neither productively nor allocatively efficient in the long run and short run
short-run impacts of abnormal profits under monopolistic competition
- new firms attracted to market
- however they cannot enter in short run due to fixed costs
Long-run impacts of abnormal profits under monopolistic competition
- incumbent firms cannot maintain abnormal profit due to new firms entering the market because of the absence of barriers to entry, and goods being partially substitutable
interdependence
in market theory, when the actions of one firm will have an impact on other firms in the market
Game theory and conclusions
price rigidity (bottom right) cause non price comp
tempted to collude (top left)
incentive to cheat on collusion ( bottom left, top right)
Nash equilibrium
a situation where no player can improve their position given the choice of the other players
bottom right
The Competition and Markets Authority (CMA)
government agency responsible for advising on and implementing UK competition policy
Resale Price Maintenance (RPM)
imposing minimum prices on distributors such as shops
Predatory pricing
cutting prices below cost in order to force a smaller or weaker competition out of the market
Tacit collusion
where firms collude without any formal agreement and where there has been no explicit communication between firms about market conduct strategy
Bounded rationality
when making decisions, an individual’s rationality is limited by the information they have, the limitations of their minds, and the finite amount of time available in which to make decision
Creative destruction
a process where firms produce or create innovative goods that replace or destroy existing goods in the market
Internal economies of scale
long-run average costs falling caused by growth of the firm
Advantages of oligopoly (4)
- Economies of Scale (3.6.2)
Lower Costs: Large firms benefit from bulk buying and specialisation (e.g., Tesco’s distribution networks).
AQA Link: Drives down LRAC, allowing lower consumer prices. - Innovation & Dynamic Efficiency (3.4.2)
R&D Investment: Supernormal profits fund innovation (e.g., Apple vs. Samsung smartphone competition).
AQA Example: Pharmaceutical oligopolies develop life-saving drugs. - Price Stability (Kinked Demand Curve – 3.6.5)
Avoids destructive price wars, protecting jobs and firm survival. - Consumer Choice & Quality
Non-price competition (e.g., branding, features) increases variety (e.g., car models).
Disadvantages of oligopoly (2)
- Higher Prices & Allocative Inefficiency
Mechanism: Firms restrict output to maximise profits (P > MC).
Effect:
Deadweight loss (reduced consumer surplus).
Example: UK energy market (Big 6 firms accused of overcharging).
AQA Diagram:
Oligopoly Welfare Loss
- Collusion & Cartels (3.6.5)
Risk: Firms secretly fix prices/output (e.g., 2015 Truck Cartel fined €2.9bn).
AQA Link: Illegal under UK Competition and Markets Authority (CMA).
- Barriers to Entry (3.6.2)
High startup costs (e.g., car manufacturing) → limits competition.
Predatory pricing (e.g., Amazon undercutting small retailers).
- Non-Price Competition Waste
Excessive advertising (e.g., Coca-Cola vs. Pepsi) raises costs without improving quality. - Price Stickiness (Kinked Demand Curve)
Firms delay price cuts in recessions → prolongs economic downturns.
Describe the shape of the AR curve under oligopoly
- kinked
- more price elastic at a lower level of output than the kink
- more price inelastic at a higher level of output
Price discrimination
charging different prices to different customers for the same product or service, with the price based on different willingness to pay
First-degree price discrimination
where a firm charges each customer for each unit the maximum price which the customer is willing to pay for that unit
First-degree price discrimination example (1)
- a market stall trader not putting any prices on the wares, instead choosing to haaggle
Second-degree price discrimination
where a firm charges a consumer so much for the first so many units purchased, a different price for the next so many unit purchased, and so on
Second-degree price discrimination examples (3)
- electricity is more expensive for the first number of units
- after 10 minutes calls become cheaper
- loyalty cards reward frequent buyers with discounts on future products
Third-degree price discrimination
where a firm divides consumers into different groups and charges a different price to consumers in different groups, but the same price for all consumers within a group
Third-degree price discrimination examples (4)
- student discounts
- cheaper prices by the time of the day (e.g. happy hours in pubs)
- senior citizen rail card
- peak/ off-peak travel
Effects of price discrimination that directly benefit consumers (4)
- some consumers will benefit from lower prices and products that might not otherwise be supplied
- allows firms to cross-subsidise loss-making services
- may increase total sales and generate economies of scale, perhaps lowering prices
- better capacity utilisation by firms will lower costs and may lead to lower prices
Effects of price discrimination that DO NOT directly benefit consumers (5)
- some consumers will face a higher price
- can be used as a barrier to entry, reducing competition
- allows the producer to convert consumer surplus into producer surplus
- allows producers to reduce fixed costs by spreading demand more evenly
- allows producer to increase revenue and profit
Conditions required to price discriminate (3)
- firm must have some monopoly power
- it must be possible to identify different groups of customers for the good. This can happen because of differing knowledge or differing ability to shop around. At any particular price, the different groups must have different PEDS.
- markets must be separated to prevent seepage
Contestable market
a market in which the potential exists for new firms to enter the market. A perfectly contestable market has no entry or exit barriers and no sunk costs, and both incumbent firms, and new entrants have access to the same level of technology
Conditions of contestable markets
- absence on entry barriers
- absence of exit barriers (sunk costs)
- consumers don’t have total brand loyalty to already existing firms within the market
Sunk costs
costs that have already been incurred and cannot be recovered
Break even
- occurs when the number of sales is maximised while still generating normal profit
- AKA sales maximisation
- AC = AR
deadweight loss for negative externality
deadweight loss for positive externality
Free Market Forces
