1The idea in one paragraph

A firm with market power can raise its price without losing all of its customers. A firm without market power cannot: the moment it asks for a penny more, everyone buys the identical thing next door. That single difference decides everything else. A firm with no power takes the price the market hands it and ends up producing where price equals marginal cost, which is exactly the amount society wants. A firm with power holds output back to keep its price up, so price ends up above marginal cost, some units that were worth making never get made, and community surplus is smaller than it could have been. That gap is why market power sits in the syllabus under market failure, and everything in this unit is either a way of drawing that gap or a way of arguing about what a government should do about it.

2The four market structures

A market structure is a description of the competitive conditions a firm operates in: how many rivals it has, how easy it is for new firms to join, and how similar the products are. The guide names four.

Perfect competition. Many firms, all small. Free entry, meaning no barrier stops a new firm joining or an existing one leaving. Homogeneous products, meaning every firm's output is identical, so buyers have no reason to prefer one seller. No firm has any market power at all. It is a model, not a photograph of a real market, and it is on the syllabus as a benchmark: the yardstick every other structure is measured against.

Monopoly. A single firm, or one dominant firm, supplying the whole market. High barriers to entry keep rivals out: a patent, ownership of the only mine, a licence from the state, or a cost advantage so large that nobody can match it. There are no close substitutes, so buyers cannot go elsewhere.

Imperfect competition covers the two structures in between, and both are named in the guide.

• Oligopoly. A few large firms dominate. Barriers to entry are high. The defining feature is interdependence: each firm's best move depends on what it expects the others to do, and each knows the others are thinking the same way. No other structure has this.
• Monopolistic competition. Many firms and free entry, as in perfect competition, but with product differentiation: each firm's version is a little different, by recipe, location, branding or service. That difference gives each firm a small amount of market power, because a few customers will stay even after a price rise.

Figure 1 lines all four up. Read it left to right as market power rising, and notice that only the first column ends with "allocatively efficient". Everything from section 6 onwards is about why.

3How any firm picks its output: profit maximisation

The guide's phrase is rational producer behaviour, and it means one assumption: a firm chooses the output that makes its profit as large as possible. There are two ways to find that output, and they always agree.

First, the definitions. All five are examinable and all five are just divisions or differences.

• Total revenue (TR) is price × quantity: all the money coming in.
• Total cost (TC) is everything the firm pays out, including normal profit — the minimum return the owner needs to stay in this business rather than do something else. Economists treat that minimum as a cost, which is why it sits inside TC.
• Profit = TR − TC.
• Average revenue (AR) is TR ÷ Q, which for a firm charging one price is the price itself. So AR = P, always.
• Average cost (AC) is TC ÷ Q: the cost of a typical unit.
• Marginal revenue (MR) is the change in TR from selling one more unit: ΔTR ÷ ΔQ.
• Marginal cost (MC) is the change in TC from making one more unit: ΔTC ÷ ΔQ.

Method one: the largest TR − TC. Work out profit at every output and pick the biggest number.

Method two: MC = MR. Keep making units while each one brings in more than it costs, and stop when it stops doing so. That gives the rule the whole unit runs on:

Every firm, in every market structure, produces where MC = MR. Then read the price up to the demand curve — never off MR.

Now the guide's calculation, with our own numbers. Harbour Ice sells bags of ice from one depot. Output is in thousands of bags a week, so TR, TC and profit are in € thousand, while AR, AC, MR and MC are in € per bag.

Every column is built from the two you are given. TR = P × Q, so at Q = 3 that is €7 × 3,000 = €21,000. AC = TC ÷ Q = 18,000 ÷ 3,000 = €6.00. MR for the third thousand is (21 − 16) ÷ 1 = €5. MC for the third thousand is (18 − 15) ÷ 1 = €3.

Both methods pick Q = 3. The profit column peaks at €3,000 there. And the third thousand bags brings in €5 while costing €3, so it is worth making, while the fourth brings in €3 and costs €5, so it is not. With whole thousands the two curves cross between 3 and 4; produce 3, the last output at which MR is still above MC.

Figure 2 draws both. On the left, profit is the vertical gap between TR and TC, and that gap is widest at 3. On the right, the same answer appears where MC passes above MR.

Last, the three profit outcomes, which you signal on a diagram by shading a rectangle. All three compare average revenue with average cost at the chosen output.

• Abnormal profit: AR > AC. More than the minimum needed to keep the firm in the business. Sometimes called supernormal or economic profit.
• Normal profit: AR = AC. Exactly the minimum. The firm stays, and the owner is content, even though the profit rectangle has no height.
• Loss: AR < AC. Less than the minimum. In the long run the firm leaves.

At Q = 3, Harbour Ice has AR = €7 and AC = €6, so it earns abnormal profit of (7 − 6) × 3,000 = €3,000 a week. That is the same €3,000 the profit column shows, because profit = (AR − AC) × Q. Use that formula and you will never mislabel the rectangle.

4Market power, and the firm that has none

Market power is the ability of a firm to set its own price rather than accept one. A firm with no market power is a price taker; a firm with some is a price maker. That is the whole distinction, and it decides the shape of the demand curve the firm faces.

Start with the firm that has none. In perfect competition every firm sells an identical product and every buyer knows it. Charge one penny above the going price and you sell nothing at all, because the same bag of ice is available next door. Charge below it and you are giving money away, since you could have sold your whole output at the market price anyway. So each firm faces a perfectly elastic demand curve: a horizontal line at whatever price the industry has settled on.

Figure 3 is the two-panel diagram the guide asks for, and you should draw it the same way. The left panel is the industry, with ordinary sloping demand and supply curves setting P₁. The right panel is one firm inside that industry, drawn at a completely different scale, facing a flat line at P₁.

That flat line carries four labels at once, and the guide names all four: P = D = AR = MR. Here is why each one holds. It is D because it shows what the firm can sell at each price. It is P because the height of the line is the market price. It is AR because average revenue is TR ÷ Q, and if every bag sells for €7 then the average is €7 whatever the quantity. It is MR because the next bag also sells for €7, so each extra unit adds exactly the price to revenue. For a price taker, and only for a price taker, marginal revenue equals price.

Write all four labels on the line in an exam. They are separate marking points.

5Perfect competition in the short run and the long run

Apply the MC = MR rule to a price taker. Since MR is the flat line at the market price, the firm produces where MC meets that line, and then its price is already on the line. Nothing has to be read upwards, which is what makes this the easiest of the four diagrams.

In the short run, the price is whatever the industry has handed the firm, so all three profit outcomes are possible.

Figure 4 shows one firm with one set of cost curves and three different prices. Read each panel in the same four steps. Find where MC cuts the horizontal AR = MR line; drop to the axis for the output; go up or down from that output to the AC curve; then shade the rectangle between AR and AC, out to the quantity. When the price is above minimum AC the rectangle is abnormal profit. When it equals minimum AC the two curves touch and the rectangle disappears: normal profit. When it is below, AC sits above AR and the rectangle is a loss.

Note where MC crosses AC in all three panels: at the very bottom of the AC curve. That is not a drawing choice, it is arithmetic. While the next unit costs less than the average, it pulls the average down; when it costs more, it pushes the average up; so the two curves must meet exactly where the average stops falling.

The long run is where free entry does its work, and this is the part examiners look for.

Follow the chain in Figure 5. Firms are earning abnormal profit at P₁. There is no barrier to entry, and the profits are visible, so new firms join the industry. More firms means more supply at every price, so industry supply shifts right from S₁ to S₂ and the market price falls. As it falls, each firm's flat demand line drops with it, and the profit rectangle shrinks. Entry stops only when there is no longer any abnormal profit to attract it, which is when the price has fallen to the minimum of AC. At P₂, AR = AC, and every firm earns normal profit.

The same chain runs backwards from a loss: firms leave, supply shifts left, the price rises, and it stops rising when the survivors are back at normal profit. So the long-run outcome in perfect competition is always the same. Price = minimum AC, and every firm earns normal profit.

6Allocative efficiency, and productive efficiency

Two efficiency ideas run through the rest of this subtopic. The guide names the first and asks for its necessary conditions; the second is the natural partner to it and is worth the same two lines in an evaluation.

Allocative efficiency means society's resources are being used to produce the combination of goods that people value most. The condition is that, for the last unit made, price equals marginal cost: P = MC. The same condition is written MB = MC, marginal benefit equals marginal cost, because the demand curve shows what the next unit is worth to the buyer. When both hold, community surplus — consumer surplus plus producer surplus — is at its maximum.

Figure 6 shows why no other quantity can beat Q*. To the left of Q*, the demand curve is above the supply curve: the next unit is worth more to a buyer than it costs to make, so not making it wastes a gain. To the right of Q*, the cost of the unit is above what anyone will pay for it, so making it destroys value. Only at Q*, where the two are equal, is every worthwhile unit made and no wasteful one made. That is why the shaded area is largest there.

Productive efficiency is a different question: not whether the right goods are made, but whether they are made as cheaply as possible. The condition is that the firm produces at the minimum of its average cost curve. A firm sitting to the left or the right of that point is using more resources per unit than it needs to.

Perfect competition delivers both, and it is the only structure that does. Allocative efficiency comes free because MR is the price, so producing where MC = MR is producing where MC = P. Productive efficiency arrives in the long run, because entry pushes the price down to the minimum of AC, and the firm ends up at exactly that output. Hold those two sentences; the comparison in section 11 is built on them.

7The price maker, and monopoly

Now the other three structures. A price maker faces the market's own downward-sloping demand curve, or a large slice of it. To sell more it must lower the price, and — this is the step students skip — it must lower the price on every unit it sells, not only the extra one. So the revenue gained from the extra unit is partly cancelled by the revenue lost on all the earlier units. Marginal revenue is therefore less than price, and the MR curve lies below the AR curve, falling twice as steeply.

That one fact produces the whole result.

In Figure 7 the firm still obeys the rule: output where MC = MR, at Qₘ. But MR is below AR, so the price the buyers will pay for Qₘ is higher than the MR that fixed Qₘ. You read the price up from Qₘ to the demand curve, arriving at Pₘ. The result is the gap the guide asks you to draw: AR > MC. The last unit is worth more to buyers than it cost to make, and it was still worth making — yet the firm does not make any more, because making more would mean cutting the price on everything. Market power is exactly this mark-up, and it is what makes every price maker allocatively inefficient.

A monopolist protected by high barriers can keep this going.

Figure 8 is the diagram to practise until you can draw it in ninety seconds. Four curves: AR sloping down, MR below it and steeper, MC cutting AC at AC's minimum. Find Qₘ where MC = MR. Go up to AR for Pₘ. Go to AC for ACₘ. Shade between Pₘ and ACₘ, out to Qₘ. Label it abnormal profit. Because entry is blocked, no new firm arrives to compete it away, so unlike perfect competition this rectangle can survive in the long run.

Can, not must. A monopolist is only the sole seller of its product; that is no guarantee that anyone wants to buy it at a price covering costs.

Figure 9 shows the other two outcomes with the same rule and the same demand curve. On the left, costs are high enough that AR only just touches AC at the chosen output: normal profit. On the right, costs are higher still and AC lies above AR at every output the firm would pick, so it makes a loss, and in the long run it closes. A monopoly on a product nobody much wants is simply a small failing firm with no competitors.

Now the comparison the guide asks for by name.

Figure 10 takes one industry and asks what happens if it is run competitively and then handed to a single firm. Under perfect competition the industry supply curve is the sum of the firms' marginal cost curves, so the market settles where D meets MC, at Q꜀ and P꜀, and that is allocatively efficient. Give the same industry to a monopolist and it now sees an MR curve below that demand curve, so it stops at Qₘ where MC = MR and charges Pₘ. Output is restricted and the price is higher.

The shaded triangle is the welfare loss: the community surplus that existed at Q꜀ and no longer exists at Qₘ. Every unit between Qₘ and Q꜀ was worth more to a buyer than it cost to produce, and none of them is now made. Consumers lose twice, paying more for the units they still get and going without the units nobody makes; some of what they lose becomes monopoly profit, and the rest — the triangle — is lost to everyone. That is the sense in which market power is a market failure.

8Natural monopoly

Sometimes one firm is genuinely the cheapest way to serve a market. A natural monopoly exists where a single firm can supply the whole market at a lower average cost than two or more firms could, because fixed costs are so large relative to demand that average cost is still falling at every output the market wants. Water pipes, the electricity grid and rail track are the standard cases: laying a second set of pipes down the same street would double the fixed cost and halve each network's output.

Figure 11 looks different from the others and the difference is the point. The AC curve never turns upwards inside the diagram, because the enormous fixed cost is being spread over more and more units. Whenever AC is falling, MC lies below it, so MC is beneath AC everywhere on the figure.

That creates a problem a regulator cannot fully solve, which is why this diagram keeps appearing next to policy questions. Left alone, the firm produces Q₁ where MC = MR and charges P₁. Force it to price where P = MC, at Q₃, and it is allocatively efficient — but MC is below AC there, so the price is below average cost and the firm makes the loss shaded in the figure. It would need a subsidy or state ownership to survive. The usual compromise is the middle point, Q₂, where the regulator sets the price equal to average cost: the firm covers its costs and earns normal profit, output is much higher than the firm would choose, and allocative efficiency is still not quite reached.

9Oligopoly

An oligopoly is a few large firms behind high barriers, and its defining feature is interdependence: what happens to one firm depends on what the others decide. A price cut only wins customers if rivals do not match it, and they usually do.

That leaves two paths, and the guide names both.

Non-collusive oligopoly. Firms compete independently, guessing at each other's moves. Because a price cut is likely to be matched, cutting brings no extra customers and everyone ends up with a lower price and the same share. Worse, it can turn into a price war: repeated matching cuts that drive the price down towards cost and hurt every firm in the market. Knowing that, oligopolists often leave the price alone and compete in other ways.

• Price competition means winning customers by charging less. In an oligopoly it is dangerous, because it is easy to copy.
• Non-price competition means everything else: advertising, branding, product design, loyalty schemes, warranties, opening hours, store locations. It is harder for a rival to copy quickly, and it does not start a war. This is why the most concentrated markets are often the most heavily advertised.

Collusive oligopoly. Because price wars hurt everybody, firms have an incentive to collude: to agree, formally or by quiet understanding, on a price or on how much each will produce. A formal agreement is a cartel. If it holds, the firms jointly behave as one monopolist.

Figure 12 is the diagram the guide asks for, and it is deliberately the monopoly diagram with new labels. The curves are now the whole market's. The cartel picks the total output where the market's MC equals the market's MR, charges the price read up to market demand, and then divides that output between its members as quotas. The profit rectangle is shared out. For consumers the outcome is a monopoly outcome — higher price, restricted output, allocative inefficiency, the same welfare loss as in Figure 10 — even though several firms exist.

But every cartel member also has an incentive to cheat. If the others hold the agreed price, one firm that quietly shaves its price or exceeds its quota takes sales from them and earns more than its share.

Figure 13 is the payoff matrix named in the guide: a table showing what each firm earns for each combination of choices. Read it one firm at a time. If Borel holds at €10, Aster earns €40 thousand by holding and €55 thousand by cutting, so Aster cuts. If Borel cuts to €8, Aster earns €15 thousand by holding and €25 thousand by cutting, so Aster cuts. Cutting wins whatever Borel does, which makes it Aster's dominant strategy — the choice that is better no matter what the other firm decides. The matrix is symmetric, so it is Borel's too. Both cut, both end on €25 thousand, and both would have been better off at €40 thousand. That is the tension at the heart of every cartel: collusion pays collectively, and cheating pays individually.

Finally, the guide's measure of how concentrated a market is. A concentration ratio adds up the market shares of the largest few firms. CR4 is the four-firm ratio, CR3 the three-firm ratio, and so on. Market share is one firm's sales as a percentage of total market sales.

Our own market: 20 million parcels are delivered a week.

Swift Post's share is 6.8 ÷ 20 × 100 = 34%. Then CR4 = 34 + 26 + 18 + 9 = 87%, and CR3 = 34 + 26 + 18 = 78%. Four firms out of fifteen carry almost nine parcels in ten, which is the arithmetic signature of an oligopoly.

Say what the number cannot tell you as well as what it can. It says nothing about whether the firms compete or collude, nothing about how contestable the market is, and nothing about the shares of the firms inside the total — 87% split evenly between four firms is a different market from 80% held by one firm and 7% by three. There is no official threshold, so a concentration ratio is only informative next to another market's, or next to the same market's figure five years earlier.

10Monopolistic competition

Many firms, free entry, differentiated products. Think of the independent cafés in one city: each one has its own recipes, its own location and its own regulars, but nothing stops a new café opening.

Differentiation gives each firm a little market power, so its demand curve slopes down and its MR curve sits below it — the same shape as monopoly, drawn smaller. Free entry then does the same job it did in perfect competition.

Figure 14 gives the three outcomes the guide asks for. In the short run the firm can earn abnormal profit (left panel) or make a loss (middle panel), exactly as before. What free entry changes is what happens next. Abnormal profit attracts new cafés, and every new café takes a few customers from the others, so each existing firm's demand curve shifts left and its profit shrinks. Losses push firms out, and the survivors' demand curves shift right. Movement stops only when there is neither profit to attract entry nor loss to force exit, which is where the demand curve just touches the AC curve: the right panel, normal profit in the long run.

That long-run position is worth a second look, because two exam points live in it. The firm is not allocatively efficient, since the price still sits above marginal cost. And it is not productively efficient either: the tangency happens on the falling part of AC, to the left of the minimum, so the firm is running with excess capacity — it could produce more cheaply per unit by being bigger, and it never will be.

How much market power does it have? Less than a monopolist, and the guide asks you to show why.

Figure 15 gives two firms identical costs and different demand curves. The monopolist's demand is steep, because there are no close substitutes and a price rise sends few customers away — demand is relatively inelastic. The monopolistic competitor's demand is flatter, because there are many close substitutes and a price rise sends plenty of customers to the café across the road — demand is more elastic. Both stop where MC = MR, but the flatter curve gives a lower price, a larger output, and a much smaller gap between price and marginal cost.

So monopolistic competition is allocatively inefficient, and it is a market failure, but a milder one than monopoly. Set against that, it delivers something the other structures do not: product variety. Fifty different cafés give consumers a genuine choice that fifty identical ones would not, and that choice has a value which the welfare loss triangle does not capture. Use that sentence in evaluation.

11The four structures compared on efficiency

Every evaluation question in this subtopic is answered out of this table, so learn the reasons and not just the yeses and noes.

Three things to carry into an answer. The failure is the same failure in all three imperfect structures — price above marginal cost — and only its size changes. The size depends on how elastic the firm's demand is, which is another way of saying how many substitutes buyers have. And profit lasts only where barriers to entry are high, which is why free entry, not the number of firms, is what decides the long run.

12The case for large firms, and the risks

Paper 1 part (b) wants both sides, so the guide sets out both.

Advantages of significant market power.

• Economies of scale. Large firms often have lower average costs than small ones: they spread fixed costs over more units, buy inputs in bulk, and can afford specialised machinery. A lower AC curve can mean a lower price than many small firms could offer, even after the mark-up. The natural monopoly of section 8 is the strongest form of this argument, because there splitting the firm up would raise average cost for certain.
• Abnormal profits may finance research and development. R&D is expensive and risky, and a firm earning only normal profit has nothing spare to fund it. A protected monopolist can afford to spend on it, and the prospect of holding on to the profits is part of why it bothers. That is the case for patents: a temporary monopoly bought in exchange for innovation. Innovation lowers costs and creates new products over time, which can be worth more to consumers than the static welfare loss triangle costs them.

Risks in markets dominated by one or a few very large firms. The guide frames these as risks to output, price and choice.

• Output is restricted. Figure 10 is the whole argument: the firm holds back units that were worth making, and resources go elsewhere.
• Price is higher than marginal cost, and higher than it would be under competition. That transfers surplus from consumers to producers, which is an equity question as well as an efficiency one.
• Consumer choice narrows. One dominant firm decides what is on the shelf, and rivals who might have offered something different are kept out by the barriers.

Add two more that follow from the same position. Without competitive pressure a dominant firm may let its costs drift upwards, because normal profit is never in danger. And the innovation argument cuts both ways: a firm with no rivals may have less reason to improve anything, so whether abnormal profit is spent on R&D or simply kept is an empirical question, not a certainty.

The honest evaluative line is that it depends on which market. Where economies of scale are large and barriers arise naturally, one big firm may serve consumers better than many small ones. Where the barriers are artificial and the product is simple, the welfare loss is real and nothing much is bought with it.

13Government intervention when market power is abused

Notice the guide's wording: intervention responds to the abuse of significant market power, not to size in itself. Three tools are named.

Legislation and regulation. Laws that forbid particular conduct and a regulator that enforces them. Typical content: banning price-fixing agreements between competitors, blocking a merger that would leave one firm dominant, requiring a network owner to give rivals access to its infrastructure, and price controls on a natural monopoly of the kind shown in Figure 11. Strengths: it can be targeted at the behaviour rather than the firm, and the threat alone changes conduct. Weaknesses: the regulator knows far less about the firm's costs than the firm does, cases take years, and a price cap set too low discourages the investment the network needs.

Government ownership. The state owns the firm and runs it for something other than maximum profit, so output can be set where P = MC even if that means a subsidy. This is most defensible for natural monopolies, where competition is not an option anyway. Weaknesses: without the profit motive or the threat of exit, costs can rise, and the subsidy has an opportunity cost — money spent covering losses is money not spent on something else.

Fines. A penalty after the fact, usually for collusion or for abusing a dominant position. A fine large enough to exceed the expected gain removes the incentive to cheat consumers, and many competition authorities cut the fine for the first cartel member that confesses, which attacks the cartel exactly where Figure 13 says it is weakest. Weaknesses: the conduct has to be detected and proved first, which is hard when the agreement was never written down, and a fine that is small next to the profits is simply a cost of doing business.

Judge any of these three the same way: does it raise output towards the allocatively efficient level, what does it cost to run, and what does it do to the incentive to invest and innovate? Say which market you are talking about — the right answer for a water network is not the right answer for a coffee chain.