The four efficiency concepts

• Allocative efficiency — P = MC. The price consumers are willing to pay for the last unit exactly equals the cost of the resources used to make it. Society's welfare (consumer + producer surplus) is maximised; resources reflect consumer preferences.
• Productive efficiency — production at the minimum of AC. No waste; output is produced at the lowest possible average cost.
• Dynamic efficiency — efficiency over time: supernormal profit is reinvested in R&D and innovation, shifting the whole cost curve downwards in the long run (Schumpeter's "creative destruction").
• X-inefficiency — costs are above the AC curve because there is no competitive pressure to keep them down (bloated management, gold-plated offices). A monopoly's problem.

The central tension of the whole topic: perfect competition delivers static efficiency (allocative + productive) but no supernormal profit to fund innovation. Monopoly is statically inefficient but may be dynamically efficient. That trade-off wins evaluation marks in almost every 25-marker.

Which efficiency?

Perfect competition

Assumptions: a very large number of buyers and sellers; a homogeneous product; perfect information; no barriers to entry or exit; firms are price takers and profit maximisers.

The long-run equilibrium is remarkable: P = MC = minimum AC = AR. The firm is both allocatively and productively efficient, and earns only normal profit. That is the benchmark against which every other structure is judged.

But: zero supernormal profit means no funds for R&D, so perfect competition is likely dynamically inefficient. And with homogeneous products there is no choice for consumers. Also, no real market satisfies all the assumptions.

The long-run adjustment

Monopolistic competition

Many firms, low barriers to entry, but — the crucial difference from perfect competition — differentiated products. Think hairdressers, restaurants, plumbers, coffee shops.

• Differentiation gives each firm a downward-sloping (but very elastic) demand curve — a little price-setting power, because its customers are somewhat loyal.
• Short run: supernormal profit is possible (MC = MR, P from the AR curve).
• Long run: low barriers mean entry competes profit away. Equilibrium occurs where AR is tangent to AC — normal profit only.

The key contrast to nail: in long-run equilibrium the tangency happens on the downward-sloping part of AC, not at its minimum. So a monopolistically competitive firm is neither productively efficient (it has excess capacity — it could lower AC by producing more) nor allocatively efficient (P > MC). But consumers get choice and variety, which perfect competition denies them.

Oligopoly: the defining features

Oligopoly is defined by conduct, not just by numbers:

• High barriers to entry and exit.
• High concentration ratio — a few firms hold most of the market.
• Interdependence — each firm's best action depends on what its rivals do. This is the defining feature.
• Product differentiation and heavy non-price competition (branding, loyalty schemes, quality, advertising).

Limitation of the CR: it says nothing about contestability. A market with CR4 = 90% but zero barriers to entry may still behave competitively. Nor does the CR show how the share is split between the leading firms.

Concentration ratio

The kinked demand curve

Sweezy's model explains why oligopoly prices are often sticky. The firm makes two asymmetric assumptions about its rivals:

• If it raises price, rivals will not follow — they happily take its customers. So demand above the current price is elastic: TR falls sharply.
• If it cuts price, rivals will follow to protect their share. So demand below the current price is inelastic: it gains few extra sales but earns less per unit.

Evaluation of the model: it explains price stickiness but not how the price P* was set in the first place — a serious weakness. Real oligopolies do sometimes have price wars, which the model cannot explain.

Game theory and the prisoner's dilemma

Interdependence is modelled with a payoff matrix. Two firms, each choosing a high or low price. Payoffs are annual profit in £m — (Firm A, Firm B).

This is the prisoner's dilemma: individually rational choices produce a collectively worse outcome. A Nash equilibrium is a position where neither firm can improve its payoff by unilaterally changing strategy — here, (Low, Low).

Why it matters: the dilemma explains both the powerful incentive to collude (to reach 50, 50) and the equally powerful incentive to cheat on a cartel (defect to 70). It also explains why price wars break out — and why repeated games, where cheating can be punished later, make collusion more sustainable.

The cost of the dilemma

Dominant strategy

Collusion, price and non-price competition

• Overt collusion — a formal cartel: firms openly agree output quotas or prices (OPEC). Illegal in the UK and EU.
• Tacit collusion — no agreement, but firms follow an understood pattern, often via price leadership (a dominant firm moves; the rest follow). Hard to prosecute.
• Conditions favouring collusion: few firms, similar costs, a homogeneous product, high barriers to entry, stable demand, and the ability to detect and punish cheating.
• Why collusion breaks down: the incentive to cheat (see the payoff matrix), a recession, new entrants, and the threat of leniency programmes — the first cartel member to confess to the CMA gets immunity, which is designed to trigger exactly the prisoner's-dilemma logic against the cartel.

Price competition: price wars (mutually destructive); predatory pricing (pricing below cost to drive a rival out, then raising price — illegal); limit pricing (setting price just low enough to make entry unprofitable — legal, and a barrier to entry).

Non-price competition: advertising and branding, loyalty cards, quality and after-sales service, product differentiation, free delivery. Oligopolists prefer this because it cannot be instantly matched the way a price cut can — and it doesn't destroy margins.

Monopoly

A pure monopoly is a single seller. In law, the CMA treats a firm with a market share above 25% as having monopoly power.

High barriers to entry are essential — otherwise supernormal profit would attract entry. Barriers include legal ones (patents, licences), economies of scale, high sunk costs, brand loyalty, and control of a key resource.

Costs of monopoly: higher prices, lower output, allocative and productive inefficiency, X-inefficiency, less choice, and monopsony power over suppliers. Benefits: economies of scale can make AC (and therefore price) lower than under competition; supernormal profit funds R&D (dynamic efficiency); patents reward innovation; national champions compete globally.

The monopolist's price

The monopolist's supernormal profit

Price discrimination & natural monopoly

Third-degree price discrimination is charging different prices to different groups for the same good, where the price difference is not justified by a difference in cost (a peak rail fare, a student cinema ticket).

Three necessary conditions:

• The firm must have price-setting (monopoly) power.
• The groups must have different PEDs — charge the higher price to the inelastic group.
• The firm must be able to separate the groups and prevent resale (seat-only tickets, ID checks).

Effects: the firm converts consumer surplus into profit and raises total profit. Consumers in the inelastic market lose; those in the elastic market may gain a lower price. Extra profit may cross-subsidise loss-making services or fund investment — and some consumers get served who otherwise would not be.

Natural monopoly: where fixed costs are so vast relative to the market (water pipes, the rail network, the National Grid) that LRAC is still falling at the level of market demand. One firm can supply the whole market at a lower AC than two could — so duplication is wasteful. Note that here MC < AC, so forcing P = MC would make the firm loss-making and require a subsidy; regulators often set P = AC instead.

Price discrimination

Monopsony

A monopsony is a single (or dominant) buyer — market power on the demand side. Examples: the NHS as an employer of nurses and a buyer of drugs; the big supermarkets buying from farmers; Amazon buying from small publishers.

• Benefits to the firm: it can force lower input prices, cutting its costs and raising profit.
• Benefits to consumers: lower input costs may be passed on as lower prices — the supermarkets' standard defence.
• Costs to suppliers: squeezed margins, less profit to reinvest, possible exit from the industry. Farmers forced to sell milk below the cost of production is the stock example.
• Costs to employees: a monopsony employer faces an upward-sloping supply of labour, so to hire one more worker it must raise the wage for everyone — its marginal cost of labour exceeds the wage. It therefore hires fewer workers at a lower wage than a competitive labour market would.

Link to 3.5: monopsony is the reason a national minimum wage can raise both wages and employment — an unusual result you should be ready to explain.

Contestable markets

Baumol's insight: what disciplines a firm is not the number of rivals but the threat of entry. A perfectly contestable market has:

• Free entry and exit — no barriers.
• No sunk costs — costs that cannot be recovered on exit. This is the crucial one.
• Equal access to technology and perfect information.

If a market is contestable, incumbents are vulnerable to "hit-and-run" entry: an entrant swoops in to grab supernormal profit and exits costlessly when price is competed down. Knowing this, incumbents keep prices near normal profit, cut X-inefficiency and use limit pricing — even if they are a monopoly by market share.

Powerful evaluation: a 90% market share is not automatically bad. If the market is contestable, the firm behaves competitively anyway. Conversely a market with several firms but massive sunk costs (aircraft manufacture) may be very uncontestable. Always ask about the barriers, not just the count.

Which market structure?

Tap a feature, then tap the structure it belongs to.

Match the efficiency concept

Tap a condition on the left, then its concept on the right.

Is a high market share always bad?

The big ideas to know

You've covered the whole of Edexcel 3.4. Press Finish to see your score.