Perfect competition

The theoretical benchmark. Assumptions: many buyers and sellers, each too small to affect price; a homogeneous (identical) product; perfect information; freedom of entry and exit; no externalities; perfect factor mobility.

• Each firm is a price taker: it faces a perfectly elastic (horizontal) demand curve at the industry price, so AR = MR = P. Charge a penny more and you sell nothing.
• Short run: the firm still profit-maximises at MC = MR, and can make supernormal profit (or a loss) depending on where AC lies.
• Long run: supernormal profit attracts entry → industry supply rises → price falls → profit is competed away until only normal profit remains (AR = AC). Losses cause exit, supply falls, price rises back to normal profit. The long-run equilibrium is P = MC = AC at the minimum of AC.

Evaluate it. It achieves both static efficiencies — but it is a fiction. No real market has perfect information and a genuinely homogeneous product. And because firms earn only normal profit, there is no surplus to fund R&D: perfect competition may be dynamically inefficient. Agriculture and foreign exchange are the usual real-world approximations.

Long-run perfect competition

Monopoly, price discrimination and natural monopoly

A pure monopoly is a single seller. In practice a monopoly is defined by market power: the UK's legal test is a 25% market share. The monopolist is a price maker, so its demand curve slopes down and MR < AR. It profit-maximises at MC = MR, then reads the price up off the AR curve — so P > MC.

Barriers to entry are what let supernormal profit survive into the long run: legal barriers (patents, licences), huge sunk costs, economies of scale, control of an essential resource, brand loyalty built by advertising, network effects, and limit pricing (deliberately pricing below the entrant's average cost).

Costs of monopoly: output is restricted and price raised; P > MC so it is allocatively inefficient (there is a deadweight welfare loss); it does not produce at minimum AC, so it is productively inefficient; sheltered from competition, costs drift upward — X-inefficiency; consumer surplus is transferred to producer surplus.

Benefits of monopoly: supernormal profit can fund R&D and innovation — dynamic efficiency (Schumpeter's "creative destruction"; patents exist precisely to create temporary monopoly as a reward for invention); huge economies of scale can make a monopolist's costs so low that price is lower than under competition; and a national champion may compete globally.

Price discrimination — charging different prices to different consumers for the same good, where the difference is not due to cost. It requires (1) market power, (2) the ability to separate markets with different PEDs, and (3) no resale (seepage) between them. Charge more where demand is inelastic (peak-time rail, business flyers) and less where it is elastic (off-peak, students, advance bookings). It converts consumer surplus into producer surplus and raises profit — but it can raise output above the single-price level, allowing some consumers to be served who otherwise would not be, and cross-subsidising loss-making routes.

Natural monopoly — where economies of scale are so vast relative to demand that LRAC is still falling at the level of total market demand: one firm can supply the whole market more cheaply than two. Water pipes, the rail network, the electricity grid. Duplicating the network would waste resources. Here competition is not the answer — regulation is (RPI − X price caps, or state ownership).

Price discrimination

Your turn — monopoly profit

Monopolistic competition

The most realistic model of the high street: many firms, low barriers to entry, but a differentiated product (real or imagined) — restaurants, hairdressers, plumbers, coffee shops.

• Differentiation gives each firm a little market power: its demand curve slopes down, but is highly elastic because close substitutes are everywhere.
• Short run: profit-maximise at MC = MR; supernormal profit is possible.
• Long run: low barriers mean supernormal profit attracts entry. Each firm's demand curve shifts left and becomes more elastic as rivals crowd in, until AR is tangent to AC → normal profit only.

At that long-run tangency, AR is downward-sloping, so tangency occurs on the falling part of AC — the firm does not produce at minimum AC. Hence:

• Productively inefficient (excess capacity: the firm could cut average cost by producing more).
• Allocatively inefficient (P > MC).

But evaluate: the "excess capacity" is the price of choice. Consumers demonstrably value variety, and a town with five different restaurants each running below capacity may be better off than one with a single canteen running at minimum AC. Efficiency is not the only thing that matters to welfare.

Oligopoly: concentration, interdependence and collusion

An oligopoly is a market dominated by a few large firms (UK supermarkets, banks, energy, mobile networks). The defining feature is not the number of firms but interdependence: each firm's best move depends on what it thinks the others will do.

The n-firm concentration ratio measures dominance: the combined market share of the largest n firms.

Behaviour:

• Non-price competition dominates — advertising, branding, loyalty cards, product quality, service. Why? Because a price cut is instantly matched (so nobody gains share, everyone loses margin), while a price rise is not matched (so you lose share). Prices are therefore sticky.
• The kinked demand curve model captures this: demand is elastic above the current price (rivals don't follow a rise, you lose lots of custom) and inelastic below it (rivals follow a cut, you gain little). The kink produces a discontinuity in the MR curve, so MC can shift within that gap without changing the profit-maximising price at all — a formal explanation of price rigidity.
• Collusion — firms cooperate instead of competing. Overt collusion is a formal cartel agreeing price or output (illegal in the UK/EU; OPEC does it internationally). Tacit collusion is unspoken parallel behaviour or price leadership, where everyone follows the dominant firm. Collusion is easier with few firms, similar costs, a homogeneous product, transparent prices, high barriers and stable demand — and is destabilised by the incentive on each member to cheat and undercut.

Your turn — concentration ratio

Game theory and the prisoner's dilemma

Interdependence makes oligopoly a game. The classic is the prisoner's dilemma. Two firms each choose to keep price High (collude) or Low (cheat). Payoffs are (Firm A profit, Firm B profit) in £m:

This explains three things at once: why cartels are unstable (every member has a dominant strategy to cheat); why firms nonetheless try to collude; and why repeated games change the answer — if the game is played over and over, punishment strategies ("tit-for-tat") can sustain cooperation, which is why tacit collusion survives in long-lived oligopolies.

Policy hook: competition authorities offer leniency (immunity to the first cartel member to confess). That deliberately sharpens the prisoner's dilemma — and it is how most cartels are now caught.

Dominant strategy

Contestable markets

Baumol's insight: what disciplines a firm's behaviour may not be the number of rivals in the market but the threat of entry. A market is contestable when entry and exit are cheap and easy — low barriers, and crucially low sunk costs, so a challenger can "hit and run": enter, take the supernormal profit, and leave costlessly.

• In a perfectly contestable market, even a single incumbent must behave competitively — setting price close to average cost and earning only normal profit — because any supernormal profit would invite instant entry.
• So market structure alone does not determine conduct. A monopolist in a contestable market may be more competitive than a cosy oligopoly protected by huge sunk costs. This is the single most powerful evaluation point in the whole topic.
• Sunk costs are the key barrier: costs you cannot recover on exit (bespoke machinery, brand advertising). High sunk costs make hit-and-run entry too risky and destroy contestability.
• Incumbent responses: limit pricing (price low enough to make entry unprofitable), predatory pricing (price below cost to bankrupt an entrant — illegal), building excess capacity as a credible threat, brand proliferation, loyalty schemes.

Policy implication: if contestability is what matters, competition policy should focus on lowering barriers to entry (deregulation, open access to networks, banning predatory pricing) rather than simply breaking up big firms.

Contestability

Judging market structures: the four efficiencies

• Allocative efficiency — P = MC. Achieved by perfect competition (P = MR = MC). Failed by every price maker, because P > MC.
• Productive efficiency — production at minimum AC. Achieved in long-run perfect competition. Failed by monopoly and monopolistic competition (excess capacity).
• Dynamic efficiency — innovation and falling costs over time, funded by reinvested supernormal profit. This is where monopoly and oligopoly can win: pharmaceutical R&D is only funded because patents guarantee temporary monopoly profit.
• X-inefficiency (Leibenstein) — costs drifting above the minimum possible because weak competition removes the pressure to control them: featherbedding, gold-plated offices, complacency. Monopolies are prone to it.

Monopsony deserves a mention: a single (or dominant) buyer. A supermarket chain facing thousands of small farmers can drive the price it pays below the competitive level, restricting the quantity traded — the mirror image of monopoly, and a source of allocative inefficiency in its own right. (You will meet it again as an employer in the labour market.)

The examinable judgement: perfect competition wins on the two static efficiencies; monopoly may win on the dynamic one, and on economies of scale. Whether monopoly is bad therefore depends on: the size of the economies of scale, whether the profit is actually reinvested, how contestable the market is, and how effective the regulator is.

Your turn — a monopolist's mark-up

Efficiency comparison

Natural monopoly

Which market structure?

Tap a description, then tap the structure it fits.

Match the efficiency concept to its definition

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered market structures from the OCR A-level Economics (H460) specification. Press Finish to see your score.