📚 A-LEVEL ECONOMICS (9708) STUDY NOTES: DIFFERENT MARKET STRUCTURES

Hello future Economist! This chapter is one of the most practical and exciting areas of Microeconomics. We are moving away from studying generic supply and demand curves and diving into the real world, asking: "How do firms behave?"

The structure of a market (whether it has one firm or a thousand firms) fundamentally changes how prices are set, how efficient the economy is, and how much profit companies make. Mastering these structures—Perfect Competition, Monopoly, Oligopoly, and Monopolistic Competition—is crucial for your success in A-Level Economics!

1. The Spectrum of Market Structures (7.6.1, 7.6.2)

Markets are usually categorised based on four main characteristics. Think of it as a spectrum, ranging from the most competitive (Perfect Competition) to the least competitive (Monopoly).

1.1 Key Determinants of Market Structure

The structure of a market is determined by:

  • Number of Buyers and Sellers: Are there many small players, or just a few dominant giants?
  • Product Differentiation: Are the products identical (homogeneous) or unique (heterogeneous)?
  • Freedom of Entry and Exit (Barriers): How easy is it for new firms to start up or existing firms to leave?
  • Availability of Information: Do buyers and sellers have perfect, complete knowledge?

Quick Review Box: The Four Main Structures

Structure Firms Product Barriers Example
Perfect Competition (PC) Many Homogeneous (Identical) None (Free Entry/Exit) Agricultural Markets (e.g., specific crops)
Monopolistic Competition (MC) Many Differentiated Low Restaurants, Hair Salons
Oligopoly Few (Dominant) Homogeneous or Differentiated High Airlines, Mobile Networks
Monopoly One Unique Very High (Complete) Local Utility Providers (Historically)

2. Perfect Competition (PC)

Perfect competition is a theoretical benchmark. No real-world market is perfectly competitive, but some primary product markets come close.

2.1 Characteristics of Perfect Competition

  • Atomistic Market: There are so many small firms that no single firm can influence the market price.
  • Homogeneous Product: The products are identical (e.g., one bushel of wheat is the same as another).
  • Perfect Knowledge: Consumers and producers know everything about prices and quality.
  • No Barriers: Firms can enter or leave the industry freely and instantly.
  • Firms are Price Takers: Because they are so small, firms must accept the price set by the industry's supply and demand forces.

2.2 Revenue and Profit Maximisation in PC (7.5.8, 7.6.4)

Since a PC firm is a price taker, the price (P) is constant regardless of how much the firm produces.

  • Average Revenue (AR): \(AR = P\)
  • Marginal Revenue (MR): \(MR = P\) (Selling one extra unit adds the exact market price to total revenue).
  • Therefore: \(P = AR = MR\)
  • The firm's demand curve is perfectly elastic (horizontal).

Profit Maximisation: All firms (regardless of structure) maximize profit where: \(MR = MC\). In PC, this means: \(P = MR = MC\).

2.3 Short Run vs. Long Run Outcomes in PC

Short Run (SR)

In the SR, a PC firm might earn supernormal profit (SNP), normal profit (NP), or subnormal profit (loss).

  • SNP: If \(P > AC\) (Average Cost).
  • NP: If \(P = AC\).
  • Subnormal Profit/Loss: If \(P < AC\).
Long Run (LR)

Due to the absence of barriers to entry and exit, the market forces competition until only Normal Profit remains.

  1. If firms earn SNP in SR, new firms enter the market.
  2. This increases industry supply (S shifts right), causing the price (P) to fall.
  3. P continues to fall until it reaches the minimum of the Average Cost curve.
  4. In LR Equilibrium: \(P = MR = MC = AC_{min}\).

2.4 Efficiency in Perfect Competition (7.6.4)

Perfect Competition is considered the most efficient market structure.

  • Allocative Efficiency (AE): Achieved when Price equals Marginal Cost (\(P = MC\)). Resources are allocated exactly where consumers want them.
  • Productive Efficiency (PE): Achieved when production occurs at the lowest point on the Average Cost curve (\(P = AC_{min}\)). Goods are produced at minimum cost.

Key Takeaway: PC achieves both Allocative and Productive efficiency in the Long Run.

Did you know? (7.6.4 - Shutdown Price) A firm should continue producing in the Short Run even if it is making a loss, as long as the price covers its Average Variable Cost (AVC). If \(P < AVC\), the firm cannot even cover its day-to-day running costs and should shut down immediately.

3. Monopoly and Natural Monopoly

A Monopoly exists when a single firm dominates the entire market. (Technically, the EU defines a monopoly as a firm having over 25% market share, but in exam terms, think of a pure monopoly having 100%).

3.1 Characteristics of Monopoly

  • One Seller: The firm is the industry.
  • Unique Product: No close substitutes exist.
  • High Barriers to Entry (7.6.3): These barriers ensure SNP can be maintained in the Long Run.
  • Price Maker: The firm can choose the price or the output, but not both (constrained by the market demand curve).

3.2 Revenue and Profit Maximisation in Monopoly

Since the monopolist is the only firm, its demand curve is the same as the industry demand curve—it is downward sloping.

  • Average Revenue (AR): The AR curve is the demand curve.
  • Marginal Revenue (MR): Because the firm must lower the price on *all* units to sell one more, MR is always less than AR (MR curve lies below the AR curve).
  • Profit Maximisation: Achieved at \(MR = MC\). The monopolist sets output at this level and then reads the highest possible price from the AR (Demand) curve.

A monopolist will usually earn Supernormal Profit (SNP) in both the Short Run and the Long Run, provided demand is sufficient, because barriers prevent new firms from entering and stealing market share.

3.3 Monopoly and Efficiency (7.6.4)

Monopolies generally result in significant market inefficiency:

  • Allocative Inefficiency: \(P > MC\). Consumers pay more than the cost of the resources used to produce the marginal unit. This leads to a deadweight welfare loss.
  • Productive Inefficiency: Production does not occur at the minimum point of the AC curve.
  • X-Inefficiency: Because there is no competition, the monopolist may become complacent and fail to minimise costs. The firm operates above its lowest possible AC curve.

3.4 Natural Monopoly

A Natural Monopoly occurs when the economies of scale are so vast relative to market demand that the most efficient outcome is to have only one producer.

Analogy: Imagine laying water pipes or electricity cables. It is hugely expensive to build the network (fixed costs). It would be wasteful and inefficient to have three competing companies each digging up the road to lay separate pipes. One firm can serve the entire market at a lower average cost than two or more firms.

In this case, government regulation is often required to ensure the single provider doesn't abuse its power.

Key Takeaway: Monopolies earn SNP in the LR due to high barriers and are generally inefficient, but a Natural Monopoly might be cost-effective for society (though it needs regulation).

4. Monopolistic Competition (MC)

This is the market structure most commonly found in the real world. Think of the high street: cafés, local shops, clothing brands.

4.1 Characteristics of Monopolistic Competition

  • Many Firms: Like PC, there are many firms.
  • Differentiated Product: This is the crucial difference from PC. Products are similar but not identical (e.g., based on location, brand name, quality, or service).
  • Low Barriers to Entry/Exit: Relatively easy to start up (e.g., opening a new bakery).
  • Some Market Power: Because the product is differentiated, the firm has a loyal customer base and is a limited price maker.

4.2 Revenue and Profit Maximisation in MC

Because of product differentiation, the demand curve (AR) is downward sloping, but it is typically quite elastic because many close substitutes exist.

Long Run Outcome

The LR result mirrors PC: firms only earn Normal Profit.

  1. If firms earn SNP in the SR (e.g., a new café becomes popular), the low barriers mean new rivals enter the market quickly.
  2. The entry of new rivals draws customers away from existing firms.
  3. The existing firm’s demand curve (AR) shifts inwards (left).
  4. This continues until the demand curve (AR) is tangent to the AC curve, meaning \(P = AC\).
  5. LR Equilibrium: \(AR = AC\) (Normal Profit), and \(MR = MC\) (Profit Maximising Output).

4.3 Monopolistic Competition and Efficiency

MC is generally inefficient, but less so than Monopoly:

  • Allocative Inefficiency: \(P > MC\) (since the demand curve is downward sloping).
  • Productive Inefficiency: The firm produces to the left of the minimum AC point. (There is excess capacity).

However, consumers benefit from variety and choice and non-price competition (better service, innovation), which are seen as important benefits that outweigh some of the inefficiencies.

Key Takeaway: MC is characterized by many firms, differentiated products, and the earning of only Normal Profit in the LR.

5. Oligopoly

An Oligopoly is dominated by a few large firms. Think of the competitive nature of supermarkets, oil companies, or fast food chains.

5.1 Characteristics of Oligopoly

  • Few Firms: A small number of firms dominate the market, often measured by the Concentration Ratio (7.6.5).
  • High Barriers to Entry: High start-up costs or strong brand loyalty prevent easy entry.
  • Interdependence: This is the most important feature. The actions of one firm (e.g., changing prices or launching an advert) directly affect the profits and decisions of the other rival firms.

Concentration Ratio (7.6.5): This measures the combined market share of the largest ‘N’ firms in the industry (e.g., the 5-firm concentration ratio might be 85%, meaning the top five firms control 85% of the market).

5.2 Price Competition and Rigidity (7.8.5)

Oligopolists often prefer non-price competition (advertising, loyalty schemes, product quality) because price wars can be destructive. This behaviour is explained by the Kinked Demand Curve Model.

The Kinked Demand Curve

This model relies on asymmetric reactions by rivals:

  • Above the Current Price (P*): If Firm A raises its price, rivals will ignore the change. Firm A loses many customers (demand is elastic).
  • Below the Current Price (P*): If Firm A lowers its price, rivals will match the cut immediately to avoid losing market share (demand is inelastic).

Result: The firm's demand curve has a 'kink' at the current market price, making prices very rigid (sticky) and discouraging firms from changing prices.

5.3 Collusion, Cartels, and Conflict (7.6.4, 7.7.4)

Since interdependence makes aggressive competition risky, firms often seek stability through cooperation.

  • Collusion: Firms cooperate to limit competition, often aiming to act like a single monopolist to maximize joint profits.
    • Overt Collusion (Cartel): Formal agreement (often illegal). A Cartel (7.7.4) is a group of firms acting together to fix prices or restrict output. Example: OPEC.
    • Tacit Collusion: Informal understanding or following a Price Leader (7.8.4) without formal communication.
The Prisoner's Dilemma (7.6.4)

This concept, drawn from game theory, explains why cartels are inherently unstable and often break down.

Analogy: Two suspects (Firm A and Firm B) are arrested and questioned separately. If they cooperate (collude/stay silent), they both get a minor sentence (joint SNP). If one cheats (confesses/cuts price) and the other doesn't, the cheater gets the best outcome, and the loyal one gets the worst. If both cheat, they both get a bad outcome (lower profits).

The self-interest of each firm (to cheat and maximize individual profit) leads to an equilibrium where both are worse off than if they had colluded. This explains the temptation to cheat on a price-fixing agreement.

Key Takeaway: Oligopoly is defined by interdependence. Firms prefer non-price competition and may resort to collusion, although cartels are unstable due to the incentive to cheat (Prisoner's Dilemma).

6. Barriers to Entry and Contestable Markets (7.6.3, 7.6.4)

The existence and strength of Barriers to Entry (BTE) determines the structure of the market and whether firms can sustain Supernormal Profit.

6.1 Types of Barriers to Entry (7.6.3)

  • Cost Barriers:
    • Economies of Scale (EoS): Existing firms benefit from large-scale production, giving them a massive cost advantage that new, small entrants cannot match.
    • Control of Key Resources: Existing firms might own the entire supply of a vital raw material.
  • Legal Barriers:
    • Patents and Copyrights: Exclusive legal rights to produce a product or use a production process for a period of time.
    • Licensing: Governments granting sole rights to operate (e.g., utility provision).
  • Market Barriers:
    • Brand Loyalty: Consumers strongly prefer established brands (e.g., Apple, Coca-Cola).
    • Advertising and Marketing: High spending on advertising makes it expensive for new firms to gain recognition.
  • Physical Barriers: Control over distribution networks or physical locations (e.g., the best retail locations).

6.2 Contestable Markets (7.6.4)

A Contestable Market is a market where there are zero barriers to entry AND exit.

Don't worry if this seems tricky! Contestability is about the threat of competition, not necessarily the current number of firms. Even a market with only one firm (a potential monopoly) can be highly contestable if a potential rival can enter easily.

The key factor is Sunk Costs: costs that cannot be recovered upon exit (e.g., complex advertising campaigns, specialized machinery). If sunk costs are low, the market is highly contestable.

Implications: Even monopolists in contestable markets are forced to keep prices low and operate efficiently to prevent 'hit-and-run' entry by new firms.

7. Differing Objectives and Pricing Policies of Firms (7.8)

While we often assume firms only aim for Profit Maximisation (7.8.1) (where \(MR = MC\)), real firms have many other goals (7.8.2).

7.1 Alternative Objectives of Firms (7.8.2)

  • Revenue Maximisation: Maximizing total sales revenue (achieved where \(MR = 0\)). This may occur when managers are paid based on company size or growth, not just profit.
  • Sales Maximisation (or Growth Maximisation): Maximizing the volume of output, often subject to the constraint that the firm must earn at least normal profit (\(AR = AC\)).
  • Survival: Especially important during downturns or recessions.
  • Profit Satisficing: Managers aim for "enough" profit to keep shareholders happy, but then pursue other goals like leisure, status, or power. (This relates to the Principal-Agent Problem 7.7.5, where owners want profit maximization, but managers may have different goals.)

7.2 Other Pricing Policies (7.8.4)

  • Limit Pricing: Setting the price low enough to deter new entrants, often resulting in lower-than-maximum profit for the incumbent firm.
  • Predatory Pricing: Setting prices below cost (AVC) temporarily to force rivals out of the market. This is usually illegal.
  • Price Leadership: One dominant firm sets the price, and smaller firms in the industry follow suit. This is a form of tacit collusion in oligopoly.

7.3 Price Discrimination (7.8.3)

Definition: Charging different prices to different consumers for the exact same product or service, where the price difference is not due to cost differences.

Conditions for Price Discrimination (PD)

For PD to be effective, a firm must meet three conditions:

  1. Market Power: The firm must be a price maker (Monopoly, Oligopoly, or MC).
  2. Separate Markets: The firm must be able to segment the market into groups with different Price Elasticities of Demand (PED).
  3. Prevent Resale: The firm must prevent consumers in the low-price segment from selling the product to consumers in the high-price segment.
Degrees of Price Discrimination
  • First-Degree PD (Perfect PD): Charging every consumer the maximum price they are willing to pay. Example: A custom negotiation (like haggling for a car).
  • Second-Degree PD: Charging different prices based on the quantity consumed. Example: Bulk discounts or peak vs. off-peak electricity tariffs.
  • Third-Degree PD: Dividing the market into two or more groups based on easily identifiable characteristics (e.g., age, time, or location) and charging a higher price to the group with the more inelastic demand. Example: Student/Senior discounts, different prices for economy vs. business class flights.

Consequences of PD (7.8.3):

  • It increases the producer's profit (by capturing consumer surplus).
  • It can allow firms to stay in business that might otherwise fail (if high fixed costs are spread over higher revenues).
  • It is considered unfair by some high-paying consumers.
  • It can lead to a more efficient (higher) output than a standard monopoly if it enables the firm to sell to people who otherwise couldn't afford the single monopoly price.

Key Takeaway: Firms have multiple objectives besides profit. Price Discrimination requires market segmentation and different PEDs to be effective.