Unit 2: Microeconomics Part II - Market Power
Understanding Market Structures, Costs, Revenue, and Profit Maximization
Introduction: Market Structures and Market Power
Market structure refers to the characteristics of a market that determine the behavior of firms and the nature of competition. The degree of market power (ability to influence price) varies across different market structures.
Spectrum of market power:
- Perfect Competition: No market power (price takers)
- Monopolistic Competition: Some market power (product differentiation)
- Oligopoly: Significant market power (few dominant firms)
- Monopoly: Maximum market power (single seller)
Costs of Production
Understanding Firm Costs
Before analyzing different market structures, we must understand how firms' costs behave. Costs determine supply decisions and profitability.
1. Fixed Costs (FC)
Fixed costs do not vary with output level. They must be paid even if production is zero.
Examples:
- Rent for factory building
- Insurance premiums
- Salaries of permanent staff
- Loan repayments
- Depreciation of machinery
Notation: \(FC\) or \(TFC\) (Total Fixed Costs)
2. Variable Costs (VC)
Variable costs change with the level of output. They are zero when output is zero.
Examples:
- Raw materials
- Electricity for production
- Hourly wages
- Packaging
- Transportation costs
Notation: \(VC\) or \(TVC\) (Total Variable Costs)
3. Total Cost (TC)
Total Cost Formula
\[ TC = FC + VC \]Total cost is the sum of all fixed and variable costs at any given output level.
4. Average Costs
Average Cost Formulas
Average Fixed Cost (AFC):
\[ AFC = \frac{FC}{Q} \]Average Variable Cost (AVC):
\[ AVC = \frac{VC}{Q} \]Average Total Cost (ATC or AC):
\[ ATC = \frac{TC}{Q} = \frac{FC + VC}{Q} = AFC + AVC \]Where \(Q\) = Quantity of output
5. Marginal Cost (MC)
Marginal Cost Formula
Marginal cost is the additional cost of producing one more unit of output.
\[ MC = \frac{\Delta TC}{\Delta Q} = \frac{\text{Change in Total Cost}}{\text{Change in Quantity}} \]Key insight: Since FC doesn't change, \(MC = \frac{\Delta VC}{\Delta Q}\)
Cost Curve Relationships
Important Cost Curve Properties
1. AFC curve:
- Continuously downward sloping
- Never touches horizontal axis (approaches zero)
- Fixed costs spread over more units as Q increases
2. AVC curve:
- U-shaped due to diminishing returns
- Initially falls (increasing productivity)
- Then rises (diminishing marginal productivity)
3. ATC curve:
- U-shaped (sum of AFC and AVC)
- Falls initially (spreading fixed costs, efficiency gains)
- Rises eventually (diminishing returns dominate)
4. MC curve:
- U-shaped
- Intersects AVC and ATC at their minimum points
- When MC < ATC, ATC is falling
- When MC > ATC, ATC is rising
📊 COST CURVES DIAGRAM
Vertical Axis: Costs ($)
Horizontal Axis: Quantity (Q)
MC: U-shaped, intersects AVC and ATC at minimums
ATC: U-shaped, above AVC
AVC: U-shaped, below ATC
AFC: Downward sloping hyperbola
Gap between ATC and AVC = AFC (narrows as Q increases)
Revenue
Types of Revenue
Revenue Formulas
Total Revenue (TR):
\[ TR = P \times Q \]Average Revenue (AR):
\[ AR = \frac{TR}{Q} = \frac{P \times Q}{Q} = P \]Key insight: AR = Price = Demand curve
Marginal Revenue (MR):
\[ MR = \frac{\Delta TR}{\Delta Q} = \frac{\text{Change in Total Revenue}}{\text{Change in Quantity}} \]MR is the additional revenue from selling one more unit.
Revenue in Different Market Structures
Perfect Competition (Price Taker):
- Firm faces horizontal demand curve at market price
- \(P = AR = MR\) (constant)
- Can sell any quantity at market price
Imperfect Competition (Price Maker):
- Firm faces downward-sloping demand curve
- \(P = AR > MR\)
- To sell more, must lower price on all units
- MR falls faster than AR
Profit Maximization
Economic Profit vs. Accounting Profit
Profit Definitions
Accounting Profit:
\[ \text{Accounting Profit} = TR - \text{Explicit Costs} \]Economic Profit:
\[ \text{Economic Profit} = TR - \text{Explicit Costs} - \text{Implicit Costs} \] \[ \text{Economic Profit} = TR - TC \text{ (where TC includes opportunity costs)} \]Where:
- • Explicit costs: Direct monetary payments (wages, rent, materials)
- • Implicit costs: Opportunity costs (foregone salary, interest on own capital)
Types of Profit
Normal Profit:
- Economic profit = 0 (TR = TC including opportunity costs)
- Firm covers all costs including opportunity cost
- Minimum profit needed to keep firm in industry
- Entrepreneur earns as much as next best alternative
Supernormal/Abnormal Profit:
- Economic profit > 0 (TR > TC)
- Earning more than opportunity cost
- Attracts new firms to enter industry (long run)
Loss (Subnormal Profit):
- Economic profit < 0 (TR < TC)
- Not covering opportunity costs
- Firms exit industry (long run)
Profit Maximization Rule
Universal Profit Maximization Condition
All firms maximize profit where:
\[ MC = MR \]Logic:
- If \(MR > MC\): Producing one more unit adds more to revenue than to cost → Increase output
- If \(MR < MC\): Producing one more unit adds more to cost than to revenue → Decrease output
- If \(MR = MC\): Cannot improve profit by changing output → Profit maximized
Profit calculation:
\[ \text{Profit} = TR - TC = (AR - ATC) \times Q \]Or on diagram: Rectangle with height (P - ATC) and width Q
1. Perfect Competition
Characteristics
Assumptions of Perfect Competition
1. Many small firms:
- Each firm is tiny relative to market
- No single firm can influence market price
- Firms are price takers
2. Homogeneous (identical) products:
- Perfect substitutes
- No brand loyalty or product differentiation
- Consumer indifferent between suppliers
3. Perfect information:
- All buyers and sellers know prices, quality, availability
- No information asymmetries
4. Freedom of entry and exit:
- No barriers to entry or exit
- Firms can freely enter if profits exist
- Firms can exit without cost if making losses
5. Perfect mobility of factors:
- Resources can move freely between uses
Example: Agricultural Commodities
Wheat market:
- Many small farmers (no single farmer affects price)
- Wheat is homogeneous (standard grade)
- Prices known (commodity exchanges)
- Relatively easy entry/exit
Note: Even agricultural markets aren't perfectly competitive in reality (government intervention, branding, quality differences), but they're closest to the model.
Perfect Competition: Short Run
Short Run Equilibrium
Firm's decision:
- Firm takes market price as given (\(P = MR = AR\))
- Maximizes profit where \(MC = MR\)
- Can make supernormal profit, normal profit, or loss
Short Run Outcomes
Supernormal Profit: If \(P > ATC\) at profit-maximizing output
\[ \text{Profit} = (P - ATC) \times Q \]Normal Profit (Break-even): If \(P = ATC\)
\[ \text{Profit} = 0 \]Loss: If \(P < ATC\) but \(P > AVC\)
- Firm continues operating (covers variable costs plus some fixed costs)
- Better than shutting down (would lose all fixed costs)
Shutdown point: If \(P < AVC\)
- Firm shuts down (can't even cover variable costs)
- Loss = FC (minimum loss possible)
📊 PERFECT COMPETITION - SHORT RUN SUPERNORMAL PROFIT
Horizontal demand curve at market price (P = MR = AR)
MC curve intersects MR at profit-max quantity
At profit-max Q: P > ATC
Supernormal profit = Shaded rectangle (P - ATC) × Q
Rectangle between price level and ATC curve
Perfect Competition: Long Run
Long Run Adjustment
If firms make supernormal profit in short run:
- New firms attracted (no barriers to entry)
- Market supply increases
- Market price falls
- Continues until only normal profit remains
If firms make losses in short run:
- Some firms exit (no barriers to exit)
- Market supply decreases
- Market price rises
- Continues until losses eliminated
Long Run Equilibrium Condition
In long run equilibrium:
\[ P = MC = ATC_{\text{min}} \]- • All firms earn normal profit (economic profit = 0)
- • No incentive for entry or exit
- • Firms produce at minimum ATC (productive efficiency)
- • Price equals MC (allocative efficiency)
📊 PERFECT COMPETITION - LONG RUN EQUILIBRIUM
P = MC = MR = AR at minimum point of ATC
Firm produces at lowest point on ATC curve
No supernormal profit (P = ATC)
Both productive and allocative efficiency achieved
Efficiency in Perfect Competition
Why Perfect Competition is Efficient
1. Allocative Efficiency:
\[ P = MC \]- Resources allocated according to consumer preferences
- No deadweight loss
- Consumer and producer surplus maximized
2. Productive Efficiency:
\[ P = MC = ATC_{\text{min}} \]- Firms produce at lowest possible cost
- No wasteful production
3. Dynamic Efficiency (debatable):
- Competitive pressure drives innovation
- BUT: Small firms may lack resources for R&D
2. Monopoly
Characteristics
Defining Features of Monopoly
1. Single seller:
- Only one firm in the market
- The firm IS the industry
- Significant market power
2. No close substitutes:
- Product is unique
- Consumers have no alternatives
3. Price maker:
- Firm sets price (doesn't take it from market)
- Faces downward-sloping demand curve
- Can increase price without losing all customers
4. High barriers to entry:
- Other firms cannot enter market
- Monopoly protected from competition
Barriers to Entry
1. Legal barriers:
- Patents: Exclusive rights to invention (pharmaceuticals)
- Copyright: Protection for creative works
- Licenses: Government-granted exclusive rights (utilities)
- Trademarks: Brand protection
2. Natural monopoly:
- Economies of scale so large that one firm can supply entire market at lower cost than multiple firms
- High fixed costs, low marginal costs
- Examples: Water supply, electricity grid, railways
3. Control of essential resources:
- Firm owns or controls key input
- Example: De Beers diamond mines (historically)
4. Economies of scale:
- Large firm has cost advantage
- New entrants cannot compete on cost
5. Aggressive tactics:
- Predatory pricing (temporarily lowering prices to drive out competition)
- Exclusive contracts with suppliers
Real-World Monopoly Examples
1. Microsoft Windows (historically):
- Dominated operating system market
- Network effects (everyone uses it, so more software developed for it)
- High barriers to entry for competitors
2. Local utility companies:
- Natural monopolies (wasteful to duplicate infrastructure)
- Government-granted exclusive licenses
- Often regulated to prevent exploitation
3. Pharmaceutical patents:
- Legal monopoly for period of time
- No generic alternatives during patent
- High prices to recoup R&D costs
Monopoly Profit Maximization
Monopoly Equilibrium
Profit maximization:
\[ MC = MR \]Key differences from perfect competition:
- Monopoly faces downward-sloping demand (AR) curve
- MR curve below AR curve (MR < AR)
- To sell more, must lower price on ALL units
Price determination:
- Find quantity where MC = MR
- Read price from demand (AR) curve at that quantity
- \(P > MC\) (allocatively inefficient)
Profit:
\[ \text{Profit} = (P - ATC) \times Q \]📊 MONOPOLY EQUILIBRIUM
Downward-sloping AR (demand) curve
MR curve below AR (steeper slope, twice as steep if linear)
MC curve (U-shaped)
ATC curve (U-shaped)
Profit-max: MC = MR determines quantity (Qm)
Price (Pm) read from AR curve at Qm
Pm > MC (allocatively inefficient)
Supernormal profit = Rectangle (Pm - ATC) × Qm
Monopoly vs. Perfect Competition
| Aspect | Perfect Competition | Monopoly |
|---|---|---|
| Number of Firms | Many small firms | One firm |
| Market Power | Price taker | Price maker |
| Barriers to Entry | None | Very high |
| Product | Homogeneous | Unique, no substitutes |
| Price | P = MC (lower) | P > MC (higher) |
| Quantity | Higher | Lower (restricted output) |
| Long Run Profit | Normal profit only | Supernormal profit |
| Allocative Efficiency | Yes (P = MC) | No (P > MC) |
| Productive Efficiency | Yes (P = minimum ATC) | No (not at minimum ATC) |
Welfare Loss Under Monopoly
Deadweight Loss
Problem: Monopoly produces where \(P > MC\), creating allocative inefficiency
- Quantity lower than socially optimal
- Price higher than competitive level
- Some mutually beneficial transactions don't occur
- Deadweight loss = triangle between MC and demand from Qm to Qpc
Consumer welfare:
- Consumer surplus reduced (higher prices, lower quantity)
- Some consumer surplus transferred to producer (becomes profit)
- Some consumer surplus lost entirely (deadweight loss)
Potential Benefits of Monopoly
Arguments FOR Monopoly
1. Economies of scale:
- Natural monopolies produce at lower cost than multiple firms
- Single firm can spread high fixed costs
- May benefit consumers despite higher prices
2. Dynamic efficiency (innovation):
- Supernormal profits fund R&D
- Patent protection incentivizes innovation
- Example: Pharmaceutical R&D requires monopoly profits
3. International competitiveness:
- Large domestic firms compete globally
- National champions in strategic industries
3. Monopolistic Competition
Characteristics
Features of Monopolistic Competition
1. Many firms:
- Large number of sellers
- Each relatively small market share
2. Product differentiation:
- Products similar but not identical
- Differentiated by quality, branding, features, location
- Gives firms some market power
3. Low barriers to entry:
- Relatively easy for new firms to enter
- Not as easy as perfect competition due to brand loyalty
4. Non-price competition:
- Compete through advertising, branding, quality
- Heavy spending on marketing
5. Some market power:
- Downward-sloping demand curve (like monopoly)
- But less elastic than monopoly (more substitutes available)
Examples of Monopolistic Competition
- Restaurants: Many options, but each has unique cuisine, atmosphere, location
- Coffee shops: Starbucks vs. local cafés—similar products but differentiated
- Hairdressers: Many salons, differentiated by style, service, reputation
- Clothing retailers: Many brands, differentiated by fashion, quality, image
- Gas stations: Similar product but differentiated by location, convenience, brand
Monopolistic Competition: Short Run
Short run equilibrium:
- Profit maximization: \(MC = MR\)
- Can make supernormal profit if demand strong
- Faces downward-sloping AR and MR curves (like monopoly)
- Price read from AR curve: \(P > MC\)
Monopolistic Competition: Long Run
Long Run Adjustment
If supernormal profits in short run:
- New firms attracted by profits
- Market becomes more crowded
- Existing firms' demand curves shift left (lose market share)
- Profits eroded until only normal profit remains
Long run equilibrium:
\[ P = ATC \text{ (normal profit)} \]- But still \(P > MC\) (allocatively inefficient)
- And \(P > \text{minimum ATC}\) (productively inefficient)
- Excess capacity exists
📊 MONOPOLISTIC COMPETITION - LONG RUN
Downward-sloping AR and MR curves
MC = MR determines quantity
AR curve tangent to ATC curve (P = ATC, normal profit)
P > MC (allocatively inefficient)
Not at minimum ATC (productively inefficient)
Excess capacity: Could produce more at lower cost
Evaluation of Monopolistic Competition
Advantages
- Product variety: Consumers benefit from choice
- Quality competition: Firms compete to improve products
- Innovation: Incentive to differentiate through new features
- Low barriers: Entry possible, limiting exploitation
Disadvantages
- Allocative inefficiency: \(P > MC\), deadweight loss exists
- Productive inefficiency: Not at minimum ATC, excess capacity
- Wasteful advertising: Resources spent on persuasion rather than production
- Higher prices: Than perfect competition (though less than monopoly)
4. Oligopoly
Characteristics
Features of Oligopoly
1. Few large firms dominate:
- Market dominated by small number of firms
- High concentration ratio (e.g., top 4 firms control 70%+ of market)
2. Interdependence:
- Firms must consider rivals' reactions when making decisions
- One firm's action affects others
- Strategic behavior crucial
3. High barriers to entry:
- Economies of scale
- Brand loyalty
- High capital requirements
- Legal barriers (patents, licenses)
4. Product may be differentiated or homogeneous:
- Differentiated: Cars, smartphones, airlines
- Homogeneous: Steel, oil, cement
5. Non-price competition common:
- Advertising and branding
- After-sales service
- Product innovation
Real-World Oligopoly Examples
- Airlines: Few major carriers dominate routes
- Telecommunications: 3-4 major providers in most countries
- Automobiles: Toyota, VW, GM, Ford dominate globally
- Smartphones: Apple, Samsung dominate market
- Soft drinks: Coca-Cola and PepsiCo control most of market
- Supermarkets: Few chains dominate (Walmart, Tesco, Carrefour)
Oligopoly Behavior: Game Theory
Strategic Interactions
Key insight: Oligopolists face strategic uncertainty—they must predict and respond to rivals' actions
Possible strategies:
- Collusion: Firms cooperate to act like monopoly
- Competition: Firms compete aggressively (price wars)
- Price leadership: One firm sets price, others follow
- Tacit collusion: Unspoken cooperation without formal agreement
Collusion and Cartels
Collusive Oligopoly
Collusion: Firms agree to coordinate actions to reduce competition
Cartel: Formal agreement among firms to fix prices, limit output, or divide markets
Example: OPEC (Organization of Petroleum Exporting Countries)
- Oil-producing nations coordinate output
- Restrict supply to raise prices
- Act collectively like monopoly
Benefits of collusion:
- Higher prices and profits for all members
- Reduced uncertainty
- Avoid destructive price wars
Problems with collusion:
- Illegal: Most countries ban explicit collusion (antitrust laws)
- Cheating incentive: Each firm tempted to break agreement for individual gain
- Entry: High profits attract new competitors
- Coordination difficulty: Hard to agree on price/output, especially with many members
Kinked Demand Curve Model
Explaining Price Rigidity in Oligopoly
Observation: Oligopoly prices tend to be "sticky" (don't change often)
Kinked demand curve explanation:
- If firm raises price: Rivals don't follow → Firm loses customers → Demand elastic above current price
- If firm lowers price: Rivals match price cuts → Firm doesn't gain many customers → Demand inelastic below current price
- Result: Demand curve has "kink" at current price
- MR curve has discontinuity (vertical gap) at kink
- Wide range of MC can intersect MR at same quantity
- Costs can change without changing price
📊 KINKED DEMAND CURVE
AR curve has kink at current price P*
Elastic above kink (shallow slope)
Inelastic below kink (steep slope)
MR curve has vertical discontinuity at quantity Q*
MC can shift within vertical gap without changing P* or Q*
Explains price rigidity
Evaluation of Oligopoly
Potential Benefits
- Dynamic efficiency: Large profits fund R&D and innovation
- Economies of scale: Large firms produce at lower cost
- Product variety: Non-price competition leads to innovation
- Price stability: Less volatility than perfect competition
Problems
- Allocative inefficiency: \(P > MC\), especially if collusion exists
- Productive inefficiency: May not produce at minimum ATC
- High prices: Especially if firms collude
- Restricted output: Less than competitive level
- Barriers to entry: Prevent new competition
- Consumer exploitation: If collusion successful
Summary Comparison of Market Structures
| Characteristic | Perfect Competition | Monopolistic Competition | Oligopoly | Monopoly |
|---|---|---|---|---|
| Number of Firms | Very many | Many | Few | One |
| Market Power | None (price taker) | Some | Significant | Maximum (price maker) |
| Product | Homogeneous | Differentiated | May be either | Unique |
| Barriers to Entry | None | Low | High | Very high |
| Long Run Profit | Normal only | Normal only | Supernormal possible | Supernormal |
| Allocative Efficiency | Yes (P = MC) | No (P > MC) | No (P > MC) | No (P > MC) |
| Productive Efficiency | Yes (min ATC) | No (excess capacity) | Variable | No |
| Examples | Agricultural commodities | Restaurants, retail | Airlines, telecoms | Local utilities |
IB Economics Exam Tips
Diagram Essentials
- Perfect competition: Horizontal demand at market price (P = MR = AR)
- Imperfect competition: Downward-sloping AR, MR below AR
- Always show: MC, ATC, MR, AR curves
- Mark clearly: Profit-max quantity (MC = MR), price (from AR curve), profit area
- Label axes: Price/Cost/Revenue on Y-axis, Quantity on X-axis
Key Formulas to Remember
- \(TC = FC + VC\)
- \(ATC = \frac{TC}{Q} = AFC + AVC\)
- \(MC = \frac{\Delta TC}{\Delta Q}\)
- \(TR = P \times Q\)
- \(Profit = TR - TC = (AR - ATC) \times Q\)
- Profit maximization: \(MC = MR\) for ALL market structures
- Perfect competition long run: \(P = MC = ATC_{min}\)
Common Mistakes to Avoid
- Wrong profit-max rule: Always use MC = MR, not MC = AR
- Reading price from wrong curve: Price always comes from AR (demand) curve, not MR
- Confusing MR and AR: In imperfect competition, MR < AR (MR is steeper)
- Forgetting long-run adjustment: Entry/exit occurs unless high barriers
- Missing profit area: Rectangle = (P - ATC) × Q, not triangle
- Wrong efficiency assessment: Perfect competition is only fully efficient structure
Evaluation Points
- Real-world context: Pure perfect competition and monopoly rare; most markets somewhere in between
- Trade-offs: Efficiency vs. innovation, competition vs. economies of scale
- Dynamic efficiency: Imperfect competition may drive more innovation than perfect competition
- Consumer welfare: Consider price, quality, variety, innovation—not just efficiency
- Government role: When to intervene (monopoly regulation) vs. when to allow (natural monopoly)
✓ Market Power Checkpoint
You should now understand how to calculate costs (TC, AC, MC) and revenue (TR, AR, MR); the profit maximization rule (MC = MR) that applies to all market structures; the characteristics and efficiency outcomes of perfect competition, monopolistic competition, oligopoly, and monopoly; how market structure affects pricing, output, and welfare; and how to draw and interpret cost-revenue diagrams for each market structure. These concepts are essential for analyzing firm behavior, market outcomes, and the rationale for competition policy in IB Economics SL.