Section 3.3.3Unit 3: Business Behaviour
Unit 3: Business Behaviour
Market Structures and Contestability
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Many firms sell identical products and are price takers — in the long run, freedom of entry competes away all supernormal profit, leaving firms earning just normal profit at P = MC.
Perfect competition is a market structure with many firms, each selling a homogeneous (identical) product. Because no single firm is large enough to influence the market price, each is a price taker — it accepts the price set by market supply and demand. This means the firm's demand curve is perfectly elastic: AR = MR = P.
In the short run, a perfectly competitive firm can earn supernormal profit if the market price is above average total cost. However, because there are no barriers to entry, new firms are attracted by supernormal profit. As they enter, market supply shifts right, the price falls, and supernormal profit is competed away. In long-run equilibrium, each firm earns normal profit only (AR = ATC). At this point, the firm produces where P = MC (allocative efficiency) and at the minimum point of ATC (productive efficiency).
Real Example: Agricultural commodity markets like wheat approximate perfect competition. Thousands of farmers sell an identical product, no single farmer can influence the world price, and entry barriers are relatively low — making them price takers in a global market.
Exam Matters: Examiners expect you to draw the two-panel diagram: the market (supply and demand setting the price) and the firm (horizontal AR = MR = P line, with MC and ATC). Practise showing the shift from short-run supernormal profit to long-run normal profit — this is one of the most frequently tested diagram sequences.
Many firms sell differentiated products with low barriers to entry — supernormal profit is possible in the short run, but entry competes it away, leaving excess capacity in the long run.
Monopolistic competition combines elements of both perfect competition and monopoly. There are many firms, each selling a slightly differentiated product — think different restaurant cuisines, branding, or quality levels. Because products are not identical, each firm has a small degree of market power and faces a downward-sloping demand curve.
In the short run, firms can earn supernormal profit if demand is strong enough. But because barriers to entry are low, new firms enter, attracted by profit. Entry shifts each existing firm's demand curve leftward (customers are shared among more firms). In long-run equilibrium, the AR curve is tangent to the ATC curve — the firm earns normal profit only. Crucially, the tangency point is not at the minimum of ATC, meaning the firm has excess capacity — it could produce more at a lower average cost but chooses not to.
Real Example: The restaurant industry is a classic example of monopolistic competition. Hundreds of restaurants in any city sell differentiated meals (Italian, Thai, vegan), entry costs are low, and while a popular new restaurant may earn supernormal profit initially, rival openings soon erode it.
Exam Matters: The key diagram skill is drawing the long-run tangency: AR just touching ATC at exactly one point, to the left of ATC's minimum. Examiners penalise diagrams where AR cuts through ATC (that would show supernormal or subnormal profit, not normal profit). Label the excess capacity gap clearly.
A market dominated by a few large interdependent firms — the kinked demand curve explains price stickiness because rivals match price cuts but ignore price rises.
An oligopoly is a market dominated by a few large firms that together hold a significant share of total output. Key features include high barriers to entry (economies of scale, branding, patents), interdependence (each firm must consider rivals' reactions before changing price or output), and products that may be differentiated or homogeneous.
The kinked demand curve model explains why prices in oligopolies tend to be sticky. If one firm raises its price, rivals do not follow — the firm loses customers and demand is elastic above the current price. If the firm cuts its price, rivals match the cut to protect market share — demand is inelastic below the current price. This creates a kink at the prevailing price and a discontinuous gap in the MR curve. Costs can shift within this gap without changing the profit-maximising price or output.
Real Example: The UK supermarket industry — dominated by Tesco, Sainsbury's, Asda, and Morrisons — is a classic oligopoly. When one supermarket launches a price-matching campaign, rivals respond immediately, making sustained price cuts unprofitable and keeping prices broadly stable.
Exam Matters: Examiners expect you to draw the kinked demand curve with the discontinuous MR gap. Show how a shift in MC that stays within the MR gap does not change price or output. This is the diagram that explains price rigidity — make sure the kink is clearly at the prevailing price level.
The prisoner's dilemma shows why collusion is unstable — every cartel member has a dominant strategy to cheat by secretly increasing output, which is why most cartels eventually collapse.
Game theory analyses strategic interaction between interdependent firms. The prisoner's dilemma illustrates the core problem: if both firms cooperate (keep prices high), they share monopoly profit. But each firm has a dominant strategy to cheat — cutting its price to steal market share. When both cheat, they end up worse off than if they had cooperated. This is the Nash equilibrium: neither firm can improve its position by changing strategy alone.
A cartel is a formal agreement between firms to fix prices, restrict output, or divide markets. By acting as a collective monopoly, cartel members can earn supernormal profit. However, cartels are inherently unstable because each member has an incentive to secretly increase output above its quota — gaining revenue at other members' expense. Tacit collusion avoids illegal agreements: firms follow a price leader (usually the largest firm) without explicit communication.
Real Example: OPEC is the world's most prominent cartel, coordinating oil output among member nations. Yet OPEC regularly struggles with compliance — members like Iraq and Nigeria frequently exceed their production quotas to boost national revenue, undermining the cartel's ability to keep prices high.
Exam Matters: Examiners love a simple 2x2 payoff matrix. Practise drawing one showing: mutual cooperation (high profit each), mutual cheating (low profit each), and the temptation payoff (one cheats while the other cooperates). Clearly identify the Nash equilibrium and explain why it differs from the jointly optimal outcome.
A monopolist sets MC = MR then reads price from the AR curve — charging P > MC creates allocative inefficiency and a deadweight loss triangle that represents lost consumer and producer surplus.
A pure monopoly is a single firm that is the sole supplier in a market, protected by high barriers to entry (legal, technical, or strategic). The monopolist faces the entire market demand curve, which slopes downward — to sell more, it must lower the price on all units, so MR < AR at every output level.
The monopolist maximises profit at MC = MR, then charges the price consumers are willing to pay on the AR (demand) curve above. Because P > MC, the monopolist is allocatively inefficient — it produces too little and charges too much relative to the competitive outcome. The gap between the monopoly outcome and the competitive outcome creates a deadweight loss triangle, representing surplus that is lost to society entirely. Unlike in perfect competition, supernormal profit persists in the long run because barriers to entry prevent new firms from entering.
Real Example: Thames Water is a regional monopoly supplying water to 15 million customers in London and the South East. Customers cannot switch supplier, giving Thames Water significant market power — which is why Ofwat regulates its prices to prevent exploitation.
Exam Matters: The monopoly diagram is the most important in the entire unit. Practise drawing: downward-sloping AR, MR below AR (twice the slope), MC = MR intersection to find output, then read price from AR. Shade the supernormal profit rectangle (P minus ATC times quantity) and the deadweight loss triangle. Label everything.
Charging different prices to different consumers for the same product — it requires market power, consumer separation, and no resale, and can actually increase total output above the single-price level.
Price discrimination occurs when a firm charges different prices to different consumers for the same product, where the price difference is not justified by cost differences. There are three degrees: first-degree (each consumer pays their maximum willingness to pay — all consumer surplus extracted), second-degree (different prices for different quantities — e.g. bulk discounts), and third-degree (different prices for different groups identified by elasticity — e.g. student discounts, peak pricing).
Three conditions must hold: the firm must have market power (downward-sloping demand), it must be able to separate consumers into groups with different price elasticities, and there must be no possibility of resale between groups. Third-degree discrimination is the most common and exam-relevant: the firm charges a higher price in the market with inelastic demand and a lower price where demand is elastic.
A key evaluation point: price discrimination can increase total output above the single-price monopoly level. Some consumers who would have been priced out under a single price now receive the product at a lower price. This can improve allocative efficiency, though it also transfers consumer surplus to the producer.
Real Example: Train operators like Avanti West Coast charge vastly different fares for the same journey — peak-time commuters with inelastic demand pay far more than off-peak leisure travellers. The same seat, same route, same service, but different prices based on time of travel and willingness to pay.
Exam Matters: Examiners test the three conditions (market power, separation, no resale) almost every session. For a top-band answer, draw two side-by-side diagrams: one for the inelastic market (high price) and one for the elastic market (low price), showing MC = MR in each. Explain that combined output exceeds the single-price monopoly level.
What disciplines firm behaviour is not the number of existing competitors but the threat of entry — if sunk costs are low, even a monopolist must price competitively or face hit-and-run entry.
The theory of contestable markets, developed by William Baumol, argues that the threat of entry matters more than the actual number of firms in a market. A perfectly contestable market has zero sunk costs — meaning a firm can enter, compete, and exit without losing any investment. In such a market, even a single incumbent firm (a monopoly) would be forced to behave competitively.
The key concept is hit-and-run entry: if an incumbent earns supernormal profit, a new firm can enter, undercut the price, capture the profit, and exit before the incumbent can respond — provided there are no sunk costs trapping the entrant. Sunk costs are the crucial barrier to contestability: the higher the sunk costs (advertising, specialised equipment, brand building), the less contestable the market. Contestability shifts the focus from market structure to market behaviour — a monopoly in a contestable market may produce outcomes closer to perfect competition.
Real Example: The budget airline industry demonstrates contestability. Airlines like Ryanair and easyJet lease aircraft rather than buying them (reducing sunk costs), can quickly switch routes, and face low exit costs — making the threat of new entrants on any profitable route a constant discipline on pricing.
Exam Matters: Examiners reward students who distinguish between fixed costs and sunk costs. A factory (fixed cost) can be resold; a national advertising campaign (sunk cost) cannot. Sunk costs are the true measure of contestability — always make this distinction explicitly in your answer.
No single market structure achieves every type of efficiency — perfect competition delivers static efficiency but not dynamic, while monopoly may deliver dynamic efficiency but not static. This trade-off is the heart of competition policy.
Allocative efficiency (P = MC) and productive efficiency (minimum ATC) are both achieved in long-run perfect competition. However, perfectly competitive firms earn only normal profit and have no funds for research and development — they lack dynamic efficiency (innovation and technological progress over time). The identical products and tiny firm sizes leave no room for investment in new processes or products.
Monopoly is the mirror image: persistent supernormal profit funds R&D and innovation (Schumpeter's argument for dynamic efficiency), but P > MC means allocative inefficiency and production may not occur at minimum ATC. The policy question becomes whether the long-run gains from innovation outweigh the short-run losses from higher prices and restricted output.
This trade-off is central to competition policy. Regulators like the CMA must weigh static efficiency losses (deadweight loss, higher prices) against potential dynamic efficiency gains (new products, lower future costs). Patent systems explicitly make this trade-off: they grant a temporary monopoly to incentivise innovation, accepting short-run inefficiency for long-run gains.
Real Example: Pharmaceutical patents grant companies like Pfizer a 20-year monopoly on new drugs. The resulting high prices are allocatively inefficient, but without the monopoly profit incentive, firms would not invest the billions required for R&D — a deliberate policy trade-off between static and dynamic efficiency.
Exam Matters: Top-band 25-mark essays always discuss the efficiency trade-off. Structure your evaluation: static efficiency favours perfect competition, dynamic efficiency may favour monopoly, and contestability shows that the threat of entry can achieve competitive outcomes regardless of structure. Conclude that the best policy depends on the specific market — there is no one-size-fits-all answer.
Many firms sell identical products and are price takers — in the long run, freedom of entry competes away all supernormal profit, leaving firms earning just normal profit at P = MC.
Many firms sell differentiated products with low barriers to entry — supernormal profit is possible in the short run, but entry competes it away, leaving excess capacity in the long run.