• The number of firms in the market. The more firms there are, the more competitive the market
is. This also includes the extent of competition from abroad.
• The degree of product differentiation. The more differentiated the products, the less competitive
the market. In a perfectly competitive market, products are homogenous. Products can be
differentiated using price, branding and quality. This affects cross price elasticity of demand
• Ease of entry into the market. This is the number and degree of the barriers to entry. Barriers to
entry are designed to prevent new firms entering the market profitably. This increases
producer surplus. The higher the barriers to entry, the less competitive the market. Examples
include:
• Economies of scale.
• Brand loyalty, which makes demand more inelastic. It is hard for new firms to gain
consumer loyalty, when one firm’s brand name is already strong.
• Controlling the important technologies in the market.
• Having a strong reputation.
• Backwards vertical integration, which controls supply, means firms can control the
price they pay their suppliers. This makes it hard for new firms to compete on price,
which is a barrier to entry.
• Barriers to entry can be structural, where they arise due to differences in production
costs, strategic, where firms use different pricing policies, such as undercutting
another firm’s price, or statutory, where patents protect a franchise. An example of
this is a television broadcasting licence.
2. Perfect competition
Perfect competition is a market where there is a high degree of competition, but the word ‘perfect’
does not mean it maximises welfare or produces ideal results. There are few industries which fit this
type of market structure, one example may be agriculture but government interferences may prevent it
from being so. In reality, the assumptions made rarely hold and no market is completely perfectly
competitive.
2.1 Characteristics of perfect competition:
For a market to be perfectly competitive, there must be four key characteristics. These mean that
demand for the firm’s goods is perfectly elastic, and prices are solely determined by interaction of
demand and supply; the firms are price takers.
• There must be many buyers and sellers. This means that no one firm or customer will be able
to influence the market. For example, the decision of one firm to double their output or the
decision of one buyer to double their consumption will have no effect. If the firm did manage
to have and effect, this would mean the market was no longer perfectly competitive as there
would be one large firm and other smaller firms, or one large buyer and other smaller buyers.
• There must be freedom of entry and exit from the industry. This is important as it means that
when a business is making profits anyone can enter that market and start producing that
, product for themselves. As a result, business are unable to make huge profits in the long run
and if they are making losses they are able to leave. In the long run, they make normal profits.
• There must be perfect knowledge. This enables firms to know when other firms are making
profits which will attract them to join the market. Moreover, all firms have the same costs as
they can use the sane production techniques. It also means that any attempt to raise prices
above the level determined by the market will lead to no sales, as customers will be aware
they can buy the same good for a lower price and firms know there is no point lowering the
price as they will sell all their goods at the higher price determined by the market.
• The product must be homogenous, where they are identical so it is impossible to tell the
difference between one make and another e.g. semi-skimmed milk. This is important because
it means if a firm raises it price above the competitors’ no one will buy it and they will not
gain from lowering their price because they can sell all of your product at the same price as
everyone else.
2.2 Profit maximising equilibrium:
Firms are assumed to short run profit maximise and so the firm will produce at MC=MR. In the short
run, it is possible for the firm to make a normal profit, a supernormal profit or a loss. However, firms
in perfect competition can only make normal profit in the long run. This can be seen on the
diagram.
In the short run, firms are making the supernormal profit of the shaded area. Prices are set by the
market at P1, where S1=D1. As a result, the firm faces the demand curve of AR1=MR1 and produce
where MC=MR1 at Q1 goods. However, since there is perfect information and ease of entry, the fact
they are making supernormal profits will encourage new entrants to the market. This will increase
supply from S1 to S2 and lead toa fall in price from P1 to P2. The firm now has the demand curve
AR2=MR2 and produces where MC=MR2 at Q2. This is also where AR2=AC and so they are making
normal profits. If the firm was making a loss, firms would leave the industry and this would decrease
supply, pushing prices up and reverting to the long run equilibrium.
,2.3 Efficiency:
• Perfect competition is productively efficient, since they produce where MC=AC. They are
also allocative efficient since they produce where P=MC. Thus, they are static efficient.
• However, they are not dynamic efficient. No single firm will have enough for research and
development and small firms struggle to receive finance. The existence of perfect
information also means one firms’ invention will be adopted by another firm and so the
investment will give the firm no competitive benefit. Governments tend to have to do all the
research
• Competition should keep costs, and therefore prices, low. However, firms will be unable to
benefit from economies of scale and this may mean costs are higher than they otherwise
could be.
3. Monopolistic competition
Monopolistic competition is a form of imperfect competition, with a downward sloping demand
curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely
exist in a pure form in real life. Some examples of firms in monopolistic competition are hairdressers,
estate agents and restaurants.
3.1 Characteristics:
❖ There must be a large number of buyers and sellers in the market, each of whom are
relatively small and act independently. This means that no one buyer or seller has a large price
setting power.
❖ There are no barriers to entry or exit, allowing new firms to enter when supernormal profits
are being made and some to leave in the case of losses. As a result, only normal profits can be
made in the long run.
❖ The difference between monopolistic competition and perfect competition is that in
monopolistic competition firms produce differentiated, non-homogenous goods or services.
This means that individual firms do have some price setting power, and so the curve is
downward sloping.
3.2 Profit maximizing equilibrium:
In the short run, firms can make supernormal profits, losses or normal profits. However, due to the
lack of barriers to entry/exit, firms can only make normal profits in the long run. This is shown by the
diagram.
, Firms are assumed to be short run profit maximisers, producing at MC=MR1 in the short run. As a
result, they produce Q1 at price P1 and make a supernormal profit of the shaded area. However, in the
long run, new firms will enter the industry as they know that supernormal profits are being earnt. This
will cause demand for the individual firm to decrease and therefore the AR and MR curves will shift
to the lift. The firm will produce where MC=MR2 at P2Q2. At this point, AC=AR2 and so the firm is
making normal profits. If the firm was making a loss, firms would leave the industry and thus demand
for the individual firm would increase as they had less competition. This would lead to normal profits
in the long run.
The limitation of this model is that information may be imperfect and so firms will not enter the
market as predicted as they are unaware of the existence of abnormal profits. Also, firms are likely to
be different in their size and cost structure as well as in their products, which may allow some firms to
maintain supernormal profits because firms cannot compete on equal terms.
3.3 Efficiency:
• Since they can only make normal profit in the long run, AC=AR and since they profit
maximise, MR=MC. Therefore, the firm will not be allocatively or productively efficient,
as MR does not equal AR so AC cannot equal MC and AC cannot equal MR.
• They are likely to be dynamically efficient since there are differentiated products and so know
that innovative products will give them an edge over their competitors and enable them to
make supernormal profits in the short run. However, since the firms are small they may
struggle to receive finance or have the retained profits necessary to invest.
• In monopolistic competition compared to perfect competition, less is sold at a higher price
and firms may not necessarily be producing at the lowest cost. However, the market will offer
greater variety and may be able to enjoy some degree of economies of scale.
4. Oligopoly
is. This also includes the extent of competition from abroad.
• The degree of product differentiation. The more differentiated the products, the less competitive
the market. In a perfectly competitive market, products are homogenous. Products can be
differentiated using price, branding and quality. This affects cross price elasticity of demand
• Ease of entry into the market. This is the number and degree of the barriers to entry. Barriers to
entry are designed to prevent new firms entering the market profitably. This increases
producer surplus. The higher the barriers to entry, the less competitive the market. Examples
include:
• Economies of scale.
• Brand loyalty, which makes demand more inelastic. It is hard for new firms to gain
consumer loyalty, when one firm’s brand name is already strong.
• Controlling the important technologies in the market.
• Having a strong reputation.
• Backwards vertical integration, which controls supply, means firms can control the
price they pay their suppliers. This makes it hard for new firms to compete on price,
which is a barrier to entry.
• Barriers to entry can be structural, where they arise due to differences in production
costs, strategic, where firms use different pricing policies, such as undercutting
another firm’s price, or statutory, where patents protect a franchise. An example of
this is a television broadcasting licence.
2. Perfect competition
Perfect competition is a market where there is a high degree of competition, but the word ‘perfect’
does not mean it maximises welfare or produces ideal results. There are few industries which fit this
type of market structure, one example may be agriculture but government interferences may prevent it
from being so. In reality, the assumptions made rarely hold and no market is completely perfectly
competitive.
2.1 Characteristics of perfect competition:
For a market to be perfectly competitive, there must be four key characteristics. These mean that
demand for the firm’s goods is perfectly elastic, and prices are solely determined by interaction of
demand and supply; the firms are price takers.
• There must be many buyers and sellers. This means that no one firm or customer will be able
to influence the market. For example, the decision of one firm to double their output or the
decision of one buyer to double their consumption will have no effect. If the firm did manage
to have and effect, this would mean the market was no longer perfectly competitive as there
would be one large firm and other smaller firms, or one large buyer and other smaller buyers.
• There must be freedom of entry and exit from the industry. This is important as it means that
when a business is making profits anyone can enter that market and start producing that
, product for themselves. As a result, business are unable to make huge profits in the long run
and if they are making losses they are able to leave. In the long run, they make normal profits.
• There must be perfect knowledge. This enables firms to know when other firms are making
profits which will attract them to join the market. Moreover, all firms have the same costs as
they can use the sane production techniques. It also means that any attempt to raise prices
above the level determined by the market will lead to no sales, as customers will be aware
they can buy the same good for a lower price and firms know there is no point lowering the
price as they will sell all their goods at the higher price determined by the market.
• The product must be homogenous, where they are identical so it is impossible to tell the
difference between one make and another e.g. semi-skimmed milk. This is important because
it means if a firm raises it price above the competitors’ no one will buy it and they will not
gain from lowering their price because they can sell all of your product at the same price as
everyone else.
2.2 Profit maximising equilibrium:
Firms are assumed to short run profit maximise and so the firm will produce at MC=MR. In the short
run, it is possible for the firm to make a normal profit, a supernormal profit or a loss. However, firms
in perfect competition can only make normal profit in the long run. This can be seen on the
diagram.
In the short run, firms are making the supernormal profit of the shaded area. Prices are set by the
market at P1, where S1=D1. As a result, the firm faces the demand curve of AR1=MR1 and produce
where MC=MR1 at Q1 goods. However, since there is perfect information and ease of entry, the fact
they are making supernormal profits will encourage new entrants to the market. This will increase
supply from S1 to S2 and lead toa fall in price from P1 to P2. The firm now has the demand curve
AR2=MR2 and produces where MC=MR2 at Q2. This is also where AR2=AC and so they are making
normal profits. If the firm was making a loss, firms would leave the industry and this would decrease
supply, pushing prices up and reverting to the long run equilibrium.
,2.3 Efficiency:
• Perfect competition is productively efficient, since they produce where MC=AC. They are
also allocative efficient since they produce where P=MC. Thus, they are static efficient.
• However, they are not dynamic efficient. No single firm will have enough for research and
development and small firms struggle to receive finance. The existence of perfect
information also means one firms’ invention will be adopted by another firm and so the
investment will give the firm no competitive benefit. Governments tend to have to do all the
research
• Competition should keep costs, and therefore prices, low. However, firms will be unable to
benefit from economies of scale and this may mean costs are higher than they otherwise
could be.
3. Monopolistic competition
Monopolistic competition is a form of imperfect competition, with a downward sloping demand
curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely
exist in a pure form in real life. Some examples of firms in monopolistic competition are hairdressers,
estate agents and restaurants.
3.1 Characteristics:
❖ There must be a large number of buyers and sellers in the market, each of whom are
relatively small and act independently. This means that no one buyer or seller has a large price
setting power.
❖ There are no barriers to entry or exit, allowing new firms to enter when supernormal profits
are being made and some to leave in the case of losses. As a result, only normal profits can be
made in the long run.
❖ The difference between monopolistic competition and perfect competition is that in
monopolistic competition firms produce differentiated, non-homogenous goods or services.
This means that individual firms do have some price setting power, and so the curve is
downward sloping.
3.2 Profit maximizing equilibrium:
In the short run, firms can make supernormal profits, losses or normal profits. However, due to the
lack of barriers to entry/exit, firms can only make normal profits in the long run. This is shown by the
diagram.
, Firms are assumed to be short run profit maximisers, producing at MC=MR1 in the short run. As a
result, they produce Q1 at price P1 and make a supernormal profit of the shaded area. However, in the
long run, new firms will enter the industry as they know that supernormal profits are being earnt. This
will cause demand for the individual firm to decrease and therefore the AR and MR curves will shift
to the lift. The firm will produce where MC=MR2 at P2Q2. At this point, AC=AR2 and so the firm is
making normal profits. If the firm was making a loss, firms would leave the industry and thus demand
for the individual firm would increase as they had less competition. This would lead to normal profits
in the long run.
The limitation of this model is that information may be imperfect and so firms will not enter the
market as predicted as they are unaware of the existence of abnormal profits. Also, firms are likely to
be different in their size and cost structure as well as in their products, which may allow some firms to
maintain supernormal profits because firms cannot compete on equal terms.
3.3 Efficiency:
• Since they can only make normal profit in the long run, AC=AR and since they profit
maximise, MR=MC. Therefore, the firm will not be allocatively or productively efficient,
as MR does not equal AR so AC cannot equal MC and AC cannot equal MR.
• They are likely to be dynamically efficient since there are differentiated products and so know
that innovative products will give them an edge over their competitors and enable them to
make supernormal profits in the short run. However, since the firms are small they may
struggle to receive finance or have the retained profits necessary to invest.
• In monopolistic competition compared to perfect competition, less is sold at a higher price
and firms may not necessarily be producing at the lowest cost. However, the market will offer
greater variety and may be able to enjoy some degree of economies of scale.
4. Oligopoly
