Theory of the Firm and Market Failure
This domain tests cost and revenue relationships, objectives, market structures and efficiency, then applies them to market failure and remedies. You need precise diagrams in words and clear links between market structure and welfare.
Core rules and concepts
- Profit maximisation occurs where MR = MC. Revenue maximisation occurs where MR = 0. Normal profit is included in cost; supernormal profit is profit above normal profit.
- Short-run costs reflect diminishing returns. Long-run average cost falls with economies of scale and rises with diseconomies; minimum efficient scale is the lowest output at which LRAC is minimised.
- Perfect competition: many firms, homogeneous product, free entry and exit, price takers. Long-run equilibrium gives normal profit, P = MC and minimum AC.
- Monopoly: single seller, barriers to entry, price maker. It restricts output and creates deadweight loss but may generate economies of scale and dynamic efficiency.
- Oligopoly features interdependence, concentration ratios, collusion and game theory. The kinked demand curve explains price rigidity when rivals match price cuts but not increases.
- Efficiency: allocative (P = MC), productive (minimum AC), X-efficiency and dynamic efficiency.
- Market failure includes externalities, public goods, merit and demerit goods, asymmetric information, monopoly power and factor immobility. Remedies include taxes, subsidies, regulation, permits, property rights and public provision.
Worked example
Demand is P = 100 − 2Q and MC = 20. A competitive market sets P = MC: 100 − 2Q = 20, so Q = 40 and P = 20. A monopolist sets MR = MC. MR = 100 − 4Q, so 100 − 4Q = 20, giving Q = 20 and P = 60. The deadweight loss is the triangle between demand and MC from Q = 20 to Q = 40: 0.5 × (40 − 20) × (60 − 20) = 400. The monopoly restricts output by 20 units and raises price by 40, creating an allocative loss.
Traps that cost marks
- Confusing normal and supernormal profit.
- Assuming profit maximisation always means maximum revenue.
- Claiming monopolies are always inefficient; natural monopolies may have lower average costs.
- Mixing up public goods (non-rival and non-excludable) with merit goods.
- Drawing an externality diagram without identifying the welfare loss triangle.