Market structures, competition and pricing
Market structures, competition and pricing
This domain tests the spectrum from perfect competition to monopoly, the strategic interaction of oligopolists, and how regulators price natural monopolies.
Core rules
- Perfect competition: many firms, homogeneous product, free entry. Long-run equilibrium gives P = MC = minimum AC and zero economic profit.
- Monopoly: MR = MC, with P > MC and a deadweight loss. The Lerner index (P − MC)/P equals 1/|ε| at the optimum.
- Monopolistic competition: differentiated products, free entry erodes supernormal profit, but price still exceeds MC and excess capacity persists.
- Oligopoly: interdependence matters. Cournot (quantity competition), Bertrand (price competition collapses to marginal cost with homogeneous goods), Stackelberg (first-mover advantage), kinked demand curve (price rigidity), and prisoners' dilemma games.
- Price discrimination needs market power, no arbitrage and identifiable groups with differing elasticities. First degree extracts all surplus; second degree uses self-selection; third degree segments markets.
- Contestability: the threat of entry can discipline incumbents even with few firms.
- Natural monopoly: declining AC over the relevant range, so marginal cost pricing produces a loss; regulators use average-cost pricing or RPI−X.
Worked example
A monopolist faces P = 100 − 2Q and MC = 20. TR = 100Q − 2Q², so MR = 100 − 4Q. MR = MC gives Q = 20 and P = 60. The competitive outcome sets P = MC: Q = 40. Deadweight loss = ½ × (60 − 20) × (40 − 20) = 400. The Lerner index is (60 − 20)/60 = 0.667, implying demand elasticity of 1.5 at the optimum.
Traps
- Setting output from the demand curve rather than MR.
- Confusing the Herfindahl index with a simple firm count.
- Assuming oligopolists always collude or always compete.
- Saying perfect competition yields zero accounting profit - it is economic profit that is zero.