Market Structure and Price Determination
Domain 5 is about how price and output are determined under different market forms, and how each form is identified from its features and revenue curves.
Perfect competition
Features: many buyers and sellers, homogeneous product, free entry and exit, perfect knowledge, perfect factor mobility, no transport costs. The firm is a price taker, so its demand curve is horizontal and AR = MR = price. Equilibrium: MC = MR with MC rising. The short run may yield supernormal profit, normal profit or loss; the shut-down point is minimum AVC. Long run: price equals minimum LAC, so only normal profit survives.
Monopoly
One seller, no close substitute, strong barriers to entry, price maker. Demand slopes downward, so MR < AR and, for linear demand, MR falls twice as fast as price. Equilibrium: MC = MR, with price read off the demand curve, so P > MC, which is the source of deadweight loss. Price discrimination requires market separation and different elasticities.
Monopolistic competition
Many sellers, differentiated products, selling costs such as advertising, free entry. The short run resembles monopoly; in the long run entry shifts the firm demand curve left until normal profit is restored, with tangency on the falling part of LAC, hence excess capacity.
Worked example
A firm sells at P = Rs 10; MC at outputs 1 to 4 is 6, 8, 10, 12. At Q = 3, MC = 10 = MR = price, and MC is rising beyond, so Q = 3 is the equilibrium output. Profit equals (10 - AC) x 3, so AC data are needed before the profit figure can be stated.
Traps
- Drawing a downward-sloping demand curve for a perfectly competitive firm.
- Locating the shut-down point at minimum AC instead of minimum AVC.
- Saying a monopolist charges the highest possible price; the profit-maximising choice is where MC = MR.
- Forgetting that long-run equilibrium in monopolistic competition is not at minimum LAC.