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Microeconomics Unit 4: Imperfect competition

Firms with market power restrict output and charge prices above marginal cost, creating deadweight loss.

Covers: Monopoly, price discrimination, monopolistic competition, oligopoly and game theory

Study guide

A monopoly is a single seller of a product with no close substitutes, protected by barriers to entry like control of resources, patents, government licenses or economies of scale. A natural monopoly arises when one firm can supply the market at lower cost than several firms. Because the monopolist faces the downward-sloping market demand, it must lower price to sell more, so marginal revenue is less than price. It produces where MR = MC and charges the price on the demand curve above that quantity. Compared with perfect competition, a monopoly produces less, charges more, and creates deadweight loss; it isn't allocatively efficient (P > MC) or productively efficient. Monopolies can earn economic profit in the long run because of barriers to entry. Regulators may set a price at P = MC (socially optimal) or P = ATC (fair return).

Price discrimination means charging different customers different prices for the same good. It requires market power, the ability to separate customers, and preventing resale. Perfect price discrimination captures all consumer surplus and produces the allocatively efficient quantity.

Monopolistic competition has many firms selling differentiated products, with easy entry and exit, like restaurants and clothing brands. Firms have some price-setting power and use advertising and branding. In the long run, entry drives economic profit to zero, but firms still charge P > MC and have excess capacity. Oligopoly has a few interdependent firms, often with high barriers to entry. Game theory analyzes their strategic decisions using payoff matrices: a dominant strategy is best no matter what the other firm does, and a Nash equilibrium is where no player can benefit by changing strategy alone. Cartels like OPEC try to collude but face incentives to cheat, as in the prisoner's dilemma.

For a monopolist with linear demand, the MR curve has twice the slope of demand. MR is positive where demand is elastic, zero at the unit-elastic midpoint (where total revenue peaks) and negative where demand is inelastic. A profit-maximizing monopolist therefore always produces in the elastic range of demand. To change a player's choice, a tax, subsidy or payment must shift that player's payoffs enough that the alternative becomes the better response. Find the gap between the two payoffs for the relevant column or row and change it by just over that amount. In a payoff matrix, check each player's best response to each of the other player's choices. Every cell where both players are already making their best response is a Nash equilibrium, and a game can have more than one.

Firms in monopolistic competition and oligopoly advertise and differentiate their products to raise demand and make it less elastic, so they can charge higher prices without losing as many customers. A perfectly price-discriminating monopolist charges each buyer their maximum willingness to pay, so its MR curve is the demand curve. It produces where demand meets MC, leaving no consumer surplus and no deadweight loss.

Key ideas

• Monopolies produce less and charge more than competitive markets.
• For a monopolist, marginal revenue is below price.
• Price discrimination requires market power and separable customers.
• Monopolistic competitors earn zero long-run profit but have excess capacity.
• Game theory models oligopolists' strategic choices.

Formulas and rules

Common mistakes

• Charging the price where MR = MC; the monopolist charges the higher price on the demand curve.
• Thinking monopolistic competitors earn long-run profit; entry erases it.

Words to know

Monopoly

A single seller with no close substitutes.

Barriers to entry

Obstacles that keep new firms out, like patents or high startup costs.

Natural monopoly

One firm can supply the market at the lowest cost.

Price maker

A firm that sets its own price.

Marginal revenue (monopoly)

Less than price, because the firm lowers price to sell more.

Socially optimal price

Regulated price where P = MC.

Fair-return price

Regulated price where P = ATC.

Price discrimination

Charging different prices to different customers for the same good.

Perfect price discrimination

Charging each customer their maximum willingness to pay.

Monopolistic competition

Many firms with differentiated products and easy entry.

Product differentiation

Making products distinct through brand, quality or features.

Excess capacity

Producing less than the output at minimum ATC.

Oligopoly

A market with a few interdependent firms.

Game theory

The study of strategic decision making.

Payoff matrix

A table of outcomes for each combination of strategies.

Dominant strategy

The best choice no matter what the rival does.

Nash equilibrium

No player can improve by changing strategy alone.

Cartel

A group of firms that collude to restrict output and raise prices.

Prisoner's dilemma

A game where self-interest leads to a worse outcome for both.

Sample practice questions

5 more questions like these, from level 1 to 5, are in the practice set.