IGCSE 0455 – Microeconomics: Decision‑Makers and Market Structures
Learning Objective
Understand how the number of firms operating in a market influences price, quality, consumer choice and profit, and be able to apply this knowledge across the full range of syllabus topics.
1. The Basic Economic Problem
1.1 Scarcity, Choice and Opportunity Cost
- Scarcity: Resources are limited while human wants are unlimited.
- Choice: Because of scarcity we must decide which goods/services to produce.
- Opportunity Cost: The value of the next best alternative fore‑gone when a choice is made.
1.2 Factors of Production
| Factor | Definition | Example |
|---|
| Land | All natural resources | Minerals, forests |
| Labour | Human effort – physical & mental | Factory workers, teachers |
| Capital | Man‑made tools, machinery, buildings | Computers, factories |
| Enterprise | Risk‑taking & organisational ability | Business owners, entrepreneurs |
1.3 Production Possibility Curve (PPC)
- Shows maximum output combinations of two goods when all resources are fully and efficiently employed.
- Points on the curve = efficient production.
Points inside the curve = under‑utilisation (inefficiency).
Points outside the curve = unattainable with current resources.
- Movement along the curve illustrates opportunity cost – to produce more of one good, some of the other must be given up.
Example
Country X can produce either 100 000 t of wheat or 200 000 t of corn, or any efficient combination in between. Producing 60 000 t of wheat forces production of 120 000 t of corn – the opportunity cost of 1 t wheat = 2 t corn.
2. Allocation of Resources
2.1 Demand and Supply
Key Concepts
- Demand: Quantity of a good that consumers are willing & able to buy at each price, ceteris paribus.
- Supply: Quantity of a good that producers are willing & able to sell at each price, ceteris paribus.
- Law of demand – price ↑ → quantity demanded ↓ (downward‑sloping demand curve).
- Law of supply – price ↑ → quantity supplied ↑ (upward‑sloping supply curve).
Determinants of Demand (shift factors)
| Factor | Effect on Demand Curve |
|---|
| Consumer income | Normal good: ↑ income → shift right; Inferior good: ↑ income → shift left |
| Prices of related goods | Substitutes ↑ → shift right; Complements ↑ → shift left |
| Tastes & preferences | More favourable → shift right |
| Expectations of future price | Expect price rise → shift right now |
| Number of buyers | More buyers → shift right |
Determinants of Supply (shift factors)
| Factor | Effect on Supply Curve |
|---|
| Input prices | Higher input cost → shift left |
| Technology | Improvement → shift right |
| Number of sellers | More firms → shift right |
| Expectations of future price | Expect price rise → shift left now (hold stock) |
| Taxes & subsidies | Tax ↑ → shift left; Subsidy ↑ → shift right |
Market Equilibrium
- Intersection of demand and supply curves.
- At equilibrium: Quantity demanded = Quantity supplied and there is no tendency for price to change.
- Any shift in demand or supply creates a new equilibrium price and quantity.
2.2 Price Elasticity
Definitions
- Price Elasticity of Demand (PED): % change in quantity demanded ÷ % change in price.
- Price Elasticity of Supply (PES): % change in quantity supplied ÷ % change in price.
Interpretation
| Elasticity | Range | Meaning |
|---|
| Elastic | |E| > 1 | Quantity responds strongly to price change. |
| Inelastic | |E| < 1 | Quantity responds weakly to price change. |
| Unit‑elastic | |E| = 1 | Proportional response. |
Numerical Example (Demand)
Price of smartphones falls from £400 to £360 (‑10%). Quantity demanded rises from 1 000 units to 1 300 units (+30%).
\[
\text{PED}= \frac{+30\%}{-10\%}= -3.0
\]
Since |‑3.0| > 1, demand is elastic – a 1 % fall in price leads to a 3 % rise in quantity demanded.
2.3 Market Failure
- Definition: When the free market does not allocate resources efficiently, resulting in a loss of total welfare.
- Common types:
- Public goods – non‑rival & non‑excludable (e.g., street lighting).
- Merit goods – under‑consumed if left to market (e.g., education, vaccinations).
- Externalities – costs or benefits that affect third parties (e.g., pollution, herd immunity).
- Monopoly power – covered in Section 4.
- Government intervention (taxes, subsidies, regulation, provision of public goods) aims to correct these failures.
2.4 Mixed Economy
- Combines market mechanisms with government intervention.
- Advantages: efficient allocation of most goods, plus equity & provision of public/merit goods.
- Disadvantages: possible inefficiency from bureaucracy, risk of over‑regulation.
- Typical examples: United Kingdom, United States – markets dominate but the state provides health, education, defence, etc.
3. Micro‑Decision‑Makers
3.1 Money, Banking and the Financial System
- Money: Medium of exchange, store of value, unit of account.
- Banking: Accepts deposits, provides loans, creates credit (fractional‑reserve banking).
- Interest rate: Price of borrowing; influences consumer spending and business investment.
- Central bank (e.g., Bank of England) uses monetary policy (interest rates, open market operations) to influence inflation and economic growth.
3.2 Households
- Consume goods & services, supply labour, save or invest income.
- Decision‑making based on:
- Budget constraint (income vs. prices).
- Preferences (utility maximisation).
- Opportunity cost of time (e.g., work vs. leisure).
3.3 Workers (Labour Market)
- Supply labour – influenced by wages, working conditions, education, demographics.
- Demand labour – derived from firms’ demand for output; depends on product price, technology, input prices.
- Equilibrium wage = intersection of labour supply and demand curves.
- Wage differentials arise from skill levels, location, unionisation, discrimination.
3.4 Firms (Production & Cost)
- Goal: maximise profit (Total Revenue – Total Cost).
- Short‑run cost curves: TC, TVC, TFC, AVC, ATC, MC.
- MC intersects AVC and ATC at their minimum points.
- Profit‑maximising output where MR = MC.
- Long‑run: all factors variable; firms can adjust plant size to achieve lowest possible ATC (economies of scale).
3.5 Government (Regulation & Policy)
- Imposes taxes, subsidies, price controls, competition law.
- Regulates monopolies, protects consumers, corrects externalities.
4. Types of Market Structures & the Effect of the Number of Firms
Cambridge distinguishes four main market structures. The table below summarises how the number of firms influences price, quality, consumer choice and profit in each.
| Market Structure |
Typical Number of Firms |
Price |
Quality & Product Differentiation |
Consumer Choice |
Profit (short‑run vs. long‑run) |
| Perfect Competition |
Very many (often thousands) |
Price = marginal cost (P = MC); lowest possible price. |
Products homogeneous → little scope for quality improvement; competition is on price. |
Many sellers of the same good – abundant sources but limited variety. |
Short‑run: possible economic profit.
Long‑run: free entry/exit drives profit to zero (normal profit only). |
| Monopolistic Competition |
Many (dozens to hundreds) |
Price > MC but < price in monopoly; firms have some price‑setting power. |
Product differentiation (branding, quality, features) is the main competitive tool. |
Variety of similar but differentiated products – higher perceived choice. |
Short‑run: can earn economic profit.
Long‑run: entry erodes profit → zero economic profit (normal profit). |
| Oligopoly |
Few (2‑10 dominant firms) |
Price above MC; often higher than in competitive markets. May be stable (price‑rigidity) or involve price wars. |
Often differentiated (cars, smartphones) or homogeneous (steel). Quality can be a key battleground. |
Limited number of brands, but each may offer a range of models – moderate choice. |
Short‑run: can earn substantial economic profit.
Long‑run: profit depends on strategic interaction (collusion, non‑price competition, barriers). |
| Monopoly |
One |
Price set above MC; highest price among the four structures. |
Quality may be low because no competition forces improvement, though a monopolist may raise quality to increase demand. |
Only one supplier → very limited choice. |
Can sustain economic profit indefinitely because high barriers prevent entry. |
4.1 Why the Number of Firms Matters – Underlying Mechanisms
| Mechanism | Effect of More Firms | Effect of Fewer Firms |
|---|
| Price competition | More firms → greater pressure to lower price → price tends toward MC. | Fewer firms → less pressure; firms can charge a markup over MC. |
| Product differentiation | Many firms encourage innovation & branding to stand out. | Few firms may rely on brand dominance; less incentive to innovate. |
| Consumer sovereignty | Abundant alternatives give consumers more bargaining power. | Limited alternatives give firms more market power. |
| Barriers to entry | Low barriers → easy entry → profits are eroded over time. | High barriers (legal, technological, economies of scale) protect profits. |
| Economies of scale | Smaller firms may not achieve low average costs; price may stay higher. | Large‑scale monopolist can lower average cost, but may not pass savings to consumers. |
4.2 Detailed Look at Each Market
4.2.1 Perfect Competition (Many Firms)
- Firms are price‑takers; market price is determined by overall demand and supply.
- Short‑run equilibrium: MR = MC = P and firms may earn profit or loss.
- Long‑run equilibrium: free entry/exit forces P = MC = minimum ATC → zero economic profit.
Numerical Example – Competitive Bottled Water
Cost: \(C(q)=50+2q\) \(MC=2\) \(ATC=\frac{50}{q}+2\)
Market price falls to £3 (price‑taker). Profit per firm:
\[
\pi=(P-ATC)q=\left[3-\left(\frac{50}{q}+2\right)\right]q=q-50
\]
Set \(\pi=0\) → \(q=50\) L. At this output, \(ATC=3\) and the firm makes only normal profit.
4.2.2 Monopolistic Competition (Many, but Not Too Many)
- Each firm sells a differentiated product → faces a downward‑sloping demand curve.
- Short‑run: profit maximisation where \(MR=MC\); price is taken from the demand curve (P > MC).
- Long‑run: entry of similar firms shifts each firm’s demand curve leftward until only normal profit remains.
Numerical Example – Café Market
Cost: \(C(q)=20+q\) \(MC=1\).
Demand faced by one café: \(P=10-0.2q\).
\(TR=10q-0.2q^{2}\) → \(MR=10-0.4q\).
Set \(MR=MC\): \(10-0.4q=1\) → \(q^{*}=22.5\).
Price: \(P^{*}=10-0.2(22.5)=5.5\).
ATC at \(q^{*}\): \(\frac{20+22.5}{22.5}=1.89\).
Profit per café: \((5.5-1.89)×22.5≈81\) (short‑run economic profit).
In the long‑run, new cafés enter, demand shifts left, profit falls to zero.
4.2.3 Oligopoly (Few Firms)
- Interdependence: each firm’s decision depends on expectations about rivals.
- Common models:
- Kinked‑demand model: price rigidity – firms match price cuts but ignore price rises.
- Collusive behaviour: explicit (cartel) or tacit agreement to restrict output and keep price high.
- Barriers to entry (high start‑up costs, patents, control of essential resources) help sustain profits.
Numerical Example – Mobile‑Phone Oligopoly
Two firms, A and B, produce identical phones. Joint market demand: \(P=200-0.5Q\) (where \(Q=Q_A+Q_B\)).
Both have MC = £50. If they collude and act as a monopoly:
\[
MR = 200 - Q \quad\text{(derived from }TR = P·Q = 200Q - 0.5Q^{2}\text{)}
\]
Set \(MR = MC\): \(200 - Q = 50\) → \(Q = 150\).
Price: \(P = 200 - 0.5(150) = 125\).
Each firm produces 75 units, earning profit \((125-50)·75 = £5,625\).
If competition resumes and each firm behaves as a price‑taker, price falls to MC = £50 and profit disappears.
4.2.4 Monopoly (Single Firm)
- Only seller; faces the whole market demand curve.
- Profit‑maximising output where \(MR = MC\); price taken from the demand curve (P > MC).
- High barriers to entry protect long‑run economic profit.
Numerical Example – Local Water Supply
Cost: \(C(q)=20+q\) \(MC=1\).
Demand: \(P=30-0.5q\).
\(TR = 30q - 0.5q^{2}\) → \(MR = 30 - q\).
Set \(MR = MC\): \(30 - q = 1\) → \(q^{*}=29\).
Price: \(P^{*}=30-0.5(29)=15.5\).
ATC at \(q^{*}\): \(\frac{20+29}{29}=1.69\).
Profit: \((15.5-1.69)·29 ≈ £400\) (economic profit).
4.3 Diagram Guidance (What to Sketch in Exams)
- Perfect Competition: Market supply & demand intersecting at price P; firm’s MC curve touching ATC at its minimum.
- Monopolistic Competition: Downward‑sloping demand, MR below demand, MC intersecting MR; long‑run demand tangent to ATC.
- Oligopoly (Kinked Demand): Demand curve with a kink at the current price; MR discontinuity leading to price rigidity.
- Monopoly: Demand, MR (steeper), MC; profit area between price and ATC at the profit‑maximising output.
5. Implications for Different Decision‑Makers
5.1 Consumers
- Competitive markets: low prices, high output, limited variety.
- Monopolistic competition: more choice, ability to pay for brand or quality differences.
- Oligopoly: moderate choice; prices may be higher than in competition but lower than monopoly.
- Monopoly: highest prices, lowest choice; may benefit from stable supply.
5.2 Firms
- Competitive firms focus on cost‑efficiency; may seek non‑price competition (service, branding) where allowed.
- Monopolistically competitive firms invest in product differentiation and marketing.
- Oligopolists use strategic tools: advertising, R&D, capacity decisions, possible collusion.
- Monopolists exploit economies of scale, invest heavily in R&D, but must watch for regulation.
5.3 Government / Policy‑Makers
- Promote competition (anti‑trust law, removing unnecessary barriers) to lower prices and increase welfare.
- Regulate natural monopolies (price caps, quality standards) to curb excess profit.
- Intervene in market failures (taxes on negative externalities, subsidies for merit goods, provision of public goods).
- Use monetary and fiscal policy to influence overall demand, which in turn affects firm profitability across market structures.
6. Summary Checklist (IGCSE 0455)
- Define the basic economic problem and list the four factors of production.
- Draw and label a Production Possibility Curve; explain opportunity cost.
- State the laws of demand and supply and identify at least three determinants for each.
- Explain market equilibrium and illustrate how a shift in demand or supply creates a new equilibrium.
- Calculate price elasticity of demand and supply; interpret the result.
- Identify four types of market failure and give an example of government intervention for each.
- Describe the characteristics of a mixed economy and its advantages/disadvantages.
- Summarise the roles of households, workers, firms, banks and government in the micro‑economy.
- For each market structure (perfect competition, monopolistic competition, oligopoly, monopoly):
- Number of firms
- Price‑setting ability
- Product differentiation
- Typical consumer choice
- Short‑run vs. long‑run profit outcome
- Key diagram to sketch
- Explain how increasing the number of firms affects price, quality, choice and profit, using the mechanisms table.
- Provide a short numerical illustration for at least two market structures (e.g., competitive bottled water and monopoly water supply).
- Recall the main policy tools a government can use to correct market failure or curb monopoly power.