Learning Objective
Explain how the number of firms in a market (perfect competition, monopolistic competition, oligopoly and monopoly) influences price, quality, consumer choice and profit. Relate monopoly to market failure and describe the role of government intervention. Also cover the broader IGCSE syllabus topics on economic systems, market failure, money & banking, household & worker behaviour, and firm costs.
1. Market Economic System
Definition
An economic system in which the allocation of resources and the distribution of goods and services are primarily determined by the interaction of buyers and sellers in markets, with limited government intervention.
Arguments for the market system
- Efficient allocation of resources – firms produce where P = MC.
- Encourages innovation and entrepreneurship.
- Provides a wide variety of goods and services to meet consumer preferences.
- Consumer sovereignty – buyers decide what is produced.
Arguments against the market system
- Can lead to inequality of income and wealth.
- May produce market failures (e.g., monopoly, externalities, public goods).
- Short‑run focus on profit can ignore social and environmental costs.
- Information asymmetry can disadvantage consumers.
2. Market Failure
A situation where the free market does not allocate resources efficiently, resulting in a loss of total surplus (dead‑weight loss).
2.1 Public, Merit and Demerit Goods
| Type of Good | Characteristics | Typical Example |
|---|
| Public good | Non‑rival & non‑excludable | National defence, street lighting |
| Merit good | Undervalued by consumers, socially beneficial | Education, vaccinations |
| Demerit good | Over‑consumed, socially harmful | Cigarettes, illegal drugs |
2.2 Externalities
- Negative externality: a cost imposed on third parties (e.g., pollution).
Diagram suggestion: marginal private cost (MPC) below marginal social cost (MSC); equilibrium at Qm (over‑production) creates DWL.
- Positive externality: a benefit to third parties (e.g., education).
Diagram suggestion: marginal private benefit (MPB) below marginal social benefit (MSB); equilibrium at Qm (under‑production) creates DWL.
2.3 Monopoly as a Market Failure
A single firm with price‑making power can set price above marginal cost, producing less than the efficient output and generating dead‑weight loss.
3. Mixed Economic System
Definition
An economy that combines free‑market mechanisms with government intervention to correct market failures, provide public goods, and promote a more equitable distribution of income.
Arguments for a mixed system
- Markets retain efficiency for most goods and services.
- Government can intervene where markets fail (e.g., monopoly, externalities, public goods).
- Provides a safety net and reduces extreme inequality.
Arguments against a mixed system
- Excessive intervention may reduce incentives for efficiency and innovation.
- Risk of government failure – misallocation due to bureaucracy or political pressure.
Typical Government Tools
- Regulation (price caps, quality standards).
- Public ownership of natural monopolies.
- Subsidies or taxes to internalise externalities.
- Legislation to promote competition (e.g., anti‑trust laws).
4. Money & Banking
Forms of Money
- Commodity money (e.g., gold, silver).
- Fiat money – paper notes and coins issued by the government.
- Electronic money – bank deposits, credit‑card balances.
Functions of Money
- Medium of exchange.
- Unit of account.
- Store of value.
- Standard of deferred payment.
Central Bank vs. Commercial Bank
| Central Bank | Commercial Bank |
|---|
| Issues legal tender, sets monetary policy, acts as lender of last resort. | Accepts deposits, provides loans, offers payment services to households and firms. |
| Controls interest rates (e.g., base rate) and reserves. | Creates money through the fractional‑reserve banking process. |
5. Households – Influences on Spending, Saving & Borrowing
- Income level – higher disposable income → higher consumption.
- Interest rates – higher rates discourage borrowing and encourage saving.
- Consumer confidence – optimism boosts spending; pessimism reduces it.
- Age and life‑stage – younger households tend to spend more, older households save more.
- Cultural & social factors – values, habits and peer pressure affect preferences.
6. Workers – Wage Determination, Trade Unions & National Minimum Wage
Wage Determination
- Marginal productivity of labour (MPL) – firms pay a wage equal to the extra output generated by an additional worker.
- Supply of labour (workers) and demand for labour (firms) intersect to set the market wage.
Trade Unions
Collective organisations that negotiate with employers on behalf of workers. They can shift the labour‑demand curve leftward (higher wage, lower employment) or achieve a wage above the competitive equilibrium.
National Minimum Wage (NMW)
- Government‑set price floor for wages.
- If set above the equilibrium wage, it creates unemployment (excess labour supply).
- Diagram suggestion: labour‑market diagram with wage floor, showing surplus of labour (unemployment).
7. Firms – Costs, Revenue & Economies of Scale
Cost Concepts
- Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC).
- Average Cost (AC) = TC ÷ Q; Marginal Cost (MC) = ΔTC ÷ ΔQ.
- Short‑run AC curve is typically U‑shaped because MC falls then rises.
Revenue Concepts
- Total Revenue (TR) = P × Q.
- Average Revenue (AR) = TR ÷ Q (equals price for a price‑taker).
- Marginal Revenue (MR) = ΔTR ÷ ΔQ (falls faster than AR when the firm has market power).
Economies & Diseconomies of Scale
- Economies of scale: AC falls as output rises because fixed costs are spread and operational efficiencies are realised.
- Diseconomies of scale: AC rises after a certain size due to management difficulties, bureaucracy, etc.
Diagram suggestion: Long‑run AC curve showing a downward‑sloping portion (economies) and an upward‑sloping portion (diseconomies).
8. Types of Markets – Effect of the Number of Firms on Price, Quality, Choice & Profit
8.1 Perfect Competition
- Number of sellers: Many.
- Product: Homogeneous.
- Price‑setting power: None – price taker; market price set where industry demand = industry supply.
- Price: P = MC (allocative efficiency).
- Quality & Choice: High quality maintained through competition; many sellers give consumers a wide range of service options.
- Profit: Short‑run can be positive; long‑run zero economic profit (P = ATC) because entry erodes profit.
- Advantages: Allocative & productive efficiency, maximum consumer surplus.
- Disadvantages: Little incentive for product innovation beyond what is needed to stay in the market.
- Diagram suggestion: Horizontal demand (= MR) at market price, MC intersecting MR, ATC tangent to price line (zero profit).
8.2 Monopolistic Competition
- Number of sellers: Many.
- Product: Differentiated (brand, quality, location, size).
- Price‑setting power: Some – faces a downward‑sloping demand curve.
- Price: P > MC but below monopoly level.
- Quality & Choice: Firms compete on features, advertising and service, giving consumers a broad variety.
- Profit: Possible short‑run economic profit; long‑run zero economic profit as entry drives P down to ATC.
- Advantages: Variety, some innovation, non‑price competition.
- Disadvantages: Excess capacity (output less than in perfect competition) and a small dead‑weight loss.
- Diagram suggestion: Downward‑sloping demand, MR below demand, MC intersecting MR, ATC tangent to price at long‑run equilibrium.
8.3 Oligopoly
- Number of sellers: Few large firms.
- Product: Can be homogeneous (steel) or differentiated (cars).
- Price‑setting power: Significant – each firm’s decision depends on rivals (strategic interaction).
- Strategic behaviour:
- Collusion – firms cooperate (cartel) to act like a monopoly, setting high prices.
- Price competition – firms undercut each other, potentially driving price toward MC.
- Kinked‑demand model – rivals match price cuts but not price rises, creating price rigidity.
- Price: Can be close to MC (price competition) or far above MC (collusion).
- Quality & Choice: Limited number of brands, but each may offer several models; quality can be high if firms compete on non‑price factors.
- Profit: Potentially large if collusion succeeds; otherwise depends on competitive dynamics.
- Advantages: Economies of scale, large R&D budgets, lower unit costs.
- Disadvantages: Risk of collusion, higher prices, reduced consumer choice.
- Diagram suggestion (optional): Kinked‑demand curve with a discontinuous MR curve illustrating price rigidity.
8.4 Monopoly
- Number of sellers: One.
- Product: Unique, no close substitutes.
- Price‑setting power: Full – price maker.
- Price: Sets output where MR = MC, then reads price from the market demand curve; therefore P > MC, creating dead‑weight loss.
- Quality: May offer the lowest quality that still satisfies demand, because higher quality raises cost without guaranteeing higher revenue (unless regulated).
- Choice: Very limited – only one supplier, no close substitutes.
- Profit: Long‑run economic profit is possible because high barriers (legal, technological, natural) prevent entry. Profit = (P – ATC) × Q.
- Advantages: Economies of scale (especially natural monopolies), stable supply, ability to fund large‑scale R&D.
- Disadvantages: Higher price, lower quality and choice, dead‑weight loss, risk of abuse of market power.
- Diagram suggestion: Monopoly diagram with demand, MR, MC, ATC; profit area shown as rectangle between price and ATC at the profit‑maximising output.
9. Comparative Summary of the Four Market Structures
| Aspect | Perfect Competition | Monopolistic Competition | Oligopoly | Monopoly |
|---|
| Number of firms | Many | Many | Few | One |
| Product type | Homogeneous | Differentiated | Homogeneous or differentiated | Unique, no close substitutes |
| Price relative to MC | P = MC (efficient) | P > MC but < monopoly price | Varies – near MC (price competition) or far above MC (collusion) | P > MC (inefficient) |
| Quality incentives | High – competition forces improvement | Moderate – competition on features & branding | Varies – high if non‑price competition, low if collusion | Low to moderate (depends on regulation) |
| Consumer choice | Very wide – many identical sellers | Wide – many differentiated products | Limited – few brands, each with several models | Very limited – single product |
| Long‑run profit | Zero economic profit (free entry) | Zero economic profit (free entry) | Can be positive (collusion) or zero (price competition) | Positive economic profit (entry barriers) |
10. Key Take‑aways
- More firms → more competition → price tends toward marginal cost, higher quality, greater choice and zero long‑run economic profit.
- Fewer firms → greater market power → price above marginal cost, possible lower quality and choice, and the ability to earn sustained economic profit.
- Monopoly is a classic market failure; government may intervene through regulation, price caps, public ownership or by promoting competition.
- The IGCSE syllabus expects you to link market structures to the broader concepts of economic systems, market failure, and the role of money, households, workers and firms.
11. Glossary (Key Terminology)
- Price‑maker: A firm that can set its own price (e.g., monopoly).
- Price‑taker: A firm that must accept the market price (e.g., perfect competition).
- Dead‑weight loss (DWL): Loss of total surplus when market output is below the efficient level.
- Economies of scale: Lower average costs as output increases.
- Natural monopoly: A market where a single firm can supply the whole market at lower cost than any combination of multiple firms (high fixed costs, low marginal costs).
- Regulation: Government rules that control price, output, or quality of a monopoly.
- Price cap: A maximum price that a regulated monopoly may charge.
- Marginal cost (MC): The additional cost of producing one more unit.
- Marginal revenue (MR): The additional revenue from selling one more unit.
- Average total cost (ATC): Total cost divided by output.
12. Suggested Diagrams for Classroom Use
- Perfect competition – price‑taker diagram (horizontal demand, MC, ATC tangent).
- Monopolistic competition – downward‑sloping demand & MR, MC, ATC tangent at long‑run equilibrium.
- Oligopoly – kinked‑demand curve with discontinuous MR (optional).
- Monopoly – demand, MR, MC, ATC with profit area and dead‑weight loss.
- Negative externality – MPC vs. MSC diagram showing over‑production.
- National Minimum Wage – labour‑market diagram with price floor and unemployment.
- Economies of scale – long‑run AC curve showing falling and rising portions.