IB DP Economics - Unit 2 - Degrees of market power-Study Notes - New Syllabus

Perfect Competition (HL)

No Market Power — Firm as Price Taker

In perfect competition, firms have no market power and are price takers, meaning they must accept the market price determined by demand and supply.

Firm → Cannot influence price → Takes market price

Explanation:

• There are many firms producing identical products.
• Each firm is too small to influence market price.
• If a firm raises its price, consumers switch to other firms.
• Thus, the firm faces a perfectly elastic demand curve at the market price.

AR = MR = Price

Profit Maximization in Perfect Competition

Firms maximize profit where:

MC = MR

1. Short Run Profit Maximization

In the short run, firms can earn abnormal profit, normal profit, or losses.

Explanation:

• Firm produces where MC = MR.
• Since MR = AR = price, equilibrium occurs where MC = Price.
• Profit depends on the relationship between AR and AC:

• If AR > AC → Abnormal profit
• If AR = AC → Normal profit
• If AR < AC → Loss

Economic Logic:

• Firms adjust output to maximize profit at given market price.
• No control over price, only over output.

2. Long Run Profit Maximization

In the long run, firms earn only normal profit.

Explanation:

• If firms earn abnormal profit → new firms enter the market.
• Entry increases supply → price falls.
• If firms make losses → firms exit the market.
• Exit reduces supply → price rises.
• This process continues until:

AR = AC → Normal profit

Long Run Equilibrium Condition:

MC = MR = AR = AC

• Firms earn zero economic profit.
• Market is stable with no incentive to enter or exit.

Economic Significance:

• Perfect competition leads to efficient outcomes.
• Firms produce at the lowest possible cost.
• Resources are allocated optimally.

Allocative Efficiency (HL)

Meaning and Necessary Conditions

Allocative efficiency occurs when resources are allocated in a way that maximizes total benefit to society. This happens when the goods and services produced are those most desired by consumers.

Allocative efficiency → Producing what society wants most

Meaning:

• Resources are used to produce goods that provide the highest possible satisfaction.
• The value consumers place on a good equals the cost of producing it.
• There is no underproduction or overproduction.

Marginal Benefit (MB) = Marginal Cost (MC)

Necessary Conditions:

1. Price Equals Marginal Cost

• In a competitive market, price (P) represents marginal benefit (MB).
• Marginal cost (MC) represents the cost of producing one more unit.
• Allocative efficiency occurs when:

P = MC

• This ensures the benefit to consumers equals the cost to society.

2. No Market Failure

• Markets must operate without externalities, public goods, or information failure.
• Otherwise, prices do not reflect true social costs or benefits.

3. Competitive Market Conditions

• Firms must be price takers.
• No firm should have significant market power.
• Ensures price reflects true market conditions.

What Happens If Conditions Are Not Met:

• If P > MC → Underproduction (society values more output).
• If P < MC → Overproduction (resources are wasted).

P ≠ MC → Inefficiency (deadweight loss)

Economic Significance:

• Allocative efficiency maximizes social (community) surplus.
• Achieved in perfect competition in the long run.
• Often not achieved in real markets due to market power or externalities.

Imperfect Competition (HL)

Varying Degrees of Market Power — Firm as Price Maker

In imperfect competition, firms have varying degrees of market power, meaning they can influence the price of their product. Unlike perfect competition, firms are price makers rather than price takers.

Imperfect competition → Market power → Price maker

Explanation:

• Firms face a downward-sloping demand curve.
• To sell more output, firms must lower the price.
• This gives firms control over pricing decisions.
• The degree of control depends on the level of competition.

Price Maker Behaviour:

• Firms choose both price and output.
• They maximize profit where:

MC = MR

• Price is then determined from the demand (AR) curve.
• Thus, price is usually:

P > MR

Degrees of Market Power:

• Monopolistic competition → Low market power (many firms, differentiated products).
• Oligopoly → Moderate to high market power (few firms, interdependence).
• Monopoly → Very high market power (single firm, no close substitutes).

Economic Logic (HL Insight):

• Market power arises from barriers to entry and product differentiation.
• Firms can restrict output to raise price.
• This leads to:

• Higher prices
• Lower output
• Potential inefficiency

Implications of Price Maker Behaviour:

• Firms can earn abnormal profit in the long run.
• Price is greater than marginal cost:

P > MC

• Leads to allocative inefficiency.
• Creates deadweight loss (loss of social welfare).