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Flashcards · AP® Microeconomics · Unit 4

Unit 4: Imperfect Competition flashcards

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4.1 Introduction to Imperfectly Competitive Markets

What are the imperfectly competitive market structures?
Monopolistic competition (many sellers, differentiated products, low barriers), oligopoly (a few large firms, high barriers) and monopoly (one seller, no close substitutes, very high barriers). In factor markets: monopsony, a single buyer.
Why is MR below price when demand slopes down?
To sell one more unit, the firm must cut the price on all units. MR = new price − (price cut × units sold before). It is a revenue idea only, not a cost one.
Graph: how do you draw MR for a straight-line demand curve?
Price on the vertical axis, quantity on the horizontal. MR has the same price intercept as demand and twice the slope, so it reaches zero halfway to demand's quantity intercept. Never draw MR on or above demand.
How is MR linked to the price elasticity of demand?
MR is positive where demand is elastic and negative where it is inelastic. Total revenue is largest where MR = 0.
What are the main barriers to entry?
High fixed or start-up costs (steel mill, power grid), legal barriers (patent, copyright, government licence) and exclusive ownership of a key resource. Profit lasts only if barriers block new firms.
At a firm's chosen output, P = $40 and MC = $25. Is output efficient?
No. The next unit is worth about $40 to a buyer but costs $25, so output is too low. Efficiency needs P = MC. Do not confuse P above MC (inefficiency) with P above ATC (profit).
A firm's demand is P = 30 − 3Q. What is the MR of the 3rd unit?
TR at 2 units = 24 × 2 = 48; TR at 3 = 21 × 3 = 63. MR = 15, below the $21 price.

4.2 Monopoly

How does a monopoly choose its quantity and price?
It produces where MR = MC and charges the price on the demand curve above that quantity. Because MR is below price, P exceeds MC.
Graph: describe a profit-maximising monopoly.
Price on the vertical axis, quantity on the horizontal: downward D, MR below it, MC and ATC. Qm is where MR = MC; go up to D for Pm. Profit is the rectangle (Pm − ATC) × Qm. The deadweight loss triangle lies between D and MC from Qm to where D meets MC.
Demand is P = 50 − Q and MC = ATC = $10. Find the monopoly quantity, price, profit and DWL.
MR = 50 − 2Q = 10, so Q = 20 and P = $30. Profit = (30 − 10) × 20 = $400. D = MC at Q = 40, so DWL = ½ × (30 − 10) × (40 − 20) = $200.
Why does a monopoly produce where demand is elastic?
It sets MR = MC, and MC is positive, so MR is positive at its output, which happens only on the elastic part of demand. The revenue-maximising output (MR = 0) is beyond the profit-maximising one.
What is a natural monopoly?
A market where long-run ATC falls over the whole range of market demand and MC lies below ATC, so one firm supplies the market more cheaply than two or more. Forced to charge P = MC, it would make a loss.
How does monopoly compare with perfect competition?
Monopoly: P above MC, lower quantity, smaller consumer surplus, a deadweight loss, and long-run profit possible because barriers block entry. Perfect competition: P = MC, higher quantity, no deadweight loss, zero long-run profit.
Is monopoly profit part of the deadweight loss?
No. Profit is a transfer from consumers to the firm; the deadweight loss is surplus lost to everyone.

4.3 Price Discrimination

What is price discrimination?
Charging different buyers different prices for the same product when the cost of serving them is the same. A price difference based on cost differences is not price discrimination.
What conditions does price discrimination need?
Market power, a way to identify buyers with different willingness to pay, and a way to prevent resale (arbitrage). A perfectly competitive firm cannot price discriminate.
With group pricing, which group pays the higher price?
The group with less elastic demand. The firm sets MR = MC separately in each group. If adults' demand is less elastic than children's, adults pay more.
Graph: describe perfect price discrimination.
Price on the vertical axis, quantity on the horizontal. Each buyer pays their maximum willingness to pay, so the MR curve is the demand curve. Output is where demand meets MC, the competitive quantity. Consumer surplus and deadweight loss are zero; profit is the whole area under demand and above MC.
Is perfect price discrimination efficient?
Yes, allocatively: it produces where P = MC and removes the deadweight loss, even though consumers keep no surplus.
P = 100 − 2Q with MC = ATC = $20. Compare a single price with perfect price discrimination.
Single price: MR = 100 − 4Q = 20 gives Q = 20, P = $60, profit $800, CS $400, DWL $400. Perfect price discrimination: Q = 40, profit = ½ × 40 × 80 = $1,600, CS = 0, DWL = 0.

4.4 Monopolistic Competition

What are the features of monopolistic competition?
Many small firms selling differentiated products (close but not perfect substitutes), with easy entry and exit. Each firm faces a downward-sloping, fairly elastic demand curve, so MR lies below demand.
Graph: describe long-run equilibrium in monopolistic competition.
Price on the vertical axis, quantity on the horizontal. The firm's demand curve is tangent to ATC at the quantity where MR = MC, on the falling part of ATC. P = ATC, so economic profit is zero, but P is above MC, and output is left of minimum ATC.
How does a monopolistically competitive market reach long-run equilibrium?
Short-run profit attracts entry: each firm's demand shifts left and becomes more elastic until P = ATC. Losses cause exit: each firm's demand shifts right and becomes less elastic until the loss is gone.
What is excess capacity?
The quantity at minimum ATC minus the quantity produced. Demand slopes down, so it touches ATC to the left of minimum ATC, and the firm is not productively efficient in the long run.
How does advertising affect a monopolistically competitive firm?
It aims to raise demand and make it less elastic. It is a fixed cost, so it raises ATC, not MC.
How does monopolistic competition compare with perfect competition in the long run?
Both earn zero economic profit. Perfect competition has P = MC and output at minimum ATC. Monopolistic competition has P above MC (allocatively inefficient) and output below the minimum-ATC level (excess capacity).
A firm produces 50 units where MR = MC; P = $9 and ATC = $7. What happens next?
Profit = (9 − 7) × 50 = $100. Firms enter and this firm's demand shifts left until P = ATC.

4.5 Oligopoly and Game Theory

What are the features of oligopoly?
A few large firms, high barriers to entry and interdependence: each firm's best choice depends on its rivals' choices. Products can be identical (cement) or differentiated (cars). A two-firm oligopoly is a duopoly.
What is a dominant strategy?
An action that is better for a player whatever the other player does. In a payoff matrix, the row player's same action wins in both columns, comparing only the row player's own payoffs.
What is a Nash equilibrium?
An outcome where no player can raise its payoff by changing its own action alone: each action is a best response to the other's. It is not the cell with the highest total.
What is a prisoner's dilemma?
A game in which the players' dominant strategies lead to an outcome that is worse for both than cooperation.
Payoffs (Row, Column): Up/Up (5, 5), Up/Down (1, 7), Down/Up (7, 1), Down/Down (3, 3). Find the dominant strategies and the Nash equilibrium.
Row's dominant strategy is Down (7 beats 5 and 3 beats 1); Column's is also Down. The Nash equilibrium is Down/Down with (3, 3). It is a prisoner's dilemma: both would prefer Up/Up with 5 each.
Why do cartels tend to break down?
Firms gain by colluding to act like one monopoly, but each member gains more by cheating, cheating is hard to detect, and collusion is illegal in many places.
How large must a payment be to make an action dominant?
It must exceed the largest payoff gap across the other player's actions, so that it reverses every comparison. Closing only the smaller gap is not enough.
How do oligopoly outcomes compare with other market structures?
Prices are usually higher and quantities lower than in perfect competition, but rarely as extreme as monopoly. Price is usually above MC, so there is a deadweight loss.

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