AQA A-level Economics: Perfect competition and monopolistic competition (7136) – Revision Notes

Condensed notes for the Perfect competition and Monopolistic competition sub-sections of AQA A-level Economics (7136), specification version 1.3, 29 June 2022 (3.1.5.3 and 3.1.5.4 on the AQA website). For full explanations and worked examples, read the study guide. Test yourself with the practice set, and see the wider microeconomics revision notes, the course hub, the checklist and the free diagnostics. Every figure here is invented.

Definitions

• Price taker: a firm too small to influence the market price; it accepts it.
• Perfect competition: many producers, identical products, free entry and exit, perfect knowledge.
• Normal profit: the minimum reward needed to keep the firm in the market (TR = TC, with opportunity cost included).
• Supernormal profit: profit above normal profit.
• Monopolistic competition: a market with a large number of sellers of differentiated goods, where entering or leaving is easy.
• Non-price competition: competing through branding, quality, service, design or location, not price.
• Excess capacity: producing below the output at which AC is lowest.

Perfect competition at a glance

Assumption	What it implies
Large numbers of producers	Firm is a price taker; demand is horizontal
Identical products	No scope for price differences or advertising
Free entry and exit	Only normal profit in the long run
Perfect knowledge	Buyers find the lowest price; rivals copy techniques at once

Key equalities: P = AR = MR (firm). Profit maximised at MC = MR.

Method: short-run decision

1. Set MR equal to the market price.
2. Find the output where MC = MR (MC rising through MR).
3. Work out TR = P × q and TC = AC × q.
4. Compare: profit if TR > TC, loss if TR < TC.
5. Shut-down test: if price is below AVC at that output, close in the short run. Otherwise keep producing while covering variable cost.

Diagram sketch (long-run firm)

Price
 |  AC               MC
 |   \             /
 |    \           /
 |-----\---------/---- D = AR = MR  (P = min AC)
 |      \_______/
 +---------------------- Output
          q*

Axes: price against output. AC falls then rises (U-shaped); MC is drawn rising and cuts AC at its lowest point. The horizontal D = AR = MR line touches that lowest point at q*. Normal profit only.

Worked reminder: short run, then long run

Firm in Country C (illustrative): at price £18, MC = 18 at 9 units, AC = £14. Profit per unit £4, so total supernormal profit 4 × 9 = £36. Entry shifts supply right; price falls until it equals the lowest AC and profit is zero.

Worked reminder: loss and shut-down (study guide figures)

At price £20 the firm produces 4 units: TR = 80, TC = 148, loss £68. Variable cost is 48, so revenue covers it with 32 left towards fixed cost of 100. Staying open loses 68; closing loses 100. So it stays. At price £8, below the lowest AVC of £11, revenue cannot cover variable cost, so it closes.

The long-run adjustments (chain of reasoning)

• Supernormal profit, then entry, then supply shifts right, then price falls, then profit falls to normal.
• Loss, then exit, then supply shifts left, then price rises, then loss disappears.

Link the adjustment to the market diagram: demand rises from D1 to D2, price rises along the short-run supply curve, firms earn supernormal profit, entry shifts supply from S1 to S2, and price returns to the lowest point of AC. In the study guide example the number of firms rises from 200 to 300 and market output from 1,000 to 1,500.

Efficiency proposition and its critique

• Proposition: given certain assumptions (for example no externalities), perfect competition gives an efficient allocation of resources.
• Why: P = MC (the value of the last unit equals its opportunity cost) and P = minimum AC.
• Critique points: externalities; public goods and merit goods; imperfect information; economies of scale; little long-run profit for research; no variety; unequal incomes; unrealistic assumptions.
• Evaluate: judge which points matter most in the context given.

Worked reminder: externality

Competitive output 1,000 with private cost matching value at £50. External cost £9 a unit means MSC is £59 at that output. The market overproduces, so the optimum is lower (900 in the study guide example).

Evaluation chains to learn

• Externality chain: no externality gives P = MC private and social, so efficient; a negative externality makes MSC exceed MPC, so the market overproduces even under perfect competition; the size of the external cost decides how serious this is.
• Scale chain: if the lowest AC is reached only at a large output, a market of many tiny firms cannot reach it, so the competitive structure and low cost cannot both hold.
• Dynamic chain: only normal profit in the long run leaves little to fund research, so efficiency now may come with slower product improvement later. Whether this matters depends on how much the industry relies on innovation.

Yardstick role

Perfect competition in product and labour markets is a benchmark. Compare real price with MC to see misallocation, for example price £70 against MC £50 is a £20 gap (40% of MC). In labour markets the benchmark is many employers and a market-set wage, against which a dominant employer can be judged. A yardstick is not a goal to be achieved.

Monopolistic competition at a glance

Feature	Perfect competition	Monopolistic competition
Number of firms	Very many	Many
Product	Identical	Differentiated
Entry and exit	Free	Low barriers
Demand curve	Horizontal	Downward sloping, fairly elastic
Price setting	Price taker	Some power
Long-run profit	Normal	Normal
Long-run P against MC	P = MC	P > MC
Output against lowest AC	At lowest AC	Below it (excess capacity)

Method: monopolistic competition diagrams

1. Draw downward-sloping AR with a steeper MR.
2. Draw MC and AC. Mark the output where MC = MR.
3. Go up to AR for the price, and to AC for the cost.
4. Short run: AR above AC gives a supernormal profit rectangle.
5. Long run: entry shifts AR left and makes it flatter until AR touches AC at the profit-maximising output; the touching point is a tangent.

Worked reminder (study guide figures)

Short run: q = 30, P = £29, AC = £23, profit = 6 × 30 = £180. Long run: q = 40, P = AC = £21, profit zero, lowest AC at q = 60, so excess capacity of 20 units. P exceeds MC by £5.

Non-price competition

Method	Aim
Branding and advertising	Raise demand and make it less elastic
Quality and design	Stand out from close substitutes
Service and loyalty schemes	Retain customers
Location, opening hours	Convenience

Costs: advertising raises fixed costs and AC. Benefits fade when rivals imitate.

Worked reminder: effect of advertising (study guide figures)

Advertising of £60 lifts fixed cost to 420 and moves demand to P = 50 − 0.5q. MC = MR gives q = 35, P = £32.50, TR = 1,137.50, TC = 822.50, profit £315 against £180 before. The gain is only secure while rivals do not respond. If they copy, demand shifts back left, and the firm keeps the higher cost.

Must-know distinctions

• Normal profit against supernormal profit.
• Shut-down (short run, price below AVC) against exit (long run, loss).
• Allocative (P = MC) against productive (lowest AC) efficiency.
• Price taker against price maker.
• Movement along a curve against shift of demand caused by entry.

Quick self-test

1. Why is a perfectly competitive firm’s demand curve horizontal?
2. A price taker faces a price of £12. MC is £12 at 20 units and rises. How much is TR at 20 units?
3. A firm has TR = £500, TC = £460. State its profit.
4. Price £9, AVC £11 at the best output. What should the firm do in the short run?
5. What happens to price when firms enter a profitable competitive market?
6. State the one assumption that makes perfect competition efficient and say why.
7. In long-run monopolistic competition, is profit normal or supernormal?
8. A monopolistically competitive firm sells 25 units. The lowest AC is at 40 units. How large is its excess capacity?
9. Give two forms of non-price competition.
10. Price £30 and MC £22: by how much does price exceed MC, as a percentage of MC?
11. A competitive firm sells 15 units at £8 with AC £6.50. Find supernormal profit.
12. Why does entry make a monopolistically competitive firm’s demand curve more elastic?

Answers

1. The firm is too small to affect the price and can sell any amount at it, so the demand curve is perfectly elastic.
2. TR = 12 × 20 = £240.
3. £500 − £460 = £40 supernormal profit.
4. Shut down, because revenue does not cover variable cost.
5. It falls, because market supply shifts right.
6. No externalities, so private cost equals social cost.
7. Normal profit, because entry removes the supernormal profit.
8. 40 − 25 = 15 units.
9. Any two of branding, advertising, quality, service, loyalty schemes, location.
10. 30 − 22 = 8; 8 ÷ 22 = 0.364, which is 36.4%.
11. (8 − 6.50) × 15 = 1.50 × 15 = £22.50.
12. More rivals sell close substitutes, so buyers switch more easily when its price rises.

Where marks are usually lost

• Drawing a downward-sloping demand curve for the competitive firm.
• Marking the monopolistically competitive long-run firm at the lowest point of AC.
• Not showing that MC cuts MR from below.
• Calling any loss a reason to shut down immediately.
• Listing the assumptions without saying what each implies for behaviour.
• Defining efficiency but giving no critical assessment of the proposition.
• Forgetting that entry shifts a firm’s demand curve, not just the industry.
• Treating advertising as always wasteful, or always beneficial, with no judgement.

Official syllabus

AQA AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, AQA, for first teaching from September 2015.