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

This guide covers the Perfect competition and Monopolistic competition sub-sections of AQA A-level Economics (7136), as set out in the AQA AS and A-level Economics specification, version 1.3, 29 June 2022. They are numbered 3.1.5.3 and 3.1.5.4 on the AQA website (the combined specification PDF prints them as 4.1.5.3 and 4.1.5.4). The specification states no AS-only or A-level-only labels for this content. All figures below are invented and illustrative.

Go on to the revision notes and the practice set afterwards. The wider unit is in the Individuals, firms, markets and market failure guide. See the course hub, the checklist and the free diagnostics.

What you must be able to do

Specification content	You must be able to
Perfectly competitive model, short and long run	Draw and explain the firm and industry diagrams
Large numbers, identical products, free entry and exit, perfect knowledge	Explain what each implies for behaviour of firms and the industry
Price takers	Explain why the firm’s demand curve is horizontal
Efficient allocation proposition	State it, then assess it critically
Yardstick (product and labour markets)	Use perfect competition to judge real markets
Monopolistic competition, short and long run	Draw and explain the diagrams
Characteristics and non-price competition	Describe them and analyse their effects

Perfect competition

The assumptions and what each implies

• Large numbers of producers. Each firm is tiny relative to the market, so its output cannot move the price. The firm is a price taker.
• Identical (homogeneous) products. No firm can charge more than another, because buyers see no difference. Branding and advertising have no point.
• Freedom of entry and exit. No barriers, so any supernormal profit attracts new firms and any loss drives firms out. This makes the long run self-correcting.
• Perfect knowledge. Buyers know every price and sellers know every technique and cost. A firm that raised its price would lose all its customers; rivals can copy any cost saving immediately.

The firm’s demand curve

The market sets the price. Each firm can sell any quantity at that price, so its demand curve is horizontal (perfectly elastic) at the market price. Price equals average revenue equals marginal revenue: P = AR = MR. Profit is maximised where MC = MR with MC cutting MR from below.

Worked example: short run

A small grower in a market in Country A (illustrative) has total costs TC = 100 + q³ − 6q² + 20q, so fixed cost is 100.

q	TC	MC	AC	AVC
1	115	15	115.00	15.00
2	124	9	62.00	12.00
3	133	9	44.33	11.00
4	148	15	37.00	12.00
5	175	27	35.00	15.00
6	220	45	36.67	20.00
7	289	69	41.29	27.00

The market price is £56. MR = £56. Produce while MC ≤ 56: MC is 45 at 6 units and 69 at 7, so q = 6. TR = 56 × 6 = £336. TC = £220. Supernormal profit = 336 − 220 = £116.

Diagram in words: price (£) on the vertical axis and output on the horizontal. The horizontal line at £56 is D = AR = MR. The rising MC curve cuts it at 6 units. At 6 units, AC is £36.67, so the shaded rectangle between £56 and £36.67 over 6 units shows supernormal profit.

Worked example: long run

Suppose 200 identical firms each produce 5 units at £35, so market output is 1,000. Demand rises. With 200 firms, each now produces 6 at £56, so market output is 1,200 and each firm earns £116.

1. Profit signals attract entrants, who have the same costs and full knowledge.
2. Industry supply shifts right. Price falls.
3. Entry stops when price is £35, the lowest point of AC: at 5 units, TR = 175 and TC = 175, so profit is zero (normal profit).
4. If demand at £35 is 1,500, there are 1,500 ÷ 5 = 300 firms, so 100 have entered.

In the long run, a firm in equilibrium has P = MC = AC, at the minimum of its AC curve.

Losses, exit and shut-down

If demand falls and price drops to £20: MC is 15 at 4 units and 27 at 5, so q = 4. TR = 80, TC = 148, loss £68. Variable cost is 148 − 100 = 48, so revenue covers variable cost with 32 towards fixed cost. Closing would lose all £100 of fixed cost, so the firm stays open in the short run. Exit is a long-run response: supply shifts left until price rises to £35.

At £8, which is below the lowest AVC (£11 at 3 units), revenue cannot cover variable costs. The firm shuts down in the short run.

The efficient allocation proposition

The proposition: given certain assumptions, perfect competition results in an efficient allocation of resources.

• In long-run equilibrium P = MC. The price shows the value consumers place on the last unit, MC shows the opportunity cost of making it. When they are equal, resources are in their best use (allocative efficiency).
• P = minimum AC, so output is made at the lowest unit cost (productive efficiency).

The key assumption is no externalities (and no public goods or merit goods). Then marginal private cost equals marginal social cost.

Critical assessment

Challenge the proposition on these grounds:

1. Externalities. Take a dye market in Country B (illustrative). Demand: P = 110 − 0.06Q. Private supply (MPC): P = 20 + 0.03Q. The market clears where 110 − 0.06Q = 20 + 0.03Q, so Q = 1,000 and P = £50. If pollution costs £9 per unit, MSC = 29 + 0.03Q. Socially, 110 − 0.06Q = 29 + 0.03Q, so Q = 900 and price £56. At 1,000 units MSC is £59 against a value of £50, so 100 units are overproduced even though the market is perfectly competitive.
2. Missing markets and information. Public goods are not supplied; real buyers lack perfect knowledge.
3. Scale. Where economies of scale are large, many tiny firms cannot reach the lowest cost. Competition would not survive.
4. Dynamic limits. With only normal profit in the long run, there is little finance or incentive for research. Identical products rule out variety.
5. Equity. The result depends on the existing distribution of income, so efficient does not mean fair.
6. Realism. Few markets meet all four assumptions, so the model is a benchmark, not a prediction.

A strong evaluation says how much each point matters. A large external cost makes point 1 weighty, and large economies of scale make point 3 weighty. Where spillovers are small and scale economies are exhausted early, the proposition holds well.

The yardstick role

The model provides a yardstick for judging how efficiently real markets perform, in product and labour markets, and how far resources are misallocated.

• Product market: a market has price £70 but MC of £50. The £20 gap (40% of MC) shows the market is not at P = MC, so too little is produced. Look for the cause: few firms, barriers, branding.
• Labour market: in the competitive ideal there are many employers and many identical workers, so each firm is a wage taker and the market sets the wage. A town where one firm hires nearly everyone can be compared to this ideal to examine whether pay and employment are held below the competitive level.

The yardstick does not say perfect competition is achievable, or that real markets should be forced into it.

Monopolistic competition

Characteristics

• Many firms, each with a small share.
• Differentiated products (real or perceived differences): different brands, styles, locations.
• Low barriers to entry and exit, so firms come and go.
• Firms have some price-setting power, so the demand curve slopes downward, but it is fairly elastic because close substitutes exist.
• Firms use non-price competition.

Examples are restaurants, hairdressers and boutiques in a town.

Worked example: short run

A café has AR (demand) P = 44 − 0.5q, so MR = 44 − q. Its costs: TC = 360 + 8q + 0.1q², so MC = 8 + 0.2q.

• MC = MR: 8 + 0.2q = 44 − q, so 1.2q = 36 and q = 30.
• P = 44 − 15 = £29. TR = 870. TC = 360 + 240 + 90 = 690, so AC = £23.
• Supernormal profit = 870 − 690 = £180.

Diagram in words: downward-sloping AR with steeper MR beneath it; MC cuts MR at 30 units; read the price up to AR (£29) and the cost up to AC (£23). The profit rectangle has height £6 and width 30 units.

Worked example: long run

Supernormal profit attracts entrants offering close substitutes. Each firm’s demand shifts left (a smaller share) and becomes more elastic (more substitutes). Entry continues until demand is tangent to AC and profit is normal.

In this example AC = 360/q + 8 + 0.1q. Long-run demand is P = 26 − 0.125q, so MR = 26 − 0.25q.

• MC = MR: 8 + 0.2q = 26 − 0.25q, so q = 40.
• P = 26 − 5 = £21. AC = 9 + 8 + 4 = £21. Profit = zero.
• The lowest AC is at q = 60 (AC = £20). The firm produces 40, so it has excess capacity of 20 units.
• MC at 40 is £16, so P exceeds MC by £5.

Result: normal profit, but P > MC (allocative inefficiency) and output below the minimum-cost point (productive inefficiency). Unlike perfect competition, the price is not at the bottom of AC.

Evaluating the outcome

• For: consumers get variety and choice; the inefficiency may be small when demand is very elastic; entry keeps long-run profit normal.
• Against: excess capacity; resources spent on differentiation that adds little; brands can confuse buyers.

Non-price competition

Rivalry takes the form of branding and advertising, product design and quality, customer service, loyalty schemes, location and opening hours.

Aim: shift demand right and make it less elastic (customers become loyal), allowing a higher price or more sales. Costs: advertising raises fixed cost, so AC shifts up.

Worked example: the café spends £60 on advertising, raising FC to 420. Demand moves to P = 50 − 0.5q, so MR = 50 − q. MC = MR gives 8 + 0.2q = 50 − q, so q = 35 and P = £32.50. TR = 1,137.50; TC = 420 + 280 + 122.50 = 822.50; profit = £315, up from £180. In the long run, rivals copy and the gain erodes, leaving higher costs and normal profit.

Common errors

• Drawing a perfectly competitive firm’s demand curve sloping down.
• Having a firm close down as soon as it makes a loss. The short-run test is price against AVC.
• Showing the long-run monopolistically competitive firm at the minimum of AC.
• Claiming perfect competition is always efficient without naming the externality assumption.
• Treating advertising as a price tactic.

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.