Edexcel IAL Economics: Efficiency, concentration ratios and perfect competition (YEC11) – Revision Notes

These notes condense section 3.3.3 (Market structures and contestability), items 1 to 3, of the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics (YEC11) specification, Issue 2, June 2018. Unit 3, Business behaviour, is labelled IA2 and is compulsory for the full International Advanced Level only. Units 1 and 2 are the International Advanced Subsidiary units.

For full explanations read the study guide. Test yourself with the practice questions, find all topics on the Edexcel A Level Economics hub, and tick off outcomes on the printable checklist. The free 10-minute diagnostics show which topics need work first.

The figures here are made up for revision.

Key definitions (1a)

Term	Meaning	Condition or sign
Productive efficiency	Output produced at the lowest possible average cost	Output at the bottom of the ATC curve, where MC = ATC
Allocative efficiency	Resources produce what consumers value most	P = MC (no externalities assumed)
Dynamic efficiency	Gains in efficiency over time, driven by investment, research and new technology	Falling costs, better or new products
X-inefficiency	Cost above the lowest possible because of weak cost control or little competitive pressure	Actual cost curve above the lowest possible one

Worked reminders

• Allocative: demand P = 40 - 0.04Q and MC = 10 + 0.02Q. Set equal: 30 = 0.06Q, so Q = 500 and P = MC = 20. At Q = 400, P = 24 and MC = 18, so consumers value the next unit above its cost and the market underproduces. The welfare loss is 0.5 x 100 x 6 = 300.
• X-inefficiency: lowest possible unit cost 5.00, actual 6.25, output 800. Excess 1.25 = 25% above the lowest. Wasted cost = 1.25 x 800 = 1,000.
• Dynamic: unit cost falling 6% a year from 10.00 reaches 7.81 after four years of improvement, a fall of about 21.9%. A firm with unchanged cost is not dynamically efficient even if it is productively efficient today.

Efficiency in different structures: market power can allow X-inefficiency and P above MC, but supernormal profit can fund research. Competition pushes costs down but may leave little to invest. State both sides, then judge.

Formulas

Item	Formula
CRn	(sales of n largest firms) / (total market sales) x 100
Profit	TR - TC, or (AR - ATC) x Q
Perfect competition revenue	P = AR = MR
Profit-maximising output	MC = MR, with MC rising
Supernormal profit per unit	P - ATC
Shutdown test	Short run: P below minimum AVC
Percentage above minimum cost	(actual unit cost - lowest unit cost) / lowest unit cost x 100

Concentration ratios (2a, 2b)

Method in steps

1. Find total market sales (include every firm, including the small ones).
2. Rank firms from largest to smallest.
3. Add the sales of the top n.
4. Divide by the total and multiply by 100.

Reminder: in a market with total sales of 1,500, the top three sell 420, 310 and 190. CR3 = 920 / 1,500 = 61.3%. If the second and third firms merge (500), the top three are 500, 420 and 130, so CR3 = 1,050 / 1,500 = 70.0%.

Significance: high versus low

High ratio	Low ratio
Few firms hold market power	Many firms compete
Higher prices and less choice possible	Closer to perfect competition
Collusion easier	Rivalry stronger
Rising ratio may signal mergers	Falling ratio may signal entry

Limitations to quote

• The same ratio can hide different structures. Four firms with 15% each and one firm with 57% plus three with 1% each both give CR4 = 60%.
• The result changes with how the market is defined.
• Imports, foreign rivals and the threat of entry are ignored.
• Sales, output and employment give different figures.

Perfect competition (3a to 3d)

The model is a benchmark for judging other structures. Few real markets meet every assumption.

Assumptions

• Many buyers and sellers, so each is a price taker.
• Homogeneous products.
• Perfect information.
• Freedom of entry and exit.
• Profit maximisation.

Method in steps: short-run equilibrium

1. Read the market price from industry demand and supply.
2. Draw the firm’s demand curve horizontal at that price (P = AR = MR).
3. Find output where MC = MR, on the rising part of MC.
4. Compare price with ATC at that output to see supernormal profit, normal profit or loss.
5. Compare price with AVC to decide whether to stay open.

Worked reminder

For a firm with TFC = 1,600 and lowest ATC of 16.00 at 200 units (invented figures): at P = 25.5 it produces 250 units. ATC is 16.90, so profit per unit is 8.60 and total supernormal profit is 2,150. At P = 9.5 it produces 150 units, AVC is 6.50, so the firm covers variable cost, contributes 450 to fixed cost, and loses 1,150, which beats the loss of 1,600 from closing.

Shutdown point

Price	Short-run decision	Long-run decision
Above ATC	Produce, supernormal profit	Others enter
Equal to ATC	Produce, normal profit	Stay
Between AVC and ATC	Produce, a loss but some fixed cost covered	Leave unless price rises
Below AVC	Shut down	Leave

Long-run adjustment: chain of reasoning

Supernormal profit → new firms enter (free entry, perfect information) → industry supply shifts right → market price falls → each firm’s horizontal demand falls → supernormal profit disappears → entry stops at P = MC = lowest ATC.

Losses work in reverse: exit → supply shifts left → price rises → normal profit restored.

Sketch in words

On the firm diagram, ATC and MC are U-shaped and MC cuts ATC at its lowest point. In long-run equilibrium the horizontal price line touches ATC exactly at that point. The firm produces at that output with no gap between price and ATC.

Efficiency summary

	Productive	Allocative
Short run	Not generally (output differs from the lowest-ATC output)	Yes (P = MC)
Long run	Yes (P = lowest ATC)	Yes (P = MC)

Evaluation: externalities break the link between P = MC and social efficiency. Dynamic efficiency is questionable because there is no long-run supernormal profit and innovations are copied quickly. Small scale may leave unit costs above those of larger firms.

Must-know distinctions

• Normal profit is a cost included in ATC. Supernormal profit is revenue above ATC.
• Shutdown uses AVC. Long-run exit uses ATC.
• Productive efficiency concerns cost per unit. Allocative efficiency concerns whether the right quantity is made.
• A concentration ratio measures how concentrated a market is. It does not say how firms behave.

Quick self-test

1. State the condition for allocative efficiency.
2. Define X-inefficiency.
3. Total market sales are 600. The three largest firms sell 150, 120 and 90. Calculate CR3.
4. A perfectly competitive firm sells 50 units at 8 coins. State TR, AR and MR.
5. The price is 6, output is 40 and ATC is 5.2. Calculate supernormal profit.
6. The price is 4.5 and AVC is 5. Should the firm continue in the short run?
7. In the long run the price is 15, demand is Q = 900 - 20P and each firm produces 30 units. How many firms are in the industry?
8. A firm’s lowest possible ATC is 11 at 60 units. Its actual ATC is 12.5. Calculate the extra cost per unit as a percentage and the wasted cost.
9. In a market of 500 sales, the top three firms sell 200, 125 and 50. Calculate CR3.
10. Explain one reason why perfect information may reduce the incentive to innovate.

Answers

1. P = MC.
2. Production at a higher cost than necessary, so the actual cost curve lies above the lowest possible one, usually from weak cost control or little competitive pressure.
3. (150 + 120 + 90) / 600 = 360 / 600 = 60%.
4. TR = 8 x 50 = 400. AR = 400 / 50 = 8. MR = 8.
5. (6 - 5.2) x 40 = 32.
6. No. The price is below AVC, so revenue fails to cover variable cost, with a loss of 0.5 on each unit before fixed cost. Shutting down loses only fixed cost.
7. Demand = 900 - 300 = 600. Firms = 600 / 30 = 20.
8. Excess = 1.5, which is 1.5 / 11 = 13.6%. Wasted cost = 1.5 x 60 = 90.
9. (200 + 125 + 50) / 500 = 375 / 500 = 75%.
10. Any innovation is copied at once by rivals, so the innovator cannot keep a profit advantage to repay the cost of research.

Where marks are usually lost

• Using total sales of the top n firms as the denominator for a concentration ratio.
• Writing that perfect competition has no profit at all. Normal profit is earned in the long run.
• Drawing a downward-sloping demand curve for a single firm in perfect competition.
• Stating that the firm shuts down whenever there is a loss, without comparing price with AVC.
• Using ATC to explain the short-run shutdown point.
• Saying that perfect competition is productively efficient in the short run.
• Describing concentration ratios as measuring prices or profits, rather than market share.
• Leaving out evaluation on externalities, dynamic efficiency or market definition when asked to assess.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018, published by Pearson Education Limited. Section 3.3.3, items 1 to 3.