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

This guide covers 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. These items are efficiency, concentration ratios and perfect competition. Units 1 and 2 are labelled International Advanced Subsidiary (IAS). Unit 3, Business behaviour, is labelled IA2 and is a compulsory unit for the full International Advanced Level only, not for the IAS.

Use the Edexcel A Level Economics hub for all topics and the printable checklist to tick off outcomes. Not sure where you stand? Try the free 10-minute diagnostics. After this guide, use the revision notes and the practice questions. Monopolistic competition, oligopoly and monopoly have their own pages, so this guide stays within items 1 to 3.

All figures below are invented and illustrative. They are not real statistics.

What this guide covers

Item	What you must be able to do
1a	Explain allocative efficiency, productive efficiency, dynamic efficiency and X-inefficiency, and efficiency or inefficiency in different market structures
2a	Calculate n-firm concentration ratios
2b	Explain the significance of concentration ratios
3a	State the assumptions of perfect competition
3b	Show profit-maximising equilibrium in the short run and the long run
3c	Explain the short-run shutdown point
3d	Assess productive and allocative efficiency in the short run and the long run

1. Efficiency (1a)

Productive efficiency means producing at the lowest possible average cost. A firm is productively efficient where output is at the bottom of the average total cost (ATC) curve, which is where marginal cost (MC) cuts ATC.

Allocative efficiency means resources are used to produce the goods and services consumers value most. The condition is price (P) equal to marginal cost (MC). Price measures the value consumers place on the last unit. MC measures what that unit costs society to make, assuming no externalities. If P is above MC, consumers want more than is made. If P is below MC, resources are wasted on units that cost more than they are worth.

Dynamic efficiency means productive and allocative efficiency improving over time, through investment, research and development, innovation and new technology. It shows up as falling costs, better products and new products.

X-inefficiency means a firm produces at higher cost than it needs to, so its actual cost curve lies above the lowest possible one. Causes include weak cost control, poor management and lack of competitive pressure.

Worked example: allocative efficiency

In a market in Country A, demand is P = 40 - 0.04Q and marginal cost is MC = 10 + 0.02Q.

1. Allocative efficiency needs P = MC: 40 - 0.04Q = 10 + 0.02Q, so 30 = 0.06Q and Q = 500.
2. At Q = 500, P = 40 - 20 = 20 and MC = 10 + 10 = 20. Allocatively efficient.
3. At Q = 400, P = 24 and MC = 18. Consumers value the next unit at 6 more than it costs. Underproduction.
4. The welfare loss from stopping at 400 is the triangle between demand and MC from 400 to 500: 0.5 x 100 x 6 = 300.
5. At Q = 600, P = 16 and MC = 22. Each unit costs 6 more than it is worth. Overproduction, with the same loss of 300.

Worked example: X-inefficiency

A bakery chain could make 800 loaves at a lowest possible unit cost of 5.00 coins. Its actual unit cost is 6.25.

• Excess unit cost: 6.25 - 5.00 = 1.25, which is 1.25 / 5.00 = 25% above the lowest possible.
• Wasted cost: 1.25 x 800 = 1,000 coins (actual total cost 5,000 against 4,000).

Worked example: dynamic efficiency

Firm F spends 2,000 coins a year on research and its unit cost falls 6% a year from 10.00: 10.00, 9.40, 8.84, 8.31, 7.81 over five years. That is a fall of about 21.9% across four years of improvement. A rival with no research keeps a constant 10.00. The rival may be productively efficient at any one moment, but it is not dynamically efficient.

Efficiency in different market structures

Market power can be linked to both outcomes. Where firms face little competition, X-inefficiency is more likely and price may exceed MC. Equally, supernormal profit can fund research, so dynamic efficiency may be higher. Intense competition pushes firms towards low costs but may leave little profit to invest. No structure is automatically best on all four measures. Each other structure is covered on its own page.

2. Concentration ratios (2a, 2b)

An n-firm concentration ratio adds up the market shares of the biggest n sellers in one market.

CRn = (sum of the n largest firms’ sales) / (total market sales) x 100

Worked example

Sales in the ready-meal market of Country B (invented), in coins m: firm V 420, W 310, X 190, Y 130, Z 90, and ten smaller firms 360 together. Total = 420 + 310 + 190 + 130 + 90 + 360 = 1,500.

Ratio	Working	Result
CR1	420 / 1,500	28.0%
CR3	(420 + 310 + 190) / 1,500 = 920 / 1,500	61.3%
CR4	1,050 / 1,500	70.0%
CR5	1,140 / 1,500	76.0%

Suppose W and X merge. The merged firm has sales of 500, so the top three are 500, 420 and 130. The new CR3 is 1,050 / 1,500 = 70.0%, up from 61.3%. The market has become more concentrated even though no firm left.

Significance

• A high ratio suggests a few firms hold market power, so they may set prices above competitive levels, restrict choice and find collusion easier.
• A low ratio suggests many competing firms and greater rivalry.
• Rising ratios over time point to mergers or growth by large firms, and are of interest to competition authorities.
• Ratios allow markets to be compared, and a market with a low ratio is closer to perfect competition. The specification sets no cut-off, so quote the figure rather than inventing a rule.

Limitations

• The same ratio can hide different structures. In Market P, four firms hold 15% each. In Market Q, one firm holds 57% and three hold 1% each. Both have CR4 = 60%, yet Market Q is dominated by one firm.
• The ratio depends on how the market is defined. Defined narrowly it is high. Defined broadly it falls.
• It ignores foreign competition, imports and the threat of entry. A concentrated market may still behave competitively if entry is easy.
• It can use sales, output or employment, and these give different figures.

3. Perfect competition (3a to 3d)

Assumptions (3a)

• Many buyers and sellers, each too small to affect price.
• Homogeneous (identical) products.
• Perfect information about prices and quality.
• Freedom of entry and exit, with no barriers.
• Firms are price takers and profit maximisers.

The model is a benchmark. Few real markets meet every assumption.

Short-run equilibrium (3b)

The market price is set where industry demand meets industry supply. Each firm takes it as given, so its demand curve is horizontal at that price: P = AR = MR. A firm maximises profit where MC = MR, with MC rising. Profit depends on price relative to ATC.

Worked example: one firm, with a cost table

TFC = 1,600. TVC = 8Q - 0.04Q² + 0.0002Q³. MC = 8 - 0.08Q + 0.0006Q².

Q	MC	AVC	ATC
100	6.00	6.00	22.00
150	9.50	6.50	17.17
200	16.00	8.00	16.00
250	25.50	10.50	16.90

The lowest AVC is 6.00 at Q = 100. The lowest ATC is 16.00 at Q = 200.

Supernormal profit. Market price is 25.5. MC = P at Q = 250. Revenue = 25.5 x 250 = 6,375. Total cost = 1,600 + 2,625 = 4,225. Profit = 2,150, or 8.60 per unit (25.5 - 16.9).

Loss, but keep producing. Price falls to 9.5. MC = P at Q = 150. Revenue = 1,425. TVC = 975. Contribution to fixed cost = 450. Total cost = 2,575, so the loss is 1,150. Shutting down would lose all 1,600 of fixed cost, so the firm stays open. Normal profit is covered in ATC, so a price equal to ATC gives normal profit and zero supernormal profit.

Short-run shutdown point (3c)

A firm should stop producing in the short run when price falls below minimum AVC, because revenue then fails to cover variable costs. Here that is a price below 6.00. At P = 5, producing 100 units gives revenue 500 against TVC 600, and a loss of 1,700. Shutting down limits the loss to the 1,600 of fixed cost. Between AVC and ATC the firm makes a loss but covers some fixed cost, so it continues. In the long run, a firm that cannot cover ATC leaves the industry.

Long-run equilibrium (3b)

Supernormal profit attracts entry. Industry supply shifts right, price falls, and entry stops when profit is only normal. Losses cause exit, supply shifts left, and price rises. The long-run position is P = MC = lowest ATC.

For the firm above: P = 16, Q = 200, revenue 3,200, total cost 1,600 + 1,600 = 3,200, profit zero. Suppose industry demand is Q = 12,600 - 200P. At P = 25.5 demand is 7,500, which is 30 firms producing 250 each. At P = 16 demand is 9,400, which is 47 firms producing 200 each. So 17 firms enter.

Price
 25.5 |        Firm supernormal profit (SR)
      |
 16   |-------- MC = AR = MR = lowest ATC (LR)
      |
 9.5  |        Firm loss, still produces (SR)
      |_________________________________ Output

Efficiency in perfect competition (3d)

	Productive efficiency	Allocative efficiency
Short run	Not generally. Q = 250 at P = 25.5 is above the Q = 200 minimum ATC. Q = 150 at P = 9.5 is below it	Yes, since P = MC at every equilibrium
Long run	Yes, since P = lowest ATC at Q = 200	Yes, since P = MC

Evaluation: allocative efficiency assumes no externalities, so a polluting firm can have P = MC and still overproduce from society’s view. Dynamic efficiency is doubtful. Zero long-run supernormal profit leaves little to invest, and perfect information means any innovation is copied at once. Small firms may also fail to reach minimum efficient scale, so real markets with the lowest costs may need fewer, larger firms.

Common errors

• Writing that the firm shuts down whenever it makes a loss. It shuts down only if P is below AVC.
• Using ATC instead of AVC for the shutdown point.
• Stating that perfect competition is productively efficient in the short run.
• Dividing by the wrong total when calculating CRn. Use the whole market, not the top n firms.

Next, use the revision notes to condense this, then the practice questions.

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.