Pearson Edexcel International Advanced Level Economics: Monopolistic competition (YEC11) – Revision Notes

These notes condense 3.3.3 item 4 (monopolistic competition, a to d) and item 8 (contestability, a to d) from the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. They belong to Unit 3, Business behaviour, which the specification labels an IAL compulsory unit: it is International A2 content for the full International Advanced Level, not part of the IAS. Figures are invented. For full explanations read the study guide, then test yourself with the practice questions. Also see the course hub, the checklist, exam preparation and the free diagnostics.

Key definitions

Term	Meaning
Monopolistic competition	Many firms, differentiated products, low barriers to entry and exit
Product differentiation	Making a product seem different from close substitutes
Physical differentiation	Product features such as taste, size, design
Marketing differentiation	Advertising, packaging, branding
Distribution differentiation	Shop, online or telephone sales
Excess capacity	Output below the output at minimum ATC
Contestable market	Rivals can enter and leave cheaply and quickly, so the possible arrival of entrants restrains incumbents
Hit-and-run entry	Entering to take profit and leaving before the incumbent can respond
Limit pricing	Setting the highest price that still makes entry unprofitable
Sunk cost	Cost that cannot be recovered on leaving the market

4a: Assumptions

• Many small firms, none with a large share.
• Differentiated products, so each firm has a downward-sloping demand curve.
• Low barriers to entry and exit.
• Profit-maximising firms with some price-making power.
• Imperfect information; non-price competition is common.

The specification names the topic but does not list the assumptions, so use this standard set and say which you are using.

4b: Differentiation in one line each

Physical: change the product. Marketing: change how it is seen. Distribution: change how it is reached. Success raises loyalty, lowers PED, raises price-making power, but adds cost.

4c: Equilibrium, method in steps

1. Find MR from the demand curve (twice the slope for a straight line).
2. Set MR = MC to find Q.
3. Read P from the demand curve at that Q.
4. Compare P with ATC at that Q: P above ATC is supernormal profit, P equal is normal profit, P below is a loss.

Case	Position	Result
Short run, profit	AR above ATC at MR = MC	Entry, demand shifts left
Short run, loss	AR below ATC at MR = MC	Exit, demand shifts right
Long run	AR touches ATC at one point	Normal profit, no entry or exit

Small worked reminder (invented cake shop). TC = 400 + 2Q + 0.01Q², demand P = 14 − 0.03Q.

• MR = 14 − 0.06Q and MC = 2 + 0.02Q, so Q = 150 and P = 9.50.
• TR = 1,425, TC = 925, profit = 500.
• After entry, demand is P = 10 − 0.03Q: Q = 100, P = 7, ATC = 7, profit = 0.
• If demand falls to P = 8 − 0.03Q: Q = 75, P = 5.75, ATC = 8.08, loss = 175. AVC is 2.75, so it stays open in the short run.

Long-run shapes to remember. Demand is downward sloping and tangent to ATC on the downward-sloping part of ATC. That is why the tangency output lies to the left of minimum ATC.

4d: Efficiency

Test	Condition	Long run, cake shop example
Productive	Q at minimum ATC	Q = 100 against 200 at minimum ATC (ATC 7 against 6): fails
Allocative	P = MC	P = 7, MC = 4: fails

Both fail in the short run and the long run. The gap between actual output and minimum-ATC output is excess capacity (100 cakes here).

Evaluation checklist. Variety and choice; zero long-run profit pushes cost control; weaker funds for research; advertising may inform or only persuade; the loss is smaller where demand is flatter.

8a: Characteristics of contestable markets

• Low or no barriers; low or no sunk costs.
• Same costs and technology for entrants and incumbents.
• Quick entry, so hit-and-run entry is possible.
• Good information; incumbents cannot change price instantly.
• Number of firms does not matter: even one firm can be disciplined.

8b: Profitability and limit pricing

• Contestable: supernormal profit invites entry, so profit tends to normal and price towards average cost, even with few firms.
• Limit price: where the entrant’s total profit just equals its sunk entry cost.

Method for a limit price (equal share, n years).

1. Entrant’s total profit = (n/2) × (P − MC) × (A − P) when demand is P = A − Q and the entrant takes half the market.
2. Set this equal to the sunk cost F and solve the quadratic.
3. Take the lower root (the smaller price). Check it against the monopoly price.

Reminder example. Demand P = 30 − Q, MC = 6, n = 2. Monopoly price is 18 with profit 144. With F = 108: (P − 6)(30 − P) = 108, P = 12 or 24, so the limit price is 12 and profit is 108.

8c: Costs and benefits

	Benefits	Costs
Consumers	Lower prices, choice, quality	Quality or safety cut; cherry-picking
Firms	Efficient entrants can grow; cost pressure	Lost supernormal profit; less investment; defensive spending

Evaluate by degree: the less contestable the market, the weaker the discipline.

8d: Sunk costs

Sunk cost F	Limit price	Incumbent profit
0	6	0
108	12	108
144 or more	18	144

Higher sunk costs mean a weaker threat, a higher sustainable price and more profit for the incumbent. Recoverable assets (resale value) reduce sunk costs and make the market more contestable.

Describing the diagrams in words

Long-run monopolistic competition. Axes: price and costs (vertical), quantity (horizontal). Draw a downward-sloping AR curve with MR below it, a rising MC and a U-shaped ATC. Output is where MC cuts MR. Price is read up to AR. AR touches ATC at exactly that output, so profit is normal. Label the minimum-ATC output to the right and mark the gap as excess capacity.

Short-run profit. The same curves, but AR lies above ATC at the profit-maximising output. Shade the rectangle between price and ATC for supernormal profit. For a loss, ATC lies above AR; shade the rectangle between ATC and price.

Limit pricing. Describe a price line below the monopoly price. At the limit price the entrant’s expected profit just covers its sunk cost, so no entry occurs. The incumbent’s profit is smaller than at the monopoly price.

Chains of reasoning to learn

• Supernormal profit, so entry, so each firm’s demand shifts left and becomes more elastic, so profit falls to normal.
• Losses, so exit, so remaining firms’ demand shifts right, so loss disappears.
• Higher sunk cost, so riskier entry, so weaker threat, so higher limit price and more incumbent profit.
• Fewer barriers, so credible entry threat, so lower price and cost pressure even with few firms.

Must-know distinctions

• Sunk cost versus fixed cost: fixed costs may be recoverable.
• Productive efficiency (minimum ATC) versus allocative efficiency (P = MC).
• Normal profit in the long run does not mean efficiency.
• Contestable does not mean many firms.

Quick self-test

1. State three assumptions of monopolistic competition.
2. Name the three types of product differentiation in the specification.
3. A firm has demand P = 20 − 0.5Q. Find MR.
4. TC = 100 + 4Q + 0.02Q² gives MC = 4 + 0.04Q. With MR = 20 − Q, find Q and P (demand P = 20 − 0.5Q).
5. At that output ATC is 100/Q + 4 + 0.02Q. Find ATC and profit.
6. Why does supernormal profit disappear in the long run?
7. What is excess capacity?
8. In the long run, how does AR relate to ATC?
9. Give two characteristics of a contestable market.
10. In the coach route reminder, what is the limit price if F = 80?

Answers

1. Any three: many firms; differentiated products; low entry barriers; some price-making power; imperfect information.
2. Physical, marketing, distribution.
3. MR = 20 − Q.
4. 20 − Q = 4 + 0.04Q, so 16 = 1.04Q and Q = 15.4 (to 3 s.f.), P = 20 − 7.69 = 12.31.
5. ATC = 100/15.38 + 4 + 0.31 = 6.50 + 4 + 0.31 = 10.81, profit per unit 12.31 − 10.81 = 1.50, so profit about 23.1.
6. New firms enter, taking customers from existing firms, so demand shifts left until AR just touches ATC.
7. Output below the output at minimum ATC.
8. They touch at one point (tangent).
9. Any two: low or no sunk costs; no barriers; quick entry; same costs for entrants; good information.
10. 10 (the lower root of (P − 6)(30 − P) = 80).

Where marks are usually lost

• Drawing long-run AR crossing ATC, which shows profit or loss.
• Reading price off MR instead of AR.
• Saying monopolistic competition is productively efficient because profit is normal.
• Stating contestability needs many firms.
• Mixing up sunk and fixed costs.
• Describing limit pricing without saying why the incumbent sacrifices profit.
• Listing benefits and costs without a judgement or a condition.
• Calling every differentiated market monopolistic competition without checking entry barriers.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, first teaching September 2018, published by Pearson Education Limited. See sections 3.3.3 item 4 and item 8.