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

This guide follows the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. It covers 3.3.3 item 4 (a to d, monopolistic competition) and item 8 (a to d, contestability). Both sit in Unit 3, Business behaviour. The specification calls Units 1 and 2 the International AS (IAS) units and Units 3 and 4 the additional International A2 (IA2) content for the full International Advanced Level. Unit 3 is an IAL compulsory unit, so this material is in the full International Advanced Level only, not the IAS. Every firm, market and figure below is invented for illustration.

Related pages: revision notes, practice questions, price elasticity of demand, exam preparation, the course hub, the checklist and the free diagnostics. Efficiency concepts, perfect competition, oligopoly and monopoly are separate items of 3.3.3 and are not taught here.

What this guide covers

Item	You must be able to	Section
4a	State the assumptions of monopolistic competition	1
4b	Explain physical, marketing and distribution differentiation	2
4c	Show profit-maximising equilibrium in the short run and long run	3
4d	Judge productive and allocative efficiency in both periods	4
8a	Describe the characteristics of a contestable market	5
8b	Explain the effect on profitability and on pricing (limit pricing)	6
8c	Weigh costs and benefits of contestability for firms and consumers	7
8d	Explain why sunk costs matter	8

1. Assumptions of monopolistic competition (4a)

The specification asks for the assumptions without listing them. The usual set is:

• many small firms, each with a small share of the market;
• differentiated products, so each firm faces a downward-sloping demand curve;
• low barriers to entry and exit, so the number of firms adjusts to profit;
• firms are price makers within limits, because close substitutes exist;
• firms aim to maximise profit and compete on non-price factors as well as price;
• information is imperfect, so buyers do not know every alternative.

Monopolistic competition sits between perfect competition (identical products) and monopoly (no close substitute). Think of cake shops, hairdressers or small cafes in a town.

2. Types of product differentiation (4b)

Differentiation makes buyers see a firm’s product as different, which lowers the cross elasticity with rivals and makes the firm’s own demand less elastic.

Type	Meaning	Example
Physical	Product features: taste, size, design, quality	A cake shop that bakes a vegan range
Marketing	Advertising, packaging, branding	Distinctive boxes and a loyalty scheme
Distribution	How the product reaches the buyer: shop, online, telephone	Home delivery and online ordering

Chain of reasoning. Successful differentiation raises brand loyalty, so a price rise loses fewer customers, so demand is more inelastic, so the firm can set a higher price. Differentiation also costs money (advertising, design), which raises average cost.

3. Short-run and long-run equilibrium (4c)

Demand (AR) slopes down and MR lies below it. The firm produces where MC = MR and reads the price from the demand curve at that output.

Worked example. Shop A, an invented small cake shop, sells Q cakes a week. Costs are TC = 400 + 2Q + 0.01Q², so MC = 2 + 0.02Q and ATC = 400/Q + 2 + 0.01Q. Prices are in currency units (cu).

Short run. Demand is P = 14 − 0.03Q, so MR = 14 − 0.06Q.

• MR = MC: 14 − 0.06Q = 2 + 0.02Q, so 12 = 0.08Q and Q = 150.
• P = 14 − 0.03(150) = 9.50 cu. MC = 5 cu.
• TR = 9.50 × 150 = 1,425 cu. TC = 400 + 300 + 225 = 925 cu.
• Profit = 500 cu. Equivalent check: ATC = 925/150 = 6.17, so profit per cake is 9.50 − 6.17 = 3.33 and 3.33 × 150 = 500.

This is supernormal profit. Because entry is easy, it signals new firms to enter.

Long run. Entrants take customers, so Shop A’s demand shifts left until it is P = 10 − 0.03Q. Demand also tends to become more elastic as substitutes multiply.

• MR = 10 − 0.06Q = 2 + 0.02Q gives Q = 100 and P = 7 cu.
• ATC = 400/100 + 2 + 1 = 7 cu, so AR = ATC and profit is normal (0).

The demand curve now just touches the ATC curve at Q = 100. This tangency is the long-run equilibrium: no firm gains by entering or leaving.

Point on the diagram	Where it sits
Profit-maximising output	Where MC cuts MR from below, Q = 100
Price	Up to the AR curve at that output, P = 7
ATC curve	U-shaped, touching AR at Q = 100 and nowhere else
Minimum ATC	Further right, at Q = 200

A loss-making case. If demand falls to P = 8 − 0.03Q, MR = MC gives 8 − 0.06Q = 2 + 0.02Q, so Q = 75 and P = 5.75 cu. ATC = 400/75 + 2 + 0.75 = 8.08 cu. The loss is (8.08 − 5.75) × 75 = 175 cu. Check: TR = 431.25 and TC = 606.25, a loss of 175. AVC = 2 + 0.75 = 2.75, which is below the price, so the firm covers variable costs and may carry on in the short run. Losses cause exit, which shifts demand for the survivors right until normal profit returns.

4. Productive and allocative efficiency (4d)

Productive efficiency means producing at minimum ATC. Allocative efficiency means P = MC.

Shop A in the long run.

• Minimum ATC: ATC is lowest where 400/Q² = 0.01, so Q² = 40,000 and Q = 200. ATC = 2 + 2 + 2 = 6 cu.
• Actual output is 100 and ATC is 7 cu. The firm is not productively efficient and has excess capacity of 100 cakes.
• At Q = 100, MC = 4 cu but P = 7 cu. P exceeds MC by 3 cu, so the firm is not allocatively efficient. Output is too low and price too high compared with P = MC.

Short run. At Q = 150, P = 9.50 and MC = 5, so there is no allocative efficiency, and ATC (6.17) is above the 6 cu minimum, so no productive efficiency either. In the long run, neither efficiency holds, even though profit is only normal.

Elasticity link. At the long-run point, PED = −(1/0.03) × (7/100) = −2.33, so demand is elastic. Differentiation limits how elastic it becomes. The more differentiated the product, the steeper the demand, the bigger the gap between P and MC and the larger the excess capacity.

Evaluation.

• The inefficiency is the price of variety: buyers value choice, and a more differentiated market suits different tastes.
• Competition for customers pushes firms to improve quality and cut costs, since zero long-run profit leaves no room for waste.
• Normal profit leaves little to fund research, so dynamic efficiency may be weak, though firms keep innovating to differentiate.
• Advertising can inform buyers or only persuade them. In the second case it raises ATC without raising value.
• The size of the efficiency loss depends on how steep demand is and on how large fixed costs are.

5. Characteristics of contestable markets (8a)

A contestable market is one in which rivals can enter and leave cheaply and quickly, so the possibility of entry alone holds down what sellers already there can do, however few they are. The key characteristics are:

• no or very low barriers to entry and exit;
• low or zero sunk costs, so costs can be recovered on exit;
• entrants have access to the same technology and costs as the incumbent;
• perfect information about prices and costs, and entrants can enter quickly (hit-and-run entry);
• incumbents cannot cut price at once after entry, because buyers can switch before the incumbent responds.

A contestable market may contain one firm or many. A single airline on a route is still constrained if rivals could land planes there tomorrow.

6. Profitability and limit pricing (8b)

Profitability. If supernormal profit would be earned, entrants (even hit-and-run) arrive and take it. So in a perfectly contestable market firms earn only normal profit, and price is driven towards average cost. Threat alone is enough: the entrant does not have to appear.

Limit pricing. Where entry costs exist, an incumbent can set the highest price that still makes entry unprofitable.

Worked example. An invented coach route between two towns has demand P = 30 − Q, where Q is thousands of passengers a year and P is in cu. The incumbent’s MC is 6 and constant. An entrant must pay a sunk entry cost F (in thousands of cu), expects to win half of the market at the incumbent’s price and plans to run for two years.

• Monopoly price. MR = 30 − 2Q = 6 gives Q = 12 and P = 18. Profit = (18 − 6) × 12 = 144.
• Is entry profitable at 18? The entrant sells 6, earning (18 − 6) × 6 = 72 a year, or 144 over two years. If F = 108, net gain is 144 − 108 = 36, so entry happens.
• Limit price. Entry breaks even when the entrant’s two-year profit equals F: (P − 6)(30 − P) = F. For F = 108: P² − 36P + 288 = 0, so P = 12 or 24. The lower root, 12, is the limit price, since the higher root lies above the monopoly price.
• At P = 12, Q = 18 and incumbent profit = 6 × 18 = 108. Entrant: 54 a year, 108 in total, equal to F. No entry.

So the incumbent gives up 144 − 108 = 36 of profit to stay safe, and consumers pay 12 rather than 18.

7. Costs and benefits of contestability (8c)

	Benefits	Costs
Consumers	Lower prices, closer to cost; more choice; better quality and service	Quality or safety may be cut to keep price down; service may vanish if entrants cherry-pick profitable routes
Firms	Efficient firms can enter and grow; pressure to cut costs and innovate	Incumbents lose supernormal profit; uncertainty and lower investment; wasteful defensive spending

Chain of reasoning. Easy entry means high profit cannot last, so incumbents hold prices near cost and keep costs low, so consumers gain allocative and productive efficiency without needing many firms. Against that, a firm that cannot keep profit may not invest in long-lived assets, and hit-and-run entry can leave the market unstable.

Evaluation. Few markets are perfectly contestable. The benefits are largest where sunk costs are low and government removes legal barriers; they are weakest where incumbents have brands, contracts or economies of scale that entrants cannot match.

8. Significance of sunk costs (8d)

A sunk cost cannot be recovered on leaving the market, for example advertising or specialised equipment with no resale value. Sunk costs matter because the entrant risks losing them, so the entry threat becomes weaker.

Using the coach route above, the limit price depends on F:

Sunk cost F	Limit price	Incumbent profit
0	6	0
80	10	80
108	12	108
140	16	140
144 or more	18 (monopoly price)	144

With F = 0 the market is perfectly contestable and the incumbent earns nothing. With F of 144 or more entry is never profitable, so the market is not contestable at all. Notice that the incumbent can also raise sunk costs for rivals through advertising and special equipment, which makes its own position stronger.

Common errors

• Writing that monopolistic competition has homogeneous goods or no entry barriers at all. The goods are differentiated.
• Drawing long-run demand cutting ATC, which shows profit. It should touch ATC at one point.
• Claiming excess capacity means the firm is losing money.
• Saying a contestable market must have many firms.
• Confusing sunk costs with fixed costs. Fixed costs may be recoverable.

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.