IB DP Economics: Market power (HL)

This guide covers sub-topic 2.11, market failure – market power, in Unit 2 Microeconomics. It follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. The whole of 2.11 is HL only, so SL candidates do not need it. The firms, countries and figures used as examples are all made up.

The revision version is in the market power revision notes, and you can test yourself with the market power practice questions. Course overview: IB DP Economics hub and the printable checklist. For surplus and P = MC ideas, see competitive market equilibrium and demand, supply and equilibrium.

What 2.11 asks you to do

Content	Skill needed
Market structures	Describe perfect competition, monopoly, oligopoly and monopolistic competition
Profit maximisation (calculation, HL only)	Find profit, MC, MR, AC and AR from data; apply MC = MR
Degrees of market power	Draw and use the perfect competition diagrams, including allocative efficiency
Monopoly	Draw profit, normal profit and loss; compare with perfect competition; natural monopoly
Oligopoly	Collusion, interdependence, game theory payoff matrix, price and non-price competition, concentration ratios
Monopolistic competition	Short and long run diagrams; compare with monopoly
Evaluation	Advantages and risks of large firms; government intervention

The guide sets the depth as application and analysis (AO2) for the definitions of the structures, AO2 and AO4 for profit maximisation, AO3 and AO4 for the degrees of market power, monopoly, oligopoly and monopolistic competition diagrams, and AO3 for the advantages and risks of large firms and government intervention.

Market power and the four structures

Market power is a firm’s ability to influence the price it charges. A firm with none is a price taker. A firm with some is a price maker.

Structure	Firms	Entry	Product	Market power
Perfect competition	Many	Free	Homogeneous	None
Monopoly	One, or one dominant	High barriers	No close substitutes	Highest
Oligopoly	A few large	High barriers	Often differentiated	High, but interdependent
Monopolistic competition	Many	Free	Differentiated	Some, limited by substitutes

Imperfect competition covers the last three. The more substitutes consumers have, the more elastic each firm’s demand curve and the less market power it has.

Profit maximisation (HL calculations)

Definitions:

• Total revenue TR = price × quantity. Average revenue AR = TR/Q, which is the price, so AR is the demand curve.
• Marginal revenue (MR) is what one more unit adds to revenue.
• Average cost AC = TC/Q. Marginal cost MC is the extra cost of one more unit.
• Profit = TR - TC.
• Abnormal profit: AR > AC. Normal profit: AR = AC. Loss: AR < AC.

A rational producer maximises profit at the output where MC = MR. Up to that point each extra unit adds more to revenue than to cost. Beyond it, each unit adds more to cost.

Worked example (data). A made-up firm, Quillon Ltd, faces the demand P = 60 - 5Q (units are illustrative).

Q	P = AR	TR	MR	TC	MC	Profit
1	55	55	55	50	20	5
2	50	100	45	62	12	38
3	45	135	35	72	10	63
4	40	160	25	84	12	76
5	35	175	15	102	18	73
6	30	180	5	126	24	54

Working: MR is the change in TR, for example MR at Q = 4 is 160 - 135 = 25. MC is the change in TC, for example MC at Q = 4 is 84 - 72 = 12. At Q = 4, MR (25) exceeds MC (12); at Q = 5, MR (15) is below MC (18). The firm produces 4 units at price 40. AC at Q = 4 is 84/4 = 21, so AR (40) > AC (21): abnormal profit of (40 - 21) × 4 = 76, which matches TR - TC = 160 - 84.

On a diagram, abnormal profit is the rectangle between AR and AC, from the axis to the profit-maximising quantity.

Perfect competition: no market power

A perfectly competitive firm is a price taker, so its demand curve is horizontal at the market price: P = D = AR = MR. Each extra unit sells at the same price, so MR equals the price.

Short run. The firm sets MC = MR, which here means MC = P. Three outcomes follow:

• P > AC: abnormal profit.
• P = AC: normal profit.
• P < AC: loss.

Long run. Entry is free. Abnormal profit attracts new firms, market supply shifts right, and price falls. Losses push firms out, supply shifts left, and price rises. Entry or exit stops when firms earn normal profit.

Worked example. Take a made-up firm with TC = 100 + 4Q + Q², so MC = 4 + 2Q and AC = 100/Q + 4 + Q. AC is lowest at Q = 10, where AC = 24 and MC = 24.

Price	MC = P gives Q	TR	TC	Result
40	18	720	496	Abnormal profit 224
24	10	240	240	Normal profit
16	6	96	160	Loss 64

At price 40, entry follows and price falls. At price 16, exit follows and price rises. The long-run price is 24, at the lowest point of AC.

Allocative efficiency means resources go where they are most valued: the price (what buyers will pay for the final unit) equals the marginal cost of making it, P = MC. In terms of the demand and supply diagram, MB = MC and social (community) surplus is at its maximum. Perfect competition meets this condition in the long-run example above (P = MC = 24).

Monopoly

A monopolist is the only seller or the dominant one, faces the whole market demand, and has AR above MR (the demand curve slopes down, so selling more means lowering the price on every unit). It still maximises profit at MC = MR, but it then reads the price from the AR curve above that point. Its market power appears as AR > MC.

Worked example. A made-up monopolist faces P = 96 - 2Q, so MR = 96 - 4Q. Its costs are TC = 180 + 12Q + Q², so MC = 12 + 2Q.

• MC = MR: 12 + 2Q = 96 - 4Q, so 6Q = 84 and Q = 14.
• Price: P = 96 - 28 = 68. MC at Q = 14 is 40.
• TR = 68 × 14 = 952. TC = 180 + 168 + 196 = 544. Profit = 408. AC = 544/14 = 38.9, below AR.

Change the fixed cost and the same demand gives other outcomes. With fixed cost 588, TC = 952 and AR = AC at Q = 14, so the monopolist earns normal profit. With fixed cost 700, TC = 1,064 and the monopolist makes a loss of 112, because AR is below AC. On the diagram the AC curve then touches, or lies above, the AR curve at the profit-maximising output.

Compared with perfect competition

Suppose the same industry were perfectly competitive, with the same MC curve acting as supply. Then P = MC: 96 - 2Q = 12 + 2Q, so Q = 21 and P = 54.

	Perfect competition	Monopoly
Output	21	14
Price	54	68
P compared with MC	P = MC (54 = 54)	P > MC (68 > 40)

The monopolist restricts output and charges more. Output 14 is allocatively inefficient, because units between 14 and 21 are valued by consumers above their marginal cost but are not produced. The welfare loss is the triangle between the demand and MC curves from Q = 14 to Q = 21: ½ × (21 - 14) × (68 - 40) = ½ × 7 × 28 = 98. This is market failure from market power.

Natural monopoly

A natural monopoly arises where economies of scale are so large that average cost keeps falling across the whole market demand, so one firm can supply at lower cost than two. The AC curve is still falling where it meets demand.

Worked example. A made-up water network has demand P = 40 - Q, constant MC = 4 and fixed cost 180, so AC = 180/Q + 4.

• Unregulated: MR = 40 - 2Q = 4, so Q = 18 and P = 22. AC = 14, giving profit (22 - 14) × 18 = 144.
• P = MC (allocatively efficient): Q = 36, P = 4, but AC = 9, so a loss of (9 - 4) × 36 = 180. No private firm would stay.
• P = AC: 40 - Q = 180/Q + 4 gives Q² - 36Q + 180 = 0, so Q = 30 (or 6). P = 10 = AC, normal profit, and more output than the unregulated case.

A regulator may therefore cap the price at AC rather than MC.

Oligopoly

An oligopoly has a few large firms and high barriers to entry. Firms are interdependent: each firm’s best choice depends on how rivals react.

Concentration ratio. The CR for n firms is the sum of the market shares of the n largest. With made-up shares of 30, 25, 15, 10, 8, 7 and 5 per cent, CR4 = 30 + 25 + 15 + 10 = 80 per cent. A high ratio signals a market dominated by few firms, though it says nothing about how they behave.

Collusive and non-collusive. Firms that collude agree prices or output, often secretly. Together they can behave like a monopoly: the group sets industry output where industry MC = MR and shares the profit. Non-collusive firms compete, and the risk is a price war, where rivals cut price in turn and profits fall. Whichever way they behave, oligopolists with market power price above marginal cost (P > MC), so oligopoly is allocatively inefficient, a market failure like monopoly; a collusive group that acts as a monopoly shows the same output restriction and welfare loss.

Payoff matrix. Two made-up firms, Aurel and Borin, each choose High or Low price. Payoffs are profit (Aurel, Borin):

	Borin High	Borin Low
Aurel High	40, 40	15, 55
Aurel Low	55, 15	25, 25

If Borin charges High, Aurel gains by choosing Low (55 against 40). If Borin charges Low, Aurel again does better with Low (25 against 15). The same holds for Borin, so both choose Low and earn 25 each, though both would prefer 40 each. This is the incentive to collude (joint profit 80 against 50) and the incentive to cheat (55 for the firm that undercuts).

Price and non-price competition. Price competition means cutting price. Non-price competition uses advertising, branding, quality, service and loyalty schemes, and avoids starting a price war.

Monopolistic competition

Many firms sell differentiated products and entry is free. Because substitutes are close, each firm’s demand is more elastic than a monopolist’s.

Worked example. A made-up café has AR = 50 - 2Q, MR = 50 - 4Q, TC = 100 + 10Q so MC = 10 and AC = 100/Q + 10.

• Short run: MR = MC gives Q = 10, P = 30, AC = 20. Abnormal profit = (30 - 20) × 10 = 100.
• Long run: profit attracts entrants. Their rival products take customers, so the café’s demand shifts left and becomes more elastic. Entry stops when the demand curve is tangent to AC. In the example the long-run demand is AR = 30 - Q, which is lower and flatter than 50 - 2Q (more elastic at any given price): MR = 30 - 2Q = 10 gives Q = 10, P = 20, AC = 100/10 + 10 = 20. AR = AC and the curves touch, so the café earns normal profit.
• Losses do the opposite: exit shifts the remaining firms’ demand right.

In the long run P (20) exceeds MC (10), so there is allocative inefficiency, but less than monopoly, and consumers gain product variety.

Large firms: advantages and risks

Advantages. Economies of scale lower average cost, and natural monopolies are the extreme case. Abnormal profit can pay for research and development, producing innovation.

Risks. Less output and higher price (shown above), reduced consumer choice, and possible abuse of power such as price fixing.

Government intervention

• Legislation and regulation: laws against collusion and abuse of a dominant position, and price caps for natural monopolies.
• Government ownership: taking the firm into public ownership, so output and price can serve social goals.
• Fines: penalising firms that break the rules.

To evaluate, weigh the gains in price and output against the costs: regulators may lack cost information, public firms may be inefficient, and fines may be passed to consumers.

Common errors

• Reading the monopolist’s price off the MR curve. Find Q at MC = MR, then go up to AR.
• Calling a positive profit “normal”. Normal profit means AR = AC.
• Drawing the welfare loss to the MR curve instead of between demand and MC.
• Treating a high concentration ratio as proof of collusion.

Test yourself on the practice questions, and take a free 10-minute check in the diagnostics.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization (February 2020), sub-topic 2.11.