OCR A Level Economics: Perfect competition and monopolistic competition (H460)

This guide follows the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. It covers part of the topic on market structures in Component 1, Microeconomics: perfect competition, monopolistic competition, and barriers to entry and exit. The specification labels no content as AS or Extension. Every figure below is invented and illustrative.

Related pages: the Microeconomics overview, the efficiency and market failure guide, the revision notes, the practice questions, the OCR Economics hub, the printable checklist and the free diagnostics.

What this unit covers

Area	You must be able to
Perfect competition	Explain the characteristics and why the firm is a price taker; explain short-run supernormal profit or loss and long-run normal profit; explain allocative and productive efficiency; evaluate the usefulness of the theory
Monopolistic competition	Explain the characteristics; explain short-run and long-run price and output; explain supernormal profit or loss in the short run and normal profit in the long run; evaluate advantages and disadvantages
Barriers	Explain barriers to entry and exit

Every explanation is expected “with the aid of a diagram”. In this guide each diagram is put into words and small tables, and you should be able to draw each one.

1. Tools you need first

Total revenue (TR) is P × Q. Average revenue (AR) is revenue per unit sold, which is just the price, so a firm’s AR curve traces out its demand curve. Marginal revenue (MR) is what one extra unit adds to TR.

• Normal profit is the minimum reward that keeps the owner in the industry. It is counted as an opportunity cost, so it sits inside AC. TR = TC means normal profit.
• Supernormal profit is TR above TC. A loss is TR below TC.
• A firm maximises profit (or minimises loss) where MC = MR, with MC cutting MR from below. Producing a unit adds more to revenue than to cost until that point.

2. Perfect competition: characteristics

1. Many buyers and many sellers, each tiny relative to the market.
2. A homogeneous (identical) product, so buyers have no reason to prefer one seller.
3. Perfect knowledge of prices and technology.
4. Free entry and exit: no barriers.
5. Firms are profit maximisers, and factors can move freely.

It is a theoretical benchmark. Some markets for standardised goods come close, but none meets every condition.

3. Why the firm is a price taker

The market sets the price where market demand meets market supply. The single firm cannot change that price.

• Above the market price: buyers can find an identical product at the market price, so the firm sells nothing. Its demand is perfectly elastic (PED = infinity) at the market price.
• At the market price: it can sell any quantity it can produce, so there is no need to cut price.

So the firm’s demand curve is horizontal at the market price, and AR = MR = P at every output. In words: the market diagram has demand sloping down and supply sloping up, meeting at the equilibrium price. The firm diagram shows a flat line at that price, with a U-shaped MC curve crossing it from below.

4. Short run: supernormal profit or loss

A firm with this invented cost function (units per day, costs in pounds) has total fixed cost of 256. Output of 4 to 10 gives:

q	TC	AC	AVC	MC
4	368	92.00	28	12
5	381	76.20	25	15
6	400	66.67	24	24
7	431	61.57	25	39
8	480	60.00	28	60
9	553	61.44	33	87
10	656	65.60	40	120

MC is the extra cost of one more unit. It cuts AVC at its minimum (24, at 6 units) and cuts AC at its minimum (60, at 8 units).

Supernormal profit, price 87. MR = P = 87, and MC = 87 at 9 units. TR = 87 × 9 = 783, TC = 553, profit = 783 − 553 = 230. Per unit, price 87 exceeds AC of 61.44. On the diagram this is the rectangle between the price line and the AC curve, up to 9 units.

Loss that is worth bearing, price 39. MC = 39 at 7 units. TR = 39 × 7 = 273, TC = 431, loss = 158. AVC at 7 units is 25, below the price, so each unit covers its variable cost and contributes 14 towards fixed cost. The loss of 158 is smaller than the fixed cost of 256, which would be lost anyway. The firm stays open.

Shut-down, price 15. MC = 15 at 5 units. TR = 75, TC = 381, loss = 306. Price 15 is below the AVC of 25. Producing loses more than the fixed cost of 256, so the firm should stop. The short-run shut-down rule is: stay open if P ≥ AVC.

5. Long run: normal profit only

Entry and exit are free, so profit signals move firms in and out.

1. Supernormal profit attracts entrants.
2. Market supply shifts right and the market price falls.
3. Entry stops when price equals minimum AC, where TR = TC.
4. Losses work the other way: exit shifts supply left and price rises until losses vanish.

Worked example. Market demand is Qd = 1752 − 16P. With 40 identical firms at price 87, each produces 9, so market output is 360. Check demand: 1752 − 16 × 87 = 360, so the market clears. Each firm earns 230, so firms enter. The price falls to 60, the minimum of AC. At 60, each firm produces 8 and earns TR 480 less TC 480 = 0. Market demand is 1752 − 960 = 792, so the number of firms is 792 ÷ 8 = 99. 59 firms have entered.

The long-run equilibrium has P = AR = MR = MC = AC at the lowest point of AC. The firm earns normal profit only.

6. Allocative and productive efficiency

• Allocative efficiency is P = MC. The price shows the marginal benefit consumers get, and MC shows the marginal cost of resources, so the last unit is worth exactly what it costs. A perfectly competitive firm sets MC = MR and MR = P, so P = MC holds in both the short and long run. At price 87 above, MC is 87.
• Productive efficiency is producing at the lowest point of AC. This holds only in the long run: at 8 units AC is 60, its minimum, but in the short run at 9 units AC is 61.44, above the minimum.

7. Evaluating the usefulness of perfect competition

Useful because:

• It is a benchmark: other structures are judged against its efficiency outcome.
• It shows how free entry removes supernormal profit, a mechanism that holds in less extreme form in many markets.
• It predicts that price takers respond to price signals, which helps explain commodity-type markets.

Limited because:

• The assumptions (identical products, perfect knowledge) rarely hold.
• If MES is large relative to market demand, only a few firms fit, so many small firms may not be possible.
• Where long-run profit is only normal, firms may lack spare funds for innovation, so dynamic efficiency may suffer.
• P = MC is allocative efficiency in private terms only. If there are external costs or benefits, the competitive outcome is not socially optimal.

Judgement. The theory is more useful as a yardstick and a way to reason about entry than as a description of real firms. Its value depends on the question: it is strong for analysing price signals and weak for predicting innovation.

8. Monopolistic competition: characteristics

1. Many firms, each with a small market share.
2. Differentiated products, through branding, quality, location or service, so close but imperfect substitutes.
3. Each firm faces a downward-sloping, fairly elastic demand curve, so it has some price-setting power.
4. Low barriers to entry and exit, though not zero.
5. Non-price competition such as advertising and design.
6. Firms act independently, because each is small relative to the market.

9. Equilibrium price and output

The firm sets MC = MR and reads price from its demand curve at that output.

Short run, worked example. A town has many independent bakeries. One has TC = 36 + 4q + q², so MC = 4 + 2q and AC = 36/q + 4 + q. Its demand is P = 34 − 2q, so MR = 34 − 4q.

• MC = MR gives 4 + 2q = 34 − 4q, so q = 5.
• P = 34 − 10 = 24.
• TR = 120, TC = 36 + 20 + 25 = 81, supernormal profit = 39. AC at 5 units is 16.20.

At this point PED = (dQ/dP) × (P/Q) = (−1/2) × (24/5) = −2.4, which is elastic.

Long run. The profit attracts new bakeries. Customers divide between more sellers, so each firm’s demand curve moves left and gets flatter as buyers find more alternatives. Entry stops when the demand curve just touches the AC curve (tangency). Here demand becomes P = 22 − 1.25q, so MR = 22 − 2.5q.

• MC = MR gives 4 + 2q = 22 − 2.5q, so q = 4.
• P = 22 − 5 = 17. AC at 4 units = 9 + 4 + 4 = 17.
• TR = 68, TC = 68, profit 0: normal profit only. PED is now (−1/1.25) × (17/4) = −3.4.

Short-run loss. Suppose demand were P = 22 − 2q, so MR = 22 − 4q. MC = MR gives 4 + 2q = 22 − 4q, so q = 3 and P = 16. TR = 48 and TC = 36 + 12 + 9 = 57, a loss of 9. AVC is 4 + 3 = 7, below the price, so the bakery stays open in the short run. In the long run some bakeries exit, and demand for the survivors shifts right until normal profit returns.

Efficiency in the long run. Minimum AC is at 6 units (AC = 16). The firm produces 4 units: excess capacity of 2 units, and AC of 17 exceeds the minimum, so it is not productively efficient. P = 17 exceeds MC = 12, so it is not allocatively efficient.

10. Advantages and disadvantages

Advantages

• Product variety and choice that consumers value.
• Competition keeps profit near normal in the long run and encourages firms to improve quality.
• Low barriers allow new ideas and small firms in.

Disadvantages

• P > MC, so output is below the allocatively efficient level.
• Excess capacity, with AC above its minimum.
• Spending on advertising and differentiation adds cost and may add little real value.

Evaluation. The inefficiency is small if close substitutes make demand very elastic, because P is then close to MC. Consumers may value variety more than the lost efficiency, so the structure can raise welfare overall. Much depends on whether product differences are real or only created by marketing.

11. Barriers to entry and exit

Take a barrier to entry to be any obstacle that raises the cost or difficulty for a newcomer trying to start trading. A barrier to exit is any obstacle that makes leaving the market expensive.

Barriers to entry	Barriers to exit
Economies of scale, so a small entrant has higher unit costs	Sunk costs that cannot be recovered
High start-up capital or sunk cost	Specialised equipment with a low resale value
Legal protection: patents, licences	Redundancy and contract-termination costs
Brand loyalty and heavy advertising	Long-term contracts with suppliers
Control of key inputs or distribution	Reputation damage from closing

Perfect competition has none. Monopolistic competition has low barriers. The higher the barriers, the longer supernormal profit can survive. Barriers to exit matter because a firm making a loss may stay open if leaving costs more, which slows the long-run adjustment.

Common errors

• Drawing a downward-sloping demand curve for a perfectly competitive firm. It is horizontal.
• Using the market price as AC. Profit needs a comparison of price with AC at the chosen output.
• Setting output where MC = AC instead of MC = MR.
• Claiming a firm shuts down whenever it makes a loss. The test is price against AVC.
• Saying the monopolistically competitive firm is productively efficient in the long run. It is not, because of excess capacity.
• Treating MR as equal to price for a monopolistically competitive firm. MR lies below the downward-sloping demand curve.

Official syllabus

OCR, A Level in Economics (H460) specification, Version 3.0 (June 2026), first assessment 2021, Component 1 Microeconomics, topic on market structures. Test yourself on this unit with the practice questions.