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2.11

Market failure: market power

Unit 2 · Microeconomics · Higher level only

This topic is higher level only, and it is the most diagram-heavy in the course. Market power is a firm’s ability to set its price above marginal cost. This page builds up from revenue, cost and profit, through perfect competition (no power) and monopoly (maximum power), to the two structures in between, oligopoly and monopolistic competition, and ends with what governments do about abuse. Paper 1 asks about it almost every session.

🎯What you need to be able to do

  • HL Describe perfect competition, monopoly, oligopoly and monopolistic competition by number of firms, barriers to entry and type of product.
  • HL Explain profit maximization (TR − TC, MR = MC) and abnormal profit, normal profit and losses; calculate profit, MC, MR, AC and AR from data.
  • HL Draw the perfectly competitive firm as a price taker, with abnormal profit, normal profit and losses in the short run, and long-run equilibrium with allocative efficiency (P = MC).
  • HL Draw a monopolist making abnormal profit, normal profit and losses; compare monopoly with perfect competition, including the welfare loss; draw a natural monopoly.
  • HL Explain oligopoly: collusion and cartels, interdependence, price wars, a simple game-theory payoff matrix, price and non-price competition, concentration ratios.
  • HL Draw monopolistic competition in the short and long run.
  • HL Evaluate the advantages and risks of large firms with market power, and government responses: legislation and regulation, government ownership and fines.

📚The economics

Four market structures

Perfect competition
many small firms; homogeneous (identical) products; free entry and exit; perfect information. Each firm is a price taker. Closest real cases: some agricultural and commodity markets, foreign exchange.
Monopolistic competition
many firms; differentiated products; free entry and exit. Some price-setting power. Cafés, hair salons, warung, clothing boutiques.
Oligopoly
a few large firms dominate; high barriers to entry; interdependence: each firm must consider rivals’ reactions. Mobile networks, cement, airlines, soft drinks.
Monopoly
a single (or dominant) firm; high barriers to entry; no close substitutes. Price maker. State electricity distribution, patented medicines, local water supply.

Barriers to entry protect market power: economies of scale, legal barriers (patents, licences), control of essential resources, high set-up costs, brand loyalty, network effects, and aggressive tactics by incumbents.

Revenue, cost and profit

Total revenue TR = P × Q
Average revenue AR = TR ÷ Q = P (so AR is the demand curve)
Marginal revenue MR = ΔTR ÷ ΔQ
Total cost TC
Average cost AC = TC ÷ Q
Marginal cost MC = ΔTC ÷ ΔQ

Economic costs include opportunity costs, including the return the owners could earn elsewhere. So:

Normal profit (AR = AC)
TR = TC: the minimum profit needed to keep the firm in the industry. Zero economic profit.
Abnormal profit (AR > AC)
TR > TC: profit above normal. Attracts entry if barriers allow.
Loss (AR < AC)
TR < TC. In the long run, loss-makers leave.

Profit maximization: MR = MC. If the next unit adds more to revenue than to cost (MR > MC), produce it; if it adds more to cost (MR < MC), don’t. Profit is greatest where MR = MC (with MC rising through MR).

Marginal revenue falls 20, 16, 12, 8, 4, 0 and marginal cost rises 3, 5, 7, 9, 11, 13 for units one to six. The third unit has MR 12 above MC 7; the fourth has MR 8 below MC 9, so profit is maximized at 3 units, with profit 13 dollars.
From the worked example below: profit is maximized at the last unit for which MR ≥ MC.

Perfect competition: no market power

Because there are many sellers of an identical product, each firm’s output is too small to affect the price. It must accept the market price set by industry demand and supply. If it charged more it would sell nothing; it can sell as much as it likes at the market price. So the firm’s demand curve is perfectly elastic, and P = D = AR = MR.

Left: industry demand and supply set the equilibrium price Pe. Right: the individual firm faces a horizontal demand line at Pe, labelled P equals D equals AR equals MR.
The industry sets the price; the firm takes it.

Short run. The firm produces where MR (= P) = MC. Whether it makes a profit depends on where the price lies relative to its AC:

Three panels of a perfectly competitive firm with the same MC and AC curves. At price 20, output 9 where MR equals MC, with AC 15, giving abnormal profit of 45 dollars shaded green. At price 14, output 6 at the minimum of AC: normal profit. At price 11, output 4.5 with AC 14.5: a loss of 15.75 dollars shaded red.
Short run: abnormal profit, normal profit or a loss, depending on the market price.

A loss-making firm continues in the short run as long as the price covers its average variable cost (it contributes something to fixed costs, which must be paid anyway). If price falls below AVC, it shuts down immediately.

Long run. Abnormal profits attract new firms (no barriers), so industry supply shifts right and the price falls until only normal profit remains. Losses make firms leave, supply shifts left and the price rises. Long-run equilibrium: P = MR = MC = minimum AC, normal profit only.

Left: industry supply shifts right from S1 to S2 as firms enter, and the price falls from 20 to 14. Right: the firm's price line falls from P1 = MR1 at 20, where it produced 9 units with abnormal profit, to P2 = MR2 at 14, the minimum of AC, where it produces 6 units and makes normal profit.
Entry competes away abnormal profit: why it exists only in the short run.

Efficiency: in long-run equilibrium, P = MC means price (the marginal benefit to consumers) equals marginal cost: allocative efficiency, with social surplus maximized (MB = MC). Firms also produce at minimum AC: productive efficiency. This is the benchmark for judging the other structures.

Monopoly

A monopolist faces the whole downward-sloping market demand curve. To sell one more unit it must lower the price on all units, so MR lies below AR (for a straight-line demand curve, MR has twice the slope). It maximizes profit at MR = MC, then charges the highest price consumers will pay for that output, read off the AR curve. Because barriers block entry, abnormal profit can persist in the long run.

Three panels of a monopolist with the same MC and AC curves. Abnormal profit: MR equals MC at 5 units, price 22 on AR above AC of 14.20, profit shaded green. Normal profit: AR is tangent to AC at 4 units where price equals AC equals 15. Loss: AR lies below AC at every output, with the loss shaded red.
A monopolist can make abnormal profit, normal profit or losses; its monopoly status does not guarantee profit.

Monopoly compared with perfect competition. Suppose a competitive industry is taken over by a single firm with the same costs (constant MC = AC).

Demand from 32 dollars and a horizontal MC equal to AC at 8 dollars. Perfect competition produces 12 units at 8 dollars. A monopoly sets MR equal to MC at 6 units and charges 20 dollars, earning 72 dollars of profit. The grey triangle between 6 and 12 units, below demand and above MC, is the welfare loss of 36 dollars.
The monopoly restricts output and raises price; the grey triangle is the welfare loss.
  • Higher price, lower output: $20 and 6 units, against $8 and 12.
  • Allocative inefficiency: P ($20) > MC ($8). Consumers value units 7 to 12 above their cost, yet they are not produced: a welfare loss of ½ × 6 × 12 = $36. This is market failure.
  • Redistribution: part of consumer surplus ($72 here) becomes monopoly profit.
  • Possible X-inefficiency (costs higher than necessary without competitive pressure) and less choice.

Natural monopoly. Where economies of scale are so large that average costs keep falling over the whole range of market demand, one firm can supply the market more cheaply than two or more. Electricity grids, water pipes, rail track and gas networks are examples: duplicating them would waste resources.

A long-run average cost curve that falls across the whole market demand curve, with LRMC below it. The unregulated monopolist produces Q m where MR equals LRMC and charges P m. At the output where price equals LRMC, average cost is above price, so the firm would make a loss.
A natural monopoly: forcing P = MC would make the firm loss-making.

This creates a dilemma. Left alone, a natural monopoly charges a high price. Forced to price at MC (allocative efficiency), it makes a loss because P < AC. Governments therefore often own natural monopolies (Indonesia’s PLN electricity and PAM water companies) or regulate their prices (for example average-cost pricing, P = AC).

Oligopoly

A few firms dominate, so each firm’s best decision depends on what its rivals do: interdependence.

  • Collusive oligopoly: firms cooperate to limit competition, usually to fix prices or share markets. A formal agreement is a cartel (OPEC coordinating oil output is the best-known international example). Colluding firms act together like a monopoly: they set joint MR = MC and share the abnormal profit, so the monopoly diagram above applies. Most countries ban collusion; Indonesia’s competition authority, KPPU, has brought cartel cases in several industries, including cooking oil.
  • Tacit collusion: no formal agreement, but firms follow a price leader or avoid price cuts.
  • Non-collusive oligopoly: firms compete, but are wary of price wars: if one cuts price, rivals match it and all lose profit. So prices tend to be stable, and firms compete through non-price competition: advertising, branding, loyalty schemes, product features, after-sales service.

Game theory models interdependent decisions. In the payoff matrix below, both firms would be best off colluding on a high price (50 each), but each has an incentive to cheat: whatever the rival does, pricing low earns more. So both price low and earn 25: the prisoner’s dilemma. This explains why cartels are unstable, and why firms still try to collude.

A two by two payoff matrix. Both high price: 50 each. A high and B low: A 10, B 70. A low and B high: A 70, B 10. Both low: 25 each. Pricing low is each firm's dominant strategy, so both end up at 25 each rather than 50.
The incentive to collude (50, 50) and the incentive to cheat (70 > 50).

Concentration ratios measure how dominated a market is. The n-firm concentration ratio (CRn) is the combined market share of the n largest firms. A four-firm ratio (CR4) above about 50% suggests oligopoly; close to 100% for one firm indicates monopoly. Limitations: they ignore the relative sizes within the top n, foreign competition, and how contestable the market is.

Monopolistic competition

Many firms sell differentiated products, so each has a downward-sloping demand curve, but because there are many close substitutes it is much more elastic than a monopolist’s.

Left, short run: a relatively elastic demand curve AR with MR below it; MR equals MC at output Q where price P is above AC, giving abnormal profit. Right, long run: entry has shifted demand left until AR is tangent to AC at output Q, with P equal to AC, normal profit, and output below the minimum of AC.
Short-run abnormal profit attracts entry; in the long run only normal profit remains.
  • Short run: abnormal profit (or losses) are possible, exactly as in the monopoly diagram.
  • Long run: abnormal profit attracts new firms with similar products (free entry). Each firm’s demand curve shifts left (and becomes more elastic) until it is tangent to AC: normal profit. Losses cause exit, shifting demand right.
  • Efficiency: P > MC, so it is allocatively inefficient, but less so than monopoly because demand is more elastic. Firms produce below minimum AC (excess capacity), so not productively efficient.
  • Benefit: more product variety and choice, which consumers value.

Large firms with market power: advantages and risks

Advantages
Economies of scale lower average costs, which can mean lower prices than many small firms could charge (natural monopolies especially). Abnormal profits finance research and development, hence innovation: new medicines, technology platforms. Stable firms can invest long-term and compete internationally.
Risks
Output restricted and prices higher than under competition; less consumer choice; allocative inefficiency and welfare loss; X-inefficiency; power over suppliers and workers; political lobbying; abuse such as predatory pricing or tying products together to exclude rivals.

Government responses to abuse of market power

  • Legislation and regulation (competition policy): laws banning cartels and abuse of dominance; blocking mergers that would reduce competition; price caps on regulated monopolies (utilities). Indonesia’s competition law (1999) is enforced by KPPU.
  • Fines: penalties for anti-competitive behaviour. The European Commission fined Google €2.42 billion (2017) over its shopping comparison service and €4.34 billion (2018) over Android.
  • Government ownership: the state runs the natural monopoly itself, pricing for social goals (PLN, PAM water).
  • Other options: breaking up dominant firms; promoting entry (deregulation, trade liberalization, 3.7).

Evaluation: regulators may lack information about costs, may be captured by the industry, and cases take years; fines may be small relative to profits; breaking up firms can sacrifice economies of scale. Dynamic markets (technology) also change faster than regulation.

✏️Worked example HL

A firm with some market power faces the following demand and costs.
Q
0, 1, 2, 3, 4, 5, 6
P (= AR) / $
22, 20, 18, 16, 14, 12, 10
TC / $
20, 23, 28, 35, 44, 55, 68
(a) Calculate TR, MR and MC for each output.
(b) Identify the profit-maximizing output and calculate the profit.
(c) Is this abnormal profit? Use AR and AC.

(a) TR = P × Q: 0, 20, 36, 48, 56, 60, 60. MR (change in TR): 20, 16, 12, 8, 4, 0. MC (change in TC): 3, 5, 7, 9, 11, 13.

(b) Produce each unit while MR ≥ MC: unit 3 has MR 12 > MC 7, unit 4 has MR 8 < MC 9. So Q = 3. Profit = TR − TC = 48 − 35 = $13. (Check: profit at Q = 2 is 36 − 28 = 8 and at Q = 4 is 56 − 44 = 12, both lower.)

(c) AR = $16; AC = 35 ÷ 3 = $11.67. AR > AC, so it is abnormal profit: (16 − 11.67) × 3 = $13.

Check it. MR falls by $4 per unit while P falls by $2: with straight-line demand, MR falls twice as fast as AR, as the theory predicts.
Stopping where MR = MC exactly. With discrete data there is often no exact MR = MC. Produce every unit whose MR is at least its MC, and stop before the first unit where MC exceeds MR.

📝Practise

All HL. Tagged questions are modelled on a real IB question from that session, with our own wording and context.

1. [2 marks, Paper 2 style] The four largest firms in a market have sales of $40 m, $25 m, $15 m and $10 m. Total market sales are $120 m. Calculate the four-firm concentration ratio.
CR4 = (40 + 25 + 15 + 10) ÷ 120 × 100 = 90 ÷ 120 × 100 = 75%: a highly concentrated market, consistent with oligopoly.
2. [10 marks, Paper 1 (a) — modelled on May 2024 HL Paper 1 Q1(a)] Using diagrams, explain what happens to a price-taking firm’s profit, and to the number of firms in the industry, after a permanent rise in market demand.

Define perfect competition (many firms, homogeneous product, free entry and exit, perfect information) and abnormal profit (AR > AC). Short run: an increase in demand raises the market price; the price-taking firm produces where P = MR = MC, with P > AC: abnormal profit (firm and industry diagrams).

Long run: perfect information means outsiders see the profit, and with no barriers they enter. Industry supply shifts right and the price falls until P = min AC, so only normal profit remains (two-panel long-run diagram). Explain each step of the adjustment in words linked to the diagram.

3. [10 marks, Paper 1 (a) — modelled on November 2024 HL Paper 1 Q1(a)] Explain why barriers to entry let a monopolist keep earning abnormal profit that a café owner in a busy tourist town cannot.
Both face downward-sloping demand and maximize profit at MR = MC, so both can earn abnormal profit in the short run. The difference is barriers to entry. A monopoly is protected by high barriers (economies of scale, legal protection, control of resources), so rivals cannot enter and the profit persists (monopoly diagram). In monopolistic competition, entry is free: new firms offering similar products take customers, each firm’s demand shifts left until it is tangent to AC, leaving normal profit (long-run diagram).
4. [15 marks, Paper 1 (b) — modelled on May 2023 HL Paper 1 Q1(b)] Using real-world examples, evaluate whether consumers are better served by a market of many small firms selling differentiated products or by one dominated by a few large firms.

For monopolistic competition: more elastic demand, so less allocative inefficiency; only normal profit in the long run (prices closer to cost); lots of variety and choice; free entry keeps firms responsive; no collusion risk (too many firms).

For oligopoly: economies of scale can mean lower costs and prices; abnormal profits fund R&D (pharmaceuticals, smartphones); non-price competition drives quality and innovation; competition between a few large firms can still be fierce (airlines, telecoms price wars).

Against oligopoly: collusion and cartels, high prices, barriers. Against monopolistic competition: excess capacity, waste on advertising, small firms cannot afford R&D.

Judgment: depends on the industry (cafes suit monopolistic competition; steel, telecoms or aircraft making need scale), on whether oligopolists collude, and on the strength of competition policy.

5. [15 marks, Paper 1 (b) — modelled on November 2023 HL Paper 1 Q1(b)] Using real-world examples, examine the options open to a competition authority when four firms control most of a country’s cement market.

Explain concentration ratios and why high concentration may mean market power (oligopoly or monopoly), with a diagram of monopoly/collusive oligopoly and welfare loss.

Responses: investigate and ban collusion (fines, as in EU competition cases); block mergers; regulate prices (price caps on utilities); government ownership of natural monopolies; encourage entry (deregulation, lower trade barriers, support for small firms).

Evaluation: high concentration is not proof of abuse (economies of scale, contestable markets, international competition); regulators’ information problems; risk of government failure; the cost of breaking up efficient firms. Conclude with a context-dependent judgment.

6. Explain, with a diagram, why a natural monopoly is often owned or regulated by the government.
Average costs fall across the whole market because of huge fixed costs (a grid, pipes): one firm is the cheapest way to supply. Left unregulated, it sets MR = MC, restricting output and charging a high price. Competition is not the answer (duplicate networks waste resources). If the government forces P = MC for allocative efficiency, P < AC and the firm makes a loss, so it needs a subsidy; alternatively P = AC gives normal profit with more output than monopoly. Hence state ownership (PLN electricity) or price regulation. Diagram: falling LRAC, LRMC below it, D and MR, marking the MR = MC and P = MC outputs.

🔗Go deeper — other people’s work

These are external resources, not mine. If one stops working, tell me and everything above it on this page still stands.

  • Khan Academy — Forms of competition unit: perfect competition, monopoly, oligopoly and game theory.
  • European Commission competition cases database — decisions and fines against Google and others.
  • KPPU (Indonesia’s Business Competition Supervisory Commission) — published decisions on cartels and mergers.