Imperfect Competition: Monopoly, Oligopoly, Monopolistic Competition

Picture a new allergy pill. While one company holds its patent, a bottle sells for $90. The year the patent runs out, the same pill sells for $9. It costs no less to make. So what held the price up? This is Module 4.1, Introduction to Imperfect Competition. The answer: market power, and the barrier behind it.

Market power is a firm's ability to influence its own price, though buyers still set limits. Two questions sort markets: how many firms sell, and are their products identical or differentiated, meaning different but still substitutes, like two headphone brands? The answers build a ladder. Bottom rung, perfect competition: many firms, identical products, no barriers, like thousands of egg farms. Monopolistic competition: many firms, differentiated products, and free entry and exit in the long run, like a city's barbershops.

Oligopoly: a few firms behind high barriers, like a city served by three cell-phone carriers. Each one's choices affect the others. Monopoly: one firm, no close substitutes, and barriers that keep rivals out, like the pill maker under its patent. The top three rungs are imperfect competition. So is monopsony, a single buyer in a factor market such as labor: Unit 5.

So what just happened? One: count the firms. Two: identical or differentiated products? Three: check the barriers, how easily rivals get in.

Now, market power on a graph.

Quick refresher from Module 3.7: a price taker sells all it wants at the market price, so its demand is horizontal. An egg farm gets $3 a dozen: 10 dozen bring $30, 11 bring $33.

The extra dozen adds the full $3. With market power, demand slopes down: to sell more, the firm must cut its price.

Take a barbershop. It sells 10 haircuts a day at $20. To sell 11, it must cut the price to $19, for every customer.

Quick refresher: total revenue is price times quantity. 10 haircuts at $20 is $200. 11 at $19 is $209.

So the 11th haircut sells for $19, but revenue rises only $9. That $9 is its marginal revenue. Where did the other $10 go? Into the price cut. The first 10 customers each pay $1 less: $10 lost. $19 gained minus $10 lost is $9. Module 4.2 calls that $10 the price effect. It's why the barbershop's marginal revenue, $9, is below its $19 price. So when a firm must cut its price for every buyer to sell more, MR lies below demand. Monopoly, oligopoly and monopolistic competition graphs all show it.

So what just happened? One: 10 haircuts at $20 bring $200. Two: 11 at $19 bring $209, only $9 more. Three: the $1 cut cost $10, so MR is below the price.

Exam trap: never give a firm with market power a horizontal demand curve, or draw MR on top of demand. AP exam graders report both errors.

Now say each haircut costs the shop $10: its marginal cost.

Quick refresher from Module 3.5: make one more unit only if its marginal revenue is at least its marginal cost. The 11th haircut adds $9, costs $10. Skip it.

So the shop won't go past 10. On the graph, its $20 price sits above its flat $10 marginal cost. Shade that gap.

Quick refresher from Module 3.7: allocative efficiency needs price equal to marginal cost, so every unit worth more than it costs gets made.

But a customer valued that 11th haircut at $19, almost twice its cost, and it never happens. Price above marginal cost marks an inefficient market.

So what just happened? One: the 11th haircut adds $9 but costs $10, so the shop won't go past 10. Two: its $20 price tops its $10 marginal cost. Three: that gap means inefficiency.

Market power can also bring economic profit. In perfect competition, profit doesn't last.

Quick refresher from Module 3.7: profit draws new firms in. If eggs sell for $3 a dozen and the lowest average total cost is $2, farms enter until the price falls to $2 and economic profit is zero.

Barriers to entry block that. The AP course names three. One: high fixed or start-up costs, like building a chip factory. Two: legal barriers, like a patent or a copyright. Three: exclusive ownership of a key resource, like an island's only quarry. Behind barriers, profit can't pull rivals in, so firms can keep economic profit in the long run, with price above marginal cost. Exam trap: high barriers don't make firms price takers; that's perfect competition. And they don't push long-run profit to zero; that takes free entry.

Back to the pill. When its patent expires, that legal barrier falls, and rivals enter with the same medicine.

Quick refresher from Unit 2: price elasticity of demand is the percent change in quantity demanded over the percent change in price. Price up 10%, quantity down 30%: 30 over 10 is 3, elastic. More substitutes, more elastic.

Before, buyers had no close substitute. Now they have several, so if the original maker raises its price, many switch: its demand is more elastic. Its market power shrinks, and its price falls toward the rivals' prices. That's how $90 became $9.

So what just happened? One: the patent kept rivals out. Two: it expired, rivals entered, buyers got substitutes. Three: demand grew more elastic, and the price fell.

Exam trap: write 'more elastic', not just 'elastic', and give the reason: more firms, so more substitutes. 'Less elastic' or 'no change' loses the point.

Exam moment: two questions the way the AP exam asks them, then one free-response part.

Suppose a cement plant costs so much to build that only three firms supply a region. Which is most likely true of them in the long run? A) Each faces a horizontal demand curve B) Each sets price equal to marginal cost C) Each can keep earning economic profit D) Entry drives each firm's profit to zero E) Each produces at its lowest average total cost.

The answer is C. The huge start-up cost is a barrier to entry, so profit can't pull rivals in, and it lasts. A: a price taker. B: P = MC. E: lowest average total cost. All three are perfect competition. D: zero profit needs free entry, which the barrier blocks.

A city has 40 dog groomers, each with its own style, and new ones open easily. One raised its price from $30 to $33 and kept 80 of its 100 customers. Which market structure is this? A) Perfect competition B) Monopolistic competition C) Oligopoly D) Monopoly E) Monopsony.

The answer is B. Many sellers and easy entry, plus a price rise that kept 80 of 100 customers: differentiated products. A: a price taker that raised its price would lose every customer. C, oligopoly, needs few firms and high barriers; D, monopoly, one seller. E, monopsony, is one buyer in a factor market.

Free response. A firm's patent on a lightweight solar roof tile expires, and rival firms enter. Will demand for the firm's tiles become more elastic, become less elastic, or remain the same? Explain.

To earn the point: more elastic, plus the reason. Rival firms enter, so buyers have more substitutes and respond more to the firm's price changes. The costly mistake: 'less elastic', 'no change', plain 'elastic', or no reason. On a recent AP exam, more than a third of students lost this point.

So what earned the point? One: more elastic. Two: rivals enter once the patent ends. Three: more substitutes, so buyers respond more to price.

Recap: firms, product and barriers name the structure. Cutting price for every buyer puts MR below demand and price above marginal cost. Barriers let profit last; when one falls, demand gets more elastic. So what does one firm do with all that power? Next: Module 4.2, Monopoly.