Theory of The Firm (HL) Notes

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1.5 Theory of the firm and market structures
Production and costs
Distinguish between the short run and long run in the context of production.
• Short run: At least one input is fixed

• Long run: All inputs are variable
Define total product, average product and marginal product, and construct diagrams to show their
relationship.
• Total product (TP): Total quantity of output produced by firm

• Average product (AP): Produce per unit input
• Marginal product (MP): Extra / additional output resulting from one additional variable input
• Generalised product curves (above)

• MP curve intersects AP curve when AP is maximum
- MP > AP = Increasing AP
- MP < AP = Decrease AP
Explain the law of diminishing returns.
• Law of diminishing returns: As more and more units of variable inputs are added to one or more fixed
inputs, the MP of the variable input at first increases, but comes to a point where it begins to decrease.
- Assumption made is that technology of production and fixed inputs remain unchanged
Calculate total, average and marginal product from a set of data and/or diagrams.
TP = AP x units of variable input
AP = TP / Units of variable input
MP = Change in TP / Change in variable input
(Note: TP is cumulative, add in values from previous variable inputs)

someibnotes.wordpress.com IB Economics HL Notes
Explain the meaning of economic costs as the opportunity cost of all resources employed by the firm
(including entrepreneurship).
• Because of scarcity, economic costs (including all costs of production) are opportunity costs of all
resources used in production.
Distinguish between explicit costs and implicit costs as the two components of economic costs.
• Economic costs: Sum of explicit and implicit costs, or total OC incurred by a firm for its use of resources
(purchased and self-owned)
1. Explicit costs: Payments by firms to outsiders (e.g. resource suppliers) to acquire resources for use in
production
- OC of using resources not owned by firm = amount paid to acquire them
- Money could have been used to buy something else
2. Implicit costs: Sacrifice of income (that would have been earned if resource was used for its best
alternative use) arising from the use of self-owned resources by firm
Explain the distinction between the short run and the long run, with reference to fixed costs and
variable costs.
• Fixed costs (FC): From the use of fixed inputs (do not change as output changes)
- e.g. rental payments, property tax, insurance premiums, interests on loans
• Variable costs (VC): From the use of variable inputs (change as output changes)
- e.g. wages (sometimes)
• Total costs (TC): Sum of fixed and variable costs

- Short run total cost = sum of fixed and variable costs
- Long run total cost = variable costs
Distinguish between total costs, marginal costs and average costs.
• Total costs (TC): Sum of fixed and variable costs

- Total fixed costs (TFC) is a constant amount
- Total variable costs (TVC) does not increase at constant rate because of law of diminishing returns
• Marginal costs (MP): Extra / additional cost of producing one more unit of output
• Average costs (AC): Cost per unit output
Draw diagrams illustrating the

relationship between marginal costs
and average costs, and explain the
connection with production in the
short run.
• Generalised cost curves (shown)
• MC intersects both AVC and ATC curves

at minimum points
- MC > ATC = ATC decreasing
- MC < ATC, ATC increasing
• AFC decreases as output increases

(TFC divided growing quantity of output)
• Vertical difference between ATC and
AVC curves at any level of output is
equal to AFC which gets smaller as
output grows
Explain the relationship between the product curves (average product and marginal product) and the
cost curves (average variable cost and marginal cost), with reference to the law of diminishing
returns.
• MP curve intersects AP curve when AP is maximum Product curves (MP and AP)
- MP > AP = Increasing AP are mirrors of the cost curves
- MP < AP = Decrease AP (MC and AVC) because of the
law of diminishing returns
• MC intersects both AVC and ATC curves at minimum points
- MC > ATC = ATC decreasing
- MC < ATC, ATC increasing
• Law of diminishing returns:

- Increase AP = MP require more units of input —> AVC decrease
- Decrease AP = MP require less units of input —> AVC increase
Calculate total fixed costs, total variable costs, total costs, average fixed costs, average variable
costs, average total costs and marginal costs from a set of data and/or diagrams.
TC = TFC + TVC 
AFC = TFC / Q
AVC = TVC / Q
ATC = TC / Q
MC = Change TC / Change Q = Change TVC / Change Q
Distinguish between increasing returns to scale, decreasing returns to scale and constant returns to
scale.
• Increasing returns to scale: Output increases more than in proportion to the increase in all inputs
• Decreasing returns to scale: Output increases less than in proportion to increase in inputs
• Constant returns to scale: Output increases proportionately with increase inputs
Outline the relationship between short-run average costs and long-run average costs.
• LRAC curve is made up of an infinite number of single points from SRAC curves representing all possible
combinations of fixed and variable inputs that could be used to produce different levels of output for firms
- Shows lowest possible average cost that can be attained by firm
Explain, using a diagram, the

reason for the shape of the long-
run average total cost curve.
• LRAC decreases as output

increases = Increasing returns to
scale (decreasing portion)
• LRAC constant as output increases
= Constant returns to scale
(minimum point)
• LRAC increases as output
increases = Deceasing returns to
scale (increasing portion)
LRAC is boundary between unit costs

levels that are attainable (area above
LRAC) and unattainable (area below
LRAC). Firms wishing to minimise
costs per output produce at points on
the LRAC (difficult in short run).
Describe factors giving rise to economies of scale, including specialisation, efficiency, marketing
and indivisibilities.
• Economies of scale: Decreases in LRAC as firm increases all inputs —> increasing returns to scale
Specialisation • Growth of firm —> workers / managers able to specialise in individual

areas of expertise —> increase efficiency —> decrease AC
- Areas of expertise e.g. production, finance, marketing
Efficiency • Large firms able to purchase large (better, more efficient) machinery
which decreases AC
- Increase in efficiency of capital equipment —> decrease AC
• Some machinery can only be used efficiently when producing large
quantities (which small firms do not need — see indivisibility of efficient
processes)
Marketing • Cost of marketing (sales promotion and advertising) is fixed while output
increases —> lower cost of marketing per unit output
Indivisibilities • Indivisibility of capital equipment

- Machines only available in large sizes (and cannot be divided into
smaller machinery) and require large volumes of output to be used
effectively
• Indivisibility of efficient processes
- Production processes, e.g. mass production processes, require
large volumes of output in order to be used efficiently
- Small output cannot achieve same degree of efficiency
Describe factors giving rise to diseconomies of scale, including problems of coordination and
communication.
Problems of • Growth of firm —> increased difficulty for management to control and
coordination and coordinate activities of firm —> inefficiency, increases in AC
communication - Larger firms have increased need for effective communication, to
prevent breakdowns
Poor worker motivation • Growth of firm —> workers and managers feel that alienated, loss of
identity —> lose sense of belonging and motivation —> less productive,
increase in AC
(OOS) Constant returns to scale
• Constant returns to scale: Increase in

output does not result in an increase or
decrease in costs, i.e. the firm does not
experience economies or diseconomies
of scale.
• Qmes = minimum efficient scale

- Level of output at which economies
of scale are exhausted; beyond
that are either constant or
diseconomies of scale
- Constant returns to scale occur
when the firm produces at Qmes
- Larger firms have larger Qmes
Revenues
Distinguish between total revenue, average revenue and marginal revenue.
• Revenues: Payments firm receives when they sell goods and services they produce
• Total revenue (TR): Total payment firm receives when they sell goods and services they produce
• Average revenue (AR): Revenue per unit of output sold
• Marginal revenue (MR): Additional revenue arising from sale of an additional unit of output
Illustrate, using diagrams, the relationship between total revenue, average revenue and marginal
revenue.
• When firm does not control price

- TR diagonal, P = MR = AR is straight line
• When firm controls price (seen above)
Calculate total revenue, average revenue and marginal revenue from a set of data and/or diagrams.
TR = P x Q
AR = TR / Q
MR = Change TR / Change Q 
Profit
Describe economic profit as the case where total revenue exceeds economic cost.
• Economic profit = Total revenue - economic costs

= Total revenue - (explicit + implicit costs)
Describe normal profit as the amount of revenue needed to cover the costs of employing self-owned
resources (implicit costs, including entrepreneurship) or the amount of revenue needed to just keep
the firm in business.
• Normal profit: Amount of revenue needed to cover the costs of employing self-owned resources (implicit
costs, including entrepreneurship) or the amount of revenue needed to just keep the firm in business.
- Minimum revenue needed to keep firm running
- Normal profit earned at break-even point where TR = economic costs and economic profit = 0
Explain that economic profit is profit over and above normal profit, and that the firm earns normal
profit when economic profit is zero. + Explain the meaning of loss as negative economic profit
arising when total revenue is less than total cost.
• Economic profit is profit over and above normal profit

- Positive economic profit: TR > TC = supernormal (abnormal) profit
- Zero economic profit: TR = TC = normal profit
- Negative profit profit: TR < TC = loss
Explain why a firm will continue to operate even when it earns zero economic profit.
• Economic profit = 0 = normal profit and firm is earning just enough to keep running
- At normal profit, a firm still covers all opportunity costs and is able to operate
Calculate different profit levels from a set of data and/or diagrams.
Yes.
Goals of firms
Explain the goal of profit maximisation where the difference between total revenue and total cost is
maximised or where marginal revenue equals marginal cost.
• Profit maximisation: Involves determining the level of output that the firm should produce at to make the
profit as large as possible
- TR - TC (= economic profit) is largest
- Profit maximisation point is when MR = MC
Describe alternative goals of firms, including revenue maximisation, growth maximisation, satisficing
and corporate social responsibility.
Revenue maximisation • Increasing sales —> revenue maximisation

- Sales more easily measured over short run (more so than profits)
- Increased sale targets serve as motivation for workers
- Revenue increases at a greater rate than costs —> increase
profits (TR - TC)
- muh feels
Growth maximisation • Growth maximisation is a goal because:
- Economies of scale = decrease AC
- Diversification, reduce dependence on single product or market
- Greater market power, increased ability to influence price
- Reduced risks in economic downturn
- Interests of owners and managers
Satisficing • A goal of firms to achieve satisfactory results, rather than pursue a single
maximising objective, e.g. to maximise profits or revenues
- Large firms have numerous objectives that party overlap / conflict
—> forces compromise and reconciliation of conflicts rather than
optimal results
Corporate social • Firms pursuing ethical and environmentally responsible behaviour —>
responsibility positive image of firm —> increased worker productivity, sales; decrease
government regulation
- Avoidance of polluting activities, participate in environmentally
sound practices
- Supporting human rights, e.g. no child labour
- Art and athletic sponsorships
- Donations to charities
Perfect competition
Describe, using examples, the assumed characteristics of perfect competition: a large number of
firms; a homogeneous product; freedom of entry and exit; perfect information; perfect resource
mobility.
Large number of firms • Industry is made up of a very large number of firms

• Firms are small relative to size of industry, incapable of altering its own
output to affect supply — “Price-takers”
Homogenous product • Products produced by each firm are identical and impossible to
distinguish from each other
• No branding or marketing to differentiate
Freedom of entry and • No barriers to entry or exit: Firms in industry cannot stop firms from
exit entering or leaving
Perfect information • All producers and consumers have perfect knowledge of market
- Producers aware of market prices, costs, workings of market
- Consumers aware of prices, quality, and availability of products
Perfect resource • Resources bought by firms are completely mobile and can easily be
mobility transferred to another firm / industry without any cost
e.g. EU wheat-growing industry

- Many wheat farms that are very small in relation to the whole industry
- Individual farm can increase output many times without noticeable effect on total supply of
wheat in EU, and cannot affect wheat price in EU
- Farm has to sell at whatever existing price is
- Wheat is wheat there is no difference
Explain, using a diagram, the shape of the perfectly competitive firm’s average revenue and marginal
revenue curves, indicating that the assumptions of perfect competition imply that each firm is a price
taker.
• Industry: Demand and supply curves are normal (downward sloping D; upward sloping S)
• Firm: Demand is perfectly elastic
- Price-taking firms cannot sell at a lower / higher price than price determined by free market
equilibrium, price-taking firms therefore have to take the price set in the industry
- At industry price, firms can choose to sell any output (increase output does not affect industry supply
curve)
Explain, using a diagram, that the perfectly competitive firm’s average revenue and marginal revenue
curves are derived from market equilibrium for the industry.
• Market equilibrium (P, Q) and perfectly elastic D results in P = D = AR = MR

• Profit is maximised at MC = MR (P, q)
Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic profit
(supernormal profit), normal profit or negative economic profit in the short run based on the marginal
cost and marginal revenue profit maximisation rule.
Short-run abnormal profits Short-run losses
• Abnormal profits: Covering TC + OC • Losses: Not covering TC

• Maximising profits (MC = MR), selling at Pq • Maximising profits (MC = MR), selling at Pq
• At q, AC < AR —> firm earning P - C on each unit • AC > AR —> firm losing C - P on each unit
Note: Shaded area in both graphs indicate abnormal profits / losses respectively.
Note again: Firms continue to produce at profit maximising level of output, because any other output would
create greater loss. They are loss minimising. 
Explain, using a diagram, why, in the long run, a perfectly competitive firm will make normal profit.
SR abnormal —> LR normal SR loss —> LR normal
• No barriers to entry —> new firms enter industry • No barriers to exit —> firms begin to bankrupt /
attracted by opportunity to make abnormal profit leave industry when there are losses made
(shaded area) (shaded area)
• Large volume of firms entering industry —> S • Large volume of firms leaving industry —> S
increases to S1 (rightward shift) —> D for firm decreases to S1 (leftward shift) —> D for firm
decreases to D1 —> P decreases to P1 = C1 —> increases to D1 —> P increases to P1 = C1 —>
price-taking firms sell at P1 and abnormal profits price-taking firms sell at P1 and losses are
are competed away in the LR reduced to normal profit in LR
• OC covered, firms do not enter / exit (normal profit • OC covered, firms do not enter / exit (normal profit
does not incentivise firms) does not incentivise firms)
• Outcome is much bigger industry producing Q1 • Outcome is much smaller industry producing at Q1
(with firms producing q1) (with firms producing q1)
Explain, using a diagram, how a perfectly competitive market will move from short-run equilibrium to
long-run equilibrium.
• Perfectly competitive firms make normal profits in LR

• MC = MR (maximising profits by producing at P)
• P = AC —> normal profits
• No incentive to enter / exit industry —> equilibrium will persist until there is a change in industry
- Change in D / costs that firms face —> enter short-run abnormal profits / loss —> industry will
readjust or firms will enter / exit industry until long-run equilibrium is restored
Distinguish between the short run shut-down price and the break-even price.
• In the LR, a loss-making firm shuts down and exits the industry when the price < AC
• SR shut-down price is P = minimum AVC: firm shuts down (stops producing) when price < AVC
• LR shut-down price is P = minimum ATC: firm shuts down (leaves industry) when price < ATC
• SR and LR break-even price is P = minimum ATC

- In LR, shut-down price = break-even price
Explain, using a diagram, when a loss-making firm would shut down in the short run. + Explain,
using a diagram, when a loss-making firm would shut down and exit the market in the long run.
• SR shut-down price is P = minimum AVC: firm shuts down (stops producing) when price < AVC
• LR shut-down price is P = minimum ATC: firm shuts down (leaves industry) when price < ATC
Calculate the short run shut-down price and the break-even price from a set of data.
Shut-down price is when P (= AR = MR) = minimum AVC. Therefore, find minimum AVC value.
Break-even price is when P (= AR = MR) = minimum ATC. Therefore, find minimum ATC value.
Explain the meaning of the term allocative efficiency. + Explain that the condition for allocative
efficiency is P = MC (or, with externalities, MSB = MSC).
• Allocative efficiency: Occurs when firms produce the optimal mix of goods and services required by
consumers
• P (=MB) = MC
Explain the meaning of the term productive/technical efficiency. + Explain that the condition for
productive efficiency is that production takes place at minimum average total cost.
• Productive efficiency: Firm produces its product at the lowest possible cost (AC)
• Achieved when production takes place at minimum ATC
Explain, using a diagram, why a perfectly competitive market leads to allocative efficiency in both the
short run and the long run, and why a perfectly competitive firm will be productively efficient in the
long run, though not necessarily in the short run.
Productive and allocative efficiency in the long-run
In long-run equilibrium under perfect competition, the firm achieves both allocative efficiency (P = MC) and
allocative efficiency (production at minimum ATC). At the level of the industry, social surplus (consumer plus
producer surplus) is maximum, and MB = MC.
Allocative efficiency but not productive efficiency in the short-run
In the short run, the perfectly competitive firm achieves allocative efficiency (at profit-maximising level of
output, P = MC) but is unlikely to achieve productive efficiency (because ATC is higher than / lower than level
of output produced).
Firms are only productively efficient in the short-run if they are producing normal profit.
Monopoly
Describe, using examples, the assumed characteristics of a monopoly: a single or dominant firm in
the market; no close substitutes; significant barriers to entry.
Single or dominant firm • Only one firm producing the product so the firm is the industry
in the market - Single firm in industry = pure monopoly
No close substitutes • No substitute goods so consumers have no choice but to buy monopolist
produced goods
Significant barriers to • Barriers to entry stop new firms from entering the industry and maintains
entry the monopoly —> allows monopolist to make abnormal profits in the
long-run
e.g. Underground railway company has monopoly of underground travel (but it does face competition
from other industries, such as buses, taxis, and private forms of transport)
Describe, using examples, barriers to entry, including economies of scale, branding and legal
barriers.
Economies of scale • Economies of scale: Firms gain AC advantages as their size increases
- Specialisation, division of labour, bulk-buying, financial economies
—> cost savings, lower cost per unit
• Large monopolies experience economies of scale
- Firms entering industry will not have EoS enjoyed by monopolist
- Even if firm is the same size, new firms lack expertise in industry,
e.g. managerial economies, promotional economies, R&D etc.
- New firms unable to compete —> have to reduce price —> make
losses because AC is higher —> lack of economies of scale acts
as a deterrent to firms entering monopoly industry
Branding • Monopolist produces product that has gained huge brand loyalty
- Consumers think product = brand, e.g. Hoover vacuums
- New firms unable to attract same kind of brand loyalty and
consumers unwilling to buy new varieties —> deterrents to firms
entering monopoly industry
Legal barriers • Firms given legal right to be only producer in the industry (i.e. legal right
to be monopoly)
1. Patents: Right given by government to firm that has developed a new

product / invention to be sole producer for specified period of time
- Patents meant to encourage invention
- Intellectual property rights, e.g. pharmaceutical industry
2. Licenses: Granted by governments for particular professions or

particular industries
- e.g. Licenses to be doctors, dentistry, architecture, law
- Does not usually result in monopoly, but limits competition
3. Copyrights: Guarantee that an author has sole rights to print, publish,

and sell copyrighted works
4. Public franchises: Granted by government to a firm which is to

produce or supply a particular good or service
5. Tariffs, quotas, and other trade restrictions: Limit quantities of a

good that can be imported into a country, thus reducing competition
Explain that the average revenue curve for a monopolist is the market demand curve, which will be
downward sloping.
• Monopolist firm = industry, so monopolist’s demand

curve is the industry (market) demand curve, which
will be downward sloping
- Monopolists controls either level of output or
the price of product (not both, to sell more they
have to lower the price and still follows law of
demand)
Explain, using a diagram, the relationship between

demand, average revenue and marginal revenue in
a monopoly.
• Monopolist has normal demand curve

• MR < D
• Profit maximisation (MC = MR)
Explain why a monopolist will never choose to operate on the inelastic portion of its average revenue
curve. (Teacakes pg. 184 for diagram)
• PED elastic (> 1), P and TR change in opposite direction (decrease P = increase TR)
• PED inelastic (< 1), P and TR change in same direction (decrease P = decrease TR)
- The monopolist will not produce any output in the inelastic portion of its demand curve (which is also
its average revenue curve)
• TR maximum when MR = 0 and PED = 1 (unit elastic)
Explain, using a diagram, the short-run and long-run equilibrium output and pricing decision of a
profit maximising (loss minimising) monopolist, identifying the firm’s economic profit (or losses).
Abnormal profit Losses
• Monopolist making abnormal profit in SR with • Monopolist making losses in SR —> option of
effective barriers to entry —> other firms cannot closing down temporarily (if not covering AVC) or
enter the industry and compete away profits continue production for time being
• Maximising profits (MC = MR) • Maximising profits (MC = MR) but AC is higher up
• Abnormal profits (shaded area) • Losses (shaded area)
Note: Possible for industry to collapse when monopoly closes down.

Profit maximisation based on marginal revenue and cost approach
• Profit-maximising (loss-minimising) level of output at MC = MR

• Profit or loss per unit: Profit / Q = P - ATC
- P > ATC = profit
- P < ATC = loss
- P = ATC = normal
• Total profit / loss = ( Profit / Q ) x Q
Explain the role of barriers to entry in permitting the firm to earn economic profit.
• Under monopoly, high barriers to entry prevent potential competitor firms from entering a profit-making
industry, and the monopolist can therefore continue to make abnormal profits indefinitely in the long-run.
• Exception to this case being if the monopolist produces a product that has low demand (unlikely)
Explain, using a diagram, the output and pricing

decision of a revenue maximising monopoly firm.
• Revenue maximisation: Monopolist may decide to

maximise revenue rather than profits
- Produce at MR = 0 instead of MC = MR
- Decrease PPM to PRM
- Increase qPM to qRM
- Revenue maximising level of output is the level of
output where MR curve cuts horizontal axis
(When reading set of data, MR = 0 is the revenue

maximising level of output and this is just something extra to take up the
space so my notes look nice)
Compare and contrast, using a diagram, the equilibrium positions of a profit maximising monopoly
firm and a revenue maximising monopoly firm.
• Profit maximising: MC = MR
• Revenue maximising: MR = 0
Calculate from a set of data and/or diagrams the revenue maximising level of output.
Find the data values where MR = 0.
With reference to economies of scale, and using examples, explain the meaning of the term “natural
monopoly”. + Draw a diagram illustrating a natural monopoly.
• Natural monopoly: When a

single large firm can produce
for the entire market at a lower
average total cost than two or
more smaller firms
- Market demand for
product is within range
of falling LRATC
- Economies of scale so
large that it can support
the entire market
Minimum efficient scale is the

lowest level of output where
lowest ATC is achieved.
Note: LRATC curve = big ATC.

Explain, using diagrams, why the profit maximising choices of a monopoly firm lead to allocative
inefficiency (welfare loss) and productive inefficiency.
• Allocative inefficiency: P > MC (underallocation)

• Productive inefficiency: Production at higher than
minimum ATC
• Profit maximising level of output —> loss of social

benefits (both consumer and producer surplus) due to
monopoly’s higher price and lower quantity
- Monopoly price > Perfect competition price
- Monopoly output < Perfect competition output
• Presence of welfare (deadweight) loss in monopoly

indicates there is allocative inefficiency, shown also by
P (=MB) > MC at Qm.
• The monopolist gains at the expense of consumers as
a portion of consumer surplus is converted into
producer surplus.
Explain why, despite inefficiencies, a monopoly may be considered desirable for a variety of reasons,
including the ability to finance research and development (R&D) from economic profits, the need to
innovate to maintain economic profit, and the possibility of economies of scale.
Ability to finance • Economic profits —> ability to finance large R&D projects
research and • High barriers to entry —> protection from competition —> favour
development from innovation and product development by offering firms the opportunity to
economic profits enjoy profits arising from innovating activities (rationale for awarding
patent protections)
- e.g. New inventions, new products, new technologies etc.
Need to innovate to • Product development, technological development as a means of
maintain economic maintaining economic profits over long term
profit - Barriers of entry to new potential rivals (who are unable to produce
their good) —> less likely to enter industry with innovating
monopolist
Possibility of economies • Monopolies are really big —> extensive economies of scale in large firms
of scale help achieve lower costs as they grow in size
- When monopoly achieves substantial economies of scale, it is
possible that its lower costs will permit price and output levels that
approach those of a perfectly competitive industry
Evaluate the role of legislation and regulation in reducing monopoly power.
Legislation 1. Legislation to protect competition

+ Preventing collusion —> increase allocative efficiency —> lower
prices higher output
- Difficulties in proving that firms have colluded
- Difficulties in interpreting legislation (vague, conflicting views on
what involves anti-competition)
- Inconsistencies in implementing laws in different countries
2. Legislation preventing mergers

+ Limits on size of combined firms —> no possibility that a single
firm may be created from merging of smaller firms —> competition
- Questions and uncertainties about what firms should be allowed to
merge and which shouldn’t
- Inconsistencies in implementing laws in different countries
Regulation 1. Marginal cost pricing

+ Charge where P = MC —> allocative efficiency
+ Forces efficient allocation of resources —> quantity of good
produces to a socially desirable level
- Losses for natural monopolist (Pmc lies below ATC) —> shut down
2. Average cost pricing

+ Charge where P = ATC —> avoids creating losses for monopolists
+ Fair return pricing, where monopoly is forced to earn normal profit
- Productive inefficiency (not at minimum ATC)
- Allocative inefficiency (P ≠ MC)
Draw diagrams and use them to compare and contrast a monopoly market with a perfectly
competitive market, with reference to factors including efficiency, price and output, research and
development (R&D) and economies of scale.
Monopoly Perfect competition
Effiency • No allocative efficiency (P > MC) • Allocative efficiency (P = MC)

• No productive efficiency (production • Productive efficiency (production takes
higher than minimum ATC) place at minimum ATC)
Price and • Smaller quantity of output • Higher quantity of output

output • Higher price • Lower price
R&D • Economic profits maintained over LR • Small firms have no economic profits
gives financial resources to pursue R&D over LR that can finance R&D
• Product differentiation and new • Produce homogenous products and are
innovations are necessary to create not interested in product development or
barriers to entry creating barriers to entry
Economies • Yes (if big enough they might be able to • No

of scale achieve PC price and output level)
why is this chapter so

fucking long
what the fuck

Monopolistic competition
Describe, using examples, the assumed characteristics of a monopolistic competition: a large

number of firms; differentiated products; absence of barriers to entry and exit.
(Same as perfect competition, just with product differentiation.)

Large number of firms • Fairly large number of firms
• Firms are small relative to industry size and the actions of one firm are
unlikely to have great effect on competitors
• Firms act independent of each other
Differentiated products • Slightly product differentiation where a good or service is perceived to be
different from other goods or service in some way
- e.g. Brand name, colour, appearance, packaging, design, quality of
service, skill levels etc.
Absences of barriers to • Firms are able to freely enter / exit industry

entry and exit
e.g. Nail (manicure) salons, car mechanics, plumbers, and jewellers
Explain that product differentiation leads to a small degree of monopoly power and therefore to a
negatively sloping demand curve for the product.
• Product differentiation —> brand loyalty —> retains some customers despite increase in price —> firms
have some element of independence when deciding on price — “Price-makers”
- Price-makers face a downward sloping demand where MR < D
- Profit maximisation MC = MR (P, q)
- Relative elastic since there are many substitutes
Explain, using a diagram, the short-run equilibrium output and pricing decisions of a profit
maximising (loss minimising) firm in monopolistic competition, identifying the firm’s economic profit
(or loss).
SR abnormal SR loss
• Profit maximisation (MC = MR) • Profit maximisation (MC = MR)

• AC < P = abnormal profit (shaded area) • AC > P = loss (shaded area)
Explain, using diagrams, why in the long run a

firm in monopolistic competition will make
normal profit.
• In LR, SR abnormal profits attract new entrants

into the industry —> demand shifts to the left
and profit is competed away —> normal profit
• In LR, SR losses cause firms to shut down /

leave —> demand shifts to the right, and firms
pick up trade from leaving firms —> normal profit
• LR normal profit: maximising profits (MC = MR)

and C = P so firm is covering all costs including
OC. There is no incentive for firms to leave /
enter the industry.
Distinguish between price competition and non-price competition.
• Price competition: Occurs when a firm lowers its price to attract customers away from rival firms, thus
increasing sales at the expense of other firms.
• Non-price competition: Occurs when firms use methods other than price reductions to attract customers
from other firms / rivals
Describe examples of non-price competition, including advertising, packaging, product development

and quality of service.
• Product differentiation i s a common form of non-price competition

- Advertising, packaging, product development and quality of service convinces consumers that their
product is superior —> less elastic demand —> greater monopoly power —> increase firms potential
to increase SR economic profits
• Generally the more differentiated a product is from its competitors the more successful they are in
increasing sales and market share
Explain, using a diagram, why neither allocative

efficiency nor productive efficiency are achieved by
monopolistically competitive firms.
Short-run:
• In both abnormal profit and losses, we see that firm
produces at level of output where profit is maximised, as
opposed to the productively efficient level of output and
the allocatively efficient level of output.
Long run (still):

• Allocative inefficiency (P ≠ MC)
• Productive inefficiency (not minimum ATC)
Note: Product differentiation —> producing greater than

minimum ATC —> excess capacity (not so inefficient)
Compare and contrast, using diagrams, monopolistic competition with perfect competition, and
monopolistic competition with monopoly, with reference to factors including short run, long run,
market power, allocative and productive efficiency, number of producers, economies of scale, ease
of entry and exit, size of firms and product differentiation.
Monopolistic competition Perfect competition
Short run and • SR: Abnormal profit or losses

long run • LR: Normal profit
- Profits and losses disappear in the long run because of the lack of barriers to
enter / exit the industry (enter profitable industries; exit unprofitable)
Market power • Firms have some market power and • No market power and are unable to
ability to influence price influence price
• Product differentiation and brand loyalty, • Price takers, reflected in perfectly elastic
reflected in downward sloping demand demand curve
Efficiency • Achieves neither allocative efficiency nor • Allocative efficiency and productive
productive efficiency in LR (ATC not efficiency in LR
minimum —> higher prices than PC)
Number of • Lots
producers
Economies of • Small room for achieving economies of • Cannot achieve economies of scale
scale scale but only to a relatively small because they are too small
degree due to size limitations
Ease of entry • No barriers to enter / exit

and exit
Size of firms • Large number of firms

Product • Great lengths of product differentiation • Homogenous products
differentiation - Product variety is an advantage
over competitors though this is
what causes higher costs
Monopolistic competition Monopoly
Short run and • SR: Abnormal profit or losses • Monopoly able to earn abnormal profits
long run • LR: Normal profit in long run due to high barriers to entry
Market power • Firms have some market power and • Greater market power because there
ability to influence price reflected in are no substitutes for their good
downward sloping demand curve • Price-maker (downward sloping D)
Efficiency • Achieves neither allocative efficiency nor productive efficiency in LR
Number of • Large number of firms • Single / dominant firm(s) in industry
producers
Economies of • Small economies of scale • Greater potential for economies of scale

scale which can benefit consumer (low price)
Ease of entry • No barriers to enter / exit • High barriers to enter / exit

and exit
Size of firms • Smalls • Biggie

Product • Great lengths of product differentiation • Innovation / product differentiation
differentiation - Non-price competition required to keep up barriers to entry
Oligopoly
Describe, using examples, the assumed characteristics of an oligopoly: the dominance of the
industry by a small number of firms; the importance of interdependence; differentiated or
homogeneous products; high barriers to entry.
Dominance of the • Industry dominated by small number of firms which hole majority of
industry by a small percentage market share
number of firms
Importance of • Small number of firms in oligopoly —> interdependent

interdependence - Change in behaviour = major impact —> firms aware of rivals
- Collusion to act as monopoly (sometimes)
Differentiated or • Differentiated e.g. pharmaceuticals, cars, aircrafts, cereal etc.
homogenous products • Homogenous e.g. oil, steel, aluminium, copper, cement etc.
High barriers to entry • Economies of scale achieved by oligopolists make it difficult for new
firms to compete e.g. aircraft, car industry
• Legal barriers such as patents e.g. pharmaceutical
• Control of natural resources e.g. oil, copper, silver
• Aggressive tactics such as advertising or threats of takeovers of potential
new firms
• High start-up costs (the costs of starting a new firm associated with
developing / differentiating a product) —> oligopolies invest a lot in
product differentiation also
e.g. Oil, OPEC, the bunch
Explain why interdependence is responsible for the dilemma faced by oligopolistic firms— whether
to compete or to collude.
• Conflicting incentives
- Incentive to collude: Agreement between firms to limit competition between them, usually by fixing
the price / lowering quantity produced —> reduce uncertainties and behave as monopoly
- Incentive to compete: Vigorous competition in order to gain greater market share at expense of
other firms
Explain how a concentration ratio may be used to identify an oligopoly.
• Concentration ratio: Indication of the percentage of output produced b the largest firms for which a
concentration is calculated
- Higher the concentration ratio = lower the degree of competition; low concentration ratio = higher
degree of competition
Explain how game theory (the simple prisoner’s dilemma) can illustrate strategic interdependence
and the options available to oligopolies.
• Strategic interdependence and strategic behaviour: What happens to the profits of one firm depends on the
strategies adopted by the other firms, avoiding uncertainties and surprises
• Conflicting incentives (to collude or to compete)
• Worse off as a result of price competition / trying to capture sales from rivals by cutting prices since rivals
are likely to match price cuts —> all firms end up with lower prices and lower profits (price war)
• Strong interest in avoiding price wars —> incentive for non-price competition instead
Explain the term “collusion”, give examples, and state that it is usually (in most countries) illegal.
• Collusion: Agreement between firms to limit competition between them, usually by fixing the price /
lowering quantity produced —> reduce uncertainties and behave as monopoly (usually illegal)
Explain the term “cartel”. + Explain that the primary goal of a cartel is to limit competition between
member firms and to maximise joint profits as if the firms were collectively a monopoly.
• Cartel: Formal agreement between firms in an industry to take actions to limit competition in order to
increase profits
- Involves formal (open) collusion e.g. fixing quantity produced by each (price increase), fixing price at
which output can be sold, restrictions on non-price competition, dividing market according to
geography or other factors, setting up barriers to entry etc.
- Increase monopoly power —> increase profits (against interest of consumers)
- e.g. OPEC (Organisation for Petroleum Exporting Countries) setting production quotas and prices for
all world oil markets in a form of formal collusion, which is legal
Explain the incentive of cartel members to cheat.
• Firm that cheats is able to increase market share and profits at expense of other firms
Analyse the conditions that make cartel structures difficult to maintain.
• Many firms cheating —> cartel at danger of collapsing

• Cost difference between firms —> some firms with higher average costs and have lower profits —>
difficulties in agreeing on common price
• Firms face different demand curves based on market share
• Too many cooks too many cooks
• Price war
• Recessions
• Industry lacks dominant firm
• I’m so lazy
• Sorry
Describe the term “tacit collusion”, including reference to price leadership by a dominant firm.
• Tacit collusion: When firms in oligopoly charge the same prices without any formal collusion
- Price leadership by a dominant firm: Other firms follow a price change by dominant firm
- Not necessary to communicate price changes
Explain that the behaviour of firms in a non-collusive oligopoly is strategic in order to take account
of possible actions by rivals.
• Strategic behaviour: Plans of action that take into account rival’s possible actions
- Mutual interdependence —> planning / guessing actions to formulate own strategy —> avoid
surprises or unexpected outcomes
Explain, using a diagram, the existence of price

rigidities, with reference to the kinked demand curve.
Kinked demand curve representing non-collusive oligopolies,

where oligopolistic firms do not agree (informally and
formally) to fix prices or collaborate.
Each firm perceives demand curve it faces to be elastic for

prices above P, and inelastic for prices below P. If one firm
raises its price above P, the others will not follow; if it lowers
its price below P, the others will match the price decrease.
Firms are worse off in both cases.
Thus, no firm take incentive to change its price, and

oligopolies are stuck at point a for long periods of time.
Explain why non-price competition is common in oligopolistic markets, with reference to the risk of
price wars.
• Everyone is worse off in a price-war, so oligopolistic firms resort to non-price competition to gain market
share over the other firms
- Product differentiation increase firms profits without risks of retaliation, and takes time for firms to
retaliate
Describe, using examples, types of non-price competition.
• Considerable financial resources (due to large profits) —> invest in product differentiation, e.g. advertising,
branding
• Financial resources —> R&D —> development of new technology provides competitive edge —> increase
monopoly power, demand becomes less elastic 
Price discrimination
Describe price discrimination as the practice of charging different prices to different consumer
groups for the same product, where the price difference is not justified by differences in cost.
• Price discrimination: Practice of charging different prices to different consumer groups for the same
product, where the price difference is not justified by differences in cost
Explain that price discrimination may only take place if all of the following conditions exist: the firm
must possess some degree of market power; there must be groups of consumers with differing price
elasticities of demand for the product; the firm must be able to separate groups to ensure that no
resale of the product occurs.
Firm possesses some • Producer must have price-setting ability, i.e. market must be imperfect
degree of market power • Greater price-making ability = easier for price discrimination to take place
- Often found in oligopoly / monopoly markets
- Impossible in perfect competition
Groups of consumers • Differing PED = willing to pay different prices for product
with differing price - PED < 1 = prepared to pay higher prices than PED > 1
elasticities of demand - Elasticity signifies importance to customers
for the product
Firm able to separate • Separating groups prevents consumer that pays lower price to resell to
groups to ensure no consumer that pays higher price
resale of the product - Through time,age, gender, income, geographical distance, types of
occurs consumer etc.
Draw a diagram to illustrate how a firm maximises profit in third degree price discrimination,
explaining why the higher price is set in the market with the relatively more inelastic demand.
• Third degree price discrimination: Takes place when consumers are identified in different market
segments and a separate price is charged per segment (due to different PED)
- Inelastic demand signifies higher importance / inflexibility —> firms use this as an opportunity to
charge a higher price

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com IB Economics HL Notes

1.5 Theory of the firm and market structures

Production and costs

• Short run: At least one input is fixed

• Total product (TP): Total quantity of output produced by firm

• Generalised product curves (above)

Explain the law of diminishing returns.

TP = AP x units of variable input

AP = TP / Units of variable input

MP = Change in TP / Change in variable input

(Note: TP is cumulative, add in values from previous variable inputs)

• Total costs (TC): Sum of fixed and variable costs

Distinguish between total costs, marginal costs and average costs.

• Total costs (TC): Sum of fixed and variable costs

Draw diagrams illustrating the

• Generalised cost curves (shown)

• MC intersects both AVC and ATC curves

• AFC decreases as output increases

• Law of diminishing returns:

MC = Change TC / Change Q = Change TVC / Change Q

Explain, using a diagram, the

• LRAC decreases as output

LRAC is boundary between unit costs

Specialisation • Growth of firm —> workers / managers able to specialise in individual

Indivisibilities • Indivisibility of capital equipment

(OOS) Constant returns to scale

• Constant returns to scale: Increase in

• Qmes = minimum efficient scale

Distinguish between total revenue, average revenue and marginal revenue.

• When firm does not control price

• When firm controls price (seen above)

• Economic profit = Total revenue - economic costs

• Economic profit is profit over and above normal profit

Calculate different profit levels from a set of data and/or diagrams.

Revenue maximisation • Increasing sales —> revenue maximisation

Large number of firms • Industry is made up of a very large number of firms

e.g. EU wheat-growing industry

• Market equilibrium (P, Q) and perfectly elastic D results in P = D = AR = MR

Short-run abnormal profits Short-run losses

• Abnormal profits: Covering TC + OC • Losses: Not covering TC

SR abnormal —> LR normal SR loss —> LR normal

• Perfectly competitive firms make normal profits in LR

• SR and LR break-even price is P = minimum ATC

Productive and allocative efficiency in the long-run

Allocative efficiency but not productive efficiency in the short-run

1. Patents: Right given by government to firm that has developed a new

2. Licenses: Granted by governments for particular professions or

3. Copyrights: Guarantee that an author has sole rights to print, publish,

4. Public franchises: Granted by government to a firm which is to

5. Tariffs, quotas, and other trade restrictions: Limit quantities of a

• Monopolist firm = industry, so monopolist’s demand

Explain, using a diagram, the relationship between

• Monopolist has normal demand curve

• TR maximum when MR = 0 and PED = 1 (unit elastic)

Abnormal profit Losses

Note: Possible for industry to collapse when monopoly closes down.

Profit maximisation based on marginal revenue and cost approach