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Credit Sprint's Guide to Microeconomics Unit 4: Imperfect Competition

AP® weight 15–22%CLEP® weight 18–24%

When firms have market power, they face downward-sloping demand, so marginal revenue is below price. A monopoly produces where MR = MC, charges the price on the demand curve, and creates deadweight loss. Monopolistic competitors earn zero economic profit in the long run with excess capacity, and oligopolists act strategically, which game theory models with payoff matrices.

What you need to know

  • For a single-price monopolist, MR < P because lowering price to sell one more unit lowers it on every unit.
  • A monopolist sets Q where MR = MC, then charges the highest price buyers will pay at that Q (read up to demand).
  • A monopolist always operates on the elastic portion of demand (where MR > 0).
  • Monopoly is allocatively inefficient (P > MC) and creates deadweight loss; it can earn long-run profit because of barriers to entry.
  • Natural monopoly: economies of scale over the whole market. Regulators can set P = MC (socially optimal, may need a subsidy) or P = ATC (fair return, zero economic profit).
  • Perfect price discrimination: MR = D, output rises to the efficient level, there is no deadweight loss, and the firm captures all consumer surplus.
  • Monopolistic competition: differentiated products and free entry, so long-run ATC is tangent to demand: zero economic profit, P > MC, and excess capacity.
  • Oligopoly: few interdependent firms. A dominant strategy is best no matter what the rival does. In a Nash equilibrium, neither player can gain by changing strategy alone.
  • Cartels are unstable because each member has an incentive to cheat by producing more.

Formulas

Linear demand P = a − bQ → MR = a − 2bQ (twice as steep)
Profit = (P − ATC) × Q
Socially optimal regulation: P = MC; fair-return regulation: P = ATC

Exam traps

Watch forMonopolies do NOT charge the highest possible price. They charge the price on demand at the MR = MC quantity.
Watch forRead the price off the DEMAND curve, not the MR or MC curve.
Watch forA dominant strategy compares payoffs for ONE player across the rival's choices. Look at the right number in each cell.
Watch forLong-run zero profit in monopolistic competition still has P > MC (not allocatively efficient).

Key terms

  • Monopoly: A single seller of a product with no close substitutes, protected by barriers to entry.
  • Barriers to entry: Anything that keeps new firms out: patents, control of a key resource, economies of scale, licenses.
  • Marginal revenue (monopoly): Below price, because selling another unit requires lowering the price on all units.
  • Natural monopoly: An industry where one firm can supply the whole market at lower ATC than two or more firms.
  • Socially optimal price: Regulated price where P = MC. Allocatively efficient, but a natural monopoly may need a subsidy.
  • Fair-return price: Regulated price where P = ATC, giving the monopoly zero economic profit.
  • Price discrimination: Charging different customers different prices for the same good, based on willingness to pay.
  • Monopolistic competition: Many firms selling differentiated products with easy entry. Zero economic profit in the long run.
  • Excess capacity: Producing less than the output at minimum ATC. Typical of monopolistic competition in the long run.
  • Oligopoly: A market with a few large, interdependent firms and high barriers to entry.
  • Dominant strategy: A strategy that gives a player the best payoff no matter what the other player does.
  • Nash equilibrium: An outcome where no player can do better by changing only their own strategy.
  • Cartel: A group of firms that agree to restrict output and raise prices. Unstable because members want to cheat.
  • Product differentiation: Making a product different from rivals' through quality, style, location or brand.

Practice questions

Five of the 52 Unit 4 questions in Credit Sprint. Every choice is explained in the app.

1. For a single-price monopolist, marginal revenue is less than price because
  1. its costs rise as it produces more
  2. demand is perfectly elastic
  3. it faces many competitors
  4. the government taxes each unit
  5. to sell one more unit, it must lower the price on all units it sells
Show answer

to sell one more unit, it must lower the price on all units it sells. The price cut on earlier units drags MR below price.

2. The deadweight loss from monopoly exists because the monopolist
  1. produces too much
  2. has high fixed costs
  3. charges a price below marginal cost
  4. earns economic profit
  5. produces less than the quantity where price equals marginal cost
Show answer

produces less than the quantity where price equals marginal cost. Units worth more to buyers than they cost aren't produced.

3. Monopolistic competition is characterized by
  1. a few firms that are interdependent
  2. high barriers to entry
  3. many firms with identical products
  4. many firms, differentiated products and easy entry
  5. one firm with no close substitutes
Show answer

many firms, differentiated products and easy entry. Like restaurants, salons and clothing stores.

4. Two firms choose High or Low prices. Payoffs (Firm A, Firm B): both High (50, 50); A High, B Low (10, 70); A Low, B High (70, 10); both Low (30, 30). The Nash equilibrium is
  1. both Low
  2. A High, B Low
  3. A Low, B High
  4. there is no Nash equilibrium
  5. both High
Show answer

both Low. Low is each firm's dominant strategy: 70 > 50 and 30 > 10.

5. If a linear demand curve is P = 80 − Q, the marginal revenue curve is
  1. MR = 80 − Q
  2. MR = 40 − Q
  3. MR = 160 − 2Q
  4. MR = 80 − 2Q
  5. MR = 80 − 0.5Q
Show answer

MR = 80 − 2Q. Same intercept, twice the slope.