Imperfect Competition

A firm with market power faces a downward-sloping demand curve, so to sell one more unit it must cut its price, and (unless it can price discriminate) that lower price applies to every unit it sells. That puts its marginal revenue (MR) curve below the demand curve; for a straight-line demand curve, MR starts at the same point on the price axis and falls twice as steeply. MR is positive where demand is elastic and negative where it's inelastic, so a profit-maximizing firm with market power produces in the elastic range of its demand curve. Barriers to entry, such as high start-up costs, legal protections like patents, or control of a key resource, keep rivals out.

A monopoly is the only seller of a product with no close substitutes, protected by barriers to entry. A natural monopoly happens when economies of scale let one firm supply the whole market at a lower average total cost than several firms could. On a graph with price on the vertical axis and quantity on the horizontal, the monopolist produces where MR = MC and charges the price on the demand curve directly above that quantity. Its profit is (P − ATC) × Q when price is above average total cost. Because price stays above marginal cost, it produces less than the efficient quantity, which leaves a deadweight loss.

Price discrimination means charging different buyers different prices for the same product when the difference isn't due to cost. It only works if the seller has market power, can tell groups of buyers apart, and can stop them from reselling. A perfectly price-discriminating firm charges every buyer the most they're willing to pay, so its marginal revenue curve is the demand curve. It produces the efficient quantity, where demand meets marginal cost, so there's no deadweight loss, but consumer surplus is zero and the firm captures all of the surplus.

Monopolistic competition has many firms selling differentiated products (think restaurants or hair salons) with easy entry and exit. Each firm has a downward-sloping demand curve and competes through branding, quality and advertising. Short-run profits draw in new firms and losses push firms out until each firm's demand curve just touches its average total cost curve. In the long run, price equals ATC and economic profit is zero, but the firm still produces less than the quantity at minimum ATC (excess capacity) and charges a price above marginal cost.

An oligopoly is a market with a few large firms, protected by high barriers to entry, that are interdependent: each firm's best choice depends on what its rivals do. Firms can gain by colluding like a cartel, but each one has a reason to cheat on the deal. Game theory models these choices with a payoff matrix for two players with two choices each. A dominant strategy is best no matter what the other player does, and a Nash equilibrium is a pair of choices where neither player can do better by changing only its own choice. In a prisoner's dilemma, that equilibrium leaves both players worse off than if they had cooperated.