AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/4/4-1)
Unit 4 · Topic 4.1
4.1 Introduction to Imperfectly Competitive Markets
Most firms aren't price takers. When a firm faces a downward-sloping demand curve, it has to lower its price to sell more, so each extra unit brings in less than its price. This topic sets up the marginal revenue curve and the barriers to entry that every later topic in the unit uses.
Key terms
- market power
- price maker
- barriers to entry
- marginal revenue
- elastic range of demand
- total revenue test
Price takers and price makers
In perfect competition (3.7), each firm is a price taker. It's so small that it can sell as much as it wants at the market price, so its demand curve is a horizontal line at that price, and price = marginal revenue (MR) = average revenue.
An imperfectly competitive firm has market power: some ability to set its own price. It's a price maker. Its demand curve slopes down, so if it raises its price it loses some customers but not all of them, and if it wants to sell more it has to cut its price.
The three imperfectly competitive structures in this unit differ in how many firms there are and how easy it is to get in.
| Market structure | Number of firms | Product | Barriers to entry | Example |
|---|---|---|---|---|
| Perfect competition (3.7) | Very many | Identical | None | Wheat farms |
| Monopolistic competition (4.4) | Many | Differentiated | Low | Pizza places |
| Oligopoly (4.5) | A few | Identical or differentiated | High | Cell phone carriers |
| Monopoly (4.2) | One | No close substitutes | Very high | A local water utility |
Why marginal revenue is less than price
Marginal revenue is the extra total revenue from selling one more unit. For a firm that charges everyone the same price, selling one more unit has two effects. You gain the price of the extra unit. But you also had to cut the price on all the units you were already selling.
Say a firm sells 4 units at $12 (total revenue $48). To sell a 5th, it must drop the price to $10. Now total revenue is 5 × $10 = $50. The 5th unit sold for $10, but MR is only $2, because the first 4 units each lost $2.
So after the first unit, MR is below price at every quantity. (A firm that can charge each buyer a different price avoids this; see 4.3.)
Drawing demand and MR
Put price and revenue on the vertical axis and quantity on the horizontal axis. Demand (which is also average revenue) is a downward-sloping line. For a straight-line demand curve, the MR curve starts at the same point on the vertical axis but falls twice as steeply. It crosses the horizontal axis at exactly half the quantity where demand hits the horizontal axis.
Example: if demand runs from $40 on the price axis down to 80 units on the quantity axis, MR runs from $40 down to 40 units and keeps going below zero after that.
MR, elasticity and the total revenue test
Recall the total revenue test (2.3): if a price cut raises total revenue, demand is elastic; if it lowers total revenue, demand is inelastic. Since MR is the change in total revenue, it tells you where you are on the demand curve.
- MR > 0: total revenue rises as output rises, so demand is elastic. This is the upper-left part of a straight-line demand curve.
- MR = 0: total revenue is at its maximum, and demand is unit elastic. This is the midpoint of a straight-line demand curve.
- MR < 0: total revenue falls as output rises, so demand is inelastic. This is the lower-right part.
- A profit-maximizing firm with market power produces where MR = MC (3.5). Marginal cost is positive, so MR must be positive too. That's why these firms always operate in the elastic range of demand.
Barriers to entry
Market power only lasts if rivals can't easily copy you. Anything that keeps new firms out is a barrier to entry.
- High start-up costs or economies of scale: a new firm can't match an established firm's low average cost.
- Legal protection: patents, copyrights, licenses and government franchises.
- Control of a key resource, like the only mine for a mineral.
- Network effects: a product is worth more when more people already use it, like a social media platform.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Finding marginal revenue from a demand schedule
A firm faces this demand schedule: at $18 it sells 1 unit, at $16 it sells 2, at $14 it sells 3, at $12 it sells 4, at $10 it sells 5 and at $8 it sells 6. Find total revenue and marginal revenue at each quantity. Where is demand elastic, and where is it inelastic?
Show the solutionHide the solution
- Step 1: Total revenue = price × quantity: 1 × 18 = $18, 2 × 16 = $32, 3 × 14 = $42, 4 × 12 = $48, 5 × 10 = $50, 6 × 8 = $48.
- Step 2: Marginal revenue = change in total revenue: $18, then 32 − 18 = $14, 42 − 32 = $10, 48 − 42 = $6, 50 − 48 = $2, and 48 − 50 = −$2.
- Step 3: Compare with price. The 3rd unit sells for $14 but adds only $10 of revenue, because the first 2 units now sell for $2 less each. After the first unit, MR is always below price.
- Step 4: MR is positive from 1 to 5 units, so demand is elastic in that range (price cuts raise total revenue). MR is negative going from 5 to 6 units, so demand is inelastic there.
Answer: TR: $18, $32, $42, $48, $50, $48. MR: $18, $14, $10, $6, $2, −$2. Demand is elastic up to 5 units and inelastic between 5 and 6 units.
- Example 2
Should a firm in the inelastic range raise its price? (classic trap)
A firm with market power is selling at a point where demand for its product is inelastic. A manager argues: 'Our customers barely respond to price, so we're doing fine. Raising the price would lose sales.' Is the firm maximizing profit?
Show the solutionHide the solution
- Step 1: Inelastic demand means a price increase raises total revenue, because quantity falls by a smaller percentage than price rises.
- Step 2: Raising the price also means selling fewer units, so total cost falls.
- Step 3: Revenue up and cost down means profit rises. So the firm is not maximizing profit; it should raise its price.
- Step 4: Another way to see it: in the inelastic range, MR < 0, and marginal cost is positive, so MR can't equal MC there. The profit-maximizing point must be in the elastic range.
Answer: No. The firm should raise its price and sell less, moving into the elastic part of its demand curve; this raises total revenue and lowers total cost.
Common mistakes
- Drawing MR on top of the demand curve for a firm with market power. MR = demand only for a perfectly competitive firm (or a perfect price discriminator); otherwise MR lies below demand.
- Drawing MR hitting the quantity axis at the same place as demand. For a straight-line demand curve, MR hits the axis at half that quantity.
- Thinking 'price maker' means the firm can charge any price it likes. It picks a price, but demand decides how much it can sell at that price.
- Saying a monopolist produces where demand is inelastic because buyers 'need' the product. As long as marginal cost is positive, a profit-maximizer always produces in the elastic range.
On the exam
- Expect to be asked where total revenue is maximized (where MR = 0, the unit-elastic midpoint) or whether demand is elastic at a given quantity. Check the sign of MR.
- On a graph you describe, label the vertical axis 'Price' and the horizontal axis 'Quantity', and make clear that MR starts at the same price intercept as demand and lies below it.
Connected topics
Videos
Check yourself
4 questions on 4.1 Introduction to Imperfectly Competitive Markets. Pick an answer to see if you got it, and why.
| Price | Quantity demanded (units) |
|---|---|
| $18 | 1 |
| $16 | 2 |
| $14 | 3 |
| $12 | 4 |
| $10 | 5 |
| $8 | 6 |
| $6 | 7 |
Hypothetical demand schedule for a firm with market power that charges the same price to every buyer
What is the marginal revenue from selling the fourth unit?
When the firm lowers its price from $10 to $8, which of the following is true?
If the firm's marginal cost is constant at $5 per unit, what quantity and price maximize its profit?
The marginal revenue of the second unit ($14) is less than its price ($16) because
0 of 4 answered