How does the degree of competition shape price, output and efficiency, from perfect competition to contestable markets?
1.4 Market structures: the spectrum of competition, the characteristics and outcomes of perfect competition, barriers to entry and exit, and the theory of contestable markets.
An OCR H460 answer to market structures, covering the spectrum from perfect competition to monopoly, the assumptions and short-run and long-run outcomes of perfect competition, barriers to entry and exit, and the theory of contestable markets.
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What this dot point is asking
OCR wants you to place market structures on a spectrum from perfect competition to monopoly, to explain the assumptions and the short-run and long-run outcomes of perfect competition, to identify barriers to entry and exit, and to explain the theory of contestable markets.
The spectrum of competition
The more competitive the structure, the less market power any single firm has, the lower the price and the closer the outcome to allocative and productive efficiency. As you move toward monopoly, firms gain price-setting power and can earn persistent supernormal profit.
Perfect competition
Perfect competition is a theoretical benchmark with four assumptions: many small buyers and sellers, a homogeneous (identical) product, perfect information, and free entry and exit with no barriers. These mean each firm is a price-taker: it must accept the market price and faces a horizontal (perfectly elastic) demand curve, so price equals average revenue equals marginal revenue.
- Short run. A firm produces where . If the market price is above average cost, it earns supernormal profit; if below, it makes a loss but continues while price covers average variable cost.
- Long run. Supernormal profit attracts new entrants (free entry), raising supply and lowering price until only normal profit remains. Losses cause exit until losses are eliminated. In long-run equilibrium price equals minimum average cost, so the firm is productively efficient (lowest AC) and allocatively efficient ().
Barriers to entry and exit
The height of barriers largely determines how competitive a market really is, which leads directly to the theory of contestable markets.
Contestable markets
In a perfectly contestable market, incumbents cannot earn supernormal profit for long, because any such profit would attract entrants who could enter, undercut and leave before incumbents respond. To deter this, incumbents may use limit pricing (setting price low enough to make entry unprofitable). Contestability theory shifted competition policy toward keeping entry easy (removing barriers) rather than just counting firms.
Examples in context
- Agricultural and commodity markets. Wheat and foreign-exchange markets approximate perfect competition: many traders, near-homogeneous products and price-taking behaviour.
- Airline routes. Often cited as contestable: low sunk costs (aircraft can be redeployed) mean the threat of entry can discipline incumbents on a route even with few carriers.
- Patents as barriers. Pharmaceutical patents are a legal barrier to entry that lets firms earn supernormal profit to recoup research costs.
Try this
Q1. State the four assumptions of perfect competition. [4 marks]
- Cue. Many small firms, homogeneous product, perfect information, free entry and exit.
Q2. Explain what makes a market contestable. [3 marks]
- Cue. Low barriers to entry and exit and low sunk costs, so the threat of entry disciplines incumbents.
Exam-style practice questions
Practice questions written in the style of OCR exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
OCR H460/01 20205 marksExplain why a firm in perfect competition earns only normal profit in the long run.Show worked answer →
A short structured question. State the assumptions of perfect competition: many small firms, a homogeneous product, perfect information, and free entry and exit, so each firm is a price-taker facing a horizontal demand curve (price equals AR equals MR).
Develop the chain: if firms earn supernormal profit in the short run, free entry attracts new firms; supply rises, price falls, and profits are competed away until only normal profit remains. If firms make losses, some exit, supply falls, price rises, and losses are eliminated. In long-run equilibrium price equals minimum average cost, so only normal profit is earned.
Markers reward the assumptions, the entry and exit mechanism, and the long-run equilibrium where only normal profit remains.
OCR H460/01 202312 marksAssess whether a contestable market delivers the same benefits as perfect competition.Show worked answer →
A levels-of-response question. Knowledge and application: define a contestable market (low barriers to entry and exit, so the threat of entry disciplines incumbents, even with few firms) and perfect competition (many firms, homogeneous product). Explain that contestability relies on hit-and-run entry and sunk costs being low.
Analysis: a contestable market can force incumbents to price near average cost and stay efficient because of the entry threat, mimicking some competitive outcomes even with few firms.
Evaluation: contestability is rarely perfect (sunk costs and incumbent advantages exist), incumbents may use limit pricing or build barriers, and a contestable market need not give the full allocative efficiency of perfect competition. Conclude that contestability delivers some but not all of the benefits, depending on how low barriers really are.
Related dot points
- 1.4 Imperfect competition: monopolistic competition, oligopoly and interdependence, monopoly and price discrimination, and the costs and benefits of monopoly power.
An OCR H460 answer to imperfect competition, covering monopolistic competition, oligopoly and interdependence (collusion, price wars and non-price competition), monopoly and price discrimination, and the costs and benefits of monopoly power.
- 1.4 Costs, revenues and profit: fixed and variable costs, marginal, average and total cost, the law of diminishing returns, economies and diseconomies of scale, total, average and marginal revenue, and normal and supernormal profit.
An OCR H460 answer to costs, revenues and profit, covering fixed and variable costs, marginal, average and total cost, the law of diminishing returns, internal and external economies and diseconomies of scale, the revenue concepts, and normal versus supernormal profit.
- 1.4 Business objectives: profit maximisation, revenue and sales maximisation, growth, satisficing and corporate social responsibility, and the principal-agent problem from the divorce of ownership and control.
An OCR H460 answer to business objectives, covering profit maximisation at MC equals MR, revenue and sales maximisation, growth, satisficing and corporate social responsibility, and the principal-agent problem that arises from the divorce of ownership and control.
- 1.4 The labour market: the demand for and supply of labour, wage determination in competitive labour markets, monopsony, trade unions, and the effect of a national minimum wage.
An OCR H460 answer to the labour market, covering the derived demand for and supply of labour, wage determination in a competitive labour market, monopsony employers, trade unions and collective bargaining, and the employment effects of a national minimum wage.
Sources & how we know this
- OCR A Level Economics (H460) Specification — OCR (2023)