Market Structures

Question 1

What are internal economies of scale?

Answer 1

Internal EOS refer to a fall in average cost that a firm enjoys as it expands its scale of production

Question 2

List at least 3 examples of internal EOS.

Answer 2

Technical EOS: indivisibilities, specialization and division of labour

Marketing EOS: Bulk purchase, large-scale advertisement

Financial EOS: Increase in creditworthiness, cheaper to borrow funds

The above EOS will lead to a decrease in the unit cost of production. Remember to offer contextual examples in your answers.

Question 3

What is meant by external EOS?

Answer 3

External EOS refer to a fall in average cost that a firm enjoys as the industry expands

Question 4

What is the minimum efficient scale?

Answer 4

It is the minimum output level beyond which a firm can no longer reap internal EOS. It is usually used as an indicator of firm size.

Question 5

What are barriers to entry?

Answer 5

They are impediments which inhibit a potential firm from entering the market to compete with existing firms.

Question 6

What are some examples of barriers to entry?

Answer 6

Artificial- licensing/ long patent period/ laws enacted by government bodies

Natural- high start-up costs/ specific knowledge required/ technical know-how/ EOS gains resulting in a firm’s ability to sell a good at a low price which potential entrants cannot match.

Question 7

How can the impact of EOS on a firm’s price and output decision be illustrated on a diagram?

Answer 7

We can show a downward shift of MC curve to illustrate how price and output change with economies of scale. Note that the AC curve shifts down as well.

Question 8

What does the 70/30 rule refer to under this topic?

Answer 8

In explaining a firm’s pricing behavior (AKA price and output determination),

70% of the answer should be devoted to explaining how a firm maximizes profits based on the MC=MR condition.

The remaining 30% cover firm-specific types of pricing behavior – specifically (i) price-taking (PC); (ii) price-rigidity (oligopolies); and (iii) price discrimination (firms with market power, usually oligopolies and monopolies).

Remember to include the AC-curve when explaining pricing behavior (Cambridge’s requirement).

Question 9

What is meant by market power?

Answer 9

It is the ability of firms to set price above the marginal cost. Level of market power usually depends on the strength of barriers to entry.

Question 10

Define price discrimination

Answer 10

It is the practice of charging different price for different units of the same good or to different consumers, when such differences are not due to cost considerations.

Question 11

What is meant by allocative efficiency from a production view?

Answer 11

P=MC. That is, scare resources are directed to producing the right good in the right quantity, such that the price charged is equal to the marginal cost of producing the last unit of output.

Question 12

What is productive efficiency?

Answer 12

Production at the lowest cost, using the least cost combination of factors of production.

Question 13

What is dynamic efficiency?

Answer 13

It is growth in a firm’s efficiency over time, usually achieved through R & D. Dynamic efficiency can result in better-quality goods or cheaper products (through use of more efficient production techniques).

Question 14

Why do different market structures exist in the same industry?

Answer 14

When explaining the existence of various types of firms, we can attribute the difference to the following factors (BEN-S):

• Strength of barriers to entry
• Ability to earn EOS
• Nature of product/service
• Subcontracting relationships (i.e. some small firms exist to support larger firms).

Question 15

What do we consider under firm behavior?

Answer 15

When explaining behavior of a firm (a popular concept in the ‘A’ levels), recall that we consider both pricing and competitive behaviour.

Question 16

What are the IDENTIFYING features of a firm?

Answer 16

Use the BICEPS acronym.
Barriers to entry (consider both natural and artificial)
nature of Info
how they Compete
Economies of scale
Product nature
Share of market (consider whether the market concentration ratio table is available)

Question 17

Which 2 features in the BICEPS acronym are the most defining characteristics of a firm? (take note for low-weightage CSQ questions)

Answer 17

B (barriers to entry) and S (Share of market)

Question 18

How are market power and the level of barriers to entry related?

Answer 18

Because of high barriers to entry, new firms cannot enter an industry easily. Hence, existing firms are able to retain and grow their market share, resulting in the accumulation of market power (price-setting ability). Note that when a question asks for the basis of a firm’s market power, the answer should focus on the existence of high BTE.

Question 19

How do we DIFFERENTIATE between different types of firms?

Answer 19

Other than looking at differences in BICEPS, we should also consider the differences in profit outcomes (BICEPS + P)
Eg, Monopolies retain supernormal profits in the long run while MC firms earn only normal profits.

Question 20

Why do some firms remain small?

Answer 20

1) By choice: preference for flexibility and control
2) By nature: personalized service (e.g. nail spa); small clientele (e.g. walking sticks for visually impaired); small MES (usually tied to firms with low set-up cost, hence lack of scope to earn technical EOS); support big firms through sub-contracting

Question 21

What are some factors that affect marginal cost (MC)?

Answer 21

EOS, technology, wage and rental changes

Note that a change in variable cost affects both MC and AC, while a change in fixed cost affects AC also. EOS affects both MC and AC curves.

Question 22

What are some factors that affect MR?

Answer 22

Level of barriers to entry determine the existing position and steepness of the MR curve, while changes in demand conditions (EGYPT) lead to shifts in the MR curve (due to shifts in AR/dd).

A change in market share due to entry or exit of firms should affect both the position (demand) and slope (PED) of the AR and MR curves.

Question 23

How do we explain why profits are maximized at the point where MC equals MR?

Answer 23

From a graphical point of view, any production to the left of where MC = MR means that the firm can earn more profits by producing more. This is because the addition to total cost is lower than the addition to total revenue from an extra unit of output.

Similarly, any production to the right of where MC=MR means that the firm can increase profits by producing less, since the addition to total cost is higher than the addition to total revenue from an extra unit of output.

Hence profits will be maximized when MC = MR, where MC is rising.

Question 24

Why is a perfect competitive firm a price taker?

Answer 24

The market price is determined by the intersection of the market demand and supply curves and the firm must accept this price. If the firm sets a price above this price, it will lose all its customers which turn towards other firms selling the same product. There is also no incentive to undercut the market price since the PC firm can sell as much as it wants at the market equilibrium price (hence a perfectly-elastic demand curve)

Question 25

Why do PC firms earn normal profits in the long run?

Answer 25

Since there are no barriers to entry, new firms can enter easily and erode away the supernormal profits. Similarly, when earning subnormal profits, firms will leave the industry in the long-run, leaving remaining firms with normal profits. The adjustment in profits is due to shifts in the market supply curve, which changes the equilibrium price that PC firms have to take.

Question 26

Why does price rigidity occur among oligopolies?

Answer 26

Price rigidity occurs among oligopolies due to mutual interdependency between firms. This is based on the assumption that rival firms match price decreases but not price increases.

Hence, any price increase will lead to a firm losing disproportionately more customers to its competitors; while if it decreases its price, this will not bring in a proportionate increase in the number of customers. In both cases, total revenue falls for the firm. ,Hence there is no incentive for the firm to deviate from the equilibrium price, even when there are small changes in the marginal cost.

Question 27

Will oligopolies always experience price rigidity?

Answer 27

If the change is marginal cost is too big (such that the new MC curve does not cut the vertical section of the MR curve), the equilibrium price will change.

Also note that price rigidity is just one of the many theories which explain an oligopolistic firm’s behavior.

Question 28

What should students consider when asked whether firms ALWAYS set price based on the profit-maximising condition?

Answer 28

1) Explain why production at MC (rising)=MR is profit-maximising.
2) Explain that determination of cost function (MC) may not always be straightforward due to difficulty in estimating economic cost (which includes implicit cost).
3) Explain that determination of revenue function (MR) may not always be straightforward due to the range of factors that affect AR, and hence MR (EGYPT).
4) Explain that firms may possess alternative objectives (show revenue-max and market-share max objectives on diagram). Loss-leader strategy can be discussed too.
5) Explain that firms subject to MC/AC-pricing may be unable to produce at the point where MC=MR.
6) Synthesise by stating that alternative objectives may not always be incongruent with profit-maximisation, especially in the long run. E.g. a firm seeking to maximize market share in the short run may maximize profits thereafter, given a larger and steeper set of revenue curves (with more market share).

Question 29

What are the criteria that a firm must meet before it can practise price discrimination?

Answer 29

The firms must possess extensive market power

The firm must have the ability to segment the market based on different PED values. The resale of goods across different markets must not be possible.

Resale here does not just refer to the possibility of re-selling tickets bought directly from the organiser. Specifically, we are referring to the sale of cheaper tickets from the price-elastic market to consumers in the price-inelastic market (otherwise known as ‘arbitrage’).

Question 30

When answering questions on price discrimination, what do students have to note?

Answer 30

1) Check against definition of price discrimination (same good; no difference in cost)
2) Identify type of pd (usually 3rd deg)
3) Check against criteria for pd (market power; segment markets based on different PED; resale not possible)
4) Evaluate if question accounts for 4m or more.

Question 31

Does price rigidity mean that firms set price at the same level?

Answer 31

No. Price rigidity explains the reluctance of firms to change prices, and does not necessarily require firms to charge the same price.

Question 32

What is 1st degree price discrimination?

Answer 32

Consumers are charged the maximum price which they are willing to pay for each unit of the good. (AR becomes MR).

Question 33

What is 2nd degree price discrimination?

Answer 33

It is known as block pricing, where the firm sets a price of P0 for the first Q0 units of the good, followed by a lower price P1 for subsequent (Q1-Q0) units, usually to encourage bulk purchase.

Question 34

What is 3rd degree price discrimination?

Answer 34

A lower price is charged in the market with price-elastic demand and a higher price in the market with price-inelastic demand. The purpose is to increase total revenue earned.

Question 35

What aspects should we consider when evaluating whether higher prices represent an act of price discrimination?

Answer 35

1) Subtle cost differences:
For example, movie tickets are more costly during the weekend, and this resembles price discrimination since the duration of the movie and the cost of screening the movie remains unchanged. However, if the cost of hiring ushers and ticket salesperson is higher during the weekends, then the difference in ticket prices may be partly due to cost differences.

2)	Whether quality differences justify price differentials: 
For example, while passengers on business class enjoy better service and comfort, these material differences may not fully justify the extra thousands of dollars that business class travelers pay compared to economy class travelers. 

3) Is the government involved?
Price discrimination may not always happen due to monopolies seeking higher revenue, but could be a consequence of government regulation. For example, public transport operators may be required by the government to charge concessionary fees to students and senior citizens to promote greater equity in society.

Question 36

What does having high BTEs suggest?

Answer 36

The firm’s revenue curves are steeper and higher, hence it has higher price-setting ability.

Question 37

Will a dominant firm always charge a higher price than a more competitive firm?

Answer 37

Not necessarily. If the larger output scale associated with monopolies allows it to reap higher economies of scale, they may experience lower marginal costs, which can be passed down to consumers in the form of lower prices. Hence, from a graphical point of view, the monopoly will be able to charge a lower price, which is closer or even lower compared to an MC firm.

Question 38

How do firms engage in non-price competition?

Answer 38

1) Product development (real) –e.g. undertaking R and D to improve the quality of products
2) Product promotion (imaginary) –e.g. through advertising campaigns to promote brand awareness and brand loyalty. Note that this may result in wastage of resources.

Question 39

Do PC firms engage in price competition?

Answer 39

No, since they are price takers. PC firms only make normal profits in the long run and can sell as much as they want at prevailing market prices.

Question 40

Do MC firms engage in price competition?

Answer 40

Seldom. Rather, they engage in non-price competition. Since their products are slightly differentiated, any non-price competition is likely to be taken on a smaller scale, given the MC’s inability to retain supernormal profits in the long run.

Question 41

What is the significance of an MC-firm experiencing excess capacity?

Answer 41

Due to an MC-firm being able to earn only normal profits in the long run, its long-run equilibrium output level will be lower than the minimum point of the LRAC (since a downward-sloping AR curve can only cut the LRAC at a tangent). Hence, internal EOS are not fully reaped. Productive efficiency from society’s perspective is not achieved.

Question 42

Do oligopolies engage in price competition?

Answer 42

Firms mainly engage in non-price competition through product development or product promotion due to the assumption that rival firms match price decreases but not price increases.

However, firms may engage in aggressive price wars in an attempt to force out competitors and to secure more market share for themselves. Predatory pricing to discourage entry of new firms is likely too.

Question 43

Do monopolies engage in price competition?

Answer 43

Since a monopoly is a single producer of a good, monopolies generally do not need to engage in competition. However, when the market is contestable, monopolies may engage in predatory pricing or product innovation to restrict competition and to secure their dominant position.

Question 44

What do producers seek to maximise?

Answer 44

Profits, which can be attained through higher revenue and lower cost

Question 45

What do consumers seek to maximise?

Answer 45

Consumer surplus (price and output), variety and quality

Question 46

What does the government seek to achieve within a society?

Answer 46

Efficiency (AE, PE and DE) and equity

Question 47

When asked to explain why a certain market structure e.g. oligopoly is becoming more prevalent, what should we consider?

Answer 47

• Small firms are becoming bigger (link to benefits of large-scale production e.g. EOS and higher revenue)
• Large firms are retaining market share (link to high BTE)
• Monopoly power is being eroded (e.g. due to globalisation and advancement of technology, traditional BTEs e.g. licensing/cost-advantage through EOS are being eroded).

Question 48

What is the impact of higher market power on producers’ revenue?

Answer 48

Generally, revenue will rise.

1) With higher market power, demand curves are steeper and higher. Hence, firms gain a revenue advantage and can charge a higher price to increase revenue.
2) With higher market power, firms will be able to practise price discrimination to earn higher revenue.
3) Revenue benefits from expansion across markets

Question 49

What is the impact of higher market power on producers’ cost?

Answer 49

1) As firms enjoy economies of scale, the marginal cost of production may drop.
2) If the firm grows beyond an optimal size, diseconomies of scale may set in.

Question 50

What is the impact of higher market power on consumers? (take note of impact on surplus, variety and quality)

Answer 50

1) Consumer surplus falls as monopolies can charge a higher price and reduce the output.
2) With 1st degree PD, ALL consumer surplus is siphoned off
3) With EOS, monopolies may pass on cost-savings in the form of lower prices and higher output (higher surplus), although this depends on whether the market is facing a threat of competition.
4) Product variety falls due to fewer producers.
5) 1st degree PD may lead to the possibility of supplying goods with higher average cost, which would otherwise not be produced, hence adding to variety.
6) There may be dynamic efficiency as monopolies earn supernormal profits and can engage in R and D to improve the quality of products, although the incentive to do so is questionable.

Question 51

What is the impact of higher market power on efficiency (from society’s point of view)

Answer 51

1) There is a greater loss of allocative efficiency since the gap between P and MC is now larger
2) There is a loss of productive efficiency since there is a lack of competitive pressures. Hence, firms may have lax controls over cost.
3) There may be increased dynamic efficiency as monopolies earn supernormal profits and can engage in R and D to improve the quality of products. However, the incentive to do so is questionable

Question 52

What is the impact of higher market power on equity (from society’s point of view)

Answer 52

1) Higher prices set in a dominant firm setting may result in lower-income families not being able to afford the good, especially in the case of necessities, worsening equity
2) However, with 3rd degree PD, equity may be improved for certain groups of people with PED > 1 as the good is now offered to them at a lower price.
3) Between producers and consumers, the income gap may grow as producers siphon off consumer surplus

In general, when considering equity from a consumer’s point of view, the good in question is usually a necessity. When considering equity between two different parties (e.g. consumers and producers), we assess whether one party gains at the expense of the other.

Question 53

What is the shut-down condition?

Answer 53

In the short run–when average variable cost is higher than average revenue.

In the long run, if the firm makes subnormal profits, it will leave the industry.

Take note that when questions ask about the “survival” of a firm, this could be a cue to consider the shutdown condition too.

Question 54

Explain the framework that can be used when assessing the impact of an event on a firm.

Answer 54

Cost impact
Revenue impact
Adaptive ability
Supernormal profits available to cushion adverse impacts?
Shut-down condition

Question 55

When is the 4-lined diagram used?

Answer 55

To compare a dominant firm with a less dominant one (firm-level comparison). Useful for illustrating different revenue outcomes. The gap between P and MC can be used to illustrate different extents to which allocative efficiency is lost.

Question 56

When is the monopoly-PC diagram used?

Answer 56

To compare a PC market with a monopoly (market-level comparison). Useful to illustrate the deadweight loss that exists under a monopoly. Most commonly-used diagram to evaluate the impact of market power on a firm’s performance.

Question 57

What is the difference between productive efficiency at firm and societal levels?

Answer 57

While a firm is productively efficient as long as it produces along the long-run average cost curve (LRAC), it is only productively efficient from a societal angle if the firm produces at the lowest point of its LRAC, i.e. the MES. This means that the firm must have the ability to reap economies of scale.

Question 58

Distinguish between fixed cost and variable cost.

Answer 58

Total fixed costs are costs that do not vary with output (e.g. rental, cost of buying machines) and total variable costs are costs that vary positively with output (e.g. cost of hiring employees that will increase with more output)

Question 59

Distinguish between horizontal integration and vertical integration.

Answer 59

Horizontal integration occurs when 2 or more firms producing the same product or service come together. Such mergers allow for EOS to be reaped and make the firm more competitive in the industry.
Vertical integration involves the joining of firms that are at different stages of production

Question 60

What does total cost comprise of?

Answer 60

Total cost is the sum of total fixed cost (cost incurred even if production level is zero and total variable cost (cost that varies positively with output)

Question 61

What are some alternative objectives of firms?

Answer 61

1) Market share maximization.

2) Revenue maximization

Question 62

Evaluate MC-pricing and AC-pricing.

Answer 62

MC-pricing: firm makes a loss, but can be covered with 2-part tariif though concerns over equity may remain.

AC-pricing: no AE, but output rises/price falls. Firms may suffer from lack of dynamic eff (no supernormal profits) and productive eff (push up AC, since only normal profits can be made).