Paper 1 - Market Structures

Question 1

Draw and Analyse Long run Equilibrium under Perfect Competition (9)

Answer 1

1. Market price is set through interactions of the market forces of supply and demand, resulting in equilibrium price being P1 and output of the whole industry being Q1.
2. As goods are homogeneous and there are many sellers in the market who are all “price takers “ as they are unable to charge a price above P1 due to demand being perfectly price elastic (if they increase the price demand will fall), which is caused by perfect knowledge held by both firms and consumers.
3. This results in the demand curve ( also AR + MR curve) being horizontal. Firms are still able to increase output sold without cutting prices meaning P1 is also the Marginal revenue for each unit.
4. MC curve will cut the AC curve at the lowest point because when MC>AC this causes a rise in AC.
5. Due to firms being profit maximisers they produce where MR = MC which is at q1.
6. At q1 this firm produces on the lowest point of the AC curve meaning it is productively efficient due to it fully exploiting economies of scale, resulting in it also being X efficient
7. Furthermore at Q1, the price P1 is equal to the MC meaning it is also Allocatively efficient due to resources perfectly following consumers demands.
8. This means that price is low allowing for consumer surplus to rise , increasing choice inevitably benefiting the consumer.
9. As a result of there being no supernormal profit it means there is no dynamic efficiency within this market meaning consumers will not be seeing innovation of products ect.

Allocative + Productive efficiency is for firms not the market = this could still fall if demerit goods are being produced.

Question 2

Draw and Analyse Profit in Short run under Perfect Competition (8)

Answer 2

1. Price is determined by conditions in the market as a whole meaning demand is perfectly price elastic at P1.
2. Firms will be able to make a supernormal profit of C1P1AB due to a decrease in Average costs meaning AR > AC.
3. As a result of firms being profit maximisers they produce where MR = MC which is at q1.
4. Firms receiving supernormal profits acts as a signal for new firms to enter the market which they are able to do so due to an absence of barriers to entry.
5. This causes a rightward shift of the demand supply curve from S1 to S2, lowering the market price from P1 to P2. As a result of demand being perfectly price elastic the firm’s product curve will shift downwards from D2=AR2=MR2.
6. Firms being profit maximisers they will need to produce where MR=MC at the new price of P2 and quantity of Q2.
7. The firms will return to the long run equilibrium position giving firms less incentive to join the market due to only normal profits being left.
8. In the Short run average cost isn’t minimised meaning at q1 the firm is productively inefficient however P = MC so firm is allocatively efficient

Question 3

Draw and Analyse Economic Loss in SR under perfect competition (8)

Answer 3

1. Market price which is determined by conditions of the market as a whole is P1.
2. Firms being profit maximisers produce where MR = MC at Q1.
3. However for a reason such as increased cost of materials firms Average Cost greater than Average Revenue meaning they will be making a Loss of P1C1BA in the short run only.
4. In the the Long run firms will not make an economic loss.
5. Firms not longer making economic profit gives them an incentive to leave the industry and use their factors of production to produce their opportunity cost to enable them to make a profit.
6. This causes a leftward shift of the market supply curve from S1 to S2, increasing market price from P1 to P2.
7. As the firms demand curve is price elastic this will shift the demand curve upwards to D2=AR2=MR2 meaning remaining firms will return to long run equilibrium position.
8. Price will increase until there is no more incentive to leave the market and normal profit is made in the LR.

Question 4

Key features of Monopoly (5)

Answer 4

• Differentiated goods
• Firms are price makers
• High barriers to entry + exit
  
  • Brand loyalty
  • Economies of scale
  • Legal reasons - Patents
  • Knowledge + Expertise
• Imperfect information
• Firms are profit maximisers = produce where MR = MC

Question 5

Draw and Analyse Monopoly Diagram (7)

Answer 5

Pure Monpoly - Only 1 seller of a good and no subsitutes
Working Monopoly - Firms own 25% or more shares within a Market
1. Monopolists have a price setting ability so assuming they will profit maximise they will produce quantity where MR=MC, which is above QM charging a price of PM.
2. Total revenue is OP1AQ1 ( selling price x sales volume)
3. Firms total costs are OC1BQ1 (AC x quantity produced)
4. Means firm will produce an supernormal profit of C1P1AB which is shown by the shaded area.
5. At this level of output the firm is Allocatively inefficient due to them charging a price above P=MC, allowing them to exploit consumers by making them pay more than cost of production, decreasing consumer surplus.
1. Furthermore, firms restrict output + choice which can possibly lead to poorer quality of good leading to a deadweight lost of AED
6. Firms is productively inefficient due of them not producing on the lowest point of the AC curve.
1. Firms voluntarily forgo economic of scale = don’t minimise price due to them having the ability to increase price meaning consumer lost surplus while producers gain surplus

Question 6

Cons of Monopoly (4)

Answer 6

1. Allocatively inefficient
   
   1. P > AC = consumers exploited by having to pay more than what it costs to produce lowering consumer surplus.
   2. Firms restrict output + choice and may be quality issues leading to a deadweight lost of GEB
2. Productively inefficient
   
   1. Forgo economies of scale = don’t have to minimise their costs = able to increase price since they are price makers
   2. Consumers lose surplus as price increases
3. X - inefficiency
   
   1. Firms allow for waste in their production process
   2. Complacency due to lack of competitive drive
   3. Produce above AC curve allowing for excess costs
4. Inequalities - Necessity ( i.e. food, hygiene ect)
   
   1. Price increases the poorest will suffer

Question 7

Pros of Monopoly (3)

Answer 7

1. Dynamic efficiency
   
   1. High supernormal profits allows for investment
   2. Good for consumers due to increases innovation, increasing consumer surplus, due to there being more choice within the market
   3. BUT allows for producers to gain bigger share in market by opening patents
2. Greater economies of scale
   
   1. Due to their size, Monopolies MC curve lower than MC curve of competitive firms due to increased economies of scale
   2. So Monopolies could charge lower prices + produce higher quantities than a competitive firm if they were allocatively efficient
3. Cross subsidisation
   
   1. Use supernormal profits to subsidise loss making products that are desirable to consumers + keep consumers happy

Question 8

Evaluation Points for Monopoly (3)

Answer 8

1. Will Dynamic efficiency occur?
   
   1. Theoretically it should but firms may spend supernormal profits on erasing debt or for saving
2. Economies of scale or will diseconomies of scale occur?
   
   1. Depends on size of firm
3. Firms objective?
   
   1. Theoretically its to profit maximise
   2. However it may be sales maximisation = better for society

Question 9

Draw and Analyse Deadweight Loss In Monopoly (6)

Answer 9

Monopoly = Only 1 seller in the Market and no substitues
1. Monopolists restrict output and raise price = Consumers have nowhere else to buy good = Protection from Barriers to Entry (Economies of Scale, Patents, Knowledge) allow them to maintain high prices
2. Firm under competitive conditions would produce where supply = demand, In following diagram this is QC
3. The market clearing price would be PC, meaning the consumer surplus would equal PCAB.
4. Instead firms pursue profit maximisation where MR=MC, causing them to restrict output to QM, causing them to raise price to PM.
5. Area of consumer surplus reduced to PMAE meaning the area PCPMEF has been appropriated by monopolists into producer surplus however FEB has been lost completely
6. Area GFB represents producer surplus lost for the same reason making GEB the deadweight loss of welfare to society.

Question 10

Draw and Analyse Monopolistic Competition Diagram (8)

Answer 10

1. Under monopolistic competition each firm has some characteristics which differentiate their products from their rivals giving them a degree of price setting ability causing them to have a downward sloping demand curve.
2. Firms profit maximise so produce where MR=MC causing them to behave like a Monopoly.
3. However Monopolistically competitive markets are contestable and the economic profit earned acts as both a signal and incentive for other firms to join the market.
4. This causes existing firms products to no longer be sufficiently differentiates causing a barrier to entry due to new firms in the market producing close substitutes.
5. Availability of new substitutes decreases demand for the incumbent firms products shifting the demand curve leftwards from D1=AR1 to D2=AR2
6. This results in all the economic profit being competed away (lost) resulting in the market going back to its long run equilibrium.
7. Furthermore like Monopolies, Monopolistically competitive firms are both productively inefficient due to them not producing on lowest point of AC curve (LR) and allocatively inefficient due to P > MC causing consumers to be exploited in the Long run.
8. Also Monopolistically competitive firms are Dynamically inefficient in the LR due to there being no supernormal profit to reinvest.

Question 11

Key Features Monopolistic competition (4)

Answer 11

1. Large Num of Firms in Market
2. No Barriers to Entry and Exit in LR
   Only Normal Profit Made in LR
3. Goods differentiated = Downward sloping demand curve
4. Lower + Steeper MR curve

Question 12

Key Features of Perfect Competiton (5)

Answer 12

1. Many buyers and seller
2. Goods are homonogeneous
3. No barriers to entry or exit
4. Perfect Knowledge
5. Firms “Price Takers” NOT “Price Makers” = Same good can be found elsewhere for cheaper if “price makers”

Question 13

Draw and Analyse Natural Monopoly Diagram (4)

Answer 13

A natural monopoly occurs when it is more efficient for a single firm to provide a good or service to the entire market due to high fixed costs and low marginal costs of production.
1. The fixed costs or natural monopoly are quite high so the minimum efficient scale of production is not seen on the diagram.
2. Firms Would profit maximised where MR=MC at Q1, charging a price of P1, making the Firms Total Revenue 0P1AQ1 and their Total costs 0C1BQ1 making Economic profit C1P1AB
3. If Natural Monopoly was broken up there would be increased consumption shifting AR and MR curves
4. At a Higher Quantity AC would be higher along with price at a new profit maximising level

5. At Q2 with regulations Monopolist AC>AR meaning firm is making economic loss
6. Government must subside market with subsidy of EF per unit to ensure firms make more than their average cost, ensuring firms don’t have incentive to leave the market

Question 14

Reasons for Natural Monopoly (3)

Answer 14

1. Huge Fixed costs
2. Enormous potential for economies of scale
3. Rational for 1 Firms to Supply entire Market
   
   1. Competition is UNDESIRABLE
      
      1. Competition = wasteful duplication of Resources + non exploitation of full economies of scale = PRODUCTIVE + ALLOCATIVELY INEFFICIENT
      2. New Firms don’t have Economies of Scale like OLD = Priced out of Market = Waste of Infrastructure

Question 15

Regulation in Natural Monopoly (2)

Answer 15

• Ensure outcome is Allocatively efficient at Q2 where AR = MC however AC is bigger than AR meaning monopolists will make an economic loss
• Government MUST give Subsidy of EF per unit to ensure firms are able to make more than their average costs ensuring they don’t leave the market

Question 16

Draw and Analyse Oligopoly (10)

Answer 16

Oligopoly - Market Dominated by a few firms between whom there is conscious interdependence = each firms is affected by decisions of all other firms and they are aware of this fact = Also Barriers to entry i.e Economies of Scale + Brand loyalty = Make economic profit
1. Oligopoly markets are dominated by a few markets who are all consciously interdependence meaning each firm is affected by the decision of all other firms and they are aware of this
2. As a result if 1 firm increases its price from P1 to P2, it will cause a decrease in demand from Q1 to Q2 due to the proportionality decreasing more than the price meaning demand is price elastic. Also total revenue will fall.
3. This means other firms within the market will not follow suit resulting in the firm losing some of their market share which other firms wish to gain
4. However if 1 firm decreases their price from P1 to P3 their quantity demand will increase from Q1 to Q3 and be price inelastic but less proportionality meaning other firms will have to follow suit decreasing total revenue possibly resulting in a price war.
5. This would cause price INstability + non price competition = Gain consumers through Quality, Advertising, Customer Service = Increase CS
6. This can be explained by Nash equilibrium where all firms choose their best strategy based of their opponents actions.
7. As a result of interdependence it may be tempting for firms to see to collude in order to form a cartel which effectively acts as a monopoly by agreeing to price fix.
8. This causes prices to be made artificially high relative than what they would be under competition however this is illegal. Firms may instead overtally collude through price leadership which is where there is a market leader and other firms follow suit
9. Another pricing strategy is limit pricing in which firms set prices so low that it would make it unprofitable for new firms to enter the market detering hit and runs competition.
10. Firms will remain profitable by using limit pricing if incumbent firms have significant economies to scale.

Question 17

Evaluation of Monopolistic competition VS Perfect competition and Monopoly (12)

Answer 17

1. There is competition within Monopolistic competition so firms price setting ability is lower meaning price exploitation will not be as bad as there in Monopolies.
   
   1. There is still a loss of consumer surplus however it wont be as great as it would be under a Monopoly
   2. Perfect competitive firms only produce Homogeneous goods which isn’t what consumers desire
   3. Allocative inefficiency may not be such a bad thing and may be seen as desirable due to price exploitation not being as bad as it is under Monopolies
   4. Furthermore unlike in Perfect competition consumers still have the ability to choose between having the ability to buy substitutes of some expensive goods.
   5. An example of this is the Fashion Industry where stores such as Primark produce dupes of Burberry shirts allowing for people to buy substitutes for expensive goods.
2. Productively inefficient compared to Monopoly isn’t as bad due to there being substitutes of goods
   
   1. In perfect competition there aren’t any economies of scale where as on Monopolistic competition there are
      
      1. Meaning economies of scale being exploited may be greater reducing the price of goods lower than they would be under perfect competition
   2. Productive inefficiency may also be due to product differentiation which inevitably makes it harder for firms to exploit economies of scale since differentiated goods cant be produced in bulk as easily.
3. Monopolies have Dynamic efficiency always whereas Perfect competition will never
   
   1. However it could be said that in Monopolistic competition Dynamic efficiency may occur
   2. Firms may be able to use their short run supernormal profits if high enough to re invest
   3. In competitive markets firms could still achieve dynamic efficiency by using their normal profits to reinvest and it could be said that this is necessary in allowing firms to differentiate themselves further from their competition
      
      1. This can be seen in the fashion industry where firms need to produce new fashion lines in order to keep up with trends
   4. Furthermore, its not 100% certain that in Monopolies firms will reinvest their supernormal profits due to them not having an incentive such as competition to do so

Question 18

State 4 Conditions for Price Discrimination to Occur

Answer 18

1. Monopolists must FACE different demand curves for Different groups of Buyers = PED MUST DIFFER
2. Information to Seperate Market
   
   1. Monopolist Must Split Market into distinct groups of Buyer Or else unable to distinguish between those prepared to pay Diff prices
3. Monopolist must KEEP Markets SEPARATE at Low Cost
4. Prevent Market Seepage
   
   1. Stop buying where price is lower and selling for higher price

Question 19

1st Degree / Perfect Price Discrimination (2)

Answer 19

<aside>
💡 Charging Exact Price Consumers willing to pay = Eroding all CS

</aside>

• Only occurs when monopolists PERFECTLY SEGMENT Market

Question 20

2 Degree Price Discrimination (3)

Answer 20

<aside>
💡 Firms selling off Excess surplus capacity at lower price than previously advertised

</aside>

• Firms with High Fixed Costs i.e. Airlines → No sense to leave Spare Capacity = IF they did lose money = Fixed Costs High
  
  • ↓ Price to fill Excess Capacity

Question 21

3rd Degree

Answer 21

Occurs when Monopolists Split Consumers into 2 or more Separate Groups = I.e. = Group A Need Good = Full time worker + Group B Wants but Can’t Afford at high price

Question 22

Entire monopoly analysis on one diagram (always draw this on monopoly question)

Answer 22

1. Monopoly will always profit maximise so they produce at QM where MR = MC
2. They charge the maximum price they can, so set prices at PM
3. Cost of producing QM units is C1
4. Profit = revenue - cost , so total economic profit is C1PMAB
   1. This makes the monopoly dynamically efficient as they have economic profit to reinvest
   2. But productively inefficient as not producing on lowest point of AC curve
   3. Allocatively inefficient as price is not equal to marginal cost (PM≠MC1)
5. Under perfect competition, the firm would produce where supply equals demand, at point QC pricing at PC
6. Consumer surplus would be PcFG
7. Instead by profit maximising the monopoly restricts output to PM and increases prices to PM
8. This reduces consumer surplus to PmFA
9. The area PcPmAE is consumer surplus that has been lost and then converted into producer surplus
10. EGH is the lost producer surplus caused by restricting output
11. AGH is the deadweight lost of welfare also caused by restricting output