Model Answer – Economics HL Paper 1 Question 1



Model Answer – May 2007 Economics HL Paper 1 Question 1

a) Explain how barriers to entry may affect market structure. [10 marks]

Barriers to entry are obstacles that make it difficult, costly or even impossible for new firms to enter an industry. For instance, patents make it impossible for rivals to produce machines or pharmaceuticals that have been invented by a particular firm. Similarly, if a mining company controls the only source of a particular mineral, then again rivals will be unable to provide that mineral and so compete with the company. As well, some firms by virtue of their size enjoy considerable cost savings, and these economies of scale can also be impossible for newcomers to match, thus also creating a formidable barrier to new entrants. Lastly, if firms have spent a lot of money creating a successful brand, this might also discourage new firms from entering the industry as they may be unwilling to spend the amount of money necessary to match the established firm’s brand power.

Market structures are often defined by the number of firms in an industry, but equally, they can be categorized according to the presence or absence of barriers to entry.

For instance, perfect competition and monopolistic competition are characterized by an absence of barriers to entry. As a result, in perfectly competitive industries, firms tend not to earn supernormal profits as if they do so, their success inspires rivals to enter the industry (which is easy to do in the absence of barriers to entry), increasing the quantity supplied and driving down prices until such profits are eliminated. In monopolistically competitive industries, the absence of barriers to entry means that, in order to earn small supernormal profits in the short run, firms make constant efforts to innovate and experiment in order to stay one step ahead of their rivals. If they fail to offer new products or novel experiences, they will lose customers to rivals who, seeing their success, copy their formula. We all know of restaurants or clothing brands which were once ‘hot’, but which did not keep ahead of imitators and so lost their appeal and their profitability.

On the other hand, in markets that are monopolistic (controlled by one firm), or oligopolistic (controlled by a few firms), there are barriers to entry. The evidence is that these firms often manage to earn supernormal profits in the short and long run. If there were no barriers to entry, this situation would not persist. The fact that these firms can remain few in number and earn supernormal profits points to an ability to discourage rivals from entering the industry and competing with them.

Interestingly, the scale of the barriers to entry does affect the behaviour of monopolistic and oligopolistic firms. Where barriers to entry are relatively low, making the market a contestable one, firms may not exploit their market power to the fullest extent and so will earn less than maximum profits. By doing so, they make entering the industry less attractive for potential rivals, and so maintain their monopolistic or oligopolistic position.

b) Evaluate the view that monopoly is an undesirable type of market structure

A monopolistic industry is one controlled by one firm. This firm enjoys the benefits of barriers to entry and does not face competition from close substitutes. As a result, the monopolist is able to set output levels so as to achieve his revenue goals, be they maximizing revenues or profits.

The diagram below shows a monopolist’s situation clearly. As the only seller in the industry, he knows the industry demand curve (D). As such, he also can construct a corresponding marginal revenue curve (MR). Given standard marginal and average cost curves, his profit maximizing point is at (A), with an output level of Q(A) and a price of P(A). Note that the monopolist is able to enjoy substantial monopoly profits (box beneath P(A)). The down side, though, is that the monopolist is neither productively nor allocatively efficient. He does not produce at the output at which his average costs are lowest (PE) nor do all customers with the ability to pay the marginal costs of production get the opportunity to buy his goods. Note the welfare loss resulting from this allocative inefficiency (marked WL).

$

MC

P (A)

AC

WL

PE

A D (=AR)

Q

Q(A)

MR

In general, the view that monopoly is an undesirable type of market structure is one that can be supported through looking at diagrams such as these. The most negative impact of monopolies is their impact on efficiency. Monopolies consistently underprovide goods to the market at prices that do not reflect their costs, especially in contrast to a market operating under perfect competition. As such, the consumers of the goods are made to suffer, and a significant amount of wealth is transferred from the pockets of the consumers to that of the monopolist. Looking at the diagram above, we can see that the equilibrium point for a competitive industry (C) results in both greater output (QC) and lower prices (PC). Further, the lack of competition could lead to wasteful inefficiencies that lead to higher overall average costs, further damaging productive efficiency.

However, monopolies may in some cases be desirable. If the monopolist’s position is due to his achieving economies of scale (ie the monopoly is a natural monopoly) then the consumer may be well served so long as these efficiency gains are shared. Similarly, if the monopolist’s supernormal profits are invested in research and development in order to develop new products or services of genuine use to customers, again, the gains to society may be such that monopoly is viewed as desirable.

Overall, the efficiency losses and the higher prices and lower output that are characteristic or monopolies lead us to view them critically. The presence of anti-trust and anti-monopoly bodies in most governments confirms this view, that they are an undesirable type of market structure.

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