(2023) A Level H2 Econs Essay Q3 Suggested Answer by Mr Eugene Toh (A Level Economics Tutor)
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3a.
Introduction
The level of competition in an industry significantly impacts a firm's decision-making process, particularly in terms of pricing and determining output levels. This influence can be best understood by contrasting two extreme market structures: perfect competition and monopoly.
Price and output level of Perfect Competition
In perfectly competitive markets, the presence of many small firms and the homogeneity of the products mean that individual firms have no control over the market price. The market price is determined by the collective actions of all firms and consumers in the market, reflecting the overall supply and demand. Since each firm produces a small fraction of the total industry output and the product is undifferentiated, firms are unable to influence the market price and must accept it as given. This is the essence of being a price taker, illustrated by a perfectly elastic demand curve facing each firm, meaning they can sell as much as they like at the market price but cannot charge more.
For a firm in perfect competition, the primary goal is to maximize profit, which involves producing at an output level where marginal cost (MC) equals the market price (P). This rule is derived from the principle that, to maximize profit, a firm should continue producing additional units as long as the revenue from selling those units exceeds the cost of producing them. Therefore, the firm increases production until the additional cost of producing one more unit (MC) equals the revenue earned from that unit (P). Producing beyond this point would mean MC exceeds P, leading to a decrease in profit.
In the long run, the entry and exit of firms ensure that firms in perfect competition make zero economic profits, as any supernormal profits are eroded by new entrants attracted by these profits, increasing supply and driving prices down to the point where price equals average total cost (P = ATC).
Price and output levels of a monopolist
In a monopolistic market structure, the existence of a single firm or a dominant player with significant market power contrasts sharply with perfect competition. The monopolist, has substantial control over the market, primarily due to the lack of close substitutes for its product or service.
As a result, the firm is a price setter. Unlike in perfect competition, where firms are price takers, the monopolist faces a downward-sloping demand curve.
The monopolist's decision-making process revolves around balancing its output level and the price it sets to maximize profits. This involves determining the output level where the marginal cost (MC) of producing an additional unit equals the marginal revenue (MR) gained from selling that unit.
By restricting output (compared to what would be produced in a competitive market) and setting a higher price, the monopolist can earn supernormal profits.
The monopolist can also possibly adopt price discrimination, charging different groups of consumers different prices for the same good, to capture increased consumer surplus and increasing revenues.
Note: For this question, you could answer this question using different approaches. It is not sensible to compare all 4 market structures for a 10m question. You could thus choose two contrasting market structures to answer this question. The above uses PC vs Monopoly.
You could also use MC vs Oligopoly like below:
Pricing and output decisions in Monopolistic Competition
In monopolistic competition, where many firms produce differentiated products, each firm must consider the level of competition when setting prices and determining output levels.
The differentiation of products provides firms with some degree of market power, allowing them to set prices above marginal cost. However, the presence of many competitors offering similar, though not identical, products limits this power.
Firms must carefully balance their pricing strategy to ensure that their product remains attractive compared to close substitutes.
While firms strive to produce at MC = MR, the competitive environment in this market structure ensures that firms cannot set prices too high, as this would lead to loss of market share to competitors with similar products.
Consequently, while firms in monopolistic competition have some leeway in pricing due to product differentiation, the competitive pressure limits this power and affects their output decisions.
Pricing and output decisions in Oligopoly
In an oligopoly, where a few large firms dominate the market, the level of competition has a significant impact on a firm’s pricing and output decisions. The key characteristic of oligopolies is mutual interdependence; the decision of one firm directly affects, and is affected by, the decisions of other firms in the industry. This interdependence makes decision-making complex.
Firms in an oligopoly must consider the potential reactions of their competitors when setting prices or deciding on output levels.
For instance, a firm contemplating a price reduction must consider the likelihood of competitors matching or undercutting this price, which could lead to a price war.
Conversely, if one firm raises prices, others may follow, this will result in a less than proportionate increase in quantity demanded (as demand remains price inelastic), resulting in a fall in total revenue.
The presence of barriers to entry in oligopolies allows these firms to maintain higher prices and output levels that would not be sustainable in more competitive market structures. The decisions made by firms in an oligopoly are thus heavily influenced by the anticipated responses of a few significant competitors, unlike in monopolistic competition where the focus is on differentiating the product to carve out a niche in a market with many competitors.
3b.
Introduction
Market failure due to a lack of competition can be explained in the context of a monopoly occurs when a single firm dominates the market, leading to an inefficient allocation of resources and a loss of economic welfare, commonly referred to as deadweight loss. In a monopolistic market, the monopolist sets a higher price and produces a lower quantity than would be the case in a competitive market. This results in a price (P) that is higher than the marginal cost (MC), leading to allocative inefficiency.
Why consumers might be disadvantaged
In the diagram below, the deadweight loss is represented by the area ABC. This area signifies the net loss in total surplus due to the monopolist’s output and pricing decisions. Consumers pay a higher price and consume less than in a competitive market, which leads to a reduction in consumer welfare (compare consumer surplus between PC vs Monopoly). At the same time, although the monopolist gains from higher prices, this gain is smaller than the loss in consumer surplus, resulting in an overall loss in economic welfare (why there is market failure)
Why consumers might not be disadvantaged
In the context of a natural monopoly, the concept of minimum efficient scale plays a crucial role in understanding why consumers may not be disadvantaged. A natural monopoly arises in an industry where the minimum efficient scale—the smallest scale at which a firm can produce such that its long-run average costs are minimized—is so large relative to market demand that there is room for only one efficient provider. This is often the case in industries with high fixed costs and significant economies of scale, such as utilities or public transportation. In these sectors, one firm can produce the entire output for the market at a lower cost per unit than if multiple firms were to divide the market among themselves.
When a single firm operates at the minimum efficient scale in a natural monopoly, it can achieve the lowest possible cost per unit, potentially leading to lower prices for consumers. This is particularly advantageous in industries where the duplication of infrastructure (such as electricity grids or railway systems) by multiple firms would lead to inefficiencies and higher costs. Regulated appropriately, a natural monopoly can pass these cost savings on to consumers through lower prices, while still maintaining an adequate level of service and quality.
Most appropriate form of intervention
Regulation plays a pivotal role in ensuring that natural monopolies, such as those in telecommunications and public transport, deliver high standards of service while preventing cost-cutting measures that could degrade service quality. Singapore's approach to regulating its telecommunications sector and public transport services provides insightful examples of how quality regulation can be effectively implemented.
In the public transport sector, the Land Transport Authority (LTA) of Singapore regulates service quality through a framework that includes regular assessments and penalties for service disruptions. Public transport operators are required to meet specific performance standards related to punctuality, service regularity, and the condition of vehicles and stations. The LTA also mandates investments in infrastructure upgrades and fleet renewals to enhance service reliability and passenger comfort. For example, initiatives like the Bus Service Enhancement Programme and the ongoing renewal of train systems are aimed at improving the overall quality and capacity of public transport services. These measures ensure that despite the limited number of operators, competition for quality remains high, and the focus is on delivering the best possible service to commuters.
Note: It is possible to provide other forms of interventions as answers e.g price regulation such as MC or AC pricing.
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