Model Answer May 2007 Economics HL Paper 1 Question 1

a) Explain ow !arriers to entry may a"ect mar#et structure$ %10

mar#s&
'arriers to entry are o!stacles tat ma#e it di(cult) costly or e*en
impossi!le +or new ,rms to enter an industry$ -or instance) patents
ma#e it impossi!le +or ri*als to produce macines or parmaceuticals
tat a*e !een in*ented !y a particular ,rm$ .imilarly) i+ a minin/
company controls te only source o+ a particular mineral) ten a/ain
ri*als will !e una!le to pro*ide tat mineral and so compete wit te
company$ As well) some ,rms !y *irtue o+ teir si0e en1oy considera!le
cost sa*in/s) and tese economies o+ scale can also !e impossi!le +or
newcomers to matc) tus also creatin/ a +ormida!le !arrier to new
entrants$ Lastly) i+ ,rms a*e spent a lot o+ money creatin/ a
success+ul !rand) tis mi/t also discoura/e new ,rms +rom enterin/
te industry as tey may !e unwillin/ to spend te amount o+ money
necessary to matc te esta!lised ,rm2s !rand power$
Mar#et structures are o+ten de,ned !y te num!er o+ ,rms in an
industry) !ut e3ually) tey can !e cate/ori0ed accordin/ to te
presence or a!sence o+ !arriers to entry$
-or instance) per+ect competition and monopolistic competition are
caracteri0ed !y an a!sence o+ !arriers to entry$ As a result) in
per+ectly competiti*e industries) ,rms tend not to earn supernormal
pro,ts as i+ tey do so) teir success inspires ri*als to enter te
industry 4wic is easy to do in te a!sence o+ !arriers to entry))
increasin/ te 3uantity supplied and dri*in/ down prices until suc
pro,ts are eliminated$ 5n monopolistically competiti*e industries) te
a!sence o+ !arriers to entry means tat) in order to earn small
supernormal pro,ts in te sort run) ,rms ma#e constant e"orts to
inno*ate and experiment in order to stay one step aead o+ teir ri*als$
5+ tey +ail to o"er new products or no*el experiences) tey will lose
customers to ri*als wo) seein/ teir success) copy teir +ormula$ 6e
all #now o+ restaurants or clotin/ !rands wic were once 7ot2) !ut
wic did not #eep aead o+ imitators and so lost teir appeal and teir
pro,ta!ility$
8n te oter and) in mar#ets tat are monopolistic 4controlled !y one
,rm)) or oli/opolistic 4controlled !y a +ew ,rms)) tere are !arriers to
entry$ 9e e*idence is tat tese ,rms o+ten mana/e to earn
supernormal pro,ts in te sort and lon/ run$ 5+ tere were no !arriers
to entry) tis situation would not persist$ 9e +act tat tese ,rms can
remain +ew in num!er and earn supernormal pro,ts points to an a!ility
to discoura/e ri*als +rom enterin/ te industry and competin/ wit
tem$
5nterestin/ly) te scale o+ te !arriers to entry does a"ect te
!ea*iour o+ monopolistic and oli/opolistic ,rms$ 6ere !arriers to
entry are relati*ely low) ma#in/ te mar#et a contesta!le one) ,rms
may not exploit teir mar#et power to te +ullest extent and so will
earn less tan maximum pro,ts$ 'y doin/ so) tey ma#e enterin/ te
industry less attracti*e +or potential ri*als) and so maintain teir
monopolistic or oli/opolistic position$
!) E*aluate te *iew tat monopoly is an undesira!le type o+ mar#et
structure
A monopolistic industry is one controlled !y one ,rm$ 9is ,rm en1oys
te !ene,ts o+ !arriers to entry and does not +ace competition +rom
close su!stitutes$ As a result) te monopolist is a!le to set output
le*els so as to acie*e is re*enue /oals) !e tey maximi0in/ re*enues
or pro,ts$
9e dia/ram !elow sows a monopolist2s situation clearly$ As te only
seller in te industry) e #nows te industry demand cur*e 4:)$ As
suc) e also can construct a correspondin/ mar/inal re*enue cur*e
4M;)$ <i*en standard mar/inal and a*era/e cost cur*es) is pro,t
maximi0in/ point is at 4A)) wit an output le*el o+ Q4A) and a price o+
P4A)$ =ote tat te monopolist is a!le to en1oy su!stantial monopoly
pro,ts 4!ox !eneat P4A))$ 9e down side) tou/) is tat te
monopolist is neiter producti*ely nor allocati*ely e(cient$ He does
not produce at te output at wic is a*era/e costs are lowest 4PE)
nor do all customers wit te a!ility to pay te mar/inal costs o+
production /et te opportunity to !uy is /oods$ =ote te wel+are loss
resultin/ +rom tis allocati*e ine(ciency 4mar#ed 6L)$
>
M?
P 4A)
A?
6L
PE
A : 4@A;)
Q
Q4A)
M;
5n /eneral) te *iew tat monopoly is an undesira!le type o+ mar#et
structure is one tat can !e supported trou/ loo#in/ at dia/rams
suc as tese$ 9e most ne/ati*e impact o+ monopolies is teir impact
on e(ciency$ Monopolies consistently underpro*ide /oods to te
mar#et at prices tat do not reAect teir costs) especially in contrast to
a mar#et operatin/ under per+ect competition$ As suc) te consumers
o+ te /oods are made to su"er) and a si/ni,cant amount o+ wealt is
trans+erred +rom te poc#ets o+ te consumers to tat o+ te
monopolist$ Loo#in/ at te dia/ram a!o*e) we can see tat te
e3uili!rium point +or a competiti*e industry 4?) results in !ot /reater
output 4Q?) and lower prices 4P?)$ -urter) te lac# o+ competition
could lead to waste+ul ine(ciencies tat lead to i/er o*erall a*era/e
costs) +urter dama/in/ producti*e e(ciency$
Howe*er) monopolies may in some cases !e desira!le$ 5+ te
monopolist2s position is due to is acie*in/ economies o+ scale 4ie te
monopoly is a natural monopoly) ten te consumer may !e well
ser*ed so lon/ as tese e(ciency /ains are sared$ .imilarly) i+ te
monopolist2s supernormal pro,ts are in*ested in researc and
de*elopment in order to de*elop new products or ser*ices o+ /enuine
use to customers) a/ain) te /ains to society may !e suc tat
monopoly is *iewed as desira!le$
8*erall) te e(ciency losses and te i/er prices and lower output
tat are caracteristic or monopolies lead us to *iew tem critically$
9e presence o+ antiBtrust and antiBmonopoly !odies in most
/o*ernments con,rms tis *iew) tat tey are an undesira!le type o+
mar#et structure$