Market failure—market power Paper 1

IBDP Economics  HL – Microeconomics – Market failure—market power -Paper 1 Exam Style Practice Questions

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Market failure—market power Paper 1? 

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Exam Style Question for IBDP Economics HL- Market failure—market power -Paper 1

Question

Discuss the view that legislation is the best way of dealing with the problem of monopoly power

▶️Answer/Explanation

Answers may include:

  • definition of monopoly, monopoly power, oligopoly, legislation
  • diagram to show equilibrium in situation of monopoly power, monopoly, oligopoly
  • an explanation of the features of monopoly and government responses
  • example(s) of industries that are or have been able to exercise monopoly power, government responses
  • synthesis or evaluation (discuss).

Question

Discuss whether price will always be lower and output will always be higher in perfect competition compared to monopoly.

▶️Answer/Explanation

Answers may include:

  • definitions of perfect competition, monopoly, price and output
  • diagrams to compare long-run equilibrium in perfect competition and monopoly
  • explanation of how in perfect competition the characteristics of the market lead to normal profit and economic efficiency and consequently lower prices and a higher output than a less efficient market like monopoly
  • examples of perfect competition and monopoly
  • synthesis or evaluation (discuss).

Question

Explain why prices tend to be relatively rigid in oligopolistic markets.

▶️Answer/Explanation

Answers may include:

  • definition of oligopoly
  • diagram to show the kinked demand curve with price inelastic demand below the market price and price elastic demand above the market price
  • explanation of price rigidities, with reference to the risk of price wars and/or with reference to the effect that a change in price would have on the total revenue of the oligopolistic firm
  • examples of industries where there are rigid prices/non-price competition/strategic interdependence.

Question

Discuss whether an oligopolistic firm should collude rather than compete.

▶️Answer/Explanation

Answers may include:

  • definitions of oligopoly, collusion
  • diagram to show open/formal collusion (single, downward-sloping demand curve as in monopoly diagram)
  • explanation of how open/formal collusion would limit competition between member firms and maximize joint profits as if the firms were collectively a monopoly and/or the term “tacit collusion”, including reference to price leadership by a dominant firm
  • examples of where firms have colluded
  • synthesis or evaluation (discuss).

Question

Evaluate the view that monopoly is an undesirable market structure as it fails to achieve productive and allocative efficiency.

▶️Answer/Explanation

Answers may include:

  • definitions of monopoly, productive efficiency, allocative efficiency
  • diagrams to show productive and allocative inefficiency under profit-maximizing monopoly firm, economies of scale leading to lower prices and higher output
  • explanation of why the profit maximizing choices of a monopoly firm lead to productive and allocative inefficiency
  • examples of inefficiencies in monopoly markets in practice
  • synthesis or evaluation (evaluate).

Question

Explain why monopoly power may be considered a type of market failure.

▶️Answer/Explanation

Answers may include:

  • definition of monopoly power, market failure
  • diagram to show deadweight loss under monopoly
  • explanation that market failure in this case is a form of welfare loss, illustrated by productive and allocative inefficiency
  • examples of monopoly.

Question

Examine the role of barriers to entry in making monopoly a less desirable market structure than perfect competition.

▶️Answer/Explanation

Answers may include:

  • definition of market structure, monopoly, perfect competition, barriers to entry
  • diagram to illustrate economic/abnormal profit under monopoly in the short and long run, diagram to show abnormal profit in the short run, normal profit in the long run under perfect competition
  • explanation that without barriers to entry, monopolies could not earn economic/abnormal profit in the long run, whereas firms in perfect competition can earn only normal profit in the long run because of the absence of barriers to entry
  • examples of barriers to entry sustaining monopolies
  • synthesis and evaluation (examine).

Question

Explain how a natural monopoly may arise.

▶️Answer/Explanation

Answers may include:

  • definition of natural monopoly
  • diagram to show falling long-run average costs at least up to the point where the LRAC curve intersects the market demand curve
  • explanation that a natural monopoly is a firm that experiences such significant economies of scale (eg due to investment in fixed capital) that it is able to satisfy the demand for the entire market at a level of output where it still experiences falling average total cost and/or that natural monopoly arises due to a natural barrier to entry such as ownership of vital input for production
  • examples of natural monopoly.

Question

Explain how a natural monopoly may arise.

▶️Answer/Explanation

Answers may include:

  • definition of natural monopoly
  • diagram to show falling long-run average costs at least up to the point where the LRAC curve intersects the market demand curve
  • explanation that a natural monopoly is a firm that experiences such significant economies of scale (eg due to investment in fixed capital) that it is able to satisfy the demand for the entire market at a level of output where it still experiences falling average total cost and/or that natural monopoly arises due to a natural barrier to entry such as ownership of vital input for production
  • examples of natural monopoly.

Question

Discuss how governments restrict monopoly power.

▶️Answer/Explanation

Answers may include:

  • definition of monopoly power
  • a monopoly diagram to show a monopoly which is not producing at the profit-maximizing level of output because the price of its product is regulated by the government
  • explanation of why governments might choose to restrict monopoly power and how it might be done through government regulation of prices, legislation to prevent cartels and mergers, nationalization or the break-up of firms with monopoly power
  • examples of industries that were monopolized where a government has sought to exercise control
  • synthesis or evaluation (discuss).

Question

Discuss the consequences of a perfectly competitive market becoming a monopoly market.

▶️Answer/Explanation

Answers may include:

  • definitions of perfect competition, monopoly
  • diagrams of a perfectly competitive firm with only normal profit (producing at a level of output that is productively and allocatively efficient) and a monopoly with abnormal profit (producing at a level of output that is productively and allocatively inefficient)
  • explanation that the firm that will dominate the industry will be able to charge a higher profit-maximizing price, make economic (abnormal) profit in the long run and produce at a level of output that is neither allocatively nor productively efficient
  • examples of cases where a perfectly competitive market may be monopolized are not required, but candidates may use real-world examples of markets that have the characteristics of perfect competition or monopoly in their answers
  • synthesis or evaluation (discuss).

Question

Discuss the view that governments should always try to prevent the creation of barriers to entry in a market.

▶️Answer/Explanation

Answers may include:

  • definitions of barriers to entry, market
  • diagram showing a firm that faces a downward-sloping average revenue (demand) curve and realizes economic profit
  • explanation of barriers to entry and how they permit a firm to achieve monopoly power and realize economic profit by restricting competition from other firms
  • examples of barriers to entry in practice and/or firms that have acquired monopoly power because of economies of scale, strong brands or legal barriers to entry
  • synthesis or evaluation (discuss).

Question

Evaluate the view that the use of legislation and regulation by government is the most effective way to control monopoly power.

▶️Answer/Explanation

Answers may include:

  • definition of monopoly power
  • diagram of monopoly
  • an explanation of how legislation and regulation can be used to limit the pricing power of monopoly firms
  • examples of a monopoly being subjected to legislation and regulation by a government
  • synthesis or evaluation (evaluate).

Question

Explain why producers in an oligopolistic market might choose to engage in non-price competition.

▶️Answer/Explanation

Answers may include:

  • definitions of oligopoly, non-price competition
  • diagram of non-collusive oligopoly showing price-elastic demand above the market price and relatively price-inelastic demand below the market price and/or prisoner’s dilemma
  • an explanation of how interdependence in oligopolistic markets incentivizes oligopolistic firms to keep prices stable and therefore pursue non-price competition
  • examples of oligopolistic firms that pursue non-price competition.

Question

Explain two factors that might give rise to economies of scale for a firm.

▶️Answer/Explanation

Answers may include:

  • definition of economies of scale
  • diagram to show the impact of economies of scale on the shape of the long run average cost curve
  • an explanation of two factors that give rise to economies of scale like specialisation, financial, technical, bulk buying.etc.
  • example(s) of economies of scale.

Question

Explain why a monopolistically competitive firm can make economic (abnormal) profit in the short run, but not in the long run.

▶️Answer/Explanation

Answers may include:

  • definitions of monopolistic competition, economic (abnormal) profit, short run, long run
  • diagram of a monopolistically competitive firm that makes economic profit in the short run by producing the quantity of output where MR=MC and price is lower than ATC; diagram of a monopolistically competitive firm that makes normal profit in the long run by producing the quantity of output where MR=MC and price is equal to ATC
  • explanation that in the long run the economic profit will disappear, because the lack of barriers to entry in the industry will allow the entrance of new firms, which will attract customers away from existing firms (decreasing the demand)
  • examples of monopolistically competitive markets in practice (e.g. restaurants, legal and tax services, dental care).

Question

Distinguish between perfect competition and monopolistic competition.

▶️Answer/Explanation

Answers may include:

  • Terminology: monopolistic competition, perfect competition
  • Explanation: that perfect competition is characterised by many firms, free entry and exit, homogeneous products and perfect knowledge, whereas monopolistic competition is characterised by many firms, free entry and exit and product differentiation; and the impact of these features on the two markets with regard to pricing power, long-term economic profits and allocative efficiency
  • Diagram: use of a perfect competition diagram and/or a monopolistic competition diagram.

Question

Using real-world examples, discuss the impact of large firms having significant market power.

▶️Answer/Explanation

Answers may include:

  • Terminology: market power
  • Explanation: of the impact of significant market power in terms of the monopoly and oligopoly models
  • Diagram: showing monopoly/collusive oligopoly (significant market power)
  • Synthesis (discuss): the advantages and disadvantages of significant market power in terms of economies of scale, including natural monopolies, abnormal profits to finance investment in R&D and innovation; the possible welfare loss, the risks in relation to price, output and consumer choice, the possibility that such firms may pursue goals other than profit maximization
  • Examples: real-world examples of large firms that have significant market power.

Question

Explain why, in monopolistic competition, abnormal profits can be made only in the short run.

▶️Answer/Explanation

Answers may include:

  • Terminology: monopolistic competition, short run, abnormal profit, barriers to entry.
  • Explanation: of the short run profit-maximizing position with abnormal profit being made; and of the long run position being affected by entry of new firms, resulting in decrease in demand for existing firms, with abnormal profits being eliminated and normal profits eventually being made.
  • Diagram: short run and long run monopolistic competition diagrams.
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