1. a. D Revenue
1. b.
2. a. and b.
2. c. D Increase Substitutes
3. a. and b.
4. a.
b. D Unspoken agreements
5. a. C Horizontal integration
5. b. They may achieve technical economies of scale. This is because some machinery and
processes are more efficient at a larger scale. This efficiency allows them produce at a lower
average cost and therefore make greater profits.
5. c. One concern the regulator may have had is that the car makers would get greater
market share in the consumer car business. This would allow them to gain greater market
power. This may allow them to influence prices to be higher than they would otherwise be,
to increase profits. This harms consumers.
6 (a) With reference to Figure 1, calculate the three-firm concentration ratio for branded
coffee shop chains. (5)
0.52955 = 52.955%
(b) With reference to Figure 2 and your understanding of price elasticity, examine two
factors that may cause significant changes in the international price of coffee beans. (8)
The price of coffee fluctuated rapidly over 2020, regularly changing over 8% in a month, that
is relatively volatile for an internationally traded commodity. From its low point in February,
the price rose almost around 18.5% to its peak in September.
One factor that may have increased the price volatility is relative price inelasticity of supply.
This is caused by the fact that production of coffee takes time to increase, trees must be
planted, grow and mature before they produce coffee. This means that a relatively small
change in demand (such as a change in incomes and consumption during Covid) can cause
rapid swings in price.
Another factor that may have increased the volatility of the price relative price inelasticity of
demand. This is caused by several factors, the caffeine in coffee is addictive and habit
forming. This also contributes to coffees status as a necessity (low, positive income elasticity
if demand) in most developed countries. Bother of these factors make coffee relatively price
inelastic, this means that a small change in supply (such as disruption to supply chains
during Covid) can cause rapid, large changes in price.
Both of these factors have their effects reduced by the fact that coffee can be stored, both
by producers and consumers, reducing those elasticities and therefore making the price
more stable.
(c) Profit maximisation is assumed to be the business objective of most firms.
With reference to Extract A, assess whether this is the case for coffee shop owners. (10)
Firstly, as the extract states, a large number of coffee shops are independent. As the extract
states, they are often run as a “part of the local community”. This suggests that the business
owner has entirely non-financial reasons for operating the business. This can be seen as
community spirited altruism, which while not withing the narrow definition of economic
rationality, is common social behaviour. This means that the independent shops may be
focusing on "atmosphere and customer service” over and above profitability. This leads to
profit margins as low as 2%. This is shown on diagram 1 as an independent café making
normal profit at q0.
The extract mentions that this low profit margin means that the entry of a large chain in to
the market can put an independent café out of business. This is shown as the entry of the
chain causing demand for the chain to fall, causing them to be making a loss at q1. This will
cause them to exit the market in the long run. This suggests that working in the interests of
the community makes the independent cafes costs too high, leading them to go out of
business.
Coca-Cola said it intends to maximise “long term returns”. This largely means maximising
profits in the long run. This can mean forgoing short term profits to pursue investment. This
is generally seen as good thing as it increases dynamic efficiency. However long run returns
could also involve predatory pricing to gain market share. This would increase Costas market
power, allowing them to reduce quantity supplied to increase prices and therefore profits.
This is not in the interests of most other market participants, generally increasing
inefficiency. However Coca-Cola also mention “sustainable communities”. This is likely a
reference to fair trade practices with their coffee farmers. This on the surface seems not to
maximise profit and instead to be altruistic. However this is good branding and can therefore
be seen as profit maximising in the long run as it increases demand for costa products and
prevents scandals.
(d) Using a cost and revenue diagram, discuss the likely impact of ‘rising costs’ for coffee
shops on their profitability (Extract A, line 2). (12)
The effect of the increase in costs on the coffee shops depends largely on their scale. This is
seen from the different impacts mentioned in the essay. The larger chains are slowing down
expansion (Costa is down 60%) but generally still expanding. They are not downsizing or
going out of business entirely. This contrasts with independent shops which are going out of
business, especially when faced with competition from chains.
Chains appear able to remain in business and even grow while costs are increasing. This is
partly because they have large market shares. This means they are likely to have some
market power. This will allow them to reduce change the quantity they supply to increase
prices. This can sometimes increase profits. This market power is shown in diagram 2 by the
downward sloping average revenue curve. Another benefit of a large market share is that
they can take advantage of economies of scale. This means that they can produce at lower
average costs. They do this by reducing the inefficiencies of small firms such as having
central management, accounting and advertising. This also forms a national brand,
increasing demand and therefore average revenue. These allow the chains to generate super
normal profits. These mean that when prices increase the chains can absorb this reduction
in profitability (shown as the slashed area on diagram 2) while still making at least normal
profit (the firm actually keeps making super normal profit on diagram 2, shown as the dotted
area).
Independent shops are less able to remain in business for the opposite reasons. They do not
have market power and therefore face lower demand and therefore lower average revenue.
They also operate at smaller scale and therefore cannot make use of economies of scale,
leading to higher average costs. This is shown in diagram 3. This means that when cost
increase (from AC0 to AC1) the firm goes from making normal profit to making a loss. This
means they will go out of business in the long run. The rising costs are possibly made less
extreme by the independent shops status as “part of the community”. This is because people
may be willing to pay more to stop the shop from going out of business. The workers may
also be willing to work for below market rates in order to keep working for an employer that
is seen as treating its workers well and giving genourous benefits.
(e) With reference to the information provided, discuss whether the coffee shop market is
contestable. (15)
For a market to be contestable the entry and exit of firms into and out of it must be free.
This means there must be no barriers to entry or exit. However absolutely no barriers is
unrealistic as almost all markets have at least some barriers to entry. Therefore, it shall from
here on be treated as few, small barriers to entry, not prohibitive.
Firstly, one barrier to entry are the economies of scale. This is because if there are large
economies of scale then the existing firms will be producing more efficiently and therefore
at a lower cost, than is possible for a new entrant. There are economies to scale in running a
coffee shop. Firstly, running several shops reduces duplication. This is because it allows for
central management and accounting functions. This reduces cost, making the business more
profitable. However, there must still be onsite management to run the shop therefore this
economy is not too large. Advertising duplication can also be reduced. This not only reduces
costs by contributes to building a brand. This increases consumers awareness of the chain
and therefore increases demand. This means the shop can possibly charge more, therefore
being more profitable.
There are also barriers to exit. These reduce contestability in 2 ways. Firstly, they incentivise
firms to remain in the market even when it is not profitable. This artificially supresses the
price which forms a barrier to entry. They also act as a deterrent to new entrants if the exit
costs are sunk. Because if the venture is not profitable and the firm has to exit any sunk
costs are lost, therefore this may make a firm hesitant to enter in the first place. An example
of this in the coffee shop market would be the costs of exiting contracts. These include rental
contracts and those with culinary and coffee suppliers. There are also the losses of
“goodwill” and brand loyalty that come with exiting a market entirely.
The above factors suggest the market is not contestable however, when compared to other
markets the coffee market is relatively contestable. It does not require large sums of capital
to enter. It does require some however, to make a rent downpayment, to initially pay staff
and advertise. There is also the need for experience in making coffee. Barista training is costs
money and time and is therefore a barrier to entry. The entrant could also hire a barista (as
mentioned in extract A, the wages for baristas are rising) but this further increases the initial
wage bill. These costs are significant but not prohibitive. This is demonstrated by the around
25,000 independent coffee shops (extract A). This large number means that there must be
entry into the market.
7. Tesla held an 82% market share of the electric vehicle market in the United States during
the first half of 2020.
Evaluate whether a monopoly is likely to operate efficiently. Refer to at least one monopoly
of your choice.
Efficiency is a necessary condition for the maximising net economic welfare.
Static efficiency, is efficiency at one point in time. Specifically it is allocatively and
productively efficient. It also minimises X-inefficiency.
Allocative efficiency is achieved when the equilibrium price in the market is equal to the
marginal cost of producing a good. This is show on diagram 4, as clearly not happening
under monopoly. This is because the price must be equal to marginal cost and that is clearly
not true for diagram 4. Allocative efficiency is actually impossible for a profit maximising
monopolist in equilibrium. A monopolist faces the demand curve directly and by the law of
demand that demand curve is downwards sloping. Therefore the marginal revenue curve is
below the average revenue curve for all positive quantities, MR < AR, therefore AR ≠ MR.
Equilibrium means that P* = AR. Profit maximising means that the monopolist produces a
quantity such that marginal revenue equal marginal costs, MR = MC. AR ≠ MR and AR = P*,
therefore P* ≠ MR and MR = MC, therefore MC ≠ P*. Therefore a profit maximising
monopoly cannot be productively efficient. An example of this is tesla, it may choose to set
price higher than marginal cost because it doesn’t face sufficient competition to force it to
lower them, therefore it is not allocatively efficient.
Productive efficiency is achieved when production takes place at minimum long run average
cost. This is also not true for diagram 4, because average cost intersects marginal cost at the
minimum point on the AC and therefore AC would be equal to marginal cost if the
monopolist were productively efficient. Therefore the monopolist Monopolists are generally
not productively efficient however, it is not impossible for a profit maximising monopolist to
achieve productive efficiency. The monopolist could happen to produce at the productively
efficient point however this would be coincidental and therefore unlikely. An example of this
is tesla, it may chose to supress quantity supplied (to increase the price and therefore
profit), in doing so it is possibly forgoing economies of scale, and therefore not producing at
the productively efficient point. It is also possible that tesla has such market power that
other companies cannot compete with it despite the fact it is competing beyond the
productively efficient point (and therefore suffering diseconomies of scale)
However given large enough economies of scale, a market becomes a natural monopoly.
This is where the economies of scale are such that only one firm can operate at minimum
efficient scale (and therefore be productively efficient) at the extent of market demand. In
this situation a perfectly competitive market would be producing at a higher long run
average cost, due to fewer economies of scale. Therefore a natural monopoly is the most
productively efficient feasible outcome. An example of this is also seen in tesla, it is likely
that minimum efficient scale for a product as technically complex as an electric car is larger
than the extent of demand in any one country. Several studies have suggested this to be the
case. This is because of the massive technical and physical economies of scale of the
production process. Such as the exponential gains from research and development as well as
the economies from division of labour. This is because the division of labour allows greater
capital intensity (machines are better are short, more repetitive task, therefore favour labour
that is divided).
A competitive monopoly (one achieved by the action of the monopolist) can be efficient in
some ways. This depends on its actions. If the firm choses to revenue maximise, it will sell
far more and at a lower price and likely higher marginal cost, therefore coming closer to
allocative efficiency. It may also chose to produce at the minimum point on the long run
average cost curve, to minimise costs, thus achieving productive efficiency.
Dynamic efficiency is different to static efficiency as it is efficiency over a period of time,
usually referred to as the long run. Dynamic efficiency is hypothesised by Schumpeter to
require super normal profit. This profit allows reinvestment into things like research and
development and improving production processes. This reduces the long run average cost
(achieving dynamic productive and X efficiencies). Super normal profit is possible under
monopoly, as shown in diagram 4. However the existence of supernormal profit does not
guarantee reinvestment and therefore dynamic efficiency. Firms may choose instead to
return the profits to shareholders. This is not per se inefficient however it does not achieve
dynamic efficiency.