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.