GCE A-LEVEL ECONOMICS REVISION TOPIC: Market Structure (H2 Only) (a) Explain how, in economic theory, a monopolist

would determine the price that would max profits. [8] (b) Discuss whether firms want to, and are able to max profits, in reality. [17] Part (a): A Conditions qn, that is needed to reach a state. Suggested Answer A monopolist is a single firm in a market, with no existing competitors. Due to formidable barriers to entries (BTEs), the lack of competition implies that the good or service provided is consider unique. Remarks Content

The BTEs may be natural, such as the huge initial start up costs required to penetrate the market. It may be legal, such as the obtaining of a government licence. Without a licence, potential entrants are not allowed to enter the industry to compete. Given its sole seller position, the monopolist has a lot of market power. Content Unlike a price taker, she can set price in order to achieve her objectives. Usually, it is assumed that the monopolist aims to maximise profits, which occurs when the difference between total revenue (TR) - total costs (TC) is a maximum, or when marginal revenue (MR) = marginal costs (MC). When MR=MC, it means that the additional revenue received for the last unit sold exactly equals the extra costs incurred for producing that last unit of the good. Figure 1 illustrates why profit max must occur at the point whereby MR=MC. To max profits, the monopolist produces at pt E, where MR=MC. The TR earned is area OPECQE. The TC incurred is AC (average cost) x output = area OP1DQE. Hence the profits earned = TR-TC =area P1PECD. This supernormal profit earned is the maximum and if she produces at any output levels, she will not be maximizing profits. For eg, if she produces at output level Q1, MR>MC (MR is represented at by pt A, and MC is represented by pt B), meaning for the last unit of the good, the extra revenue received exceeds the extra costs incurred in producing it. The consumers value the benefits more than the costs, so the monopolist will raise her profits by raising her production, until MR=MC. Similarly, if she produces at output Q2, MR<MC, so the extra revenue received is less than the extra cost incurred. The monopolist will raise her profits by actually reducing her output, until MR=MC. Hence, the output

HigherO rder : ANALYS IS

DIAGRA MMATIC AL) ANALYS IS 1

that corresponds to MR=MC is the optimal output level, and that maximises profits. Fig 1: Profit Max Monopolist Price

SS=MC

Pf Ppc P1 MR Q1 QF Q2 Qpc AR = P = DD AC

Quantity

In conclusion, the monopolist in theory, will determine the price that max profits by producing at the point whereby MR=MC. At this point, equilibrium price is P and output Q respectively.

Part (b) Evaluate usefulness Suggested Answer As already explained, all firms, just like a monopolist, max profits when they produce where MR=MC. Most firms exist because they have the objective of maximising profits. By using available resources such as land, capital such as machinery and equipment, and labour to produce goods and services, and organising them in a way so that the lowest cost of production is incurred, firms are able to earn profits. However, in reality, some firms exist with other objectives. For eg, some firms aim to maximise welfare of the population. Also known as non-profit organisations, they are usually charitable organisations who aim to care for the less fortunate in society, such as the disabled, the orphans, etc. Then such firms usually provide their goods and services at low prices or even free. Approximately, they produce at the perfectly competitive output level, P=MC. Some other firms, especially newer firms have growth, or expansion or greater market share as their main objective. Hence, instead of maximising profits, such firms aim to only earn a certain rate of return on their initial investment or start up funds. Also known as satisficing, this alternative seeks a satisfactory level of profits, rather than to maximise profits. In fact, certain firms even resort to making subnormal profits, i.e. making losses in the short term, so that they can put other firms out of business. Termed as predatory pricing, firms can deliberately set price lower than MC, make losses in the short run (SR), gain market share in the long run (LR), then dominate the market and set profit maximising prices, with the new and larger market share. In theory, the objective of profit maximisation is a very strong aim for firms to follow. Profit maximization ensures firms survival in the SR, and growth and maturity in the LR. In reality, however, exact profit maximisation can be a very difficult objective to achieve, meaning it has limited usefulness in practice. For eg, in reality, there is the difficulty in determining the demand (DD) curve that represents consumers willingness and ability to buy the good at various prices. Recall that AR = TR/Q = P, so the DD curve also shows the average revenue that is earned for selling a particular output level. Since the MR curve is derived the AR curve, thus the difficulty of knowing the exact AR curve also extends to knowing the exact MR curve. Being Antithesis: Dont want to Antithesis: Dont want to Remarks Thesis: Want to

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unable to know the MR curve, it is very difficult to max profits in practice. Similarly, it is very difficult to know the exact MC curve. MC includes the explicit costs, such as the labour costs, that involve cash payment. This is easily observable. MC however, also includes the implicit costs such as opportunity costs incurred for foregoing the next best alternative. It may be an alternative good that can be produced or an alternative business the owner can undertake, etc. Since implicit costs are hard to predict, then MC in reality is also hard to determine exactly. Therefore, MR=MC rule to max profits are hard to use in reality. Hence, many firms in reality are not able to max profits. What is worse that, in reality, demand and costs conditions do not remain static over time. Even if it is poss to determine exactly MR and also MC, their frequent changes make such determination very time consuming and even costly! Thus, most firms actually resort to satisficing in practice. For eg, a firm may settle for a rate of return of 50% on their costs incurred as a satisfactory level of profits. And they raise the rate of return over time, as a way of estimating the performance of the firm. Another reason why some firms in reality are not able to max Evaluation profits is because of regulation by governments. Governments wish to protect consumer welfare in terms of lower prices, higher quantity and quality and also a larger variety. In the cases of a monopolist, for eg, an unregulated market will see the monopolist charging the market price at PE, as seen in Fig 1. A government may see such conduct as a form of exploitation of consumers. In order to lower prices, the government may impose rules such as MC pricing. In Fig 1, if the monopolist is regulated to only implement MC pricing, then the market price is only PPC, which is < than PE. In certain cases, especially natural monopolies, the usual government response is to nationalise the industry and take control of the monopolist. Usually involving goods and services such as utilities like electricity, gas, water, the government actually runs the firm themselves. The govt-run firm has welfare max objective, and the profit max objective can no longer be carried out. Finally, another reason maybe certain firms face very tight competition in the market, such that they are unable to max profits. For eg, in the case of an oligopolistic market, such as telecommunication industry in Spore, the 3 Telco firms have a degree of mutual interdependence among themselves. This results in rival awareness and pricing and putout decisions have to take into account rivals poss responses. For eg, Singtel may incur a higher cost of production (COP), say due to firm growing too large and managerial diseconomies of scale set in. Singtel should cover

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this rise in COP by raising prices. However, if this rise leads to a rise in the price significantly higher vs M1s and Starhubs prices, then Singtel would lose market share. Hence, Singtel can only maintain market share by absorbing the higher COP, and let prices remain the same. Since costs rise, then profits fall. In this instance, again some firms cannot max profits due to the need mutual interdependence and to remain as competitive as their rivals. In summary, most firms want to max profits, although some do not want to max profits as they aim for faster growth of their firms and sacrifice some profits. In reality, due to the difficulty of knowing exactly Mr and of MC, most firms, if not all, are unable to max profits. Even if poss, government regulation of firms and the high degree of competition in a market may also see firms being unable to max profits. Thus, a significant majority of the firms want to max profits although none of the firms are able to max profits in reality.

Conclusion Your conclusion has to be clear and forceful in the part b essay. NO ambiguity pls.