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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
Remarks
A monopolist is a single firm in a market, with no existing competitors. Due to formidable
BTEs, the lack of competition implies that the good or service provided is consider
unique.

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.

Content
Given its sole seller position, the monopolist has a lot of market power. 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.

Content
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 OP
E
CQ
E.

The TC incurred is AC (average cost) x output = area OP
1
DQ
E.


Hence the profits earned = TR-TC =area P
1
P
E
CD. This supernormal profit earned is the
maximum and if she produces at any output levels, she will not be maximising profits.

Higher-
Order :
ANALYSIS

For eg, if she produces at output level Q
1
, 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 Q
2
, 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 that corresponds to MR=MC is the optimal
output level, and that maximises profits.

(DIAGRAM-
MATICAL)
ANALYSIS
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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
Remarks
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.

Thesis:
Want to
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.

Anti-thesis:
Dont want
to
O
C
D
P
1
MR
E
A
B
Q
E
Q
PC

Q
1

Q
2

AR = P = DD
SS = MC
Price
P
E
P
PC
Qty
Fig 1: Profit Max Monopolist
AC
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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.


Anti-thesis:
Dont want
to
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.

Evaluation:
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 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.

Evaluation
Another reason why some firms in reality are not able to max 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 P
E,
as seen in Fig 1.

Evaluation
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(You may wish to redraw a new diagram, if you wish)

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 P
PC
,
which is < than P
E
.

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 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.

Evaluation




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.