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(b) Discuss whether the conduct of firms that operate in an imperfect market
is necessarily harmful to society. [15]
Question requirement
This question requires you to clearly explain and compare how prices are
determined under perfect and imperfect markets.
Price determination
Body: Similarity Regardless of the market structure that the firm operates in,
between firms in the price is determined by both buyers and sellers in the
perfect and imperfect markets. The demand curve will illustrate the willingness and
competition ability to pay of the consumers while the producers would
indicate their willingness and ability to produce through the
supply curve. However, there are differences in exactly how
the price is determined under each structure.
Body: Price
determination Revenue/
under PC Cost ($) MC Revenue/ Industry S
Firm Cost ($) P1
P AR=MR P
0
Qe Output Q1 Q Q2 Output
0
Figure 1
Revenue/Cost
MC (SS)
B
C
Pm Figure 2
Ppc A
D
E
AR (DD)
MR
0 Output
Qm Qpc
The monopolist determines its profit maximising output
according to the MC=MR rule. As shown in the above diagram,
the profit maximizing or equilibrium output will be where its MC
cuts its MR at point D. Thus, the monopoly is seen to be
producing output Qm. Its price will be Pm as indicated by its
AR (DD) curve. Since it decides on the output, the price is
determined by the position of the demand curve, that is,
the consumer decides.
Body: Highlight the Using the framework of a monopoly and PC market, the
differences of price differences in price determination can be highlighted. In a
determination perfect market, the market demand and supply will determine
between PC and the price and the PC firm, being a price taker will sell at the
monopoly market equilibrium price. Conversely, under imperfect market
Thinking Process Content / Analysis / Evaluation
like a monopoly, it has the ability to set price. Hence the
equilibrium output is first determined using the MC=MR
condition before getting the price from the consumers’ demand
curve.
(b) Discuss whether the conduct of firms that operate in an imperfect market is
necessarily harmful to society. [15]
Command word
Discuss - requires
you to Key word Key word Key word
- use economic Key word Harmful – Conduct – to Imperfect
concepts to Necessarily need to examine the market – to
explain the – need to examine behaviour of examine the
impact on society examine the firms under impact on
of imperfect situations negative imperfect society of
market firms ‘ where effects of market MC,
behaviour imperfect imperfectly monopoly
- evaluate the market market and oligopoly
impact on society firms’ firms’ firms’
of firms’ behaviour behaviour
behaviour might be
beneficial
Harmful Beneficial
- not AE and PE - ability to reap EOS
- x-inefficiency - ability to do R & D
- inequity - can contribute to employment
of economy and increase
export revenue
Body: inequity A monopolist and oligopolistic firm can earn supernormal profits even in
the long run due to the substantial barriers to entry. Thus, income is
being redistributed from the consumers (the many) to the firms (the few).
This will increase income inequity in the economy and is thus harmful to
society.
Body: ability to reap Though the conduct of firms under imperfect market might seem to be
EOS harmful to society, there are circumstances where they may be beneficial
to society. The monopolist can actually charge a lower price and produce
a higher output compared to the PC industry when it reaps substantial
internal economies of scale. As the PC industry comprises many small
firms, each firm is not able to reap substantial EOS. On the other hand,
the monopolistic firm which produces on a large scale is able to reap
internal EOS, which enables its MC curve to be lowered and shift from
MC to MC1 as shown in figure 3.
Price per unit
MC
Pm Figure 3
PC MC1
P1
MR AR Output
0 QmQc Q1
The benefit arising from EOS is even more prominent in the case of
natural monopolies. A natural monopoly occurs in an industry where
there is substantial cost savings due to large scale production, e.g. the
utilities industry. As a result, the LRAC of a natural monopoly is falling
even when the entire market demand is satisfied. Thus it is more efficient
for one firm to produce for the entire market. However, given that a
natural monopoly has substantial market power even in the long run, it is
possible that it does not pass the cost savings to the consumers. Hence,
the government may want to regulate the monopoly so that it would not
exploit the consumers but instead would pass the cost savings to the
consumers.
Body: ability to do R&D A monopoly or oligopolistic firm has the financial ability and incentive to
innovate and engage in R&D due to their supernormal profits. Besides,
such market structures may be more dynamic efficient than PC. They
have the financial resources to engage in R&D which may help to lower
the price and raise the quality of its good. Moreover, in trying to maintain
their barriers to entry, they may have the incentive to innovate and
improve the quality of its product. On the contrary, PC lacks resources
and the incentive for innovation and hence consumers may not always
benefit. The incentive to innovate by the monopolist is stronger especially
in a contestable market. This happens when the market has low cost of
entry and exit which increases potential competition in the market by “hit
and run” producers. Thus, the monopolist must be on its toes and
constantly innovate to keep its prices low and quality high so as to
prevent new firms from usurping their monopoly position. Thus,
consumers are not necessarily worse off.
Body: Macro benefits In the increasingly globalised world, the presence of foreign competitors
means that monopoly and oligopolistic firms face stiff competition. This
can help to minimise the risk of exploitation by the domestic firms. Such
firms also help to promote the macroeconomic aims of employment,
economic growth and BOP as large firms such as monopoly and
oligopolistic firms offer greater stability and compete more effectively in
the global market, thus increasing the export revenue. This would benefit
the society, especially consumers as their SOL can increase with a rise in
employment and national income.
Body: Product variety Firms under MC structure can also be beneficial to society as they offer
and advertising consumers with a wide product variety in terms of style, quality, services
and design to suit their differing tastes and preference, increasing
consumer welfare. The large variety of restaurants and retail shops
available certainly help to increase the choices available to consumers.
Such firms also engage in non-price competition through advertising
and product development. This in turn creates jobs for the workers in
industries like advertising companies, broadcasting stations and
publishers etc.
Conclusion In conclusion, it can be seen that the conduct of firms that operate under
imperfect market is not necessarily harmful to society. Though they tend
Thinking Process Essay
to be allocative and productive inefficient, there are possible
circumstances where they benefit the society in terms of lower prices due
to EOS, more innovations and achieving the macro aims. Moreover,
industries which involve a high start-up cost like utilities might be more
suited to a natural monopoly structure. The government can do its part in
minimising the harmful effects by regulating the big firms to ensure that
they do not engage in unfair practices which may restrict competition.
Government can regulate them using policies such as taxation and
pricing policy. The important thing is that the regulation should consider
carefully the costs and benefits so as to lead to a more efficient allocation
of resources and higher welfare for the society.
(a) With the use of an example, explain the concept of price discrimination and the
conditions under which it may occur. (10)
Question requirement
This question requires you to clearly explain and compare how prices are
determined under perfect and imperfect markets.
Price determination
E.g. airlines and bus companies charge different fares for adults and children/students.
After listing out the example, students should identify the type of price discrimination
(most commonly third degree price discrimination)
Illustrate figure 1:
Illustrate Figure 2
3. The firm must be able to segment the market into separate and identifiable
groups. Each submarket must have different price elasticity of demand. A higher
price is charged in the submarket with a more inelastic demand e.g. business
class air tickets (note that there are some cost differences in this case, but
nowhere near enough to explain the price differential). The business user will
travel as and when necessary regardless of the price. The leisure traveler, on the
other hand, is far more likely to be price sensitive.
(b) Discuss the view that a price discriminating monopolist will always be preferred to a
perfectly competitive market. (15)
Assumptions: For ease of answer, candidate should opt to explain first degree price
discrimination. This allows the candidate to use an economic framework to analyse the
effects on consumer, firm and society. The main comparison should be focused on the
basis of productive and allocative efficiency, equity, innovation and consumer choice.
Both firm/industry achieves allocative efficiency. PC industry produces at the point where
dd = ss and all firms are producing where P=MC in LR. General desirability of PC
industry: PE and AE
However,
If students argue this point citing 3rd degree price discrimation, answer can also
be accepted.
3. Higher profits for the firm
The discriminating producer enjoys higher revenue and thus profits. Higher
profits may benefit society if these profits are re-invested into research and
development which leads to product improvement and cost reductions. This is
compared to the PC market, where there is no innovation due to the
homogeneity of product as well.
Evaluation
Possible evaluation in the body or in the conclusion: Note that evaluative points must be
explained. E.g.
• How important are the individual costs and benefits to the
consumer?
• Do the good aspects of price discriminating monopolist outweigh
the bad aspects? Do all consumers gain or only some groups of consumers?
• Appeal to reality; Effects arising from globalization; Government
intervention
• Alternative theories like theory of contestability
a) With the use of examples, differentiate between the key features of the economic
models of monopolistic competition and monopoly.
[8]
(b) Discuss the view that more market power leads to the exploitation of consumers.
[17]
Distinguish the two economic models of monopolistic competition and monopoly by comparing
their key features: number of firms relative to the market size, the nature of product, availability of
information and the ease of entry and exit into the industry.
Marking Scheme
Level 1 Expect a largely inaccurate or incomplete answer. Attempts to explain the key features of
(1-3) the two models but no attempts at differentiation/ comparison. Examples of the 2 models
are not provided.
Level 2 Expect an accurate but undeveloped answer that attempts to differentiate between the
(4-6) two models. Examples are provided but with limited elaboration.
Level 3 A comprehensive answer that differentiates between the 2 economic models based on all
(7-8) 4 key features and well-illustrated with examples.
(b) Discuss the view that more market power leads to the exploitation of consumers.
[17]
Introduction:
More market power may lead to the exploitation of consumers because of the higher price they
pay and the lower quantity which is transacted on the market. However, firms with larger market
power may also enjoy economies of scale which may benefit consumers in the form of lower
prices and better quality products in the light of competition for greater market share which
entices the firms to engage in R&D.
Body:
The extent to which a firm can exercise its influence on market prices is an indication of its
market power.
Barriers to entry
If information on the product prices and quality is readily available to all consumers,
producers have less influence over the market price since any price increase will be made
known to the consumers and they would experience a fall in the demand for their good.
Similarly, information on the production processes and technology is easily available to the
producers and no firm has an exclusive right to technology, as such they all have similar
production techniques. In this case, firms are unlikely to have any influence over the
market.
Hence, when consumers and producers have perfect information on the product, such
market structure is known as a Perfectly Competitive market structure. For Imperfect
market structures, consumers lack information on the products and some firms tend to
have far superior technology and advance production processes compared to their
competitors. Such firms tend to have greater market power over the market.
Firms with market power include firms in imperfect markets such as Monopoly, Oligopolies and
Monopolistically Competition. Firms in these markets can either influence price or output in order
to maximize profits. A perfectly competitive industry is one in which firms have no market power
to set prices.
The question is about “more market power” and whether that would lead to the exploitation of
consumers. As such, students need to discuss and focus on “market power” and use the different
market structures as illustration.
Areas to discuss:
- prices, quantity
- variety of choices
- allocative efficiency
P.C
- Infinitely many small firms in the industry, each firm is small.
- Homogenous/identical products
- Free entry and exit from the industry
- Perfect knowledge of market by buyers and sellers.
Assuming that the PC industry and the Monopoly have the same revenue and cost structures,
Grey areas:
Lesser choice/ variety for consumers? P.C. – no market power but also identical product.
Monopoly with tremendous market power – also no variety. However, does seem to indicate
that less market power (like M.C industry) has more variety of products than an
monopoly/oligopolies
In a monopoly, there is no need for innovation as there is no competition in the industry. But it
is the same in a P.C. with no market power. In industries with more market power, firms tend
to engage in innovation and R & D in order to increase the variety/quality of products. This will
benefit consumers.
As firms compete for market share, they compete in terms of price and non-price competition.
Product innovation may thus occur.
For example, as firms in the bakery industry such as Breadtalk, Four Leaves, Qbread and
other neighbourhood shops compete for business, they come up with better and more
interesting variety of bread for consumers to choose.
Hair salons offer differentiated services and may try to compete on service quality (e.g. more
personalized services, head scalp massage etc) as well as lowering prices (on hair cuts and
hair treatments) which benefits consumers.
Anti-thesis: More market power may not lead to the exploitation of consumers but benefit
them instead.
Given the scale of production that a large firm with more market power carries out, it is more
likely to enjoy EOS (e.g. Technical, Marketing, Managerial, Financial, Risk-bearing EOS)
which can lower the cost of production, and leading to lower prices in the cost savings are
passed on to consumers. Consumers thus gain greater consumer surplus.
The pursuit of LR profits leads to product innovation. The large firm earns supernormal profits
to engage in R & D which can benefit consumers. Firms in the Monopolistically Competitive
industry do not have the ability to engage in R & D and there may not be any real differences
in the products that they innovate.
Price discrimination
Given the market power of large firms (e.g. oligopolies), they would sometimes practice price
discrimination. The most common form tends to be 3rd degree PD where consumers are
segmented into different groups and prices are charged according to the group. For example,
in the telecommunication industry in Singapore, all the firms charge a higher price for certain
groups (working adults) but provides the same services if not more to other groups (students
and senior citizens) at a lower price.
Furthermore, with other forms of PD, certain essential services would also then be provided to
those with lower ability to pay, thus increasing their welfare. For example, certain unprofitable
bus routes can be kept running because of cross subsidization using PD. This would not be
possible if firms do not have substantial market power to practice PD.
Conclusion
The level of market power influences the conduct of firms in the industry. Although a larger
degree of market power may lead to the exploitation of consumers, there are also instances when
more market power might actually be beneficial instead. The outcome would generally depend on
the type of industry. Furthermore, given various government regulators and competition law
present, the firms would be less able to engage in activities that would exploit the consumers.
Marking Scheme:
Level 1 Where the answer is mostly irrelevant and contains only a few valid points made
(1-5) incidentally in an irrelevant context.
For a one-sided answer showing how more market power could lead to more
exploitation of consumers or how more market power could benefit consumers.
The question has not been properly grasped, and there is inadequate development of
analysis and application.
Little/no examples given.
Level 2 For a one-sided answer that explains how more market power may lead to exploitation
(6-9) of consumers or how more market power could benefit consumers.
There is evidence of development of analysis and application though it may not be fully
developed.
Or for an accurate but undeveloped explanation answer with a balanced view.
Answer is illustrated with some examples.
Level 3 Expect a good knowledge of the facts and theory of the question. Clear evidence of the
(10-13) ability to present a logical and reasoned analysis.
Answer is well-illustrated with examples.
E1 (1-2) For an assessment that is not supported by analysis
E2 (3-4) For an evaluative assessment based on economic analysis