IBDP Economics 2.3 Competitive market equilibrium HL Paper 1 - New Syllabus
Question
(a) Explain why firms in monopolistic competition may make abnormal profit in the short-run but not in the long-run. [10]
(b) Using real-world examples, evaluate the view that the existence of significant market power is always undesirable. [15]
Most-appropriate topic code (CED):
• TOPIC 2.11: Market failure—market power (HL only) – part (b)
▶️ Answer/Explanation
(a) Answer:
Monopolistic competition is a market structure characterized by a large number of relatively small firms, differentiated products, relatively low barriers to entry and exit, and considerable competition between firms.
Because firms sell differentiated products, each firm has some degree of market power. This means that its demand, or average revenue (AR), curve is downward-sloping. However, because there are relatively few barriers to entry, firms cannot maintain abnormal profit in the long run.
In the short run, a firm in monopolistic competition may earn abnormal profit. The profit-maximizing firm produces at the output where MR = MC. If the price determined by the firm’s AR curve is greater than its average total cost (ATC) at this output, the firm earns abnormal profit.
Abnormal profit provides an incentive for existing firms to expand and, importantly, attracts new firms into the market. This is possible because monopolistic competition has relatively low barriers to entry.
As new firms enter, consumers have more products and substitutes from which to choose. The demand for each existing firm’s product therefore falls. This is represented by a leftward shift of the firm’s AR (demand) curve.
The firm’s marginal revenue curve also shifts leftward because it is derived from the firm’s demand curve. The firm consequently faces a lower demand at each possible price.
The entry of new firms continues as long as firms in the industry are earning abnormal profit. Eventually, the demand curve shifts sufficiently to the left that the price at the profit-maximizing output is equal to average total cost.
At this point, the firm earns normal profit. Normal profit is the minimum return required to keep resources in their current use and is included within the firm’s economic costs.
Once only normal profit is being earned, there is no further incentive for new firms to enter the market. The industry therefore reaches a long-run equilibrium.
A short-run firm diagram can show the firm producing where MR = MC and earning abnormal profit because price is above ATC. A second diagram can show the firm’s AR and MR curves shifting left as new firms enter, until the price equals ATC and only normal profit remains.
Therefore, firms in monopolistic competition may earn abnormal profit in the short run because their differentiated products give them some market power. However, relatively free entry allows new firms to enter when abnormal profits exist, reducing the demand faced by existing firms until abnormal profit is eliminated in the long run.
(b) Answer:
Market power refers to the ability of a firm to influence the price or other conditions of exchange in a market. Significant market power may arise from factors such as barriers to entry, economies of scale, control over essential resources, brand loyalty or technological advantages.
The existence of significant market power may be considered undesirable because firms with substantial market power can restrict output and charge prices above the competitive level. This can result in allocative inefficiency and a loss of economic welfare.
Under perfect competition, firms are price takers and the market equilibrium occurs where price reflects marginal cost. In contrast, a firm with significant market power faces a downward-sloping demand curve and can choose a profit-maximizing output where MR = MC.
Since price is determined from the firm’s demand curve, the profit-maximizing price can be greater than marginal cost. This means that consumers may face a higher price and receive a lower quantity than under a more competitive market structure.
Diagram: A comparison of monopoly and perfect competition can show the monopoly producing a lower quantity at a higher price. The resulting area between the social marginal benefit and marginal cost curves represents the welfare loss associated with allocative inefficiency.
Significant market power can therefore reduce consumer surplus. Consumers who are willing to purchase the product at the competitive price may be excluded from the market because the firm charges a higher price.
Market power may also result in productive inefficiency. A firm protected from competition may have weaker incentives to minimize its production costs because it does not face the same competitive pressure as firms in highly competitive markets.
Furthermore, abnormal profits earned through market power can create a transfer of income from consumers to producers. If the firm maintains high prices over a long period, this may increase inequality between consumers and owners of the firm.
Pharmaceutical markets provide an example of how market power can create concerns. Patents temporarily prevent competitors from producing identical medicines, allowing pharmaceutical companies to charge prices above marginal cost. While this can create access and affordability concerns, the market power is partly intended to reward innovation.
However, significant market power is not always undesirable. One important potential advantage is the ability of large firms to achieve economies of scale.
Economies of scale occur when average costs fall as the scale of production increases. Large firms may be able to spread fixed costs over a greater level of output, purchase inputs in bulk and use specialized technology more efficiently.
If these cost savings are sufficiently large, a market may be most efficiently served by one large firm. This is the case of a natural monopoly.
Examples include industries such as electricity distribution, water networks and some railway infrastructure, where constructing multiple competing networks may involve substantial duplication of infrastructure and very high average costs.
In such circumstances, significant market power may allow a single firm to exploit economies of scale and provide the market at a lower average cost than several smaller competing firms.
However, because a natural monopolist may still have the ability to charge high prices, governments may regulate its behaviour. Price regulation can attempt to ensure that consumers benefit from the economies of scale without allowing the firm to exploit its market power excessively.
Another potential benefit of market power is increased investment in research and development (R&D). Firms earning abnormal profits have greater financial resources available to invest in innovation.
Successful innovation can generate dynamic efficiency by improving products, reducing production costs and creating new technologies. Some of these benefits may eventually spill over to other firms and consumers.
Apple provides an example of a firm with significant market power in parts of the smartphone and technology markets. Its strong brand loyalty and differentiated products allow it to exercise substantial market power. At the same time, its large revenues provide resources for substantial investment in product development, technology and innovation.
Market power may also encourage firms to undertake risky investments that would not be attractive if firms could not earn returns above normal profit. The possibility of earning abnormal profit can therefore act as an incentive for innovation.
However, whether this benefit is large enough to outweigh the costs depends on the degree and persistence of market power. Temporary market power may provide strong incentives for innovation, whereas permanently protected firms may have weaker incentives to improve efficiency.
The impact on consumers also depends on how firms use their market power. A firm may use market power to charge high prices, but it may alternatively use its financial resources to improve quality, provide better customer service or develop innovative products.
Government policy is therefore important. Competition authorities can prevent firms from abusing dominant positions through practices such as predatory pricing, exclusionary agreements or anti-competitive mergers.
At the same time, excessive government intervention could reduce some of the benefits associated with market power. If regulation prevents firms from earning sufficient returns from innovation, firms may have less incentive to invest in R&D.
The desirability of market power therefore depends on the source, degree and duration of that market power. If market power results from genuine innovation or substantial economies of scale, it may generate efficiency benefits. If it results mainly from artificial barriers to entry or anti-competitive behaviour, the welfare costs are more likely to outweigh the benefits.
Overall evaluation: The existence of significant market power is not always undesirable. It can result in higher prices, lower output, allocative inefficiency, reduced consumer surplus and welfare loss. These effects are particularly concerning where firms can maintain market power without providing corresponding efficiency or innovation benefits.
However, significant market power can also generate economies of scale, particularly in natural monopoly industries, and can provide firms with the abnormal profits necessary to finance research and development and innovation.
Therefore, the strongest judgement is that significant market power is desirable only under certain circumstances. Where market power reflects economies of scale or successful innovation, the efficiency benefits may outweigh the costs. Where it is used to restrict competition and exploit consumers, it is likely to reduce economic welfare.
Consequently, governments should generally seek to regulate or limit abuses of market power rather than assume that all market power is inherently harmful. The appropriate policy depends on whether the market power generates sufficient dynamic and productive efficiency benefits to compensate for the resulting loss of allocative efficiency.
Question
(a) Explain why in perfect competition abnormal profits are only made in the short run. [10]
(b) Using real-world examples, evaluate the view that firms will always seek to maximize their profits. [15]
Most-appropriate topic code (CED):
• TOPIC 2.4: Critique of the maximizing behaviour of consumers and producers (HL only) – part (b)
▶️ Answer/Explanation
(a) Answer:
Perfect competition is a market structure characterized by a large number of buyers and sellers, homogeneous products, perfect information, and the absence of significant barriers to entry or exit. Individual firms are price takers because no single firm is large enough to influence the market price.
In the short run, firms in perfect competition may earn abnormal profit. Abnormal profit occurs when a firm’s total revenue is greater than its total economic cost, including opportunity cost. In the standard model, the profit-maximizing firm produces where MR = MC.
Because a perfectly competitive firm is a price taker, its marginal revenue is equal to the market price. Therefore, the firm chooses its profit-maximizing output where P = MR = MC. If the market price is above the firm’s average total cost at this output, the firm earns abnormal profit.
In the short run, the number of firms in the industry is fixed because firms need time to enter or leave the market. Consequently, an existing firm can earn abnormal profit if market conditions allow the price to remain above its average total cost.
However, in the long run, there are no significant barriers to entry into a perfectly competitive market. The existence of abnormal profit acts as an incentive for new firms to enter the industry because they are attracted by the opportunity to earn higher returns.
As new firms enter, the market supply curve shifts to the right. The increase in market supply creates downward pressure on the market price. Since each individual firm is a price taker, the lower market price also reduces the firm’s average revenue and marginal revenue.
The process of entry continues as long as abnormal profit remains available. Eventually, the market price falls to the level at which firms earn only normal profit.
Normal profit is the minimum return necessary to keep the entrepreneur’s resources in their current use. It is therefore included as part of the firm’s economic costs. When a firm earns normal profit, there is no additional incentive for new firms to enter the industry.
A firm diagram can show the short-run equilibrium where the price is above average total cost at the profit-maximizing output, creating an abnormal-profit area. A market diagram can then show entry of new firms shifting supply to the right and reducing the market price. Alternatively, the firm’s demand curve can be shown shifting downward until abnormal profit is eliminated.
Therefore, abnormal profits in perfect competition can exist in the short run because the number of firms is fixed. In the long run, the absence of barriers to entry allows new firms to enter whenever abnormal profits exist, increasing market supply and reducing the price until firms earn only normal profit.
(b) Answer:
Profit is the difference between a firm’s total revenue and its total cost. The conventional economic assumption is that a rational producer seeks to maximize profit. Profit maximization occurs at the level of output where the difference between total revenue and total cost is greatest, or equivalently where marginal revenue (MR) equals marginal cost (MC), provided the relevant profit-maximizing condition is satisfied.
The assumption of profit maximization is useful because firms face the problem of allocating scarce resources. A firm that aims to maximize profit has an incentive to choose an output where the additional revenue from producing one more unit is equal to the additional cost of producing it.
If MR > MC, producing an additional unit adds more to revenue than to cost, so profit can be increased by expanding output. If MC > MR, the additional unit adds more to cost than to revenue, so reducing output increases profit. Therefore, profit is maximized where MR = MC.
Diagram: A standard firm diagram can show the downward-sloping MR curve intersecting the upward-sloping MC curve at the profit-maximizing output. The corresponding price or average revenue can then be used to determine the firm’s profit.
There are strong reasons why firms may seek profit maximization. Profit provides a return to the owners of the business and provides funds that can be used for investment, research and development, expansion and innovation.
Profitability can also help a firm survive in competitive markets. Firms that consistently make losses may eventually be forced to leave the market, while profitable firms have greater resources to expand their productive capacity.
However, the statement that firms will always seek to maximize profit is too strong. Firms may have several objectives that conflict with short-run profit maximization.
One alternative objective is profit satisficing. Managers may seek to achieve a satisfactory level of profit rather than the maximum possible profit. Once an acceptable profit has been achieved, managers may pursue other objectives such as reducing their workload, improving working conditions or increasing employee satisfaction.
Firms may also seek to maximize market share. A firm may deliberately charge a lower price than the profit-maximizing price in order to attract customers and increase its share of the market.
This strategy may involve sacrificing short-run profit in the expectation that a larger market share will create benefits in the future. A larger customer base may generate economies of scale, stronger brand recognition and greater bargaining power with suppliers.
Another possible objective is growth maximization. A firm may reinvest a large proportion of its profits in new factories, technology, employees or international expansion. This may reduce current profits but increase the firm’s size and future earning potential.
Firms may also pursue corporate social responsibility (CSR). A business may voluntarily incur higher costs in order to reduce its environmental impact, improve employee conditions, support local communities or use ethically sourced inputs.
For example, a firm may choose to use more expensive renewable energy or sustainably sourced raw materials. This could increase its costs and reduce short-run profit compared with the least-cost alternative, but the firm may consider environmental sustainability and its reputation important objectives.
Unilever, for example, has publicly emphasized sustainability and social objectives alongside financial performance. Such objectives can influence business decisions even where pursuing them may increase costs in the short run.
Firms may also prioritize long-term survival rather than maximum short-run profit. During a period of weak demand, a firm might reduce its price to maintain customer relationships and protect its market position rather than immediately maximizing its profit margin.
The assumption that producers are always fully rational also has limitations. Managers may have imperfect information about future demand, costs and competitors’ behaviour. As a result, even a firm that intends to maximize profit may not know exactly which output and price would produce the maximum profit.
There may also be a separation between owners and managers. In large corporations, shareholders own the firm while professional managers make many of the decisions. Managers may have personal objectives such as higher salaries, greater job security, prestige or larger departments.
These managerial objectives can conflict with shareholder profit maximization. A manager may therefore choose an output or investment strategy that increases the size of the firm or improves their own position rather than maximizing shareholder profit.
Real-world firms also face dynamic competition. A decision that maximizes profit today may damage the firm’s long-term competitive position. For example, a firm may invest heavily in research and development even though this reduces current profit, because failure to innovate could cause the firm to lose market share in the future.
The degree to which firms pursue profit maximization can also depend on their market structure. A firm with strong market power may have greater freedom to pursue alternative objectives because it faces less immediate competitive pressure. In highly competitive markets, however, firms may have stronger incentives to control costs and maintain profitability.
There are also circumstances where a firm may deliberately accept lower profits to build a brand. Promotional campaigns, introductory pricing and investment in customer service may reduce current profitability but increase customer loyalty and future revenue.
Therefore, the objective of profit maximization should be viewed as an important benchmark rather than a universal description of all firms. Profit remains essential for survival and provides resources for investment, but firms may simultaneously pursue market share, growth, satisficing, CSR and other objectives.
Overall evaluation: The view that firms will always seek to maximize profits is not fully supported by real-world behaviour. The assumption is useful in economic theory because it provides a clear basis for predicting firms’ output decisions, particularly through the MR = MC condition.
However, firms operate in complex environments with imperfect information, managerial objectives and long-term strategic considerations. They may deliberately sacrifice short-run profit to increase market share, achieve growth, improve their reputation or meet social and environmental objectives.
For example, a firm pursuing aggressive expansion may accept lower current profits to gain market share, while a firm emphasizing sustainability may accept higher production costs to achieve environmental objectives. These decisions may still contribute to long-term success even though they do not maximize short-run profit.
Thus, profit maximization is an important objective for many firms, but it is not necessarily their only objective and cannot be assumed to apply in every situation. The word “always” makes the statement too absolute. The importance of profit maximization depends on the firm’s ownership structure, market conditions, management objectives, time horizon and wider strategic or social goals.