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 firms 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 monopolists 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
monopolists 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
monopolists 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.