Economics International Baccalaureate (IB) Practice Question: 1. Explain why a loss-making company in perfect competition is likely to shut down in the long run. 2. Using real-world...

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Definitions

1. Perfect Competition: A market structure with a large number of small firms that have no control over output prices. All firms sell an undifferentiated product and there are no barriers to entry.
2. Long Run: A period in which all factors of production are variable, and firms can enter or exit the market.

Diagram

• Diagram: A cost and revenue diagram for a firm in perfect competition.
  • Indications:
    • The diagram should show the firm's average total cost (ATC), average variable cost (AVC), marginal cost (MC), and marginal revenue (MR) curves.
    • The price (P) is determined by the market and is equal to MR.
    • The area between the ATC and the price line indicates the loss per unit.

Explanation

• Understanding Perfect Competition:

  • In perfect competition, firms are price takers due to the large number of firms and identical products.
  • The market determines the price, and individual firms cannot influence it.

• Short-Run vs. Long-Run Decisions:

  • In the short run, a firm may continue to operate even if it is making a loss, as long as it covers its average variable costs (AVC).
  • The firm will shut down immediately if the price falls below AVC, as it cannot cover its variable costs.

• Long-Run Dynamics:

  • In the long run, all costs are variable, and firms will exit the market if they cannot cover their average total costs (ATC).
  • Loss-making firms will exit the market because they are unable to make normal profit (zero economic profit), which is the minimum requirement for firms to stay in the market in the long run.

• Market Adjustment:

  • As loss-making firms exit, the market supply decreases, leading to an increase in the market price.
  • The remaining firms will eventually reach a point where they can cover their ATC, achieving normal profit.

• Inductive Reasoning:

  • Start by explaining that firms in perfect competition are price takers.
  • Illustrate how a firm making losses in the short run might continue to operate if it covers AVC.
  • Transition to the long run, where all costs are variable, and explain why firms must cover ATC to remain in the market.
  • Conclude with the market adjustment process, where the exit of loss-making firms leads to a new equilibrium with normal profit.

• Additional Explanation:

  • Discuss the concept of "creative destruction," where inefficient firms exit the market, allowing resources to be reallocated to more efficient uses.
  • Mention that in the long run, only firms that can innovate or reduce costs will survive, contributing to overall economic efficiency.

Answers may include:

Definitions

1. Perfect Competition: A market structure with a large number of small firms that have no control over output prices. All firms sell an undifferentiated product and there are no barriers to entry.
2. Monopolistic Competition: A market structure with many firms selling similar but not identical products, with some degree of market power and low barriers to entry.

Economic Theory

• Perfect Competition:

  • Firms are price takers due to the large number of sellers and identical products.
  • In the long run, firms earn normal profits as any supernormal profits attract new entrants, shifting the supply curve rightward until profits are eroded.
  • Allocative efficiency is achieved as price equals marginal cost (P=MC), ensuring resources are distributed according to consumer preferences.
  • Productive efficiency is achieved as firms produce at the lowest point on the average cost curve.

• Monopolistic Competition:

  • Firms have some degree of market power due to product differentiation, allowing them to set prices above marginal cost.
  • In the long run, firms earn normal profits as new entrants erode supernormal profits, but they do not achieve productive or allocative efficiency.
  • Product differentiation leads to a variety of products, increasing consumer choice but potentially leading to excess capacity and higher average costs.

Diagram

• Perfect Competition Diagram:
  • Show a firm in long-run equilibrium where P=MC=AC, indicating allocative and productive efficiency.
• Monopolistic Competition Diagram:
  • Show a firm in long-run equilibrium where P>MC and not at the minimum point of AC, indicating inefficiencies.

Evaluation

• Stakeholders:

  • Consumers may benefit from lower prices and greater efficiency in perfect competition but enjoy more variety in monopolistic competition.
  • Producers in monopolistic competition can differentiate products and potentially earn higher short-term profits, but face inefficiencies in the long run.

• Long-run vs. Short-run:

  • In the short run, monopolistic competition may offer innovation and variety, but in the long run, perfect competition achieves greater efficiency.
  • Real-world Example: The agricultural sector often resembles perfect competition, with many small farmers producing identical products, leading to low prices and high efficiency. In contrast, the fast-food industry, with brands like McDonald's and Burger King, exemplifies monopolistic competition, offering variety and brand differentiation.

• Advantages vs. Disadvantages:

  • Perfect competition maximizes efficiency and consumer surplus but lacks innovation and product variety.
  • Monopolistic competition provides product diversity and innovation but at the cost of higher prices and inefficiencies.

• Prioritize:

  • The desirability of a market structure depends on the priority given to efficiency versus variety and innovation. In sectors where efficiency is paramount, perfect competition may be more desirable. In contrast, in industries where consumer preferences for variety are strong, monopolistic competition may be preferred.

Conclusion

1. Perfect competition is more desirable for maximizing efficiency and consumer surplus.
2. Monopolistic competition is more desirable for innovation and product variety.
3. The desirability of each market structure depends on the specific context and priorities of stakeholders.