Economics International Baccalaureate (IB) Practice Question: 1. Explain why a monopolistically competitive firm can make economic (abnormal) profit in the short term, but not in the...

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Definitions

1. Monopolistic Competition: A market structure characterized by many firms selling similar but not identical products, with low barriers to entry and exit.
2. Economic (Abnormal) Profit: When a firm's average revenue is greater than its average costs.
3. Normal Profit: When a firm’s total revenue exactly covers total costs. It is the minimum level of profit that the firm needs to earn in order to remain in the market in long term.

Diagram

• Short-Run Diagram: Show a downward-sloping demand curve (D) and a corresponding marginal revenue curve (MR). The average total cost curve (ATC) should be below the demand curve at the profit-maximizing quantity, indicating economic profit.
  • Long-Run Diagram: Show the demand curve tangent to the ATC curve at the profit-maximizing quantity, indicating normal profit.

Explanation

• Short-Run Economic Profit:

  • In the short run, firms in monopolistic competition can make economic profits due to product differentiation, which gives them some degree of market power.
  • The firm maximizes profit where marginal cost (MC) equals marginal revenue (MR). At this point, if the price (determined by the demand curve) is above the average total cost (ATC), the firm earns economic profit.
  • Diagram Reference: The area between the price and ATC at the profit-maximizing quantity represents economic profit.

• Long-Run Normal Profit:

  • In the long run, the presence of economic profits attracts new firms into the market due to low barriers to entry.
  • As new firms enter, the demand for the existing firm's product becomes more elastic, shifting the demand curve to the left.
  • This process continues until firms are only able to make normal profit, where the demand curve is tangent to the ATC curve at the profit-maximizing quantity.
  • Diagram Reference: The long-run equilibrium is shown where the demand curve is tangent to the ATC, indicating zero economic profit.

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Definition

1. Market Failure: Occurs when firms fail to efficiently allocate the resources within an economy.
2. Monopoly: A market structure with one single dominant firm that has substantial control over output prices. The firm sells a unique product and is protected by high barriers to entry.
3. Market Power: The degree to which a firm in a market is able to control its output price.

Economic Theory

• Monopoly and Market Failure:
  • Monopolies can lead to market failure due to allocative inefficiency, where the price (P) is greater than marginal cost (MC), resulting in a deadweight loss.
  • Monopolies may produce at a lower quantity and charge a higher price compared to competitive markets, reducing consumer surplus.
• Government Ownership:
  • Government ownership can potentially reduce market failure by aligning production with social welfare rather than profit maximization.
  • The government can set prices closer to marginal cost, increasing output and reducing prices, thus improving allocative efficiency.
  • Public ownership may lead to productive inefficiency due to lack of profit incentives, potentially increasing costs.

Diagram

• The diagram should illustrate a monopoly with the demand curve (D), marginal revenue curve (MR), marginal cost curve (MC), and average total cost curve (ATC).
• Indicate the monopoly price (Pm) and quantity (Qm) versus the socially optimal price (P*) and quantity (Q*).
• Highlight the area of deadweight loss due to monopoly pricing.

Evaluation

• Stakeholders:

  • Consumers may benefit from lower prices and increased output under government ownership.
  • Taxpayers may bear the cost of inefficiencies and potential losses from government-run enterprises.
  • Employees might experience more job security but less incentive for productivity.

• Long-run vs. Short-run:

  • In the short run, government ownership can quickly address high prices and low output.
  • In the long run, lack of competition may lead to inefficiencies and innovation stagnation.

• Advantages vs. Disadvantages:

  • Advantages: Potential for improved allocative efficiency, increased access to essential services, and reduced prices.
  • Disadvantages: Risk of productive inefficiency, bureaucratic management, and potential for political interference.

• Prioritize:

  • The effectiveness of government ownership depends on the specific market and how well the government can manage the enterprise.
  • Real-world Example: The nationalization of the UK railways in the mid-20th century aimed to improve service and reduce prices but faced challenges with efficiency and funding.

Conclusion

• Government ownership can address market failure in monopolies by improving allocative efficiency and reducing prices.
• However, it may introduce productive inefficiencies and require careful management to avoid political and bureaucratic pitfalls.
• The success of this policy depends on the government's ability to balance social welfare goals with operational efficiency.