Paper 1 Essay Plans

Negative Externalities Essays:

Evaluate two policies a government could impose to reduce effects of a negative

externality in Production. Use an industry of your choice in your essay.

Intro: Beef cattle production is a booming industry in America - $66 billion in added value to
the U.S. However, huge negative externality in production –> pollution.

P1: Indirect Tax

 Point: An indirect tax can be used to reduce the negative externality.
 Cause of externality:
 Cows produce more CO2 then the emissions from 22 million cars a year -> Negative
externality is a cost to a third party -> Respiratory illnesses + Global warming ->
health risk -> Market failure -> inefficient allocation of resources.
 Research showed that taxes of 40% on beef would be suitable to account for the
damage of production via climate change onto people
 How to reduce it:
 In free market good is overconsumed and overproduced -> high Social cost -> welfare
loss -> Role of the government to eliminate this -> indirect tax:
 Causes cost to suppliers to increase -> Shifts MPC by the size of the tax -> new
equilibrium is formed at Q1,P1 (socially optimum level) -> dead weight loss no longer
cost to society -> if the size of the tax is correct -> completely internalise the
externality -> also a source of revenue for government. Tax diagram.
 Example: Australia carbon tax in 2012 -> Greenhouse gases emission decreased 9.6%
Evaluation:
 Depends on elasticity of supply curve -> if inelastic -> not much output change ->
won’t reach optimum level. Burden on Consumers/producers
 Shift supply to other countries -> decline in industry -> decrease in tax revenue.
 Government may have sufficient knowledge/info to set appropriate tax -> difficulty of
quantifying it.
 With $60 billion of beef being retailed in the USA, taxing beef production could be
economically unviable as it would harm many agricultural firms and those firms
which they supply.

P2: Tradable pollution permits:

 Point: Tradable Pollution permits can be used to reduce pollution.
 Cause:
 They are rights to sell and buy actual and potential pollution in artificially created
markets. They are issued by the government to firms to allow them to pollute up to
a certain limit.
 Consequence:
  Any pollution above this limit -> fines -> key function is that it works through market
system -> people can sell and buy permits -> incentive to become green -> therefore
can sell permit -> make profit -> reduce pollution.
 According the to the European Commission, the scheme has been responsible for
an 8% decline in emissions from big emitters in Europe from 2005-10.

Evaluation:
 There is still pollution occurring just less than before.
 Large efficient firms may buy up permits -> increased pollution -> ineffective way of
dealing with pollution.
 Short-run -> works, long run -> another solution is needed.
 According to a UBS research team, emissions could have been reduced by 40% if
the funds that were invested into the EU Emissions Trading Scheme were invested
into other emission cutting methods.

Assess the policies that might be most effective in reducing the scale of plastic
pollution in the UK and other countries of your choice.

P1: Government policy of taxation in order to internalise the externality:

Ø Production of plastic leads to significant pollution both in terms of the air pollution
created by the factories as well as the fact that it takes a long time to decompose. Thus,
there is a negative externality of production. (Draw Diagram)
Ø Government can enforce a tax on plastic pollution, Phillip Hammond announced March
2018 he intends for UK government to introduce a tax on single-use plastics (i.e. specific tax
on each unit produced)
Ø The tax (seen as vertical distance between P3 and P1) would shift MPC to the left,
increasing the price (P1- P2) and decreasing the quantity produced (Q1-Q2) towards the
socially optimal level (Q2 P2). Thus, the government tax has effectively internalised the
externality and the scale of plastic production has been reduced to a level that benefits
society.

Evaluation:
Ø However, due to the fact that the price elasticity of demand for Plastic is very inelastic due
to it being a necessity good, the government would need to impose a very large tax in order
to significantly reduce the quantity of plastic produced. (Draw diagram with very inelastic
demand).
Ø As plastic is used in so many of the products that we use every day, consumers will not
change the quantity of plastic products that they consume despite a change of price. Thus,
the government tax, increasing the price form P1 to P2 would only decrease quantity by Q1-
Q2 and so the policy may not be that effective.
P2- Provide subsidies for alternative clean products.
Ø The government could subsidise alternatives to plastic, such as biodegradable
thermoplastics. Currently, producing ordinary plastic is far cheaper than the production of
biodegradable thermoplastic, and thus ordinary plastic can be sold for much less, and thus a
far greater quantity of ordinary plastic is demanded and thus there is significant plastic
pollution. (Draw Subsidy diagram). A large government subsidy for such alternatives would
shift the supply curve (S1-S1+subsidy) and this would allow production of such plastics to
increase (Q1-Q2) whilst price fell significantly (P1-P2). Thus, Biodegradable thermoplastics
would become more affordable for consumers, and thus it could be argued that the
government policy would mean that, if price is reduced enough, consumers would switch
their spending from polluting ordinary plastics to environmentally friendly biodegradable
thermoplastics, essentially reducing the scale of plastic pollution.

Evaluation:
Ø However, due to information gaps and habitual behaviour, the cross elasticity of demand
for plastics may be very low and thus consumers may not switch consumption. Many
consumers unaware of the existence of new plastic alternatives, and due to the influence of
habitual behaviour, many consumers, even if they do know about the existence of
alternatives may never switch consumption and continue to demand the same ordinary
plastic products. Thus, it is likely that plastic and environmentally plastic alternatives would
be weak substitutes will have a low cross elasticity of demand (around -0.5). Thus, despite
the government subsidy to reduce the price of plastic alternatives, many consumers may not
switch their spending and thus the scale of plastic production and thus pollution will
continue.
Market Structure Essays:

Neo-classical theory of competition implies that more firms in a market is the only
way to improve outcomes for consumers. With reference to examples, assess the
what extent you agree.

P1: Having lots of firms in a market

 Point: More firms in a market can increase the economic welfare for consumers.
 Cause:
 Perfect competition -> price takers -> lots of firms in market due to low barriers to
entry.
 Consequence:
 Allocative efficiency -> P=MC -> firm will produce at the allocatively efficient level of
output -> as the consumers are willing and able to pay exactly the cost of production
for that marginal product -> concerned with whether we are producing goods that
match consumer needs.
 Productive efficiency -> MC=AC -> this is concerned with producing goods with the
optimal combination of inputs to produce the maximum output for minimal cost
 Prices are lower -> increase consumer surplus -> better quality goods -> firms more
efficient -> increase in economic welfare -> good outcome for consumers.
 Monopolistic competition -> similarly efficient -> lower prices.
Evaluation:
 Due to intense level of competition in such markets, firms will be unable to be
dynamically efficient and thus invest in R&D, which might have lowered AC in the
long run. Although markets with smaller numbers of firms can be dynamically
efficient, they have no incentive to do so.

P2: Price caps (diagram)

 Point: There are other ways of improving outcomes for consumers, such as Price
caps.
 Cause:
 Price caps in markets with small numbers of firms in particular can reduce producer
surplus and increase consumer surplus.
 Consequence:
 Encourages firms to cut their costs -> encourages allocative efficiency -> P=MC ->
firm will produce at the allocatively efficient level of output -> as the consumers are
willing and able to pay exactly the cost of production for that marginal product ->
concerned with whether we are producing goods that match consumer needs.
 Increases productive efficiency -> MC=AC -> this is concerned with producing goods
with the optimal combination of inputs to produce the maximum output for minimal
cost
 Reduction in quantity of dead weight loss -> reduces monopoly power.
 Prices are lower -> increase consumer surplus -> better quality goods -> firms more
efficient -> increase in economic welfare -> improve outcomes for consumers.

Evaluation:
  Regulators may not know the position of a firm’s cost curves due to imperfect
information, thus unable to judge how efficient the firms is and possibly causing
government failure if the price cap is place in the wrong position.
 Increased consumer outcome may be sacrificed in the long run: reduction in size of
supernormal profits -> reduced ability for firms to re-invest into R&D for instance and
hence increase long term productivity. However, never much incentive to invest in
R&D in a monopoly.

Conclusion:
 Regulation may be difficult to upkeep and hence having more firms in the market will
tend to lead to better outcomes for consumers, due to less government intervention
-> higher competition -> long run economic increased welfare.

‘A perfectly competitive firm is always more efficient than a monopoly firm’ To

what extent do you agree with this statement?

P1: Perfect competition

 Point: Perfect competition can be seen as more efficient than a monopoly firm.
 Cause:
 no barriers to entry, Perfect information, Many small firms , Homogenous products,
therefore price taker -> long run static efficiency.
 Consequence:
 E.g. If losses are being made in the SR -> can’t cover their fixed costs -> some firms
will leave the market to reduce the supply in the market -> increase price -> normal
profits in the long run.
 Classic supply curve shifting leading into cost and revenue diagram :
 At first P1 on cost revenue was above AC curve at profit maximising quantity. Final
shift makes new price intersect with AC and MC, meaning allocative and productive
efficiency.
 Consumer benefits as they are paying marginal cost of producing the good. Therefore
allocative efficiency means no consumer exploitation.
 Also firm is operating at the point of lowest AC meaning its production is at optimal
efficiency
 Therefore allocatively and productively efficient in the long run -> lower price ->
larger consumer surplus -> better quality goods -> more choice -> increased
economic welfare.
Evaluation:
 The assumptions made are very unrealistic as there will always be elements of
barriers to entry; be it brand loyalty, Perfect information also implausible as
consumers simply cannot take in all information to make the rational choice of
always switching to the lower cost good, Moreover assumes homogeneity between
firms and their products but not true always will be product differentiation which
appears in most markets as an element of non-price competition.
 Lack of supernormal profits mean little money with which to invest -> no opportunity
for dynamic efficiency -> therefore no R&D spending likely, slowing down innovation
-> no new and improved products in the long run. Also unlikely to be efficient in
 production in the long run due to less technological advancements created by
successful R&D.
 Eg. telecommunications industry would not thrive in perfect competition due to
the need for technological advancements in the industry.

P2: Monopoly
 Point: However, Monopolies can be seen as efficient.
 Cause:
 Legally defined as a company with 25% + market share -> Therefore a price setter.
 Consequence:
 This means they will not have productive or allocative efficiency as a monopoly can
be assumed to operate rationally, and therefore profit maximise, which occurs when
MR = MC. As it is a price setter, MR is double the gradient of AR, meaning the price
to consumers of the good will not be equal to MC, therefore opening up consumers
to potential exploitation.

 Economies of scale can occur in a monopoly market:

 Due to price setting power and large market share, monopoly firms can grow in size:
 Draw economies of scale diagram.
 Due to large size of firm, it can afford to increase its output by undertaking
investment into its production line or also new and improved products (dynamic
efficiency)
 This will push long run average costs down, for many reasons:
 Technical economies of scale : investing into specialised machinery making
production cheaper and therefore more efficient.
 Bulk buying lowering costs
 Greater workforce specialisation boosts efficiency
 Financial economies of scale : cheaper easier loans
 All of these benefits mean that the monopoly firms long run costs will decrease,
causing it to become a more efficient producer and supplier of these goods, which
could lead to benefits passed onto the consumer and a lower price of the good.
Evaluation:
 X inefficiencies may occur: less competitive pressure → less incentive to cut costs and
keep production efficient → higher than should be average costs
 Dynamic efficiency doesn’t necessarily occur due to less competitive pressure so no
incentive to innovate as profits can just be saved by the firm to improve balance
sheets or executive pay.
 Would need to be regulated effectively to display efficient behaviour
  Diseconomies of scale : Firm begins to increase its output to too high a level, causing
inefficiencies in production and rising long run average costs. Could be down to many
reasons such as -> Loss of business direction, Lack of worker motivation, Poor
communication, Difficulties managing large workforce -> Would cause firms to
become inefficient in production.

Conclusion:
Certain efficiencies more useful for certain industries:
Tech industries need innovation, therefore dynamic.
Restaurants or corner shops have less need for innovation and sell fairly homogenous
products so less consumer exploitation and more price competition benefits
economy.
However, perfect competition always has these efficiencies, no guarantee a monopoly
would, which means a need for regulation.
Perfect competition improbably due to unrealistic characteristics.

“Oligopoly is the market structure most likely to promote consumer welfare” To

what extent do you agree with this statement?

P1: Oligopoly:
 Point: Oligopoly do not promote consumer welfare
 Cause:
 Draw kinked demand curve: upper part of demand curve is elastic, meaning that an
increase in prices would lead to a huge loss of market share as consumers are very
responsive towards changes in prices. Lowering prices will simply lead to a loss of
revenue in the long term, because other firms in the oligopolistic market will follow
suit by lowering prices, resulting in a price war.
 Game theory (draw pay-off matrix) also reflects the idea that oligopolistic firms will
usually keep their prices the same, depending on collusion.
 Consequence:
 Therefore, by maintaining this price level, which tends to be one where supernormal
profits are being made, there will be a dead weight loss and a lack of allocative and
productive efficiency
Evaluation:
 Price wars can occur due to the illegal nature of collusion/firms cannot ensure that
other firms will indeed keep their price the same. Price wars lead to lower prices,
hence benefitting the consumer
 The fact that firms in an oligopoly look to compete on non-price factors in particular
can lead to gains in consumer welfare if the product quality increases for instance.

P2: Perfect Competition:

  Point: Perfect competition can be seen as more beneficial for consumers than
oligopoly.
 Cause:
 No barriers to entry, Perfect information, Many small firms , Homogenous products,
therefore price taker -> long run static efficiency.
 Consequence:
 E.g. If losses are being made in the SR -> can’t cover their fixed costs -> some firms
will leave the market to reduce the supply in the market -> increase price -> normal
profits in the long run.
 Classic supply curve shifting leading into cost and revenue diagram :
 At first P1 on cost revenue was above AC curve at profit maximising quantity. Final
shift makes new price intersect with AC and MC, meaning allocative and productive
efficiency.
 Consumer benefits as they are paying marginal cost of producing the good. Therefore
allocative efficiency means no consumer exploitation.
 Also firm is operating at the point of lowest AC meaning its production is at optimal
efficiency
 Therefore allocatively and productively efficient in the long run -> lower price ->
larger consumer surplus -> better quality goods -> more choice -> increased
economic welfare -> better for consumers than oligopoly.
Evaluation:
 Lack of supernormal profits mean little money with which to invest -> no opportunity
for dynamic efficiency -> therefore no R&D spending likely, slowing down innovation
-> no new and improved products in the long run.
 Therefore perfect competition may have higher average costs than an oligopoly firm
as economies of scale can occur in an Oligopoly market:
 Due to price setting power and large market share -> grow in size -> afford to
increase its output by undertaking investment into its production line or also new
and improved products (dynamic efficiency) -> This will push long run average costs
down, e.g. Bulk buying lowering costs -> Oligopoly firms long run costs will decrease,
causing it to become a more efficient producer and supplier of these goods, which
could lead to benefits passed onto the consumer and a lower price of the good.

Conclusion:
 In the long run Oligopoly may be seen as better for consumers than monopolies and
perfect competition firms due to lower long run average costs and incentive to
differentiate their products to gain a competitive advantage over their competitors
without starting a price war.
 Perfect competition seen as most efficient but may not have low prices as in theory.

Discuss whether Technological Developments, such as the internet, are making

markets more competitive and making competition theory more realistic.
P1: More realistic
 Point: Technological advancements have helped make markets more realistic.
 Cause:
 Internet and Tech -> easier for firms to set up online -> lower barriers to entry.
 Consequence:
 Internet -> emergence of online shops -> easier to set up than a physical store -> low
sunk costs -> lower barriers to entry.
 Internet -> easier to obtain info on other firms/products -> easier to see whether
enter market or compare prices -> increases competition -> Compare the Market ->
best offers -> increases knowledge and information assumption -> strengthens
perfect competition.
 National and global barriers reduced -> products world-wide reach -> reduce pricing
power of domestic monopolies -> more competition.
Evaluation:
 Consumer loyalty/ inertia -> 50% of consumers stay with British gas despite better
deals elsewhere -> prevents flexibility of consumer spending.
 International retail may be undesirable -> currency changes -> expensive ->
consumers may not be bothered -> goods aren’t verified or seen -> lack of perfect
information.
 Perfect competition inherently a text book model -> unrealistic assumptions.

P2: Less Realistic

 Point: Technological advancements have helped make markets less realistic.
 Cause:
 Less competitive market for some technological firms -> tend towards a monopoly.
 Consequence:
 Facebook -> network effect; use and value of consumer increases as more people
sign up -> more people sign up -> leading to greater revenues -> dominates market
-> lessen competition. (Ebay & Amazon dominate auction/online purchasing world)
 Patents -> lessens competition -> gives right to firms to stop other firms making
product -> lessen homogeneity of goods.
 Opportunity for more differentiating of goods -> as can access online and
international markets -> more choice -> more different products -> firms incentivised
to differentiate products -> less prefect competition -> more differentiated products
-> harder to compete -> more monopoly power.
Evaluation:
 More choice and availability of goods -> harder to differentiate products -> so many
goods flood the market -> increase competition -> less monopoly power as can find
similar goods all over the internet no matter how differentiated.
 Business like Facebook incentivise other firms to come up with similar ideas and
small firms can grow quickly due to the network effect hence compete with the big
dogs.
Examine the role of barriers to entry in earning economic profit in industries of
your choice

P1: Low barriers to Entry

  Point: Low barriers to entry may limit the level of supernormal profit a firm can
make.
 Cause:
 Low barriers to entry -> firms easily move into market -> increased competition ->
perfect competition -> price takers.
 Consequence:
 If losses are being made in the SR -> can’t cover their fixed costs -> some firms will
leave the market to reduce the supply in the market -> increase price -> normal
profits in the long run.
 If supernormal profits are being made -> more firms will enter the market -> increase
of supply in market -> lower prices -> long run normal profit -> perfect competition
e.g. selling items on eBay. Therefore low barriers to entry & exit limit the levels of
supernormal profits.
 Also occurs in contestable markets, even though there are fewer firms, but lower
barriers to entry force firms to operate at AC=AR due to the threat of hit and run
competition.
Evaluation:
 Nationalised firms may decide not to make economic profits because they are not
incentivised by profits - may produce at an allocatively efficient level of output rather
than profit maximising
 Assumptions of price takers unrealistic -> not all homogenous goods -> some level of
profit will be made due to product differentiation -> therefore higher economic profit
than in theory.

P2: High barriers to entry e.g. high fixed capital costs or high sunk costs
 Point: High barriers to entry tend to lead to higher profits.
 Cause:
 Less competition -> more differentiated products -> price setting power -> increased
profits.
 Consequence:
 Oligopoly: incumbent firms tend to compete on non-price factors -> which makes it
more difficult for new firms to enter the market and steal away market share -> firms
in the market are able to retain their high profit margins.
 Monopoly: high barriers to entry like high fixed capital costs or economies of scale
can prevent new firms from undercutting the incumbent firms -> Therefore, they can
make large amounts of supernormal profits due to the high barriers of entry.
Evaluation:
 Certain types of firms may be regulated through price capping for instance because
they might have excessive monopoly power e.g. OFWAT will reduce water bills by
5% in real terms in the next 5 years -> less economic profit.
 Price wars can occur in oligopoly if collusion fails -> possibly eliminating supernormal
profits
To what extent does the threat of competition affect a firms behaviour? Answer
with an industry of your choice.

Intro:
Contestability – ease of which firms can enter or exit an industry.
Characteristics of Contestable Market;
 low barriers to entry
 low sunk costs
 consumers have perfect knowledge.
Therefore, firms can easily enter the market and pose challenges to incumbent firms.
Hence, firms may act as if in perfect competition even if firms are yet to join the market.

P1: Pricing strategies

 Point: Firms can stop other firms from entering the market through price strategies.
 Cause:
 Due to the threat of competition a firm -> move away from profit maximisation -> to
a level where possible entrants can’t compete -> because they have higher costs and
haven’t exploited economies of scale in the industry -> due to the incumbent firm
being able to sustain this position in the long run -> e.g. sales maximisation where
AR=AC.
 Consequence:
 Therefore due to this, the incumbent firm makes normal profit -> hence no incentive
for firms to enter the market.
 Tesco lost 3% of its market share after Aldi and Lidl joined, hence it decided to do
the ‘Big Price Drop’ - price of 3,000 everyday foodstuffs cut by 30% -> less supernormal
profit -> keep consumer with Tesco due to lower prices.
 Other alternative: predatory pricing -> cut costs below AC -> force out firms from market
-> increases competition -> stops firms from entering it.
Evaluation:
 Effectiveness of limit pricing dependant on the difference between unit costs of
incumbent firm and if already exploiting E.O.S may not need to lower costs below
profit max position as other firms would not be able to compete at this higher cost.
 Firms behaviour depends on firms ability to absorb short term losses and decreases
in profit, may not price compete if not liquid.

P2: Non Price strategies

 Point: Firms may be able to compete through non-price competition.
 Cause:
 Choose to advertise heavily -> keeping customers happy -> reducing effects of
competing firms.
 Consequence:
 More marketing -> larger sunk costs -> increases barriers to entry -> harder for firms
to join the market -> reduces threat of entry.
 Sainsburys spend heavily on advertising to build a brand and consumers switch less
easily -> increase in brand loyalty.
 Product proliferation -> reduce threats of entry -> entrants find it harder to break
through saturated market.
 Occurs in Laundry detergent industry, as P&G and Unilever control almost entire
market, but each have around 5 different brand of laundry detergent -> deters new
entry into market -> they have a duopoly over good .
 R&D -> benefits of E.O.S -> price other entrants out of the market while maintaining
supernormal profits -> technological advantage -> high product quality -> lowering
competition -> less entrants able to produce same good at that quality.
  Vertical integration -> higher barrier to entry -> stops other firms gaining supply.
Evaluation:
 However, the threat of competition could do very little even if none of the measures
were taken in markets with artificial barriers. A firm would see np behavioural
changes as it has a patent or license, meaning potential entrants area not able to
compete.
 The firms behaviour depends on size of threat. If the threat comes from many small
businesses we may see pricing changes which make small firms uncompetitive, but
large entrants who can match E.O.S would be approached differently, through
building brand loyalty and decreasing the likelihood that consumers churn.

Evaluate that 3rd degree price discrimination is always against the public interest.

Intro: 3rd degree PD is when different price is charged to different consumer groups/
segments of the market. Conditions Different PED, No resell, Monopoly power.

P1: Against 3rd PD

 Cause:
 Monopoly power needed -> increase super normal profits -> turning consumer
surplus into producer surplus -> consumer pays more than they would otherwise pay
if the price wasn’t differentiated.


 Consequence:
 Consumers in a captive sub-market are being exploited due to their inelasticity ->
extraction of Consumer surplus turned into higher producer surplus/ super-normal
profits -> Reinforces the abuse of monopoly power/ dominance of existing firms ->
moves further away from P=MC (allocative efficiency) -> consumers pay far above the
cost of production -> diminishing welfare -> leads to x-inefficiency as monopoly
power stronger -> higher prices -> not in the long run interest of consumers.
Evaluation:
 If operations overseen by e.g. OFGEM -> regulation of gas and electricity -> price cap
-> stop exploitation of high inelasticity -> lessens diminishing consumer welfare.
 Economies of scale; given that charging different prices can increase sales volume,
especially as a result of new consumers entering the market, attracted in by the
discounted prices, firms can benefit from the economies of scale which arise from
increased output and production. This could lead to lower prices in the long run.
 Dynamic efficiency too could lead to better quality goods as profits can be
reinvested into goods.
P2: Good for Public interest
 Cause:
 Allows more people to join the market, as previously priced out.
 Consequence:
 By charging a higher price to inelastic group, the elastic group will receive lower
prices, hence reduced price after PD -> more people can join market which couldn’t
before.
 If we look specifically at goods and services consumed by children, but where adults
are needed to accompany them, it can be argued that charging children a much
lower price enables families as a whole to benefit -> gain increased group utility. For
example, if cinemas or theme parks set low prices for children, offer with family
discounts, more parents will be able to attend, and accompany their children. This
means that, in the longer term more consumers can enter the market.
 Better use of spare capacity, and helps keep businesses in business.
Evaluation:
 Issue of cross subsidization above if often lead to predatory pricing -> lower prices ->
accept lower profits -> force out firms -> long run higher prices -> more PD -> more
monopoly power.

Conclusion: Not always against the interest of consumers. It could lead to exploitation due
to different PD. But it can benefit consumers if prices are lowered in the long run.

Evaluate whether it was always the case that monopoly power is neither beneficial
to consumers or society

Intro: Monopolies have differentiated products giving them price setting power and make
supernormal profits, but this may not always be in the interest of consumers.

P1: Benefits of Monopolies:

 Point: Monopolies could be seen as more beneficial than not.
 Cause:
  Due to large supernormal profits -> due to profit maximising, MC=MR -> monopoly
can operate in the long-run with supernormal profits, without facing the threat of
new entrants to the market (due to barriers to entry) -> therefore they can take risks
into long term investments into production techniques -> reinvest their profits on
improving their goods and services (through R&D etc.) and so can be dynamically
efficient, where resources are allocated efficiently over time due to innovation being
at an optimal level.
 Example, Tesla’s large profits means it can focus on producing goods that reduce
negative externalities and are sustainable like top quality electric cars.
 Consequence:
 Thus, consumers are likely to see the good/service produced by the monopoly firm
to improve over time, with both quality and choice being expanded -> rise in
economic welfare.
 Monopolies also give guaranteed supply to suppliers -> increased profits for suppliers
-> greater job security -> increased economic welfare.
Evaluation:
 Monopolies do not operate in competitive markets -> lack of incentive to produce
efficiently -> lack reason to waste profits on dynamic efficiency -> x-inefficiency ->
prices rise.
 Monopolies may decide to exploit monopsony power -> drive down price and
quantity for suppliers -> unemployment to cover costs -> reduce welfare.

P2: Costs of Monopolies:

 Point: Monopolies tend to be against the interest of consumers and society.
 Cause:
 Monopolies will seek to profit maximise and so produce at a significantly higher price
than firms in industries with significant competition. ( draw diagram show profit
maximisation)
 Monopoly is not allocatively efficient (P not equal to MC) and thus consumers are
paying more for the good than the marginal utility that they gain from consuming the
good.
 Monopoly is not productively efficient (produce where MC is not equal to AC) and
thus the firm is not producing on its PPF where price is equal to the lowest average
cost possible, and so consumer surplus is not maximised (as it would be with perfect
competition).
 Monopoly may also price discriminate -> Consumers can also have prices exploited
by monopolies due to 3 degree price discrimination. This is where monopolies
rd

charge different groups different prices for the same good/service for non-cost
reasons -> Groups with high inelasticity can be separated out (for example adults at
peak times for train tickets) and pay much higher prices, and thus monopolies able
increase their profits by cutting into consumer surplus.
 Consequence:
 Monopolies lead to less choice- large firms keep to the brands that reap in the most
profits and so are unwilling to take risks and bring out new and different products.
 Monopolies lead to lower quality- firms with no competition might not have the
incentive to produce better quality gods or services, and the after-care service may
be very limited. E.g. Quality of service on railways very bad (trains often
 late/cancelled) whereas in the banking industry, where there is significant
competition, if you do not get the service you desire it is likely that you can switch
banks to a bank that will offer the service you require.
Evaluation:
 Governments often happy to tolerate the existence of monopolies as by profit
maximising and charging high prices -> benefit from Economies of Scale -> move
along their average cost curve ( draw diagram comparing perfect competition with
monopoly cost curve) -> thus in the long-run the industry will have very low average
costs -> lower prices and better quality.
 Example: Walmart keeps prices low by bulk buying its goods -> lower price and larger
quantity -> transferred to consumers through lower retail prices -> larger consumer
welfare therefore beneficial.

Government intervention Essays:

Using your own knowledge, evaluate the argument that economic welfare can be
best promoted through regulation of businesses with monopoly power

P1: show a price cap on a monopoly on a diagram

 Point: A regulator cam impose a limit on price increases by firms.
 Cause:
  Usually done using Retail price index measure of inflation – RPI -X -> X is a measure
of the amount of efficiency savings the regulator believes a frim can make -> Allows a
firm to raise price by RPI – X.
 Consequence:
 Encourages firms to cut their costs -> increases allocative efficiency -> firm will
produce at the allocatively efficient level of output, where MC=MR -> as the
consumer is willing and able to pay exactly the cost of production for that marginal
product.
 Increases productive efficiency -> this is concerned with producing goods with the
optimal combination of inputs to produce the maximum output for minimal cost
 Reduction in quantity of dead weight loss -> reduces monopoly power.
 Prices are lower -> increase consumer surplus -> better quality goods -> firms more
efficient -> increase in economic welfare.
Evaluation:
 Increased economic welfare may be sacrificed in the long run: reduction in size of
supernormal profits -> reduced ability for firms to re-invest into R&D for instance and
hence increase long term productivity. However, never much incentive to invest in
R&D in a monopoly.
 Regulators do not have perfect information, meaning that the price cap could be set
lower since the firm is operating with X-inefficiencies.
 Price caps will be more effective at increasing consumer surplus when demand is
price inelastic

P2: Deregulation
 Point: By lowering barriers to entry and exit it will help to increase contestability.
 Cause:
 Removing direct controls of firms can allow for more competition in markets. UK
‘Red tape challenge’ -> simplify regulation for businesses -> easier for small and
mediums sized businesses to innovate and enter markets.
 Consequence:
 Thus increasing the risk that the incumbent monopoly firm gets undercut ->
incentivising limit pricing.
 Presence of more firms in the market would lower prices through greater
competition, benefiting consumers.
 Post services in UK have been subject to large scale deregulation -> Royal mail no
longer a monopoly -> more choice, better quality goods and lower prices -> increase
in economic welfare.
Evaluation:
 A natural monopoly may exist, with more than one firm in the market creating a less
socially optimal output.
 If an oligopoly is created, collusion may begin to occur, harming the interests of the
consumers if prices are maintained at a high level.

P1: Regulation Benefit

 Point: Regulation can help increase economic welfare.
  In a monopoly market -> lacking competitive pressure -> high prices charged to the
consumer even if costs low -> no other incentive to lower prices other than gov
intervention because no firms seeking to take away market share by price competing
-> Would put prices above competitive equilibrium causing allocative inefficiency.
 Solution: Regulation
 Regulation into monopolies can therefore lower prices for consumers, by cutting into
supernormal profits.
 An example is Thames water which is regulated in a way which does not allow them
to raise their price above certain levels. (RPI – X + K , look at previous point)
 This is because water is a necessity which would have very inelastic demand ->
allowing the suppliers to abuse their market power -> charge very high prices to
maximise their welfare, instead of the consumers.
Evaluation:
 Dependant on the regulation, economic welfare may not be maximised after
regulation.
 If regulation is only into price competition, causing the firm to reduce costs, it may
cut these by increasing their abuse of monopsony power -> squeezing their suppliers
and therefore lessening the impact on their own supernormal profits -> making the
suppliers lose theirs to cover the regulatory costs.
 Additionally quality of service could decrease if incentive is to cut costs and they are
the only firm in the market.

P2: Dynamic efficiency

 Point: Regulation may not benefit economic welfare.
 Cause:
 Many monopoly industries, due to less competition -> can afford to profit maximise,
giving large supernormal profits -> therefore can afford to invest into R&D, creating
dynamic efficiency.
 Consequence:
 This will create innovation -> create a better product in the long run -> as well as
potentially creating advances in production further lowering costs or negative
externalities in this production.
 This will only occur if companies have large supernormal profits and can afford to
undertake risks such as spending substantial sums on research which could prove
futile.
 If the company is overregulated it may see its profits diminished substantially -> this
would create less R&D and less innovation -> meaning no possibility of new and
improved products in the long-run.
  R&D often leads to lower consumer prices in the long run e.g. innovation into
technology throughout the 20th century brought price of radios and TVs down very
substantially as firms found ways to cheaply and quickly mass-produce.
Evaluation:
 No guarantee this dynamic efficiency would occur as a firm with little competitive
pressure would not have the incentive to improve their production or their products.
 This would lead to X-inefficiencies as well as monopoly firms making large profits do
not feel the incentive to cost minimise or become as efficient in production.
 Regulation could state a specific % of profits need to reinvested, which could help
mitigate the effect regulation had on their incentive to do so -> forces firms with no
competitive pressure to innovate to do just that.
Conclusion:
 Can help stop consumer exploitation but also slow down technological innovation
and progress. Economic welfare not maximised if firms profits diminished but
consumers not exploited - weigh it up
 Very difficult to regulate big firms as difficult to know what type of regulation best as
every type has its own issues it causes in the long run.

Energy market
Evaluate the argument that consumers would benefit from the government
imposing a price cap on household energy bills

P1: Price cap

 Point: Price caps in natural monopolies are necessary in keeping energy bills low.
 Explanation:
 Energy is a natural monopoly due to extremely high start-up costs involved in the
industry it makes sense to run the industry as a monopoly.
 However, an industry allowed to operate as a natural monopoly will face very little
competitive pressure from other firms and so they have a large incentive to profit
maximise.
 The elasticity of demand for energy is inelastic as people need energy for many
necessities.
 Therefore profit maximisation would occur at very high prices charged to the
consumer, causing consumer exploitation.
 A price cap would mean that the energy firm could not exploit consumers as they
would be forced to sell energy below the “market price”, e.g. their profit maximising
price.
 This means that the majority of consumers will see a reduction in price for their
energy, creating an increase in consumer surplus.
Evaluation:
 However, a max price will almost always be created below the market equilibrium, as
it would be pointless above it -> This means therefore that the max price is
‘artificially low’
 This means there is now excess demand in the economy as producers have less
incentive to produce, and at this lower price more people are demanding the good.
This means that the price max helps Q1 amount of people, but now there is a
 shortage of the good, and people can no longer buy the necessity. Therefore, it
benefits one group but harms another.

P2: Price Cap Negatives

 Point: A price cap may make the industry inefficient in the long-run.
 Cause:
 Price cap would mean lower price charged -> Therefore lower supernormal profits
for the energy firm.
 Consequence:
 Less profits -> less funds for investment -> less R&D.
 Previously firms may have wanted to get out in front and be the industry leaders in
new renewable sources but now with less supernormal profits this is less likely.
 Therefore less likelihood of more efficient energy production in the future, and less
money available for research into renewable sources.
 Renewable sources usually more expensive energy production therefore larger
negative externality in the production of energy.
 Ruins environment for future generations
 Higher long run average costs -> higher prices in future -> bad for consumers
Evaluation:
 Dynamic efficiency - no incentive to do this as in the short term firms would rather
use fossil fuels as they are cheaper to mine and extract and turn into energy. No
incentive to create better production processes thus unlikely that costs in the long
run reduce and so price wont either.
 Even with less profits they may keep investing into renewable sources as in the long
run, when fossil fuel levels deplete and renewable sources become more cost
efficient, the firms who invested would have higher market shares as they are privy
to better technologies and more infrastructure to support renewable sources.

Examine the policies a government might use to make food affordable to lower
income groups.

P1: Subsidies to producers

 Point: Subsidies to producers can help make food more affordable.
 Explanation:
  Subsidising an industry which is seen to be a staple, such as wheat farmers by the
amount AB will cause the Supply curve to shift rightward.
 This is because lower income earners will less likely be shopping for expensive food
items, but instead for basic, necessities, such as bread, made from wheat.
 Producers are willing to supply more at a given price level due to extra profits they
now make from the subsidy.
 Consequence:
 Causes equilibrium to shift to a lower price level and a larger quantity supplied.
 This increases the consumer and producer surpluses, with consumer surplus
increasing by P,P1,B,L which shows that the consumer will see a benefit from this
subsidy, as parts of the subsidy will be passed onto the consumer in the form of a
lower price of the good.
 This would therefore make food most commonly bought by low income earners
more affordable for that income group.
Evaluation:
 Depends on the elasticity of demand for the good. If demand is very elastic -> there
will be a very small change in the price of the good -> meaning food doesn’t become
much more affordable -> as the quantity produced increases far more than the price
level. This means the benefits are mainly seen in the producer surplus
 If demand is very inelastic, almost all of the subsidy will be passed onto the
consumer with a lower price in the market, meaning that this policy would be very
effective.
 Therefore very important government can predict if industry targeted has elastic or
inelastic demand, which is tough to do

P2: Price MAX

 Point: A price max could be used in order to keep prices low.
 Cause: Lower income earners buy staple goods on a regular basis -> Implement a
maximum price on a wide range of these staple goods -> This would mean that firms
cannot exploit consumers with very high prices on staple goods, which the
government would deem as, necessities.
 Consequence:
  Lower price at q1 below equilibrium level -> prevent inflation rise -> incentive for
business to cut costs to maintain profits -> therefore make necessity goods affordable
for lower income earners as it guarantees price reductions.
Evaluation:
 However, a max price will almost always be created below the market equilibrium, as
it would be pointless above it -> This means therefore that the max price is
‘artificially low’
 This means there is now excess demand in the economy as producers have less
incentive to produce, and at this lower price more people are demanding the good.
This means that the price max helps Q1 amount of people, but now there is a
shortage of the good, meaning Qe – Q1 amount of people can no longer buy the
necessity and must switch away to other foods which are likely more expensive.
Therefore, it benefits one group but harms another.
 Moreover, producers could react to this price cap by cutting costs to keep their profit
levels similar, which would likely cause a reduction in quality of the good or in more
serious cases monopsony power abuse as producers squeeze their suppliers to help
maximise their own profit levels.
 Therefore in this scenario the food would become more affordable but also of a
lesser quality.

To what extent should government intervention be used to protect the interest of

various stakeholders of a business?

P1: Protection from Monopsonies and Price Cap

 Point: Legislation and price caps can help protect employees and suppliers.
 Cause:
 Monopsonies may have the power to reduce price and quantity and hence squeeze
profits of suppliers. In this case supermarkets may keep prices low by squeezing
 farmers and other suppliers. 2015 Groceries Code Adjudicator independently aims to
protect these suppliers and limit power of monopsonies.
 Examples:
 Minimum guaranteed price per kilo for each good -> monopsony can’t negotiate
lower price -> interest of stakeholder (farmer) -> ensures guaranteed level of revenue
-> less risk of supplier being exploited and having to cut costs to run.
 Legislation surrounding farmer collectives and trade unions may be introduced ->
collective bargaining power -> increase price of good.
 Price Cap -> protect consumers (OFGEM) -> RPI-X -> setting a cap for over 10 million
UK households -> save £120 energy fuel bills.
Evaluation:
 Price caps/ minimum price may not be in interest of stakeholders -> supplier benefits
-> consumer (other stakeholder) may not benefit -> higher prices or worse quality to
cover costs -> decrease in economic welfare.
 Dependent on which stakeholder it benefits -> which stakeholder firm wants to
appease.

P2: Nationalisation
 Point: By acquiring assets from the public sector and transferring them to state
ownership it may be beneficial for stakeholders.
 Cause:
 Railway industry -> may be better to nationalise -> criticism of private provision for
poor service despite winning the bid to operate it through competitive tendering.
 Consequence:
 Nationalisation -> protect workers and other firms relying on failing firm -> stops firm
collapsing (Carillion) -> through direct cash injection.
 Nationalised firms also may be allocative efficient -> P=MC -> maximise social welfare
-> positive externalities -> cover costs in short run -> may focus on quality of product
instead of profit maximisation -> best interest of stakeholders.
Evaluation:
 Loss of competitive pressures -> X-inefficiency -> long run costs rise -> inefficient ->
prices may rise in long run -> may be sold back to private sector as it may be
provided more efficiently.
 Less competition in market -> less incentive to be efficient for other private firms ->
reduce dynamic efficiency -> price rises -> not productively efficient.
 Probably more efficient if PFI or Contracting out as can raise funds and do projects
now without government needing to find the money in the short run.
Assess the policies that might be most effective in improving housing affordability
in the UK economy (25)

P1: Subsidies/grants to producers

 Point: Subsidies to producers can help make housing more affordable.
 Explanation:
  Subsidising by the amount AB will cause the Supply curve to shift rightward.
 Producers are willing to supply more at a given price level due to extra profits they
now make from the subsidy.
 Or grant pay 5% deposit instead of 20% -> cheaper to access housing ladder.
 Consequence:
 Causes equilibrium to shift to a lower price level and a larger quantity supplied.
 This increases the consumer and producer surpluses, with consumer surplus
increasing by P,P1,B,L which shows that the consumer will see a benefit from this
subsidy, as parts of the subsidy will be passed onto the consumer in the form of a
lower price housing.
Evaluation:
 Depends on the elasticity of demand for the good. As demand and Supply are very
inelastic -> there will be a very small change in the quantity of the housing-> as it
may be difficulty to construct due to lack of space or environmental reasons.
 Hence subsidy may not be very efficient in improving the quantity so the prices will
remain high as demand will still be very high for this good and so their price will only
rise.

P2: Taxes on unused Properties

 Point: By taxing unused properties it could help lower prices in the housing market.
 Cause:
 A tax would incentivise people not to buy a house or now have an incentive to sell
their house if not using it.
 Consequence:
 Increase supply on market -> decrease prices -> people also willing to accept lower
price -> as want to get rid of house quickly in order not to pay tax -> reduce peoples
income from those assets -> free up houses across country -> lack of demand for
housing from foreigners who may not be there all the time -> decrease the price of
housing. (draw diagram rightward shift of supply curve and left shift of demand.
Evaluation:
 Inelastic supply -> small shift leads to large change in price -> but not as much
quantity.
  May only affect a few people -> not a large change in supply -> inertia -> people not
bothered to sell house -> don’t mind paying tax.
 Ways to make housing more responsive to changes in demand may be more effective
-> done by reducing regulation on planning and by increasing investment into R&D it
may make housing easier to build and at a faster rate.

Labour Market Essay:

Evaluate the factors that determine wages in competitive and non-competitive
labour markets
P1: Wage determination in Competitive Market
 Point: Many factors affect the wage rate these are known as wage differentials.
 Cause:
 Wage determination in a competitive market is dependent on the supply and
demand of labour, and the wage rate is where they meet.
 This is affected by;
 Level of education and training -> people are more skilled -> more specialised jobs ->
higher wage rate needed to attract them into the job. For example lawyers supply is
inelastic due to their high qualifications needed -> their Marginal revenue product is
higher -> if successful they can make a lot of revenue -> therefore they receive higher
wages than e.g. a McDonalds worker whose work won’t affect revenue much as his
MRP is low and low skills needed -> elastic supply.


 Hence due to a Lawyers higher MRP -> greater reward for revenue -> higher wage
rate.
 Level of income tax and how generous benefits are will determine if there is a
sufficient supply of labour.
 If taxes are too high and benefits too generous -> lack of incentive to join labour
market -> shortages of labour -> raises wages to attract labour -> higher wage.
Evaluation:
 Factors are all reduced by the fact that in reality the labour market is rather inflexible
-> wages are ‘sticky’ -> therefore difficult to raise or lower wages of workers who are
more or less productive -> due to nature of long-term contracts.
 Elasticities of labour have large affect too -> if labour is a large proportion of costs of
firm -> elastic -> therefore rise in wages -> unemployment -> long term lowering of
wages -> affects price of employment.

P2: Wage determination in uncompetitive markets

 Point: Labour markets tend to be relatively uncompetitive where employers have
monopsony power. E.g. NHS with nurses.
 Cause:
  A firm may have monopsony power over an employee due to the fact that they are
the only employer in the market -> workers have no other options -> weak bargaining
power -> accept lower price -> monopsony firm reduces wage and quantity of labour.
 However;
 Trade Unions can help push up wages -> protect exploited workers -> use collective
bargaining power.
 Draw diagram:

 In monopsony situation firms would employ at q1 and pay w1 -> showing low level of
employment and wage. But, Trade Unions can set a wage line -> raise price ->
increase employment and raise wage rate -> more income.
 Nearly half a million members of UNISON work in NHS as NHS lowers prices and
trade union tries to reduce it by alleviating pressures on workers.
Evaluation:
 However, trade unions may have negative effects on the employment rate.

 As if it sets the wage rate too high -> firms costs increase too much -> must lay off
workers -> unemployment (q1 to q2) and deadweight loss (triangle of q1, q2 ,w2) ->
adverse impact on employment -> make labour markets less flexible.
 NMW similar example of how wage determination can be affected and help reduce
power of monopsonies -> lowering effect of their power in wage setting -> making
trade unions more important factor in wage setting.
 Public sector wage setting in NHS could easily directly affect wage rate of employees
without need of NMW or trade unions.