Thursday, April 16, 2009

Long Essay Micro Higher Economics November 2007

Final exams are approaching, there are no more classes so here are some ideas on an old higher level long essay. No diagrams are posted (as I don't know how to incorporate diagrams in a post...!). This is the question:

(a) Explain the difference between short run equilibrium and long run equilibrium in monopolistic competition (10 marks)

Monopolistic Competition is a market structure with:

• very many small firms (e.g. hairdressers etc)
• differentiated product (and the differences may be ‘real’ or ‘imaginary’)
• no entry barriers

Since each firm produces a differentiated product it faces a negatively sloped demand, as if it increases price it will not lose all of its customers. Short run equilibrium is thus analytically identical to that of a monopoly firm. If supernormal profits are made (explain the term), entry of new firms will be induced.

As new firms the market enter (as more hairdressers establish in the same area/ market) , demand for each firm ‘shrinks and tilts’ i.e. it decreases (as at each price, quantity demanded will fall) and it becomes more price elastic (as consumers will now face more substitutes to choose from). (Draw short run and long run diagrams - the long run one is a pain to get right; use a pencil and an eraser in the final May exams; REM that you can use a colored pencil BUT NOT A RED OR A GREEN AS THESE ARE USED BY EXAMINERS......)

The process continues until economic profits become zero i.e. each firm makes only normal profits (define).

(Conversely, if losses are made --> exit, so demand each faces increases and becomes more price inelastic until economic profits become zero i.e. normal)

The main difference is thus that in the SR a firm in such a market may make positive, negative or zero economic profits but in the long run it will be forced to make only zero (normal) as a result of free entry.

(b) ‘Perfect competition is a more desirable market form than monopolistic competition’. Discuss. (15 marks)

--> Explain perfect competition using diagrams: very many small firms, homogeneous product, meaning that the product is considered identical across consumers, no entry barriers as well as perfect information and perfect factor mobility; market demand and market supply determine the market price which each firm will take (‘price takers’) thus facing a perfectly elastic demand curve for its product which is also the marginal and average revenue curve; assuming profit maximization, the typical firm will choose that output level q for which marginal revenue is equal to marginal cost (and MC is rising); entry and exit ensure that in the long run profits are driven to zero which means that each firm is making normal profit (the minimum it requires to remain in business)

--> Explain the long run efficiencies that characterize perfectly competitive markets:
Allocative efficiency results because all units for which price (the valuation by consumers) is bigger than marginal cost (how much society sacrifices for the production of each extra unit) are produced up until and including that unit for which P=MC: just the right amount of the good is produced from society’s point of view and thus there is no resource misallocation

Productive (technical) efficiency results as production takes place with minimum average cost i.e. resource waste

--> Explain that in monopolistic competition neither allocative not technical efficiency are achieved (draw long run equilibrium diagram or refer to the one in (a) and that excess capacity characterizes such firms (empty tables in restaurants most of the time) (as neither condition holds)

--> But, consumers have variety and this is considered very important. Each consumer has a better chance of finding exactly what he or she wants. Higher average costs may be the result of differentiation and of (local) advertising and in this sense may not be as wasteful.

It seems that even though the efficiency properties of perfect competition make it theoretically more desirable, the product variety of monopolistic competition and the fact that the price charged can not exceed marginal cost by much while profits are driven down to normal make it an attractive alternative.

Neither though can lead to product innovation (new products and/or new processes) as both models require free entry.

This is not a 'model' answer. Remember that IB examiners are always instructed to accept any answer that is theoretically sound. More to come (perhaps..!)

Study hard, my dear friends - this is it!

PS: This essay with diagrams can be found at our wiki here

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