tutorial 23 - market structure part 3 section b and c

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

Section B: Short Case study (1hour)

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

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a) Explain why Apple in 2005 might have been considered to be a monopoly in digital players and digital downloads. [4]

Note: In your answers, you have to state the characteristic of a monopoly very explicitly before elaborating with evidences.

Characteristics of a monopoly

Evidences

Single seller: 100% market share and the firm is the industry

From para 1, Apple had a share of 63 per cent for its iPod in the US market and in the world markets, it had an 83 per cent share for legal digital downloads.

Clearly, Apple does not enjoy the theoretical monopoly. However, in practice it enjoys monopoly power because it has a large proportion of the market and the rest of the market is highly fragmented.

It is considered a ‘near monopoly’. Unique product due to high barriers to entry:No close substitutes – when firm charges a high price, consumers cannot turn to alternatives.

There are significant barriers of entry to both iPod and iTunes market.

Para 2, Apple has devised a simple to use, iconic must-have product which other manufacturers have to date found impossible to replicate. With iTunes, it has a simple to use piece of software which allows digital downloads only to iPods.

b) Using a monopoly diagram, explain how Apple succeeded increasing its profits ten-fold, mainly through sales of iPods, between 2003 and 2005. [4]

State Apple was able to increase its profits ten-fold because demand for its iPod product increased enormously.

Elaborate with economic analysis

Apple did it by creating the ‘iconic must-have’ in people and also worked with recording companies for legal download. These increased the demand for iPods significantly. This can be shown in the above diagram when AR and MR increase. Output increased from Q0 to Q1, price increased from P0 to P1 and total revenue increased from 0P0AQ0 to 0P1XQ1. Total costs increased from 0C0BQ0 to 0C1YQ1 and profits increased from P0C0BA to P1C1YX.

Exemplify with evidences from Data

In 2005, Apple sales were more than double those of 2003 but profit increased from $1.3 billion in 2003 to $137 billion in 2005.


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Price/Revenue/Cost ($)

MC

AC

MR0

P1 X MC

AR1

MR1

Q1Q0

AR0

P0 A

C0 B C1 Y

0 Output



(c) Discuss whether Apple’s strategy of charging high prices for its iPod was in its best long term interests. [6]

YesPerspective for evaluation: Best interests Increase profits

Thesis: Yes it is in its best interests Anti-thesis: No it may not be in its best interestsState Apple can earn high revenue and

profits through charging high prices.State Apple may not be able to increase profits

through charging high prices.Elaborate with economic analysis

Demand for iPod is price-inelastic. Hence by increasing price, quantity demanded falls less than proportionally, and total revenue earned by Apple increases. Hence, even by charging high prices, Apple’s revenue remains high, which contributes to supernormal profits.


The danger is that a competitor will bring out a rival product which is easy to use as the iPod and is much lower in price; This could lower the demand for iPod which in turn reduces revenue of Apple.

With such close substitutes, there is a possibility that other brands will leapfrog iPod in terms of sales in digital players. Demand for iPod may become less price-inelastic and charging higher prices may lead to fall in revenue, which could reduce the profits earned by Apple.

Exemplify with evidence from Data

Profit was $1.3 bn, a ten-fold increase from $137 million in 2003.


It also can set aside bigger budget for advertisements to continue to strengthen its iconic ‘must-have’ in youngsters. This further maintains the price inelasticity of demand for Apple products, which ensures that high revenue is earned through charging high prices.This supernormal monopoly profits give Apple the funds to develop new products. In the long term strategy may be to bring out a series of new products which, like the iPod, will gain technological superiority in its segment of the market.


Apple produced a stylish, easy to use piece of hardware at just the right time in terms of changing technologies. It combined that with easy to use software for downloading music. Again, Apple was in the right place and the right time.


2006 could be the year when a rival, like Sony or Samsung, come up with a better product

StandApple has the first mover advantage in that it has already gained a huge market share and the iconic ‘must-have’ image of iPod is a strong barrier to entry and thus allows Apple to continue charging high price in the short-run. In such a competitive market, Apple needs to constantly upgrade its product and reinforce its image by heavy advertising (to defend their monopoly position) and this warrants to charge a high price to ensure it has the money to pump into R&D and advertisement.

However, Apple must always be on a lookout for potential rivals and it might have to match the price cut of worthy competitors to prevent a huge loss in revenue and thus profits.


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Section C: Data Response question (N2004 Qn 1) (1 hour)

The Market for Sugar in the UK

(a) (i) Compare the EU price of sugar with the world price of sugar over the period shown. [2]

With reference to Fig 1

Similarity: BOTH prices experienced a falling trend. [1]

Differences (1 of the 2):The EU price is 2 - 3 times higher than the world price. [1]ORThe EU price is much more stable compared to the world price which is much more volatile. [1]

Note: To gain full marks, must have 1 similarity and 1 difference. Cap at 1 mark for 2 differences. But there are instances when there is indeed no similarity, 2 differences will be acceptable.

Students may think that it is a good idea to write “there is fluctuation in the price over the period” as an answer for a trend question. Caution that real world data usually involves fluctuations and not to single it out as a point to highlight. This case is an exception as the contrast between the volatility and the relative stability is great.

(a) (ii) Explain any differences that you have observed. [2]

EU price was a guaranteed price floor which is fixed and controlled and as a result more stable [1]. The world price on the other hand was determined by the forces of supply and demand which explains the huge fluctuations [1]. ORThe EU price is higher than world price because of the import quotas of sugar cane in the EU that raised the cost of production and thus the price. [1] On the other hand, the subsidies given to EU exports of sugar lowered the world price. [1]


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(b) (i) Identify two characteristics of BSC that suggest that it has monopoly power. [2]

Any 2 of the following:

Characteristics of monopoly POWER EvidenceLarge market share Para 2 mentioned that BSC enjoys a large market share of

the market for refined white sugar.High barrier to entry Para 2: BSC is the sole processor of sugar beet grown in the

UKPara 3: Imports of sugar cane are limited by quotas and that ensures BSC faces little competition.

Ability to carry out predatory practice Para 4: Blocking the entry of another firm into the market.Note:

Monopoly power is different from being a monopoly. Dominant firms in an oligopoly are assumed to have a monopoly power also.

Possible misconceptions: the fact that BSC received a guaranteed price for its sugar indicated monopoly power.

(b) (ii) Explain one possible way in which BSC may have prevented the entry of another firm into the market. [2]

Suggest a method [1] & explain how it works in the context of the market for sugar described in the text [1].

Control of raw material supplies e.g. ownership of sugar beet plantations through backward integration. This will prevent rival firms from having access to essential input or gaining cost advantage through purchase of raw material supplies at competitive price. This is also known as vertical price squeezing, where a vertically integrated firm, which controls the supply of an input, charges competitors a high price for that input so that they cannot compete with it in selling the finished good i.e. refined white sugar.

Predatory pricing policy : By selling below cost to drive competitors from the market. This is possible if BSC cross-subsidize prices in a competitive market, thereby driving out competitors and establishing itself as a monopoly in that market. Cross-subsidize refers to the use of profits in one market to subsidize prices in another.

Queries from students:1) BSC cannot practise predatory pricing since there is a price floor and the graph also does not show a huge drop in price.Precisely! Charging a price lower than the price floor is illegal and thus BSC is found guilty.The graph will not sure such a drop in price as it ever happened, it is only for a short period of time.

2) Is vertical integration illegal?It is if the firm is trying to consolidate its monopoly position by controlling raw material to BLOCK ENTRY. Being the sole processor of beet, it may not be via vertical integration, it can be through contractual agreement with beet producers - 'evil alliance'.

All these may have violated anti-trust laws and thus BSC was found guilty.


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(c) With the aid of a diagram, explain the impact of BSC's monopoly power on producer surplus and consumer surplus in the market for sugar. [4]

In a perfectly competitive market, equilibrium will be achieved at output QPC where P=MC and there is allocative efficiency maximising consumers surplus as shown by area EBPPC.

The impact of BSC's monopoly power would result in equilibrium at profit maximizing level of MC=MR at pt D, setting price higher at PM and lowering output to QM.

This results in a reduction of consumer surplus to a smaller area of EAPM and the loss of consumer surplus of area PM ABPPC.

PM AC PPC, is translated as a gain to producer in the form of producer surplus. Producer surplus changes from PpcBX to PmADX. [1]

However, there is a deadweight loss of area ABD as output [QPC - QM] is not produced. Examiners’ comments: Many candidates failed to identify the correct producer surplus. Diagram is important for this question. Producer surplus is not the same as total excess profit.


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Price & Output comparison for a monopoly & a PC industry under Constant Cost Conditions

MRDd = AR

PPC

X

Cost/Rev($)

Output0

MCMonopoly = SSPC

PM

QM QPC

A

C B

D

E



(d) With the aid of a diagram, discuss what the impact would be on BSC's profits if free trade were allowed in the European sugar market. [5]

Note: The original is a 3m ‘explain’ question.

Will there still be supernormal profits? Or will there be normal profits? Or subnormal profits? It depends on how much the demand has fallen for BSC. Given that it is an incumbent firm and consumers might have certain brand loyalty and assuming the price and quality difference is minimal, demand will not fall drastically.

Queries from students:

1) Why can’t demand for BSC’s sugar increase with free trade since there will be a bigger market?EU’s price is higher than world price with opening up of the market to free trade, it is more likely that consumers will turn to imports.

2) Another common question is that will cost change with free trade as BSC might be able to import cheaper raw materials.

This is not quite possible as BSC’s raw material comes from UK not the rest of the world unlike Tate & Lyle where the cane sugar is imported.

Examiners’ comments: Use the CORRECT diagram for explanation.A large no. of candidates responded with a market SS and DD diagram. With an appropriate explanation, this was a valid approach in explaining the process in terms of the impact upon price and market share. This was insufficient to explain the impact on profits. The decline in price of sugar is likely to lower revenue. But, to explain the impact on profits, it is necessary to refer to costs, which could be shown on a monopoly firm diagram but will not appear on a market SS and DD diagram.


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Price/Revenue/Cost ($)

Output

P0 A MC AC P1 X C1 Y C0 B MR1 MR0 AR1 AR0

0 Q1 Q0

As a result of free trade in the European sugar market, new firms would enter the industry. A fall in demand will cause AR0

and MR0 to decrease to AR1 and MR1 respectively. These resulted in lower output from Q0 to Q1, lower price from P0 to P1 and unit cost rises from C0 to C1. Supernormal profit decreases from P0C0BA to P1C1YX.



L3 Elaborate (Extend to include analysis)Good explanation and illustration with diagram on the impact on BSC's profits if free trade were allowed in the European sugar market.

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L2 Consolidate (Add some details – application) Explained impact on BSC's profits with diagram with little reference to context.

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L1 Knowledge/Recognise (Description)Explained impact on BSC's profits with diagram without profits area shown (no cost curves) with no/little reference to context.

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Reform of EU farm policy(http://www.bbc.co.uk/news/world-europe-11216061)

- What is CAP, how much it costs, who benefits from it, what reforms are being planned- Students may be interested to find out more given recent EU crisis

EU Sugar Subsidies(http://news.bbc.co.uk/2/hi/business/4118448.stm)- How much EU’s sugar subsidies cost, what reforms were being planned


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http://news.bbc.co.uk/2/hi/business/4118448.stm

http://www.bbc.co.uk/news/world-europe-11216061




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http://www.reformthecap.eu/

The Common Agricultural Policy (CAP) needs fundamental reform. Every year, €57 billion – more than 40% of the EU budget – are spent without creating significant value for society.

Key Data on the CAP2009 overall budget (European Agricultural Guarantee Fund): EUR 41,131 million

Policy Objectives Main Instruments2009 Expenditure

Market Interventions

Raise and stabilise market prices

Intervention buying; export subsidies

3,410

Coupled Subsidies

Increase production of selected goods

Production premia; area payments

4,846

Direct Income Support

Reward farmers' historic support entitlements

Single Farm Payment; Single Area Payment

31,295

Source: Financial Report from the Commission to the European Parliament and the Council on the European Agricultural

Guarantee Fund 2009 Financial Year.

Export Subsidies (€ milllion)

2008 Expenditure

Total 926

Cereals 10

Sugar and Isoglucose 501

Fruit and Vegetables 19

Products of the Wine-Growing Sector 15

Milk and Milk Products 29

Beef and Veal 33

Pigmeat, Eggs, Poultry and Beekeeping 201

Processed Agricultural Products 118

Source: European Commission, 2009. Annexes to the Commission Staff Working Document Accompanying the 2nd

Financial Report from the Commission to the European Parliament and the Council on the European Agricultural

Guarantee Fund - 2008 Financial Year: SEC(2009) 1368 Part II. Hwa Chong Institution. All Rights Reserved. Tutors' Copy

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http://www.reformthecap.eu/sites/default/files/2009%20first%20pillar.pdf

http://www.reformthecap.eu/



Subsidies per member state in 2013 (€ million)

Member States Direct Aids Pillar 2 Sum

Austria 752 533 1285

Belgium 615 78 693

Denmark 1049 106 1155

Finland 571 289 859

France 8521 1279 9800

Germany 5853 1387 7240

Greece 2217 672 2888

Ireland 1341 352 1692

Italy 4370 1441 5811

Luxembourg 37 13 50

Netherlands 898 103 1001

Portugal 606 611 1217

Spain 5139 1284 6424

Sweden 771 267 4737

United Kingdom 3988 749 4737

EU-15 36727 9163 45890

Bulgaria 580 396 976

Cyprus 53 21 75

Czech Republic 909 424 1334


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Estonia 101 113 214

Hungary 1319 585 1904

Latvia 146 151 298

Lithuania 380 254 634

Malta 5 11 16

Poland 3045 1851 4896

Romania 1264 1356 2620

Slovakia 388 320 708

Slovenia 114 113 257

EU-12 8336 5595 13930

Total 45062 14758 59821


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CAP Reform in a Nutshell

The Problem EU agricultural tariffs and subsidies distort the economy. European agriculture is not

aligned with its comparative advantage, but skewed in favor of those products that receive

disproportional protection. Worse, support to agriculture acts like an invisible tax on the

manufacturing and service sectors.

The CAP harms EU trade interests. It discredits the free-trade argument and serves as a

pretext for maintaining barriers to trade in agriculture, manufacturing and services.

The CAP is socially unfair. Poor farmers benefit little from the CAP. 20% of recipients reap

roughly 80% of the direct income support. More generally, social policies should be targeted at

the poor and not at farmers or any other sector.

The CAP has a weak environmental record. Only a tiny fraction of its budget is spent on

efficient agri-environmental payments, while environmentally harmful farming practices, such

as drainage of wetlands, are still subsidized.


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The CAP undermines global food security and the fight against poverty. The EU

subsidizes exports which disrupt production abroad. Furthermore, investing in agricultural

research and development, especially if adapted to developing country needs, is much more

effective than subsidizing European farm income and production.

The CAP is a burden on European integration. It creates an image of a bureaucratic, non-

transparent, and ill-managed EU. It wastes resources that could, if employed more wisely,

convince European citizens of the benefits of integration. It nurtures a culture of national

egoism that stymies rational, efficiency-oriented decision-making on EU expenditures and

budget financing.

The Opportunity There is a good chance that the CAP will be revolutionized after 2013 when a new long-term

EU budget comes into force. The economic crisis has left a heavy burden on public budgets,

strengthening the hand of finance ministers.

The ecological crisis requires substantial shifts from wasteful handouts to programs that

preserve the climate, biodiversity, soils, and water.

The long-term trend of increasing agricultural prices and incomes weakens the case for

income-supporting subsidies that do not promote the provision of public goods.

The Solution European money should only be spent on European public goods. If agricultural policies

do not have positive effects that spill across national borders, they should be fully financed by

the member states that are in a better position than the EU to pursue local preferences with

financial responsibility.


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The focus of the CAP should be on environmental objectives, such as biodiversity

protection, climate change mitigation and responsible water management.

Accordingly, the CAP budget should be significantly reduced. The first pillar of the CAP

should be progressively abolished and many policies under the second pillar should be

removed.

EU oversight of national farm policies should be strengthened to avoid subsidy payments

that distort competition or hurt the environment.


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tutorial 23 - market structure part 3 section b and c

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