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

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
Single seller:
100% market share and the
firm is the industry
Evidences
Unique product due to high

barriers to entry:
No close substitutes when
firm charges a high price,
consumers cannot turn to
alternatives.
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.
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]
Price/Revenue/
Cost ($)
MC
P1
P0
MC
C0
C1
AC
B
Y
MR0
0
State
Elaborate with
economic analysis
Exemplify with
evidences from
Q0
AR1
AR0
MR1
Q1
Output
Apple was able to increase its profits ten-fold because demand for its iPod product
increased enormously.
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.
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.

Data
(c) Discuss whether Apples strategy of charging high prices for its iPod was in its best long term
interests. [6]
Yes
Perspective for evaluation: Best interests Increase profits
Thesis: Yes it is in its best interests
Apple can earn high revenue and
profits through charging high prices.
Elaborate
Demand for iPod is price-inelastic.
with
Hence by increasing price, quantity
economic
demanded
falls
less
than
analysis
proportionally, and total revenue
earned by Apple increases. Hence,
even by charging high prices, Apples
revenue
remains
high,
which
contributes to supernormal profits.
State
Exemplify
with
evidence
from Data
Elaborate
with
economic
analysis
Profit was $1.3 bn, a ten-fold increase

from $137 million in 2003.
Exemplify
with
evidence
from Data
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.
Anti-thesis: No it may not be in its best interests

State
Apple may not be able to increase profits
through charging high prices.
Elaborate
The danger is that a competitor will bring out
with
a rival product which is easy to use as the
economic
iPod and is much lower in price; This could
analysis
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 priceinelastic and charging higher prices may
lead to fall in revenue, which could reduce
the profits earned by Apple.
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.
Exemplify
with evidence
from Data
2006 could be the year when a rival, like

Sony or Samsung, come up with a better
product
Stand
Apple 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.

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]
OR
The 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].
OR
The 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]

(b) (i) Identify two characteristics of BSC that suggest that it has monopoly power. [2]
Any 2 of the following:
Characteristics of monopoly POWER
Large market share
High barrier to entry
Evidence
Para 2 mentioned that BSC enjoys a large market share of
the market for refined white sugar.
Para 2: BSC is the sole processor of sugar beet grown in the
UK
Para 3: Imports of sugar cane are limited by quotas and that
ensures BSC faces little competition.
Para 4: Blocking the entry of another firm into the market.
Ability to carry out predatory practice

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.

(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]
Cost/Rev($)
MCMonopoly = SSPC
E
Price & Output comparison for a
monopoly & a PC industry under
Constant Cost Conditions
PM
C
PPC
B
D
MR
X
0
QM
Dd = AR
QPC
Output
In a perfectly competitive market, equilibrium will be achieved at output Q PC 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 EAP M 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.

(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.

Price/Revenue/Cost ($)
P0
P1
C1
C0
MC
AC
X
Y
B
MR1 MR0
0
As a result of free trade in the

European sugar market, new firms
would enter the industry.
A fall in demand will cause AR 0 and
MR0 to decrease to AR 1 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.
AR1
AR0
Output
Q1 Q0
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 cant demand for BSCs sugar increase with free trade since there will be a bigger market?
EUs 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 BSCs 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.

L3
L2
L1
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.
Consolidate (Add some details application)
Explained impact on BSC's profits with diagram with little reference to context.
Knowledge/Recognise (Description)
Explained impact on BSC's profits with diagram without profits area shown (no cost
curves) with no/little reference to context.
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 EUs sugar subsidies cost, what reforms were being planned
5-6
3-4
1-2


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 CAP
2009 overall budget (European Agricultural Guarantee Fund): EUR 41,131 million
Policy
Objectives
Market
Interventions
Raise and
prices
Coupled
Subsidies
Increase production of selected Production

goods
payments
Direct
Support
2009
Expenditure
Main Instruments
stabilise
Income Reward
farmers'
support entitlements
market Intervention
subsidies
buying;
export
premia;
area
3,410
4,846
historic Single Farm Payment; Single

31,295
Area Payment
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.
10

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
11

Estonia
101
113
214
Hungary
1319
585
1904
Latvia
146
151
298
Lithuania
380
254
634
Malta
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
12

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.
13

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, nontransparent, 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.
14

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.
15

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HWA CHONG INSTITUTION

Year Two H2 Economics 2014

Section B: Short Case study (1hour)

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Unique product due to high

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Profit was $1.3 bn, a ten-fold increase

Apple produced a stylish, easy to use

Anti-thesis: No it may not be in its best interests

It also can set aside bigger budget for

2006 could be the year when a rival, like

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

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

With reference to Fig 1

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

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Ability to carry out predatory practice

Queries from students:

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Note: The original is a 3m explain question.

As a result of free trade in the

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Elaborate (Extend to include analysis)

Reform of EU farm policy

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Increase production of selected Production

historic Single Farm Payment; Single

Export Subsidies ( milllion)

Sugar and Isoglucose

Fruit and Vegetables

Products of the Wine-Growing Sector

Milk and Milk Products

Beef and Veal

Pigmeat, Eggs, Poultry and Beekeeping

Processed Agricultural Products

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Subsidies per member state in 2013 ( million)

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

CAP Reform in a Nutshell

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

HWA CHONG INSTITUTION

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

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

Hwa Chong Institution. All Rights Reserved. Tutors' Copy

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