Market analysis — practice questions

Step 1 — Market structures (a): before: a monopoly — one seller protected by a legal barrier to entry, the patent. After: a competitive market — many sellers of an identical product and free entry.

Step 2 — The demand curve facing the firm (b): a monopolist faces the downward-sloping market demand curve: to sell more it must lower the price, so it chooses the price and output that maximise profit and can hold price well above cost. After entry each firm is one of many and faces a horizontal (perfectly elastic) demand curve at the market price — raise the price above $5 and customers switch to an identical rival. The firm becomes a price taker.

Step 3 — Consumers (c): the price falls from $20 to $5 and output rises, so more patients are treated and consumer surplus rises. Quality is unchanged because the product is identical.

Step 4 — The original firm (c): its supernormal profit is competed away as price falls towards cost. It may respond by cutting costs, building a brand, or investing in research for a new patented medicine.

Evaluation: the patent was a trade-off — high prices for a limited period in exchange for the incentive to develop the medicine in the first place.

Step 1 — Revenue and profit (a): revenue = 50 million × $2 = $100 million. Total cost = 50 million × $1.20 = $60 million. Profit = 100 − 60 = $40 million a year — a large supernormal profit.

Step 2 — Natural monopoly (b): pipes, reservoirs and treatment works are huge fixed costs that are spread over every cubic metre sold. One network serving the whole city gives an average cost of $1.20; five parallel networks would duplicate the fixed costs, raising average cost to $1.80. When one firm can supply the market more cheaply than several, the industry is a natural monopoly.

Step 3 — Competition or regulation (c): introducing competition would raise costs by $0.60 per cubic metre, so the lowest sustainable price ($1.90) is barely below today's $2 and consumers gain little while resources are wasted on duplicate pipes. Regulation — a price cap of, say, $1.40 — would keep the low-cost single network, cut consumers' bills by $30 million a year, and still leave the company $10 million profit to maintain the system.

Step 4 — Evaluation: regulation is the better response because this is a natural monopoly. The risks are that the regulator sets the cap too low (under-investment, leaks) or too high (profits continue). In an industry without large fixed costs, competition would be the better answer.