Market failure: market power: notes and practice questions
- This topic examines market power as a cause of market failure, focusing on different market structures.
- Market power refers to a firm's ability to influence the market price of its product.
- Profit maximization for any firm occurs where marginal cost equals marginal revenue .
- Abnormal profit is earned when average revenue exceeds average cost .
- Monopolies are characterized by a single dominant firm, high barriers to entry, and no close substitutes.
- Monopolies often lead to allocative inefficiency and a welfare loss compared to perfect competition.
- Government intervention, such as legislation, regulation, or fines, may address the abuse of market power.
How it is examined
The heaviest HL Paper 3 subtopic. May 2025 Paper 3 Q1 asked for a sketch of the average cost curve for a natural monopoly, 2 marks, and used a game theory payoff matrix over two parts worth 1 and 2 marks. Also a standard HL Paper 1 pairing: a 10-mark `explain` on why monopoly is allocatively inefficient with a 15-mark `evaluate` on whether governments should intervene.
Guiding questions
- What happens to efficiency when a firm can set its own price?
Linking questions
- Allocative efficiency is defined in 2.3 and used as the benchmark here.
- Welfare loss is the same construct as in 2.8, applied to output restriction rather than to an externality.
- Alternative business objectives in 2.4 (HL) qualify the profit maximisation assumption.
- Economies of scale reappear as a benefit of trade in 4.1 and of trading blocs in 4.4.
Practice questions
3 questions · 3 hardQuestion 1
HardPaper 1 · no calculator25 marks(a) Explain why a firm in perfect competition is considered to be both productively and allocatively efficient in the long run, whereas a monopoly is not.
(b) Using real-world examples, evaluate the effectiveness of government intervention aimed at reducing the market power of monopolies.
Start by defining productive efficiency (producing at minimum average total cost) and allocative efficiency (producing where price equals marginal cost). Then, for each market structure (perfect competition and monopoly), draw the long-run equilibrium diagram and use it to explain whether these two types of efficiency are achieved.
Consider the reasons why governments intervene to control monopolies (e.g., to correct allocative inefficiency). Then discuss different types of intervention, such as price regulation, competition policy (anti-trust laws), and nationalization. For each type, evaluate its strengths and weaknesses, supporting your points with specific real-world examples of government actions against firms like Google, Microsoft, or utility companies.
Question 2
HardPaper 1 · no calculator25 marks(a) Explain why the profit-maximizing output of a monopoly is likely to result in allocative and productive inefficiency.
(b) Using real-world examples, evaluate the view that government intervention is the most effective way to address the problems associated with monopoly power.
Start by drawing the standard monopoly diagram. Identify the profit-maximization point (where MC=MR). Then, recall the conditions for allocative efficiency (P=MC) and productive efficiency (producing at the minimum of ATC). Compare the monopolist's output and price to these efficient points on your diagram.
Consider different types of government intervention, such as competition policy, regulation, and nationalization. For each, discuss its potential effectiveness and limitations. Then, consider alternatives to government intervention, such as promoting contestable markets or relying on technological change ('creative destruction'). Use real-world examples of government action against firms like Google, or regulation of utility companies, to support your arguments.
Question 3
HardPaper 1 · no calculator25 marks(a) Explain why a monopoly is likely to be able to earn abnormal profits in the long run, whereas a firm in perfect competition is not.
(b) Using real-world examples, evaluate the effectiveness of government policies aimed at reducing monopoly power.
Start by defining the key characteristics of monopoly and perfect competition. Focus on the role of barriers to entry. Your explanation should be supported by two separate, clearly labelled diagrams: one for a monopoly in the long run and one for a perfectly competitive firm in the long run.
Identify several distinct government policies used to control monopoly power (e.g., competition law, regulation, nationalization). For each policy, explain how it is intended to work. Then, evaluate its effectiveness by considering both its potential benefits and its limitations or drawbacks. Support your arguments with specific real-world examples of governments applying these policies to particular companies or industries.
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Where marks are lost
- No real-world example, or a stated one. An answer that names a country and stops cannot reach the top two bands.
- One-sided argument. Balance is an explicit axis. A student who argues only that a policy works is capped at 9 out of 15 on that axis alone.
- Diagram present but not explained. The diagram bullet escalates across three bands: included, included and explained, included and fully explained. A diagram dropped into an answer without prose that refers to it sits at 5 to 6 on a 10-mark part.
