Market failure—market power (HL only): Practice Questions

Which of the following is considered a legal barrier to entry that allows a firm to maintain significant market power?

(HL Only) In the diagram of a monopoly market, the firm produces at the profit-maximizing level where \(MC = MR\). Compared to the allocatively efficient level of output, the monopoly results in a welfare loss because:

Consider two firms, X and Y, in a duopoly choosing between a High Price and a Low Price strategy. The payoffs (Profit X, Profit Y) in millions of dollars are:
(X Low, Y Low): \((10, 10)\)
(X Low, Y High): \((25, 2)\)
(X High, Y Low): \((2, 25)\)
(X High, Y High): \((20, 20)\)

If the firms do not collude and follow their dominant strategies, what will be the total industry profit?

Which of the following is a primary characteristic of a natural monopoly?

A profit-maximizing monopolist is currently producing at an output level where its marginal revenue (MR) is positive. What does this imply about the price elasticity of demand (PED) for its product at this specific output level?

Define the term natural monopoly and state the primary condition related to long-run average costs that leads to its formation.

(HL Only) Explain why the exercise of market power by a firm, resulting in prices above marginal cost, causes allocative inefficiency in the market.

Using the inverse elasticity rule, explain how the degree of market power (measured by the markup over marginal cost) is related to the price elasticity of demand (PED) faced by a firm.

A natural monopoly is a specific case of market failure where a single firm can supply the entire market at a lower average cost than two or more firms.

(a) Explain, with reference to economies of scale, why a natural monopoly typically has a declining Long Run Average Cost (LRAC) curve across the entire range of market demand.
(b) Using a diagram illustrating a natural monopoly's LRAC, Marginal Cost (MC), and Average Revenue (AR) curves, explain why a government regulator’s decision to impose marginal cost pricing (\(P = MC\)) would result in the firm making a loss.
(c) Contrast the outcomes of marginal cost pricing and average cost pricing (\(P = ATC\)) in terms of allocative efficiency and the firm’s financial sustainability.