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Practice question on market structures
Here is a practice question on government intervention for market structures. This is written in the style of Edexcel Economics A.
Evaluate policies to mitigate the effects of market power. (25 marks)
Quick essay plan
Here is a quick essay plan for the essay.
Analysis point 1: Maximum price, using a cost-revenue diagram.
Evaluation point 1: Regulatory capture.
Analysis point 2: Lowering barriers to entry.
Evaluation point 2: Dynamic inefficiency and a reduction in investment.
Conclusion: Maximum price is effective, but must be set at a level to allow investment. Lowering barriers to entry may be less effective, as some regulations are still needed.
Full model answer
Analysis point 1
A maximum price may prevent abuse of market power. Energy companies have been investigated for potential price leadership in 2013-14, though Ofgem found no evidence of collusion. This could suggest that the energy market is oligopolistic. Take the price cap imposed by Ofgem on energy, which is updated quarterly. This prevents energy companies from using market power to raise prices, keeping energy prices low and thus increasing consumer surplus. Because the energy company increases supply of energy in this case to maximise its profits subject to the price cap, social welfare increases. In the diagram the price cap is set at p1, below the profit-maximising price of p. This increases the output level from q to q1. The lower price also means fewer people in energy poverty. Inequality also falls, as those on low incomes have to spend a greater proportion of their income on energy relative to those on high incomes, and thus those on low incomes benefit more from the fall in energy prices. Also the price cap increases social welfare by moving the outcome closer to the allocatively efficient outcome where AR=MC.
Evaluation point 1
However, regulatory capture may occur, which is when regulators may be bribed or be promised lucrative future jobs in private energy firms, in exchange for watering down the price cap. There are reports of Ofgem’s director in charge of the price cap having worked with British Gas owner Centrica in the past, with critics suggesting this could create conflicts of interest. This may keep the price cap relatively high, for instance near the profit maximising price. In this case, energy prices do not fall with a price cap. So consumer surplus does not rise and there is still allocative inefficiency.
Analysis point 2
Another option is to remove barriers to entry in the energy industry. For example, having fewer legal and financial requirements for new entrants to the energy industry. This reduces costs for energy firms, so more firms may enter the market. This includes firms such as Octopus Energy disrupting the dominance of the “big six” energy firms. This shifts the supply of energy to the right from S to S1. At the original price p, there is now excess supply. So the price falls to eliminate the excess supply by increasing demand (rationing function in reverse). The price mechanism means the energy market moves from the old equilibrium of (q,p) to the new equilibrium with a lower price p1 and higher quantity q1. Consumer surplus rises by the orange shaded area, as energy has become more affordable for consumers. This also gives consumers more choice between different energy providers, encouraging firms to compete on non-price factors, such as customer service to attract customers. This further increases consumer welfare. Incumbent firms may engage in a limit pricing strategy as barriers to entry fall and the market becomes more contestable. This means pricing where AR = AC to discourage other firms from entering. This would also bring down prices and increase consumer surplus.
Evaluation point 2
However, lowering barriers to entry could reduce profits and investment. Making the energy market more contestable could lead incumbent firms to engage in limit pricing (AR = AC, normal profit). Alternatively, firms may enter where profit margins exist in the industry, driving down AR until AR = AC for each firm. This makes energy firms dynamically inefficient, as they have no supernormal profit to reinvest in improving the efficiency of energy infrastructure. This could slow improvements in energy infrastructure, such as pipes and transmission for the grid, which could keep energy distribution costs high and prevent a fall in energy prices over time. Indeed if there is a lack of investment, energy infrastructure could go through wear and tear, becoming less efficient. So energy costs could increase over time, increasing energy bills.
Conclusion
Overall, a price cap is effective to a large degree in mitigating the effects of market power. In particular the price cap can achieve allocative efficiency, provided it must be set at the right level – allowances for a certain level of investment may be needed to avoid dynamic inefficiency. The risk of a revolving door could be mitigated with tighter rules and transparency on regulator hires and departures. Removing barriers to entry can reduce energy prices but it may be less effective. There do need to be some regulations or entry barriers for suppliers, for instance to make sure firms’ finances are strong enough to hedge against wholesale energy price hikes. The absence of such regulation contributed in part to a number of UK energy suppliers collapsing in 2021 and 2022. This could disrupt supply of a necessity, energy, to consumers, which left the taxpayer paying to support failed companies such as Bulb to keep energy supplies going.
Commentary on the answer
This answer on market power interventions has many of the features of a top level answer. These include:
- Chains of reasoning explaining the effects of the maximum price and of lowering barriers to entry.
- Diagrams with use of areas, such as the welfare gain and the change in consumer surplus.
- Evaluation of maximum price and lower barriers to entry, referencing regulatory capture and dynamic inefficiency.
- Conclusion that weighs up which policy may be preferred and why.
- Real world examples throughout to support the essay.
Because of this, the answer is likely to score full marks or close to this.
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