Chapter 8 Part 1 Tut Memo

Economics 3A Tutorial Questions
1. Explain how economies of scale works and how it can lead to winners and losers in a
competitive market. 3marks (NB! Students, please note that this answer gives you a
whole understanding, your answer do not have to be this long. Take note of before and
trade and how we can have winners and losers)
Answer:
Economies of scale
Ø In simple terms, with economies of scale, the average cost (AC) decreases as
the scale of output increases. That is a cost advantage.
Ø It’s a case whereby output quantity goes up by a larger proportion than does the
total cost (TC), as output increases. If the quantity expands faster than an
increase in TC, then the AC (computed as the TC/no of units priced) of
producing a unit of output decreases as output increases. E.g if the TC is 20 and
N is 40 then AC is 0.5, if TC is 30 and N is 80 then AC is 0.4, If TC is 30 and N is
160 the AC IS 0.2 and so on.
Ø There are two types of economies of scale: internal economies of scale and
external economies of scale.
I．Internal economies of scale
Ø Internal economies of scale is a cost advantage to an individual firm( larger),

producers of a product produce at a lower AC
Ø Economies of scale that are internal to the firm can drive an industry away from
perfect competition (Of the standard trade theory). This is because internal
economies of scale drive individual firms to be larger than small firms that
populate perfect competitive industry. By how far away depends on the size and
extent of the economies of scale.
Examples of internal economies of scale :
a. Monopolistic competition: - Large number of firms selling differentiated product.

Because each firm’s product is somewhat different, each firm has some control
over the price.
- There is internal economies of scale in producing a product variant
- Easy entry and exit of firms in the LR
To understand Monopolistic competition, internal economies of scale and trade: Let

use the automotive industry as an example and assuming that we only consider the
assembly of cars in each country.
Before trade: SA produce variety of models ( ford ranger, Toyota hilux, VW polo,
Nissan NP200, Toyota fortune, Isuzu) and sell them locally.
Winners: Consumers because they have more access to more and closer substitutes
for any car model.
Losers: Domestic producers. First, the demand for any car model become price
elastic as there are more models. Each firm loses some pricing power as the market
becomes more rivalrous. Secondly, due to market demand of a compact cars in SA,
an increase in the number of models produced means individual models will be
produced at a smaller level of output. The crowding out effect of the car models in
the market reduces the ability of each firm to achieve economies of scale. Lastly,
firms earn zero economic profits on its car model due to free entry and exit.
After trade: SA export their car products to US, while importing the 2019 Chevrolet
Sonic, 2018 Toyota Highlander, 2019 Ford Escape, 2019 BMW X5, Honda CR-V etc
From US
Winners: Consumers in each country have access to more car models than would
before trade.
Another source of gain arises from the international competition that can lower prices
of a domestic varieties.
Local producers can now produce more and export some of their products at a lower
cost however in the long run they earn zero economic profits
b. Oligopoly (Few firms dominating the industry. In global markets, it is few firms
accounting for most of the world’s production and in extreme cases, one firm
dominate the world market) and Monopoly ( Single producer of the product)
- Exploit substantial internal economies of scale. If the substantial economies of
scale exist over a larger range of output, then production of a product tends to be
concentrated in a few larger facilities in a few countries.
Few examples of industries in the world dominated by few industries:
1. Commercial aircraft: Boeing and Airbus
2. Firms that design and sell most of the world’s video game consoles: Nintendo,
Sony and Microsoft
Oligopoly (and in some cases Monopoly), Internal economies of scale and Trade.
Before trade: Each country must produce for its own consumption.
Winners: Local producer (Oligopoly or monopoly) of that product (Earn more profit by
taking cost advantages, produce more product for local consumers and charge
higher prices thus generating more profit)
Losers: Consumers of the local country (Given that there are many buyers and few
sellers, this will lead to excess demand)
After trade: Net exporters of the product take full advantage of the cost- reducing
benefits of the economies of scale. However, if oligopoly firms compete aggressively
on price, then more gain goes to the foreign buyers and less is captured by the local
oligopoly firms. If instead, the oligopoly firms can restrain their price competition,
then the oligopoly firm can earn large economic profit on their sales and less to
foreign buyers.
- Local Consumers, can get more products available (export and imports)
II. External economies of scale
Cost advantage based on the size of an entire industry within a specific

geographic area in each country. The AC of the typical firm producing the
product declines as the output of the industry (all local firms producing this
product) is larger.
Ø External economies of scale explains the clustering of the production of some

products
Ø They can arises concentration of an industry firms attract greater local supplies
of a specialized services. Second, result as new knowledge about the product
and production technology ( or other useful businesses) diffuses quickly among
firms in the area.
Few examples of external economies of scale:
Ø Filmmaking firms cluster in Hollywood
Ø Computer and related high-tech business in Silicon Valley
Ø Watch-making in Switzerland
Ø Financial services in SA
Third form of market structure that deviates from the perfect competition is an
industry that benefit from substantial external economies of scale.
Assumptions: - Large number of small firms exist in the industry in each location.
- No internal economies of scale, thus an individual firm does not need to be large to
achieve low cost
Therefore, we have a case in which substantial exnal economies of scale coexist

with a highly competitive industry.
Before trade: Each firm would respond to the stronger demand by raising output. If
each firm act alone and affected only itself, the extra demand would push the market
up.
After trade: The increase in industry output brings additional external economies of
scale (e.g knowledge spillovers from firm to firm). Thus, an increase in demand
triggers a great expansion of supply and lowers costs and prices.
Winners: Exporting producers win although lower prices mitigate gains in the future.
- Consumers (home and foreign alike) gain because of lower prices and increase
consumption.
Losers: Producers in importing countries lose producer surplus.

2. Explain how the pricing decision may vary for an oligopoly and monopolistic firm
(page 200)
The pricing decisions of firms under the Oligopoly market structure are interdependent.
Each firm tries to understand the price behaviour of other firms in the market before it
fixes the prices of its own products.
The pricing decisions of firms under monopolistic are not interrelated. Every firm has a
certain degree of monopoly power and can take initiative to set a price.
3. Explain the difference between market equilibrium for a monopoly and monopolistic
firms in terms of the profit that can be made (use 2 graph)
a. Monopoly profit maximization
 A monopoly is an industry with only one firm. E.g Eskom
How a Profit-Maximizing Monopoly Decides: Price in Step 1, the monopoly chooses
the profit-maximizing level of output Q1, by choosing the quantity where MR = MC.
In Step 2, the monopoly decides how much to charge for output level Q1 by
drawing a line straight up from Q1 to point R on its perceived demand curve. Thus,
the monopoly will charge a price (P1). In Step 3, the monopoly identifies its profit.
Total revenue will be Q1 multiplied by P1. Total cost will be Q1 multiplied by the
average cost of producing Q1, which point S shows on the average cost curve to be
P2. Profits will be the total revenue rectangle minus the total cost rectangle, which
the shaded zone in the figure shows.
You can use the first graph to explain the second one (lecture slide)
b. Monopolistic profit maximization

 Monopolistic competition is a simple model of an imperfectly competitive
industry that assumes that each firm
1. can differentiate its product from the product of competitors, and
2. takes the prices charged by its rivals as given—it ignores the impact of
its own price on the prices of other firms. Ex. Mr. price
How a Monopolistic Competitor Determines How Much to Produce and at What Price
The process by which a monopolistic competitor chooses its profit-maximizing quantity
and price resembles closely how a monopoly makes these decisions process. First, the
firm selects the profit-maximizing quantity to produce. Then the firm decides what price
to charge for that quantity.
Step 1. The monopolistic competitor determines its profit-maximizing level of output. In
this case, the Authentic Chinese Pizza company will determine the profit-maximizing
quantity to produce by considering its marginal revenues and marginal costs. Two
scenarios are possible:
If the firm is producing at a quantity of output where marginal revenue exceeds
marginal cost, then the firm should keep expanding production, because each marginal
unit is adding to profit by bringing in more revenue than its cost. In this way, the firm
will produce up to the quantity where MR = MC.
If the firm is producing at a quantity where marginal costs exceed marginal revenue,
then each marginal unit is costing more than the revenue it brings in, and the firm will
increase its profits by reducing the quantity of output until MR = MC.
In this example, MR and MC intersect at a quantity of 40, which is the profit-maximizing
level of output for the firm.
Step 2. The monopolistic competitor decides what price to charge. When the firm has
determined its profit-maximizing quantity of output, it can then look to its perceived
demand curve to find out what it can charge for that quantity of output. On the graph,
this process can be shown as a vertical line reaching up through the profit-maximizing
quantity until it hits the firm’s perceived demand curve. For Authentic Chinese Pizza, it
should charge a price of $16 per pizza for a quantity of 40.
Although the process by which a monopolistic competitor makes decisions about
quantity and price is similar to the way in which a monopolist makes such decisions, two
differences are worth remembering. First, although both a monopolist and a
monopolistic competitor face downward-sloping demand curves, the monopolist’s
perceived demand curve is the market demand curve, while the perceived demand curve
for a monopolistic competitor is based on the extent of its product differentiation and
how many competitors it faces. Second, a monopolist is surrounded by barriers to entry
and need not fear entry, but a monopolistic competitor who earns profits must expect
the entry of firms with similar, but differentiated, products.
4. The last couple of years the sales revenue of firm A has gone down by 5%. Using the
following function explain how firm A can improve their sales.
Q=S[1/n - b(p-p*)]
For firm A to increase their sales revenue they must decrease their firm's price. External
factors can only influence the price of firm's A product but only firm A can change their
internal price.
E.g Assume South Africa street vendor industry selling apples. All this vendor make up a
small industry.
P* is the price of the industry.
If P decrease of firm A this will increase the Q (individual firm sales). This is also with the
assumption that (1/n) one vendor exit the industry, therefore other firms sale will
increase.
5. If country A reduces its trade restrictions, explain the impact on the following
variables.
(Reduced trade restrictions will allow an operation of more firms, which will increase
the size of the market. This means more production will occur and thus lower average
cost due to economies of scale. An increase in the number of firms will also lead to a
decrease in prices but the PP remains constant) (example in figure 8-4).
Variable Impact
Average Cost Decrease
Number of firms Increase
PP curve Constant
Price of goods Decrease

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Economics 3A Tutorial Questions

I．Internal economies of scale

Ø Internal economies of scale is a cost advantage to an individual firm( larger),

Examples of internal economies of scale :

a. Monopolistic competition: - Large number of firms selling differentiated product.

- Easy entry and exit of firms in the LR

To understand Monopolistic competition, internal economies of scale and trade: Let

Few examples of industries in the world dominated by few industries:

1. Commercial aircraft: Boeing and Airbus

II. External economies of scale

Cost advantage based on the size of an entire industry within a specific

Ø External economies of scale explains the clustering of the production of some

Few examples of external economies of scale:

Ø Filmmaking firms cluster in Hollywood

Ø Computer and related high-tech business in Silicon Valley

Therefore, we have a case in which substantial exnal economies of scale coexist

Losers: Producers in importing countries lose producer surplus.

b. Monopolistic profit maximization

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