Model essay (a): why some profits last and others vanish

What this lesson teaches

• I can explain how current and possible competition shapes a firm's decisions.

  Syllabus 9570, 2.2.3(b). Firms' Decisions and Strategies: Firms consider the existing and potential levels of competition in the industry when making decisions and engaging in strategies

Make a guess

Bubble tea shops earn high profits, and opening a new shop is cheap. What happens to those profits in the long run?

1. They rise further, as the market grows.
2. New shops enter until only normal profit is left.
3. They stay high, because bubble tea is popular.

The answer to part (a)

Introduction

Normal profit is the profit just enough to keep a firm in its industry. Total revenue covers all costs, including what the owner could earn elsewhere. Supernormal profit is any profit above this. Whether supernormal profit lasts into the long run depends mainly on barriers to entry: anything that makes it hard for new firms to enter a market.

Paragraph 2: low barriers let entry compete profit away

Bubble tea is a monopolistically competitive market. There are many shops, each selling a slightly different drink. Suppose a new drink becomes a craze. In Figure 1, each shop's demand is AR0. It produces Q0, where MR0 equals MC, and charges P0. Since P0 is above average cost, it earns the shaded supernormal profit. This profit attracts new shops. Each existing shop loses some customers, so its AR shifts left. Customers also have more close substitutes, so its AR becomes more elastic. Entry continues until AR1 just touches AC at point b. There the shop charges P1, equal to AC, and earns only normal profit. No new firm has a reason to enter, and none has a reason to leave.

Paragraph 3: why entry is easy in bubble tea

Entry is easy because the barriers are low. A new brand needs only a small shop or kiosk, simple equipment and ingredients such as tea and tapioca that are easy to buy. No special licence or patent is needed beyond food hygiene rules. Customers try new brands readily, so an existing shop's brand gives little protection. Overseas brands can also open with a franchise partner. With such low start-up costs, any lasting profit draws in new rivals quickly.

Paragraph 4: high barriers protect profit

In other markets, high barriers stop entry, so supernormal profit can last. Building a mobile phone network needs a government licence, the right to use radio frequencies and a huge investment in equipment. Existing telcos also enjoy large economies of scale, so a new firm would start with much higher average costs. Some platforms are protected by network effects. A ride-hailing app with many drivers and riders is more useful to each user, so a new app struggles to attract either side. In these markets new firms cannot enter easily, so AR does not shift left and price can stay above AC.

Paragraph 5: the role of potential entry

What matters is how easily firms can enter and leave, not only how many firms exist. A market with few firms but low sunk costs, which are costs that cannot be recovered on leaving, is contestable. Even the existing firms there keep prices close to AC, because high profits would attract a quick entrant.

Conclusion

Firms in bubble tea earn only normal profit in the long run because low barriers let new shops enter until price equals average cost. Where barriers such as licences, economies of scale and network effects are high, entry is blocked and supernormal profit can continue.

Margin notes: how each paragraph scores

Introduction

Defines both kinds of profit precisely and names the deciding factor. The examiner sees the line of argument at once.

Paragraph 2

L3 rigour: the full long-run adjustment on Figure 1. It shows MR = MC, the profit area and both shifts of AR (left and more elastic). It ends where AR touches AC.

Paragraph 3

Context used as evidence: real features of the bubble tea market explain why barriers are low. This is what 'examples of different markets' in a mark scheme looks for.

Paragraph 4

The second requirement with the same depth, using three different barriers and real markets. It explains what the barriers stop happening on the diagram.

Paragraph 5

A short extension on contestability. It shows a fuller understanding of the theory, which helps a script reach the top of L3.

Conclusion

Answers both halves in two sentences. No evaluation marks are available, so no judgement is needed.

Overall: L3, 9 or 10 marks

Both requirements explained with a correct firm diagram and examples from different markets. Explaining only the bubble tea case, or giving no diagram, would cap the answer at L2.

Worked example: A 3-minute plan

Two requirements, one link: barriers to entry.

1. Intro: normal and supernormal profit; barriers to entry decide which lasts.
2. Low barriers: supernormal profit attracts entry; AR shifts left and flattens; Figure 1, P = AC.
3. Why entry is easy in bubble tea: low start-up cost, simple inputs, little brand loyalty.
4. High barriers: licences, scale, network effects; AR does not shift, profit lasts.
5. Close: the height of barriers, and how contestable the market is, decides.

Watch out for this

In the long run bubble tea shops make zero profit, so the owners would be better off closing.

Normal profit is not zero reward. It is the profit just enough to keep the owner in the business, because it covers all costs, including what the owner could earn elsewhere.

Check your understanding

In Figure 1, why does AR become more elastic as well as shifting left?

1. Each shop's costs rise as more firms enter, so it has to charge higher prices than before.
2. Consumers' incomes fall when more shops open, so they buy less bubble tea.
3. Customers now have more close substitutes, so they respond more strongly to a change in price.