Explain how the lowering of barriers to entry in the banking market might lead to lower prices and a situation in which banks make normal profit
AQA A-Level Economics Paper 2 June 2018
Extract C (lines 10–11) states that ‘There is ample opportunity for new players to enter the sector.’
With the help of a diagram, explain how the lowering of barriers to entry in the banking market might lead to lower prices and a situation in which banks make normal profit. (9 marks)
The banking market can be modelled as monopolistic competition since there are low barriers to entry, as mentioned in extract C in lines 10-11.
Monopolistic competition is the market structure that has low barriers to entry. There is also slight product differentiation between firms. This means that most firms face a relatively elastic average revenue (AR) curve; if firms raise prices, quantity demanded is likely to fall by a larger proportion due to the number of close substitutes available to customers in the market. Firms aim to maximise profits, so they produce at the point where marginal costs = marginal revenue (MC=MR). This means that firms can make supernormal profit in the short run, as shown by the shaded rectangle op1c1q1.
Since there are low barriers to entry, profit-maximising firms are able to enter the market quite easily. They are incentivised to do so because they know that existing firms are making profit in excess of normal profits, meaning firms are able to at least cover the cost and the opportunity cost of entering the market. As a result of new firms entering the market, market supply increases. Therefore, each firms’ average revenue falls as they have to accept a lower market price. This eventually leads to a new long-run profit maximising equilibrium where existing firms are only able to make normal profit.
Note: I would recommend that students add their own application to this answer. For example:
- low barriers to entry: digital banks do not need to have a physical store
- new entrants: firms like Monzo and Revolut
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