Monopoly (Edexcel A-Level Economics A): Revision Notes

Monopoly

Introduction to monopoly

A monopoly is a market structure where there is only one seller of a good or service. This single firm has complete market power and faces no direct competition. The monopoly model helps us understand how firms behave when they have significant control over their market.

Key assumptions

The economic model of monopoly rests on three fundamental assumptions:

1. Single seller - There is only one firm producing and selling the good in the market.

2. No substitutes - There are no close substitutes for the product, either actual or potential. Consumers who want the product must buy from the monopolist.

3. Barriers to entry - Significant barriers to entry prevent other firms from entering the market to compete with the monopolist.

The model also assumes that the monopoly firm aims to maximise profits. These assumptions stand in sharp contrast to those of perfect competition. In fact, monopoly can be thought of as sitting at the opposite end of the market structure spectrum.

Monopoly in equilibrium

Understanding the monopolist's position

Unlike firms in perfect competition, a monopoly firm faces the entire market demand curve. This gives the monopolist significant influence over price. The firm is a price maker rather than a price taker, meaning it can choose different points along the demand curve by varying output levels.

However, the monopolist cannot set both price and quantity independently. The firm is still constrained by market demand. If the monopolist chooses a high price, consumers will buy less. If it wants to sell more, it must accept a lower price. The firm must choose a location along the demand curve.

Elasticity and total revenue

The relationship between price elasticity of demand and total revenue is crucial for understanding monopoly behaviour. This relationship determines where on the demand curve a profit-maximising monopolist will choose to operate.

The diagram shows how price elasticity varies along a straight-line demand curve. In the upper portion, demand is price elastic - a fall in price leads to a proportionally larger increase in quantity demanded, so total revenue rises. At the midpoint of the demand curve, demand has unit elasticity - total revenue is at its maximum. In the lower portion, demand is price inelastic - a fall in price leads to a proportionally smaller increase in quantity, so total revenue falls.

Marginal revenue

The marginal revenue (MR) curve shows the additional revenue gained from selling one more unit of output. For a monopolist, MR lies below the demand curve (AR). This happens because to sell an additional unit, the monopolist must reduce the price not only on that extra unit but on all previous units as well.

Profit maximisation

Like all firms, a monopolist maximises profits by producing where marginal revenue equals marginal cost ($\text{MR} = \text{MC}$). Having determined this optimal output level, the monopolist then identifies the maximum price consumers will pay for that quantity by reading up to the demand curve.

The diagram illustrates monopoly profit maximisation. The firm produces output $Q_m$ where $\text{MR} = \text{MC}$. At this output level, the firm charges price $P_m$. The yellow shaded area represents supernormal profit - the profit above the normal return needed to keep the firm in the industry. This is calculated as:

$\text{Supernormal Profit} = (\text{AR} - \text{AC}) \times Q$

or the profit per unit multiplied by the number of units sold.

Barriers to entry protect profits

The existence of barriers to entry is critical for understanding why monopolists can earn supernormal profits in the long run. In a perfectly competitive market, supernormal profits attract new firms, increasing supply and pushing down prices until only normal profits remain.

Possibility of losses

A monopolist is not guaranteed to make supernormal profits. The size of profits depends on the position of the demand curve relative to the cost curves.

If the monopolist's costs are relatively high compared to the market demand, the firm may actually make losses in the short run. In this situation, if the firm produces where $\text{MR} = \text{MC}$, it charges price $P_m$, but this price is below average cost $\text{AC}_m$. The yellow area shows the loss per unit multiplied by quantity.

Changes in market conditions

Response to increased demand

If a monopoly experiences (or can induce) an increase in demand for its product, the firm benefits through higher profits. When demand increases, both the demand curve (AR) and the marginal revenue curve shift to the right.

Initially, the monopoly faces demand curve $D_0$ and produces $Q_0$ output at price $P_0$ where $\text{MR}_0 = \text{MC}$. When demand increases to $D_1$, the MR curve shifts to $\text{MR}_1$ (notice the fixed relationship between AR and MR). The monopolist now produces $Q_1$ output where $\text{MR}_1 = \text{MC}$ and charges the higher price $P_1$, earning higher profits than before.

Response to increased costs

Suppose a monopoly experiences an increase in its average cost, perhaps caused by an increase in variable costs like wages or raw material prices.

The original position has the firm maximising profits where $\text{MC}_0 = \text{MR}$ at point X, setting price $P_0$ and producing output $Q_0$. The profit is given by the area $P_0\text{BHG}$.

When costs increase, the MC curve shifts up to $\text{MC}_1$, and the AC curve shifts up to $\text{AC}_1$. The firm now maximises profits where $\text{MC}_1 = \text{MR}$ at point Y, setting a higher price $P_1$ and producing lower output $Q_1$. The profit area has shrunk to $P_1\text{AFE}$. Consumers must pay a higher price and can buy less of the good. The firm faces lower profits.

How monopolies arise

Monopolies can develop in a market for several different reasons.

Legal monopolies

In some instances, governments create monopolies through legal authority. For example, for 150 years the UK Post Office held a licence giving it a monopoly on delivering letters. This service was eventually opened to limited competition in the 2000s, though companies wishing to deliver packages weighing less than 350 grams and charging less than £1 could only do so by applying for a licence.

Natural monopoly

A natural monopoly arises when the technology and cost structure of an industry creates substantial economies of scale throughout the relevant range of output. In such cases, there may only be room for one firm to operate efficiently in the market.

The diagram shows a natural monopoly situation. The key feature is that the long-run average cost (LAC) curve continues to decline throughout the range of market demand. The long-run marginal cost (LMC) curve lies below the LAC curve throughout this range.

A profit-maximising natural monopoly would produce at quantity $Q_m$ (where $\text{MR} = \text{MC}$) and charge price $P_m$.

Competitive monopoly

Some firms have risen to become monopolies through their actions in the market rather than through legal protection or technological factors. This is sometimes called a competitive monopoly.

Firms may achieve monopoly status through effective marketing, establishing their product as a widely accepted standard, or through mergers and acquisitions. For example, by 2021, Google controlled more than 90% of the global search engine market, not through legal protection or natural monopoly conditions, but through establishing market dominance.

Monopoly and efficiency

The characteristics of monopoly markets can be evaluated by examining different types of efficiency.

Productive efficiency

A firm achieves productive efficiency when it produces at the minimum point of its long-run average cost curve. This represents the lowest possible cost per unit of output.

Looking at the profit maximisation diagram, it is clear that productive efficiency is unlikely for a monopoly. The firm produces at quantity $Q_m$ where $\text{MR} = \text{MC}$, but this will only coincide with the minimum point of the LRAC curve by pure coincidence. If the marginal revenue curve happened to pass through exactly the minimum point of LRAC, productive efficiency would be achieved, but this would be a rare accident rather than a systematic outcome.

Allocative efficiency

Allocative efficiency occurs when price equals marginal cost ($P = \text{MC}$). At this point, the value consumers place on the last unit consumed (shown by the price they're willing to pay) equals the cost of producing that unit. Resources are optimally allocated from society's perspective.

Dynamic efficiency

Dynamic efficiency refers to efficiency over time, particularly relating to innovation and technological progress. A firm achieves dynamic efficiency when it uses supernormal profits to invest in research and development, creating new products or reducing production costs in the future.

Monopolies may be able to achieve dynamic efficiency. Because they can earn supernormal profits, they have the financial resources available to invest in R&D. This may lead to cost reductions or new product development that benefits consumers in the long run.

Comparing perfect competition and monopoly

We can identify the welfare effects of monopoly by comparing it with perfect competition operating under the same cost conditions. To simplify the analysis, let's assume no economies of scale, so we can use the same cost curves for both market structures.

The diagram compares equilibrium outcomes under both market structures:

Under perfect competition: The market operates where the long-run supply curve ($\text{LRS} = \text{LMC}_m$) intersects the demand curve. The competitive equilibrium produces quantity $Q_{pc}$ at price $P_{pc}$. Consumer surplus is the entire area under the demand curve above the price - shown as the area $AP_{pc}E$.

Under monopoly: The profit-maximising monopolist produces where $\text{MR} = \text{MC}$, resulting in quantity $Q_m$ at price $P_m$. Consumer surplus shrinks to the area $AP_mB$. The purple/grey rectangular area $P_mBCP_{pc}$ represents a transfer from consumer surplus to producer surplus - this is profit earned by the monopolist that was previously consumer surplus.

Deadweight loss

Key insight: The monopolist produces less output than a perfectly competitive industry and charges a higher price, creating both a redistribution of welfare (from consumers to the firm) and a deadweight loss to society.

Price discrimination

Are there any conditions in which a monopoly firm would produce the level of output consistent with allocative efficiency? The answer lies in understanding price discrimination.

Perfect (first-degree) price discrimination

Consider a market operated by a monopolist who faces constant marginal cost ($\text{LMC} = \text{AC}$). Under normal monopoly behaviour with a single price, the market outcome would be at price $P^*$ and quantity $Q^*$ under perfect competition, but at price $P_m$ and quantity $Q_m$ under monopoly.

But suppose the monopolist could charge a different price to each individual consumer - charging each consumer exactly their maximum willingness to pay for the product. This is called perfect price discrimination or first-degree price discrimination.

From society's overall perspective, total welfare is the same as under perfect competition (though distributed very differently). However, this represents a massive redistribution from consumers to the monopolist. The monopolist has essentially hijacked all consumer benefits.

Reality check: Perfect price discrimination is quite rare in the real world, though it might exist in certain markets like art, fashion or designer jewellery where prices are individually negotiated between buyer and seller.

Third-degree price discrimination

More commonly observed is third-degree price discrimination, where a firm charges different prices to different groups of consumers rather than to each individual consumer separately.

Students, disabled people and older people in England may get discounted bus fares. Younger and older people may get cheaper access to sporting events or theatres. Railway passengers pay different prices for peak and off-peak travel. In all these cases, different consumer groups pay different prices for essentially the same product.

Conditions for price discrimination

For a firm to successfully practise price discrimination, three conditions must be met:

1. Market power - The firm must have some degree of market power (the ability to set prices above marginal cost). Price discrimination is impossible in perfectly competitive markets where all sellers are price takers.

2. Information - The firm must have information about consumers and their willingness to pay. There must be identifiable differences between consumers or groups of consumers, particularly differences in their price elasticities of demand (different sensitivities to price).

3. Prevention of resale - Consumers must have limited ability to resell the product. If consumers could easily resell, those who qualified for the low price could buy up the product and resell it to consumers in other market segments, engaging in arbitrage. This would eliminate the price differences and undermine the discrimination strategy.

How third-degree price discrimination works

The diagram shows how a monopolist practices third-degree price discrimination across two markets (Market A and Market B):

If the firm had to charge the same price to all consumers, it would set marginal revenue equal to marginal cost in the combined market, producing $Q^*$ output to be sold at price $P^*$. The firm would sell $q_A^*$ units in Market A and $q_B^*$ units in Market B at this single price.

In the discriminating equilibrium, the firm sells $q_A$ units in Market A at the higher price $P_A$, and $q_B$ units in Market B at the lower price $P_B$. Notice that in both situations, the amounts sold in the two submarkets sum to $Q^*$ - total output hasn't changed from the single-price scenario.

Benefits for the firm

By undertaking price discrimination, the firm can increase its profits. The discriminating monopolist shown in the three-panel diagram separates two distinct groups of consumers with differing demand curves and different price elasticities. This allows the firm to extract more revenue from consumers with lower price elasticity (less sensitive to price changes) while still making sales to consumers with higher price elasticity (more sensitive to price changes).

In essence, price discrimination allows the monopolist to capture more consumer surplus and convert it into producer surplus (profit).

Benefits for consumers

Consumers in Market B (the low-price market) benefit from this practice, as they can now consume more of the good than they would at the single higher price. Indeed, without price discrimination, the price might be so high that these consumers would not be able to consume the good at all.

Furthermore, if the monopolist uses its higher profits for research and development, consumers may benefit from new and improved products or from cross-subsidisation of other services provided by the firm.

Overall evaluation

Study tip: Be ready with the three conditions necessary for price discrimination: market power, information about different consumers and their elasticities of demand, and limited ability for consumers to resell the product.

Price discrimination creates both benefits and costs:

Benefits:

• Some consumers gain access to products that would otherwise be beyond their price range
• May lead to greater dynamic efficiency if profits fund R&D
• Can enable cross-subsidisation of other services

Costs:

• Reduces consumer surplus significantly
• Involves redistribution from consumers to producers
• May seem unfair that different groups pay different prices for the same product

Evaluation of monopoly

A profit-maximising monopoly firm produces less output at a higher price than would occur under perfect competition. Since the monopolist sets price above marginal cost, allocative efficiency is not achieved.

However, several considerations may moderate this negative assessment:

Potential benefits of monopoly:

• Economies of scale: A monopoly may be able to exploit economies of scale that would not be available to smaller firms. By producing at lower cost, a firm with a monopoly in the home market may be better positioned to compete with firms in a global market environment.

• Dynamic efficiency: The supernormal profits earned by a monopoly provide financial resources that can be used for research and development activity. This may lead to dynamic efficiency - innovation and technological progress over time. Under perfect competition, firms lack these resources for substantial R&D investment.

• Natural monopoly efficiency: In industries with substantial fixed costs but low marginal costs, having multiple competing firms would be wasteful. A natural monopoly may produce at lower cost than would be possible under competition.

• Price discrimination benefits: If a monopoly firm practises price discrimination, some consumers may gain access to products that would otherwise be beyond their financial reach. The discriminating monopolist may also produce closer to the allocatively efficient quantity.

Potential costs of monopoly:

• Allocative inefficiency: Price exceeds marginal cost ($P > \text{MC}$), meaning society values additional units more than they cost to produce, but the monopolist restricts output to maintain high prices.

• Lack of productive efficiency: The monopolist is unlikely to produce at minimum average cost and may not have strong incentives to minimise costs.

• X-inefficiency: Without competitive pressure, the monopolist may become complacent, allowing organisational slack and inefficient management practices to develop.

• Deadweight loss: The restriction of output below the competitive level creates a welfare loss to society that benefits no one.

• Distributional effects: Monopoly power transfers consumer surplus to producer surplus. While this doesn't reduce total welfare (it's a transfer, not a loss), it may raise equity concerns about the distribution of economic benefits.

• Reduced consumer choice: With only one supplier, consumers have no alternatives if they dislike the monopolist's product quality, customer service, or other characteristics.

Remember!