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Monopoly (Edexcel A Level Economics A)

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Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Updated on

Characteristics of Monopoly

  • A monopoly is a market structure in which there is a single seller

  • There are no substitute products

  • The firm has complete market power and is able to set prices and control output

    • This allows the firm to maximise supernormal profit in the short-run

    • There is no long-run erosion of supernormal profit as competitors are unable to enter the industry

  • High barriers to entry exist

    • One of the main barriers is the ability of the monopoly to prevent any competition from entering the market

      • E.g. by purchasing companies who are a potential threat

  • The UK Competition and Markets Authority defines a legal monopoly as any firm having more than 25% market share

    • It acts to prevent this from happening in most industries

Profit Maximising Equilibrium

  • As a single seller of goods/services, the firm in a monopoly market is also the entire market. Its concentration ratio is CR1=100%

    • There is no differentiation between the firm and the industry

  • It is a price maker or price setter

    • This means that its demand and revenue curves are downward sloping

  • In order to maximise profits, it produces at the point where marginal cost (MC) = marginal revenue (MR)

3-4-3-supernormal-short-run-profit_edexcel-al-economics
A diagram illustrating a monopoly making supernormal profit in the short-run and long-run as the AR > AC at the profit maximisation level of output (Q1)

Diagram analysis

  • The firm produces at the profit maximisation level of output, where MC = MR (Q1)

    • At this level, the AR (P1) > AC (C1)

    • The firm is making supernormal profit equals space left parenthesis straight P subscript 1 space minus space straight C subscript 1 right parenthesis space cross times space straight Q subscript 1

Examiner Tips and Tricks

Some exam questions require application of your knowledge. E.g. You may be asked to draw a cost and revenue diagram to show the likely impact of a reduction in sales on profits. This requires you to modify the diagram presented above by shifting the demand curve inwards. You will draw a second AR and MR curve to the left of the existing ones and then illustrate the new level of profit

Third Degree Price Discrimination

  • Price discrimination occurs when a firm charges a different price for the same good/service in order to maximise its revenue

    • There are different types (degrees) of price discrimination

  • Third degree price discrimination occurs when a firm charges different prices to different consumers for the same good/service e.g. rail fares are priced differently depending on the time of travel

  • Markets are often sub-divided based on time, age, income and geographic location

    • Some airline ticket portals charge higher prices to customers using an Apple computer as they are likely to have higher income

The Following Conditions Must Be Met for Third Degree Price Discrimination to Occur

Market Power

Varying Consumer Price Elasticity of Demand (PED)

Ability To Prevent Resale of Tickets

The firm must have the ability to change prices, which works best when there are no/few substitutes

Some consumers must be willing to pay more and the firm must be able to identify these different consumer groups, i.e. split the market into sub-markets. E.g. Leisure travellers have more price elastic demand than commuters

It must be able to prevent consumers from buying in the low-price elastic sub-market and reselling in the higher price inelastic market. The cost of separating the markets must not exceed the additional revenue gained from charging different prices

Illustrating third degree price discrimination

  • In order to illustrate third degree price discrimination diagrammatically, the different sub-market diagrams are placed side by side

  • The total market diagram is a combination of the sub-market diagrams

    • The total profit is a combination of profits from the sub-markets

  • The diagram below illustrates the market for rail travel in the UK, where price inelastic demand is 'peak' hour demand and price elastic demand is any other time of the day, i.e. 'off-peak'

3-4-5-third-degree-price-discrimination_edexcel-al-economics
A third-degree price discrimination diagram demonstrates a market that has been divided based on price inelastic (peak travel) and price elastic demand (off-peak travel). Following the revenue rule, prices are raised for peak demand and lowered for off-peak demand

Diagram analysis

  • Each train route has an effective monopoly provider

  • The overall firm is producing at the profit maximising level of output where MC=MR

    • This point is extrapolated to both sub-markets on the left by using the lower dotted line

    • The average cost is extrapolated across both sub-markets using the upper dotted line (C1)

  • A higher price for peak travel has been set at Pa and a lower price for off-peak travel has been set at Pb

  • Following the revenue rule, total revenue increases in both markets

  • The profit for sub-market A = (Pa-C1) * Q1

  • The profit for sub-market B = (Pb-C1) * Q2

  • The firm's total profit is the average selling price - the average costs

    • Total profit = (Pt-C1) * Q3

  • The firms' total profits are higher than if they had charged a single price to all customers  

Costs and benefits of third-degree price discrimination

Costs and Benefits of Third-Degree Price Discrimination to Consumers and Producers

Consumers

Producers

  • Many price inelastic consumers will lose out as they pay higher prices, lowering consumer surplus

  • Other price elastic consumers will benefit as they will be able to take advantage of the lower prices, increasing consumer surplus

  • Some consumers will gain as a higher price decreases the quantity demanded and in some markets this can increase consumer utility e.g. on train services; it helps limit over-crowding

  • The total revenue of producers increases, leading to higher profits assuming there is no change in costs

  • Firms increase their producer surplus at the expense of a decrease in consumer surplus

  • Setting up and enforcing price discrimination can increase average costs. The costs of price discrimination must not outweigh the additional revenue gained

Costs & Benefits of Monopoly

  • In several instances where the Competition and Markets Authority has acted to decrease/limit monopoly power, firms have taken the Regulator to court to attempt to convince them that the firms market power will benefit consumers

    • Theoretically this is possible, however, in many cases, the desire to maximise profits would prevent this from happening

The Advantages and Disadvantages Of Monopoly Power

Stakeholder

Advantages

Disadvantages

The Firm

  • Supernormal profits generate finance for continued investment in technology and product innovation

  • Market power enables the firm to increase its global competitiveness

  • Economies of scale can increase, thereby lowering the average cost

  • Producer surplus increases

  • Price discrimination can increase total revenue

  • Due to a lack of competition, there is a reduced incentive to be efficient

  • Cross subsidisation can create inefficiencies

  • Monopolies lead to a misallocation of resources as P > MC. The price is above the opportunity cost of providing the product

  • Due to a lack of competition, innovation sometimes lacks effectiveness 

Employees

  • Supernormal profits often result in higher wages and greater job security

  • Having only one supplier in the industry limits the opportunity to change employers

Consumers

  • Product innovation due to the firm's supernormal profits may result in a better-quality product

  • Cross subsidisation can lower prices on some products that the firm provides

  • Prices may fall If firms pass on their cost savings (due to economies of scale) in the form of lower product prices

  • A lack of competition is likely to result in higher prices as no substitute goods are available

  • A lack of competition may result in no product innovation and worse product quality over time

  • May experience worse customer service as the incentive to improve it is limited

  • Cross subsidisation is likely to increase prices on some products offered by the firm, e.g. First class air ticket prices are used by some airlines to subsidise lower economy ticket prices

  • Consumer surplus decreases

Suppliers

  • Increased sales volume for some suppliers as they are able to supply products that are distributed nationally or internationally with a secure contract

  • There is less competition for their products and a monopoly often has the power to dictate what price they will pay to suppliers (monopsony power)

  • This price may not be profitable in the long run

Natural Monopoly

  • A natural monopoly occurs when the optimum number of firms in the industry is one

    • This is often due to associated infrastructure issues e.g. delivery of utility services like water, where it does not make sense to have multiple pipelines

    • It can also be due to the significant cost that is generated when entering or exiting the industry, e.g. the sunk costs

    • It can also be due to the ability of economies of scale to lower prices for consumers, e.g. it makes sense to have one firm building five nuclear power stations as opposed to five firms, as average costs will be lower with one firm constructing

    • Even one firm in the industry cannot achieve an output at the lowest average cost where AC=MC, productive efficiency. More competition would simply increase average costs, further increasing prices for consumers

    Natural monopolies usually occur in utility industries and are regulated by the Government to ensure that consumers are not charged higher monopoly prices

    • This regulation is often in the form of a maximum price or a price cap

Examiner Tips and Tricks

When evaluating monopolies, demonstrate critical thinking by acknowledging the positives as well as the negatives. For example, Amazon has partly become a monopoly by being very good at what it does, with consumers benefiting from lower prices and a greater choice. However, its power means that it can also exploit the suppliers on its platform

When evaluating natural monopolies, consider the government failure that may occur with the regulation and the imposition of maximum prices. There is a lot of disagreement about the level of profits that natural monopolies should be allowed to make. It is a normative issue

When arguing for monopoly markets, always use your knowledge of a natural monopoly example to support the market structure. For example, consider why it is desirable for a country to only have one air traffic control provider yet advantageous to have more than one airline

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    Author
    Reviewer
    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

    Jenna Quinn

    Author: Jenna Quinn

    Expertise: Head of New Subjects

    Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.