Market Power & Monopolies (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Market Power in a Monopoly
Market power refers to the ability of a firm to influence and control the conditions in a specific market, allowing them to have a significant impact on price, output, and other market variables
The level of market power is high/absolute for monopoly firms
Monopoly firms have high market power, high/total market share and a high/perfect industry concentration ratio
There is significant market failure in monopoly firms
Governments regulate and intervene in mergers and acquisitions in order to ensure (in many economies) that no single firm gains more than 25% market share
Characteristics of Monopoly Markets
A monopoly is a market structure in which there is a single seller
There are no substitute products
The firm has complete market power & is able to set prices & 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
Characteristics of Monopoly Market Structures
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Nature of the product | Unique - no substitutes | Degree of efficiency | Usually high inefficiency as there is no competition |
Customer loyalty | High - no substitutes | Type of profit | Abnormal |
Price taker or maker? | Price maker | Level of market power | Absolute |
Barriers to entry | Extreme barriers including mergers and acquisitions, supplier control etc | Slope of the demand curve | Steepest (inelastic) |
Number of firms | No competitors/substitutes |
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A Monopoly Making Abnormal Profits
As a single seller of goods/services, the firm in a monopoly market is also the entire market
There is no differentiation between the firm & the industry
It is a price maker
This means that its revenue curves are downward sloping
In order to maximise profits, it produces at the point where marginal cost (MC) = marginal revenue (MR)
A diagram illustrating a monopoly making supernormal profit in the short-run & 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 abnormal profit
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 & MR curve to the left of the existing ones & then illustrate the new level of profit.
A Monopoly Making Normal Profits
In a monopoly market, normal profit refers to the level of profit necessary to keep the monopolist in the market in the long run
It represents the minimum amount of profit needed to cover the opportunity cost of the resources used by the monopolist
At this point, total revenue TR) equals the total cost (TC), including both explicit and implicit costs
If the monopolist is earning normal profit, it indicates that there is no abnormal profit
The monopolist is simply earning a competitive return and covering its costs of production
A monopoly may make normal profit in the short-run and this occurs at the profit maximisation level of output and where the price (AR) = ATC
Diagram Analysis
The firm is following the profit maximisation rule and producing at the level of output where MR = MC (Q1)
At this level of output, the selling price P1 (AR) = ATC
This means the firm is breaking even and this is considered to be normal profit
A Monopoly Making Losses in the Short-run
In a monopoly market, a loss minimisation position occurs when the monopolist incurs losses but aims to minimise those losses in the short run
The loss minimisation position arises when the market price (AR) is below the average total cost (ATC) but above the marginal cost (MC) of production
In the long run, a monopolist cannot sustain losses indefinitely
If losses persist the monopolist might consider exiting the market or changing its production strategies
A monopoly firm is making short-run losses as seen by the fact that at the profit maximisation level of output (MC = MR), the selling price is below the average total cost (ATC)
Diagram Analysis
The firm produces at the profit maximisation level of output where MC = MR (QE)
At this level the AR (P1) < AC (C1)
The firm is making a loss
Side by Side Comparison of Perfect Competition & Monopoly
Perfect competition tends to achieve both productive and allocative efficiency due to the presence of competition, whereas monopolies generally result in inefficiencies in both aspects
Side by side comparison of efficiency in perfect competition and monopoly markets
Diagram Analysis
Perfect competition on the left
The firm produces at the profit maximisation level of output where MC=MR (Y)
The firm is productively efficient as MC=AC at this level of output
The firm is allocatively efficient as AR (P)=MC
There is no welfare loss
Monopoly market on the right
The firm produces at the profit maximisation level of output where MC=MR (A)
The firm is not productively efficient as AC > MC at this level of output (B-A)
Productive efficiency would occur at point X where MC=AC
The firm is not allocatively efficient as AR (P) > MC at this level of output (D-A)
Allocative efficiency would occur where AR=MC (point F)
The welfare loss is equal to the area of the shaded triangle - ADF
Costs & Benefits of a Monopoly Market Structure
In several instances where a government regulator (e.g. The European Competition Commission) has acted to decrease/limit monopoly power, the 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 & Disadvantages of Monopoly Power
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The Firm |
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Employees |
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Consumers |
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Suppliers |
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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 they do & consumers benefit from lower prices & greater choice. However, this power means that they can also abuse the suppliers on their platform.
Natural Monopoly
A natural monopoly occurs when the most efficient 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 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 producing
Natural monopolies usually occur in utility industries & 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
Natural monopolies spend large sums in production and make a profit between Q1 and Q2. If another firms enters the market their demand will decrease and they will make a loss
Diagram Analysis
Assume a utility company spends $billions building out a new delivery network
Their average total costs (ATC) are initially very high, but fall as they are able to gain economies of scale
As they gain an increasing number of customers (D1 = AR1), the firm is initially in a loss making position experienced between 0 → Q1 customers
Between Q1 → Q2, the firm is now making a profit as the AR > ATC
Should another firm enter the market, the demand will be split between two firms and the demand curve for this firm will shift from D1 → D2
This shift of demand puts the monopoly in a position where AR < ATC and the firm is making a loss at every level of output
It therefore makes no sense to have more than one firm in the industry
Examiner Tips and Tricks
When evaluating natural monopolies, consider the government failure that may occur with regard to regulation & 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.
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