3.4.5a Monopoly equilibrium

Monopoly Equilibrium

Characteristics of monopoly

1. Barriers to entry are what let a monopoly persist: a regional water company, for example, faces no rivals because the sunk cost of laying a second network of pipes is prohibitive, so its supernormal profit is not competed away and can last into the long run, unlike in competitive markets where entry erodes it.
2. As the sole supplier it faces the whole market demand curve, so to sell an extra unit it must lower price; that trade-off between price and quantity is exactly what makes it a price maker rather than a price taker.
3. Strong branding, advertising and product differentiation reinforce monopoly power; in UK competition law the CMA treats a market share of 25% or more as a sign of it, so power exists well before a pure single-seller monopoly.

The profit-maximising rule

$$MC=MR$$ $$Profit=TR-TC$$

1. If MR > MC the last unit adds more to revenue than to cost, so producing it raises profit; if MR < MC it adds more to cost than to revenue, so cutting back raises profit. Profit therefore peaks exactly where MC = MR.
2. At that output the monopolist charges the highest price the demand curve will bear, read up to AR. Because AR lies above MR on a downward-sloping demand curve, price exceeds MR and so exceeds MC, which is the source of the allocative inefficiency (P > MC).
3. Where price (AR) exceeds average cost (AC), the firm earns supernormal profit equal to (AR − AC) × Q; barriers to entry stop new firms competing it away, so it persists in the long run.

The monopoly diagram

1. Put Price on the vertical axis and Quantity on the horizontal axis.
2. The demand curve is the downward-sloping AR curve, with the MR curve below it and twice as steep; add the AC and MC curves, with MC cutting AC at its lowest point.
3. Profit-maximising output Qm is where MC cuts MR from below; read the price vertically up to the AR curve at Pm, not off the MC = MR point.
4. Supernormal profit is the rectangle bounded by Pm above and AC below, across output Qm.

Does a monopolist always earn supernormal profit?

1. Usually yes, because high barriers to entry protect the firm, so its price can stay above average cost into the long run and the profit is not competed away.
2. This is reinforced where demand is price-inelastic, since the firm can hold a high price without losing many sales, widening the gap between AR and AC.
3. But not always: if market demand is weak so that AR lies below AC at every output, even a sole supplier makes a loss in the short run, as with a train operating company on a lightly used regional line that needs subsidy to keep running.
4. On balance it depends on whether AR exceeds AC at the MC = MR output: a monopoly guarantees market power, not a guaranteed profit.

3.4.5b Price discrimination and evaluation of monopoly

Price Discrimination and Monopoly

Third-degree price discrimination

1. The aim is to charge each group closer to what it is willing to pay, so the firm captures consumer surplus that a single uniform price would leave with buyers.

The three conditions and why each is needed

1. Price-setting power: the firm must be a price maker facing a downward-sloping demand curve. A price taker in perfect competition could not raise price to one group without losing every sale, so without market power there is simply no room to charge different prices.
2. Separable groups with different elasticities: the firm must identify groups whose price elasticity of demand differs and keep them apart. This is needed because the profit gain comes from charging the inelastic group more and the elastic group less, which only works if the groups can be told apart and cannot swap.
3. No resale (no market seepage): it must stop the low-price group reselling to the high-price group. Without this, arbitrage sends the cheap units into the dear market, the two prices converge and discrimination collapses, so ticket restrictions, ID checks and timing rules exist to block it.

The price discrimination diagram

$$M{R}_1=M{R}_2=MC$$

1. Draw two sub-markets side by side, each with Price on the vertical axis and Quantity on the horizontal axis, sharing a common MC because the same firm supplies both.
2. In the inelastic market the AR curve is steep, so setting output where MC = MR gives a higher price; in the elastic market the AR curve is flatter, so the same MC = MR rule gives a lower price.
3. Because MR is equalised across both markets at the common MC, total profit beats the single-price outcome: the firm converts consumer surplus into producer surplus.
4. A clear real case is rail and airline peak pricing: commuters and business flyers (inelastic) pay a high peak fare while leisure travellers (elastic) pay a low off-peak fare, with ticket restrictions preventing resale between them.

Costs and benefits of price discrimination

1. The firm gains, converting consumer surplus into producer surplus and raising total profit above the single-price level.
2. That extra profit may fund investment or cross-subsidise loss-making services, for example high peak fares helping to keep quieter routes running.
3. Some consumers gain access who could not afford a single uniform price, since the elastic group (students buying discounted cinema tickets, or off-peak rail travellers) is offered a lower one.
4. However, the inelastic group pays more and loses consumer surplus, so the main effect is a transfer of welfare from captive consumers to the firm.

Costs and benefits of monopoly

1. Consumers can face higher prices and lower output than under competition, creating a deadweight welfare loss and allocative inefficiency because P > MC.
2. Weak competition can cause X-inefficiency, so productive efficiency may fall as average cost drifts up.
3. But firms earn supernormal profit that can fund research and development, supporting dynamic efficiency, as with pharmaceutical firms reinvesting patent profit.
4. Economies of scale can lower average cost so much that price may even fall below the competitive level, benefiting consumers.
5. Employees may gain secure, well-paid jobs backed by profit, though weak competition can dull the pressure to raise wages.
6. Suppliers may enjoy large, steady orders, yet a dominant buyer can squeeze the prices it pays them.
7. On balance the verdict depends on economies of scale, contestability and whether the profit is reinvested in innovation rather than kept as X-inefficiency.

Natural monopoly

1. Long-run average cost keeps falling across the whole relevant range, so competition would merely duplicate huge fixed costs; it is typical of utilities and networks such as water, rail track and the national grid.
2. Because MC lies below the falling AC, pricing at marginal cost (the allocatively efficient rule P = MC) would leave the firm making a loss, so an unregulated firm charges far above MC instead.
3. This strengthens the case for regulation or public ownership, for example price caps set by a sector regulator such as Ofwat or Ofgem, or scrutiny by the CMA.

Is price discrimination unfair?

1. It can look unfair because the inelastic group, often commuters or business travellers with few alternatives, pay more and lose consumer surplus that transfers to the firm.
2. It can also entrench market power, since the extra profit strengthens an already dominant firm and may deter entry.
3. But it can be fair and efficient: the elastic group gains access it could not otherwise afford, and cross-subsidy can keep socially valuable but loss-making services running.
4. On balance it depends on who the groups are and how the profit is used: discrimination that widens access and funds investment is more defensible than pure surplus extraction from captive consumers.