Monopoly

What you'll learn

• What makes a market a monopoly, and why barriers to entry matter.
• How to draw and explain the profit-maximising monopoly diagram.
• Why monopoly can cause allocative, productive and X-inefficiency.
• How price discrimination and natural monopoly work, including their advantages and disadvantages.

1. The basic idea: what is a monopoly?

In everyday language, a monopoly means “one firm dominates the market”. In A-Level Economics, you need to be precise.

A monopolist faces the whole market demand curve. This matters because, unlike a firm in perfect competition, it does not have to accept the market price as given.

Key characteristics of monopoly

A monopoly typically has:

• One dominant seller, or one firm with very high market share.
• High barriers to entry, meaning obstacles that make it difficult for new firms to enter the market.
• Price-making power, meaning the firm can influence price by controlling output.
• Few close substitutes, so consumers find it hard to switch away.
• The ability to earn supernormal profit, which is profit above normal profit.
• Potential for both efficiency gains and welfare losses.

Barriers to entry can include patents, high start-up costs, ownership of key resources, strong branding, network effects, economies of scale, legal restrictions, or predatory pricing.

2. The monopoly diagram: price, output and profit

Before the diagram, quickly recap the revenue terms.

Average revenue (AR) is revenue per unit sold. For a monopolist, AR is the same as price, so the AR curve is also the demand curve.

Marginal revenue (MR) is the extra revenue gained from selling one more unit.

Marginal cost (MC) is the extra cost of producing one more unit.

Average cost (AC) is total cost per unit.

The diagram below pulls together the core OCR points: monopoly power, price-making, profit maximisation, supernormal profit, allocative inefficiency and productive inefficiency.

Why MR lies below AR

A monopolist faces a downward-sloping demand curve. To sell more output, it must usually lower the price.

If the firm charges one price to all consumers, lowering the price on the extra unit also lowers the price on previous units. That is why MR lies below AR.

Profit-maximising equilibrium

A profit-maximising firm produces where:

$$MR=MC$$

On the diagram, this gives output $Q_m$. The firm then goes up to the demand curve to find the price consumers are willing to pay, $P_m$.

Supernormal profit in the short run and long run

Normal profit is the minimum reward needed to keep enterprise in its current use. It is included in costs.

Supernormal profit is profit above normal profit. On the diagram, it is the rectangle between price $P_m$ and average cost $A{C}_m$, multiplied by output $Q_m$.

In perfect competition, supernormal profit attracts new firms and is competed away in the long run. In monopoly, barriers to entry mean supernormal profit can persist in both the short run and the long run.

3. Price maker, but not all-powerful

A monopolist is a price maker because it has enough market power to influence price. It can restrict output to raise price.

However, it is still constrained by demand. If it sets a very high price, quantity demanded will fall. So a monopolist cannot choose any price and any output combination it likes.

4. Productive and allocative efficiency

A profit-maximising monopolist is not usually productively efficient because $Q_m$ is not normally at minimum AC.

In the monopoly diagram, the allocatively efficient output is where AR equals MC. The monopolist produces less than this. Because price is above marginal cost, consumers value extra output more than it costs to produce, so society loses potential welfare.

5. Dynamic efficiency and X-inefficiency

Monopoly can support dynamic efficiency because supernormal profit gives firms funds for research and development. This is associated with Joseph Schumpeter’s argument that large firms may drive innovation.

For example, pharmaceutical firms may use patent-protected profits to fund drug development. Large technology firms may use profits to invest in artificial intelligence, cloud infrastructure or green-transition projects.

But monopoly can also reduce dynamic efficiency if the firm becomes complacent. If there is little threat of competition, it may have weaker incentives to innovate.

X-inefficiency is not exactly the same as productive inefficiency. Productive inefficiency is about not producing at minimum AC. X-inefficiency is about the whole cost curve being higher than it could be.

6. Price discrimination by a firm with monopoly power

For price discrimination to work, the firm needs:

• Monopoly power.
• Different groups of consumers with different price elasticities of demand.
• Ability to separate markets.
• Ability to prevent resale between groups.

The diagram below shows third-degree price discrimination, where a firm charges different prices to different market segments.

The firm charges a higher price in the more inelastic market, where consumers are less responsive to price changes. It charges a lower price in the more elastic market, where consumers are more price-sensitive.

Price discrimination may increase profit and sometimes increase output, especially if lower prices allow new consumer groups to access the product. But it can also reduce consumer surplus and be seen as unfair, especially where vulnerable consumers face higher prices.

7. Natural monopoly

Natural monopoly is common in network industries such as water pipes, electricity transmission, rail infrastructure and some broadband networks.

The diagram below shows long-run average cost falling across the relevant range of market demand. This means a single large provider can achieve lower average costs than multiple smaller providers.

The key issue is that competition may be wasteful. Building two rival water networks or two sets of rail tracks could duplicate fixed costs and raise average costs.

However, if left unregulated, a natural monopolist may still restrict output and charge high prices. That is why UK natural monopolies are often regulated by bodies such as Ofwat, Ofgem or the Office of Rail and Road.

8. Evaluating monopoly

Advantages of monopoly

Monopoly may bring benefits when:

• Economies of scale reduce average costs, potentially allowing lower prices.
• Supernormal profits fund research, development and long-term investment.
• Dynamic efficiency improves products and production methods over time.
• Price discrimination allows low-income or off-peak consumers to access cheaper services.
• Large firms can compete internationally, supporting exports and jobs.

Disadvantages of monopoly

Monopoly may harm welfare because:

• Price is often higher and output lower than in a competitive market.
• Allocative inefficiency creates deadweight welfare loss.
• Productive inefficiency and X-inefficiency may occur due to weak competitive pressure.
• Consumers may face less choice and poorer service quality.
• Barriers to entry may protect inefficient firms.
• Monopoly profits may worsen inequality by transferring surplus from consumers to producers.

Judgement

The impact of monopoly depends on the market. A monopoly with strong economies of scale, effective regulation and high investment may benefit consumers in the long run. A protected, unregulated monopoly with weak incentives may charge high prices, restrict output and become inefficient.

9. Evaluating natural monopoly

Natural monopoly can be beneficial because one network may minimise wasteful duplication and exploit economies of scale. For example, a single electricity grid is usually more efficient than several overlapping grids.

But the danger is monopoly abuse. A natural monopolist may charge excessive prices, underinvest, or provide poor service. Regulation can help, but regulators face information problems: the firm often knows more about its costs than the regulator does.

A strong judgement is that natural monopoly is often acceptable in infrastructure, but only if combined with regulation, performance targets, investment requirements, or competition “for the market” through franchising or tendering.