3.4.5 Monopoly

Edexcel A-Level Economics (9EC0) | Theme 3.4.5

Specification Coverage: Edexcel unit 3.4.5 - Monopoly. Students should be able to understand the characteristics of monopoly, explain how a monopoly maximises profit, analyse third-degree price discrimination, evaluate the costs and benefits of monopoly power, and explain the idea of a natural monopoly.

Key Characteristics

  • There is a single seller or dominant firm. In the UK, monopoly is commonly defined as a firm with more than 25% market share.
  • There are high barriers to entry, such as legal restrictions, patents, economies of scale, or ownership of key resources.
  • The firm is a price maker with significant market power.
  • There are no close substitutes for the product.

Profit Maximisation

A monopoly maximises profit where \( MC = MR \).

Supernormal profit diagram
Figure 1: A monopoly maximises profit where MC = MR, charging a price above MC, leading to supernormal profit (shaded area) and allocative inefficiency.

Unlike more competitive markets, monopoly can sustain supernormal profit in the long run because barriers to entry protect the firm from new competition.

Third-Degree Price Discrimination

Third-degree price discrimination occurs when a monopoly charges different prices to different consumer groups for the same product in order to increase revenue.

Conditions Required

  1. The firm must have market power.
  2. Different sub-markets must have different PED.
  3. The firm must be able to separate the markets and prevent resale or arbitrage.
Price discrimination diagram
Figure 2: Third-degree price discrimination allows a monopoly to charge a higher price in the market with more inelastic demand, increasing total profit.

The result is that the monopoly charges a higher price in the market with more inelastic demand, and a lower price in the market with more elastic demand, increasing total profit compared to charging a single price for all consumers.

Costs and Benefits of Monopoly

Stakeholder Potential Benefits Potential Costs
Firm Supernormal profit can be reinvested, supporting dynamic efficiency. Large scale may also create economies of scale. There may be X-inefficiency because lack of competition can reduce pressure to minimise costs.
Consumers Prices could be lower if economies of scale are passed on, and innovation may improve products. Consumers may face higher prices, lower output, reduced choice, poorer quality, and allocative inefficiency.
Economy A monopoly may be internationally competitive because of its size and may be able to invest in risky R&D. Monopoly may reduce consumer surplus, misallocate resources, and worsen equity.

Natural Monopoly

A natural monopoly exists when one firm can supply the whole market at a lower average cost than two or more firms because of very large economies of scale and high fixed costs.

Examples include water supply, rail networks, and energy grids.

In a natural monopoly, LRAC falls over the entire range of market demand, so competition would be inefficient.

Because of this, government regulation, such as price caps like RPI-X, is often used to prevent exploitation of consumers.

Exam Preparation

  • Draw the monopoly diagram and identify supernormal profit, allocative inefficiency \( P > MC \), and productive inefficiency.
  • Explain the conditions needed for third-degree price discrimination and describe the diagram.
  • Evaluate the case for and against monopoly power by comparing static efficiency and dynamic efficiency.
  • Define a natural monopoly and explain why it is significant.