AQA Specification focus:
‘Why the existence of monopoly and monopoly power can lead to market failure.’
Monopoly and monopoly power shape markets by restricting competition, distorting prices, and influencing resource allocation, often leading to market inefficiencies and welfare loss.
Understanding Monopoly and Monopoly Power
A monopoly exists when a single firm dominates the supply of a good or service, often defined as holding more than 25% of market share in UK competition law.
Monopoly power refers to the ability of a firm to set prices above competitive levels or restrict output, thereby influencing market outcomes to its advantage.
Monopoly: A market structure where a single firm is the sole producer or seller of a good or service, facing no close competition.
Monopoly power does not require a pure monopoly. Even firms with significant market shares can exert substantial control if barriers to entry prevent effective competition.
Sources of Monopoly Power
Firms may gain monopoly power through several mechanisms:
Barriers to entry such as high start-up costs, patents, or legal restrictions.
Economies of scale, where large firms operate at lower average costs, making competition unsustainable.
Brand loyalty that reduces consumers’ willingness to switch to alternatives.
Control of key resources, such as rare minerals or essential infrastructure.
These sources protect incumbents and limit competitive pressures.
Implications for Resource Allocation
A key AQA focus is that the existence of monopoly and monopoly power can lead to market failure. Market failure occurs when resources are misallocated, reducing economic welfare.
Allocative Inefficiency
Monopolies often set prices above marginal cost (MC) to maximise profits.
In perfect competition, price equals marginal cost, ensuring resources are allocated to maximise consumer and producer surplus. In monopoly, price exceeds MC, creating a deadweight welfare loss.
Allocative Inefficiency: A situation where resources are not distributed to maximise total welfare, typically when price is greater than marginal cost.
This leads to under-consumption of goods compared with the socially optimal level.
Productive Inefficiency
In competitive markets, firms are forced to minimise costs to survive. Monopolies, however, face less pressure, resulting in x-inefficiency — higher costs than necessary due to lack of competition.
X-inefficiency: Inefficiency arising in monopolies when firms fail to minimise costs because of reduced competitive pressure.
Dynamic Effects
Although monopolies may generate large profits that can fund research and development, this is not guaranteed. Some monopolists invest heavily in innovation, while others exploit power to extract rents without innovation.
Welfare Consequences
The welfare effects of monopoly and monopoly power can be assessed in terms of:
Consumer Surplus: Reduced due to higher prices and restricted output.
Producer Surplus: Increased in the short run as monopolists capture greater profits.
Total Welfare: Decreased because the consumer loss outweighs producer gains, creating deadweight loss.
Consumers face fewer choices, while inequality increases as wealth transfers from consumers to monopolists.
Price Discrimination
Many monopolists practise price discrimination, charging different prices to different consumer groups for the same product.
This can occur under three conditions:
The firm must have market power.
Consumers must have different price elasticities of demand.
Resale between groups must be prevented.
While price discrimination can increase monopoly profits, in some cases it allows greater output and more consumers to access the product, partly reducing welfare loss.
Price Discrimination: Charging different prices to different groups of consumers for the same product, not justified by cost differences.
Long-Run Impacts
Over time, monopoly and monopoly power may:
Discourage new entrants, entrenching dominance.
Lead to reduced innovation if complacency sets in.
Exacerbate inequality, as wealth concentrates in monopolistic firms.
Necessitate government intervention through competition policy to restore efficiency and fairness.
Evaluation
Although monopolies are often associated with market failure, the overall impact depends on context:
Natural monopolies (e.g. utilities) may operate more efficiently under a single provider due to large economies of scale.
Innovation-driven monopolies (e.g. in pharmaceuticals or technology) may deliver long-term benefits despite short-term inefficiency.
Government regulation can mitigate harmful outcomes, for example through price caps or anti-trust laws.
Students must recognise that monopoly and monopoly power generally lead to resource misallocation and welfare loss, but under specific conditions may yield benefits that justify their existence.
FAQ
Monopoly power refers to a firm’s ability to influence prices and restrict output, even without being the sole supplier. Market dominance, by contrast, is a legal or statistical measure of market share, such as exceeding 25% under UK competition law.
A firm may be dominant without significant monopoly power if entry barriers are low, while smaller firms can have monopoly power in niche markets with high barriers to entry.
Barriers to entry prevent new competitors from entering the market, allowing existing firms to maintain control. These may include:
Legal restrictions, such as patents.
High capital costs that deter new firms.
Strong brand loyalty creating consumer resistance.
Such barriers protect incumbents and prevent the competitive pressures that would otherwise erode monopoly power.
Natural monopolies occur in industries where economies of scale are so extensive that one provider can supply the market more cheaply than multiple firms.
Utilities such as water or electricity often fall into this category, where duplicating infrastructure would be wasteful. Although they display monopoly power, regulation can ensure prices remain fair while preserving efficiency gains.
Monopoly power can reduce product variety as firms face little incentive to cater to diverse consumer preferences.
Over time, lack of competition may also discourage innovation, leaving consumers with fewer alternatives and slower improvements in quality. However, in some cases monopolists use profits to diversify products, which can temporarily increase choice.
A monopolist’s ability to raise prices depends on how responsive consumers are to price changes.
If demand is inelastic, the monopolist can raise prices significantly without losing many customers.
If demand is elastic, the monopolist risks losing revenue by increasing prices.
Understanding elasticity helps explain why monopoly power allows profit maximisation at the expense of consumer welfare.
Practice Questions
Define monopoly power and explain briefly why it can lead to market failure. (3 marks)
1 mark for defining monopoly power (e.g. the ability of a firm to set prices above competitive levels or restrict output).
1 mark for stating that monopoly power leads to higher prices and/or restricted output compared to competition.
1 mark for linking this to market failure, e.g. misallocation of resources or welfare loss.
Using a diagram, explain why monopolies are allocatively inefficient. (6 marks)
1–2 marks for an accurate diagram showing monopoly price above marginal cost, including clear labelling (AR, MR, MC, possibly AC, Qm, Qc, Pm, Pc).
1 mark for correctly identifying that monopolists maximise profit where MR = MC.
1 mark for stating that price is set above marginal cost, leading to under-consumption compared to the socially optimal level.
1–2 marks for explaining that this results in allocative inefficiency and deadweight welfare loss, with clear reference to misallocation of resources.
