Monopolies represent a key market structure where a single firm exerts significant influence over price and output. This topic explores monopoly characteristics, equilibrium pricing, inefficiencies, third-degree price discrimination, and natural monopoly with real-world examples and analytical tools.
Definition and characteristics of monopoly
A monopoly exists when a single firm dominates a market. Under UK competition law, a monopoly is legally defined as a firm with 25% or more market share in a particular industry. Unlike firms in competitive markets, a monopoly acts as a price maker — it has the power to set prices rather than take the market price as given.
Key features of monopoly
Single seller: The industry is dominated by one firm, which controls the majority of output.
High barriers to entry: These prevent new competitors from entering the market. Barriers include:
Legal barriers: patents, trademarks, and government licences.
Economies of scale: cost advantages from large-scale production make it unprofitable for small firms to compete.
Strategic barriers: tactics such as limit pricing or heavy advertising deter new entrants.
Ownership of essential resources: control over a key input or distribution channel can block entry.
Price-making power: The firm sets its own prices, constrained only by consumer demand.
Imperfect information: Consumers may lack knowledge of better alternatives or fair pricing.
Examples include national rail infrastructure providers, local water utilities, and technology giants with dominant platforms.
Profit maximisation under monopoly
A monopolist aims to maximise profit where marginal cost (MC) equals marginal revenue (MR). This condition — MC = MR — determines the profit-maximising output, and price is found by extending that quantity up to the average revenue (AR) curve, which is the same as the demand curve.
Short-run equilibrium
In the short run, a monopoly can earn supernormal profits because:
It faces no direct competition.
Barriers to entry prevent other firms from challenging its position.
Price is set above marginal cost.
Diagram description:
A downward-sloping AR curve.
A steeper, downward-sloping MR curve beneath AR.
An upward-sloping MC curve intersecting MR at the profit-maximising quantity.
The vertical distance between AR and average cost (AC) at that quantity represents supernormal profit.
Long-run equilibrium
In contrast to competitive markets, long-run monopoly profits persist because high barriers block new entrants. Without entry and exit, the monopoly maintains its market position indefinitely.
Diagram description: The same as the short-run diagram, but it shows that profits remain because no competitive pressure drives them down to zero.
Inefficiencies under monopoly
Monopolies often fail to achieve allocative and productive efficiency, leading to a loss of societal welfare.
Allocative inefficiency
Occurs when price exceeds marginal cost (P > MC).
Consumers value the last unit more than it costs to produce.
This leads to underproduction of goods and services relative to the socially optimal level.
The result is a deadweight loss — a reduction in total surplus (consumer and producer).
In perfect competition, resources are allocated efficiently where P = MC. Monopoly deviates from this condition.
Productive inefficiency
Happens when the firm does not produce at the lowest point on the average cost (AC) curve.
The monopoly does not minimise costs.
It operates to the left of minimum AC, producing less than it could at the most efficient scale.
Lack of competition removes incentives to control costs or innovate for efficiency.
Monopolies may also suffer from X-inefficiency, where costs are higher than necessary due to complacency and slack management.
Third-degree price discrimination
Definition
Third-degree price discrimination occurs when a monopolist charges different prices to distinct groups of consumers based on differences in price elasticity of demand.
Consumers with inelastic demand (less sensitive to price changes) are charged higher prices.
Consumers with elastic demand (more responsive to price changes) are charged lower prices.
This is common in sectors such as:
Rail and public transport (student vs adult tickets)
Entertainment (child vs adult cinema prices)
Airline industry (business vs leisure travellers)
Conditions for price discrimination
To successfully implement third-degree price discrimination, the following conditions must be met:
Market power: The firm must have control over price (not possible in perfect competition).
Market segmentation: The firm must be able to identify and separate different consumer groups.
No arbitrage: Consumers cannot resell the product from one group to another, preventing price leakage.
These conditions are often met where identification is easy (e.g. student IDs) and resale is impossible (e.g. services, digital access).
Diagrammatic analysis
A monopolist divides its output between two markets:
Market A has inelastic demand.
Market B has elastic demand.
In each market:
The firm sets output where MC = MR.
The price in Market A is higher than in Market B due to lower elasticity.
Diagram description:
Show separate AR and MR curves for each market.
MC is constant across both.
Each market has a different price/output combination.
Combined output is higher than single-price monopoly, and total profit is greater.
Evaluation: costs and benefits of monopoly
Impact on consumers
Costs:
Higher prices than competitive markets reduce consumer surplus.
Reduced output leads to fewer choices and lower consumption.
Risk of lower quality service if the monopoly lacks competitive pressure.
Deadweight loss reduces total welfare.
Potential benefits:
Dynamic efficiency: Monopoly profits fund research, development, and innovation.
Consumers may benefit in the long run from improved products.
Monopolies may achieve cost efficiencies through economies of scale that lower long-term prices (if passed on).
Example: Pharmaceutical firms use monopoly power from patents to recoup high R&D costs, enabling drug development.
Impact on producers
Advantages:
Supernormal profits increase investment potential and financial stability.
Pricing flexibility allows strategic use of cross-subsidisation — e.g. lower prices in one area offset by profits elsewhere.
Ability to engage in price discrimination improves profitability.
Disadvantages:
Regulatory scrutiny and possible government intervention.
Risk of inefficiency due to lack of discipline from market competition.
Impact on employees and suppliers
Employees:
In profitable monopolies, employees may earn higher wages due to greater revenue.
Where monopsony power exists (firm is the dominant employer), bargaining power of workers may be limited, leading to wage suppression.
Suppliers:
Monopolies with buyer power may force down input prices.
This can hurt small suppliers reliant on a single major buyer.
However, guaranteed long-term contracts may also provide stability.
Examples: Large supermarkets exerting monopsony power over farmers and food producers.
Natural monopoly
Definition
A natural monopoly arises in industries where economies of scale are so significant that one firm can supply the entire market at a lower cost than multiple firms could.
Characteristics
High fixed costs: Large upfront capital investment (e.g. building infrastructure).
Low marginal costs: Serving an additional customer costs relatively little.
Average cost continues to fall over a wide range of output.
Serving the market with multiple firms would increase costs and reduce efficiency.
Common in utilities such as:
Water and sewage systems
Electricity distribution networks
Railway infrastructure
Diagram description
The AC curve slopes continuously downward, even as output increases.
MC lies below AC, reinforcing falling average costs.
A competitive equilibrium would occur where MC = price, but this is below AC, implying losses.
The monopoly may set a price above MC to remain profitable, leading to allocative inefficiency.
Policy implications
Governments often intervene in natural monopolies to protect public interest.
Approaches include:
Nationalisation
The state owns and operates the industry.
Prioritises social welfare over profit.
Example: UK rail network (Network Rail).
Price regulation
Private firms operate the monopoly but prices are capped by government regulators.
The RPI – X formula (Retail Price Index minus expected efficiency savings) is a common tool.
Encourages cost reduction while keeping prices fair for consumers.
Subsidies
Public funds may be used to cover losses or incentivise infrastructure expansion.
Particularly useful in sectors with universal service obligations.
Performance monitoring
Service quality, maintenance, and investment are closely monitored by regulators.
Firms may be penalised for underperformance.
Benefits of natural monopoly
Lower unit costs from economies of scale benefit society.
Avoidance of duplicated infrastructure, which would be wasteful and costly.
Ability to ensure universal access to essential services like electricity and water.
Drawbacks
Abuse of power if unregulated, leading to excessive pricing and poor service.
X-inefficiency due to lack of competitive pressure.
Underinvestment if profit motives are too weak in public provision or too strong in private monopoly.
FAQ
In a monopoly, the firm faces a downward-sloping demand curve, meaning it must lower the price to sell additional units. Since all units are sold at the same price, reducing the price to sell one more unit also reduces the revenue earned from units that could have been sold at a higher price. This causes marginal revenue (MR) to fall more quickly than average revenue (AR). For example, if a monopolist lowers the price from £10 to £9 to sell an additional unit, not only is the additional unit sold at a lower price, but all previous units now earn £1 less in revenue. This effect means that MR is always below AR, and the MR curve lies beneath the AR curve. This divergence is crucial for monopoly behaviour, as it affects the output decision: the monopolist produces where MR = MC, not where AR = MC, leading to underproduction compared to competitive markets.
When a government imposes a price ceiling (maximum price) below the monopoly’s profit-maximising price, the monopolist is no longer able to charge its usual, higher price. In this situation, it must reassess its output decision based on the new price constraint. The monopolist will now produce the quantity where marginal cost (MC) equals the new capped price, assuming that the price ceiling is above MC. This generally leads to an increase in output compared to the unregulated monopoly level and can improve allocative efficiency by moving price closer to marginal cost (P ≈ MC). However, the monopolist's profit may fall due to the lower price, potentially reducing the incentive to invest in long-term innovation or capital improvements. In some cases, if the price ceiling is set too low, it could lead to a situation where the firm makes losses, causing underinvestment or even exit from the market if sustained. Thus, price regulation must be carefully calibrated.
Yes, a monopoly can be dynamically inefficient, despite often having the financial resources and profit incentives to invest in research and development. Dynamic inefficiency occurs when a firm fails to innovate, improve products, or adopt new technologies over time. While monopolies can theoretically use supernormal profits to fund innovation, the absence of competitive pressure may reduce the urgency or motivation to do so. Without rivals threatening market share, monopolies may become complacent, focusing on maintaining the status quo rather than pursuing improvements. Furthermore, if the monopoly is protected by legal or structural barriers, such as patents or control over essential infrastructure, it may face little to no threat of displacement. In such cases, the firm may underinvest in innovation, prioritising short-term profit maximisation over long-term development. The presence of regulatory oversight, shareholder pressure, or potential technological disruption may be necessary to counteract this inertia and promote dynamic efficiency in monopolistic markets.
A monopoly and a firm in monopolistic competition both have some degree of price-setting power, but the extent and impact of their pricing decisions differ significantly. A monopoly is the sole provider in its market and faces the entire market demand curve. It maximises profit by producing where marginal cost (MC) equals marginal revenue (MR) and then setting price according to the demand curve. The result is typically a higher price and lower output than in more competitive markets. In contrast, a firm in monopolistic competition operates in a market with many competitors offering differentiated products. It also maximises profit in the short run by producing where MC = MR, but in the long run, the entry of new firms erodes any supernormal profits. As a result, the firm ends up making only normal profit and prices remain closer to marginal cost. Thus, while both types of firms have pricing power, monopolies retain it long-term, often resulting in greater inefficiency.
Under third-degree price discrimination, consumer surplus is generally reduced, though the extent depends on the market segmentation and the elasticity of demand in each group. Consumer surplus is the difference between what consumers are willing to pay and what they actually pay. By charging different prices to different groups, the monopoly extracts more surplus from those with inelastic demand by setting higher prices, effectively transferring surplus from consumers to the producer in the form of increased profit. Consumers with elastic demand may benefit slightly by paying lower prices, but overall, the reallocation of surplus typically favours the firm. In some cases, however, price discrimination can increase total output and allow some consumers — who otherwise would not have bought the good at a single monopoly price — to access it at a lower rate. This can slightly offset the welfare loss, but in general, third-degree price discrimination leads to a reduction in total consumer surplus and a gain in producer surplus.
Practice Questions
Explain two reasons why a monopoly may be productively and allocatively inefficient.
A monopoly may be productively inefficient as it does not produce at the lowest point on its average cost curve, often due to a lack of competitive pressure to reduce costs. This results in higher unit costs than necessary. It may also be allocatively inefficient because price is set above marginal cost (P > MC), meaning the value consumers place on the good exceeds the cost of producing it. This leads to underconsumption and a deadweight welfare loss, as fewer goods are produced and consumed than in a perfectly competitive market, where P = MC.
Evaluate whether price discrimination by a monopoly benefits consumers.
Price discrimination can benefit consumers if it increases access to goods and services for those with more elastic demand, such as students receiving discounts. It may also allow the firm to generate higher revenue to invest in product improvements or reduce average costs. However, some consumers face higher prices, reducing their surplus. Price discrimination may also lead to allocative inefficiency if output remains below the socially optimal level. The net effect depends on how prices differ across segments, the extent of output increase, and whether the firm reinvests profits into innovation or simply maximises shareholder gain.
