Economics (9640) | Monopoly and monopoly power

Monopoly and Monopoly Power: Study Notes (OxfordAQA 9640)

Hello Economists! This chapter moves us away from highly competitive markets and into the world of concentrated power. Understanding monopoly is crucial because these firms have massive influence—they affect the prices you pay, the quality of products you receive, and how resources are allocated across the economy. Don't worry, we'll break down how these giants operate!

1. Defining Monopoly and Monopoly Power (Syllabus 3.1.4.4)

In Economics, we look at monopoly along a spectrum of competition. At one end is Perfect Competition (many small firms), and at the other is Pure Monopoly.

What is a Pure Monopoly?

• A Pure Monopoly exists when a single firm controls 100% of the market supply for a particular good or service, and there are no close substitutes.
• Did you know? Pure monopolies are incredibly rare in the real world. Think of a local utility company like a water supplier, though even these are usually regulated.

Monopoly Power (The Key Concept)

Most firms we study do not meet the 100% threshold, but they still have Monopoly Power. This means the firm has the ability to act as a Price Maker—they can influence the price of their product by controlling the quantity they sell.

The syllabus notes that many firms have monopoly power, even if they aren't pure monopolies.

• Price Maker: A firm that faces a downward-sloping demand curve. If they restrict output, the price goes up.
• Contrast: Firms in highly competitive markets (like perfect competition) are Price Takers—they have no control over the market price.

Measuring Monopoly Power: Concentration Ratios

We measure how much monopoly power exists in a market using Concentration Ratios.

A concentration ratio (e.g., the CR4 or CR5) measures the combined market share of the largest 'N' firms in the industry.

How to Calculate a Concentration Ratio:

1. Identify the largest N firms (e.g., the top 4 firms).
2. Find the sales (or revenue) market share percentage for each of those N firms.
3. Sum these percentages together.

Example: If the four largest cereal companies (Kellogg's, Nestle, General Mills, etc.) control 80% of total industry sales, the CR4 is 80%. A high CR indicates greater monopoly power in that industry.

2. Factors Influencing Monopoly Power (Syllabus 3.1.4.4)

Monopoly power doesn't just happen by accident; it is primarily built upon Barriers to Entry (BTEs). These are obstacles that make it difficult or impossible for new firms to enter the market.

A. Barriers to Entry (BTEs)

The stronger the barriers, the greater the monopoly power held by existing firms.

• Economies of Scale: If a firm's costs continue to fall significantly as output rises, a new, small entrant will have very high average costs and cannot compete on price. This is particularly important for Natural Monopolies (e.g., water pipes or rail networks), where only one producer can fully exploit the available scale.
• Legal Barriers: Governments can grant monopolies through patents (exclusive right to produce an invention for a period) or licenses (exclusive rights to operate in a specific area, like broadcast frequencies).
• Control over Key Resources: If an existing firm controls a crucial input (like a rare mineral deposit or essential infrastructure), potential rivals cannot produce the good.
• High Start-up Costs: Industries requiring massive initial investment (e.g., aircraft manufacturing) deter new entrants. These investments are often sunk costs (costs that cannot be recovered if the firm leaves the market).

B. Other Factors

• Number of Competitors: The fewer the competitors, the easier it is to dominate.
• Advertising and Branding: Heavy advertising builds brand loyalty. This makes the product appear highly differentiated and makes consumers unwilling to switch to new entrants, even if they offer lower prices.
• Degree of Product Differentiation: If the monopolist's product is perceived as highly unique (e.g., Apple's iPhone ecosystem), it faces fewer substitutes, increasing its price-setting power.

3. The Basic Model of Monopoly: Costs (Syllabus 3.1.4.4 & 3.3.3.10)

The basic model of monopoly suggests that, when compared to a competitive market, monopolies result in undesirable outcomes for society.

Pricing, Output, and Profits

A monopolist controls the entire market demand curve (which is also their Average Revenue (AR) curve). Since the demand curve slopes downwards, if the monopolist chooses a high price, the quantity demanded will fall.

• Monopolists typically charge Higher Prices and produce Lower Output than competitive firms.
• Because of the barriers to entry, a monopolist can sustain Abnormal (Supernormal) Profits in the long run.

Inefficiency and Misallocation of Resources

One of the most significant criticisms of monopoly is that it leads to a Misallocation of Resources. Resources are not being used in a way that maximizes overall economic welfare (what society wants).

Static Efficiency Comparison (Syllabus 3.3.3.9)

Static Efficiency refers to efficiency at a specific point in time. It has two parts:

1. Productive Efficiency: Occurs when a firm produces output at the lowest possible cost, i.e., at the minimum point of the Average Total Cost (ATC) curve.
   • Monopolies may be productively inefficient because they face little competitive pressure to minimise costs.
2. Allocative Efficiency: Occurs when price (P) equals Marginal Cost (MC). This ensures that the price consumers pay reflects the true cost of the final unit produced.
   • Monopolies are Allocatively Inefficient because they restrict output to push prices up, meaning \(P > MC\). This results in too few resources being allocated to this good from society's perspective.
3. X-Inefficiency: This is specific to monopolies. It happens when firms lack the incentive to control costs, leading to waste, bureaucracy, and high operating expenses.

Welfare Loss (Syllabus 3.3.3.10)

Because monopolies are allocatively inefficient (\(P > MC\)), they cause a loss of total societal welfare, known as Deadweight Loss.

• Consumer Surplus (CS): The difference between what consumers are willing to pay and what they actually pay. Monopolies reduce output and raise prices, significantly reducing CS.
• Producer Surplus (PS): The difference between the price received and the cost of production. Monopolies increase PS due to high profits.
• Deadweight Loss (DWL): The overall loss of economic welfare to society. This occurs because output has been restricted, meaning mutually beneficial trades (where willingness-to-pay > cost) are lost. This DWL represents the misallocation of resources.

Don't worry if this seems tricky at first! Just remember: the high price and low output under a monopoly make society worse off overall.

4. Potential Benefits from Monopoly (Syllabus 3.1.4.4 & 3.3.3.9)

While the standard model highlights the costs, economists argue that monopolies can offer some significant benefits, especially concerning long-term growth and cost reduction.

A. Economies of Scale (Lower Costs)

Monopolists, due to their sheer size and high output, can often achieve substantial Economies of Scale (EOS).

• If a monopoly can achieve far lower Long-Run Average Costs (LRAC) than many small, competitive firms could, this cost saving might outweigh the disadvantages of reduced competition.
• In some cases, the cost reduction is so great that the monopoly price, despite being set above cost, could still be lower than the price in a competitive market made up of smaller, inefficient firms.

Example: A single national electricity grid operator (a natural monopoly) is far more cost-efficient than hundreds of small firms each building their own competing network of wires.

B. Invention and Innovation (Dynamic Efficiency)

Dynamic Efficiency refers to efficiency over time, particularly the rate of innovation and technological progress.

• Incentive to Innovate: Monopolists earn supernormal profits. These profits provide the large funds necessary to invest in Research and Development (R&D). Since they have barriers to entry (like patents), they know they can keep the benefits of this innovation for themselves, increasing the incentive to develop new products or lower-cost production methods.
• Competitive firms often struggle to fund expensive R&D because their low profits are quickly competed away.

5. Evaluating Monopoly: The Trade-Off

When evaluating a monopoly in an essay, you must weigh the static inefficiencies (high price, low output, P > MC, DWL) against the potential dynamic benefits.

Whether a monopoly is good or bad depends on:

• The extent of the economies of scale: If EOS is huge (like in a natural monopoly), it may be beneficial.
• The firm's behavior: Does the monopolist use its supernormal profits for R&D (benefiting consumers in the long run) or just to pay shareholders (static waste)?
• The degree of power: How high are the barriers to entry? Is the market highly contestable (easy for new firms to enter)?

Encouraging Phrase: Monopoly analysis is a great chance to show high-level economic thinking, as there is no single "right" answer. Use your concepts (like allocative efficiency vs. dynamic efficiency) to build a strong argument!