The Performance of Firms in a Monopoly Market (Cambridge (CIE) A Level Economics): Revision Note

Market power in a monopoly

• Market power refers to the ability of a firm to influence and control the conditions in a specific market, allowing them to have a significant impact on price, output, and other market variables

• Monopoly firms have high market power, high/total market share and a high/perfect industry concentration ratio

• There is significant market failure in monopoly firms

  • Governments regulate and intervene in mergers and acquisitions in order to ensure (in many economies) that no single firm gains more than 25% market share

Characteristics of monopoly markets

Market outcomes in monopoly

A monopoly making supernormal profits

• As a single seller of goods or services, the firm in a monopoly market is also the entire market

  • There is no differentiation between the firm and the industry 

• It is a price maker

  • This means that its revenue curves are downward sloping

• In order to maximise profits, it produces at the point where marginal cost (MC) = marginal revenue (MR)

Diagram analysis

• The firm produces at the profit maximisation level of output where MC = MR (Q₁)

  • At this level the AR (P₁) > AC (C₁)

  • The firm is making abnormal profit 

A monopoly making normal profits

• In a monopoly market, normal profit refers to the level of profit necessary to keep the monopolist in the market in the long run

• It represents the minimum amount of profit needed to cover the opportunity cost of the resources used by the monopolist

• At this point, total revenue( TR) equals the total cost (TC), including both explicit and implicit costs

• If the monopolist is earning normal profit, it indicates that there is no abnormal profit

• The monopolist is simply earning a competitive return and covering its costs of production

Diagram analysis

• The firm is following the profit maximisation rule and producing at the level of output where MR = MC (Q₁)

• At this level of output, the selling price P₁ (AR) = ATC

  • This means the firm is breaking even and this is considered to be normal profit

A monopoly making losses in the short-run

• In a monopoly market, a loss minimisation position occurs when the monopolist incurs losses but aims to minimise those losses in the short run

• The loss minimisation position arises when the market price (AR) is below the average total cost (ATC) but above the marginal cost (MC) of production

• In the long run, a monopolist cannot sustain losses indefinitely

  • If losses persist the monopolist might consider exiting the market or changing its production strategies

Diagram analysis

• The firm produces at the profit maximisation level of output where MC = MR (Q_E)

  • At this level the AR (P₁) < AC (C₁)

  • The firm is making a loss 

Side-by-side comparison of perfect competition and monopoly

• Perfect competition tends to achieve both productive and allocative efficiency due to the presence of competition, whereas monopolies generally result in inefficiencies in both aspects

Diagram analysis

Perfect competition on the left

• The firm produces at the profit maximisation level of output where MC=MR (Y)

• The firm is productively efficient as MC=AC at this level of output

• The firm is allocatively efficient as AR (P)=MC

• There is no welfare loss

Monopoly market on the right

• The firm produces at the profit maximisation level of output where MC=MR (A)

• The firm is not productively efficient, as AC > MC at this level of output (B-A)

  • Productive efficiency would occur at point X where MC=AC

• The firm is not allocatively efficient as AR (P) > MC at this level of output (D-A)

  • Allocative efficiency would occur where AR=MC (point F)

Natural monopoly

• A natural monopoly occurs when the most efficient number of firms in the industry is one

  • This is often due to associated infrastructure issues e.g. delivery of utility services like water where it does not make sense to have multiple pipelines

  • It can also be due to the significant cost that is generated when entering the industry e.g. the sunk costs

  • It can also be due to the ability of economies of scale to lower prices for consumers e.g. it makes sense to have one firm building five nuclear power stations as opposed to five firms as average costs will be lower with one firm producing

• Natural monopolies usually occur in utility industries and are regulated by the Government to ensure that consumers are not charged higher monopoly prices

  • This regulation is often in the form of a maximum price

Diagram analysis

• Assume a utility company spends $billions building out a new delivery network

• Their average total costs (ATC) are initially very high, but fall as they are able to gain economies of scale

• As they gain an increasing number of customers (D₁ = AR₁), the firm is initially in a loss making position experienced between 0 → Q₁ customers

• Between Q₁ → Q₂, the firm is now making a profit as the AR > ATC

• Should another firm enter the market, the demand will be split between two firms and the demand curve for this firm will shift from D₁ → D₂

• This shift of demand puts the monopoly in a position where AR < ATC and the firm is making a loss at every level of output

• It therefore makes no sense to have more than one firm in the industry