ChainWhat it assumes · how to break it
Start
One firm supplies most of a market and is protected by barriers to entry, for example patents, high sunk costs or control of a key input, so rivals cannot easily enter.
1
As a result, the firm faces the whole market demand curve, which slopes downwards, so it can choose its price instead of accepting the market price.
price maker · barriers to entry
price maker · barriers to entry
Assumes: Consumers have no close substitutes.
But: If close substitutes exist in other industries, demand is price elastic and the firm's freedom to raise price is limited.
2
Since the firm aims to maximise profit, it produces where MC = MR, and because MR lies below AR this output is lower than a competitive industry would produce.
profit maximisation · MC = MR
profit maximisation · MC = MR
Assumes: The firm's objective is profit maximisation.
But: A firm pursuing sales or revenue maximisation, or managers who satisfice, may produce more and charge less than the profit-maximising price.
3
Therefore, it charges the highest price consumers will pay for that restricted output, read from the AR curve, which is above marginal cost and above the price a competitive industry would charge.
AR · P > MC
AR · P > MC
Best link to attack
Assumes: The monopoly's costs are the same as those of the competitive industry it replaces.
Assumes: The monopoly's costs are the same as those of the competitive industry it replaces.
But: If the monopoly gains large economies of scale, its MC and AC may be so far below those of many small firms that its price is lower than the competitive price, as in a natural monopoly.
4
Consequently, the price stays above marginal cost in the long run, because new firms cannot enter and compete it down.
long-run equilibrium · barriers to entry
long-run equilibrium · barriers to entry
Assumes: Barriers to entry stay high.
But: If the market is contestable, the threat of hit-and-run entry forces the firm to keep price close to average cost.
End
Price is higher and output lower than in a competitive market, with price above marginal cost.
Evaluation chain
- E1However, whether monopoly raises price depends on whether its costs are the same as those of the competitive industry it replaces.
- E2If the monopoly gains large economies of scale, such as spreading the fixed cost of a network over the whole market, then its MC and AC curves sit well below those of many small firms.
- E3As a result, it can set MC = MR and price above MC and still charge less than the competitive price would have been.
- E4So monopoly raises price most clearly where economies of scale are small; in a natural monopoly such as a water network, price may be lower than competition could deliver, though still above MC.
Another way to attack it: A monopoly that fears investigation by the CMA, regulation or new entry may deliberately hold price below the profit-maximising level, so the observed price rise can be smaller than theory predicts.
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Questions this answers
- Assess the likely impact of monopoly power on the prices paid by consumers.
- Explain why a profit-maximising monopolist charges a price above marginal cost.
- Discuss whether a monopoly will always charge a higher price than a competitive industry.
Diagram
Monopoly diagram: downward-sloping AR with MR below it, MC and AC. Output where MC = MR, price read from AR above MC; compare with the competitive output where MC = AR, at a lower price and higher output. For the evaluation, draw a natural monopoly with falling AC to show price may be below what many small firms could charge.
Reverse and related
Loss of monopoly power → demand facing each firm becomes more elastic and price falls towards marginal and average cost.