ChainWhat it assumes · how to break it
Start
A dominant firm, for example a supplier holding the patent on a successful product, faces little competition because barriers to entry keep rivals out.
1
As a result, the firm can set a price above average cost at its profit-maximising output, where MC = MR.
MC = MR · AR > AC
MC = MR · AR > AC
Assumes: Demand is strong enough for AR to lie above AC at that output.
But: A monopoly with high fixed costs or in a shrinking market may find AR below AC and make losses despite its market power.
2
This means it earns supernormal profit, equal to the gap between price and AC multiplied by output.
supernormal profit
supernormal profit
Assumes: The firm keeps its costs under control.
But: Without competitive pressure, managers may let costs drift up, so X-inefficiency absorbs part of the potential profit.
3
Since barriers to entry such as patents, sunk costs and brand loyalty stop new firms entering, the supernormal profit is not competed away in the long run.
barriers to entry · long-run supernormal profit
barriers to entry · long-run supernormal profit
Best link to attack
Assumes: Barriers to entry stay high over time.
Assumes: Barriers to entry stay high over time.
But: Patents expire and new technology can cut the cost of entering, so the market may become contestable and entry, or the threat of it, erodes the profit.
4
Therefore, the firm keeps high profits year after year, which it can pay to shareholders or reinvest.
retained profit
retained profit
Assumes: The profit is not regulated or taxed away.
But: A regulator may cap prices, or the government may levy a windfall tax, taking part of the profit.
End
The firm earns supernormal profit, and barriers to entry let it keep that profit in the long run.
Evaluation chain
- E1However, the profit lasts only as long as the barriers to entry that protect it.
- E2Because patents run out and new technology can cut the sunk costs of entering, barriers often weaken over time.
- E3As a result, new firms enter, or the threat of entry forces the incumbent to cut price towards AC.
- E4So monopoly profit may be large in the short run, but it shrinks towards normal profit where barriers are weak, and lasts only where barriers are durable, such as network industries.
Profit can last many years: a UK patent can last up to 20 years.
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Questions this answers
- Explain why a monopolist can earn supernormal profit in the long run.
- Assess the extent to which barriers to entry determine the profits of a dominant firm.
- Discuss whether the high profits of monopolies are always against the public interest.
Diagram
Monopoly diagram: AR, MR, MC and AC, with output where MC = MR and the supernormal profit rectangle (P − AC) × Q shaded. Contrast with perfect competition, where long-run entry removes supernormal profit.
Reverse and related
Loss of monopoly power → entry competes price down towards AC, so profits fall towards normal profit.