3.4.5 Monopoly

Question 1

What is a working monopoly according to CMA?

Answer 1

A working monopoly is any firm with greater than 25% of the industries’ total sales

Question 2

What are characteristics of monopoly?

Answer 2

• Price-making power is available to any business with a downward-sloping demand curve
• There are assumed to be high entry and exit barriers into a monopoly market
• Firms in a monopoly, as in other market structures, aim to maximise profit (i.e. operate where MR = MC)
• Because firms are price makers, they will have a downward-sloping demand curve (AR)
• If AR is falling, marginal revenue (MR) is below AR (and is twice as steep)

Question 3

Why would MR be less than AR?

Answer 3

It is because that in order to sell an
additional unit, a firm is assumed to lower the price of all units sold and not just the marginal unit sold – this is the
case unless a firm is able to practise first degree / perfect price discrimination.

Question 4

What is the diagram for profit maximisation of a monopolist?

Answer 4

Question 5

What is a natural monopoly?

Answer 5

A natural monopoly occurs when a large business can supply a market at a lower price than smaller ones. A natural
monopoly is a situation in which there cannot be more than one efficient provider of a good. It is an industry where
the minimum efficient scale is a large share of market demand.

Question 6

How is a natural monopoly characterised?

Answer 6

• A natural monopoly is characterised by increasing returns to scale at all levels of output
• Thus, the long run cost per unit (LRAC) will drift lower as production expands
• LRAC is falling because long run marginal cost is always below LRAC
• There may be room only for one supplier to fully exploit economies of scale, reach the minimum efficient
  scale and achieve productive efficiency

Question 7

What does a natural monopoly look like?

Answer 7

Question 8

One example of monopoly

Answer 8

London Underground - Rail Transport

Question 9

What is an example of a natural monopoly?

Answer 9

National Grid

Question 10

How is a natural monopoly different from other industries?

Answer 10

Question 11

What is price discrimination?

Answer 11

Price discrimination is when a business charges different consumers different prices for the same good or service

Question 12

What are the aims of price discrimination?

Answer 12

1. To increase total revenue by extracting consumer surplus and turning it into producer surplus
2. To increase total profit providing the marginal profit from selling to customers is positive
3. To generate cash-flow especially during a recession
4. To increase market share and build customer loyalty
5. To make more efficient use of a firm’s spare capacity
6. To reduce the amount of waste and cut the cost of keeping products in stock / storage

Question 13

What are examples of price discrimination in action?

Answer 13

Question 14

What is 3rd degree price discrimination?

Answer 14

Charging different prices to groups of consumers segmented by price elasticity of demand, income,
age, sex

Question 15

What are conditions required to use third degree price discrimination?

Answer 15

1. Firms have sufficient monopoly (market) power
   o Monopolists always have pricing power – i.e. they are price makers not takers
2. Identifying different market segments
   o i.e. groups of consumers with different price elasticities of demand
3. Ability to separate different groups - Requires information / sufficient market intelligence on the purchasing behaviour of consumers
4. Ability to prevent re-sale (arbitrage)
   o No secondary markets where arbitrage can take place at intermediate prices e.g. limiting sales, agerestrictions,
   compulsory use of ID cards

Question 16

What does price discrimination look like on a diagram?

Answer 16

The diagrams below represent a market (such as the cinema) in which tickets for students are cheaper than those for
adults. The diagram on the right-hand side, for the non-segmented market, shows that the price would be lower for
adults but higher for students, if there was no price discrimination. Students arguably have more price elastic demand
– tickets might take up a larger proportion of their income than for adults, and they may have more substitute activities
available.

Question 17

Explain what the possible disadvantages of price discrimination are.

Answer 17

• Higher prices for some consumers, leading to a loss of consumer surplus and a reduction in allocative efficiency, if P>MC; the consumer surplus is reallocated into producer surplus (i.e. profit)
• Can increase regional inequality if some consumers can only access goods/services at higher prices
• There may be an increase in transaction costs or administration costs for businesses, as they have to ensure
  that the market is sub-divided and consumers in each group are kept separate e.g. checking ID documents
  for age / status etc. This can possibly reduce profit.
• Groupings of consumers is not perfect e.g. relatively well-off adults taking night-school courses may have a student card and be able to access student discounts, despite being able to pay the normal adult price
• Additional profits earned as a result of price discrimination may allow incumbent firms to adopt anticompetitive practices e.g. predatory pricing, higher entry barriers through more spending on advertising etc. This can entrench the firm’s dominant market position and cause even higher prices in the future.

Question 18

What are the possible advantages of price discrimination?

Answer 18

• Lower prices for some groups of consumers, who might not otherwise be able to afford the good/service in question, therefore widening market access
• More profits for the business can result in higher dividends for shareholders and a positive wealth effect
• More profits can lead to reinvestment / business growth as well as R&D
• Businesses can make better use of spare capacity, increasing demand in quieter times and reducing overcrowding / excess demand at leak times

Question 19

What are the general evaluation points of price discrimination?

Answer 19

The impact depends on the extent to which price discrimination is used
The impact depends on how businesses choose to use profits
It is very difficult in practice to agree on a ‘fair price’ - it is a matter of perspective

Question 20

Explain the economic efficiency in a monopoly

Answer 20

The standard case against monopoly is that it is leads to a loss of economic efficiency which can then cause reductions in the welfare of consumers affected. But this view can be challenged as part of your evaluation. It is important to judge the exercising of market / monopoly power on a case-by-case basis based on how businesses with such power actually conduct themselves.

Question 21

Explain the disadvantages of monopolies

Answer 21

i) Prices are higher than under competitive conditions:
o This leads to a loss of allocative efficiency (because the monopoly price > MC)
o Higher prices can have a regressive effect on lower-income households
ii) Absence of genuine market competition may lead to production inefficiencies
o X-Inefficiencies such as wasteful production and advertising spending
iii) Higher prices can limit output in a market and lead to fewer economies of scale being exploited
iv) Protected markets mean that perhaps there is less drive to innovate – leading to less dynamic efficiency
v) Monopoly may get too big – causing one or more diseconomies of scale – leading to rising long run AC

Question 22

Give chains of reasoning on monopoly power

Answer 22

Question 23

What is an analysis diagram showing the welfare loss from monopoly pricing?

Answer 23

Question 24

Explain the advantages of monopolies

Answer 24

i) Profits can be used to fund investment & research
ii) Natural monopoly allows for the applications of economies of scale which leads to lower prices
iii) Domestic monopoly businesses often face global competition
iv) Monopolistic firms can be regulated – i.e. an industry regulator acting as a proxy consumer
v) Price discrimination may help some consumers if charged a lower price than the usual monopoly price

Question 25

What is market liberalisation?

Answer 25

Introducing competition in previously monopolistic sectors such as energy supply, retail
banking and postal services

Question 26

What is arbitrage?

Answer 26

Simultaneous buying and selling of securities, currency, or commodities in different markets
to take advantage of differing prices for the same asset.