Monopoly

Question 1

A monopoly is where:

Answer 1

there’s only one firm in the market

Question 2

What assumptions do economists make to model monopolies?

Answer 2

3 assumptions:

Firstly, there’s only one firm in the market

Secondly, they want to maximise profit

Thirdly, there are high barriers to entry

Question 3

Monopoly

Answer 3

When there’s only one dominant firm in a market. Legally, a monopoly is a firm with over 25% market share.

E.g. Microsoft, who owned 90% of the operating system market.

Question 4

Why are sunk costs a barrier to entry?

Answer 4

Sunk costs are costs that cannot be recovered (e.g. advertising).

High sunk costs are a barrier to entry: they deter new firms from entering because firms know that if they fail, they won’t be able to recover any of their sunk costs.

Question 5

If an electricity-producer acquires the power grid, this is an example of what sort of inorganic growth:

Answer 5

If an electricity-producer buys a power grid, this is an example of forward vertical integration. Because the electricity producer is moving forward, acquiring a firm closer to the consumer.

And this means the electricity-producer can now prevent competitor firms from entering the market, by refusing to let them use the power grid.

Question 6

Explain how vertical integration can be an anti-competitive practice:

Answer 6

Firms can vertically integrate to take control of scarce resources (like the power grid or the oil extraction firm); and then refuse to let new firms use these scarce resources, stopping them from entering the market.

Question 7

Incumbent firm

Answer 7

A firm currently in the market.

Question 8

Legal barriers

Answer 8

Legal barriers include patents, trademarks and copyright. They enable incumbent firms to legally prevent new firms from stealing their ideas and entering their market.

Question 9

Sunk costs

Answer 9

Costs that cannot be recovered.

E.g. advertising - once you’ve paid for a TV ad, you can’t get that money back

Question 10

High sunk costs

Answer 10

High sunk deter new firms from entering because firms know that if they fail, they won’t be able to recover any of their sunk costs.

Question 11

Economies of scale

Answer 11

Economies of scale mean incumbent firms can keep their costs and prices low, creating a barrier to entry because smaller new firms without economies of scale can’t compete on price.

Question 12

Brand loyalty

Answer 12

Strong branding from incumbent firms makes it hard for new entrants, with weaker branding, to make any sales.

Question 13

Anti-competitive practices

Answer 13

Anti-competitive (or restrictive) practices include anything a firm might do, to restrict competition.
E.g. vertical integration: firms can vertically integrate to take control of scarce resources (like the power grid); and then refuse to let new firms use these scarce resources, stopping them from entering the market.

Question 14

Example of Anti-competitive practices

Answer 14

E.g. vertical integration: firms can vertically integrate to take control of scarce resources (like the power grid); and then refuse to let new firms use these scarce resources, stopping them from entering the market.

Question 15

We now know that a monopoly is:

Answer 15

A pure monopoly is when there’s only one firm in market. A legal monopoly is when a firm has over 25% market share.

Question 16

But… when economists are modelling a monopoly, we assume that:

Answer 16

3 assumptions:

Only one firm in the market

They want to maximise profit

There are high barriers to entry

Question 17

Let’s start with productive efficiency, which is when:

Answer 17

Average total cost is at its lowest, where MC = AC

Question 18

Next we have allocative efficiency which is when:

Answer 18

Welfare is maximised where MC = Price (AR).

Question 19

X-inefficiency is when:

Answer 19

X-inefficiency is when a firm is producing above its average cost curve for a given level of output.

Question 20

Dynamic efficiency occurs when:

Answer 20

AR > ATC

Question 21

a monopoly is: (in terms of efficiency)

Answer 21

Productively inefficient, allocatively inefficient, possibly dynamically inefficient, X-inefficient

Question 22

So why does the government support and own monopolies, if we know monopolies are productively, allocatively and X-inefficient?

Answer 22

There are lots of arguments but one of the most important arguments behind why the government supports certain monopolies is the natural monopoly argument.

A natural monopoly is when it’s naturally most efficient if only one firm is in the market.

E.g. with public transport, it would be very inefficient if London had multiple transport networks, it’s most efficient to have just one (like TFL) in control of everything…we’ll see exactly why next!

Question 23

Explain two economies of scale TFL can exploit to reduce their LRAC.

Answer 23

TFL could use technical economies to invest in specialist technology like the oyster card system and self-service ticket stations to replace staff, and reduce wage costs.

TFL could also use purchasing economies to buy fuel in bulk to power their trains and buses at lower costs

Question 24

So, in summary, a natural monopoly is when:

Answer 24

A natural monopoly is when it’s naturally most efficient if only one firm is in the market.

Question 25

Why do natural monopolies exist?

Answer 25

Natural monopolies exist for two reasons: firstly, high sunk costs; secondly, huge economies of scale.

Question 26

Explain why TFL is considered a natural monopoly. (4 marks)

Answer 26

Natural monopolies exist for two reasons: firstly, high sunk costs; secondly, huge economies of scale.

TFL has high sunk costs like railways, Oyster card tech development and training staff - which have been estimated as high as £129bn. It would be inefficient if a second transport firm entered the market and duplicated this £129bn cost, so it’s most efficient to have just one firm, TFL, in the market.

TFL has huge economies of scale like purchasing economies, which it can use to buy fuel in bulk to power its trains and buses at very low long run average costs. To fully exploit these economies of scale and get to its MES, TFL needs to increase its sales massively - which it can only do if it’s the only seller in the market.

Question 27

A normal firm’s LRAC curve will go down and then up because of:

Answer 27

Internal economies of scale followed by internal diseconomies of scale

Question 28

Natural monopoly

Answer 28

A natural monopoly is when it’s naturally most efficient if only one firm is in the market.

Question 29

Reasons for natural monopolies: high sunk costs

Answer 29

Very high sunk costs mean it would be inefficient if a second firm entered the market and also had to incur those sunk costs - so one firm is most efficient.

E.g. TFL’ sunk costs have been estimated as high as £129bn - it would completely inefficient for a second firm to waste £129bn to enter the market, too.

Question 30

Reasons for natural monopolies: huge economies of scale

Answer 30

Huge economies of scale means it’s most efficient for just one firm to be in the market so it can increases its output massively to reach its MES.

Question 31

two reasons of natural monopolies

Answer 31

Natural monopolies exist for two reasons: firstly, high sunk costs; secondly, huge economies of scale.

Question 32

Why does MC decrease and then increase?

Answer 32

Marginal cost initially decreases because as output increases and more workers are hired, they can specialise; increasing productivity and decreasing marginal cost.

But marginal cost will then increase because diminishing marginal returns will decrease productivity, increasing marginal cost.

Question 33

But why….why do train lines charge adults higher prices and students lower prices for train tickets!?

Answer 33

Adult demand is more inelastic, because adults have higher incomes and are therefore less responsive to price changes. This means train lines can charge adults higher prices.

Student demand, however, is more elastic, because students have less money to spend and are therefore more responsive to price changes. This means train lines have to charge students lower prices.

Question 34

Price discrimination

Answer 34

Price discrimination is when a firm charges different groups of consumer different prices, but for the same good.

Question 35

We’ve now seen that when price discriminating a firm will charge:

Answer 35

A firm will charge elastic consumers a lower price because they don’t want to lose them as customers. But they’ll charge inelastic consumers a higher price because they won’t respond much to the higher prices.

Question 36

what are the 3 conditions required for price discrimination:

Answer 36

The firm must have market power: it must be able to change their prices

The firm must have information on consumers’ elasticities: it must be able to identify which consumers are elastic and which are inelastic

The firm must be able to limit reselling: it must be able to limit elastic consumers from selling cheap tickets to inelastic consumers; like how trains require student IDs or student Oysters, to stop inelastic adult consumers using resold student tickets!

Question 37

Price discrimination

Answer 37

Price discrimination is when a firm charges different groups of consumers different prices, for the same good.

E.g. students get lower prices for train tickets than adults

Question 38

Price discrimination condition 1: market power

Answer 38

The firm must have market power: it must be able to change their prices

Question 39

Price discrimination condition 2: information on elasticities

Answer 39

The firm must be able to identify which consumers are elastic and which are inelastic.

Question 40

Price discrimination condition 3: limit reselling

Answer 40

The firm must be able to limit reselling: it must be able to limit elastic consumers from selling cheap tickets to inelastic consumers

E.g. trains require student IDs or student Oysters, to stop inelastic adult consumers using resold student tickets!