Pearson Edexcel International Advanced Level Economics: Monopoly, price discrimination and monopsony (YEC11)

This guide covers section 3.3.3 Market structures and contestability, item 6 (Monopoly, points a to h) and item 7 (Monopsony, points a and b), of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. The specification calls Unit 3 (Business behaviour) an IAL compulsory unit, and labels it IA2: Units 1 and 2 are the International AS (IAS) units, and Units 3 and 4 are the extra International A2 content. So this topic is full International A Level content only.

All firms, markets and numbers below are fictional, and money is in currency units (cu). Related pages: the revision notes, the practice questions, the elasticity guide, the exam preparation page, the Edexcel economics hub, the printable checklist and the free 10-minute diagnostics.

What the specification asks for

Item	You must be able to
6a, 6b	State the assumptions of monopoly; explain barriers to entry and exit
6c	Find the profit-maximising equilibrium
6d	Weigh costs and benefits of monopoly to firms and consumers
6e	Explain natural monopoly and its implications
6f, 6g	State the conditions for third-degree price discrimination; weigh its costs and benefits
6h	Judge productive, allocative and dynamic efficiency under monopoly
7a, 7b	State monopsony assumptions and conditions; weigh costs and benefits to firms, consumers and employees

1. Assumptions and barriers (6a, 6b)

Assumptions (6a). A pure monopoly is the only seller in its market, so its demand curve is the market demand curve and slopes downwards. It sells a product with no close substitutes. It is a price maker, and it can choose a price or an output but not both. Barriers to entry stop rivals competing away its profit. Firms are assumed to maximise profit.

Barriers to entry (6b).

• Economies of scale: if minimum efficient scale is large compared with demand, a new small entrant has higher unit costs.
• Legal barriers: patents, licences and franchises.
• Branding and loyalty: an entrant must spend heavily on marketing.
• Sunk costs: money that cannot be recovered on leaving makes entry riskier.
• Limit pricing: the incumbent sets a price low enough to make entry look unprofitable.

Barriers to exit are costs of leaving: sunk costs, redundancy payments and long contracts. High exit costs also deter entry, because a firm that cannot leave easily is wary of arriving.

2. Profit-maximising equilibrium (6c)

A monopolist faces a falling demand curve, so selling an extra unit means cutting the price on every unit. Marginal revenue (MR) is therefore below price. With a straight-line demand curve, MR has the same intercept and twice the slope.

Worked example. A sole cement producer in a remote region of Country A (illustrative) has demand P = 120 − 4Q and costs TC = 240 + 24Q + 2Q², so MC = 24 + 4Q.

Q	P (= AR)	TR	MR	MC	TC	Profit
6	96	576	72	48	456	120
7	92	644	64	52	506	138
8	88	704	56	56	560	144
9	84	756	48	60	618	138
10	80	800	40	64	680	120

Method:

1. TR = PQ = 120Q − 4Q², so MR = 120 − 8Q.
2. Set MR = MC: 120 − 8Q = 24 + 4Q, so 12Q = 96 and Q = 8.
3. Take the price from the demand curve, not from MC: P = 120 − 32 = 88.
4. TC = 240 + 192 + 128 = 560, so ATC = 70. Profit = (88 − 70) × 8 = 144 cu, which is supernormal profit.

The diagram, in words: MR cuts MC from below at output 8. Go up to the demand curve to read the price of 88. Supernormal profit is the rectangle between price 88 and ATC 70, over 8 units.

Price
 88  +------* <- price read from demand
 70  |//////|    ATC at Q = 8
 56  |......X <- MR = MC at Q = 8
     +------+----------- Quantity
            8

Shaded (//) area = supernormal profit = (88 - 70) x 8 = 144.

Because MR must be positive at the optimum, a monopolist never settles where demand is inelastic. At Q = 8, price elasticity of demand = (1/4) × (88/8) = 2.75, which is elastic (see the elasticity guide).

3. Costs, benefits and efficiency (6d, 6h)

Take the competitive benchmark P = MC: 120 − 4Q = 24 + 4Q, giving Q = 12 and P = 72.

	Monopoly	P = MC benchmark
Output	8	12
Price	88	72
Consumer surplus	128	288
ATC	70	68

Consumer surplus is a triangle: ½ × 8 × (120 − 88) = 128, against ½ × 12 × (120 − 72) = 288. The deadweight loss is the triangle between demand and MC from output 8 to 12: ½ × 4 × (88 − 56) = 64 cu.

Efficiency (6h).

• Allocative: P = 88 exceeds MC = 56, so monopoly is allocatively inefficient. Output is too low.
• Productive: minimum ATC occurs at Q = √120 ≈ 10.95, where ATC is about 67.8. The monopolist produces 8 at ATC 70, so it is not productively efficient.
• Dynamic: supernormal profit can fund research and new products, which favours dynamic efficiency. Protection from rivals can also remove the pressure to innovate, and costs may drift upwards (X-inefficiency).

Costs and benefits (6d).

	Costs	Benefits
Firms	Regulation or fines; complacency; X-inefficiency	Supernormal profit; funds for investment; economies of scale; less risk
Consumers	Higher price, lower output, less choice, possible lower quality	Lower price if scale economies are big; innovation; standardised products

Worked evaluation: can monopoly give a lower price? Demand is P = 120 − 4Q. A competitive industry with constant MC = 80 would give Q = 10 at P = 80. One firm exploiting scale economies has MC = 8, so MR = 120 − 8Q = 8 gives Q = 14 and P = 64. The monopoly price is lower. Only a large cost advantage produces this, and it depends on the savings being passed on. Judgement therefore turns on the size of the cost gap, regulation, and whether profits are reinvested.

4. Natural monopoly (6e)

A natural monopoly exists where long-run average cost keeps falling over the whole range of market demand. One firm can serve the market at lower unit cost than two or more, so competition would waste resources. Typical cases have a large fixed network and a low marginal cost.

Worked example. A pipeline operator has TC = 480 + 10Q, so MC = 10 and ATC = 480/Q + 10 always falls. Demand is P = 90 − 2Q.

Rule	Q	P	Result
Profit maximising (MR = MC)	20	50	Profit 1,000 − 680 = 320
Average cost pricing (P = ATC)	about 32.6	about 24.7	Normal profit
Marginal cost pricing (P = MC)	40	10	Loss of 480

For the second row: 90 − 2Q = 480/Q + 10 gives Q² − 40Q + 240 = 0, so Q = 20 + √160 ≈ 32.65.

Implications.

• Unregulated, the firm restricts output and charges 50. Regulation can set a price cap near average cost.
• Allocative efficiency needs P = MC, but that makes a loss equal to fixed cost (480), so a subsidy or a two-part tariff would be needed.
• Duplication is costly. If two firms each served 20 units, each would face ATC = (480 + 200)/20 = 34, against 22 for one firm serving 40. Competition raises costs.
• A regulator may lack the cost information needed to set the price correctly.

5. Third-degree price discrimination (6f, 6g)

Definition. Charging different prices to different groups for the same product, for reasons not related to cost.

Conditions (6f).

1. The firm has price-making power.
2. It can separate the markets, for example by age, location or time of purchase.
3. Resale (arbitrage) between the groups can be prevented.
4. The groups have different price elasticities of demand, so the profit-maximising price differs.

Worked example. A ferry operator (invented) has constant MC = 12. Adult demand is P = 100 − 2Q and student demand is P = 60 − 2Q.

	Adults	Students
MR	100 − 4Q	60 − 4Q
MR = 12 gives Q	22	12
Price	56	36
PED at that point	0.5 × 56/22 = 1.27	0.5 × 36/12 = 1.5
Profit	22 × 44 = 968	12 × 24 = 288

Total profit is 1,256. The group with the more elastic demand gets the lower price.

Single price comparison. Combined demand is Q = 80 − P (valid for prices up to 60), so P = 80 − Q and MR = 80 − 2Q. Setting MR = 12 gives Q = 34, P = 46, and profit 34 × 34 = 1,156. Discrimination adds 100 to profit.

Costs and benefits (6g).

• Consumers: adult consumer surplus falls from 729 (½ × 27 × 54) to 484 (½ × 22 × 44); student surplus rises from 49 to 144. Total consumer surplus falls from 778 to 628. With linear demands, total output is 34 either way, so total surplus falls by 50 as the profit gain (100) is smaller than the consumer surplus loss (150).
• Firms: higher profit, and spare capacity can be filled.
• Welfare can rise if discrimination opens a market that a single price would exclude. Suppose student demand is P = 30 − 2Q. A single price of 56 serves no students. Discrimination sells 4.5 units at 21, adding profit of 40.5 and consumer surplus of 20.25.

6. Monopsony (7a, 7b)

Assumptions and conditions (7a). A monopsony is a single (or dominant) buyer. In a labour market it is the main employer, and it is a wage maker facing an upward-sloping labour supply curve. Conditions that sustain it: workers are occupationally or geographically immobile, there are few alternative employers, and unions are weak or absent. It is usually assumed to pay one wage to all workers.

Why MCL exceeds the wage. To hire one more worker the firm must raise the wage for everyone, so the marginal cost of labour (MCL) lies above the supply curve (the average cost of labour).

Worked example. A sole employer in an isolated town (invented) faces labour supply W = 6 + 0.5L and marginal revenue product MRP = 30 − 0.5L. Total labour cost is 6L + 0.5L², so MCL = 6 + L.

	Competitive labour market	Monopsony
Rule	S = MRP	MCL = MRP
Workers	24	16
Wage	18	14

Under monopsony, 6 + L = 30 − 0.5L gives L = 16. The wage comes from the supply curve: 6 + 8 = 14. MRP at 16 workers is 22, so each worker is paid 8 less than the value of their contribution.

Minimum wage. At 18, the firm’s MCL becomes 18 up to 24 workers and employment rises to 24. At 20, labour demand is 20 workers, so employment is 20: higher than 16, but below 24. At 22, employment is back at 16.

Costs and benefits (7b).

• Firms: lower costs and higher profit; risks include poor motivation, high turnover and hard-to-fill posts. The same logic applies to a dominant buyer of farm produce paying suppliers less.
• Consumers: lower prices if cost savings are passed on; possible lower quality or supply problems if suppliers cannot survive.
• Employees: lower wages and fewer jobs than competition would give; but jobs may not exist at all without the large employer, and it may train staff.

Common errors

• Reading the monopoly price off MC instead of up to the demand curve.
• Drawing MR with a different price intercept from demand. For a straight-line demand curve they start together, and MR falls twice as fast.
• Calling any large firm a monopoly: the assumptions need one seller and high barriers.
• Saying price discrimination always harms consumers.
• Reading the monopsony wage from MCL instead of dropping down to the supply curve.

Official syllabus

Source: Pearson Education Limited, Edexcel International Advanced Subsidiary/Advanced Level in Economics (specification, Issue 2, June 2018; first teaching September 2018), section 3.3.3 Market structures and contestability, items 6 and 7.