OxfordAQA A-level Economics: Monopoly, monopoly power and the competitive market process (9640)

This study guide follows the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2, sections 3.1.4.4 (Monopoly and monopoly power) and 3.1.4.5 (The competitive market process). Section 3.1 is International AS content, which also forms part of the International A-level; the extra International A2 content in 3.3 returns to monopoly later and is not covered here. All figures below are invented and illustrative.

Related pages: revision notes, practice questions, the operation of markets, the course hub, the printable checklist and the free diagnostics.

What the specification asks for

Section	You must be able to
3.1.4.4	Distinguish pure monopoly from monopoly power
3.1.4.4	Explain what influences monopoly power: barriers to entry, number of competitors, advertising, product differentiation
3.1.4.4	Calculate and use concentration ratios
3.1.4.4	Explain why the basic model of monopoly points to higher prices, higher profits, inefficiency and misallocation compared with a competitive market
3.1.4.4	Use a demand curve to show output falls if price is raised above the competitive level
3.1.4.4	Explain possible benefits: economies of scale (shown with a long-run average cost curve), invention and innovation
3.1.4.5	Explain that firms compete on more than price: better products, lower costs, better service
3.1.4.5	Recognise that vigorous competition between large firms helps consumers, while monopoly power can misallocate resources and exploit consumers

The specification says a formal diagrammatic analysis of monopoly is not required. You need a demand curve and a long-run average cost curve, not the full theory-of-the-firm diagram. Section 3.1.4.1 lists market structures and 3.1.4.3 covers competitive markets; these are taught elsewhere.

Pure monopoly and monopoly power

A pure monopoly exists where one firm alone supplies the entire market and buyers have no close alternative. The specification notes that there are few examples of pure monopoly in practice.

Monopoly power is the ability of a firm to influence the market price, or to earn profit above the level a competitive market would allow, because it faces limited competition. Many firms have it. A firm with 40% of a market and well-known branding can have real monopoly power without being a pure monopoly.

Think of a scale rather than two boxes. At one end is a firm with many close rivals and no pricing freedom. At the other is a pure monopoly. Most real firms sit between them, and the question to ask is how much freedom a firm has to raise price without losing so many customers that it loses profit.

What influences monopoly power

• Barriers to entry. These are obstacles that raise the difficulty or cost for newcomers: large start-up costs, legal protection such as patents or licences, control of a key input, strong brands, or economies of scale so large that a newcomer cannot match the incumbent’s costs. High barriers protect a firm’s profit from new rivals.
• Number of competitors. Fewer rivals means each customer has fewer places to go. The relative size of rivals matters too: one giant and ten tiny firms is different from eleven equals.
• Advertising. It can build loyalty and make demand less sensitive to price. It also adds a cost new entrants must match. Advertising can also inform buyers, which can increase competition, so judge the effect case by case.
• Product differentiation. If a firm’s product is seen as different from rivals’, it faces its own downward-sloping demand curve and some customers will stay when it raises price.

Chain of reasoning: stronger barriers, fewer rivals, heavier advertising and greater differentiation make demand less price elastic, so a price rise loses fewer sales, so the firm can price higher and keep more profit.

Concentration ratios

A concentration ratio adds up the market shares of the leading sellers. The n-firm version is written CRn:

CRn = (combined sales of the n biggest sellers) divided by (whole-market sales), then multiplied by 100

You can measure share by sales revenue, output or employment, but use the same measure for every firm.

Worked example 1. Country A has a market for bottled juice (illustrative). Annual sales (million dollars): Firm P 84, Firm Q 61, Firm R 45, Firm S 30, Firm T 22, all other firms together 58.

Total sales = 84 + 61 + 45 + 30 + 22 + 58 = 300.

• CR1 = 84/300 = 28%
• CR3 = (84 + 61 + 45)/300 = 190/300 = 63.3%
• CR4 = (84 + 61 + 45 + 30)/300 = 220/300 = 73.3%

Next year the market is 320 and the same four firms sell 250 between them. CR4 = 250/320 = 78.1%. That is a rise of 4.8 percentage points (78.1 minus 73.3). Say “percentage points” for the gap between two percentages. A rise from 73.3% to 78.1% is also a 6.5% relative increase, which is a different thing.

What the ratio tells you and what it does not:

• A high ratio suggests firms may have market power. The ratio does not show how easily new firms can enter, how closely rivals compete, or whether the biggest firm is a pure monopoly.
• Two markets can share a CR4 of 73% but differ widely: in one the top firm has 70%, in the other four firms have about 18% each.
• The market definition matters. A firm with 90% of “bottled juice” may hold only 20% of “all soft drinks”.

The basic model of monopoly

The basic model compares a monopoly with a competitive market. In a competitive market, many firms push price down towards cost. A monopolist, protected by barriers, can restrict output and charge more.

Worked example 2. A market has demand P = 100 - 2Q, where P is price in dollars and Q is output in units (invented). Every unit costs 40 dollars to make, whoever produces it. All money figures below are in dollars.

Price (dollars)
100 |*
    |  \
 70 |    *   <- monopoly price, output 15
    |      \
 40 |        *   <- competitive price, output 30
    +--------------------- Quantity
    0   15  30       50

	Competitive market	Monopoly
Price	40	70
Output	30	15
Revenue	1,200	1,050
Total cost	1,200	600
Profit	0	450
Consumer surplus	900	225

Working: output at 70 is (100 - 70)/2 = 15. Consumer surplus is a triangle: half x (100 - price) x output, so 0.5 x 60 x 30 = 900 and 0.5 x 30 x 15 = 225. Monopoly profit = (70 - 40) x 15 = 450.

Reading the table:

• Higher price: a 75% rise from 40 to 70. Lower output: it falls 50%, from 30 to 15, moving up the demand curve. This is the demand-curve point the specification asks for.
• Higher profit: revenue falls but costs fall by more, so profit rises from 0 to 450.
• Misallocation and inefficiency: consumer surplus drops by 675 but the firm gains only 450. The remaining 225 is lost to everyone. These are units that buyers value at more than the 40 cost of making them, yet they are not produced. Resources are not used where they would be most valued.

Do not assume every monopoly acts this way. Regulation, the threat of new entry or fear of bad publicity can hold prices down.

Potential benefits of monopoly

Economies of scale. Where long-run average cost (LRAC) falls steeply as output rises, one large firm can produce more cheaply than several small ones.

Worked example 3. A market needs 80,000 units a year. A firm’s LRAC (invented): 9 per unit at 20,000 units and 6 at 80,000 units.

• One firm making 80,000: 80,000 x 6 = 480,000
• Four firms each making 20,000: 4 x 20,000 x 9 = 720,000
• Saving from single-firm production = 240,000, a third of the four-firm cost

LRAC (dollars)
 9 |*
   |   \
 6 |      \______*
   +---------------- Output
     20,000   80,000

The saving is real, but it does not automatically reach consumers. If the monopolist charges 8 dollars, buyers pay less than the 9 dollars that small firms would need to cover costs, and the firm still makes 2 x 80,000 = 160,000 dollars. If it charges 12 dollars, buyers lose, and the cost saving mostly becomes profit. Whether benefits are passed on depends on regulation, the threat of entry and what the firm aims for.

Invention and innovation. Monopoly profit can pay for research and development, and patents let a firm keep the rewards from a new product, which encourages risk-taking. Set against this, a firm with no rivals may feel little pressure to improve, so more innovation is only a possibility (“possibly more”, in the specification’s words).

The competitive market process

Competition is more than price cutting. Firms strive to:

• improve products: new features, better design, longer life
• reduce costs: better methods, bulk buying, new technology
• improve service: faster delivery, easier returns, helpful staff

Worked example 4. A small bakery cuts unit cost from 5.00 to 4.60 using a faster oven. Cost falls by 0.40/5.00 = 8%. It cuts price from 7.50 to 7.20, a 4% fall. Of the 0.40 saving, 0.30 is passed on, or 75%. Margin per loaf rises from 2.50 to 2.60. Both sides gain: the firm earns slightly more per unit, and buyers pay less. A rival that wants to keep customers must match the lower price, improve its product or find its own cost saving.

Link this to monopoly power. Large firms often compete vigorously, and consumers gain through lower prices, better quality and more choice. Where monopoly power exists, that pressure weakens: there is less reason to cut costs or improve service, prices can be higher, and consumers can be exploited. Resources then move away from where they would be most valued.

Evaluating monopoly power

A balanced judgement usually weighs:

1. Size of the economies of scale. If minimum efficient scale is close to the whole market, one firm may be the lowest-cost option.
2. Pass-through. Do cost savings reach consumers as lower prices?
3. Barriers and contestability. If entry is easy, a firm with a high share may still have to behave competitively.
4. Dynamic effects. Do profits fund innovation, or does the firm relax?
5. Time. Barriers wear away as technology changes, so monopoly power may be temporary.

Common errors

• Writing that a firm with a large market share is a pure monopoly.
• Giving a concentration ratio without checking that the market totals include all firms.
• Calling a move from 73% to 78% a “5% rise” instead of about 5 percentage points.
• Saying monopoly always means high prices without discussing pass-through, regulation or entry.
• Drawing the full theory-of-the-firm diagram, when the specification asks for a demand curve and an LRAC curve.
• Treating “competition” as only price competition.

Official syllabus

OxfordAQA International AS and A-level Economics (9640) specification, version 1.2, sections 3.1.4.4 and 3.1.4.5. First teaching September 2020, first AS exams May/June 2021, first A-level exams May/June 2022. Published by OxfordAQA.