OxfordAQA A-level Economics: Monopoly, price discrimination and contestability (9640) – Revision Notes

Quick-recall notes for sections 3.3.3.5 (monopoly and monopoly power), 3.3.3.6 (price discrimination) and 3.3.3.7 (contestable markets) of the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2. The specification puts section 3.3 in the extra International A2 content; the first International AS exams were in May/June 2021 and the first International A-level exams in May/June 2022. Explanations are in the study guide. Practise with the practice set, and use the subject hub, the checklist and the free diagnostics. All figures are invented.

Key definitions

Term	Meaning
Monopoly	One seller facing the whole market demand curve; a price maker
Monopoly power	Some ability to set price above marginal cost; most firms have a degree of it
Natural monopoly	LRAC still falling when output reaches market demand, so one firm is cheapest
Third-degree price discrimination	Different prices for different market segments, same product, gap not explained by cost
Arbitrage	Buying in the cheap segment and reselling in the dear one
Contestable market	Entry and exit are cheap enough that the threat of entry is credible
Sunk cost	A cost lost for good once the firm exits
Hit-and-run competition	Entering to take supernormal profit, leaving when the incumbent reacts

Rules and formulas

Item	Rule
Output	Where MR = MC and MC rises through MR
Price	Read from AR (demand) at that output
Supernormal profit	(P − AC) × Q
Linear demand P = a − bQ	MR = a − 2bQ
MR and elasticity	MR = P(1 + 1/PED); MR is positive only where demand is elastic
Price with constant MC	P = MC × e/(e − 1), with e the PED ignoring sign
Third-degree PD	MR = MC in each segment; the less elastic segment pays more
Entry test	(entrant price − AC) × quantity × months before reaction, minus sunk cost

Method: the monopoly calculation

1. Write demand as P = a − bQ.
2. Double the slope: MR = a − 2bQ.
3. Solve MR = MC for Q.
4. Put Q into the demand curve for P.
5. Find AC at Q and work out (P − AC) × Q.
6. For the competitive benchmark, solve P = MC.

Worked reminder (Country C): P = 130 − 5Q, MC = AC = 30.

• MR = 130 − 10Q = 30, so Q = 10.
• P = 130 − 50 = 80. Profit = (80 − 30) × 10 = 500.
• PED = −(1/5) × 80/10 = −1.6: elastic, as it must be.
• Competition: P = MC gives Q = 20. The monopolist sells half the output at 2.67 times the price.

Monopoly power

Influence	Effect
Barriers to entry	Higher barriers protect supernormal profit
Number of competitors	Fewer rivals, less pressure on price
Advertising	Builds loyalty and lowers PED; adds cost
Product differentiation	Fewer close substitutes, lower PED, bigger mark-up

Monopolistic competition and oligopoly also involve price makers, with differing amounts of this power. With MC = 30, a fall in e from 4 to 2 lifts the profit-maximising price from 40 to 60.

Natural monopoly in numbers

TC = 540 + 6Q and demand P = 42 − 0.4Q.

• One firm: Q = 45, P = 24, AC = 18, profit 270.
• Two firms of 22.5 each: AC = 30.
• P = MC: Q = 90, P = 6, AC = 12, loss 540.

Keep the lesson: pricing at marginal cost leaves a loss, while an unconstrained firm charges well above cost. How policy responds sits in the competition policy and regulation unit.

Monopoly: advantages and disadvantages

• Advantages: economies of scale; supernormal profit funding innovation; reward for risk; a single firm can be the cheapest structure.
• Disadvantages: higher price and lower output than competition; allocative inefficiency; supernormal profit; weaker cost control; less innovation if protected.
• Evaluation hooks: size of cost saving; whether profit is reinvested; strength of barriers; contestability; essential or luxury good; short or long run.

Price discrimination

Conditions: market power; separable groups; no resale; different PEDs.

Reminder (Country D): MC = 6. Segment X has P = 54 − 2Q and segment Y has P = 28 − Q.

	X	Y
MR	54 − 4Q	28 − 2Q
Q	12	11
P	30	17
Profit	288	121
PED	−0.5 × 30/12 = −1.25	−1 × 17/11 = −1.55

Total profit is 409. Segment X is less elastic, so it pays more.

Effects	Producers	Consumers
Positive	Higher profit; fuller capacity; cross-subsidy	Elastic groups pay less; some buy who could not otherwise
Negative	Cost of separating; resale risk	Inelastic group pays more

Calculate each segment on its own, then add. Real-world types: peak and off-peak fares, child and adult tickets, student discounts, home and business tariffs.

Contestable markets

• Contestability turns on potential entry, not on how many firms are present.
• Perfect contestability: no barriers to entry or exit and no sunk costs.
• Low sunk costs force even a sole supplier to keep price near AC and earn normal profit.
• High sunk costs (launch advertising, specialised kit) make hit-and-run unprofitable.
• Limits: most markets lie between the extremes, and incumbents can respond with price cuts, contracts or loyalty offers.

Entry reminder: incumbent price 20, AC 15, 60 units a month. An entrant charges 18 for 2 months: (18 − 15) × 60 × 2 = 360. Sunk cost 100 gives +260, so enter. Sunk cost 500 gives −140, so stay out.

Chains of reasoning to rehearse

• Barriers to supernormal profit: high barriers, so no entry, so supernormal profit persists, so the firm can keep price above marginal cost and has less pressure to cut costs.
• Scale economies: large fixed costs, so average cost falls with output, so one firm is cheapest. Whether consumers gain depends on pass-through, which needs rivals or a credible entry threat.
• Price discrimination: a firm that can separate groups and stop resale charges more where demand is less elastic, so profit rises. Evaluate with who pays more, who is newly served and what happens to total output.
• Contestability: low sunk costs, so hit-and-run entry pays, so the incumbent holds price near AC, so profit is normal even with one firm. Evaluate with the incumbent’s possible reactions and real barriers.

Must-know distinctions

• Monopoly (a structure) against monopoly power (a degree of price-setting ability).
• Price taker against price maker.
• AR against MR: the price is on AR.
• Third-degree PD (segments) against one price for all.
• Contestable against competitive: a contestable market may have one firm.

Quick self-test

1. A monopolist faces P = 48 − Q with constant MC of 8. Find output, price and profit.
2. Two segments have PED of −1.2 and −3.5. Which pays more under third-degree price discrimination?
3. TC = 300 + 4Q. Compare average cost for one firm making 60 units with two firms making 30 each.
4. MC = 30. A brand’s PED (ignoring sign) falls from 4 to 2. By how much does the profit-maximising price change?
5. A 10% price cut meets PED of −2.5. What happens to quantity demanded?
6. List the four conditions for price discrimination.
7. An entrant charges 13 against AC of 10, sells 40 units a month for 5 months, and has sunk costs of 350. Find its net gain.
8. Define sunk cost in your own words.
9. A 15% price rise meets PED of −0.4. What happens to revenue?
10. Why does a monopolist never choose an output on the inelastic part of demand?

Answers

1. MR = 48 − 2Q = 8, so Q = 20. P = 28. Profit = (28 − 8) × 20 = 400.
2. The segment with PED of −1.2, because it is less elastic.
3. One firm: (300 + 240)/60 = 9. Two firms: (300 + 120)/30 = 14 each.
4. From 30 × 4/3 = 40 to 30 × 2/1 = 60: up by 20, or 50%.
5. Quantity rises by about 25%.
6. Market power; separable groups; no resale; different PEDs.
7. (13 − 10) × 40 × 5 = 600, less 350 = 250.
8. A cost lost for good once the firm exits.
9. Quantity falls by about 6%. Revenue = 1.15 × 0.94 = 1.081, up about 8.1%.
10. On the inelastic part MR is negative, so it cannot equal a positive MC. Cutting output would raise revenue and cut cost.

Where marks are usually lost

• Taking the price from MR instead of AR.
• Drawing MR with the same slope as a linear AR instead of twice as steep.
• Shading total revenue as profit rather than the rectangle (P − AC) × Q.
• Forgetting that discrimination needs one product and no resale.
• Claiming discrimination always raises output, or always lowers welfare, without checking demand.
• Calling any single-firm market a monopoly without discussing contestability.
• Mixing up sunk costs and fixed costs.
• Quoting a PED with no reading of it: say whether demand is elastic and what that means for revenue.
• Listing advantages and disadvantages with no judgement.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), specification version 1.2, published by OxfordAQA: sections 3.3.3.5, 3.3.3.6 and 3.3.3.7.