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

This guide follows 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 places section 3.3 in the extra International A2 content, examined in Unit 3. The first International AS exams were in May/June 2021 and the first International A-level exams in May/June 2022.

Every firm, country and figure is invented for illustration. Related pages: the subject hub, the printable checklist, the revision notes, the practice set, the AS guide to how markets operate and the free diagnostics. The AS monopoly content in 3.1.4.4 is not repeated here.

What this unit covers

Specification	What you must be able to do
3.3.3.5	Use the monopoly diagram; explain natural monopoly; explain what influences monopoly power; weigh advantages and disadvantages
3.3.3.6	Explain third-degree price discrimination, its conditions, its diagram and its effects on producers and consumers
3.3.3.7	Explain contestability, sunk costs and hit-and-run competition, and what they imply for how an industry performs

3.3.3.5 The monopoly model

A monopolist is the only seller, so its demand curve is the market demand curve. Selling more means lowering the price on every unit, so marginal revenue (MR) lies below average revenue (AR, the demand curve). The firm sets MR = MC to find output, then reads the price from AR.

On the diagram, with price on the y-axis and output on the x-axis, MC cuts MR at the chosen quantity. Go up to AR for the price, then across to AC. The rectangle (P − AC) × Q is supernormal profit.

Worked example: a sole cable-car operator

Country A has one cable car up a mountain (illustrative). Demand is P = 105 − 3Q, with Q in thousand rides. Average cost equals marginal cost at 21 per ride.

1. Total revenue is 105Q − 3Q², so MR = 105 − 6Q.
2. Set MR = MC: 105 − 6Q = 21, so Q = 14 thousand rides.
3. Price from demand: P = 105 − 3 × 14 = 63.
4. Profit = (63 − 21) × 14 = 588 thousand. Check: TR = 882, TC = 294.

A table confirms the maximum:

Q	P	TR	TC	Profit
7	84	588	147	441
10	75	750	210	540
14	63	882	294	588
17	54	918	357	561

Between 14 and 17, MR is (918 − 882)/3 = 12, below MC of 21, so 17 is too much.

Competition with the same costs would give P = MC: Q = 28 and P = 21. The monopolist charges three times the price and sells half the output. The welfare loss triangle is 0.5 × (63 − 21) × (28 − 14) = 294. Price above marginal cost at the monopoly output is the mark of allocative inefficiency.

Elasticity and the monopolist

MR = P(1 + 1/PED). At P = 63 and Q = 14, PED = −(1/3) × 63/14 = −1.5, so MR = 63 × (1 − 1/1.5) = 21, matching MC. A profit-maximising monopolist produces where demand is elastic: MR must equal a positive MC, and MR is positive only on the elastic part of the curve.

Monopoly power

Pure monopoly is rare. Many firms hold monopoly power, meaning some ability to price above marginal cost. Firms in monopolistic competition and oligopoly are also price makers, to differing extents. The specification lists four influences.

• Barriers to entry. Economies of scale, legal protection, control of a key input or high set-up costs keep rivals out, so supernormal profit can last.
• Number of competitors. Fewer rivals mean less pressure to cut price.
• Advertising. It builds loyalty and makes demand less elastic, though it adds to cost and can itself deter entrants.
• Product differentiation. A product seen as unique has few close substitutes, so PED is lower.

With constant MC, profit maximisation gives P = MC × e/(e − 1), where e is PED ignoring sign. Take MC = 21:

e	Profit-maximising price	Mark-up over MC
1.5	63	42
3	31.5	10.5
7	24.5	3.5

If advertising moves a brand’s e from 3 to 1.5, the price that maximises profit doubles from 31.5 to 63, before counting the advertising bill.

Natural monopoly

A natural monopoly exists where long-run average cost is still falling when output reaches market demand. One firm then supplies at lower average cost than several, usually because fixed costs are huge (a heat network, a rail track, a grid).

Example: Country B has a district heating network (illustrative). TC = 540 + 6Q, so AC = 6 + 540/Q and MC = 6. Demand is P = 42 − 0.4Q.

• Unconstrained monopoly: MR = 42 − 0.8Q = 6, so Q = 45 and P = 24. AC = 6 + 540/45 = 18. Profit = (24 − 18) × 45 = 270.
• Two firms sharing 45 units would each make 22.5, with AC = 6 + 540/22.5 = 30. Duplication raises unit cost from 18 to 30.
• Pricing at MC gives Q = 90 and P = 6, but AC = 12, so TR = 540 against TC = 1,080: a loss of 540. The efficient price does not cover cost, which is why natural monopolies are awkward to handle. Policy responses belong to the competition policy and regulation unit.

Advantages and disadvantages of monopoly

Disadvantages	Advantages
Higher price, lower output than competition (63 against 21 above)	Economies of scale can lower average cost; in a natural monopoly one firm is cheapest
Supernormal profit, possibly seen as unfair	Supernormal profit can fund research, investment and innovation
Allocative inefficiency and a welfare loss	Profit rewards risk-taking on new products
Less pressure to control cost	Size can pay for quality and reliability
Weak incentive to innovate if protected

Evaluation. The verdict depends on how big the scale economies are against the price effect; whether profit is truly reinvested; how strong the barriers are; whether the good is essential; and the time horizon. A cost saving need not lower the price, because the monopolist keeps it unless rivals or the threat of entry force it to pass it on.

3.3.3.6 Price discrimination

Price discrimination is charging different prices for the same product to different groups when cost differences do not explain the gap. The specification names third-degree discrimination: a separate price for each market segment, such as adults and students, peak and off-peak, or home and business users. Everyday examples include child tickets, student discounts and cheaper off-peak travel.

Conditions

1. Market power. The firm must be a price maker.
2. Separation. It can tell the groups apart (age, time, place, proof of status).
3. No resale. Buyers in the cheap segment cannot pass the product to the dear one (arbitrage). Services are hard to resell.
4. Different elasticities. If PEDs match, splitting the market adds no profit.

Worked example: a small climbing gym

The gym (illustrative) serves adults, with demand P = 68 − 4Q, and students, with demand P = 32 − 2Q. Q is in hundred entries. MC = 12.

	Adults	Students
MR	68 − 8Q	32 − 4Q
MR = MC	Q = 7	Q = 5
Price	40	22
Profit, (P − MC) × Q	196	50
PED	−(1/4) × 40/7 = −1.43	−(1/2) × 22/5 = −2.2

Total profit is 246, and the less elastic group pays more.

Now test a single price. Adding the demands, any price up to 32 sells to both groups: Q = 33 − 0.75P. The best such price is 28, selling 10 to adults and 2 to students, so profit = (28 − 12) × 12 = 192. Charging 40 sells only to adults: 7 units, profit 196. The best single price is therefore 40 and profit is 196. Discrimination adds 246 − 196 = 50 to profit and raises output from 7 to 12, because students are now served. Compared with the single price of 40, students pay 45% less (22 against 40) while adults pay the same.

The diagram

Draw two panels side by side, each with price on the y-axis and output on the x-axis. In each, show that segment’s AR and MR, the same MC line, the quantity where MR = MC and the price read from AR. The less elastic segment shows the higher price.

Advantages and disadvantages

Producers gain profit, fuller use of capacity (empty off-peak places get filled) and revenue that can cross-subsidise services that would otherwise close. They bear the cost of separating segments, and resale or customer anger can undermine the scheme.

Consumers in elastic segments pay less, and some who could not afford the single price can buy. Those with less elastic demand may pay more than under a single price and may have no alternative.

Evaluation. The output effect depends on the demand curves. Here it opens a market that a single price shuts out; with other curves total output may not change. Discrimination is harder to defend when the higher-paying group is vulnerable or has no alternative. Fairness, use of the profit and the cost of enforcement all matter.

3.3.3.7 Contestable markets

A market is contestable when potential entrants pose a credible threat because entry and exit are cheap. What counts is potential competition, not how many firms are present. A perfectly contestable market has no barriers to entry or exit.

Sunk costs and hit-and-run competition

Sunk costs are lost for good when a firm leaves, such as launch advertising or equipment nobody will buy second-hand. Hit-and-run competition means entering to capture supernormal profit and leaving once the incumbent reacts, with little lost on exit.

Example: a regional barge service (illustrative). The incumbent charges 16, has AC of 11 and carries 90 loads a month, so supernormal profit is (16 − 11) × 90 = 450 a month. An entrant charges 14 and wins all the trade.

• Entrant profit = (14 − 11) × 90 = 270 a month. If the incumbent reacts after 3 months, the entrant has earned 810.
• With sunk costs of 200, the net gain is 810 − 200 = 610. Entry is worthwhile.
• With sunk costs of 1,000, the result is 810 − 1,000 = −190. Entry is deterred.

When sunk costs are low, the incumbent has to hold its price near AC (a cut from 16 to 11, about 31%) or lose trade. It earns only normal profit and is pushed towards productive efficiency.

Significance for performance

• A monopoly or duopoly may price modestly to avoid inviting entry, so market structure alone does not fix behaviour.
• Contestability matters most where sunk costs are low.
• Limits: few markets are fully contestable; incumbents can cut prices or tie in customers; a sector with huge sunk costs, such as a rail network, is far less contestable.

Common errors

• Reading the price off the MR curve instead of AR.
• Saying price discrimination relies on cost differences. It is one product at one cost.
• Leaving out the no-resale condition.
• Reading contestable as many firms. A single-firm market can be contestable.
• Ignoring sunk costs when judging whether hit-and-run pays.

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, with quantitative skills from section 3.5.