Chapter 7 · Market failure and socially undesirable outcomes III: Market power (HL only)
Monopoly
Find a monopoly’s profit-maximising output at MR = MC and its price on demand. Compare the outcome with allocative efficiency and welfare loss.
The economic idea
A monopoly is a market structure in which one firm is the sole or dominant supplier and substantial barriers to entry protect it from effective competition. These barriers may be legal, technological, financial, strategic or based on control of essential resources and networks.
Market power is the ability to influence price or market conditions. Because the monopolist supplies the market, it faces downward-sloping demand and must lower price to sell more output. Marginal revenue therefore lies below average revenue, which is the demand curve.
The monopolist maximises profit where MR = MC, then charges the highest price consumers will pay for that quantity on demand. It does not independently choose any price and quantity combination; demand constrains the choice.
Compared with the allocatively efficient P = MC benchmark, monopoly normally restricts output and charges a price above marginal cost. The forgone gains from trade form deadweight welfare loss, while some consumer surplus is transferred to the producer.
Abnormal profit may persist in the long run because barriers prevent entry, but it is not guaranteed. Demand and average cost still determine whether the firm earns abnormal profit, normal profit or a loss.
Reading the unregulated monopoly outcome
“Price, costs, revenue” is measured vertically and “Output” horizontally. Revenue and cost values are expressed per unit.
“D = AR” is the firm or cartel’s average-revenue curve: each point shows the price buyers will pay for a particular output.
“MR” lies below “D = AR” because selling another unit requires a price reduction that affects revenue from earlier units.
“MC” shows the extra cost of producing the next unit, while “AC” is total economic cost per unit.
Choose output at E
“E” is the profit-maximising outcome where “MR” equals “MC”. The firm produces “Q” and then charges “P” on “D = AR”. Price exceeds marginal cost, showing allocative inefficiency and market power at the displayed outcome.
Compare Q with Q*
“Q” lies below “Q*”, the output where “D = AR” meets “MC”. Mutually beneficial units are forgone and the resulting triangle is deadweight welfare loss.
Identify the current profit position
“P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output.
Keep profit, surplus and welfare loss separate
Consumer surplus is below “D = AR” and above “P”, up to “Q”. Producer surplus is above “MC” and below the price over the units sold; it covers fixed cost as well as economic profit. The profit rectangle instead compares price with “AC” at that output.
The welfare-loss triangle lies between “D = AR” and “MC”, from “Q” to “Q*”. Buyers would value those missing units more than they cost to produce. A transfer from consumers to the seller is not itself deadweight loss.
Barriers to entry can protect the seller’s position, but the diagram alone does not establish innovation, product quality or how profit is used. Those claims need evidence beyond the shaded areas.
Why MR = MC comes before the price decision
For outputs below “Q”, “MR” exceeds “MC”, so another unit adds more to revenue than to cost.
At “E”, “MR” equals “MC”, fixing the profit-maximising quantity “Q”.
Move vertically from “Q” to “D = AR” to find the price “P” consumers are willing to pay.
Compare “P” with “AC” to identify profit. “P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output.
Common mistakes to avoid
- Do not read price from “MR”. It is found on “D = AR” after output has been chosen.
- MR = MC identifies profit maximisation, not allocative efficiency. Allocative efficiency requires price, or marginal benefit, to equal marginal cost.
- Market power does not guarantee abnormal profit; high average cost can leave the firm earning normal profit or making a loss.
- A monopoly is not defined only by one visible seller; sustained barriers to entry are central to its market power.
How to draw this diagram
- Title the diagram “Monopoly”. Label the horizontal axis “Quantity” and the vertical axis “Price, costs, revenue”.
- Draw D = AR first and label it clearly.
- Draw MR next and label it clearly.
- Draw MC next and label it clearly.
- Draw AC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The model assumes a single price and does not show price discrimination between consumers or markets.
- It is static: monopoly profit may finance research, innovation and large irreversible investments, creating possible dynamic benefits.
- Contestability, buyer power, regulation and the threat of future entry may constrain price even when one firm currently dominates.
- The size of welfare loss depends on demand and cost conditions, not simply on the existence of monopoly.
- The diagram excludes externalities and distributional judgements, so its total-surplus benchmark is not a complete social evaluation.