1. 1.4.5 Monopoly and the allocation of resources What is the objective in a game of monopoly? Use your knowledge of economics to explain why a hotel on Old Kent Road is cheaper than one on Mayfair. AQA E CON 1: M ARKETS AND MARKET FAILURE

2. 1.4.5 W HAT YOU NEED TO KNOW  Candidates should understand that monopolies have market power and that the basic model of monopoly suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market  Candidates should understand that monopoly can provide an example of market failure  Candidates should be aware of the various factors which affect the behaviour and performance of firms in a variety of real world markets and are sources of monopoly power. The factors include different barriers to entry and the degree of concentration and product differentiation  Candidates should understand the potential benefits from monopoly, for example, economies of scale and possibly more invention and innovation  Note: candidates are not expected to know the formal model of monopoly. However, candidates should be able to use two diagrams to illustrate the costs and benefits of monopoly: a market demand curve showing the effect on price of producing a lower output; and a cost curve to show economies and diseconomies of scale. Knowledge of monopoly revenue curves is not required.

3. M ONOPOLY POWER  A monopoly occurs when there is only one producer in an industry  This provides the monopolist with market power leading to higher prices and abnormal profits  There will be allocative inefficiency and a misallocation of resources  Therefore, a monopoly is an example of market failure A monopoly exists where there is only one firm in the market. However, the Government refer to any company that has at least 25% market share as having monopoly powers. Market power is the ability of a firm to set price above marginal cost. Monopolies can exploit consumers by charging high prices. Therefore, monopolies are regulated in order to protect the customer. How can monopolies use their power to exploit the customer? What role do governments play in regulating monopolies?

4. M ONOPOLY POWER  Barriers to entry exist in monopoly markets. These stop firms from entering the market  They include:  High costs to enter the market, especially high capital costs  Economies of scale experienced by large firms e.g. bulk buying  Intellectual property rights/legal barriers – patents, trademark and copyright restrict other firms from producing a good or service  Unfair competition – attempting to force competitors out of a market e.g. selling products below cost price for a time period  Government regulation – restricting firms from entering a market e.g. giving sole rights to one supplier Barriers to entry are any factors that stop a firm from entering a market. Some markets will have high barriers to entry e.g. the cost of research and development in hi-tech industries.

5. M ONOPOLY POWER The degree of concentration within a market is the number of firms that operate within the market. The degree of concentration within a market refers to the number of firms that exist within that market: 1.Monopoly – one firm dominates the market 2.Duopoly – two firms dominate the market 3.Oligopoly – a small number of firms are in the industry 4.Monopolistic Competition – many firms compete in the industry selling differentiated products 5.Perfect competition – many firms in the industry with no influence on market price MONOPOLYDUOPOLYOLIGOPOLY MONOPOLISTIC COMPETITION PERFECT COMPETITION

6. M ONOPOLY POWER  Product differentiation provides a competitive advantage to a firm and ensures a degree of monopoly power  Product differentiation includes:  Quality features that competitors’ products do not have  Functional and design features that competitors’ products do not have  Imperfect information where consumers are ignorant regarding the product or of competitors’ products  Advertising creating perceived differences in the mind of the consumer  Location, where the product can only be bought geographically through one supplier Product differentiation occurs when firms try to make their product different to the competition by adapting the actual product in some way or by distinguishing the product through advertising and branding. This helps to provide a Unique Selling Point (USP) - something that distinguishes the product of a firm from those of its competitors.

7. B ENEFITS OF MONOPOLY  Economies of scale mean that monopolies can force down unit costs becoming more productively efficient  These lower costs can be passed on to the benefit of society  They have large research and development budgets allowing for the development of new products that can benefit society  This can lead to product invention and product innovation  Natural monopolies occur when it would be too expensive for a number of competing firms to provide the same product e.g. water and gas provision to households  In some cases no firms would supply the infrastructure for a market due to high costs so the government intervene Product invention occurs when an original product or process is created. Product innovation occurs when a product or process that already exists is adapted. Natural monopolies exist where the nature of the industry means that there would be high productive inefficiency if more than one firm supplied the product e.g. the water industry.

8. Average total cost Output Economies of scale Diseconomies of scale Productive efficiency As seen in unit 1.3.3 the benefits and disadvantages of increasing the scale of production can be shown diagrammatically. At first unit costs (ATC) fall due to economies of scale. At this point economies outweigh diseconomies. The optimum output occurs when unit costs are at a minimum (productive efficiency). After this unit costs rise and diseconomies outweigh economies. A COST CURVE TO SHOW ECONOMIES AND DISECONOMIES OF SCALE

9. A MARKET DEMAND CURVE SHOWING THE EFFECT ON PRICE OF PRODUCING A LOWER OUTPUT In a monopoly there is only one supplier. Therefore, demand for the monopolist's products is the demand for the whole of the market. As the monopolist reduces output price will increase. As it does not have to worry about the competition, the monopolist can choose the price that will maximise profits. Price Quantity D P 1 Q 1 P Q The monopolist prices its product at P. At this point output is Q. By reducing output to Q 1 the monopolist is able to increase price to P 1. O

10. T EST YOURSELF 1. With the use of a diagram explain how a monopoly can use its power to maximise profits? 2. State and briefly explain 2 barriers to entry. 3. What is meant by the term natural monopoly?