Evaluate whether a monopoly is likely to operate efficiently

Refer to at least one monopoly of your choice.

25 marks

Specimen paper

A monopoly is a market which is dominated by one firm. A firm can have monopoly
power by owning 25% market share. A monopoly has high barriers to entry, imperfect
information, a unique product, and price making ability. It is useful to consider if a
monopoly is productively, allocatively, or dynamically efficient.

In many ways, monopolies are not efficient. Productive efficiency is when average cost is
minimised. This happens at the quantity when MC = AC. A monopoly chooses to profit
maximise, which happens at the quantity where MC = MR. This can be seen in the
diagram below, where the monopolist sells an output of Q at a high price of P. The
shaded area shows the supernormal profit they are making.

One of the reasons that monopolies are not productively efficient is because they have
no incentive to minimise costs, because they can make profit by setting high prices
instead of worrying about lowering costs. This is called X-inefficiency. Furthermore,
monopolies are not allocatively efficient either. Allocative efficiency is when social
welfare is maximised. This happens when MC = AR, so that consumer and producer
surplus is maximised. This means setting a fair price that is in the interest of everyone in
society. A monopoly, such as Apple, prioritises maximising their profit, so they set a very
high price and sell a low output, so they do not have allocative efficiency.

However, monopolies like Apple do act in the best interest of consumers despite the high
prices. They try to produce goods and services that will be helpful to society.
Monopolies are dynamically efficient, and they are the only market structure who can
achieve this. Dynamic efficiency is when there are supernormal profits in the long run,
which can be re-invested to improve and innovate products. For example, if Apple didn't
make profit on the iPhone 4, then the iPhone 15 wouldn't exist. Every time Apple made
profit, they re-invested it and improved the next iPhone.

However, some monopolies like energy companies may make supernormal profit in the
long run, yet they will not re-invest it to improve products for customers.

If there is a way to ensure that monopolies re-invest profits, and also do not charge
excessively high prices to customers, then monopolies could be considered beneficial to
society. Overall, most monpolies are dynamically efficient but none are allocatively or
productively efficient.

Plan
Intro: Define and explain the characteristics of a monopoly. Mention the efficiences you
will discuss.

Paragraph 1: Monopolies are generally not efficient (main focus on productive and
allocative efficiency)

Paragraph 2: Monopolies have dynamic efficiency. Emphasise that they are the only
market structure which is dynamically efficient.

Tesla held an 82% market share of the electric vehicle market in the United States during the first half
of 2020.
Evaluate whether a monopoly is likely to operate efficiently. Refer to at least one monopoly of your
choice.

Definitions of efficiency: • Productive (lowest point of AC)

• Allocative (P=MC)

Case For
• Productive efficiency - larger economies of scale, types of economies of scale e.g. purchasing,
monopsony power to reduce costs, minimum efficient scale, natural monopoly
• Allocative efficiency - Lower prices (limit pricing) and good customer care deter potential entrants,
acts as a surrogate for competition
• Dynamic Efficiency - profits re-invested into cost-lowering investment, product innovation may
increase AR

Case against
• X-inefficiency -organisational slack due to managerial complacency as a result of lower competition
• Allocative inefficiency -monopoly power that makes them price makers and allows them to charge
higher prices (less welfare max)
• Productive inefficiency - profit maximising,
• Dynamic inefficiency might not reinvest but give profits to shareholders in the firm on higher
dividends, principal agent problem
• Degree of monopoly power - ability of consumers to switch to alternatives • Government intervention
- price caps, tax
• Government intervention damages efficiency, regulatory capture, strength of regulator
Diagram.

Paragraph 1: Knowledge, Application, and Analysis (KAA)

Knowledge Point 1: Productive Efficiency and Economies of Scale

Monopolies can achieve productive efficiency through economies of scale, which occur when a firm’s long-
run average costs decrease as it increases production. A monopoly typically has the resources to expand
production, and large-scale operations allow it to reduce the average cost per unit. Purchasing economies (bulk
buying) and monopsony power (the ability to influence input prices) contribute to these cost reductions,
allowing the firm to produce more efficiently than smaller firms.

Example: Tesla illustrates this with its Gigafactories. As Tesla expands production, it benefits from lower
costs per vehicle due to economies of scale. This allows Tesla to reduce prices and improve profit margins,
making it more cost-efficient than smaller competitors in the EV market.

Knowledge Point 2: Allocative Efficiency and Limit Pricing

Monopolies may also engage in limit pricing, where they set prices lower than the monopoly price to deter
potential competitors, which can lead to allocative efficiency. By charging lower prices, monopolies can
improve consumer welfare and act as a surrogate for competition, as potential entrants are discouraged from
entering the market due to lower profits.

Example: Microsoft in the 1990s can be seen as an example. Despite being a monopoly in the operating system
market, Microsoft maintained relatively low prices for Windows, which deterred competitors and kept consumer
prices lower, benefiting consumers in the short term.

Analysis: Monopoly Power and Efficiency

While a monopoly can achieve productive and allocative efficiencies in the short term, monopolistic behavior
often leads to allocative inefficiency due to the firm’s ability to set prices above marginal cost (P > MC). This
results in reduced consumer surplus and deadweight loss, as consumers who would have purchased the product
at a competitive price are excluded from the market. Therefore, while monopolies can benefit from economies
of scale and limit pricing, they often do not maximize social welfare in the long run.

Paragraph 2: Evaluation

Evaluation Point 1: X-Inefficiency and Organizational Slack

Monopolies can suffer from X-inefficiency, where the lack of competition leads to organizational slack. This
means the monopoly may not focus on minimizing costs or improving efficiency, as there is no competitive
pressure. Managers in monopolies may become complacent, leading to higher average costs than would be seen
in a competitive market.

Example: Microsoft’s monopoly power in the 1990s resulted in significant X-inefficiency, as the company had
little incentive to innovate or streamline its operations during its dominant period. Despite its large market share,
inefficiency was evident in the lack of substantial improvements in product quality and cost reductions.
Evaluation Point 2: Government Intervention and Regulatory Capture

Government intervention, such as price caps or taxes on monopolies, may aim to increase efficiency by limiting
the monopoly's market power. However, such intervention can sometimes be counterproductive. Regulatory
capture, where regulators act in the interest of the monopoly rather than consumers, can reduce the
effectiveness of intervention. Moreover, excessive regulation can stifle innovation and discourage investment,
leading to dynamic inefficiency.

Example: The case of Microsoft’s antitrust trial in the 1990s illustrates how government intervention can
disrupt a monopoly's operations, resulting in inefficiencies. The company had to adjust its business practices,
and while the intention was to foster competition, the changes imposed were often inefficient and reduced the
company’s ability to innovate freely.

Paragraph 3: Knowledge, Application, and Analysis (KAA)

Knowledge Point 1: Dynamic Efficiency through Reinvestment

Monopolies can potentially achieve dynamic efficiency by reinvesting profits into innovation and product
development. This allows the firm to reduce costs or improve product quality over time, which can benefit
consumers in the long term. Dynamic efficiency refers to the ability of a monopoly to innovate, leading to a
downward shift in its long-run average cost curve (LRAC).

Example: Tesla reinvests its profits into developing new technologies like battery efficiency and autonomous
driving features. These innovations lead to cost reductions over time and improvements in product quality,
benefiting consumers and contributing to long-term dynamic efficiency.

Knowledge Point 2: Monopoly Power and Consumer Switching

The degree of monopoly power influences the level of inefficiency. While a monopoly has the power to set high
prices, the ability of consumers to switch to alternatives can limit this power. If consumers have viable
substitutes, the monopoly may face competitive pressures that encourage efficiency. However, in industries with
high barriers to entry, monopolies can exercise significant control over pricing, leading to inefficiencies.

Example: Tesla’s position in the EV market faces growing competition from other manufacturers like Ford
and GM, which are investing heavily in electric vehicles. This growing competition forces Tesla to maintain or
improve its product offerings and prices, slightly reducing its monopoly power and encouraging efficiency.

Paragraph 4: Evaluation

Evaluation Point 1: Incentive to Reinvest and Innovation

Monopolies often have significant incentives to reinvest profits into innovation, which can result in dynamic
efficiency. These innovations could lead to lower production costs or improved consumer products, which
benefit society in the long term. However, if profits are diverted to shareholders in the form of higher
dividends, rather than reinvested into R&D, dynamic efficiency may not be achieved.

Example: Microsoft during its monopoly period was criticized for focusing on shareholder returns rather
than reinvesting in product innovation. This resulted in stagnation in certain product lines, such as the Windows
operating system, which faced little competition for a period.

Evaluation Point 2: Government Interventions and Efficiency Losses

Government interventions, such as price regulation or anti-monopoly laws, can often reduce market efficiency.
Regulatory capture or increased compliance costs for firms can create inefficiencies. While government
intervention is often necessary to curb monopoly power, it can sometimes distort the market and make firms less
responsive to consumer needs.

**Example: The U.S. government’s intervention in the Microsoft antitrust case led to changes in the
company’s business practices. While intended to increase competition, it disrupted Microsoft’s ability to
innovate freely, potentially reducing efficiency.

Conclusion

In conclusion, the efficiency of a monopoly depends on several factors. While monopolies like Tesla can
achieve productive efficiency through economies of scale and dynamic efficiency through reinvestment in
innovation, they can also face allocative inefficiencies and X-inefficiencies due to reduced competition.
Government intervention may address some of these inefficiencies but can also reduce overall market
efficiency. Ultimately, whether a monopoly operates efficiently depends on its reinvestment strategies, the
degree of competition in the market, and the nature of government regulation.

OLIGOPOLY

1. Productive Efficiency and Economies of Scale

Graph: Long-Run Average Cost (LRAC) curve for an Oligopoly

 Purpose: Similar to monopolies, firms in an oligopoly may achieve economies of scale, reducing
average costs as production increases. However, the extent of economies of scale might be smaller
because oligopolistic firms face competition from a few firms rather than just one.
 Description: Draw a downward-sloping LRAC curve representing economies of scale, but with a
relatively flatter curve than a monopoly. Oligopolistic firms, while benefiting from economies of
scale, typically face diminishing returns from large-scale production due to their limited market share.
 Label: LRAC, MES, oligopoly firms, output level

Example: Ford and General Motors in the car industry may benefit from economies of scale, but they still
face competition, which limits their ability to exploit economies of scale to the extent seen in a monopoly.

2. Allocative Efficiency and Collusion/Price Rigidity

Graph: Kinked Demand Curve (Price Rigidity in Oligopolies)

 Purpose: In an oligopoly, firms often experience price rigidity due to the kinked demand curve. This
occurs when firms are reluctant to change prices because competitors will match price cuts but not
price increases, leading to price stability despite changes in marginal cost.
 Description: Draw a kinked demand curve with a sharp bend at the current price. The upper part of
the curve is relatively elastic, while the lower part is relatively inelastic. The kink occurs where the
firm believes that price changes will lead to significant reductions in quantity demanded if they raise
their price, but only small changes in quantity demanded if they lower their price.
 Label: Kink, demand curve, price level, quantity, marginal cost (MC), marginal revenue (MR)

Example: Airlines often engage in price rigidity because they fear that if they raise their prices, competitors
will not follow, but if they lower their prices, all competitors will follow, leading to a price war.
3. X-Inefficiency and Organizational Slack

Graph: Average Cost (AC) Curve for Oligopolies vs. Perfect Competition

 Purpose: In oligopolies, firms may still suffer from X-inefficiency due to limited competition.
Although oligopolies are more competitive than monopolies, they may still face higher costs than
perfectly competitive firms because they are not under the same pressure to be as cost-efficient.
 Description: Draw a comparison between the AC curve for an oligopoly and that of a perfectly
competitive firm, with the oligopoly’s AC curve being higher due to inefficiencies like organizational
slack and limited competitive pressure.
 Label: AC (oligopoly), AC (perfect competition), output levels, inefficiency in oligopoly

Example: OPEC may be less efficient than a perfectly competitive oil market because of its ability to control
prices and output, reducing competitive pressures.

4. Dynamic Efficiency and Innovation

Graph: Innovation Shifts in the LRAC Curve

 Purpose: Similar to monopolies, oligopolies can achieve dynamic efficiency by reinvesting profits
into innovation and reducing costs over time. However, the level of innovation may be influenced by
the degree of competition and collusion in the market.
 Description: Draw a shifting LRAC curve to show how innovation reduces costs over time. The
oligopoly may invest in R&D to create new products or improve processes, leading to a downward
shift in its LRAC curve.
 Label: Shifted LRAC, initial LRAC, innovation

Example: Apple and Samsung invest heavily in innovation, particularly in their smartphones, which helps to
reduce costs and improve product quality over time.

5. Collusion and Welfare Loss

Graph: Price and Output in Collusive Oligopoly (Cartel)

 Purpose: In some oligopolies, firms may engage in collusion or form a cartel to maximize collective
profits, leading to higher prices and lower output than in a competitive market. This results in
allocative inefficiency and deadweight loss.
 Description: Draw a price and quantity graph showing the output and price levels under collusion
(cartel behavior). The monopolistic price will be higher, and the quantity produced will be lower than
in a competitive market, creating deadweight loss.
 Label: Price (collusive), price (competitive), quantity (collusive), quantity (competitive), deadweight
loss

Example: OPEC is a classic example of a cartel that controls oil prices, leading to higher prices and less output
than would occur in a competitive market.

6. Government Intervention (Anti-Trust Laws, Price Controls)

Graph: Government Intervention in an Oligopoly (Price Caps or Regulation)

  Purpose: To show the effects of price regulations or anti-trust intervention in an oligopoly.
Governments may impose price caps to reduce prices or break up cartels to increase competition.
 Description: Draw a price cap regulation graph, where the government sets a maximum price below
the equilibrium price to prevent price gouging or collusion. The graph should show the government-
imposed price and the resulting output level.
 Label: Price cap, regulated price, monopoly price, competitive price, output levels

Example: In the airline industry, governments regulate prices or intervene to prevent collusion between
airlines, ensuring that consumers benefit from lower prices and more competition.

7. Deadweight Loss and Allocative Inefficiency

Graph: Deadweight Loss in Oligopoly vs. Perfect Competition

 Purpose: Oligopolies may still create deadweight loss, even though they are more competitive than
monopolies. The market power of oligopolistic firms results in higher prices and lower output than in a
perfectly competitive market.
 Description: Draw a deadweight loss graph comparing the oligopoly market price and quantity to the
competitive equilibrium price and quantity. The price set by oligopolists is above marginal cost,
leading to allocative inefficiency and deadweight loss.
 Label: Deadweight loss, price (oligopoly), price (perfect competition), quantity (oligopoly), quantity
(perfect competition)

Example: The UK mobile network market has a few dominant firms that charge higher prices than would be
seen in a perfectly competitive market, creating deadweight loss.

Conclusion

The graphs for oligopoly focus more on the effects of competition between a few firms, price rigidity,
potential collusion, and how firms interact within the market. These graphs can help illustrate concepts like
kinked demand curves, price collusion, deadweight loss, and government intervention. By using these
graphs, you can effectively explain how oligopolies operate and how they may or may not achieve allocative
and productive efficiency.