You will have covered the basics of monopoly in your AS course. At A2 you are expected to use a full diagrammatic treatment of price and output determination in markets where businesses have some monopoly power. Textbooks tend to consider pure monopolies, but the reality is that most firms have some pricing power in any imperfectly competitive market.

Price and output under a pure monopoly

A pure monopolist can take market demand as its own demand curve. The firm is a price maker but a monopoly cannot charge a price that the consumers in the market will not bear. In this sense, the price elasticity of the demand curve acts as a constraint on the pricing-power of the monopolist.

The profit-maximising level of output is at Q1 at a price P1. This will generate total revenue equal to OP1aQ1, but the total cost will be OAC1aQ. As total revenue exceeds total costs the firm makes abnormal (supernormal) profits equal to P1baAC1.

The effect of a rise in costs on monopoly price and profits

The rise in price from P1 to P2 helps in part the monopolist to offset some of the rise in costs, but the net effect is still a reduction in total profits and a contraction in output. The extent to which a business with monopoly power can pass on a rise in costs depends in part on the price elasticity of demand – pricing power is greatest when demand is price inelastic.

Barriers to entry – protecting monopoly power in the long run

Barriers to entry are designed to block potential entrants from entering a market profitably. They seek to protect the power of existing firms and maintain supernormal profits / increase producer surplus. These barriers have the effect of making a market less contestable - they are also important because they determine the extent to which established firms can price above marginal and average cost in the long run.

The 1982 Nobel Prize winning economist George Stigler defined an entry barrier as “A cost of producing which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry”.

Another Economist, George Bain defined entry barriers in a slightly different way “The extent to which established firms can elevate their selling prices above the minimal average costs of production without inducing potential entrants to enter an industry”.

This emphasises the asymmetry in costs that often exists between the incumbent firm (i.e. the business with market power already inside the market) and the potential entrant. If the existing businesses have managed to exploit economies of scale and therefore developed a cost advantage over potential entrants, this advantage might be used to cut prices if and when new suppliers enter the market. This involves a decision to move away from short run profit maximisation objectives – but it is designed to inflict losses on new firms and thereby protect a dominant market position in the long run. The monopolist might then revert back to profit maximization once a new entrant has been rebuffed!

Different types of entry barriers exist:

• Structural barriers (innocent entry barriers) – arising from differences in production costs
• Strategic barriers (see the notes below on strategic entry deterrence)
• Statutory barriers - entry barriers given force of law (e.g. patent protection of franchises such as the National Lottery or television and radio broadcasting licences)

Entry barriers exist when costs are higher for an entrant than for the incumbent firms. This is shown in the next diagram:

In the previous diagram we assume that the incumbent monopolist has achieved economies of scale so that that its own LRAC and LRMC are lower than that of a potential entrant. If the monopolist maintains a profit maximising price of P1, a market entrant could achieve economic profits since its costs are lower than the prevailing price. At any price below Pe the potential entrant will make a loss – and entry can be blockaded.

Barriers to Exit - Sunk Costs

Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:

• Capital inputs that are specific to an industry and which have little or no resale value.
• Money spent on advertising, marketing and research and development projects which cannot be carried forward into another market or industry.

When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier to entry of new firms (they risk making huge losses if they decide to leave a market). In contrast, markets such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets have low sunk costs so the barriers to exit are low.

The frequent market entry and failure of firms in many service and retail trade industries is evidence of insubstantial entry barriers.

Strategic Entry Deterrence

Strategic entry deterrence involves any move by existing firms to reinforce their position against other firms of potential rivals. This might involve:

• Hostile takeovers and acquisitions

• Product differentiation through brand proliferation (i.e. investment in developing new products and heavy spending on marketing and advertising)
• Capacity expansion to achieve lower unit costs from exploiting economies of scale
• Predatory pricing: Incumbent businesses may offer price cuts to customers who identify lower price entrants.

Strategic barriers may be deemed anti-competitive by the British and EU competition authorities - The EU Competition Commission has been active in recent years in building cases against European businesses that have engaged in anti-competitive practices including price fixing cartels. Nonetheless we often do witness the entry of new suppliers into markets and industries where one or more firms have a clear position of market power. Entry can occur in a variety of ways:

• A takeover from outside the industry (sometimes known as the “Trojan-horse route” to by-pass any structural entry barriers that might exist within an industry)
• The widening of a product range from a firm outside a specific market but with a state of technology sufficient to challenge existing firms
• A transfer of brand names from one sector of the economy to another (for example the diversification practiced by both EasyGroup and Virgin in recent years)
• Increasing competition from overseas - perhaps stimulated by fluctuations in the exchange rate of the development of a competitive advantage by foreign businesses
• Growing markets – if demand is increasing, market prices might be expected to rise and through the working of the price mechanism, higher prices offer increased potential profits for new entrants even if their initial production costs are higher than the incumbent firms
• Existing firms may be content to control the flow of new firms coming into a market rather than engaging in strategies designed to block the entry of any new firm outright.

Barriers to Exit

For many businesses, there are also barriers to exit which increase the intensity of competition in an industry because existing firms have little choice but to “stay and fight” when market conditions have deteriorated. There are several costs associated with exiting an industry.

• Asset-write-offs – e.g. the expense associated with writing-off items of plant and machinery, stocks and the goodwill of a brand
• Closure costs including redundancy costs, contract contingencies with suppliers and the penalty costs from ending leasing arrangements for property
• The loss of business reputation and consumer goodwill - a decision to leave a market can seriously affect goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain.
• A market downturn may be perceived as temporary and could be overcome when the economic or business cycle turns and conditions become more favourable