Syllabus points
- Explain how market power (monopoly) can cause market failure.
- Compare monopoly with perfect competition on price, output and efficiency.
- Evaluate government responses to market power.
Market power as market failure
Market power is the ability of a firm to influence the price of its product. A firm with significant power, such as a monopoly, can restrict output and charge a price above marginal cost. Compared with a competitive market, this leads to a loss of allocative efficiency and welfare loss — a form of market failure.
Monopoly versus perfect competition
| Perfect competition | Monopoly | |
|---|---|---|
| Price | = marginal cost | > marginal cost |
| Output | Higher (allocatively efficient) | Restricted |
| Efficiency | Allocative & productive | Neither guaranteed |
| Long-run profit | Normal | Supernormal (barriers to entry) |
Monopoly restricts output and raises price above marginal cost → allocative inefficiency and welfare loss.
Key definitions
| Term | Exam-ready definition |
|---|---|
| Market power | A firm's ability to set price above marginal cost. |
| Monopoly | A single (or dominant) seller protected by barriers to entry. |
| Allocative efficiency | Producing where price equals marginal cost, maximising social surplus. |
| Barriers to entry | Obstacles preventing new firms competing away profits. |
Are monopolies always bad?
Not necessarily. Evaluation points:
- Economies of scale — a large firm may have lower average costs, so a natural monopoly can be more efficient than many small firms.
- Dynamic efficiency — supernormal profit can fund research and innovation.
- But without competition there is less incentive to keep costs low (X-inefficiency) or prices fair.
Government responses
- Regulation — price caps and quality standards for natural monopolies.
- Competition (antitrust) law — blocking mergers, preventing abuse of dominance.
- Public ownership — the state runs the industry in the public interest.
- Deregulation/promoting competition — lowering barriers to entry.
Worked example
A single water company supplies a region (a natural monopoly, given the huge fixed cost of pipes). Left alone it could charge high prices and restrict supply. A regulator imposes a price cap to protect consumers, but must set it carefully — too low and the firm underinvests in maintenance and future capacity.
Common exam mistakes
- Claiming monopoly is *always* harmful — weigh economies of scale and innovation.
- Confusing allocative and productive efficiency.
- Ignoring the risk that regulation itself may be imperfect (regulatory capture, information gaps).
Exam technique
Compare monopoly and competition on price, output and efficiency, then evaluate whether intervention improves welfare given natural-monopoly cost conditions and regulatory limitations.
Quick revision
- Market power → price > MC, restricted output, welfare loss.
- But economies of scale + innovation can offset.
- Responses: regulation, competition law, public ownership.