Monopoly and price discrimination

The big picture

Monopoly is the analytical engine behind every question about market concentration. Once a firm faces a downward-sloping demand curve it becomes a price maker, and its business decisions shift from minimising cost to extracting supernormal profit. The power source differs by industry, switching costs in banking, patents in pharmaceuticals, network effects in search, but the model is the same, and examiners reward candidates who re-derive price above marginal cost through the industry's specific power source. Google holds around 92% of global search; the CMA found in 2016 that weak competition in retail banking cost customers about £1bn a year in excess charges. Neither market has a single seller, and both behave like the diagram below.

The theory

Characteristics and barriers to entry

Monopoly

A market with a single seller of a good with no close substitutes; in UK competition policy a firm with 25% or more of a market is treated as having monopoly power. The monopolist is a price maker facing the market demand curve, protected by high barriers to entry.

Supernormal profit survives in the long run only if entry is blocked. The barriers to learn, each with an industry attached: economies of scale and large sunk costs (mobile masts at £6–8bn); legal barriers such as patents (insulin, where three firms hold the entire market); network effects (a search engine improves with users, so Google's 92% is self-reinforcing); brand loyalty and advertising; and control of key inputs or infrastructure. Distinguish barriers to entry from barriers to exit: sunk costs deter entry precisely because they cannot be recovered on the way out.

The monopoly diagram

Monopoly equilibrium with supernormal profit. What to draw and label in the exam: axes in words (output; costs and revenue); a downward-sloping AR, with MR below it falling twice as steeply; a rising MC and an AC curve. The firm produces Q_m where MC = MR, then charges the highest price that output will bear, P_m, read vertically up to AR. Shade the supernormal profit rectangle between P_m and AC over the output Q_m. The two most common errors are reading the price off MR instead of AR, and letting Q_m drift away from the MC = MR intersection.

The welfare case against monopoly follows from the diagram. Output is restricted below the competitive level and price is set above marginal cost, so units that consumers value above their resource cost never get made: allocative inefficiency, with the lost surplus forming a deadweight loss. Weak competitive pressure also lets costs drift above their achievable minimum, X-inefficiency: in banking, branch staff costs per account rose in real terms between 2008 and 2016 even as branches closed. Against this sit three defences. Dynamic efficiency: supernormal profit can fund innovation (AstraZeneca spent £5.1bn on R&D in 2023; Google's DeepMind produced AlphaFold), though whether profit actually flows to research rather than to shareholders is a question to press in evaluation. Economies of scale: the CMA has estimated that Big 4 supermarket scale cuts average grocery prices by roughly 10–15% against a fragmented market. And natural monopoly: where duplicating infrastructure would waste resources (around £30bn for a rival UK broadband network), one regulated provider may be the efficient outcome.

Price discrimination

Charging different prices to different consumers for the same good or service, where the difference in price does not reflect a difference in the cost of supply.

The three degrees, briefly. First degree: each consumer is charged the maximum they are willing to pay, so the whole consumer surplus transfers to the firm. Second degree: price varies with the quantity or version purchased, as with bulk discounts and off-peak tariffs. Third degree, the one to master for the exam: the market is split into groups with different price elasticities of demand, each charged a different price, as with adult and student tickets. Four conditions must hold for third-degree discrimination to work: the firm must have market power (a price maker facing downward-sloping demand); it must have the information to identify and separate the groups; it must be able to prevent resale from the low-price group to the high-price group; and the groups must have different elasticities, otherwise there is nothing to exploit.

Third-degree price discrimination. Draw two panels sharing one marginal cost level. In Market A demand is inelastic, so AR and MR are steep; setting MC = MR gives output Q_a and the high price P_a. In Market B demand is elastic, AR and MR are flatter, and the same MC = MR rule gives the lower price P_b. The dotted line carries the Market A price across so the examiner can see P_a > P_b at a glance. Label each panel's elasticity in words; the whole argument is that the inelastic group is charged more because it cannot easily switch away.

Who wins and who loses? The firm always gains, since surplus is transferred from consumers and total profit rises above the single-price level. The inelastic group loses surplus. The elastic group often gains, paying less than the single price, and some of its members are served who would otherwise be priced out entirely, so output can rise. Discrimination can even keep services running that a single price could not fund, the standard defence of peak and off-peak pricing. The equity question cuts the other way when the inelastic group is inelastic because it is desperate rather than wealthy, as with insulin.

Application

Insulin: three firms hold the market behind patents; the US price rose from about $40 to $300 a vial between 2002 and 2020 against a manufacturing cost of roughly $5, before political pressure forced cuts of around 70% in 2024. In an answer: patents are the barrier, the price-cost gap is the supernormal profit rectangle, and the 2024 reversal shows the profit was contestable by politics if never by entry.
Google: around 92% of global search, protected by network effects and default agreements; the EC levied fines totalling €8.25bn across its 2017–2019 cases. Use it to show barriers that fines do not remove, then AlphaFold as the honest dynamic-efficiency counterweight.
Retail banking: the CMA's 2016 investigation found weak competition costing about £1bn a year in excess charges, with savings rates near 0.01% while base rates sat at 0.5%. The power source is customer inertia: only around 3% switch each year.
Airlines and loyalty data: yield management means one flight can carry twenty or more simultaneous price points, and supermarket loyalty schemes give firms the customer data that personalised pricing needs. Use these to show the information condition for price discrimination being engineered in practice.

Building the paragraph

The market power chain below applies the monopoly model to UK retail banking. Topic sentence first, stating mechanism, direction and headline evidence:

Because switching costs make demand for current accounts highly inelastic, the Big 4 banks can price like monopolists despite there being four of them, which is why the CMA found in 2016 that customers were paying around £1bn a year in excess charges.

Establish structure: Lloyds, Barclays, HSBC and NatWest hold 84% of current accounts, and only around 3% of customers switch each year, with 40% having stayed 10 years or more.
Inertia is the power source: because customers rarely leave, each bank faces a steep, inelastic demand curve and becomes a price maker.
Draw the monopoly diagram (this is your diagram step): profit maximisation at MC = MR restricts the value offered, prices sit above the competitive level, and the supernormal profit rectangle is shaded between P_m and AC.
Apply the prediction: near-identical overdraft fees of about £15 a month across the Big 4 from 2016 to 2019, and savings rates held at 0.01% while base rates were 0.5% through 2010–20.
Add the second inefficiency: with competition weak, X-inefficiency let branch staff costs per account rise in real terms from 2008 to 2016 even as branches closed.
Quantify and link back: the CMA put the excess charges at around £1bn a year, plus £500m in SME overdraft charges, so concentration plus inertia delivers the allocative and productive failures the model predicts.

Evaluation

Evaluating this, the chain depends on barriers staying high, and in banking regulators have been dismantling them deliberately.

The condition: monopoly pricing persists only while entry and switching stay difficult; the power source here is inertia, and inertia can be engineered away.
The evidence: the New Bank Start-up Unit (2014), seven-day switching and Open Banking (2018) took challenger banks from 0 to around 15% of the market between 2014 and 2024, and overdraft fees have fallen by roughly half since 2018.
Cross-examine it: switching is still only about 3% a year, so the discipline operates at the margin, on the customers most likely to move, while the inert majority keeps paying.
Bounded conclusion: the £1bn harm was real and is now eroding where policy lowers barriers; monopoly power in banking is best read as declining with contestability rather than abolished by it.

Key terms

Term	Precise definition	Where it earns marks
Monopoly power	The ability to set price above marginal cost because the firm faces a downward-sloping demand curve; treated in UK policy as arising at 25% market share.	Opening the analysis without needing a literal single seller.
Barriers to entry	Obstacles (scale economies, sunk costs, patents, network effects, brand) that prevent new firms competing away supernormal profit.	Explaining why supernormal profit persists in the long run.
Deadweight loss	The surplus lost to society when output is restricted below the level where price equals marginal cost.	The welfare punchline of the monopoly diagram (AO3, and AO4 magnitude).
X-inefficiency	Costs drifting above the achievable minimum because weak competitive pressure removes the discipline to minimise them.	A second, distinct cost of monopoly beyond allocative inefficiency.
Third-degree price discrimination	Charging different groups different prices for the same product, based on their different price elasticities of demand, where cost differences do not explain the gap.	The definition plus the four conditions is a reliable AO1 opener.
Natural monopoly	A market where economies of scale are so large relative to demand that one firm can supply at lower average cost than two or more could.	The strongest defence of monopoly, and the case for regulation over break-up.

Towards the exam

1. Between 2002 and 2020 the US price of insulin rose from about $40 to $300 a vial, against a manufacturing cost of roughly $5, before price cuts of around 70% in 2024. Evaluate the costs and benefits of monopoly power in pharmaceutical markets. (25)

2. An airline's yield management system can sell seats on a single flight at twenty or more different prices at the same time. Evaluate whether price discrimination of this kind is likely to benefit consumers. (25)

3. Building a second national broadband network has been estimated to require around £30bn of largely duplicated infrastructure. Evaluate the view that a regulated natural monopoly serves consumers better than forced competition would. (25)

Then take it to the marking desk for feedback →