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Essay Plan: Limits on Monopoly Power

AS, A-Level, IB, BTEC National, BTEC Tech Award
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 30 Oct 2019

In this revision video we build an answer to this question: “Using applied examples of your choice, examine two factors that might limit the monopoly power of a business.”

Essay Plan: Limits on Monopoly Power

In theory, a firm with monopoly power such as Coca Cola which has over 40 percent of the US carbonated drinks market, has huge scope to keep their prices higher than they might be if they faced more intensive competition and therefore earn high supernormal profits. The existence of barriers to entry in the market such as strong brand loyalty, patents and copyrights also means that these abnormal profits persist in the long run generating higher returns for shareholders perhaps at the expense of consumer welfare. Brand loyalty makes demand for a firm’s products more price inelastic and this allows a business to set prices higher and extract consumer surplus turning it into producer surplus.

However, one constraint on monopoly power can be the role played by industry regulators who might act as a surrogate competitor even in markets where the degree of contestability is low. A good example of this in the UK has been the energy price cap imposed by OFGEM on the leading electricity and gas suppliers in what is an oligopolistic industry. A price cap constrains what a firm can charge which - in theory - leads to lower prices and a reduced level of supernormal profit. This is shown in my analysis diagram - we can see that total profit is lower, prices down and output higher than under a single price profit maximising monopoly. The impact of a regulatory price cap depends on where the ceiling is set and also whether suppliers respond to maximum prices by successfully cutting their own operating costs to protect profit margins.

In some industries, monopoly power is strong because established firms can take advantage of internal economies of scale which reduces their long run average cost (LRAC) and gives them a significant cost advantage over smaller rivals and also potential entrants. Economies of scale lead to higher profits and also make it more difficult for competitor businesses to successfully enter an industry. A good example of this might be the leading commercial banks such as Barclays, Lloyds and HSBC all of whom - under normal economic circumstances - make very high profits of hundreds of millions of £s each year. There are some challenger banks in the industry such as Metro Bank, but many are finding it hard to growth quickly enough to become a genuine threat to the incumbent operators. If these new banks make little impact, then commercial banks with market power can continue to offer low interest rates for savers and also charge more for personal and business loans. In some industries - known as natural monopolies - economies of scale are vast implying that only one supplier can fully exploit them. In this case, competition is likely to remain limited and market power will remain strong in the long run.

However, although economies of scale can give established banks a built-in advantage, market power can be eroded by the impact of new technologies. An example of this can be seen in retail banking services with the relative success of tech-savvy businesses such as Starling and the App-only bank Monzo which is currently the fastest-growing bank in the UK with over 2.5 million customers with savings deposits of over £1 billion. Many challenger firms operate with a different business model to existing firms and they can compete aggressively in price and non-price terms by targeting better what larger firms may have ignored. Their operating costs are usually much lower and they are less at risk of experiencing diseconomies of scale or X-inefficiencies that often plague firms with a dominant market position. Indeed in many sectors, technological change is reducing the barriers to entry for smaller enterprises, many of whom can use internet platforms such as Amazon web services to sell direct to customers. If entry barriers are lower, then a market becomes more contestable and monopoly power is diminished.

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