WSU Lexicon: Economics

Monopoly

A monopoly is a market structure with a single seller of a product that has no close substitutes, protected by high barriers to entry. The monopolist faces the entire market demand curve, so it is a price maker and maximises profit where marginal revenue equals marginal cost.

It sits at the opposite end of the market-structure spectrum from perfect competition.

The entry

Why Marginal Revenue Sits Below Price

Because the single seller faces the whole downward-sloping market demand curve, selling an extra unit requires cutting the price on every unit sold, not just the marginal one. Marginal revenue therefore equals price minus the revenue lost on inframarginal units, and lies strictly below price at every positive quantity. Written out, marginal revenue equals price multiplied by one minus the reciprocal of the absolute value of the price elasticity of demand. Two consequences follow. First, marginal revenue is negative whenever demand is inelastic, so a profit-maximising monopolist always operates on the elastic portion of its demand curve. Second, setting marginal revenue equal to marginal cost produces a quantity at which price exceeds marginal cost, and the gap, expressed as the Lerner index of price minus marginal cost divided by price, equals the reciprocal of the elasticity.

The entry

What Actually Sustains a Single Seller

Monopoly power is a statement about barriers, not about firm size. The recognised sources are control of a critical input or distribution channel, legally granted exclusivity such as patents, copyrights and utility franchises, and cost structures in which a single producer supplies the market more cheaply than several could. This last case, natural monopoly, arises where large fixed costs and low marginal costs make long-run average cost decline across the relevant range of output, as in electricity transmission, water networks and rail track. Network effects and high switching costs can produce similar durability in platform markets without any formal legal protection.

Barriers erode. Patents expire, substitute technologies appear, and new resource discoveries dilute supply control, which is why observed monopoly rents tend to be temporary rather than perpetual.

The entry

Regulatory Response and Price Discrimination

Because the unregulated outcome restricts output and creates deadweight loss, regulators intervene through price caps, rate-of-return rules or antitrust action. Marginal cost pricing restores allocative efficiency but forces a natural monopolist to operate below average cost, generating losses that require subsidy. Average cost pricing, the more common compromise, allows the firm to break even including a normal return while pushing output beyond the profit-maximising level.

Price discrimination offers the firm a different route. Charging different customers different prices for the same good, where resale can be prevented and buyer groups differ in elasticity, raises output above the single-price level and captures consumer surplus. Perfect first-degree discrimination eliminates deadweight loss entirely while transferring all surplus to the seller.

The entry

Level I Exam Application

Candidates should be able to derive the marginal revenue function from a linear demand curve, noting that it has the same intercept and twice the slope, solve for the profit-maximising quantity where it meets marginal cost, then read the price off the demand curve rather than off the marginal revenue curve. Confusing the two is the most common arithmetic error in these questions.

Equally testable is measurement of market power. Concentration ratios sum the shares of the largest firms but ignore mergers among smaller players and say nothing about barriers or elasticity. The Herfindahl-Hirschman index, the sum of squared percentage market shares, weights larger firms more heavily and responds correctly to mergers, though neither measure captures potential entry or substitution from adjacent markets.

Common trap

“A monopolist can charge whatever price it likes and is guaranteed an economic profit.”

Pricing power is bounded by the market demand curve: raising price always reduces quantity sold. And if average total cost lies above the demand curve at every output, even a monopolist makes losses and may shut down.

In practice

De Beers and the rough diamond market

For much of the twentieth century De Beers controlled the majority of global rough diamond supply, restricting volumes released to the market to support prices. Its share and pricing power eroded as new producers in Canada, Russia and Australia emerged.

Candidates ask

Questions on this term

Why does a monopolist produce less than a competitive industry would?Marginal revenue lies below price on a downward-sloping demand curve, so equating marginal revenue with marginal cost yields an output where price exceeds marginal cost. Value-creating units go unproduced, and that gap is the deadweight loss.
Does a monopolist have a supply curve?No. A supply curve maps price to quantity supplied independently of demand, which only makes sense for a price taker whose marginal cost curve performs that mapping. A monopolist chooses quantity where marginal revenue equals marginal cost and then sets price from demand, so the same marginal cost curve produces different price-quantity pairs depending on the shape and elasticity of demand.
Can a monopolist earn zero or negative economic profit?Yes. Profitability depends on whether price at the optimal output covers average total cost. If demand is weak relative to the cost structure, the best available outcome may still be a loss, and the firm shuts down in the long run. A regulated natural monopoly held to average cost pricing earns only a normal return, meaning zero economic profit by construction.

Related entries

Monopolistic CompetitionMonopolistic competition is a market structure with many sellers offering differentiated but close-substitute products, low barriers to entry, and modest pricing power.
OligopolyAn oligopoly is a market structure in which a small number of sellers dominate an industry, each large enough that its pricing and output choices materially affect rivals.
Perfect CompetitionPerfect competition is the market structure in which many small firms sell an identical product, face no meaningful barriers to entry or exit, and have no pricing power.
Price Elasticity of DemandPrice elasticity of demand measures the responsiveness of quantity demanded to a change in a good's own price, calculated as the percentage change in quantity demanded divided by the percentage change in price.

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Monopoly

It sits at the opposite end of the market-structure spectrum from perfect competition.