Market Failure & Externalities
Allocation of Resources
The syllabus lists alongside externalities and public goods as a term associated with market failure, and names the abuse of monopoly power as one of its causes.
A monopoly is a market dominated by a single firm (or, more loosely, one firm with a very large share of the market). With no close competitor to undercut it, the firm has the power to set its own price rather than accept the market price.
A monopoly causes market failure through one main mechanism the syllabus tests directly: restricted supply causing higher prices.
- To maximise its profit, a monopolist restricts the quantity it supplies below the level a competitive market would produce.
- With less of the good available, the price rises above the competitive level.
- Consumers therefore pay more and consume less than is socially desirable, so resources are misallocated — the hallmark of market failure.
A monopoly can also harm consumers in other ways: with no competition, there is less incentive to improve quality, less choice, and less pressure to keep costs and prices down, while the firm earns high (supernormal) profit. (A monopoly is not always harmful — a large single firm may achieve economies of scale and fund research — but the abuse of monopoly power is what makes it a market-failure concern.)
Governments respond to the abuse of monopoly power through competition policy, price regulation, or measures to encourage new firms to enter and compete.