Command term: Explain

Key terms to define: welfare loss, monopoly power.

Responses should also include the following:

A brief explanation of how monopolies are able to use their dominant position in order to gain abnormal profits.  Welfare loss, sometimes called deadweight loss occurs when the welfare of the society is not maximised, with firms producing below the allocatively efficient level, where MC = AR.   

A recognition that in monopoly we normally assume that prices are higher and output lower due to the monopolist restricting supply to force prices (AR) above marginal cost.  This is illustrated by the diagram showing equilibrium price (Pm) above the socially optimum level and output at Q2, below the allocatively efficient level of Q1.  The level of abnormal profit enjoyed by the monopolist is made at the expense of the consumers, who are forced to pay a higher price than the marginal cost of producing the product. 

Examples of excessive profit making by monopolies, for example the excessive profits made by some pharmaceutical firms, who have reportedly driven up the prices of vital life saving drugs in situations where they have been able to establish a monopoly position.

Command term: Examine

Key terms to define: abnormal profit, barrier to entry, short run, long run.

Real world examples might include industries where the small number of firms operating in the market have successfully restricted access to the market by high entry barriers e.g. oil exploitation business, soft drinks companies (coke and pepsi) as well as examples of businesses that have maintained a virtual monopoly over a local market.

Responses should also include the following:

In all market structures businesses in the short run, though a combination of market conditions and external circumstances, will find themselves in a position where the business is making abnormal profit. 

In perfectly competitive markets the absence of entry barriers will mean that the business returns to normal profit in the long run as new firms enter the market and force down the equilibrium price.  However, In monopoly the abnormal excessive profits can be retained because firms in those industries are able to maintain high barriers to entry which prevents new entrants from joining the industry and maintains market supply at the same level.  

Similarly when the industry is facing difficult trading conditions and making a loss or even normal profit the monopolist is able to force up prices by restricting supply.  As the only firm in the industry their own supply is the same as the industry supply.  This is represented by output level Q on the diagram which provides abnormal profit for the business. 

Examples of barriers to entry include legal, financial, brand loyalty, economies of scale as well as natural monopolies. Because of the command term examine, in this response candidates would also be expected to consider the validity of the arguments presented and reach a conclusion as to how important barriers to entry are in ensuring abnormal long run profits.