Introduction and assumptions of monopoly

A monopoly represents one extreme of the market structure spectrum. At the other end lies perfect competition, where there are many buyers and sellers, each too small to influence the market price, and where there are no barriers to entry or exit. A monopoly stands in stark contrast to this picture. By definition, a monopoly is a market structure in which there is a single seller of a good or service. This seller may control the entire supply of the product within a given industry or geographical area, and this means that the monopolist faces the entire market demand curve directly. Because there are no close substitutes for the product supplied, and because the monopolist is the only firm producing it, consumers wishing to purchase that good or service must buy from the monopolist.

The model of monopoly rests on several key assumptions. These assumptions are important because they frame the behaviour of the firm, the outcomes for consumers, and the wider effects on efficiency and welfare.

First, the monopolist is assumed to maximise profits. This means that the firm selects the level of output and the price that allows it to achieve the greatest possible difference between total revenue and total cost. Profit maximisation occurs where marginal revenue equals marginal cost. This principle applies in monopoly just as it does in other market structures, but the nature of the demand curve faced by the monopolist changes the outcome significantly.

Second, the market contains only a single seller of the good. The existence of a sole producer removes the competitive pressure that characterises markets with many firms. The monopolist therefore acts as a price maker rather than a price taker. In perfect competition, firms accept the market price as given because no single firm is large enough to influence it. By contrast, a monopolist has the power to influence the price level directly through its own production decisions, although it cannot set prices entirely without constraint. The monopolist remains bound by the shape and position of the market demand curve. If the firm sets a higher price, the quantity demanded will fall; if it sets a lower price, the quantity demanded will rise. Nevertheless, the firm can select a point along the demand curve, and therefore it enjoys market power that firms under perfect competition do not.

Third, there are no substitutes for the good, either actual or potential. This assumption is crucial because the presence of substitutes would weaken the monopolist’s control over the market. If consumers could easily switch to a substitute product, the monopolist would not have the same degree of pricing power. The absence of substitutes makes the monopolist’s product unique, cementing the firm’s dominant position. The uniqueness may be based on the physical characteristics of the product, legal protections such as patents, control over raw materials, or consumer loyalty built up over time.

Fourth, there are barriers to entry into the market. These barriers ensure that no new firms can enter to compete away the monopoly’s profits. In a perfectly competitive market, supernormal profits attract new entrants, which eventually erode profitability until only normal profits remain. In a monopoly, barriers to entry prevent this adjustment process from occurring. The monopolist can therefore protect its market position and maintain profits in both the short run and the long run. Without barriers, monopoly would be unstable, as potential rivals would be able to capture part of the market.

Taken together, these assumptions make clear why monopoly sits at the extreme end of the market structure spectrum. It embodies the maximum possible concentration of market power in a single firm. In practice, few industries satisfy all of these assumptions perfectly, but the model provides a benchmark against which real-world situations can be compared. The monopolist’s position is strongest when there is indeed only one producer, no close substitutes, significant barriers to entry, and the firm’s objective is profit maximisation.

Barriers to entry

A defining feature of a monopoly is the existence of barriers that prevent new firms from entering the market. These barriers are what allow a monopolist to preserve its dominant position over time and to maintain profits that would otherwise be eroded under competitive pressure. In markets without barriers, the appearance of new firms would steadily increase supply, driving prices down and reducing the abnormal profits of any single producer. The continuation of monopoly power, therefore, depends critically on the strength and persistence of these barriers. Several distinct categories of barriers to entry can be identified.

Economies of scale

Economies of scale are one of the most powerful barriers to entry. They arise when the average cost of production falls as output increases. This effect occurs because fixed costs can be spread over a larger volume of production, and because large firms may benefit from specialisation, bulk purchasing, and the use of advanced technologies. When a monopoly firm enjoys substantial economies of scale, it can produce at a lower average cost than any smaller potential entrant. This cost advantage allows the monopolist to supply at a price that remains profitable for itself but is below the cost level of potential rivals.

Suppose, for example, that the minimum efficient scale of production in an industry, the lowest level of output at which average costs are minimised, is very large compared to the overall size of market demand. In this case, a new entrant would have to produce at a very high output level to achieve efficient costs, but the market may not be large enough to sustain more than one such producer. The monopolist, therefore, secures a lasting advantage, since it can consistently undercut rivals on cost. In effect, the monopolist can deter entry simply by virtue of its scale of operation.

High fixed costs

Closely related to economies of scale are the effects of high fixed costs. If the cost of establishing production facilities, research laboratories, or distribution networks is very large, potential entrants face a daunting barrier before they can even begin to compete. Unlike variable costs, fixed costs must be incurred regardless of the level of output, so they represent a substantial risk to new firms.

Consider a scenario in which a new entrant would need to invest heavily in plant and equipment before being able to supply a single unit. If the market is uncertain or if the incumbent monopolist is already entrenched, the prospect of such high initial outlays may deter entry altogether. Existing monopolists can also reinforce this barrier by continuing to invest heavily themselves, thereby raising the scale of expenditure required of any challenger.

Cost advantages

A monopoly may hold absolute cost advantages unrelated to economies of scale. Such advantages might stem from exclusive access to key raw materials, control of distribution channels, or locational benefits. For instance, if a firm controls a scarce natural resource essential to production, potential entrants cannot access that input at all. Alternatively, if the monopolist has secured contracts or rights over transport and logistics, newcomers will find it difficult to distribute their products effectively.

Locational advantages can also be decisive. A firm that is geographically close to its suppliers or its main consumer base may operate at significantly lower cost than rivals who are forced to incur higher transportation expenses. These absolute cost advantages, once established, provide strong insulation against competition.

Government regulation

In many cases, barriers to entry are reinforced or even created by government regulation. Legal protection may be offered to certain firms through patents, copyright, or licences. For example, if a firm develops a new technology and secures a patent, it gains exclusive rights to exploit that innovation for a fixed period. During that time, no rival is permitted to produce or sell the same product. This legal barrier ensures that the innovating firm enjoys temporary monopoly power.

Licensing regimes can also play a role. Governments may require firms to obtain special licences to operate in industries such as broadcasting, telecommunications, or pharmaceuticals. By restricting the number of licences granted, governments effectively limit the number of firms in the market. These regulatory barriers are often justified as a means of protecting consumers, encouraging research and development, or ensuring that industries meet safety and quality standards. Nonetheless, their effect is to sustain monopoly positions.

Switching costs

Switching costs are the costs consumers face when moving from one supplier to another. They can create a psychological and financial barrier that discourages consumers from abandoning an incumbent monopolist. Such costs may be contractual, as when a consumer is tied into a fixed-term agreement with penalties for early termination. They may also be practical, such as the time and effort required to learn how to use a new product or system.

An example is the software industry, where firms such as Microsoft have benefited from customers’ reluctance to incur the costs of learning new systems. Even if a rival product offers better value, the expense and inconvenience of switching may keep consumers locked into the existing provider. High switching costs, therefore, act as an indirect barrier to entry by limiting the potential customer base available to new firms.

Strategic action

Monopolists may engage in deliberate strategic behaviour to create or reinforce barriers. This can take many forms, such as predatory pricing, where the incumbent temporarily sets prices below cost in order to drive potential entrants out of the market. Once the threat has subsided, the monopolist can raise prices again. Another form of strategic action involves patenting technologies not necessarily intended for commercial use but specifically to prevent rivals from exploiting them. The incumbent thereby blocks avenues of entry before competitors can establish themselves.

Strategic action may also involve building excess capacity that signals to potential entrants that the incumbent is prepared to flood the market with supply in response to new competition. This credible threat deters entry, since rivals expect to face aggressive retaliation.

Network effects

Finally, some products exhibit network effects, where the value of the product to each user increases as more people adopt it. Social media platforms, software file formats, and operating systems often display this characteristic. If the monopolist’s product becomes the industry standard, new entrants find it very difficult to attract users, since consumers prefer to remain within the established network.

A well-known example is Adobe’s PDF format, which became so widely used that any attempt to introduce an alternative faced enormous resistance. Because consumers benefit from using the same format as others, they are reluctant to switch, and this further entrenches the incumbent monopolist. Network effects, therefore, create self-reinforcing barriers that strengthen over time.

The monopoly model and profit maximisation

The starting point for analysing monopoly is to recognise that, unlike firms under perfect competition, a monopolist does not take the market price as given. Instead, because it is the sole supplier, the monopolist faces the entire market demand curve directly. This means that the firm is a price maker rather than a price taker. The demand curve represents the relationship between the price the firm charges and the quantity consumers are willing to buy.

Since the demand curve slopes downward, the monopolist can only sell a higher quantity by lowering the price. This is a crucial distinction. Under perfect competition, each firm faces a horizontal demand curve because its output is negligible relative to the market. For the monopolist, by contrast, the demand curve is the same as the market demand curve itself.

Average revenue and marginal revenue

The downward-sloping demand curve is also the firm’s average revenue (AR) curve, because average revenue is defined as total revenue divided by quantity sold, and this equals price. However, the monopolist also faces a separate marginal revenue (MR) curve, which lies below the AR curve. This occurs because in order to sell additional units, the firm must reduce the price not just on the extra unit but on all previous units as well.

For example, if the monopolist sells 10 units at £10 each, total revenue is £100. If it then lowers the price to £9 to sell 11 units, total revenue rises to £99. The marginal revenue of the 11th unit is therefore only -£1 (a fall in revenue compared with before), even though the price charged is £9. This example shows why the MR curve lies below AR. Marginal revenue falls faster than average revenue, and eventually becomes negative if the firm continues reducing price.

The monopolist as a profit maximiser

The monopolist, like any other firm, aims to maximise profits by producing at the level of output where marginal revenue equals marginal cost. At this point, the extra revenue from selling one more unit equals the extra cost of producing it, so profits are maximised. Producing more would add more to cost than to revenue, while producing less would leave potential profits unexploited.

Once the profit-maximising output, Qm, is identified at the intersection of MR and MC, the monopolist sets the corresponding price. This is found by tracing vertically upward from Qm to the demand curve (AR). The price, Pm, is therefore higher than would prevail under perfect competition, and the output Qm is lower. This combination reflects the monopolist’s ability to restrict output in order to raise price.

Supernormal profits in the short and long run

At the profit-maximising price and output, the monopolist typically makes supernormal profits, provided that price exceeds average cost (P > AC). These supernormal profits are represented by a rectangle on the diagram: the difference between price (Pm) and average cost at Qm (ACm), multiplied by the quantity Qm.

What distinguishes monopoly from perfect competition is that these supernormal profits can be maintained in the long run. In perfect competition, supernormal profits attract new entrants, which increase supply and drive down price until only normal profits remain. But in a monopoly, barriers to entry prevent this process. Rival firms are unable to enter the market to compete away the incumbent’s profits. As long as the barriers hold, the monopolist can continue to enjoy supernormal profits indefinitely.

This feature explains why monopolies are often criticised for inefficiency and consumer harm. High profits can persist without the discipline of competition, allowing the monopolist to charge higher prices and restrict output compared with competitive outcomes.

The role of elastic and inelastic demand

Another important point is that the monopolist will never choose to operate in the inelastic portion of the demand curve. If demand is inelastic, lowering output raises total revenue because consumers reduce their purchases only slightly when faced with higher prices. At the same time, reducing output lowers costs. This means profits rise as output is restricted further. Therefore, the monopolist always produces in the elastic range of demand, where marginal revenue is still positive.

When monopolies may incur losses

Although a monopoly is often associated with high profits, the possibility of losses still exists if costs are particularly high relative to demand. If average costs lie above the demand curve at the profit-maximising output, the monopolist will make a loss even though it still produces at MR = MC. In such a case, the shaded rectangle between AC and AR at Qm represents a loss area.

This outcome highlights that monopoly power is not a guarantee of profitability. The size and position of profits depend on the relative location of the demand and cost curves.

Monopoly and efficiency

Productive efficiency

A firm is said to be productively efficient if it produces at the minimum point of its long-run average cost curve. At this point, the firm uses resources in such a way that the cost per unit of output is minimised. Under perfect competition, the pressures of entry and exit drive firms toward this condition because firms producing at a higher-than-minimum average cost are eventually forced out of the market.

For a monopolist, however, there is no guarantee that productive efficiency will be achieved. The firm maximises profits where marginal revenue equals marginal cost, and this point may or may not coincide with the minimum of the average cost curve. If the intersection of MR and MC happens to occur at the minimum of AC, then productive efficiency is achieved, but this would occur only by coincidence. More typically, the profit-maximising output lies to the left of the minimum point of AC, meaning that the firm is producing at a higher average cost than necessary. This represents a waste of resources compared with the benchmark of productive efficiency.

Allocative efficiency

Allocative efficiency occurs when resources are distributed in such a way that the value consumers place on the last unit consumed equals the cost of producing it. In economic terms, this is where price equals marginal cost (P = MC). At this point, the social welfare from consumption is maximised, because the price consumers are willing to pay reflects the benefit they receive, and this is exactly equal to the cost of production.

In monopoly, however, allocative efficiency is rarely achieved. At the profit-maximising output Qm, price is set above marginal cost because the monopolist traces price up to the demand curve rather than charging P = MC. This means that consumers are paying more than the cost of production, and output is restricted below the socially optimal level.

The result is a welfare loss. The deadweight loss triangle shows the reduction in consumer and producer surplus that arises because fewer units are produced and sold than would occur under a competitive market. Consumers who would have valued additional units more than their cost of production are denied the opportunity to buy them, and society therefore loses the potential welfare these transactions could have generated.

X-inefficiency

Beyond productive and allocative efficiency, monopoly may also suffer from X-inefficiency. This term refers to the situation where a firm’s costs are higher than necessary because of a lack of competitive pressure. In competitive markets, firms are forced to operate at maximum efficiency because inefficiencies quickly erode profits and threaten survival. Monopolists, by contrast, may not face the same discipline.

Without rivals threatening their position, managers may allow slack to creep in. Costs may rise because of over-employment, complacency, or poor organisational practices. Firms may fail to minimise waste or may indulge in unnecessary expenditures. In this sense, the monopolist is not even minimising costs given the existing technology — it is operating inside its own cost frontier. X-inefficiency therefore compounds the productive inefficiency already present under monopoly, further reducing overall welfare.

Dynamic efficiency

Although monopolies may fail in terms of productive and allocative efficiency, they may still offer advantages in relation to dynamic efficiency. Dynamic efficiency concerns the optimal rate of innovation and investment in new products and processes over time. This requires the ability and incentive to engage in research and development, and often large financial resources to bear the associated risks.

Monopolists, by virtue of earning supernormal profits in the long run, may have both the funds and the motivation to invest in innovation. These profits can finance research that smaller competitive firms could not undertake. By investing in new technologies, monopolists may be able to lower costs in the future, introduce new products, and improve consumer welfare in ways that competition alone may not achieve.

However, the incentive for dynamic efficiency depends on the monopolist’s outlook. If the firm becomes complacent, it may use profits simply for shareholder dividends or managerial perks rather than research. On the other hand, if the monopolist recognises the threat of potential competition or wishes to maintain long-term dominance, it may channel profits into R&D. In this sense, monopoly can either hinder or enhance innovation, depending on context.

Advantages and disadvantages of monopoly

Although a monopoly is often viewed negatively because of high prices and restricted output, the picture is not entirely one-sided. Monopolies can, under certain conditions, generate advantages that benefit consumers and society. At the same time, their drawbacks are significant and have been the subject of economic criticism for centuries. A balanced analysis requires considering both sides.

Potential advantages of monopoly

Economies of scale.
A key potential advantage of monopoly lies in its ability to exploit economies of scale. Because the monopolist is often a large firm serving the entire market, it can operate at a scale that drives down average costs. These savings may be passed on to consumers in the form of lower prices than would be possible in a fragmented, competitive industry where each firm is too small to achieve the same cost efficiency.

For example, large infrastructure industries such as water supply or electricity distribution are natural monopolies precisely because economies of scale are so extensive. In these sectors, duplicating networks with multiple firms would be wasteful. A single supplier can spread the enormous fixed costs across a large customer base, reducing unit costs.

Research and development.
Supernormal profits provide the monopolist with resources to invest in research and development. In highly competitive markets, the need to survive often leaves firms with little spare profit to finance innovation. Monopolists, by contrast, can use their long-run profits to fund risky projects and long-term research. This potential for dynamic efficiency means that monopolies may be the source of important technological advances that raise productivity and benefit consumers in the future.

Cross-subsidisation of products or regions.
A monopolist supplying a wide range of goods or operating across different areas may be able to cross-subsidise. Profits from more lucrative markets can be used to support provision in less profitable ones. For example, a transport operator with a monopoly may run services to remote areas that would not be viable if left to smaller competing firms, thereby providing wider coverage for consumers.

Stable prices and security of supply.
Monopolists, by controlling the market, can sometimes provide greater stability in pricing and output than would occur under fragmented competition. In industries where volatility could be harmful to consumers, for instance, utilities, a monopoly may avoid the disruptive price wars and supply fluctuations associated with many small firms competing aggressively.

Disadvantages of a monopoly

Higher prices and restricted output.
The central disadvantage of monopoly is that consumers usually face higher prices and reduced availability of goods compared with perfect competition. The monopolist produces at Qm, where MR = MC, and charges Pm, which lies above the allocatively efficient price. The result is a transfer of surplus from consumers to the monopolist and a deadweight welfare loss.

Allocative and productive inefficiency.
As explained earlier, monopoly output is below the level that maximises social welfare, and price exceeds marginal cost. This outcome represents allocative inefficiency because not enough resources are devoted to producing the good relative to consumer demand. Monopolists may also fail to achieve productive efficiency if they do not operate at the minimum point of average cost. Society therefore suffers from both under-production and higher unit costs.

X-inefficiency.
The lack of competition means monopolists may become complacent and inefficient internally. Costs may rise unnecessarily through waste, excessive staffing, or managerial slack. Consumers then pay higher prices than would be necessary if the firm were under pressure to cut costs.

Consumer choice is limited.
Monopoly reduces variety and consumer sovereignty. In competitive markets, consumers have a wide choice among products and suppliers. In monopoly, they are forced to buy from a single firm, often at a standardised quality and range. The lack of alternatives means that consumer preferences are less well served.

Potential for abuse of market power.
Monopolists may exploit their position by engaging in unfair practices such as predatory pricing against small rivals, price discrimination that extracts higher payments from certain consumers, or lobbying governments to reinforce their protected position. Such actions may entrench monopoly further and harm both competitors and consumers.

Evaluation

Whether monopoly is beneficial or harmful depends on context. If economies of scale are strong, if supernormal profits are channelled into innovation, and if regulation ensures fair prices, monopolies may deliver outcomes comparable to or even better than competition. However, if barriers to entry simply allow complacency, high prices, and inefficiency, monopoly clearly damages welfare. Economists, therefore, often advocate oversight of monopolies through regulation, nationalisation, or encouragement of competition wherever possible.

Natural monopoly, nationalisation, privatisation, and regulation

Natural monopoly

A natural monopoly arises when the cost structure of an industry is such that a single firm can supply the entire market at a lower average cost than two or more firms could. This situation typically occurs when there are very large economies of scale relative to the size of the market.

Industries such as water distribution, electricity transmission, and rail infrastructure are common examples. In these cases, the fixed costs of building networks, laying pipelines, installing cables, or constructing track are substantial enough, while the marginal cost of serving an additional customer once the network exists is relatively low. As output expands, average costs continue to fall across the entire range of likely demand.

Because average costs decline as output increases, one firm operating alone can achieve a cost level that multiple firms cannot match. If several firms attempted to operate, each would duplicate fixed facilities, raising overall costs. Hence, a monopoly is the most efficient market structure for industries of this type.

The problem of monopoly pricing in natural monopolies

Although natural monopolies may be efficient in production terms, they still face the same incentives as other monopolists when setting price and output. Left unregulated, a natural monopolist will produce at the profit-maximising point where MR = MC and charge a price above marginal cost. This creates the familiar welfare loss associated with monopoly, with price higher and output lower than socially optimal.

The difficulty is that marginal cost pricing, which would deliver allocative efficiency, is often impractical for natural monopolies. Because of the huge fixed costs, the average cost of production lies above marginal cost across the relevant range of output. If the firm were forced to charge P = MC, price would fall below average cost, meaning the firm could not cover its total costs and would make a loss.

Nationalisation as a solution

Historically, many governments chose to nationalise natural monopolies to solve this problem. Under public ownership, the monopoly is operated not for private profit but to serve the public interest. This allows the state to set prices closer to marginal cost, even if this means running the firm at a financial loss. The deficit can be financed by general taxation.

Nationalisation can therefore achieve allocative efficiency while ensuring universal provision of essential services such as water, gas, and railways. The state can also cross-subsidise between regions, ensuring that even remote or less profitable areas receive service. The trade-off, however, is that public monopolies may suffer from inefficiency, lack of innovation, and political interference in decision-making.

Privatisation

From the late twentieth century onward, many countries shifted toward the privatisation of nationalised industries. The argument was that private ownership would encourage greater efficiency, innovation, and responsiveness to consumer needs. By exposing firms to the profit motive, governments hoped to reduce waste and stimulate investment.

However, privatised natural monopolies could still exploit market power. Without competition, they might restrict output and raise prices just as before. To prevent this, privatisation was usually accompanied by regulation. Independent regulatory agencies were established to oversee prices, service quality, and investment commitments.

Regulation of monopolies

Regulation attempts to combine the efficiency of private management with safeguards against abuse of market power. Several methods of regulation can be identified.

Price capping.
Regulators may impose a cap on the maximum price a monopolist can charge. A common method is the RPI – X formula, where the allowed annual price rise is linked to the retail price index (RPI) minus an efficiency factor (X). This formula encourages firms to cut costs because they can keep the gains from efficiency improvements, but consumers benefit from lower prices over time.

Rate-of-return regulation.
Another approach is to allow the firm to set prices that generate only a fair rate of return on capital. While this ensures the firm can cover costs and finance investment, it may blunt incentives to reduce costs, since firms are guaranteed a return regardless of efficiency.

Performance standards and quality regulation.
Regulators can also impose requirements regarding service quality, reliability, and investment. This prevents monopolists from cutting costs in ways that harm consumers, such as reducing maintenance or neglecting innovation.

Balancing efficiency and fairness

The challenge for governments is to strike the right balance. On one side, monopolies may exploit consumers if left unchecked. On the other hand, heavy intervention may discourage investment and innovation. Nationalisation ensures universal service but may be prone to inefficiency. Privatisation harnesses private incentives but requires regulation to protect the public interest.

Thus, natural monopolies illustrate a key dilemma in economic policy: how to reconcile the efficiency of scale economies with the risks of market power.

Price discrimination

Price discrimination occurs when a monopolist (or any firm with market power) charges different prices to different consumers for the same good or service, when these price differences are not explained by differences in production costs. The key aim is to extract more consumer surplus and convert it into producer surplus, thereby increasing profits.

In a single-price monopoly, the firm must charge all consumers the same price, determined by the demand curve at the profit-maximising output. Consumer surplus remains above this price, representing the difference between what some consumers would have been willing to pay and what they actually pay. Price discrimination allows the monopolist to capture part of this surplus by charging higher prices to those with greater willingness or ability to pay.

For price discrimination to occur, three essential conditions must be met:

1. The firm must have market power, so that it faces a downward-sloping demand curve and can influence price.

2. It must be possible to separate consumers into different groups based on willingness to pay or elasticity of demand.

3. The firm must be able to prevent resale or arbitrage between groups. Otherwise, low-priced units could simply be resold to high-paying consumers, undermining the strategy.

First-degree (perfect) price discrimination

First-degree price discrimination occurs when the monopolist charges each consumer the maximum they are willing to pay for each unit. In this case, the firm captures the entire area of consumer surplus, leaving consumers with no surplus at all. Every unit up to the point where price equals marginal cost is sold, so allocative efficiency is actually achieved. However, all the welfare is appropriated by the producer rather than shared with consumers.

While perfect price discrimination is rare in reality and mostly occurs in auctions, it represents an important theoretical extreme. Some modern technologies, such as personalised online pricing, can approximate it more closely.

Second-degree price discrimination

Second-degree price discrimination involves charging different prices depending on the quantity purchased or the version of the product chosen. Bulk discounts, “buy-one-get-one-free” offers, and different product versions (standard vs premium) are common examples. Here, consumers self-select into different price categories depending on their willingness to pay.

For instance, a firm may offer electricity at one price for the first 100 units and at a lower price for subsequent units. High-usage consumers then pay lower average prices than low-usage consumers. The firm increases revenue by capturing more of the surplus of low-demand consumers while still selling additional units to those with higher demand.

Third-degree price discrimination

Third-degree price discrimination is the most common and occurs when the monopolist divides consumers into distinct groups based on demand elasticity and charges each group a different price. Examples include student discounts, senior citizen pricing, peak vs off-peak transport fares, and regional price variations.

The principle is straightforward: the group with less elastic demand (less sensitive to price changes) is charged a higher price, while the group with more elastic demand is charged a lower price. This maximises total profit because the monopolist equates marginal revenue with marginal cost in each sub-market.

Welfare effects of price discrimination

The welfare consequences of price discrimination are complex. On the one hand, compared with a single-price monopoly, price discrimination may increase total output, because consumers in more elastic groups gain access at lower prices. This can reduce the deadweight loss of monopoly. Some consumers who would not have purchased at the uniform monopoly price now do so at a discounted price. In this sense, price discrimination can improve allocative efficiency.

On the other hand, much of the consumer surplus is transferred to the producer. Higher prices for certain groups reduce their welfare, while lower prices benefit others. The distribution of welfare, therefore, changes, often in favour of the monopolist.

Overall, price discrimination increases producer surplus, may increase total welfare, but reduces consumer welfare for those facing higher prices. The outcome depends on the balance between efficiency gains from expanded output and distributional losses from reduced consumer surplus.

Real-world prevalence

Although perfect price discrimination is rare, forms of second- and third-degree discrimination are widespread. Airlines use complex pricing strategies to charge different fares for the same seat based on booking time, flexibility, and passenger characteristics. Utilities use block tariffs. Software companies offer student and business licences at different prices. These practices demonstrate how monopolists and firms with market power exploit differences in demand elasticity to maximise revenue.