Efficiency & Market Failure – Market Dominance (Cambridge AS/A‑Level Economics 9708)
1. What is Market Dominance?
- A market is dominated when a single firm (or a small group of firms) controls a large share of total output or sales and can influence price, output and the terms of trade.
- Dominant firms can earn profits above the competitive level and may behave in ways that reduce economic efficiency.
2. Sources of Market Dominance
- Natural monopolies – high fixed costs and low marginal costs (e.g., water, electricity).
- Strategic behaviour – predatory pricing, exclusive contracts, vertical integration, price discrimination.
- Barriers to entry – legal restrictions (patents, licences), economies of scale, control of essential resources, high sunk costs.
- Network effects – the value of a product rises as more people use it (e.g., social‑media platforms, payment systems).
- Information asymmetry – dominant firms can withhold or manipulate information, discouraging entry.
3. Measuring Market Dominance
3.1 Concentration Ratio (CR)
The CRn is the combined market share of the n largest firms.
$$CR_n = \sum_{i=1}^{n} S_i$$
Cambridge thresholds for CR₄:
| CR₄ (%) | Interpretation (Cambridge) |
|---|
| 0‑25 | Low concentration – competitive |
| 25‑50 | Moderate concentration – possibly oligopolistic |
| 50‑75 | High concentration – likely dominant firms |
| 75‑100 | Very high concentration – monopoly or near‑monopoly |
3.2 Herfindahl‑Hirschman Index (HHI)
The HHI adds the squares of the market shares of *all* firms (shares expressed as whole numbers).
$$HHI = \sum_{i=1}^{N} s_i^{2}$$
Cambridge guidance (based on the UK Competition Commission):
| HHI | Market Structure |
|---|
| < 1 000 | Unconcentrated (competitive) |
| 1 000 – 1 800 | Moderately concentrated |
| 1 800 – 2 500 | Highly concentrated – dominant firms present |
| > 2 500 | Very highly concentrated – monopoly/oligopoly |
3.3 Example Calculation
| Firm | Market Share (%) | Share (whole number) | Square of Share |
| A | 40 | 40 | 1 600 |
| B | 30 | 30 | 900 |
| C | 15 | 15 | 225 |
| D | 10 | 10 | 100 |
| E | 5 | 5 | 25 |
| HHI | 2 850 |
Interpretation: HHI = 2 850 ⇒ very highly concentrated market; any merger that raises HHI by more than 100 points would attract strong antitrust scrutiny.
4. Welfare Implications of Market Dominance
4.1 Types of Inefficiency
- Allocative inefficiency – price (P) exceeds marginal cost (MC). The dead‑weight loss (DWL) is the triangular area between the demand curve, the MC curve and the monopoly price.
- Productive inefficiency – the dominant firm produces at a level where average cost (AC) is above its minimum point because competitive pressure is weak.
- Dynamic (X‑)inefficiency – actual costs exceed the lowest feasible costs due to weak discipline; also a reduced incentive to innovate.
4.2 Quantitative Illustration of DWL
Assume a linear demand P = 100 – 2Q and constant MC = 20.
- Competitive equilibrium: P = MC ⇒ 20 = 100 – 2Q → QC = 40, PC = 20.
- Monopoly MR: MR = 100 – 4Q. Set MR = MC ⇒ 100 – 4Q = 20 → QM = 20, PM = 60.
- DWL = ½ × (QC – QM) × (PM – MC) = ½ × 20 × 40 = 400.
4.3 Distributional Effects (Equity)
- Consumer surplus falls; producer surplus (super‑normal profit) rises.
- The net loss is a welfare loss that can widen income inequality (higher Gini coefficient).
- Policy tools such as price caps or targeted subsidies can be used to improve equity.
4.4 Externalities Linked to Dominance
- Negative externalities – a dominant producer may emit pollution that imposes social costs not reflected in price.
- Positive externalities – large R&D programmes in a dominant firm can generate spill‑overs that benefit the whole economy.
- Both types affect the overall welfare analysis and may justify government intervention (taxes, subsidies, regulation).
5. Market Structures & Behaviour (Syllabus 8.1‑8.3)
5.1 The Four Main Market Structures
| Structure | Key Characteristics | Typical Dominance |
|---|
| Perfect competition | Many small firms, price‑takers, homogeneous product | None |
| Monopolistic competition | Many firms, differentiated product, some price‑setting power | Limited |
| Oligopoly | Few large firms, inter‑dependent, barriers to entry | Often dominant firms |
| Monopoly (incl. natural monopoly) | Single firm, high barriers, price‑setter | Clear dominance |
5.2 Price Discrimination
- First‑degree (perfect) – each consumer pays their maximum willingness to pay.
- Second‑degree – versioning, bulk‑buy discounts, two‑part tariffs.
- Third‑degree – different prices for identifiable groups (students, seniors, geographic markets).
- Only possible where the firm has market power and can prevent resale.
5.3 Contestable Markets
- A market with low entry/exit barriers can discipline a monopoly even if it is the sole supplier.
- Key indicators: absence of sunk costs, no exclusive contracts, free access to essential facilities.
- “Hit‑and‑run” entry threatens to erode monopoly profits, forcing prices toward marginal cost.
5.4 X‑inefficiency
- When a firm’s actual cost exceeds the minimum feasible cost because of weak competitive pressure.
- Measured by the gap between average cost and the lowest point on the AC curve.
5.5 Growth & Survival of Dominant Firms (Syllabus 7.7)
- Economies of scale allow dominant firms to lower average cost as output expands, reinforcing market power.
- Merger & acquisition activity can be a growth strategy, but may trigger antitrust scrutiny.
- Survival depends on maintaining barriers (e.g., patents, control of essential facilities) and on adapting to technological change.
5.6 Differing Objectives of Firms (Syllabus 7.8)
- Besides profit maximisation, dominant firms may pursue:
- Revenue maximisation – raising sales even at lower profit margins.
- Market‑share maximisation – using predatory pricing to deter rivals.
- Growth objectives – expanding into new markets or product lines.
- These objectives help explain strategic behaviour such as price discrimination and exclusive dealing.
6. Labour‑Market Implications of Dominance (Syllabus 9‑11)
- Wage‑setting power – a dominant employer can act like a monopsonist, setting wages below the marginal product of labour.
- Skill‑bias – large firms often demand specialised skills, influencing regional wage differentials and the structure of the labour market.
- Unemployment effects – reduced output to raise price can lower labour demand, raising cyclical unemployment.
- Policy link – minimum‑wage legislation or employment subsidies can counteract monopsony power.
- Macroeconomic link – monopoly profits increase aggregate demand (through higher investment and consumption of owners) but can also create inflationary pressure if prices are above marginal cost.
7. Policy Responses to Market Dominance
7.1 Competition (Antitrust) Law
| Tool | Purpose | Evaluation (Pros / Cons) |
|---|
| Prohibition of abuse of dominant position (e.g., predatory pricing, exclusive dealing) |
Maintain contestability & protect consumers |
Pros: Deters exploitative behaviour; preserves consumer surplus.
Cons: Enforcement can be costly; risk of regulatory capture; may deter legitimate aggressive competition.
|
| Merger control (thresholds based on CR & HHI) |
Prevent excessive concentration before it occurs |
Pros: Early intervention; clear quantitative tests.
Cons: May delay efficiency‑enhancing mergers; firms can structure deals to avoid thresholds.
|
| Behavioural‑insight / “nudge” policies (e.g., default options, information framing) |
Improve consumer decision‑making without heavy regulation |
Pros: Low‑cost, preserves market freedom.
Cons: Limited impact on deep‑seated market power; effectiveness depends on design.
|
7.2 Regulation of Natural Monopolies
- Price caps – set a maximum price (e.g., RPI‑X formula).
Evaluation: Protects consumers but may reduce incentives for cost‑saving innovation.
- Rate‑of‑return regulation – allow a fair return on capital.
Evaluation: Ensures adequate investment but can lead to “efficiency‑waste” as firms have no incentive to cut costs.
- Public ownership – the state runs the service.
Evaluation: Aligns provision with social objectives; however, political interference may cause inefficiency.
7.3 Encouraging Entry & Reducing Barriers
- Facilitate access to essential facilities (e.g., railway tracks, spectrum).
- Support start‑ups through subsidies, tax reliefs, and R&D grants.
- Enforce transparent licensing and clear patent‑expiry regimes.
- Evaluation: Lowering barriers can increase competition and innovation, but excessive deregulation may lead to market instability or a “race‑to‑the‑bottom” on safety standards.
7.4 Addressing Information Failures
- Mandatory disclosure of prices, quality standards and financial performance.
- Consumer‑education campaigns to improve market knowledge.
- Evaluation: Improves consumer decision‑making, yet compliance costs can be high for small firms.
7.5 Equity & Redistribution (Syllabus 8.2)
- Dominance often shifts surplus from consumers to producers, widening income inequality.
- Policy options:
- Targeted subsidies or vouchers for low‑income consumers.
- Progressive taxation of monopoly profits.
- Price‑cap regimes that limit excessive consumer burden.
- Evaluation must weigh efficiency loss against the social benefit of a more equitable distribution.
8. Macro‑economic Links (AD/AS, Multiplier)
- Monopoly profits increase household income for owners, potentially raising consumption and shifting the AD curve rightward.
- Higher monopoly prices raise the overall price level, shifting the AS curve leftward** (cost‑push inflation) if input costs rise.
- The net effect on equilibrium output depends on the relative size of the consumption multiplier versus the inflationary pressure.
- Government intervention (e.g., price caps) can dampen inflation but may reduce the multiplier effect of investment in the dominant sector.
9. Diagrammatic Illustrations (Suggested for Exams)
- Monopoly welfare diagram – demand, MR, MC, price (P), quantity (QM), dead‑weight loss triangle.
- HHI calculation illustration – bar chart of market shares with the squared‑share contribution shown.
- Price‑discrimination diagram – two separate demand curves for distinct consumer groups, showing different prices.
- Contestable market diagram – monopoly price with a “hit‑and‑run” entry line illustrating the threat of entry.
- AD/AS impact of monopoly profits – shift of AD rightward and possible AS leftward, with explanation of resulting equilibrium change.
10. Summary Checklist (Exam‑Ready)
- Define market dominance and list its main sources.
- State the four market structures and indicate where dominance fits.
- Calculate CR₄ and HHI; interpret using Cambridge thresholds.
- Explain allocative, productive and dynamic (X‑) inefficiencies; sketch the DWL triangle.
- Describe externalities (positive & negative) generated by dominant firms.
- Link dominance to cost, revenue and profit concepts (super‑normal profit).
- Discuss growth & survival strategies of dominant firms (economies of scale, mergers).
- Identify differing firm objectives (profit, revenue, market‑share) and related behaviours.
- Analyse labour‑market effects and relevant government policies (minimum wage, employment subsidies).
- Show macro‑economic impacts on AD/AS and the multiplier.
- Evaluate at least two policy tools, weighing advantages against possible drawbacks (including equity considerations).
- Be able to draw and label all key diagrams listed above.