11175 Introduction to Economics

Answers to exam review questions module 6

Compare your responses to those provided below.

Question 1
A monopoly is a market structure where there is only one seller of a good or service which doesn’t have
a close substitute. What are the barriers to entry that would prevent other firms from joining such a
market? Discuss.

The most important ways a firm becomes a monopoly are through the following barriers to
entry: (1) government blocks the entry of other firms into the market; (2) the firm has control
of a key resource; (3) there are important network externalities in supplying the product; and
(4) economies of scale are so large that one firm has a natural monopoly. [Please discuss
each factor in a bit more detail if the question is in your final exam].

Question 2
Suppose that a perfectly competitive industry becomes a monopoly. Discuss the effects of this change
on consumer surplus, producer surplus and deadweight loss.

The higher price charged under monopoly reduces consumer surplus by the area equal to
rectangle A and triangle B. Some of the reduction in consumer surplus is captured by the
monopoly as producer surplus – shown by area A. Under monopoly however area C is lost as
producer surplus. So, change in surplus for the monopoly is the difference between A and C.
Since A is bigger than C, there is a net gain producer surplus for the monopoly. B and C are
deadweight loss due to monopoly.

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What gives rise to a natural monopoly? How do consumers benefit from a natural monopoly? What are
examples of natural monopoly?

A natural monopoly arises when the production exhibits economies of scale over a large
range of output. The average cost of production is lower as the output produced increases.
In this case, it is more efficient to have only one seller catering to the entire market than
having 2 or more firms. Consumers benefit from having one supplier because the supplier
will be able to pass some of the cost savings to consumers. Natural monopoly arises in
industries where the fixed cost of production is significantly higher such as the provision of
electricity, water or gas. [Please see slide 24 of week 6’s lecture for diagram on natural
monopoly].

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