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Monopoly

A monopoly is a market with a single supplier of a good or service that has no clear substitutes and in which natural or legal barriers to entry prevent competition (Pure Monopoly). Another definition of a monopoly is when one firm control 25% or more of the market share of the industry it operates in (Working Monopoly).

Monopoly along the market structures spectrum

Formation of monopoliesMonopolies can form for a variety of reasons, including the following:

1. If a firm has exclusive ownership of a scarce resource, such as Microsoft owning the Windows operating system brand, it has monopoly power over this resource and is the only firm that can exploit it.

2. Governments may grant a firm monopoly status, such as with the Post Office, which was given monopoly status by Oliver Cromwell in 1654. The Royal Mail Group finally lost its monopoly status in 2006, when the market was opened up to competition.

3. Producers may have patents over designs, or copyright over ideas, characters, images, sounds or names, giving them exclusive rights to sell a good or service, such as a song writer having a monopoly over their own material.

4. A monopoly could be created following the merger of two or more firms. Given that this will reduce competition, such mergers are subject to close regulation and may be prevented if the two firms gain a combined market share of 25% or more.

Source: http://www.economicsonline.co.uk/Business_economics/Monopoly.html

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Characteristics of Monopoly

1. One seller (pure monopoly)/ one seller controls 25% or more of the industry’s market share (working monopoly)

2. Monopolies can maintain supernormal profit in the long run. As with all firms, profits are maximized when MC = MR. In general, the level of profit depends upon the degree of competition in the market, which for a pure monopoly is zero. At profit maximization, MC = MR, and output is Q and price P. Given that price (AR) is above ATC at Q, supernormal profits are possible (area PABC).

3: Firm is a price maker i.e. it has market power 4: Barriers to entry exist and are usually high 5: A monopoly is a profit maximiser i.e. produces where MC = MR6: Product is unique (pure monopoly) or it has no close substitutes 7: Asymmetric information i.e. specialised information about production techniques unavailable to other potential producers8: Price discrimination: in a monopoly the firm can change the price and quantity of the good or service. In an elastic market the firm will sell a high quantity of the good if the price is less. If the price is high, the firm will sell a reduced quantity in an elastic market.

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Barriers to entry

1. Natural barriers to entry – a natural monopoly exists when the technology for producing a good or service enables one firm to meet the entire market demand at a lower price than two or more firms could. E.g. one electric power distributor can meet the market demand for electricity at a lower cost than two or more firms could

2. Legal barriers to entry – a legal monopoly is a market in which competition and entry are restricted by the concentration of ownership of a natural resoyrce or by the granting of a public franchise, government license, patent or copyright.(a) Concentration of ownership of a natural resource and vertical

integration - Control over supplies and distribution can be important. For example many major oil companies are vertically integrated. They control, oil extraction refining and retail outlets maintain their market power. Vertical integration gives a business control over different stages of the supply chain.

(b) Public franchise – exclusive right granted to a firm to supply a good or service e.g. MTR subway rail system in Hong Kong

(c) Government license – controls entry into particular occupations such as the accountancy profession

(d) Patent – exclusive right granted to the inventor of a good or service. Patents are legal property rights to prevent the entry of rivals. They are generally valid for 17-20 years and give the owner an exclusive right to prevent others from using patented products, inventions, or processes. The owners of patents can sell licenses to other businesses to produce versions of their patented product – this can prove to be lucrative.

(e) Copyright – exclusive right granted to the author or composer of a literary, musical, dramatic or artistic work

3. Brand loyalty & advertising – customer loyalty given to first entrant into the industry. Developing consumer loyalty by establishing branded products can make successful entry into the market by new firms much more expensive and less successful. Advertising can also cause an outward shift of the demand curve and also make demand less sensitive to price.

4. Brand proliferation - In many industries multi-product firms engaging in brand proliferation can give a false appearance of competition to the consumer. This is common in markets such as detergents, confectionery and household goods – it is an essential part of non-price competition.

5. Cost of entry – set up costs required for a firm to enter a market

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6. Learning curve effects – incumbents operating in an industry benefit from knowledge which allows them to produce at a lower cost per unit

7. Reputational effects – based on history of retaliation against new entrants and/or the resources available to incumbents to retaliate.

See - http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/monoppower.html

The monopolist's demand curveIn our analysis of perfect competition, we showed how there is a distinction between the demand curve of the individual firm and that of the market as a whole - the existence of many firms each competing against each other means that each one has no influence over price, and has to take the price that is determined in the market through the intersection of the demand and supply curves. The demand curve for each firm is therefore horizontal: an infinite amount is demanded at one price, with nothing at all being demanded at a higher price and with the charging of a lower price being inconsistent with the goal of profit maximization.

However, under monopoly there is only one firm in the industry; thus there is no difference between the demand curve for the industry and the demand curve for the firm. As the monopolist is subject to the normal law of demand, the monopolist's demand curve will be downward sloping so that to sell more, price would have to be lowered (see figure 1). In comparison to other types of market, the monopolist's demand curve is likely to be relatively inelastic as close substitutes may not be available if price is raised. Indeed, the availability or non-availability of close substitutes is one of the key factors determining the monopolist's power in the market.

Figure 1 Monopolist's demand curve

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The demand curve shown in Figure 1 presents the monopolist with a choice. The monopolist can either choose to make the price or the quantity, but cannot do both; for example, if the monopolist chooses to set a price of OP1, the market dictates that only a quantity of OQ1 could be sold; however, if the monopolist chooses to set a quantity of OQ2 to be sold, clearly the demand curve tells us that this could only be achieved at a price of OP2.

Marginal revenue and average revenue under monopoly

The table below assumes that the monopolist faces a normal demand schedule, and from this the revenue curves are derived. Try calculating the figures for total, average and marginal revenue and once you have had a go, follow the link to check your answers.

Task: Complete the table below

Output Price Total revenue Marginal revenue Average revenue

1 20

2 18

3 16

4 14

From the table two points can be seen:

a) As price has to be lowered to increase sales, marginal revenue is not equal to price as in perfect competition: the additional revenue gained from each extra sale is always less than price or average revenue, and thus the MR curve will always be below the AR curve in monopoly.b) As price is identical to average revenue, the demand curve is also the curve relating average revenue to the quantity produced.The information in this table can now be shown in diagrammatic form to show the relationship between the average and marginal revenue curves (figure 2).

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Figure 2 Marginal and average revenue curves

Price, Marginal revenue and PED

Task: Calculate total revenue, marginal revenue and price elasticity of demand in the table below

Point Price QD Total revenue

Marginal revenue

Price elasticity of demand

A 20 0 ----B 18 1C 16 2D 14 3E 12 4F 10 5G 8 6H 6 7I 4 8J 2 9K 0 10

Task: Plot average revenue (price) and marginal revenue on a diagram. Identify the relationship between total revenue and price elasticity of demand

Remember: If a price fall increases total revenue, demand is elastic, but if a price fall decreases total revenue, demand is inelastic.

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Intrepretation: The relationship between marginal revenue and elasticity implies that a monopoly never profitably produces an output in the inelastic range of its demand curve.

Profit maximisation

A monopoly maximizes profits where MR=MC. It sets a price of Pm and quantity Qmax.

So a monopolist can earn supernormal profit in both the short-run and long-run; this is mainly due to the fact that the barriers to entry will maintain the firm’s market power and restrict competitive forces.

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The Monopolist’s Profit

Example of how a patent allows a monopolist to profit maximize

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Other possible equilibrium positions

Maximising sales revenue is an alternative to profit maximisationand occurs when the marginal revenue, MR, from selling an extra unit is zero.

Revenue maximization graph

The condition for revenue maximisation is, therefore, to produceup to the point where MR = 0. This is also at the same level of output where PED = 1, namely at the mid-point of the average revenue/demand curve.

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Sales volume maximization

Sales maximisation is another possible goal and occurs when the firm sells as much as possible without making a loss.Not-for-profit organisations may choose to operate at this level of output, as may profit making firms faced with certain situations, or employing certain strategies. An example of this would be predatory pricing where, so long as costs are covered, a firm may reduce price to drive rivals out of the market.Sales maximisation means achieving the highest possible sales volume, without making a loss. To the right of Q, the firm will make a loss, and to the left of Q sales are not maximised.   

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Loss-minimizing equilibrium

A monopolist can be a loss making one if the Average Cost lies above Average Revenue. In this case the firms costs are greater than its revenue so it makes a loss. The red and blue combined add up to cost. The red box represents revenue and the blue box, loss. The cost is found by drawing a vertical line from where Quantity meets the Average Cost curve to the price line.

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Natural Monopoly

A natural monopoly is a type of monopoly that may arise when there are extremely high fixed costs of distribution, such as exist when large-scale infrastructure is required to ensure supply. Examples of infrastructure include cables and grids for electricity supply, pipelines for gas and water supply, and networks for rail and underground. These costs are also sunk costs, and they deter entry and exit.

In the case of natural monopolies, trying to increase competition by encouraging new entrants into the market creates a potential loss of efficiency. The efficiency loss to society would exist if the new entrant had to duplicate all the fixed factors - that is, the infrastructure.

It may be more efficient to allow only one firm to supply to the market because allowing competition would mean a wasteful duplication of resources.

Economies of scaleWith natural monopolies, economies of scale   are very significant so that minimum efficient scale is not reached until the firm has become very large in relation to the total size of the market.Minimum efficient scale (MES) is the lowest level of output at which all scale economies are exploited. If MES is only achieved when output is relatively high, it is likely that few firms will be able to compete in the market. When MES can only be achieved when one firm has exploited the majority of economies of scale available, then no more firms can enter the market.

Utility companiesNatural monopolies are common in markets for ‘essential services’ that require an expensive infrastructure to deliver the good or service, such as in the cases of water supply, electricity, and gas, and other industries known as public utilities.Because there is the potential to exploit monopoly power, governments tend to nationalize or heavily regulate them.

RegulatorsIf public utilities are privately owned, as in the UK, since privatization during the 1980s, they usually have their own special regulator to ensure that they do not exploit their monopoly status.Examples of regulators include Ofgem, the energy regulator, andOfcom, the telecoms and media regulator. Regulators can cap prices or the level of return gained.

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Railways as a natural monopolyRailways are often considered a typical example of a natural monopoly. The very high costs of laying track and building a network, as well as the costs of buying or leasing the trains, would prohibit, or deter, the entry of a competitor.To society, the costs associated with building and running a rival network would be wasteful.

Avoiding wasteful duplicationThe best way to ensure competition, without the need to duplicate the infrastructure, is to allow new train operators to use the existing track; hence, competition has been introduced, without duplication of costs. This is called opening-up the infrastructure.This approach is frequently adopted to deal with the problem of privatizing natural monopolies and encouraging more competition, such as:

1. Telecoms, the network is provided by BT2. Gas, the network is provided by National Grid (previously Transco)

With a natural monopoly, average total costs (ATC) keep falling because of continuous economies of scale. In this case, marginal cost (MC) is always below average total cost (ATC) over the whole range of possible output.

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ProfitsIn order to maximize profits the natural monopolist would charge Q, and make super-normal profits. If unregulated, and privately owned, the profits are likely to be excessive. In addition, the natural monopolist is likely to be allocatively and productively inefficient.

LossesTo achieve allocative efficiency, the regulator will have to impose an excessive price-cap (at P1). The output needed to be allocatively efficient, at Q1, is so high that the natural monopolist is forced to make losses, given that ATC is above AR at Q1. Allocative efficiency is achieved when price (AR) = marginal cost (MC), at A, but at this price, the natural monopolist makes a loss.A public utility’s losses could be dealt with in a number of ways, including:

1. Subsidies from the government.2. Price discrimination,  whereby splitting the market into two or more sub-

groups, and charging different prices to each sub-group can derive additional revenue.

Source: http://www.economicsonline.co.uk/Business_economics/Natural_monopolies.html

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Monopoly and Efficiency

In contrast to a competitive firm, the monopoly charges a price above the marginal cost. From the standpoint of consumers, this high price makes monopoly undesirable. However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.

Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost. This wedge causes the quantity sold to fall short of the social optimum.

The monopolist produces less than the socially efficient quantity of output. The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit.

Monopoly is also productively inefficient i.e. it will not produce at the point where MC cuts ATC at the lowest point.

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Despite being productively and allocatively inefficient, monopolies can still be desirable

Monopolies can be defended on the following grounds:1. They can benefit from economies of scale, and may be ‘natural’

monopolies, so it may be argued that it is best for them to remain monopolies to avoid the wasteful duplication of infrastructure that would happen if new firms were encouraged to build their own infrastructure.

2. Domestic monopolies can become dominant in their own territory and then penetrate overseas markets, earning a country valuable export revenues. This is certainly the case with Microsoft.

3. According to Austrian economist Joseph Schumpeter, inefficient firms, including monopolies, would eventually be replaced by more efficient and effective firms through a process called creative destruction.

4. It has been consistently argued by some economists that monopoly power is required to generate dynamic efficiency, that is, technological progressiveness. This is because:

1. High profit levels boost investment in R&D.2. Innovation is more likely with large enterprises and this innovation

can lead to lower costs than in competitive markets.3. A firm needs a dominant position to bear the risks associated with

innovation.4. Firms need to be able to protect their intellectual property by

establishing barriers to entry; otherwise, there will be a free rider problem.

5. Why spend large sums on R&D if ideas or designs are instantly copied by rivals who have not allocated funds to R&D?

6. However, monopolies are protected from competition by barriers to entry and this will generate high levels of supernormal profits.

7. If some of these profits are invested in new technology, costs are reduced via process innovation. This makes the monopolist’s supply curve to the right of the industry supply curve. The result is lower price and higher output in the long run.

Source: http://www.economicsonline.co.uk/Business_economics/Monopoly.html

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Policies to regulate monopolies

Monopoly power can be controlled, or reduced, in several ways, including price controls and prohibiting mergers. It is widely believed that the costs to society arising from the existence of monopolies and monopoly power are greater than the benefits and that monopolies should be regulated.

Options available to regulators include:1. Regulators can set price controls and formulae, often called price capping.

This means forcing the monopolist to charge a price, often below profit maximizing price. For example, in the UK the RPI – ‘X’ formula has been widely used to regulate the prices of the privatized utilities. In the formula, the RPI (Retail Price Index) represents the current inflation rate and ‘X’ is a figure which is set at the expected efficiency gain, which the regulator believes would have existed in a competitive market. However, there is a dilemma with price controls because price-capping results in lower prices, but lower prices also deter entry into the market. The formula for water is RPI + K + U, where K is the price limit, and U is any unused 'credit' from previous years. For example, if K is 3% in 2010, but a water company only 'uses' 2%, it can add on the unused 1% to K in 2011. Regulators may remove price caps if they judge that competition in the market has increased sufficiently, as in the case of OFCOM who removed BT's price cap in 2006.

2. An alternative to price-cap regulation is rate-of-return regulation. Rate of return regulation, which was developed in the USA, is a method of regulating the average price of private or privatized public utilities, such as water, electricity and gas supply. The system, which employs accounting rules for the calculation of operating costs, allows firms to cover these costs, and earn a ‘fair’ rate of return on capital invested. The ‘fair’ rate is based on typical rates of return, which might be expected in a competitive market.

3. Regulators can prevent mergers or acquisitions, or set conditions for successful mergers.

4. Breaking-up the monopoly, such as forcing Microsoft to split into two separate businesses – one for the operating system and one for software sales. In 2004, the UK telecom's regulator Ofcom recommended that BT is split into two businesses: retail and wholesale.

5. A less popular option would be to bring the monopoly under public control, in other words to nationalize it.

6. Regulators can also force firms to unbundle their products and open-up their infrastructure. Bundling means selling a number of products together in a single bundle. For example, Microsoft

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sells PowerPoint, Access, Excel and Word as one product rather than separate ones. Unbundling makes it easier for firms to enter the market, as in the case of UK telecoms, when BT was forced to apply local loop unbundling, which enabled new broadband operators to enter the market.

7. Regulators can use yardstick competition, such as setting punctuality targets for train operators based on the highly efficient Bullet trains of Japan.

8. It is also possible to split up a service into regional sections to compare the performance of one region against another. In the UK, this is applied to both water supply and rail services.

Source: http://www.economicsonline.co.uk/Business_economics/Monopoly.html

Regulating a natural monopoly

When demand and cost conditions create natural monopoly, government agencies regulate the monopoly.

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Regulating a natural monopoly in the public interest sets output where MB = MC and the price equal to marginal cost. This regulation is the marginal cost-pricing rule, and it results in an efficient use of resources.

Regulating Natural MonopolyWith price equal to marginal cost, ATC exceeds price and the monopoly incurs an economic loss. If the monopoly receives a subsidy to cover its loss, taxes must be imposed on other economic activity, which create deadweight loss. Where possible, a regulated natural monopoly might be permitted to price discriminate to cover the loss from.

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Average-cost pricing

Another alternative is to produce the quantity at which price equals average total cost and to set the price equal to average total cost — the average cost pricing rule.

Output where MB = MC and P = MC is the marginal cost pricing rule, and it results in an efficient use of resources. With price equal to marginal cost, ATC exceeds price and the monopoly incurs an economic loss. If the monopoly receives a subsidy to cover its loss, taxes must be imposed on other economic activity, which create deadweight loss.

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Evaluation of monopolies

The advantages of monopoliesMonopolies can be defended on the following grounds:

1. They can benefit from economies of scale, and may be ‘natural’ monopolies, so it may be argued that it is best for them to remain monopolies to avoid the wasteful duplication of infrastructure that would happen if new firms were encouraged to build their own infrastructure.

2. Domestic monopolies can become dominant in their own territory and then penetrate overseas markets, earning a country valuable export revenues. This is certainly the case with Microsoft.

3. According to Austrian economist Joseph Schumpeter, inefficient firms, including monopolies, would eventually be replaced by more efficient and effective firms through a process called creative destruction.

4. It has been consistently argued by some economists that monopoly power is required to generate dynamic efficiency, that is, technological progressiveness. This is because:

1. High profit levels boost investment in R&D.2. Innovation is more likely with large enterprises and this innovation

can lead to lower costs than in competitive markets.3. A firm needs a dominant position to bear the risks associated with

innovation.4. Firms need to be able to protect their intellectual property by

establishing barriers to entry; otherwise, there will be a free rider problem.

5. Why spend large sums on R&D if ideas or designs are instantly copied by rivals who have not allocated funds to R&D?

6. However, monopolies are protected from competition by barriers to entry and this will generate high levels of supernormal profits.

7. If some of these profits are invested in new technology, costs are reduced via process innovation. This makes the monopolist’s supply curve to the right of the industry supply curve. The result is lower price and higher output in the long run.

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The disadvantages of monopoly to the consumerMonopolies can be criticized because of their potential negative effects on the consumer, including:

1. Restricting output onto the market.2. Charging a higher price than in a more competitive market.3. Reducing consumer surplus and economic welfare.4. Restricting choice for consumers.5. Reducing consumer sovereignty.

Higher pricesThe traditional view of monopoly stresses the costs to society associated with higher prices. Because of the lack of competition, the monopolist can charge a higher price (P1) than in a more competitive market (at P).The area of economic welfare under perfect competition is E, F, B. The loss of consumer surplus if the market is taken over by a monopoly is P P1 A B. The new area of producer surplus, at the higher price P1, is E, P1, A, C. Thus,   the overall (net) loss of economic welfare is area A B C.The area of deadweight loss for a monopolist can also be shown in a more simple form, comparing perfect competition with monopoly.

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Alternative diagramThe following diagram assumes that average cost is constant, and equal to marginal cost (ATC = MC). Under perfect competition, equilibrium price and output is at P and Q. If the market is controlled by a single firm, equilibrium for the firm is where MC = MR, at P1 and Q1. Under perfect competition, the area representing economic welfare is P, F and A, but under monopoly the area of welfare is P, F, C, B. Therefore, the deadweight loss is the area B, C, A.

The wider and external costs of monopoliesMonopolies can also lead to:

1. A less competitive economy in the global marketplace.2. A less efficient economy.

1. Less productively efficient2. Less allocatively efficient

3. The economy is also likely to suffer from ‘X’ inefficiency, which is the loss of management efficiency associated with markets where competition is limited or absent.

4. Less employment in the economy, as higher prices lead to lower output and les need to employ labour.

Source: http://www.economicsonline.co.uk/Business_economics/Monopoly.htmlQuestions on monopoly

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1: Monopoly arises in which of the following situations?a) Coca-Cola cuts its price below that of Pepsi-Cola in an attempt to increase

its market shareb) A single firm, protected by a barrier to entry, produces a personal service

that has no close substitutesc) A barrier to entry exists but some close substitutes for the good existsd) A firm offers discounts to students and seniors e) A firm can sell any quantity it chooses at the going pricef) The government issues Tiger Woods, Inc. an exclusive license to produce

golf ballsg) A firm experiences economies of scale even when it produces the quantity

that meets the entire market demand

2: In each of the following cases, state whether the monopolist would increase or decrease output:

(a) Marginal revenue exceeds marginal cost at the output produced (b) Marginal cost exceeds marginal revenue at the output produced

3: The following table gives the total costs and total revenue schedule for a monopolist.

Quantity Total Cost Total Revenue0 144 01 160 902 170 1603 194 2104 222 2405 260 2506 315 2407 375 210

(a) Calculate the marginal revenue and marginal cost, and sketch the demand curve.(b) Determine the profit-maximising price and quantity, and calculate the resulting profit.

4: Fill in the missing data on a monopolist in the following table:

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Quantity Price Total Revenue

Marginal Revenue

Marginal Cost

Average Total Cost

1 11 18.002 10 11.003 9 7.674 8 6.755 7 6.606 6 7.007 5 8.00

(a) At what quantity will the monopolist produce in order to maximise profits? What will be the price at this level of output? What will be the profits?(b) What quantity maximises total revenue? What is the elasticity of demand at that point? Why is this not the profit-maximising quantity?

5: A Publisher faces the following demand Schedule for the next novel by one of its popular authors:

Price Quantity Demanded$100 090 100,00080 200,00070 300,00060 400,00050 500,00040 600,00030 700,00020 800,00010 900,000 0 1,000,000

The author is paid $2 million to write the book, and the marginal cost of publishing the book is a constant $10 per book.

(a) Compute total revenue, total cost and profit at each quantity. What quantity would a profit-maximising publisher choose? What price would it charge?

(b) Compute marginal revenue. How does marginal revenue compare to the price.

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(c9 Graph the marginal revenue, marginal cost and demand curves. At what quantity do the marginal revenue and marginal cost curves cross?

(d) On your graph, shade in the deadweight loss

(e) if the author were paid $3 million instead of $2 million to write the book, how would this affect the publisher´s decision regarding the price to charge?

(f) Suppose that the publisher were not profit maximising but were concerned with maximising economic efficiency. What price would it charge for the book? How much profit would it make at this price?

6: Suppose the average cost of producing a kilowatt-hour of electricity is lower for one firm than for another firm serving the same market. Without the government granting a franchise to one of these competing power companies, explain why a single seller is likely to emerge in the long run.

6:

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7:

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