Monopoly

At the opposite end of the spectrum of market structure to perfect competition is monopoly, which is a market with a single seller of a good.

In the real world, the Competition Commission, the official body for controlling the UK’s monopoly markets, is empowered to investigate a merger if it results in the combined firm having more than 25% of a market. The operations of the Competition Commission will be discussed in a future article.

Assumptions

Economic analysis of monopoly rests on four important assumptions:

  1. There is a single seller of a good.
  2. There are no substitutes for the good, either actual or potential.
  3. There are barriers to entry into the market.
  4. The firm profit maximises.

You can see that these assumptions have their counterparts in the assumptions of perfect competition.

If there is a single seller of a good, and if there are no substitutes for the good, the monopoly firm is thereby insulated from the competition. Furthermore, any barriers to entry into the market can ensure that the firm can sustain its market position into the future. The assumption that there are no potential substitutes for a good reinforces the situation.

A monopoly in equilibrium

The first point to note is that a monopoly firm faces the market demand curve directly. Thus, unlike perfect competition, the demand curve slopes downwards. For the monopolist, the demand curve may be regarded as showing average revenue. Unlike a firm under perfect competition, therefore, the monopolist has some influence over price, and can make decisions regarding price as well as output. This is not to say that the monopolist has complete freedom to set the price, as the firm is still constrained by market demand. However, the firm is a price maker, and can choose a location along its demand curve.

As a preliminary analysis, recall a piece of analysis from AS, which looked at the relationship between the own-price elasticity of demand along a straight-line demand curve and total revenue.

This analysis pointed out that the price elasticity of demand is elastic above the mid-point of the demand curve, and inelastic in the lower half, with total revenue increasing with a price fall when demand is elastic, and falling when demand is inelastic.

The marginal revenue curve (MR) has been added to the figure, and is had a fixed relationship with the average revenue curve, AR or D. This is for similar mathematical  reasons as those that explained the relationship between marginal and average costs. MR shares the intercept point on the vertical axis and has exactly twice the slope of AR. Whenever you have to draw this figure, remember that MR and AR have this relationship – meeting at A, with the distance BC being equal to the distance CD. MR is zero (meets the x axis) at the maximum point of the total revenue curve.

As with the firm under perfect competition, a monopolist aiming to maximise profits will choose to produce at the level of output at which marginal revenue equals marginal cost.

This is at Q* in the above diagram. Having selected output, the monopolist then identifies the price that will clear the market for that level of output. As AR is its demand curve, the price P* is the market clearing price.

This choice allows the monopolist to make supernormal profits, which can be identified as the shaded area in the figure. As before, the area is average revenue minus average cost, which gives profit per unit area, multiplies by quantity.

It is at this point that barriers to entry become important. Other firms may see that the monopoly firm is making healthy supernormal profits, but the existence of barriers to entry will prevent those profits from being competed away, as they would under perfect competition.

It is important to notice that the monopolist cannot be guaranteed to make such substantial supernormal profits. The size of the profits depends upon the relative position of the market demand curve to the position of the cost curve. If the cost curves in the diagram were higher, then the monopoly profits would be much smaller, as the distance between average revenue and average costs would be less. It is even possible that costs curves could be so high as to force the firm to incur losses, in which case it would probably shut down.

How do monopolies arise?

Monopolies may arise in a market for a number of reasons. In a few instances, a monopoly is created by the authorities. For example, for 150 years the Post Office held a license giving it a monopoly on delivering letters. The service is now open competition, although any company wanting to deliver packages weighing less than 350 grams and charging less than £1 can only do so by applying for a license. The Post Office monopoly formerly covered a much wider change of services, but its coverage has eroded over the years, and competition in delivering larger packages has been permitted for some time. Nonetheless, it remains an example of how a monopoly can be created.

The patent system offers a rather different form of protection for a firm. The patent system was designed to provide an incentive for firms to innovate through development of new techniques and products. By prohibiting other firms from copying the product for a period of time, a firm is given a temporary monopoly.

In some cases the technology of the industry may create a monopoly situation. In a market characterised by substantial economies of scale, there may no be room for more than one firm in the market. This could happen where there are substantial fixed costs of production by low marginal costs; for example, in establishing an underground railway in a city, a firm faces very high fixed costs in building the network of rails and stations and buying the rolling stock. However, once in operation, the marginal cost of carrying an additional passenger is very low.

The diagram above displays this point. The firm in this market enjoys economies of scale right up to the the limit of market demand. The largest firm operating in the market can always produce at a lower cost than any potential entrant, so will always be able to price such firms out of the market. Here the economies of scale act as an effective barrier to entry of new firms, and the market is a natural monopoly. A profit maximising comapany would set output to MC = MR, and therefore charge price b, earning supernormal profits of beji.

Such a market poses particular problems regarding allocative efficiency. Notice in the figure that marginal cost is below average cost over the entire range of output. If the firm were to charge a price equal to marginal cost they would inevitably make a loss, so such a pricing rule is not viable. This problem is analysed in Chapter 5.

The sort of market where a natural monopoly might emerge is one where there are substantial fixed costs of operation, but relatively low marginal costs. An example might be an underground railway system in a city, or a Channel Tunnel. The setup costs of building a rail network under a city or a tunnel under the channel are enormous compared with the marginal costs of carrying an additional passenger. Some cities so have more than one underground railway, but they do no compete on the same routes. It would not make economic sense to have parallel rail systems competing for the same passengers on a a particular route, any more than it would be sensible to have two Channel Tunnels close to each other. Notice that although the Channel Tunnel may seem an obvious natural monopoly, it does not mean that the firm operating it faces no competition. The Tunnel has to compete with ferry companies and airlines.

Another example of a natural monopoly might seem to be the manufacture of passenger aircraft. Building a plane capable of carrying a large number of passengers requires on long-haul routes has large economies of scale. There are indivisibilities in the production process, and any firm producing such aircraft has to make substantial investment of research and development up front. Thus there are large economies of scale in the production process. Furthermore, the market is relatively small, in the sense that the number of aircraft sold per year is modest. However, looking at the market it is clear that there is not a monopoly as there are two firms operating in the market – Boeing and Airbus. These are the only effective global competitors.

Does this negate the natural monopoly theory? The answer is no. In face, this market has aroused much transatlanic debate and and contention. Boeing, the US producer, has accused European governments of unfairly subsidising Airbus’ R&D programme. In return, Airbus has responded by pointing to the benefits that Boeing has received from the US military research programme. Without being drawn into this debate at this stage, the net effect of the interventions has been to create a duopoly situation (a market with just two firms) in which Boeing and Airbus compete for market share. Later discussion will examine why such competition is regarded as being more favourable for consumers than allowing an unregulated natural monopoly to develop.

There are markets in which firms have risen to become monopolies by their actions in the market. Such a market structure is sometimes known as competitive monopoly. Firms may achieve a monopoly position through effective marketing, through a process of merger and acquisition, or by establishing a new product as a widely accepted standard.

In the first Microsoft trial in 1998, it was claimed that Microsoft had gained 95% of the world market for operating systems of PCs. The firm claimed that this was because it was simply very good at what it does. However, part of the reasons that it was on trial was becuase not everyone agreed with it, and alleged unfair market tactics. This will be examined in a later post.

Monopoly and efficiency

The characteristics of monopoly can be evaluated in relation to productive and allocative 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. It is clear from the figure that this is extremely unlikely for a monopoly. The firm will produce at the minimum point of the long run average cost curve only if it it happens that the marginal revenue curve passes through this exact point – and that would only happen by coincidence.

Allocative efficiency

For an individual form, allocative efficiency is achieved when price is set equal to marginal cost. It is clear from the diagram above that will not be the case for a profit-maximising monopoly firm. The firm chooses output where MR equals MC; however, given that MR is below AR (i.e. price), price will always be set above marginal cost.

Comparing perfect competition and monopoly

It is possible to identify the extent to which a monopoly by its behaviour distorts resource allocation, by comparing the monopoly market with the perfectly competitive market.

This diagram shows the deadweight loss of consumer and producer surplus from a monopoly. A monopoly will produce at quantity Qm, and set price at Pm. Consumer surplus will therefore be the light green shaded area – the difference between what consumers are willing to pay and what they do pay. The producer surplus is the dark green shaded area – the difference between what the producer is willing to sell at and what they do sell at.

If the market was under perfect competition, the marginal revenue would be equal to the average revenue, and therefore supernormal profits would be competed away, and companies would sell at quantity Qc and price Pc – the socially optimal level. The difference in consumer and producer surplus between these two market structures is called the deadweight loss – and is the brown area.

Summary

  • A monopoly market is oen in which there is a single seller of a good.
  • The mdoel of monopoly used in economic analysis also assumes there are no substitutes  for the product produced by the monopolist, and there are barriers to the entry of new firms.
  • The monopoly faces the market demand curve, and is able to choose a point along that demand curve in order to maximise profits.
  • Such a firm may be able to make supernormal profits, and sustain them in the long run, due to barriers to entry and the lack of substitutes.
  • A monopoly may arise because of patent protection or the nature of economies of scale in the industry (a natural monopoly)
  • A profit maximising monopolist does not achieve allocative efficiency, and is unlikely to achieve productive efficiency in the sense of producing at the minimum point of the long run average cost curve.
  • A comparison of perfect competition with monopoly reveals that a profit-maximising monopoly under the same cost conditions as a perfectly competitive industry will produce less output, charge a higher price, and impose a deadweight loss on society.
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