A monopoly is defined as a market, where one firm dominates the market for a good that has no substitutes and significant barriers to entry exists.
- Single seller- when firm controls the market entirely and it is the only producer of a certain good, it is a pure monopoly. A single firm that controls a dominant share of the market is also a monopoly, this is more common.
- Unique product without close substitutes- the product must be unique as it would hold little value being a monopoly if it were easily replaceable with something else
- Price-maker- With significant market share, firms have power to set price by changing the amount of goods produced. The extent of power is limited by total demand, but can be considerable.
- Barriers to entry- The prevention of other firms from entering allows the monopoly to maintain its price-making true monopoly power and continues to make economic profits in the absence of competition
Traditionally, a monopoly might seem akin to autocracy, in which a single firm makes the rules, sets the prices and controls its output and destiny while making ludicrous profits. It is often seen that power is forged through the personality of its chief” e.g. John D Rockefeller of Standard Oil once sought to control the entire world market for the refining of oil, at its peak processing 80% of global crude oil. Public sentiment against such control often meant that government must create agencies to monitor the behaviour of monopolies and restrict malpractices.
Barriers to entry are defined as the technical, competitive and cost-related impediments to joining a market and competing against existing firms: e.g.-
- Economies of scale- If EoS occurs over a large amount of output produced, the established firm may have achieved a size that has lowered their long run average total costs (LRATC) of production to a level new entrants cannot reach, as they cannot produce enough to reach the same level of cost reduction. It is also possible that market demand is too low and doesn’t warrant the existence of more than one firm in the industry (e.g. airplane and ship building), as a result, potential new competitors are deterred from entering.
- Legal barriers- Patents, copyrights and government licenses protect the incentive to innovate. e.g. Microsoft’s patent on its Windows operating system/ government licences on radio bands. They keep potential competitors out making the industry less competitive. Protectionists policies such as tariffs and quotas also effectively present barriers to entry for foreign products into the domestic market.
- Ownership of essential resources- Industries in which certain firms own access to the resources essential to their production tend to be less competitive than those in which resources are readily available to any firms. e.g. control mines for important mineral resources.
- Aggressive tactics- A monopolist would be prudent to buy out a rival firm if faced with competition, if the expected profits without competition exceed the reduced profits as a result of purchasing the firm. They can also engage in unfair price wars such as predatory pricing, meaning they cut prices to levels below costs. This harms profits in the short run, but as they have a large reserves of profits, they drive out the new competitors as they cannot survive charging the same low prices.
Monopolies can change prices but this also changes quantity demanded. However, Qd is limited by demand and the monopolist can only increase Qd by lowering price. As it is able to freely adjust both price and Qd, it is very likely that it maximises revenues or profits. P=AR as we are assuming monopolist charge a certain same price to all consumers, MR has half the gradient of AR. TR increases initially as price is lowered because Qd increases, this suggests demand to be elastic, it then becomes unit elastic when MR=0 and TR is at its maximum and inelastic as price continues to decrease. This means further decreases when MR is negative leads to a fall in TR and any rational producer would not produce beyond the point MR=0.
A natural monopoly occurs when a single large firm produced more cheaply than 2 or more smaller firms. Typically when there required significant fixed costs for the production of the G&S, due to the large fixed costs, the LRATC only decreases after large runs of output. E.g. public utilities such as sewage and water production have enormous infrastructure costs. This means the lowest costs can only be achieved when only one firm produces in the market, this was the rationale to having a single, regulated natural monopoly, as several will make the market inefficient.
Disadvantages of monopolies:
- Higher prices and lower quantity produced- the industry output when compared with a competitive firm shows monopolies producing less, and charging higher prices
- Producer welfare gains at the expense of consumers- following from the above, the results benefits producers and harms consumers, the degree depends on the elasticities of demand and supply. There is also total welfare loss involved
- Incentive problems- as the monopolist is insulated from competition, it is likely that they are complacent. Profits made may not be used in costly R&D as monopolist may conclude that the action is not worth the cost when profits are guaranteed. The lack of innovation suggests no improvement in product quality, standardizing the products produced. Illegal aggressive tactics might be employed to preserve market power and avoid competition. This means agencies must be set up by the government, leading to a waste of resources and taxpayers’ money which brings with it an opportunity costs.
- Eos- Reduction in costs for products with high fixed costs by spreading the overhead may mean a lower price, making it competitive in the global market. The MC must be lowered, shifting it to right
- Higher profits enable greater R&D- In contrast to PC firms who achieve profits only in the SR, monopolist have greater capacity to invest in R&D as they can earn profits in the LR and have more resources available to improve efficiency. Although previously described, they may have little incentives to do so, if investment is wise, firms may yield greater profits with new products, allowing them higher market share, entrenched position with more significant barriers to entry, and a higher place and status in the global market
In the LR equilibrium, monopolies have P-mono higher than MC, suggesting under-allocation of resources and hence underproduction and more needs to be produced to achieve allocative efficiency, however not at the level of output that maximizes revenue. Again, at the profit maximizing level of output MC=MR, productive efficiency is also not achieved, as the monopoly doesn’t produce enough of the good so that P=minATC.
As natural monopolies yield lower costs and more output for consumers, they are granted exclusive production rights by the government. As they have the incentive to produce at higher costs, in order to maintain the community surplus and prevent potential welfare loss in the market, governments subsidize monopolies, effectively paying them to provide more services at lower prices. Subject to rules and regulations and government oversight.
Anti-trust laws and legislations are implemented to protect consumers from anti-competitive behaviour by monopolies that occur in the private sphere. Mergers are investigated, firms attempting to collude are prosecuted, as they seek to preserver open competition to keep markets workign efficiently. Corporate fines are the punishments when firms have flouted these laws