This article is about a monopoly. It describes the characteristics of a monopoly market and explains how the equilibrium model evolves under monopolistic conditions.
The article also shows the monopoly diagram, so you will be able to draw a neat and accurate diagram of the equilibrium position. The chart also identifies the profit maximizing position in each equilibrium position.
You will also find here the causes of monopoly power, and be able to evaluate the strengths and weaknesses of a monopoly market. Finally, price discrimination is explained and the conditions needed for it to be an effective practice are described
What is monopoly?
A monopoly is a market in which there are many buyers, but only one seller. There is only one firm that supplies the total quantity consumed for the whole market.
The four main characteristics of a monopoly include:
- One seller controls the whole market.
- The firm is a short run profit maximizer.
- The firm is a price maker.
- There are very high barriers to entry in the market not allowing other businesses in.
Monopolies do not need necessarily need to be private, national or international. They might be local or run by the government.
Short run profit maximizer
A firm operating as a monopoly will set output where Marginal Cost (MC) = Marginal Revenue (MR) to ensure that it maximizes its profits. The diagram below shows a monopoly producing quantities set at this level.
You will notice that the Average Revenue (AR) curve is also the demand curve. This is because the firm is the industry and therefore the market. Like in any market, the price must be lowered in order to increase the quantity demanded.
The two black points show the difference between Average Revenue (AR) and Average Cost (AC). This shaded area represents abnormal profit – the difference between Average Revenue (AR) and Average Cost (AC).
Remember that normal profit is included as a cost; therefore any revenue earned above the Average Cost (AC) curve is abnormal profit. Abnormal profit is desirable for the owners of a monopoly. Therefore, the diagram representing the profit maximizing level of output is also the long run quantity of output.
A monopolist = Price maker
A firm operating a monopoly does not directly compete any with other firms, and other firms cannot enter the market due to barriers to entry.
This allows the firm to make abnormal profit in the long term because the firm is able to set the price, or the quantity produced, but not both.
A firm with the ability to decide the price within the market is known as a price maker.
Barriers to Entry
Barriers to entry are obstacles preventing firms from entering into a specific market.
A monopoly is able to protect itself by keeping others out of the market. There are four main types of barriers to entry in regards to monopolists:
- Legal barriers. Legal barriers can take the form of a special license or permit from the government or the ownership of patents, copyright and Intellectual Property (IP) that other firms are unable to use. For example, the UK government has issued permits to allow companies to supply water in various regions of the country. Those without permits are unable to join the market allowing a firm to monopolize the market in the region where they operate.
- Resource barriers. Resource barriers such as owning, purchasing or attracting resources can make them unavailable for use by potential competitors. Owning land that contains a resource such as diamonds prevents other firms from mining the stones. A monopoly may also attract the most talented people from labor markets, if they are able to offer security, higher salaries and greater opportunities.
- Unfair competition. Unfair competition involves preventing new entrants having the chance to earn profit allowing a monopoly to maintain dominance. This is achieved by decreasing price to the point where profits cannot be made by the new entrant. The monopolist will have lower costs due to economies of scale. So, as long as the monopolist is covering its Variable Costs (VC), the new company will be forced out of the market. This is known as destroyer pricing.
- Natural cost advantages. Natural cost advantages exist because the monopolist will have large economies of scale. Some monopolist firms will be able to defeat competitors on price without unethical means. They will have lower average costs, thus are able to operate more efficiently. Cost barriers may also exist, if the actual cost of entry to the market is vast. Many firms are unable, or unwilling, to invest in highly expensive capital goods such as power stations or railway lines.
Barriers to entry can be overcome, if a company can find a way to differentiate its product. Product differentiation is the extent to which consumers perceive a product to be different from another.
Developing a substitute for the monopolist’s product may lead to creative destruction. This is the process of totally replacing the good offered by the monopolist.
A. Advantages and disadvantages of a monopoly to the firm
Having no genuine competitors allows a monopolistic company to set a price that is more suited to its own needs. It is not required to observe normal market conditions or worry about consumer sovereignty. Therefore, a monopoly may earn abnormal profits. A monopoly may also control the amount it produces, not only the price. The result is that a monopoly is able to produce at the lowest point on its average cost curve and be as efficient as the market situation will allow.
There are however some problems faced by monopolies. Governments and possibly other companies can put pressure on them to try and stop their business monopoly. Governments in the market system are supposed to encourage competition to benefit society. They may bring in restrictions to try and break up monopolies. Potential entrants to a market may also persuade governments to do this.
Monopolies may avoid taking risks, as it is not necessary to do so. This can result in products which are incapable of satisfying customers. Avoiding risks can also mean that a company becomes more at risk from entrants. If new firms are successful in entering the market, they can captivate consumers with innovative goods.
Management could use abnormal profits to their own advantage. For example, once shareholders have been paid, managers could set up benefits for themselves as opposed to supporting the company with reinvestment.
B. Advantages and disadvantages of a monopoly to the consumer
Consumers who are prepared to pay higher prices can enjoy a more exclusive product. Additionally abnormal profits made by the company may be reinvested into new products and services.
Often for a new entrant to join the market, they need to create a substitute which may lead to creative destruction. Creative destruction leads to new products and technologies by creating something so advanced that it is able to defeat the monopoly. For example, the Internet has mostly replaced traditional mail – sending correspondence by post.
Unfortunately, consumers must accept higher prices and lower output, since production is based on the company’s profits rather than demand. Another issue for consumers is the potential lack of innovation. This may occur, if the monopoly is afraid of taking risks.
C. Advantages and disadvantages of a monopoly to the economy
The process of creative destruction benefits an economy because resources are reallocated to provide something new and more efficient. However, this process is likely to create a new monopoly.
On another hand, a monopolist firm can become complacent and waste resources leading to inefficiency. In order to earn abnormal profit, monopolies do not produce all they could for the market. This may be regarded as a form of market failure.
Price discrimination
Consumer surplus explains that some consumers are willing and able to pay more than the market price. It is possible for some monopolies to charge different prices to different people for the same good or service. To do this, the monopolist must be able (in a cost effective manner) to prevent consumers in one segment purchasing at the lower price in another market.
A monopoly which can discriminate will usually do so on the following grounds:
- Time. Peak time is the busiest period. Train tickets are always more expensive during holiday periods to reflect higher demand and the fact people are more willing to pay a higher price during this period. Trains are usually a monopoly since they are government run or private firms that have monopolies on individual lines.
- Geography. Price can be different according to the place they are purchased – a small bottle of Coke will cost RMB3 in China, but the cost of the same product in the UK is around RMB15. Convenience stores are able to charge more than supermarkets since they are located closer to home and provide a less stressful way of shopping.
- Income. Companies can charge different prices for some goods or services depending upon the individual’s ability to pay. University education in the UK is means tested – families on higher incomes have to pay a greater contribution towards university fees.
Summary
In short, a monopoly is when there is one dominant company within an industry. It can maintain this position as long as competitors are prevented from entering the market and there is no interference from government.
A monopoly is often considered to be undesirable; however, monopolies have many advantages for the business, consumers and the economy. Price discrimination is possible, if consumers can be prevented from accessing the standard market price.
