Economics: Monopoly - Market Structures
Key Terms
Monopoly: A situation, by legal privilege or other agreement, in which solely one party (firm) exclusively provides a particular product or service, dominating that market and generally exerting powerful control over it.
Price Maker: A firm that has the ability to choose its desired selling point of their good or services, as they face a downward-sloping demand curve.
Barrier to Entry: A cost (or characteristic of the market i.e., patent) that must be incurred by a new entrant into a market, but which does not apply to incumbents.
Allocative Efficiency: A type of efficiency achieved when society is producing the correct group of goods and services relative to what consumers prefer. (Price = Marginal Cost)
X-Inefficiency: X-inefficiency occurs due to organisational slack; hence the firm is not operating at minimum costs.
Dynamic Efficiency: A perspective of efficiency that takes into account both innovation and technical progress on productive and allocative efficiency in the long run.
Economies of Scale: The characteristics of a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit.
Diseconomies of Scale: The characteristics that lead to an increase in average costs as a firm grows beyond a certain size.
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What is a Monopoly?
A monopoly is defined as a market in which a single firms is the seller of that good or service. In a monopoly market the barriers to entry are very high and often have government regulation protecting them such as patents, this results in no competition for the incumbent firm.
The monopoly model in economics is based on a series of assumptions:
The firm aims to maximise profit.
There is a single seller (the monopoly).
There are no substitutes for the good the monopoly is selling.
There are high barriers to entry in the market.
What are the Barriers to Entry in a Monopoly Market?
High barriers to entry are very important in a monopoly market as this is one of the main reasons that the firm is able to be a monopoly (maintain its position in the long-run). The key factors that create barriers to entry are:
Economies of Scale – The reason economies of scale act as a barrier to entry for new firms in the market is that the monopoly will have significant economies of scale resulting in extremely low prices. This means that it will always produce a good lower price than any entrant firm.
High Fixed Costs – Another reason that may deter new firms from entering the market is high fixed costs, if they know that they need significant investment to start producing may steer them away. Monopolies may employ strategic actions such as significant investment into research and development (R&D) to ensure this.
Costs Advantages – Monopolies may also have (absolute) cost advantages over the new firms trying to enter the market. This may be due to its already established connections with the firms that provide the input needed to produce the products or its effective supply chain distribution.
Government Regulation – Monopolies may have government regulation protecting them such as patents. (The roles of patents is to encourage research and development.)
Switching Costs – There may also be an aspect of switching costs, this is where a firms customers may incur additional costs to switch over to the new substitute, this could be in the form of contracts or an expensive expenditure (brand loyalty may also come into play).
Strategic Action – Monopolies may take strategic actions to prevent firms trying to enter, this could be via the taking out of patents that the firm has no need for but prevents new companies from entering or adopting a pricing strategy.
Network Effects – Another, factors may be network effects, this is where consumers use a specific product because they know others also use it and makes things easier, such as Microsoft Office.
The Monopoly Model
Above can be seen the model for a monopoly. The monopoly’s demand curve is downward sloping which means that the monopoly has some power over its price making it a price maker, meaning it can set its own prices (wherever along the demand curve but cannot go beyond it). The demand curve is also known as the AR which means average revenue.
As was mentioned earlier the monopolists wishes to maximise profit hence will produce at the level MR=MC (marginal revenue = marginal costs). This leads to Qm being produced and the price of Pm, if we look at the line where average costs comes, we can see the formation of the black rectangle known as our supernormal profit.
Monopolies usually make a supernormal profit however, it is worth knowing that they can also make a loss, and you should know the model for it. Below can be seen the model, in order to illustrate a loss for a monopoly the average costs curve should be higher than the average revenue point resulting in a loss.
Demand Increase for a Monopoly
Monopolies can also face increase in demand, which is a benefit for them as it increase the size of their supernormal profit. The model below demonstrates what an increase in demand looks like and its impact on a monopolies profit.
As can be seen above the demand curve D (AR) shifts to the right resulting in the new demand curve D1 (AR1), MR also shifts as it has a direct relationship with AR and becomes MR1. This results in a new price and quantity output that increases the monopolies supernormal profit.
Evaluating Monopoly in Terms of Efficiency
Monopolies can be evaluated in terms of efficiency: Productive Efficiency, Allocative Efficiency, X-Inefficiency, and Consumer Choice.
Productive Efficiency – In order for a firm to be productively efficient, output needs to occur at the lowest point on the AC curve. In a monopoly this does not occur meaning that it is productively inefficient.
Allocative Efficiency – In order for a firm to be allocatively efficient its price must be below the MC curve. Due to the monopoly making a supernormal profit this is not the case, meaning it is allocatively inefficient.
X-Inefficiency – Due to the size of the monopoly, it is argued that x-inefficiency may occur due to organisational slack and managerial laziness.
Consumer Choice – Consumer choice is also decreased as monopolies stop firms from entering in order to prevent competition. This reduces consumer choice and could be argued to decrease welfare.
Advantages of Monopoly
Monopolies also have some advantages in terms of economies of scale, dynamic efficiency, and global competition.
Economies of Scale– Monopolies have significant advantages of economies of scale due to how big it is. This means that the monopoly is able to produce goods and services at low price resulting in lower average costs. This may also lead to lower prices for consumers.
Dynamic Efficiency – In order for a firm to be dynamically efficient it must have consistent supernormal profits that it is able to reinvest into research and development. In the long-run this could reduce costs and increase consumer range increasing welfare.
Global Competition – It can also be argued that if a firm is allowed to dominate the domestic market it may later have scope to compete globally.
How are Monopolies Created?
Monopolies can arise from multiple factors the main ones being legal monopolies, vertical integrations, horizontal integrations, efficiency, innovative patents.
Legal monopiles are usually created by authorities, to server for a certain need. A great example of a legal monopoly was Royal Mail, which was created as the national postal service in the UK. Royal Mail was however privatised in 2013.
Horizontal Integration occurs when two similar firms, join together to increase their output and increase their overall market share.
Vertical Integration may also lead to a cause in a monopoly, this is where firms control different stages of the production process.
Innovative Patents also lead to the creation of a monopoly as no other firm may copy that product and it may take time for something more advanced to develop.
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References/ Further Reading:
Monopoly – Wikipedia - https://en.wikipedia.org/wiki/Monopoly