Monopoly

Characteristics of Monopoly

A Single Firm in the Market

Where there is just one firm in the market, a pure monopoly exists. In practice this is very rare. The legal definition of a monopoly focuses instead on market concentration. If one firm on its own has at least 25% of the market, it is considered to be a monopoly and can attract the attention of the competition watchdog.

It is therefore better to think of a monopoly as a firm that dominates its market, being much bigger than its rivals. For instance, ‘Facebook’ is easily the largest social media platform, although there are others.

The power of a monopolist over the market also depends on the availability of a close substitute. A monopoly water company, for instance, has much more power than a monopoly train service, since in the latter case, customers may have the option of other forms of transport.

High Entry Barriers

A monopolistic market is often difficult for new firms to enter, for the following reasons: (see also notes on 3.4.4)

1. Economies of scale – The incumbent firm may be producing at the minimum efficient scale and therefore have significant cost advantages over a new firm, which is unlikely to generate enough sales in the short or medium term to get costs down.
2. Capital costs – Some industries require huge investment in buildings and machinery before any production is possible. This makes it difficult for new firms to enter, as they may struggle to raise the capital. A new water company, for instance might struggle to raise the finance to build reservoirs
3. Natural cost advantages – Some producers may own or have better access to superior or cheaper resources which makes it difficult for new producers to compete.
4. Legal barriers – In some industries firms may be protected from new entrants by legal restrictions. For instance, it is not currently possible for new train companies to operate on routes already served by an existing operator.

All of the above barriers are described as innocent entry barriers. This is because they arise without deliberate intent or action on the part of the incumbent firm. In addition, there are other barriers, which a monopolist can deliberately create. They are sometimes called artificial entry barriers. They include the following:

1. Limit pricing – This is a pricing policy that can be used by an incumbent firm. Price may be set below the short-run profit maximising level in order to deter entrants. This may help the monopolist to maintain higher long-run profits as the industry looks less attractive to potential entrants.
2. Marketing barriers – Monopolists are likely to spend a lot of money on branding and advertising. They can spread this spending over a very large output, so the cost per unit is very low. Successful branding and advertising makes it harder for new firms to penetrate a market. A monopolist may also use multiple branding, which involves selling very similar products under different brands. This increases the number of brands that new entrants have to compete with, making it harder for them to win market share.
3. Anti-competitive practices – A monopolist can restrict a rival’s access to the market in a number of ways:

A manufacturer can threaten to cut off supplies to a retailer if the retailer stocks the product of a rival.

A firm may boycott a supplier if it supplies a rival firm.

A monopolist may use predatory pricing to deter or drive out competitors. It involves lowering the price in a part of the market where an entrant is competing to a level below cost, so deliberately incurring a loss. Once the entrant has been driven out, an incumbent can then push price back up again. The practice usually involves a cross-subsidy, where the firm uses its profits from other parts of the business to support the losses until the competitor is driven out. Anti-competitive practices are usually illegal and can result in large fines and prosecutions.

Exit Barriers

Where it is difficult for a firm to leave a market without incurring a high cost or some other penalty, an exit barrier exists. The most important of these is sunk costs. These are costs that cannot be recovered if a firm leaves the market.

Exit barriers are also entry barriers, since firms may be reluctant to enter markets they cannot easily leave.

Downward Sloping Demand Curve

Because the monopolist is the only producer, it follows that the firm’s demand curve is also the market demand curve and is therefore downward sloping (more can be sold at a lower price and vice versa).

Price Discrimination

It is sometimes possible for a firm with monopoly power to increase profits by charging higher prices to some customers and lower prices to others. This is called price discrimination.

In order for price discrimination to take place, the following conditions need to be met:

1. It must be possible to divide the market into different groups and identify customers who are prepared to pay higher prices.
2. It must be possible to maintain a separation between the different groups to prevent customers who are prepared to pay a higher price from buying at a lower price.
3. The different groups of customers must have demand with different elasticities. (where demand is more inelastic, consumers are prepared to pay a higher price).
4. The cost to the monopolist of separating the market must be less than the additional revenue gained by charging different prices.

Markets can be separated into different groups in a number of ways:

_Time _– For instance, off-peak rail fares are cheaper than at busier times of the day

_Age _– Children, students and retired people are often offered discounts

_Geography _– A company may charge higher prices in some parts of the country than others

_Income _– A water company may charge a lower price to families on low incomes.

The benefit to the firm of price discrimination is shown in Fig 2 below:

If the firm charges a single price to all its customers, it would charge a price of OA, at an output of OQA. This is the profit maximising price and output, where MC=MR. The total abnormal profit would be area AGHC.

But suppose there is a group of customers whom can be identified by the firm who are willing to pay more. This is shown by the higher price OB, where the firm is able to sell OQB.

By selling quantity OQB at price OB, and quantity (OQA - OQB) at price OA, the firm is able to make extra profit equal to area ABEF.

Equilibrium Under Monopoly

Provided that the monopolist is successful in keeping other firms from entering the market, there will be no difference between the short and long-run equilibrium outputs. The profit maximising output is where MR = MC. This is shown in Fig 1 below:

Equilibrium output is at OQ (where MC=MR). The firm makes abnormal profit of CP per unit. Total abnormal profit is shown by area ABCP.

Provided that new firms are prevented from entry, the abnormal profit will not be competed away by price being forced down (as happens under perfect competition and imperfect competition). In other words the monopolist earns permanent abnormal profit.

Is Monopoly Always Less Efficient than a Competitive Market?

The above analysis of the impact of monopoly on efficiency ignores the possibility that monopoly may be more efficient compared to firms operating in markets where there are lots of small firms (perfect or imperfect competition). This is because:

1. A monopolist may benefit from economies of scale not available to small firms. This could result in lower average costs than under more competitive market conditions. This would mean that productive efficiency is higher.
2. Because a monopolist enjoys abnormal profit it has the resources to invest in research and development (R&D). This may result in the development of new technologies leading to more efficient methods of production (ie higher dynamic efficiency). It could also lead to developing new products which satisfy consumer wants better than existing products. This would be an improvement in allocative efficiency.

The impact of monopoly on efficiency to some extent depends on whether the firm is a single-plant monopoly or a multi-plant monopoly.

Suppose all the firms in an industry that is perfectly competitive are bought up by a single owner. This would create a multi-plant monopoly. This would lead to a rise in price and fall in output, and therefore a loss of allocative efficiency. This is shown in Fig 4 below:

If the industry is perfectly competitive, the MC curves for all the firms can be aggregated to produce the market supply curve (Spc). The market demand curve is shown by Dpc. All firms are price takers at the market price of OF. The price, AR and MR are all equal to OF. The aggregate output of all firms is therefore OA, and every firm is producing where MC=MR.

Since price also equals MC, it follows that the industry is allocatively efficient. The firms are also operating at the bottom of the ATC curve.

If the industry is now monopolised, the single firm is now a price maker; if it increases output price will fall. So the market demand curve is now the monopolist’s AR curve, and therefore MR is no longer equal to AR.

The monopolist will produce where MC=MR. This occurs at output OB, resulting in a price of OG. Price is now above MC and therefore there is allocative inefficiency.

However, it is possible that a monopolist may re-organise production into fewer, larger plants (perhaps just one large factory). This could create vast economies of scale, pushing both the ATC and MC curves downwards. This is shown in Fig 5 below:

Under conditions of perfect competition, the market price and output are OG and OB respectively. Single-plant monopoly results in a downward shift of the cost curves. Price and output are now OF and OA respectively. Consumers have gained from a fall in price and increased quantity, compared to a perfectly competitive industry.

But note that there is still allocative inefficiency; the monopolist is still restricting output below the allocatively efficient level, which is OX, and a a price of OY.

A single plant monopoly may therefore be preferable to a multi-plant monopoly, but there remains a role for government to intervene to improve efficiency (see notes on 3.6.1 and 3.6.2).

Evaluation of Monopoly

Since the monopolist is in profit-maximising equilibrium (MC=MR) at an output below the level where ATC is at a minimum, it follows that there is productive inefficiency.

The monopolist produces at an output where price is above marginal cost. Therefore there is allocative inefficiency.

The economic impact of the allocative inefficiency is shown in Fig 3 below:

The profit maximising output is at OQ1. The allocatively efficient output is at OQ2. The good is under-produced, resulting in a welfare loss equal to area SXR.

This welfare loss is a deadweight loss, because there is no offsetting economic gain to anyone. This welfare loss is comprised of:

1. a loss of consumer surplus equal to area STR
2. a loss of producer surplus equal to area TRX

By restricting output to OQ1, the monopolist also gains at the expense of consumers. This is because area ABTS is transferred from consumer surplus to producer surplus.

The overall loss to consumers is area ASRB, which is the total reduction in consumer surplus.

The overall gain to the monopolist is area ABTS minus are TRX.

Costs and Benefits of Price Discrimination

__Consumers __– Some consumers will gain; namely those who would be unwilling or unable to pay a higher price, but can get the good at the lower price. Those consumers who pay the higher price lose out. Whether or not this is considered desirable may depend on the circumstances. For instance, if those who gain are on low incomes, it may be considered a good thing. But this is a value judgement, not a fact.

In some circumstances there may be no single price that enables the firm to make a profit at all. This would arise if the firms ATC curve was above its AR curve at all outputs. But, if the firm was able to charge different prices to different groups, it may be able to cover its total costs and make a profit. Without the possibility of profit the firm would shut down and there would be no good or service produced for anybody, so it could be argued that ALL consumers would gain from price discrimination in these circumstances.

Producers– As discussed above, they may be able to increase their abnormal profit through price discrimination.

Overall, the net gain is to producers, at the expense of consumers. In effect, price discrimination transfers some of the consumer surplus to producer surplus. In the rare cases where producers can charge each individual consumer the price s/he is willing to pay (called first degree price discrimination) there would be no consumer surplus at all.

Natural Monopoly

There are some circumstances in which it is uneconomic to have more than one firm in a market. This is called a natural monopoly. This arises when no one firm can fully exploit the opportunities for economies of scale. Natural monopolies exist in utilities such as rail networks, gas, electricity and water supply distribution systems and fixed line telecoms. An existing network can accommodate all existing customers, and new customers at a very low marginal cost.

If a rival (eg a new water supply network) was created, it would duplicate water mains and sewers to no advantage. If each company now had half the market, they would face much higher average costs, because of the loss of economies of scale. There would be a big loss of productive efficiency.

There would also be a loss of allocative efficiency. This is because most of the costs of running big utility networks are fixed costs (eg construction and maintenance of reservoirs and water mains). The marginal cost of supplying water to a household is very low. To make a profit, competing firms would have to charge higher prices than a single firm, to compensate for the higher average costs.

Price would therefore be higher than under a monopoly, and the gap between price and marginal cost would be greater.

NB Although competition may be wasteful in the __distribution __networks of utilities, it may still be economically beneficial to have competition in the ___production ___of services. For instance, different broaband and telecoms companies can use the fixed line network owned by BT. Various electricity producers are able to supply homes using the national grid.

Impact of Monopoly on Stakeholder Groups

__Consumers __– We have seen that monopoly is likely to result in higher prices for consumers, lower output and a loss of consumer surplus. But there are exceptions to this as discussed above.

_Shareholders __– A profit maximising monopolist will maximise the returns to shareholders, but managers may sometimes have different objectives (_see notes on 3.2.1), such as revenue or sales maximising, that would benefit managers at the expense of shareholders. A monopoly may also suffer from x-inefficiency due to the lack of competitive pressure, with managers profit-satisficing rather than profit maximising (see notes on 3.4.1).

__Employees __– A monopolist may pay higher wages compared to a more competitive market, as the managers may adopt a policy of profit satisficing, avoiding conflict with unions. They may also employ more workers, as they don’t face competitive pressure to reduce costs.

On the other hand, a monopolist committed to profit maximising may employ fewer workers as output will be lower than under perfect competition. If the monopolist was also a monopsony employer (see notes on 3.4.6) wages may be lower than under perfect competition.

__Suppliers __– Again, the consequence for suppliers also depends in part on whether or not the monopolist has monopsony power, which would enable the monopolist to drive down prices paid to suppliers.

Explain why a train company is likely to charge higher fares at certain times of the day.

Your answer should include: Price discrimination / elasticity / elasticities / separation / consumer surplus / profit