Monopoly

Understanding Monopoly Market Structure

Assumptions of Monopoly

One dominant firm in the market
Sells unique good or service with no close substitutes
High Barriers to Enter and Exit the Market

Monopolies have incredibly high market power. Being the sole provider or dominant provider of a good provides the monopoly with the ability to set the price of a good. Therefore, monopolies in private markets can bring negative effects to society as a whole. However, due to the economies of scale a large firm can benefit from, some natural monopolies exist. For example, Public utilities such as water, electricity or postal services may be better as a natural monopoly to lower costs and therefore lower prices for consumers. Normal Profits and a Loss.

Monopoly.mov

The video above will look at the assumptions of monopolies in more detail and how we show a monopoly making abnormal profits, normal profits and a loss.

What can cause high barriers to entry?

Economies of Scale

As the monopoly produces a larger output in the market, they are able to benefit from economies of scale and a lower LRATC. (Click here to review LRAC). Any firm that wishes to enter the market as a new entrant, will face a higher LRAC as they are not yet at the scale or size to be able to produce a greater quantity at a lower LRAC. Therefore, the prices the new entrant will need to charge will need to be higher in order to cover their higher LRAC, otherwise, the firm will be making a loss. As such, Economies of scale can act as a high barrier for new firms to try to enter the market.

Legal Barriers

Patents - Patents are legal rights given by governments to a firm that has developed a new product or invention. Patents prevent other firms from copying. or using that firm's designs, products, or inventions. As such, this allows the firms to become the sole provider of the good and hence, becomes a monopoly. Whilst this may seem counterproductive, patents provide firms with protection

Copyrights - These protect the rights of an author to print, publish and sell work that is copyrighted.

Licenses - Licenses could be required to run certain businesses. For example, to open a doctor's surgery, governments may require a medical license. Whilst not necessarily creating a monopoly, these policies tend to reduce competition because of the need to obtain a license to operate. Similarly, international firms may sell licenses to individuals in other countries to be the distributors of their products. These licenses can create monopolies as only firms with the licensing can sell the product.

Trade Barriers - Tariffs, Quotas, and other forms of trade protection may allow domestic firms to gain a monopoly. We will look into these more in Types of Trade Protections. Essentially, these trade barriers prevent competition by making imported goods more expensive, compared to goods produced domestically. Therefore, these can allow domestic firms to become a monopoly as international competition

Control of Essential Resources

If a firm controls the supply of an essential resource required in the production of a good, then that firm will essentially be a monopoly, as no other firm can access the resources. DeBeers, the South African diamond firm, controlled 90% of the diamond industry in the 1980s, allowing the firm to have control over the price of diamonds. Increased mining and competition have led to DeBeers losing this monopoly power and the price of diamonds being more influenced by market forces.

Aggressive Tactics

If a monopoly firm faces a potential new entrant and the resulting competition, it may use Aggressive Tactics to force the competition out of the market. For example, it may use methods such as Predatory Pricing. With this tactic, the monopoly lowers it's prices to extremely low prices compared to the new entrant. This essentially causes the consumers to purchase from the monopoly and not the new entrant, forcing the new entrant to have to exit the market. After this, the monopoly then raises its prices back to the levels before the threat of the new entrant.

Strategies such as these, aim to force any new entrant out of the market and dissuade any competition and therefore protect the monopolies power.

Understanding Monopolies effects on Market Efficiency

The following video examines Natural Monopolies and the effects of a Monopoly on Market Efficiency.

Monopoly copy.mov

Natural Monopolies are defined as firms with very high start up costs (for example of infrastructure), which in turn creates high barriers to entry within the market and therefore prevents competition. For example, the initial cost of building a countries energy sector is incredibly high. Firms will face the cost of constructing all of the infrastructure required to provide electricity, such as power stations, pylons to carry the electricity, transformers to lower the voltage for households etc. These high costs mean that having smaller firms provide a smaller quantity each (i.e. higher levels of competition), will result in a higher average cost of production, and therefore less people can consume or must pay the higher prices. This is why natural monopolies are sometimes nationalised industries, so that the goods are produced for the lowest AC and can therefore be consumed by everyone

Evaluating Monopolies

Drawbacks to Monopolies

Allocative Inefficiencies and Market Failures

As we have seen, because a monopolist produces at the point where P>MC, this means that the price in the market is higher than the Marginal Cost of Production. This is not the allocative efficient point in the market of AR=MC (P=MC) or D=S and therefore creates an underproduction in the market. Less consumers are willing and able to consume (resulting in a smaller consumer surplus) at the monopolist's price compared to the market equilibrium or AR=MC. This creates a misallocation of resources and the free market to fail to allocate resources efficiently.

Higher Prices and Lower Output

As a result of no competition, the monopolist can continue to produce at its profit maximisation level of output. This results in the Monopolist producing at a higher price and at a lower level of output. Given that the Monopolist is the only dominant firm in the market, this causes the prices in the market to be higher and the output to be lower. Due to the high barrier of entry to the market, there is a lack of competition in the market, therefore the Monopolist has no incentive to lower its prices or increase its output.

Higher prices mean consumers are worse off. This could have a negative impact on the distribution of income as factor payments, such as profits, are redistributed from consumers paying a higher price, to the owners of the monopoly.

Lack of Competition could increase costs

Due to the lack of competition, the Monopolist may not have an incentive to produce at the lowest LRAC. Higher costs may therefore cause higher prices for consumers. Due to the monopolist being the sole provider of a good or service and the high barrier that protect the abnormal profits, the firm may be less concerned about lowering costs. This is know as X-inefficiency.

Potential for Less Innovation

Again due to the high barriers and no competition, the monopolist has no incentive to innovate in new products or research & development.

Potential Benefits to Monopolies

Economies of Scale

Due to the larger output of Monopolies, a monopolist may be able to benefit from Economies of Scale. With a lower LRAC due to benefiting from EoS, this could lead to lower prices of the goods or service. This could benefit society as lower costs of production could translate into less waste of scarce resources.

Natural Monopolies

As we have seen, some goods or services benefit from a monopoly due to the high costs of operating. By producing a greater output for a lower LRAC, prices for that good or service can be lower than if there was more competition in the market, with each firm producing a lower output at a higher LRAC. If the good being produced is a necessity, such as water or electricity, this can benefit consumers as the prices for these necessity goods will be lower, increasing consumers' purchasing power.

Research & Development

Compared to smaller firms in perfectly competitive markets or monopolistic competition, a Monopolist can benefit from higher levels of abnormal profits. This abnormal profit, in turn, can be used by the monopolist to cover costs associated with research and development.

Similarly, legal protections, such as copyrights or patents, ensure the monopolist can profit from the research and development. Without that protection, firms would have less incentive to invest large amounts of money into R&D if others could copy and profit their designs or ideas. This would therefore lead to lower levels of innovation and product development as the risks for the firm not making profits on an investment would be too high.

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