MARKET STRUCTURES (CONTINUED………..):MONOPOLY

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Introduction to Economics ECO401

Lesson 6.2

MARKET STRUCTURES (CONTINUED...........)

MONOPOLY

Monopoly defines the other pole or extreme of the market structure spectrum. Usually refers to

a situation where there is a single producer in the market. However it actually depends upon

how narrowly you define the industry.

Economists are often interested in how much monopoly power any firm (not necessarily a

monopoly) has. Here monopoly stands for the extent to which the firm can raise prices without

driving away all it customers. In other words, monopoly power and price elasticity of demand

are inversely related.

Profit maximization under monopoly:

i. The profit maximizing or best level of output is given where MR=MC. Price is then

read off the demand curve which is downward sloping. Note however the

difference with perfect competition, where the firm's demand curve was horizontal

and not downward sloping like the industry. IN a monopoly, however, the firm "is"

the industry and therefore faces the same demand curve as the industry (a

downward sloping one).

ii. Depending upon the level of AC at the point where MR=MC, the monopolist might

be earn supernormal profits, breaking even or minimizing short run losses.

iii. Price is greater than MR in equilibrium. Therefore price is not equal to MC. As

such, therefore, the supply curve for the firm is not the rising part of the MC

curve.

A monopolist can make supernormal profits even in long run because there is no easy entry

for other firms as in the case of perfect competition. So a monopolist can maintain her high

price even in the long run.

How can a monopolist retain its monopoly?

i. These can be due to "natural" reasons or "active policies" pursued by the

monopolist.

ii. Large initial fixed costs may be involved which makes it prohibitive for others to

enter.

iii. Natural monopoly experiences economies of scale as its operation becomes

bigger and bigger and therefore it is cost-effective for only one single firm

producing for the entire economy, rather than two or more firms.

iv. Product differentiation or brand loyalty.

v. Active pricing strategies (limit pricing: charging a price below a potential entrant's

AC to drive him out or discourage him from entering).

vi. The "threat of takeover" by the monopolist sometimes prevents other firms from

entering.

vii. The monopolist controls the supply of key factors of production.

viii. The monopolist produces a product which no one else can imitate, i.e. is

protected by patents or copyrights.

Monopolies and the public interest:

a. Disadvantages of monopolies:

i. Monopolists produce lower quantities at higher prices compared to perfectly

competitive firms. This is because monopolists do not produce where P=MC (the

point of allocative efficiency) nor at P= ACminimum (the point of cost efficiency).

ii. Monopolists earn supernormal profits compared to perfectly competitive firms

iii. Most of the "surplus" (producer + consumer surplus) accrues to monopolists.

iv. Monopolists do not pay sufficient attention to increasing efficiency in their

production processes.

Introduction to Economics ECO401

b. Advantages of monopolies:

i. Natural Monopolies are beneficial and efficient for society.

ii. Supernormal or monopoly profits can be invested in R&D, development of new

innovative products and to sustain a price war when breaking into new foreign

markets.

c. Government regulation:

The government can regulate monopolies so as to ensure that they set a price where the AR

curve intersects the MC curve. This will ensure allocative efficiency. It might not be possible to

ensure that productive efficiency is attained as well because it is not necessary for the AR

curve to intersect MC at the ACminimum. Also, in setting AR (or P) = MC, the economist might

make a loss in which case the government would have to provide a subsidy. If the monopolist

makes a profit then a tax is warranted. Due to difficulties with implementing subsidies,

governments sometimes regulate monopolies at the point where the AR curve intersects the

AC curve. This often takes the monopolist reasonably close to the allocative and productive

efficiency points without necessitating a tax or a subsidy.

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