Monopoly - A firm that produces the entire market supply of a particular good or service.
  • In monopoly situations, the demand curve facing the firm is identical to the market demand curve for the product
  • Firms with market power confront downward-sloping demand curves for their own output
  • Competitive firms face a horizontal demand curve
Price and Marginal Revenue
  • Monopolies face a different situation, when profit maximizing, than competitive firms, nevertheless, the profit-maximizing rule remains the same.
    1. Profit-maximization rule - produce at that rate of output where Marginal Revenue = Marginal Cost.
    2. Unlike competitive firms, marginal revenue is not equal to price for a monopolist.
    3. So long as the demand curve is downward sloping, MR will always be less than price.
    4. The MR curve lies below the demand (price) curve at every point but the first.
  • Profit maximization.  
    1. We need to find the intersection of marginal cost and marginal revenue.  This will give us the profit-maximizing rate of output.
    2. Only one price is compatible with the profit-maximizing rate of output.
The Monopoly Price
  • The intersection of the marginal revenue and marginal cost curves establishes the profit-maximization rate of output.
  • The demand curve tells us how much consumers are willing to pay for that output.
  • Monopoly Profits  --  a monopoly receives larger profits than a comparable competitive industry by reducing the quantity supplied and pushing prices up.
    • high profits tend to attract profit-hungry entrepreneurs
    • profits are maintained as long as an impassable barrier to entry (e.g., a patent) prevents any competitors from entering the market
A Comparative Perspective on Market Power
  • Competitive industry
    1. High prices and profits signal consumers’ demand for more output.
    2. The high profits attract new suppliers.
    3. Production and supplies expand.
    4. Prices slide down the market demand curve.
    5. A new equilibrium is established.
    6. Price equals marginal cost at all times.
    7. Throughout the process, there is great pressure to reduce costs or improve product quality.
  • Monopoly industry
    1. High prices and profits signal consumers’ demand for more output.
    2. Barriers to entry are erected to exclude potential competition.
    3. Production and supplies are constrained.
    4. Prices don’t move down the market demand curve.
    5. No new equilibrium is established.
    6. Price exceeds marginal cost at all times.
    7. There is squeeze on profits and thus no pressure to reduce costs or improve product quality.
    8. consumers do not get the optimal mix of output (most utility from available resources).
  • The Limits to Power
    1. Monopolists only have absolute control of the quantity of output supplied to the market.
    2. Monopolists must still contend with the market demand curve.  How strong a constraint that is depends on the price elasticity of demand.
    3. The greater the price elasticity of demand, the more a monopolist will be frustrated in its attempts to establish both high prices and high volume.
  • Price Discrimination
    1. A monopolist may be able to extract greater profits by practicing price discrimination.
    2. Price discrimination  is the sale of an identical good at different prices to different consumers by a single seller.
  • Types of Barriers to Entry are:
    1. Patents – offers a producer 20 years of exclusive rights to produce a particular product.
    2. Monopoly Franchises – governments also create and maintain monopolies by giving a single firm the exclusive right to supply a particular good or service, although other firms can product it.  For example, local cable TV, local telephone service and professional baseball, basketball and football teams all enjoy local monopolies.
    3. Control of Key Inputs – A company may lock out competition by securing exclusive access to key inputs.
    4. Lawsuits – May be used to prevent new companies from successfully entering an industry.
    5. Acquisition – When all else fails, purchase a potential competitor.
    6. Economies of Scale – A monopoly may persist because of cost advantages over smaller firms
Pros and Cons of Market Power
  • Research and Development
    1. While it is clear that monopolists have a greater advantage in pursuing research and development (greater profits), they do not have a clear incentive to do so.
    2. Monopolists’ efforts into R&D are likely to be geared to enhancing their market power, resulting in an even greater redistribution of income and welfare to them.
  • Entrepreneurial Incentives
    1. While it is possible that market power can be a tremendous incentive for entrepreneurial activity, it is not necessarily true.
      • An innovator can make substantial profits in a competitive market before the competition catches up.
      • An innovator may be dissuaded by their inability to penetrate the market.
  • Economies of Scale
    1. Economies of Scale are reductions in minimum average cost that come about through increases in the size (scale) of plant and equipment.
    2. If economies of scale exist in a monopoly, the monopolists may attain much greater efficiency than a competitive market, with the same resources, could.
    3. There is no guarantee that such economies of scale will exist in a given industry.
    4. Natural Monopolies.
      • A Natural Monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply.
      • Economies of scale act as a “natural” barrier to entry.
        • Examples include:
          • Local telephone services.
          • Local cable services.
          • Other local utility services.
      • While economically desirable, natural monopolies may be abused.  
  • Contestable Markets
    1. Contestable market - an imperfectly competitive market subject to potential entry if prices or profits increase.
    2. Such markets are characterized by moderate barriers to entry where the potential profits can reach a certain level enticing competitors to enter the market
    3. If entry is possible, a monopolized market may be contestable,
    4. Structure vs. Behavior – The structure of monopoly is, in itself, not a problem.  If potential rivals force a monopolist to behave like a competitive firm, then a monopoly imposes no cost on consumers or on society at large.
  1. Sherman Act (1890) – prohibits “conspiracies in restraint of trade.
  2. Clayton Act (1914) – principally aimed at preventing the development of monopolies by prohibiting price discrimination, exclusive dealing agreements, certain types of mergers, and interlocking boards of directors among competing firms.
  3. The Federal Trade Commission Act (1914) – created the FTC to study industry structures and behavior so as to identify anti-competitive practices.

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last updated January 15, 2011