Monopoly is a term used by economists to refer to the situation in which there is a single seller of a product (i.e., a good or service) for which there are no close substitutes. The word is derived from the Greek words monos (meaning one) and polein (meaning to sell).
In economics, monopoly is a pivotal area to the study of market structures, which directly concerns normative aspects of economic competition, and sets the foundations for fields such as industrial organization and economics of regulation. There are four basic types of market structures under traditional economic analysis: perfect competition, monopolistic competition, oligopoly and monopoly. A monopoly is a market structure in which a single supplier produces and sells the product. If there is a single seller in a certain industry and there are no close substitutes for the goods being produced, then the market structure is that of a “pure monopoly”. Sometimes, there are many sellers in an industry and/or there exist many close substitutes for the goods being produced, but nevertheless firms retain some market power. This is called monopolistic competition, when there are some sellers and the commodities may be substitute for each other or not then the market is called Oligopoly.
* Single Seller: In a monopoly there is one seller of the monopolized good who produces all the output. Therefore, the whole market is being served by a single firm, and for practical purposes, the firm is the same as the industry. In a competitive market (that is, a market with perfect competition) there are an infinite number of sellers each producing an infinitesimally small quantity of output.
* Market Power: Market Power is the ability to affect the terms and conditions of exchange so that the price of the product is set by the firm (price is not imposed by the market as in perfect competition). Although a monopoly’s market power is high it is still limited by the demand side of the market. A monopoly faces a negatively sloped demand curve not a perfectly inelastic curve. Consequently, any price increase will result in the loss of some customers
Monopolies derive their market power from barriers to entry – circumstances that prevent or greatly impede a potential competitor’s entry into the market or ability to compete in the market. There are three major types of barriers to entry; economic, legal and deliberate.
* Economic Barriers:Economic barriers include economies of scale, capital requirements, cost advantages and technological superiority.
Economies of scale: Monopolies are characterized by declining costs over a relatively large range of production. Declining costs coupled with large start up costs give monopolies an advantage over would be competitors. Monopolies are often in a position to cut prices below a new entrant’s operating costs and drive them out of the industry. Further the size of the industry relative to the minimum efficient scale may limit the number of firms that can effectively compete within the industry. If for example the industry is large enough to support one firm of minimum efficient scale then other firms entering the industry will operate at a size that is less than MES meaning that these firms cannot produce at an average cost that is competitive with the dominant industry.
Capital requirements: Production processes that require large investments of capital, or large research and development costs or substantial sunk costs limit the number of firms in an industry. Large fixed costs also make it difficult for a small firm to enter an industry and expand.
Technological Superiority: A monopoly may be better able to acquire, integrate and use the best possible technology in producing its goods while entrants do not have the size or fiscal muscle to use the best available technology. In plain English one large firm can sometimes produce goods cheaper than several small firms.
No Substitute Goods:A monopoly sells a good for which there is no close substitutes. The absence of substitutes makes the demand for the good relatively inelastic enabling monopolies to extract positive profits.
* Control of Natural Resources: A prime source of monopoly power is the control of resources that are critical to the production of a final good.
* Legal Barriers: Legal rights can provide opportunity to monopolize the market in a good. Intellectual property rights, including patents and copyrights, give a monopolist exclusive control over the production and selling of certain goods. Property rights may give a firm the exclusive control over the materials necessary to produce a good.
In addition to barriers to entry and competition, barriers to exit may be a source of market power. Barriers to exit are market conditions that make it difficult or expensive for a firm to leave the market. High liquidation costs are a primary barrier to exit. Market exit and shutdown are separate events. The decision whether to shut down or operate is not affected by exit barriers. A firm will shut down if price falls below minimum average variable costs.
Monopoly versus competitive markets
While monopoly and perfect competition mark the extremes of market structures there are many point of similarity. The cost functions are the same. Both monopolies and perfectly competitive firms minimize cost and maximize profit. The shutdown decisions are the same. Both are assumed to face perfectly competitive factors markets. There are distinctions, some of the more important of which are as follows:
Market Power – market power is the ability to control the terms and condition of exchange. Specifically market power is the ability to raise prices without losing all one’s customers to competitors. Perfectly competitive (PC) firms have zero market power when it comes to setting prices. All firms in a PC market are price takers. The price is set by the interaction of demand and supply at the market or aggregate level. Individual firms simply take the price determined by the market and produce that quantity of output that maximize the firm’s profits. If a PC firm attempted to raise prices above the market level all its “customers” would abandon the firm and purchase at the market price from other firms. A monopoly has considerable although not unlimited market power. A monopoly has the power to set prices or quantities although not both. A monopoly is a price maker. The monopoly is the market and prices are set by the monopolist based on his circumstances and not the interaction of demand and supply. The two primary factors determining monopoly market power are the firm’s demand curve and its cost structure.
Product differentiation: There is zero product differentiation in a perfectly competitive market. Every product is perfectly homogeneous and a perfect substitute. With a monopoly there is high to absolute product differentiation in the sense that there is no available substitute for a monopolized good. The monopolist is the sole supplier of the good in question. A customer either buys from the monopolist on her terms or does without.
Number of competitors: PC markets are populated by an infinite number of buyers and sellers. Monopoly involves a single seller.
Barriers to Entry – Barriers to entry are factors and circumstances that prevent entry into market by would be competitors and impediments to competition that limit new firm’s from operating and expanding within the market. PC markets have free entry and exit. There are no barriers to entry, exit or competition. Monopolies have relatively high barriers to entry. The barriers must be strong enough to prevent or discourage any potential competitor from entering the market.
PED; the price elasticity of demand is the percentage change in demand caused by a one percent change in relative price. A successful monopoly would face a relatively inelastic demand curve. A low coefficient of elasticity is indicative of effective barriers to entry. A PC firm faces what it perceives to be perfectly elastic demand curve. The coefficient of elasticity for a perfectly competitive demand curve is infinite.
Excess Profits- Excess or positive profits are profit above the normal expected return on investment. A PC firm can make excess profits in the short run but excess profits attract competitors who can freely enter the market and drive down prices eventually reducing excess profits to zero. A monopoly can preserve excess profits because barriers to entry prevent competitors from entering the market.
Profit Maximization – A PC firm maximizes profits by producing where price equals marginal costs. A monopoly maximizes profits by producing where marginal revenue equals marginal costs. The rules are equivalent. The demand curve for a PC firm is perfectly elastic – flat. The demand curve is identical to the average revenue curve and the price line. Since the average revenue curve is constant the marginal revenue curve is also constant and equals the demand curve, Average revenue is the same as price (AR = TR/Q = P x Q/Q = P). Thus the price line is also identical to the demand curve. In sum, D = AR = MR = P.
Monopoly and efficiency
A natural monopoly is a firm which experiences increasing returns to scale over the relevant range of output. A natural monopoly occurs where the average cost of production “declines throughout the relevant range of product demand.” The relevant range of product demand is where the average cost curve is below the demand curve. When this situation occurs it is always cheaper for one large firm to supply the market than multiple smaller firms, in fact, absent government intervention in such markets will naturally evolve into a monopoly. An early market entrant who takes advantage of the cost structure and can expand rapidly can exclude smaller firms from entering and can drive or buy out other firms. A natural monopoly suffers from the same inefficiencies as any other monopoly. Left to its own devices a profit seeking natural monopoly will produce where marginal revenue equals marginal costs. Regulation of natural monopolies is problematic. Breaking up such monopolies is counter productive. The most frequently used methods dealing with natural monopolies is government regulations and public ownership. Government regulation generally consists of regulatory commissions charged with the principal duty of setting prices. To reduce prices and increase output regulators often use average cost pricing. Under average cost pricing the price and quantity are determined by the intersection of the average cost curve and the demand curve. This pricing scheme eliminates any positive economic profits since price equals average cost. Average cost pricing is not perfect. Regulators must estimate average costs. Firms have a reduced incentive to lower costs. And regulation of this type has not been limited to natural monopolies.
A government-granted monopoly (also called a “de jure monopoly”) is a form of coercive monopoly by which a government grants exclusive privilege to a private individual or firm to be the sole provider of a good or service; potential competitors are excluded from the market by law, regulation, or other mechanisms of government enforcement. Copyright, patents and trademarks are examples of government-granted monopolies.
Difference between different market structures
It can be useful when thinking about monopoly to look at two extreme cases. One is a pure monopoly, in which one company has complete control over the supply or sales of a product for which there are no good substitutes. The other is pure competition or perfect competition, a situation in which there are many sellers of identical, or virtually identical, products.
A seller of a product in a competitive industry (i.e., one characterized by many competing sellers of a good or service) generally can only charge a single price (i.e., the price that its competitors are charging) to all of its customers. However, monopolists not only have the ability to charge a higher price than would competitive firms supplying the same product, but they also have the ability to charge significantly different prices to different customers for the same product.
Causes of Monopoly
(1) By developing or acquiring control over a unique product that is difficult or costly for other companies to copy. This can occur as a result of a purchase, merger or research and development. An example is pharmaceuticals, which can be extremely expensive and risky to develop (and which are also protected by patents), thereby locking out all but a few large, well funded companies with ample talent. Closely related to this is control over a unique input for a product, such as a unique natural resource.
2) By having a lower production cost than competitors. This can result from having a more efficient (i.e., more output per unit of input) production technique or from having access to a unique source of low cost inputs (e.g., a mine containing exceptionally high grade ore). In some cases, a greater efficiency is the result of economies of scale, which means that the production cost per unit of product declines as the volume of output increases due to the ability to use some resource more intensively (e.g., a steel mill or railroad with lots of excess capacity).
(5) By receiving a government grant of monopoly status, i.e., becoming a government-granted monopoly. Today this is usually accomplished through the acquisition of a license, patent, copyright, trademark or franchise. Common examples include a franchise for cable television for a certain city or region, a trademark for a popular brand, copyrights on certain cartoon characters or a patent for a unique product or production technique.
Why Monopolies Can Be Beneficial
Despite their reputation for evil, monopolies can actually generate a net benefit for society under certain circumstances. These are usually situations in which the power and duration of the monopoly are carefully limited.
Natural monopolies can be particularly beneficial. This is because of their ability to attain lower costs of production, often far lower, than would be possible with competitive firms producing the same product in the same region. However, it is almost always necessary for such monopolies to be regulated by a relatively uncorrupted government in order for society to obtain the potential benefits. This is because such monopolies by themselves, as is the case with all monopolies, have little incentive to charge prices close to cost and, rather, tend to charge profit-maximizing prices and restrict output. Likewise, there is often little incentive to pay much attention to quality.
It has long been recognized that government-granted monopolies (i.e., patents, copyrights, trademarks and franchises) can benefit society as a whole by providing financial incentives to inventors, artists, composers, writers, entrepreneurs and others to innovate and produce creative works. In fact, the importance of establishing monopolies of limited duration for this purpose is even mentioned in the U.S. Constitution7. In addition to being for limited periods of time, such monopolies are also generally restricted in other ways, including that there are often fairly good substitutes for their products8.
Why Monopolies Can Be Harmful
Large monopolies have considerable potential to damage both economies and democratic governments (although they can be very beneficial for other types of governments9). Unfortunately, the full extent of the damage is usually not as obvious, at least to the general public, as are the seemingly beneficial effects. And monopolists often go to extreme lengths to disguise or hide such harmful effects. Among the ways in which unregulated monopolies can harm an economy are by causing:
(1) Substantially higher prices and lower levels of output than would exist if the product were produced by competitive companies.
(2) A lower level of quality than would otherwise exist. This includes not only the quality of the goods and services themselves, but also the quality of the services associated with such goods and services.
(3) A slower advance in the development and application of new technology. Advances in technology can improve the quality (e.g., ease of use, durability, environmental friendliness) of products, and they can also reduce their costs of production. Innovation is not as necessary for a monopolist as it is for a highly competitive firm, and, in fact, it can be a bad business strategy. Research and development by monopolists is often largely focused on ways of suppressing new, potentially competitive technologies (and includes such techniques as stockpiling patents) rather than true innovation 10. This can be a serious disadvantage, because economists have long recognized that innovation is a key factor (and possibly the single most important factor) in the growth of an economy as a whole11.
The adverse effects of monopolies can be much more noticeable on an individual level than in the aggregate. These effects include the destruction of businesses that would have survived had competition been based solely on quality and price (with a consequent loss of assets of the owners and jobs of the employees) and prices for products so high as to cause hardship or be unaffordable for some people.
It is often said, even by those who have negative opinions about monopolies, that “monopoly itself is not necessarily bad, but rather it is the abuse of monopoly power that is harmful.” This statement is an excessive simplification, and it can be indicative of a lack of understanding of the full extent of harm that can be caused by monopolies.
The abuse of monopoly power clearly can be harmful to an economy. The term abuse in this context refers to such tactics as predatory pricing, colluding with suppliers and the leveraging of a monopoly in one product to gain a monopoly for another product. But what is often overlooked, even by legislation whose supposed purpose is to restrain or regulate monopolies, is the fact that monopolies can be harmful even if they do not engage in such practices.
If a monopolist engages in behavior that produces results similar to that by firms in an industry that is characterized by intensive competition (i.e., charges prices close to cost and does not engage in price discrimination), then there might not be a problem. Unfortunately, however, this is rare even for a seemingly benevolent monopolist. The reason is that the very strong incentives to maximize profits that exist for virtually any business, whether pure monopolist, perfect competitor or somewhere in between, produce very different results for a monopolist than they would for a firm in a highly competitive industry. And monopolists (as is the case with competitive firms) usually do not rank benevolence as a top corporate priority.
Thus, the management and employees in a monopoly might not at all be aware that they are harming the economy, especially if their behavior is similar to that by a non-monopoly. In fact, they may even genuinely believe that they are benefiting the economy because of their conviction that they are more efficient and productive than a number of firms competing with each other would be.
Another reason that the positive effects of even a benevolent monopolist would not be as great as for a competitive company is that innovations that improve quality and reduce production costs are often the result of desperation. (This is something that is easy for many owners of struggling businesses to understand, but is often difficult for others to fully grasp without experiencing it firsthand.) Monopolists generally consider themselves successful, and thus, although they often are innovators to some extent (typically mainly in their earlier years), they usually just do not have that extra motivation to produce truly breakthrough innovations that smaller companies desperate to gain market share (or to just survive) have.
Disadvantages of a Monopoly
* Higher Prices Higher Price and Lower Output than under Perfect Competition. This leads to a decline in consumer surplus and a deadweight welfare loss
* Allocative Inefficiency. A monopoly is allocatively inefficient because in monopoly the price is greater than MC. P > MC. In a competitive market the price would be lower and more consumers would benefit
* Productive Inefficiency A monopoly is productively inefficient because it is not the lowest point on the AC curve.
* X – Inefficiency. – It is argued that a monopoly has less incentive to cut costs because it doesn’t face competition from other firms.Therefore the AC curve is higher than it should be.
* Supernormal Profit. A Monopolist makes Supernormal Profit Qm * (AR – AC ) leading to an unequal distribution of income.
* Higher Prices to Suppliers – A monopoly may use its market power and pay lower prices to its suppliers. E.g. Supermarkets have been criticised for paying low prices to farmers.
* Diseconomies of Scale – It is possible that if a monopoly gets too big it may experience diseconomies of scale. – higher average costs because it gets too big
* Worse products Lack of competition may also lead to improved product innovation.
* Charge Higher prices to suppliers. Monopolies may use their supernormal profits to charge higher prices to suppliers.
A Few Problems
Three problems often associated with a market controlled totally by a single firm are: (1) inefficiency, (2) income inequality, (3) political abuse.
* Inefficiency: The most noted monopoly problem is inefficiency. Market control means that a monopoly charges a higher price and produces less output than would be achieved under perfect competition. In addition, and most indicative of inefficiency, the price charged by the monopoly is greater than the marginal cost of production.
* Income Inequality: A lesser known problem with monopoly is an inequitable distribution of income. To the extent that monopoly earns economic profit, consumer surplus is transferred from buyers to the monopoly. Buyers end up with less income and the monopoly ends up with more. In addition, because price is greater than marginal cost and a monopoly receives economic profit, factor payments to some or all of the resources used by the monopoly are greater than their contributions to production. A portion of this economic profit is often “paid” to the owners of the labor, capital, or land.
* Political Abuse: A third potential problem, one tied directly to the concentration of income by the monopoly resources, is the abuse of political power. The monopoly could use its economic profit to influence the political process, especially policies that might prevent potential competitors from entering the market.