Chapter 14 - Market structure: Monopoly Flashcards
What is a monopoly?
A form of market structure in which there is one seller of a good or service.
What are the assumptions for a monopoly?
- The firms aims to maximise profits
- There is a single seller of a good
- There are no substitutes for a good, either actual or potential
- There are barriers to entry in the market
What are the barriers to entry of a monopoly market?
- economies of scale
- high fixed costs
- cost advantages
- government regulation
- switching costs
- strategic action
- network effects
How is economies of scale a barrier to entry?
Economies of scale can act as a barrier to the entry of new firms into an industry. If a monopoly firm faces significant economies of scale — for example, if the minimum efficient scale is close to the extent of market demand — then it will always be able to produce at lower cost than any potential entrant, so this will make it difficult for new firms to join the market.
How is high fixed costs a barrier to entry?
One situation in which a firm may face substantial economies of scale is where fixed costs are high relative to marginal costs. For example, if a potential entrant knows that it needs to invest heavily in set-up costs before being able to produce, this may deter entry.
There may be circumstances where the existing monopoly firm is able to consolidate its position by taking strategic action to affect its fixed costs to deter entry from new firms. For example, heavy investment in research and development (R&D) can make it difficult for potential entrants to become established in a market, because they need to undertake high expenditures before being able to compete with the existing firm.
How are cost advantages a barrier to entry?
A monopoly firm may hold some absolute cost advantage over potential entrants. For example, the firm may have control over a key input needed for the production process. This could be control over a raw material or a supply chain. Or it might be that a firm has a locational advantage, being sited close to suppliers of a key input - or, indeed, to the market for a good.
How is government regulation a barrier to entry?
In some cases, a firm may have some form of legal protection against competition. A common example of this is the patent system, whereby a firm may be protected from competition for a period following the introduction of a new innovative product. The aim of such government action is to encourage R&D and innovation in product development.
How is switching costs a barrier to entry?
In some cases, the barrier to entry may arise because a firm’s customers face high costs in switching to a new substitute product. Such costs may occur because a consumer has signed a contract for a fixed term, or simply because of brand loyalty. A person who is familiar with using Microsoft products may be reluctant to invest time in learning to use new systems and software.
How is strategic action a barrier to entry?
An incumbent firm may undertake actions that create barriers to the entry of new firms. This action could be in taking out patents that the firm does not intend to use, therefore preventing new firms from setting up in a market, or it might be that the firm adopts a pricing policy that deters entry.
How is network effects a barrier to entry?
Some goods or services have significant network effects. This is where people use a product because they know that there are many others who also use it. Adobe Acrobat’s .pdf format is so widely used that it would be difficult for a new firm to come along with a different format for files.
What is a price maker?
A firm that is able to choose the selling price for its good or service, as it faces a downward-sloping demand curve.
How does the monopoly model work?
The first point to note is that a monopoly firm faces the market demand curve directly. This means that the monopolist’s demand curve is downward-sloping. This is different to the firm’s demand curve under perfect competition, where the firm must accept the price set in the market, which means that its demand curve is horizontal.
For the monopolist, the demand curve may be regarded as showing average revenue. Unlike a firm under perfect competition, therefore, the monopolist has some influence over price, and can make decisions regarding price as well as output. This is not to say that the monopolist has complete freedom to set the price, as the firm is still constrained by market demand.
However, the firm is a price maker and can choose a location along the demand curve. As with the firm under perfect competition, a monopolist aiming to maximise profits will choose to produce at the level of output at which marginal revenue (MR) equals marginal cost (MC). MR = MC is always the profit-maximising level of output in whatever market structure the firm is operating.
Notice that a monopoly will always produce in the segment of the demand curve where MR is positive, which implies that demand is price elastic.
This choice allows the monopolist to make supernormal profits, which can be identified as the shaded area in the figure. As before, this area is average revenue minus average cost (i.e. supernormal profit per unit) multiplied by the quantity.
It is at this point that barriers to entry become important. Other firms may see that the monopoly firm is making healthy supernormal profits, but the existence of barriers to entry will prevent those profits from being competed away, as would happen in a perfectly competitive market. With secure barriers to entry, the monopolist can continue to make supernormal profits in the long run.
Why might monopolies not make supernormal profits?
A monopolist cannot be guaranteed always to make such substantial profits. The size of the profits depends upon the relative position of the market demand curve and the position of the cost curves. For example, if the cost curves in the diagram were higher, the monopoly would actually incur losses, as if the monopoly tries to maximise profits by choosing the output at which MR = MC, it will charge a price (PM) that is below average cost (AC).
What happens in a monopoly if there is an increase in demand?
If a monopoly experiences (or can induce) an increase in the demand for its product, it will benefit. Suppose that initially the monopoly faces the demand curve Do. It maximises profits by setting MR = MC, producing Q0 output and charging a price P0. If the demand curve shifts to the right, notice that the MR curve will also shift, as this has a fixed relationship with the demand curve. After the increase in demand, the monopoly chooses to produce Q1 output, where MR = MC, and now sets a higher price at P1, making higher profits.
How does efficiency work in a monopoly market?
The characteristics of the monopoly market can be evaluated in relation to productive and allocative efficiency. A firm is said to be productively efficient if it produces at the minimum point of its long-run average cost curve. It is clear from that this is extremely unlikely for a monopoly. The firm will produce at its minimum long-run average cost only if it so happens that the marginal revenue curve passes through this exact point — and this would happen only by coincidence.
For an individual firm, allocative efficiency is achieved when price is set equal to marginal cost. It is clear that this will not be the case for a profit-maximising monopoly firm. The firm chooses output where MR equals MC - however, given that MR is below AR (i.e. price), price will always be set above marginal cost.
Why is allocative efficiency a disadvantage in a monopoly?
This is best seen by comparing the monopoly market with the perfectly competitive market. To do this, the situation can be simplified by setting aside the possibility of economies of scale. This is perhaps an artificial assumption to make, but it will be relaxed later.
Suppose that there is an industry with no economies of scale, which can be operated either as a perfectly competitive market with many small firms or as a monopoly firm running a large number of small plants.
Consumer surplus represents the surplus that consumers gain from consuming this product. In other words, it is a measure of the welfare that society receives from consuming the good. Now suppose that the industry is taken over by a profit-maximising monopolist. The firm can close down some of the plants to vary its output over the long run, and the LRS can be regarded as the monopolist’s long-run marginal cost curve.
As the monopoly firm faces the market demand curve directly, it will also face the MR curve shown, so will maximise profits at quantity Q and charge a price P. So, the effect of this change in market structure is that the profit- maximising monopolist produces less output than a perfectly competitive industry and charges a higher price. It is also apparent that consumer surplus is now very different, as in the new situation it is limited.
You can see that the loss of consumer surplus has occurred for two reasons. First, the monopoly firm is now making supernormal profits. This is a redistribution of welfare from consumers to the firm, but as the monopoly is also part of society, this does not affect overall welfare. However, there is also loss to society resulting from the monopolisation of the industry. Such losses inflicted on society are often known as the deadweight loss.
Why is X-efficiency a disadvantage in a monopoly?
For the notion of X-inefficiency in the context of the principal-agent problem, the argument is that if managers of large firms were not sufficiently accountable to the firm’s owners, they would not have a sufficient incentive to be as efficient as they could be. X-inefficiency could also appear in a monopoly market, if the firm becomes complacent about its position in the market.
If the firm does not face competition (actual or potential) because of some barrier to the entry of new firms, again it could be that the incentive to be highly efficient is weak, so that X-inefficiency could creep in, and the firm may face a higher average cost curve than is optimal.
Why is consumer choice a disadvantage in a monopoly?
If the monopoly firm is able to prevent the entry of new firms into the market, this could limit consumer choice, as new firms could be innovative in providing substitute products. There is evidence that consumers do like to have choice in a market.
Why is economies of scale an advantage in a monopoly?
A monopoly firm may be able to take advantage of economies of scale, and so produce at lower cost than smaller firms. Even if this does not lead to productive efficiency, in the sense that the monopoly would not produce at its minimum average cost, this could still be production at lower average cost than could be achieved by a market made of many small firms. This may enable the firm to produce at lower average cost and make higher supernormal profits — and, perhaps, maintain its market position.
Analysis of this situation reveals that there is a deadweight loss — this reflects the allocative inefficiency of monopoly. However, there is also a gain in productive efficiency. This is part of monopoly profits, but under perfect competition it was part of production costs. In other words, production under the monopoly is less wasteful in its use of resources in the production process.
Is society better off under monopoly or under perfect competition? In order to evaluate the effect on total welfare, we need to balance the loss of allocative efficiency against the gain in productive efficiency.
What is dynamic efficiency?
A view of efficiency that takes into account the effect of innovation and technical progress on productive and allocative efficiency in the long run.
Why is dynamic efficiency an advantage in a monopoly?
Dynamic efficiency recognises that the state of knowledge and technology changes over time. For example, investment in research and development today means that production can be carried out more efficiently at some future date. Furthermore, the development of new products also means that a different mix of goods and services may serve consumers better in the long term.
The notion of dynamic efficiency stemmed from the work of Joseph Schumpeter, who argued that a preoccupation with static efficiency may sacrifice opportunities for greater efficiency in the long run. In other words, there may be a trade-off between achieving efficiency today and improving efficiency tomorrow.
An example of how a monopoly firm may create dynamic efficiency is where the firm has the capacity to undertake R&D as a result of the supernormal profits it is able to earn. This is in contrast to the situation facing firms under perfect competition, which are not able to make supernormal profits in long-run equilibrium. Such R&D could not be undertaken unless the firm makes supernormal profits. However, the question of whether a monopoly firm will actually have sufficient incentive to pursue dynamic efficiency may be open to debate.
Why is size and global markets an advantage in a monopoly?
Another argument that has been put forward is that allowing a firm to dominate the domestic market by expanding to its potential may enable it to compete more effectively with large foreign firms in global markets, therefore benefiting the domestic economy.
How do monopolies arise?
Monopolies may arise in a market for a number of reasons. In a few instances, a monopoly is created by the authorities. For example, for 150 years the UK Post Office held a licence giving it a monopoly on delivering letters. This service was opened to some competition in the 2000s, although any company wanting to deliver packages weighing less than 350 grams and charging less than £1 could do so only by applying for a licence. The Post Office monopoly formerly covered a much wider range of services, but its coverage has been eroded over the years, and competition in delivering larger packages has been permitted for some time.
Royal Mail was privatised in October 2013, becoming a quoted company on the London Stock Exchange. The company has a ‘Universal Service Obligation’, under which it must continue to provide a six days a week, one price goes anywhere postal service. It delivers to 30 million addresses in the UK, and is also subject to control on prices. These obligations are subject to regulation by Ofcom.
The patent system offers a rather different form of protection for a firm. The patent system was designed to provide an incentive for firms to innovate through the development of new techniques and products. By prohibiting other firms from copying the product for a period of time, a firm is given a temporary monopoly.
There are markets in which firms have risen to become monopolies by their actions in the market. Such a market structure is sometimes known as a competitive monopoly. Firms may get into a monopoly position through effective marketing, through a process of merger and acquisition, or by establishing a new product as a widely accepted standard. For example, by the mid-2010s, Google had come to control some 90% of the search engine market in Europe.
Monopolies may also be created through mergers and acquisitions, if one firm is able to buy out its competitors or combine with them to exploit economies of scale.
What is a natural monopoly?
A monopoly that arises in an industry in which there are substantial economies of scale that only one firm is viable.
