Monopoly Flashcards
Explain the characteristics of the monopoly and their implications on how firms behave.
1) Number of producers: There is only a single producer according to the strict definition but in the real world, there is only one dominant firm.
2) Extent of barriers to entry and exit: There are artificial barriers to entry that involve any move by the incumbent firm to keep potential entrants out of the market (include strategic - advertising, control over raw materials, hostile takeovers and statutory barriers to entry - patents, copyrights, licenses) and natural barriers to entry. However, it is a task to maintain such barriers and potential entrants may be drawn by the supernormal profits and develop new technologies and devise price strategies to break into the market.
Strategic:
By employing intensive advertising to persuade customers that there are no close substitutes (demand is more price inelastic) and induce customer loyalty, boosting demand and allowing the monopoly to charge relatively high prices for its products and prevent potential entrants from entering.
By gaining control over raw materials, the firm can control supply and hence keep prices relatively high.
Hostile takeovers and acquisitions involve the dominant company buying up a rival firm or taking a stake in a rival firm so as to gain control of supply and eliminate competition.
Statutory barriers are barriers of entry given by the force of law such as patents (protects processes and producers) and copyrights (protects ideas) give people the exclusive right to produce and sell it for a period of time. Governments can create or support monopolies through the regulation of intellectual property rights such as allowing pharmaceutical companies to act temporarily as monopolists in the market for a particular drug. This has the effect of keeping demand high and relatively price inelastic which keeps the price of a good high until the patent expires and other competitors enter with a generic version of the same drug.
Natural barriers to entry arise from differences in production and costs between the incumbent firm and a potential entrant. The incumbent firm can exploit EOS more fully and be more cost-efficient due to a much lower LRAC compared to a potential entrant which operates on a smaller scale. Hence, it is deterred from entering due to higher AC. Barriers to exit include the financial implications of leaving an industry as firms risk making huge losses if they decide to leave the market. Sunk costs are costs once committed, cannot be recovered and arise from activities that require specialized assets that cannot be readily diverted to other uses in other markets/ haveno resale value/complex IT systems.
3) Nature of good: Unique with no close substitutes
4) Imperfect knowledge: Consumers are not fully aware of the costs and production of the product. The technology used in the production is often closely guarded.
5) Market power: Price setter due to the nature of the product and very imperfect knowledge. (Price and cross elasticity of demand are low compared to other market structures)
Distinguish between perfect competition and monopoly
About pricing and output, under perfect competition, price is equal to marginal cost at the equilibrium output. Under monopoly, the firm produces where MR = MC and the price is greater than the marginal cost.
About entry, under perfect competition, there exist no restrictions on the entry or exit of firms into the industry. Under a simple monopoly, there are strong barriers to the entry and exit of firms.
Under a simple monopoly, a monopolist can charge different prices from different groups of buyers. But, in the perfectly competitive market, it is absent by definition.
The difference between price and marginal cost under monopoly results in super-normal profits to the monopolist. Under perfect competition, a firm, in the long run, enjoys only normal profits.
Under perfect competition, the supply curve can be known. It is so because all firms can sell desired quantity at the prevailing price. Moreover, there is no price discrimination. Under monopoly, the supply curve cannot be known. MC curve is not the supply curve of the monopolist.
Under perfect competition, the demand curve is perfectly elastic. It is due to the existence of a large number of firms. The price of the product is determined by the industry and each firm has to accept that price. On the other hand, under monopoly, the average revenue curve slopes downward. AR and MR curves are separate from each other. Price is determined by the monopolist.
Compare the performance of monopolist with firms in perfectly competitive market.
Firms in imperfect competition have a downward-sloping DD curve as they are price-setters and hence its AR or price is greater than MC and at the profit-maximising level, P > MC and are thus allocatively inefficient unlike firms in a perfectly competitive market. However, where there are substantial EOS to be reaped, and where industries with huge MES, the monopolists are able to enjoy significant iEOS, meaning AC keeps falling over a very large output and gives rise to a very low MC which is much lower than that of a PC, hence consumers enjoy the benefits of lower prices and higher quantity.
It does not achieve productive efficiency as it retains supernormal profits in the long run due to the presence of complete or high BTEs and can afford to be X-inefficient while existing in the industry. The merged firm may become complacent due to its market power and the lack of competition. It may be cost-ineffective and indulge in unnecessary and lavish spending. Such X-inefficiency causes the firm to operate at a point above its LRAC curve, and this is possible as the firm is still making some supernormal profits. Moreover, there is no guarantee that the merged firm will enjoy internal economies of scale.
Over-expansion and operating at an output beyond the MES can cause the firm to suffer from diseconomies of scale. It might be more difficult to co-ordinate amongst the different departments resulting in managerial diseconomies. This causes LRAC to rise instead. Due to globalisation and the removal of protectionist barriers, there has been a growth of international competition from big foreign conglomerates that vie for a share of the lucrative domestic market and these firms can be competing in terms of price-cutting or other non-pricing strategies. Hence, the sales of the incumbent will be affected and it must reduce its X-inefficiency to survive in the market.
Consumers often suffer from exploitative pricing as it tends to exacerbate inequity in the economy with its supernormal profits being concentrated at the hands of a select few monopolies which have the ability to block potential entrants or a few dominant producers at the expense of consumers who pay higher prices for a limited quantity of goods.
A monopolist may have the ability but it lacks the ability to be dynamically efficient. This is because there is less need for a monopoly to innovate and improve the quality of its products. Innovation may also erode the value of a monopoly’s past products. Thus, it may tend to favour the status quo. The lack of competition and give the new firm greater certainty about their position in the industry. This may result in a lack of incentive to innovate and thus decreases dynamic efficiency. This would mean that consumers will not benefit from improvements in quality of services and benefit from possible lower COP and price due to innovations.
Consumers lack choice given that the product of a monopoly is unique. This may mean that consumer’s welfare is not maximised as consumers have different tastes and preferences and not all of them could be met.
Explain the theory of contestability
The theory of contestability argues that what is crucial in determining the price and output is not whether the firm’s size is big or small relative to the market bu whether there is a real threat of competition.
A market is contestable when entry into and exit from the market by potential rivals is costless and can be made very rapidly. Key conditions include: no exit costs such as sunk costs, perfect information and low consumer loyalty.
This ensures that the incumbent will price its product closer to making normal profits than profit-maximising price and produces as efficiently as possible, moving towards producing at a point on the LRAC curve. Failure to do so will lead to potential competition being actual competition.
Apply the theory of contestability of markets to monopolists
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Distinguish Natural Monopoly and Monopoly
Natural monopoly is one with only one dominant firm with a very high market share and the rest are small firms with insignificant shares.
Critically evaluate the effectives of government policies in addressing the inefficiencies and equity issues as a result of monopoly power
Removing or lowering barriers to entry through antitrust laws so that other firms can enter the market to compete. Antitrust laws also referred to as competition laws, are statutes developed by the U.S. government to enforce the rules of the competitive marketplace and protect consumers from predatory business practices such as anticompetitive mergers. In Singapore, such antitrust laws are in place under the Competition act.
Governments can also regulate the prices that the monopoly can charge; operating the monopoly as a public enterprise.
