WEEK 6 - Chapter 15: Monopoly Flashcards
What is a monopoly?
A firm that is the sole seller of a product without close substitutes.
The fundamental cause of monopoly is barriers to entry – a monopoly remains the only seller in its market because other firms cannot enter the market and compete with it.
What are the 3 main sources of barriers to entry?
. Monopoly resources: A key resource is owned by a single firm.
. Government regulation: The government gives a single firm the exclusive right to produce some good or service.
. The production process: A single firm can produce output at a lower cost than can a larger number of firms.
Monopoly resources.
The simplest way for a monopoly to arise is for a single firm to own a key resource.
Eg. consider the market for water in a small town in the outback. If there is only one resident in town who can pump out underground water and it is impossible to get water from anywhere else, then that resident has a monopoly on water. Not surprisingly, the monopolist has much greater market power than any single firm in a competitive market.
In the case of a necessity like water, the monopolist can command quite a high price, even if the marginal cost of pumping an extra litre is low.
Although exclusive ownership of a key resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason. Economies are large and resources are owned by many people.
Government created monopolies.
In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service.
Sometimes the monopoly arises from the sheer political clout of the would-be monopolist.
Example of government created monopolies.
Kings, for example, once granted exclusive business licences to their friends and allies.
At other times, the government grants a monopoly because doing so is in the public interest. For instance, until October 2001, the Australian government had given a monopoly to a company called Melbourne IT to issue .com.au Internet addresses. Since then, the monopoly licence has been given to another company, AusRegistry.
Having a single company maintain the address database avoids problems such as issuing the same name twice.
Patent and copyright laws are one example of how the government creates a monopoly to serve the public interest. When a pharmaceutical company discovers a new medicine, it can apply to the government for a patent. If the government deems the medicine to be truly original, it approves the patent, which gives the company the exclusive right to manufacture and sell the medicine for a certain number of years.
In Australia, patents for medicine last for 20 years. Similarly, when a novelist finishes a book, she can copyright it. The copyright is a government guarantee that no one can print and sell the work without the author’s permission. The copyright makes the novelist a monopolist in the sale of her novel.
Natural monopoly.
A monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.
Eg. an industry is a natural monopoly when there are economies of scale over the relevant range of output.
Figure 15.1 shows the average total costs of a firm with economies of scale. In this case, a single firm can produce any amount of output at the least cost. That is, for any given amount of output, a larger number of firms leads to less output per firm and higher average total cost.
An example of a natural monopoly is the distribution of water.
Monopoly Vs Competition.
The key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output.
A competitive firm is small relative to the market in which it operates and, therefore, takes the price of its output as given by market conditions.
In contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market.
One way to view this difference between a competitive firm and a monopoly is to consider the demand curve that each firm faces. When we analysed profit maximisation by competitive firms in chapter 14, we drew the market price as a horizontal line.
Monopoly Demand vs competitive Demand.
Because a competitive firm can sell as much or as little as it wants at this price, the competitive firm faces a horizontal demand curve. In effect, because the competitive firm sells a product with many perfect substitutes (the products of all the other firms in its market), the demand curve that any one firm faces is perfectly elastic.
In contrast, because a monopoly is the sole producer in its market, its demand curve is the market demand curve. Thus, the monopolist’s demand curve slopes downwards for all the usual reasons, as in panel. If the monopolist raises the price of its good, consumers buy less of it. In other words, if the monopolist reduces the quantity of output it sells, the price of its output increases.
A monopoly’s revenue.
A monopolist’s marginal revenue is always less than the price of its good. As a result D line is above MR line (acute angle between them).
Marginal revenue for monopolies is very different from marginal revenue for competitive firms.
When a monopoly increases the amount it sells, this action has two effects on total revenue (PxQ):
. The output effect: more output is sold, so Q is higher, which tends to increase total revenue.
. The price effect: the price falls, so P is lower, which tends to decrease total revenue.
Profit maximisation - monopolies.
Firms adjusts their level of production until the quantity reaches QMAX, at which marginal revenue equals marginal cost.
Thus, the monopolist’s profit-maximising quantity of output is determined by the intersection of the marginal-revenue curve and the marginal-cost curve.
MC and MR intersect = Q-max
P is determined by bringing the Q-max line up to the Demand line
A monopolies price.
For a competitive firm: P = MR = MC
For a monopoly firm: P > MR = MC
When a patent gives a firm a monopoly over the sale of a product, the firm charges the monopoly price, which is well above the marginal cost. When the patent runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost.
Monopoly profit.
The space between Q-max and D intersection, lowest point of ATC and the vertical axis is profit.
Profit = (P - ATC) x Q
The welfare cost of monopoly.
From a consumer’s position the fact that a monopoly charges a price above marginal cost makes monopolies undesirable - cost of resource to make one more unit is less than the value of that unit to society.
However, from the standpoint of owners of the firm, the high price makes monopoly very desirable.
The inefficiency of monopoly.
The monopolist produces less than the socially efficient quantity of output.
The deadweight loss of monopoly.
The area between monopoly quantity, efficient quantity and monopoly price point on D = deadweight loss.
. The monopoly deadweight loss is similar to a tax deadweight loss.
. The difference between the two cases is that:
- the government gets the revenue from a tax
- whereas a private firm gets the monopoly profit.