Monopoly
A market structure with one single dominant firm that has substantial control over output prices. The firm sells a unique product and is protected by high barriers to entry.
The dominant firm in a monopoly market:
- Is large-sized and often operates as a single dominant firm in the industry.
- Sells a unique product with no close substitutes.
- Possesses high barriers to entry, making it difficult for new firms to compete.
- Has a very significant control over price, as they are price makers rather than price takers.
As a market structure, monopoly markets have the following characteristics:
- Make abnormal profits in the short run and long run, as barriers to entry prevent competition.
- Restrict output and charge higher prices, leading to potential market inefficiencies.
A monopoly is not a firm, it is a market structure. However, in a monopoly, the dominant firm takes such a large portion of the market that operates as the market itself.
How do monopolies emerge?
- Monopolies emerge due to barriers to entry that prevent new competitors from entering the market.
- These barriers allow monopolies to maintain market power and limit competition. They include:
- Economies of scale.
- Branding and customer loyalty.
- Legal barriers.
- Control of essential resources.
- Aggressive tactics.
Economies of scale
- Large firms benefit from economies of scale, which means lower average costs as output increases.
- A monopoly, operating at a large scale, can produce at lower costs than any new entrant, making it difficult for smaller firms to compete.
- If a new firm enters at a small scale, it will face higher costs (higher short-run average costs: SRAC) and struggle to offer competitive prices.
- If a firm tries to enter at a large scale, it will need massive startup investment, which is risky and unlikely to succeed.
Amazon benefits from economies of scale by using its vast logistics network and bulk purchasing power to lower costs, making it difficult for small online retailers to compete on price and efficiency.
Branding and consumer loyalty
- Well-established firms create strong brand recognition, making it hard for new entrants to attract customers.
- Branding convinces consumers that the monopoly's product is superior, even if alternatives exist.
- Heavy advertising and customer loyalty keep the monopoly’s position secure.
Coca-Cola dominates the soft drink market due to brand loyalty, making it difficult for new soda brands to compete.
Legal barriers
Governments often grant legal protections that create monopolies, either to encourage innovation or to regulate industries. Some types of legal barriers are:
- Patents: exclusive rights to produce a product, preventing competitors from copying inventions.
- Licenses: government permits required to operate in certain industries (e.g., broadcasting, pharmaceuticals).
- Copyrights: protection of creative works, ensuring only the owner can profit from them.
- Trade restrictions: tariffs and quotas may limit foreign competitors, protecting domestic monopolies.
Pharmaceutical companies obtain patents on new drugs, allowing them to be the sole producer for years, ensuring they recover research costs.
Control of essential resources
- Some monopolies arise because they control key resources required for production.
- If a firm owns or has exclusive access to an essential raw material, competitors cannot produce the same product.
A company controlling rare minerals used in electronics (e.g., lithium for batteries) can monopolise smartphone production.
Aggressive tactics
Monopolies may use aggressive strategies to discourage or drive out potential competitors. Common aggressive tactics include:
- Predatory pricing: temporarily lowering prices to force competitors out, then raising them again.
- Exclusive contracts: making deals with suppliers to block competitors from accessing materials.
- Hostile takeovers: buying up new competitors before they grow large enough to compete.
A large retailer might undercut smaller shops' prices, taking losses initially but driving competitors out of business in the long run.
Profit maximisation for a monopoly
- Since the monopoly is a price maker, its demand curve is downward sloping. This is because firms in monopolies must lower prices to sell more units.
- However, the profit maximising conditions hold the same for a monopoly:
Profit maximisation occurs when MR = MC.
If we combine all the marginal and average costs and revenues, as well as supply and demand into one single diagram (Figure 1), we can see the different types of profit scenarios (normal, abnormal, and losses) of firms in monopolies, when producing at a profit maximisation level of output ($Q_{max}$).
TipInterpreting Figure 1
Figure 1 illustrates three firms in monopoly markets in the short-run:
- One making normal profits.
- One making abnormal profits.
- One making losses.
The axis
- The x axis represents:
- Quantity demanded.
- Quantity produced (sold).
- This is because all those measures are expressed in terms of quantity.
- The y axis represents:
- Price.
- Revenue.
- Cost.
- This is because all those measures are expressed in terms of currency.
The demand curve
The demand curve is downward sloping because firms in a monopoly are price makers. This is because firms in monopolies can choose their own prices, but to sell. more they must lower prices to sell more units.
The marginal revenue and average revenue curves
To visualise why the marginal revenue and the average revenue curves are different from each other, picture the following information of a firm in a monopoly:
| Quantity of product produced | Price | Total revenue | Marginal revenue | Average revenue |
|---|---|---|---|---|
| 1 | 60 | 60 | 60 | 60 |
| 2 | 50 | 100 | 40 | 50 |
| 3 | 40 | 120 | 20 | 40 |
| 4 | 30 | 120 | 0 | 30 |
| 5 | 20 | 100 | -20 | 20 |
As can be seen:
- Marginal revenue (MR) and average revenue (AR) are different at each quantity produced, and have different slopes.
- Average revenue (AR) is the same as the price (P).
- Therefore:
- The AR curve is equal to the P curve, which also equals the demand (D) curve.
- The MR curve is independent than the $AR = P = D$ curve, and it is even negative.
The demand curve is downward sloping because firms in a monopoly are price makers. This is because firms in monopolies can choose their own prices, but to sell. more they must lower prices to sell more units.
Abnormal profit
- Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
- However, at this $Q_{max}$, AR > AC, and so the firm is making abnormal profit.
- The average profit per unit equals the difference between the average revenue (equal to $P_e$) and the average cost (AC).
- The total profit equal the average profit ($P_e-AC$) times the units produced ($Q_{max}$) → $($P_e-AC$) \times $Q_{max}$. This is visualised by the box.
Normal profit
- Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
- At this $Q_{max}$, AR = AC, and so the firm is making normal profit.
- The average profit per unit equals the difference between the average revenue (equal to $P_e$) and the average cost (AC).
- Since $P_e=AC$ in this case, the firm is making normal (zero) profit.
Losses
- Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
- However, at this $Q_{max}$, AR < AC, and so the firm is making losses.
- The average profit per unit equals the difference between the average revenue (equal to $P_e$) and the average cost (AC).
- The total profit equal the average profit ($P_e-AC$) times the units produced ($Q_{max}$) → $($P_e-AC$) \times $Q_{max}$. Since $AC>P_e$, the total profit is negative, and so the firm is making losses. The total losses are visualised by the box.
Note that monopolies typically do not make losses, as they don't have any incentive to charge a price(hence AR) lower than their AC.
Allocative efficiency for a monopoly
- Since in a monopoly there is only one dominant firm in the market, this firm can determine its selling price and keep it in the short run and in the long run, since there is no competition.
- As a price maker, the single firm will most likely charge a higher price than that leading to normal profits. This is because:
- A firm in a monopoly can maximise profits (MR = MC), even while making abnormal profit.
- Since there is no competition, it can stay making abnormal profits indefinitely.
- This abnormal profit price is often higher than the price that would have resulted from the market equilibrium (Figure 2).
Figure 2 above represents a monopoly market, where the dominant firm has set a higher price ($P_{mon}$) than the one set by the market if it was under perfect competition ($P_e$). As a result:
- Only those consumers with the highest willingness and ability to pay will benefit, leading to excess supply ($Q_{mon} > Q_e$).
- At this quantity $Q_{mon}$, MB > MC, leading to an under allocation of resources and allocative inefficiency (society would be better off if more was produced).
- Resultantly, there is a welfare loss (WL), following the decrease consumer surplus. from the consumers with lower willingness to pay will be lost or passed on to the monopolist.
Since there is misallocation of resources, monopoly markets are therefore a type of market failure.
TipThe dominant firm in the monopoly sets the price $P_{mon}$ because they produce at their profit maximising level of output ($Q_{mon}$), where $MC=MR$.
Natural monopoly
Natural monopoly
A single firm that can produce for the entire market at a lower average cost than if the market was shared by multiple smaller firms.
A natural monopoly forms under specific conditions:
- Large economies of scale: the firm's average costs decrease as output increases, allowing it to produce more efficiently (lower costs) than multiple firms.
- High fixed costs: industries like electricity, water, and railways require huge upfront investments, making entry difficult and overly costly for new firms.
- Low marginal costs: once the infrastructure is built, the cost of producing additional units is very low.
- Barriers to entry: the large capital investment needed discourages new firms from entering the market.
A water supply company builds an expensive pipeline network. If multiple firms try to compete, each would need to build a duplicate infrastructure, leading to higher costs, waste of resources, and inefficiencies.
Figure 4 above illustrates the reasons behind natural monopolies:
- The natural monopoly's demand curve intersects its $LRAS$ curve at a point where its long-run average costs are still falling.
- The natural monopoly operates at $Q*$, where average costs ($AC*$) are minimised due to economies of scale.
- If split into smaller firms, each firm would produce less ($Q_1$), operating on the higher-cost portion of the $LRAC$ curve ($AC_1$).
- With smaller firms operating at $Q_1$, the higher average costs ($AC_1>AC*$) would result in higher prices for consumers, making the industry less efficient overall.
Why do natural monopolies exist?
- Natural monopolies emerge because one firm can serve the entire market more efficiently than multiple smaller firms.
- If competition were introduced, costs would actually increase, leading to inefficiency. Reasons for this are:
- Splitting the market increases costs: multiple firms duplicating infrastructure (e.g., electricity grids) would be wasteful.
- One firm can spread fixed costs over more output, which leads to lower average costs for consumers.
If multiple companies built separate railway networks in the same city, the costs would be much higher than if a single company managed the system.
Evaluating Monopoly
Advantages
Economies of scale
- Monopolies benefit from economies of scale, which means their long-run average costs (LRAC) decrease as output increases.
- This cost advantage allows them to produce at a lower per-unit cost than smaller competitive firms.
- In some cases, monopolies can pass these savings to consumers by offering lower prices, though this depends on regulatory pressure and market conditions.
Large telecommunications firms invest in nationwide networks, reducing average costs per user compared to multiple competing firms with fragmented networks.
Investment in Research & Development (R&D)
- Monopolies earn higher profits, which can be reinvested into research, development, and innovation.
- They can afford to fund expensive projects that lead to new technology, improved quality, and better customer service.
- In contrast, firms in competitive markets often lack the financial stability to invest heavily in R&D due to low profit margins.
Pharmaceutical monopolies reinvest profits into drug research, leading to new medical treatments that might not be possible in a highly competitive market.
Disadvantages
High prices and reduced output
- Monopolists have no competition, so they do not need to charge competitive prices.
- They often maximise profits by restricting output, producing below the socially optimal level and keeping prices artificially high.
- This results in consumer exploitation, as they pay more for fewer goods and services than in a competitive market.
With monopoly power over the repair market of iPhones, Apple charge high repair rates due to the lack of alternative providers.
Welfare loss & market inefficiency
- As mentioned above, in a monopoly, price is set above marginal cost (P > MC), which leads to allocative inefficiency.
- Since output is restricted, fewer transactions take place, leading to deadweight loss: a loss of social surplus where consumer demand exists but is unmet due to high prices.
- This means both consumers and society as a whole are worse off compared to perfect competition.
A monopolist charging higher internet service fees discourages usage, even though marginal costs of providing internet are low.
Disproportionate impact on lower-income households
- High monopoly prices disproportionately hurt low-income consumers, as they cannot afford essential goods and services.
- This reduces consumer surplus, meaning some consumers who would have bought the product at a lower price are priced out of the market.
- As a result, monopolies contribute to greater income inequality, as only wealthier consumers can afford essential goods and services.
If a pharmaceutical company monopolises a life-saving drug, low-income individuals may struggle to afford it, reducing their access to healthcare.
Case studyGoogle as a contemporary monopoly
When: 1998 – present.
Where: Global.
What: Google dominates the search engine and digital advertising industries, holding 92% of global search market share and generating over $224 billion in advertising revenue in 2022. Its ecosystem includes Gmail, YouTube, Chrome, and Android, reinforcing its monopoly.
Advantages of monopoly
Economies of scale:
- Google operates on a massive scale, allowing it to lower long-run average costs (LRAC) through efficient data management, cloud computing, and global server networks.
- Its cost efficiency allows it to provide free services, such as Google Search and Gmail, which benefit consumers.
Investment in research & development (R&D):
- Google’s high profits enable significant investment in AI, cloud computing, and new technology, improving products and services.
- Acquisitions like YouTube (2006) and DeepMind (2014) further demonstrate how monopolistic profits fuel innovation.
Disadvantages of monopoly
High prices and reduced output:
- Google’s dominance in digital advertising limits competition, raising ad prices for businesses that rely on its platform.
- Firms depend on Google’s search rankings, making them vulnerable to policy or algorithm changes that can harm their visibility and revenue.
Welfare loss & market inefficiency:
- Since Google controls search results, it influences what information is accessible, creating allocative inefficiency where certain businesses or content receive less visibility.
- Deadweight loss occurs when businesses unable to afford high advertising costs are pushed out of the market, reducing consumer choice.
Disproportionate impact on lower-income households:
- While Google’s services are free, they profit from user data, raising concerns over privacy exploitation rather than direct pricing barriers.
- Reduced competition limits alternatives, meaning consumers must accept Google’s policies, pricing, and data collection practices.
So?
- Advantage: Google benefits from economies of scale and high R&D investment, fostering technological advancements and free services.
- Limitation: Its dominance in search, advertising, and information access limits competition, raises market inefficiencies, and raises regulatory concerns.
- Policy challenges: Google faces global antitrust lawsuits and fines, such as €8 billion from the EU, due to anti-competitive practices, including bundling Android apps and restricting competitors in digital markets.
