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 ($Q_{max}$).
Interpreting 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.
