The Role Of Monopolies In An Economy Economics Essay

A monopoly must be distinguished from monopsony, in which there is only one buyer of a product or service ; a monopoly may also have monopsony control of a sector of a market. Likewise, a monopoly should be distinguished from a cartel (a form of oligopoly), in which several providers act together to coordinate services, prices or sale of goods. Monopolies, monopsonies and oligopolies are all situations where one or a few of the entities have market power and therefore must interact with their customers (monopoly), suppliers (monopsony) and the other firms (oligopoly) in a game theoretic manner – meaning that expectations about their behavior affects other players’ choice of strategy and vice versa. This is to be contrasted with the model of perfect competition where firms are price takers and do not have market power. Monopolists typically produce fewer goods and sell them at a higher price than under perfect competition, resulting in abnormal and sustained profit. (See also Bertrand, Cournot or Steckelberg equilibria, market power, market share, market concentration, Monopoly profit, industrial economics).

Monopolies can form naturally or through vertical or horizontal mergers. A monopoly is said to be coercive when the monopoly firm actively prohibits competitors from entering the field or punishes competitors who do (see Chainstore paradox).

In many jurisdictions, competition laws place specific restrictions on monopolies. Holding a dominant position or a monopoly in the market is not illegal in itself, however certain categories of behavior can, when a business is dominant, be considered abusive and therefore be met with legal sanctions. A government-granted monopoly or legal monopoly, by contrast, is sanctioned by the state, often to provide an incentive to invest in a risky venture or enrich a domestic interest group. Patents, copyright, and trademarks are all examples of government granted and enforced monopolies. The government may also reserve the venture for itself, thus forming a government monopoly.

Market structures

In economics, monopoly is a pivotal area to the study of market structures, which directly concerns normative aspects of economic competition, and sets the foundations for fields such as industrial organization and economics of regulation. There are four basic types of market structures under traditional economic analysis: perfect competition, monopolistic competition, oligopoly and monopoly. A monopoly is a market structure in which a single supplier produces and sells the product. If there is a single seller in a certain industry and there are no close substitutes for the goods being produced, then the market structure is that of a “pure monopoly”. Sometimes, there are many sellers in an industry and/or there exist many close substitutes for the goods being produced, but nevertheless firms retain some market power. This is called monopolistic competition, whereas in oligopoly the main theoretical framework revolves around firm’s strategic interactions.

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In general, the main results from this theory compare price-fixing methods across market structures, analyse the impact of a certain structure on welfare, and play with different variations of technological/demand assumptions in order to assess its consequences on the abstract model of society. Most economic textbooks follow the practice of carefully explaining the perfect competition model, only because of its usefulness to understand “departures” from it (the so called imperfect competition models).

The boundaries of what constitutes a market and what doesn’t is a relevant distinction to make in economic analysis. In a general equilibrium context, a good is a specific concept entangling geographical and time-related characteristics (grapes sold in October 2009 in Moscow is a different good from grapes sold in October 2009 in New York). Most studies of market structure relax a little their definition of a good, allowing for more flexibility at the identification of substitute-goods. Therefore, one can find an economic analysis of the market of grapes in Russia, for example, which is not a market in the strict sense of general equilibrium theory.

Characteristics

Single seller: In a monopoly there is one seller of the monopolised good who produces all the output. Therefore, the whole market is being served by a single firm, and for practical purposes, the firm is the same as the industry.

Market power: Market power is the ability to affect the terms and conditions of exchange so that the price of the product is set by the firm (price is not imposed by the market as in perfect competition). Although a monopoly’s market power is high it is still limited by the demand side of the market. A monopoly faces a negatively sloped demand curve not a perfectly inelastic curve. Consequently, any price increase will result in the loss of some customers.

Sources of monopoly power

Monopolies derive their market power from barriers to entry – circumstances that prevent or greatly impede a potential competitor’s entry into the market or ability to compete in the market. There are three major types of barriers to entry; economic, legal and deliberate.

Economic barriers: Economic barriers include economies of scale, capital requirements, cost advantages and technological superiority.

Economies of scale: Monopolies are characterised by declining costs over a relatively large range of production.Declining costs coupled with large start up costs give monopolies an advantage over would be competitors. Monopolies are often in a position to cut prices below a new entrant’s operating costs and drive them out of the industry. Further the size of the industry relative to the minimum efficient scale may limit the number of firms that can effectively compete within the industry. If for example the industry is large enough to support one firm of minimum efficient scale then other firms entering the industry will operate at a size that is less than MES meaning that these firms cannot produce at an average cost that is competitive with the dominant firm. Finally, if long run average cost is constantly falling the least cost way to provide a good or service is through a single firm.

Capital requirements: Production processes that require large investments of capital, or large research and development costs or substantial sunk costs limit the number of firms in an industry. Large fixed costs also make it difficult for a small firm to enter an industry and expand.

Technological superiority: A monopoly may be better able to acquire, integrate and use the best possible technology in producing its goods while entrants do not have the size or fiscal muscle to use the best available technology In plain English one large firm can sometimes produce goods cheaper than several small firms.

No substitute goods: A monopoly sells a good for which there is no close substitutes. The absence of substitutes makes the demand for the good relatively inelastic enabling monopolies to extract positive profits.

Control of Natural Resources: A prime source of monopoly power is the control of resources that are critical to the production of a final good.

Network Externalities: The use of a product by a person can affect the value of that product to other people. This is the network effect. There is a direct relationship between the proportion of people using a product and the demand for that product. In other words the more people who are using a product the higher the probability of any individual starting to use the product. This effect accounts for fads and fashion trends It also can play a crucial role in the development or acquisition of market power. The most famous current example is the market dominance of the Microsoft operating system in personal computers.

Legal barriers: Legal rights can provide opportunity to monopolise the market in a good. Intellectual property rights, including patents and copyrights, give a monopolist exclusive control over the production and selling of certain goods. Property rights may give a firm the exclusive control over the materials necessary to produce a good.

Deliberate Actions: A firm wanting to monopolise a market may engage in various types of deliberate action to exclude competitors or eliminate competition. Such actions include collusion, lobbying governmental authorities, and force.

In addition to barriers to entry and competition, barriers to exit may be a source of market power. Barriers to exit are market conditions that make it difficult or expensive for a firm to leave the market. High liquidation costs are a primary barrier to exit. Market exit and shutdown are separate events. The decision whether to shut down or operate is not affected by exit barriers. A firm will shut down if price falls below minimum average variable costs.

Monopoly versus competitive markets

While monopoly and perfect competition mark the extremes of market structures there are many point of similarity. The cost functions are the same. Both monopolies and perfectly competitive firms minimize cost and maximize profit. The shutdown decisions are the same. Both are assumed to face perfectly competitive factors markets. There are distinctions, some of the more important of which are as follows:

Market Power – market power is the ability to raise the product’s price above marginal cost and not lose all your customers.Specifically market power is the ability to raise prices without losing all one’s customers to competitors. Perfectly competitive (PC) firms have zero market power when it comes to setting prices. All firms in a PC market are price takers. The price is set by the interaction of demand and supply at the market or aggregate level. Individual firms simply take the price determined by the market and produce that quantity of output that maximize the firm’s profits. If a PC firm attempted to raise prices above the market level all its “customers” would abandon the firm and purchase at the market price from other firms. A monopoly has considerable although not unlimited market power. A monopoly has the power to set prices or quantities although not both. A monopoly is a price maker. The monopoly is the market and prices are set by the monopolist based on his circumstances and not the interaction of demand and supply. The two primary factors determining monopoly market power are the firm’s demand curve and its cost structure.

Price – In a perfectly competitive market price equals marginal cost. In a monopolistic market price is greater than marginal cost.

Marginal revenue and price – In a perfectly competitive market marginal revenue equals price. In a monopolistic market marginal revenue is less than price.

Product differentiation: There is zero product differentiation in a perfectly competitive market. Every product is perfectly homogeneous and a perfect substitute. With a monopoly there is high to absolute product differentiation in the sense that there is no available substitute for a monopolized good. The monopolist is the sole supplier of the good in question. A customer either buys from the monopolist on her terms or does without.

Number of competitors: PC markets are populated by an infinite number of buyers and sellers. Monopoly involves a single seller.

Barriers to Entry – Barriers to entry are factors and circumstances that prevent entry into market by would be competitors and impediments to competition that limit new firms from operating and expanding within the market. PC markets have free entry and exit. There are no barriers to entry, exit or competition. Monopolies have relatively high barriers to entry. The barriers must be strong enough to prevent or discourage any potential competitor from entering the market.

Elasticity of Demand; the price elasticity of demand is the percentage change in demand caused by a one percent change in relative price. A successful monopoly would face a relatively inelastic demand curve. A low coefficient of elasticity is indicative of effective barriers to entry. A PC firm faces what it perceives to be perfectly elastic demand curve. The coefficient of elasticity for a perfectly competitive demand curve is infinite.

Excess Profits- Excess or positive profits are profit above the normal expected return on investment. A PC firm can make excess profits in the short run but excess profits attract competitors who can freely enter the market and drive down prices eventually reducing excess profits to zero. A monopoly can preserve excess profits because barriers to entry prevent competitors from entering the market.

Profit Maximization – A PC firm maximizes profits by producing where price equals marginal costs. A monopoly maximises profits by producing where marginal revenue equals marginal costs. The rules are not equivalent. The demand curve for a PC firm is perfectly elastic – flat. The demand curve is identical to the average revenue curve and the price line. Since the average revenue curve is constant the marginal revenue curve is also constant and equals the demand curve, Average revenue is the same as price (AR = TR/Q = P x Q/Q = P). Thus the price line is also identical to the demand curve. In sum, D = AR = MR = P.

P-Max quantity, price and profit – If a monopolist obtains control of a formerly perfectly competitive industry, the monopolist would raise prices, cut production, and realise positive economic profits.

Supply Curve – in a perfectly competitive market there is a well defined supply function with a one to one relationship between price and quantity supplied. In a monopolistic market no such supply relationship exists. A monopolist cannot trace out a short run supply curve because for a given price there is not a unique quantity supplied.As Pindyck and Rubenfeld note a change in demand “can lead to changes in prices with no change in output, changes in output with no change in price or both.” Monopolies produce where marginal revenue equals marginal costs. For a specific demand curve the supply “curve” would be the price/quantity combination at the point where marginal revene equals marginal cost. If the demand curve shifted the marginal revenue curve would shift as well and a new equilibrium and supply “point” would be established. The locus of these points would not be a supply curve in any conventional sense.

The most significant distinction between a PC firm and a monopoly is that the monopoly faces a downward sloping demand curve rather than the “perceived” perfectly elastic curve of the PC firm. Practically all the variations above mentioned relate to this fact. If there is a downward sloping demand curve then by necessity there is a distinct marginal revenue curve. The implications of this fact are best made manifest with a linear demand curve, Assume that the inverse demand curve is of the form x = a – by. Then the total revenue curve is TR = ay – by2 and the marginal revenue curve is thus MR = a – 2by. From this several things are evident. First the marginal revenue curve has the same y intercept as the inverse demand curve. Second the slope of the marginal revenue curve is twice that of the inverse demand curve. Third the x intercept of the marginal revenue curve is half that of the inverse demand curve. What is not quite so evident is that the marginal revenue curve lies below the inverse demand curve at all points. Since all firms maximise profits by equating MR and MC it must be the case that at the profit maximizing quantity MR and MC are less than price which further implies that a monopoly produces less quantity at a higher price than if the market were perfectly competitive.

The fact that a monopoly faces a downward sloping demand curve means that the relationship between total revenue and output for a monopoly is much different than that of competitive firms. Total revenue equals price times quantity. A competitive firm faces a perfectly elastic demand curve meaning that total revenue is proportional to output. Thus the total revenue curve for a competitive firm is a ray with a slope equal to the market price. A competitive firm can sell all the output it desires at the market price. For a monopoly to increase sales it must reduce price. Thus the total revenue curve for a monopoly is a parabola that begins at the origin and reaches a maximum value then continuously falls until total revenue is again zero. Total revenue reaches its maximum value when the slope of the total revenue function is zero. The slope of the total revenue function is marginal revenue. So the revenue maximizing quantity and price occur when MR = 0. For example assume that the monopoly’s demand function is P = 50 – 2Q. The total revenue function would be TR = 50Q – 2Q2 and marginal revenue would be 50 – 4Q. Setting marginal revenue equal to zero we have

50 – 4Q = 0

-4Q = -50

Q = 12.5

So the revenue maximizing quantity for the monopoly is 12.5 units and the revenue maximizing price is 25.

A company with a monopoly does not undergo price pressure from competitors, although it may face pricing pressure from potential competition. If a company raises prices too high, then others may enter the market if they are able to provide the same good, or a substitute, at a lower price. The idea that monopolies in markets with easy entry need not be regulated against is known as the “revolution in monopoly theory”.

A monopolist can extract only one premium, and getting into complementary markets does not pay. That is, the total profits a monopolist could earn if it sought to leverage its monopoly in one market by monopolizing a complementary market are equal to the extra profits it could earn anyway by charging more for the monopoly product itself. However, the one monopoly profit theorem does not hold true if customers in the monopoly good are stranded or poorly informed, or if the tied good has high fixed costs.

A pure monopoly follows the same economic rationality of firms under perfect competition, i.e. to optimise a profit function given some constraints. Under the assumptions of increasing marginal costs, exogenous inputs’ prices, and control concentrated on a single agent or entrepreneur, the optimal decision is to equate the marginal cost and marginal revenue of production. Nonetheless, a pure monopoly can -unlike a competitive firm- alter the market price for her own convenience: a decrease in the level of production results in a higher price. In the economics’ jargon, it is said that pure monopolies “face a downward-sloping demand”. An important consequence of such behaviour is worth noticing: typically a monopoly selects a higher price and lower quantity of output than a price-taking firm; again, less is available at a higher price.

The inverse elasticity rule

A monopoly chooses that price that maximizes the difference between total revenue and total cost. The basic markup rule can be expressed as P – MC/P = 1/PED. The markup rules indicates that the ratio between profit margin and the price is inversely proportional to the price elasticity of demand. The implication of the rule are that the more elastic the demand for the product the less pricing power the monopoly has.

Price discrimination and capturing consumer surplus

Improved price discrimination allows a monopolist to gain more profit by charging more to those who want or need the product more or who have a higher ability to pay. For example, most economic textbooks cost more in the United States than in “Third world countries” like Ethiopia. In this case, the publisher is using their government granted copyright monopoly to price discriminate between (presumed) wealthier economics students and (presumed) poor economics students. Similarly, most patented medications cost more in the U.S. than in other countries with a (presumed) poorer customer base. Perfect price discrimination would allow the monopolist to charge a unique price to each customer based on their individual demand. This would allow the monopolist to extract all the consumer surplus of the market. Note that while such perfect price discrimination is still a theoretical construct, it is becoming increasingly real with the advances in information technology, data mining, and micromarketing. Typically, a high general price is listed, and various market segments get varying discounts. This is an example of framing to make the process of charging some people higher prices more socially acceptable.

It is important to realize that partial price discrimination can cause some customers who are inappropriately pooled with high price customers to be excluded from the market. For example, a poor student in the U.S. might be excluded from purchasing an economics textbook at the U.S. price, that she might have purchased at the China price. Similarly, a wealthy student in China might have been willing to pay more (although naturally it is against their interests to signal this to the monopolist). These are deadweight losses and decrease a monopolist’s profits. As such, monopolists have substantial economic interest in improving their market information, and market segmenting.

There are important points for one to remember when considering the monopoly model diagram (and its associated conclusions) displayed here. The result that monopoly prices are higher, and production output lower, than a competitive firm follow from a requirement that the monopoly not charge different prices for different customers. That is, the monopoly is restricted from engaging in price discrimination (this is called first degree price discrimination, where all customers are charged the same amount). If the monopoly were permitted to charge individualised prices (this is called third degree price discrimination), the quantity produced, and the price charged to the marginal customer, would be identical to a competitive firm, thus eliminating the deadweight loss; however, all gains from trade (social welfare) would accrue to the monopolist and none to the consumer. In essence, every consumer would be just indifferent between (1) going completely without the product or service and (2) being able to purchase it from the monopolist.

As long as the price elasticity of demand for most customers is less than one in absolute value, it is advantageous for a firm to increase its prices: it then receives more money for fewer goods. With a price increase, price elasticity tends to rise, and in the optimum case above it will be greater than one for most customers.

Pricing with market power

Price discrimination is charging different consumers different prices for the same product when the cost of servicing the customer is identical. Absent price discrimination each consumer pays the same market price. The purpose of price discrimination is to capture consumer surplus and transfer it to the producer. Price discrimination is not limited to monopolies. Any firm that has market power can engage in price discrimination. Perfect competition is the only market form in which price discrimination would be impossible. There are three forms of price discrimination. First degree price discrimination charges each consumer the maximum price the consumer is willing to pay. Second degree price discrimination involves quantity discounts. Third degree price discrimination involves grouping consumers according to willingness to pay as measured by their price elasticities of demand and charging each group a different price. Third degree price discrimination is by far the most prevalent form

Purpose of price discrimination

The purpose of price discrimination is to earn higher profits by capturing consumer surplus and transferring it to the seller. A firm maximizes profit by selling where marginal revenue equals marginal cost. A firm that does not engage in price discrimination will charge the profit maximizing price, P*, to all its customers. Under such circumstances there are customers who would be willing to pay a higher price than P* and those who will not pay P* but would buy at a lower price. A price discrimination strategy is to charge less price sensitive buyers a higher price and the more price sensitive buyers a lower price. Thus additional revenue is generated from two sources. The basic problem is to identify customers by their willingness to pay and have them pay the price.

Conditions for price discrimination

There are three conditions that must be present for a firm to engage in successful price discrimination. First, the firm must have market power. Second, first must be able to sort customers according to their willingness to pay for the good. Third, the firm must be able to prevent resell.

Market power

Market power is the firm’s ability to raise prices without losing all its customers. A firm must have some degree of market power to practice price discrimination. Without market power the firm cannot charge more than the market price. Any market structure characterized by a downward sloping demand curve has market power – monopoly, monopolistic competition and oligopoly. The only market structure that has no market power is perfect competition.

Willingness to pay

Consumers must differ in their price sensitivity as reflected in their demand elasticities and the seller must know something about how demand elasticities vary among consumers. Without this information the seller will not know the relative elasticities of various groups of consumers would not be able to separate customers according to their PEDS. In plain English the objective is to divide consumers between those who will pay more than the optimal price and those who will only pay less.

Enforcement

A firm wishing to practice price discrimination must be able to prevent middle men or brokers from capturing the consumer surplus for themselves. The firm accomplishes this by preventing or limiting resale. Many methods are used to prevent resale. For example persons are required to show photo identification and a borading pass before boarding a plane. Most travelers assume that this practice is strictly a matter of security. However, a primary purpose in requesting photo id is to confirm that the ticket purchaser is the person about to board the plane and not someone who has repurchased the ticket from a discount buyer.

The inability to prevent resale is the largest obstacle to successful price discrimination. Companies have however developed numerous methods to prevent resale. For example, universities require that student show identification before entering sporting events. Governments may make it illegal to resale tickets or products. In Boston Red Sox tickets can only be resold to the team. Resale to individuals is illegal.

Basic forms

The three basic forms of price discrimination are first, second and third degree price discrimination. In first degree price discrimination the firms charge the maximum price each customer is willing to pay. The maximum price a consumer is willing to pay for a unit of the good is the reservation price. Thus for each unit the seller tries to set the price equal to the consumer’s reservation price. Direct information about a consumer’s willingness to pay is rarely available. Seller’s tend to rely on secondary information such as where a person lives (zip codes), how she dresses, what kind of car she drives, her occupation, how much money she makes and her spending patterns. First degree price discrimination most frequently occurs in the area of professional services or in transactions involving direct buyer seller negotiations. For example, an accountant who has prepared a consumer’s tax return has information that can be used to charge customers based on an estimate of their ability to pay.

In second degree price discrimination or quantity discrimination customers are charged different prices based on how much they buy. There is a single price schedule for all consumers but the prices vary depending on the quantity of the good bought. The theory behind second second degree price discrimination is a consumer is willing to buy only a certain quantity of a good at a given price and then no more. Companies know that consumer’s willingness to buy falls as more units are purchased, The task for the seller is to identify these price points and to reduce the price once one is reached in the hope that a reduced price will trigger additional purchases from the consumer. For example, sell in units blocks rather than individual units.

In third degree price discrimination or multi-market price discrimination the seller divides the consumers into different groups according to their willingness to pay as measured by their price elasticity of demand. Each group of consumers effectively becomes a separate market with its own demand curve and marginal revenue curve. The firm then attempts to maximize profits in each segment by equating MR and MC, Generally the firms charge a higher price to the group with a more price inelastic demand and a relatively lower price to the group with a more elastic demand. Examples of third degree price discrimination abound. Airlines charge higher prices to business travelers than to vacation travelers. The reasoning is that the demand curve for a vacation traveler is relatively elastic while the demand curve for a business traveler is relatively inelastic. Any determinant of price elasticity of demand can be used to segment markets. For example, seniors have a more elastic demand for movies than do young adults because they generally have more free time. Thus theaters will offer discount tickets to seniors.

Example

Assume that under a uniform pricing system the monopolist would sell five units at a price of $10 per unit. Assume that his marginal cost is 5 per unit. Total revenue would be $50, total costs would be $25 and profits would be $25. If the monopolist practiced price discrimination he would sell the first unit for $50 the second unit for $40 and so on. Total revenue would be $150, his total cost would be $25 and his profit would be $125.00. Several things are worth noting. The monopolist captures all the consumer surplus and eliminates practically all the deadweight loss because he is willing to sell to anyone who is willing to pay at least the marginal cost. Thus the price discrimination promotes efficiency. Secondly, under the pricing scheme price = average revenue and equals marginal revenue. That is the monopolist is behaving like a perfectly competitive firm. Thirdly, the discriminating monopolist produces a larger quantity than the monopolist operating under a uniform pricing scheme.

Qd

Price

1

50

2

40

3

30

4

20

5

10

Classifying customers

Successful price discrimination requires that firms separate consumers according to their willingness to buy. Determining a customer’s willingness to buy a good is difficult. Asking concumer’s directly is fruitless. Consumer’s don’t know and to the extent they do they are reluctant to share that information with marketers. The two main methods for determining willingness to buy are observation of personal characteristics and consumer actions. As noted information about where a person lives (zip codes), how she dresses, what kind of car she drives, her occupation, how much money she makes and her spending patterns can be helpful in classifying consumers.

Monopoly and efficiency

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Surpluses and deadweight loss created by monopoly price setting

According to the standard model, in which a monopolist sets a single pr