Market of Monopoly

Monopoly

Model of Monopoly

A monopoly is a type of market where there is only one seller of a good/service. In the UK the Competition Commission is in charge of investigating mergers if it would result in the merged firm having a market concentration of more than 25%.

Assumptions

There is just one seller of a good/service
There are no substitutes for the good
There are high barriers to entry into the market
The firm aims to maximise profits

The demand curve for a monopoly firm slopes downwards and can be regarded as showing average revenue. The firm has influence over the price and hence can make decisions on the price as well as output. Although the firm is a price maker it is restricted by market demand and therefore can only set prices at a point along the demand curve.

We can see to the left, the demand curve and the different elasticities along this curve. We can also see its relationship with total revenue. Total Revenue peaks when demand is unitary elastic. We can also see how the marginal revenue curve appears for a

monopoly firm.

It intercepts the y-axis at the same point as the demand curve and its gradient is twice that of the average revenue (demand) curve. It intercepts the x-axis at the peak of the total revenue.

Like perfectly competitive firms monopolists will choose to produce at MR=MC as shown below. The amount of output is decided based on MR=MC and the corresponding price (draw a vertical line from the MR=MC intersect to the AR curve) is set.

The supernormal profit of the firm is (AR-AC)*Q* and is shown by the highlighted region. In a perfectly competitive market these supernormal profits wouldn’t exist in the long run. But because there are high barriers to entry in a monopoly market these supernormal profits can persist in the long run.

It is important to note that monopoly firms don’t always make supernormal profits. Their profits are dependent on their average costs and their revenue.

Note that the point of unit elasticity occurs when total revenue is at a maximum at the point where MR=0. This is why the monopoly firm wouldn’t produce at a point of the demand curve that is below unit elasticity as marginal revenue would be negative (along the inelastic portion of the demand curve).

Monopolies can arise for a number of different reasons. It could be created by the authorities, for example, a utilities firm or a nationwide service. These firms may have legal rights to be the only firm operating the service (therefore it is impossible to legally enter the market).

The patent system can also lead to monopolies. If a firm develops an innovative product or service it can take out a patent allowing it to be the only firm to sell the good or service for a period of time. Hence limiting other firms entry into the market. The patent system was created to encourage investment. If a firm were to invest in research and development and release a new product, but wasn’t able to take out a patent, other firms with lowers costs (since they aren’t spending on research and development) can copy the product and make a large profit therefore providing no incentive to invest in research and development and in the long run lead to firms not wanting to innovate or create new products.

Some monopoly firms arise due to the substantial economies of scale in a market. If the minimum economy of scale point is at a high output then there may only be room for one large firm in a market. This usually happens when there are substantial fixed costs to production but low marginal costs.

Economies of scale can act as a barrier to entry, as a large existing firm can utilise the economies of scale and produce at a lower cost than any new entrant and so will be able to price these new firms out of the market.

In such cases that economies of scale create a natural monopoly then the marginal cost curve is usually beneath the average cost curve causing problems regarding allocative efficiency. If the firm were to charge a price equal to marginal cost (P=MC) then they would make a loss. Hence firms charge more in order to make a supernormal profit.

There is no supply curve for a monopoly firm because there is no one-to-one connection between the price of the good and the willingness to supply.

Productive Efficiency

The monopoly will produce at the point where (long-run) marginal costs = marginal revenue. Therefore monopolies would only be productively efficient if the MR curve coincidentally intersected the LRAC curve at its minimum point (the rule needed to achieve productive efficiency).

Allocative Efficiency

Allocative efficiency is when price equals marginal cost (P=MC). For a monopoly the firm produces where MR=MC, however if MR is below AR (price) then the price will always be higher than the marginal cost.

Comparing Monopolies with Perfectly Competitive Firms

One can identify the distortions of resource allocation caused by the behaviour of a monopoly by comparing the monopoly market with the perfectly competitive market.

This is done by ignoring the possibility of economies of scale. The graph to the left shows the long run supply curve (if we were ignoring economies of scale) which is also the long run marginal cost curve. If the market were operating under perfect competition then the price would be PPC (the intersect of the demand and supply curve, where LRS = AR) for a monopoly the price would be PM (MR=MC but the price is taken at AR).

Consumer surplus would be the area APPCE. For the monopoly the consumer surplus is only the area of ABPM (less than under perfect competition) and the consumers face a higher price and less would be produced if the market was a monopoly. The blue rectangle is the monopolies profit. Therefore consumer surplus has been redistributed to the monopoly firm (this does not affect overall welfare as the firm is part of society).

However the red triangle represents the deadweight loss from the monopolisation of the industry, this is lost utility as fewer people benefit from the product as they choose not to purchase it at the monopoly price.

Page last updated on 20/10/13