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Other Market Models
Monopolies
Defining Monopoly Power
Page 1 of 2
Suppose you’re a firm that has a highly desirable product and you’re the only one who offers it. How would you price your
product? How much would you sell? The more you sell, the lower the price will be according to the law of demand. But,
the higher you raise your price, the less of the product people will buy. How do you as a firm, who has market power make
the decision about how to price your product? We’re going to be studying this problem in the coming lessons, and we will
begin this lecture by introducing the concept of market power and talking about an extreme case, the case of the single
seller, a monopoly. Let me begin by defining market power. A firm is said to have market power, if it is able to influence
the market price of its good or service, that is, if it has the power to set a price for its product, rather than take the price as
given in the market. Market power is a contrast to a competitive firm; a firm that is competitive is a price taker. A firm with
market power has the ability then to set its price. An extreme case of the firm with market power is a monopolist. A
monopoly is a single seller of a good or service. Now, you may be hard pressed to come up with an idea quickly of a firm
that really exists in the real world that’s a true monopoly. In fact, monopolies are quite rare and monopolies usually arise
due to one of three factors.
The first factor that can create a monopoly is a firm that has sole ownership of a particular resource that is important to the
production of a good or service. An example of this would be the case of the market for diamonds. There was a time when
the DeBeers Diamond Cartel owned almost eighty percent of the world’s diamonds. Many of the competitive diamonds
were in the Soviet Union and were not available on the market at the time. Because one single company owns so many of
the diamond mines, they were able to have considerable influence over the price that was charged for diamonds. So, one
thing that can create a monopoly is if a company has sole ownership of a particular resource that is important in the
production of the good. Another example would be if we were at an airport, for example, and one company had sole
ownership over the space that was available for selling concessions. If they owned that space, they then would be the
only restaurant in the airport and would, therefore, be a monopoly.
This brings us to the second situation that can create a monopoly and this is monopoly that is created by government
action. Government action meaning patents, copyrights, and in some cases special licenses. In these cases, the
government creates a situation whereby entry into an industry is prohibited. For example, one of the important driving
forces in the pharmaceutical market is company’s desire to obtain a patent for a new effective drug to treat a certain kind
of illness or condition. The company that develops the new drug first will be granted a patent, and with this patent, they
will have the sole right to produce and sell this drug in the United States for a period usually as long as twenty years. In
this case, a drug patent grants a monopoly to a company allowing it to have sole right to sell this product, and because
there are not competitors, at least while the patent is in effect unless the company wants to license production to other
companies. While this company has the patent, they have the right to be a monopolist, and being a monopolist allows
them to earn extra profit and thereby recover the costs that they sank into developing this new drug. Other things that can
give companies patent granted by the government, or other things that can give companies monopolies granted by the
government, are called sole licenses. It has been the case throughout history that governments have granted single
licenses to particular companies to provide particular types of service. For example, the Hudson Bay Company, which
was licensed by the King of England to develop trade in the New World, had a monopoly right to, on behalf of England, go
and provide imports and exports to the New World.
A third case in which we get a monopoly is what we call a natural monopoly. A natural monopoly arises because of the
interaction between the size of the market and the efficient scale of operation of a single firm. Let’s look at a picture that
will make the idea of natural monopoly a littler clearer. You’ll recall from our earlier discussions that the bottom point of the
long run average cost curve determined the efficient scale of operation or the right size for a firm in a long run in this
market. Firms that want to be competitive in the long run will be operating at the bottom their long run average cost; that
is, they will be minimizing the average cost of production and thereby maximizing their profits. If it’s a competitive market,
firms will continue to enter until the price of the good drops down to the bottom of the average cost curve. Now, if the long
run average cost curve is relatively close to the axis, that is, if the long run average cost curve points to a point of efficient
scale that is small, relative to the amount of the product that the market wants to buy, that is, if the demand curve is way
out here and the point of efficient scale is way back here, then there’s room for a lot of other firms to enter this market.
We’ll get several of these blue curves fitting in adding up to the total amount of the product that the market is actually
buying. That is, if the efficient scale of operation is small, relative to the size of the market, it takes a lot of firms to meet
Other Market Models
Monopolies
Defining Monopoly Power
Page 2 of 2
demand at this minimum average cost. However, if scale economies are very great, if the economies of scale are large,
relative to the size of the market, then we can get a situation like this, with a long run average cost curve for each of its
minimum point at a point that might actually be on its intersection with the demand curve. In this case it only takes one
firm to meet the entire market’s demand for this product at minimum average cost. If we look at the point here at minimum
average cost, it’s beyond the demand curve; this firm can produce everything that the market wants to buy at a price
equal to minimum average cost. This is a case when an industry has very, very great economies of scale. Where the
opportunities for teamwork and specialization, increasing returns to scale, and diminishing average cost go on for a long
time, that is the economy or the industry grows very, very large before it runs into problems with management and
communication, all of those other things that lead to decreasing returns to scale. When the economy has a lot of scale
economies, when the firm has a lot of scale economies relative to the amount of the good that people want to buy, then
we have what we call a natural monopoly. When the point of efficient scale is enough to provide all of the goods that the
market wants to buy, from a single firm producing it, then we have a situation of natural monopoly. Some examples of this
that have been sited in the past were electrical utilities. Electrical utilities provided power to your house by stringing up
electrical wires that led to a large generating plant that used coal or water power to produce electricity that has been wired
to your house, and there was really no need for competition in this market because one utility taking care of the wires and
the generation could provide all the power that a particular market might want to buy. So, we have a situation of natural
monopoly. The alternative would be for another power company to come in, build a large tower plant and string their wire
to your house so you could then choose whose electricity you wanted to buy. As long as we think of power generation as
coming from utilities that then send the power to your house through electrical wires, it really seems that it is a natural
monopoly. We don’t want a lot of firms out there stringing their own wires and building their own plants. Now, we are going
to talk more about electrical utilities a little bit later when we talk about the possibility that monopolies might be
deregulated, but for now, let me summarize.
The three things that create monopolies are, first of all, sole ownership of some strategic resources, as in the case of the
Diamond’s Cartel. The second is government action, usually in the granting of patents or special licenses, and finally,
natural monopolies which occur when there are a lot of economies of scale in an industry so that the point of efficient
scale has a lot of production relative to the demand in the market when all the demand in the market can be met at very
low cost or a diminishing cost by a single firm. Given what we have in the monopoly or supposing that we have a
monopoly. How then will this monopoly behave? Will it charge high prices and sell little out put, or will it charge lower
prices and sell more output? In the next lesson, we take up the question then of the monopolist’s problem: how to make
the trade off between higher prices and larger sales.