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MONOPOLY
Economics – Course Companion
Blink and Dorton, 2007, Chapter 9, p105-113
Assumptions of Monopoly
• There is one firm producing the product, so
the firm is the industry.
• Barriers to entry exist, which stop new firms
from entering the industry and maintains the
monopoly.
• As a consequence of barriers to entry, the
monopolist may be able to make abnormal
profits in the long run.
What firms are monopolies?
• Whether a firm really is a monopoly depends
upon how narrowly we define the industry.
• While Microsoft may be the only producer of
a particular kind of software, it does not have
a monopoly on all software.
• The important question here is not whether
the firm is a monopoly, but rather how much
monopoly power the firm has.
The Extent of Monopoly Power
Key Questions
• To what extent is the firm able to set
its own prices without worrying about
other firms?
• To what extent can it keep people out
of the industry?
The Strength of Monopoly Power
• The strength of monopoly power possessed by
a firm will really depend upon how many
competing substitutes are available.
• For example, the underground railway in a city
may have the monopoly of underground
travel, but it will face competition from other
industries, such as buses, taxis and private
transport.
Sources of Monopoly Power
Barriers to Entry
• A monopoly may continue to be the only
producer in any industry if it is able to stop other
firms from entering the industry in some way.
• These ways to preventing entry to the industry
are known as barriers to entry as follows:
1. Economies of Scale.
2. Natural Monopoly.
3. Legal Barriers.
4. Brand Loyalty.
5. Anti Competitive Behaviour.
BARRIERS TO ENTRY
1. Economies of Scale
• Firms gain average cost advantages as their size
increases: - economies of scale.
• Specialization, division of labour, bulk-buying and
financial economies may lead to cost savings and
lower unit costs.
• If a monopoly is large, then they will be
experiencing economies of scale.
• Any firm wishing to enter the industry, will
probably have to start up in a relatively small way
and so will not have the economies of scale that
are enjoyed by the monopolist.
BARRIERS TO ENTRY
1. Economies of Scale
• Even if the new firm were able to start up with
the same size as the monopolist, it would still
not have the economies that come from
expertise in the industry, such as managerial
economies, promotional economies, and R&D
(Research and Development)
BARRIERS TO ENTRY
1. Economies of Scale
• Without economies of scale, a would be entrant
to the industry, knows that it would not be able
to compete with the existing monopolist who
would simply have to reduce the price to the level
of normal profits.
• At this level the new entrant would be making
looses, because the average costs would be
higher, so the lack of economies of scale acts as a
deterrent to firms that want to enter a monopoly
industry.
BARRIERS TO ENTRY
2. Natural Monopoly
• Some industries are classified as natural
monopolies.
• An industry is a natural monopoly if there is
only enough economies of scale available in
the market to support one firm.
NATURAL MONOPOLY
In this graph, the monopolist
is the industry and has a
demand curve D1. The long
run average cost curve faced
by the monopolist is LRAC and
its position and shape are set
by the economies of scale the
firm is experiencing. The
monopolist is able to make
abnormal profits by producing
an output between q1 and q2,
because the average revenue
is greater than the average
cost for that range of output.
If another firm were to enter
the industry, then the firm
would take demand from the
monopolist and monopolist’s
demand curve would shift to
the left, in this case to D2.
Two firms in a Monopoly Market
leads to losses.
• If a second firm enters a market which is
characteristic of a monopoly, the two firms
would now be a position, where it is
impossible for them to make even normal
profits.
• Their LRACs would be above the AR at every
level of output.
Abnormal Profits in a
Monopoly Market
• The LRAC, which is shaped by the economies
of scale experienced by the monopolist will
only give an abnormal profit if the monopolist
is able to satisfy all the demand in the market.
• The industry is a natural monopoly, because
the market will only support one firm.
Examples of Natural Monopolies
• Examples of Natural monopolies include the
industries that supplies utilities such as water,
electricity and gas.
• However, in recent years, the electricity
market has been deregulated in many
developed countries, and consumers may
have some choice between providers.
BARRIERS TO ENTRY
3. Legal Barriers
• In certain situations, a firm may have been given
a legal right to be the only producer in an
industry. This is the legal right to be a monopoly.
• This is the case with patents, which give a firm
the right to be the only producer of product for a
specific number of years, after it has been
invented.
• When a patent expires, other producers will then
be allowed to produce and sell the product.
BARRIERS TO ENTRY
3. Legal Barriers
Why do patents exist?
• Patents exists as a means to encourage invention.
• If individuals or firms put time and money into
inventions only to find that they were copied as
soon as they were successful, then there would
be little incentive to create the product.
• If a firm knows that it will be a protected
monopoly for a number of years, then it is more
likely to invest in R&D.
BARRIERS TO ENTRY
3. Legal Barriers
Intellectual Property Rights
• Patents along with copyrights and trademarks,
are examples of intellectual property rights.
• Intellectual property rights refer to creations of
the minds.
• Just as private property rights allow people to
own physical property, so patents guarantee the
creators of ideas the rights to own their ideas.
• A very good and controversial example of patent
protection is the pharmaceutical industry.
BARRIERS TO ENTRY
3. Legal Barriers
Essential Services
• The government of a country may grant the
right to produce a product or service to a
single firm.
• Examples include the state Postal Service, and
Public Transport.
BARRIERS TO ENTRY
4. Brand Loyalty
• It may be that a monopolist produces a
product that has gained huge brand loyalty.
• The consumer thinks of the product as a
brand.
• For example, in the early days of the vacuum
cleaner, there was only one brand – Hoover.
• If the brand loyalty is so strong, then new
firms may be put off from entering the
industry.
BARRIERS TO ENTRY
4. Anti Competitive Behaviour
• A monopolist may also attempt to stop
competition by adopting restrictive practices,
which may be legal or illegal.
Price War
• For example, an established monopoly should be
in strong position to start a “price war” if
another firm enters the industry.
• The monopoly can lower its price to a loss making
level and should be able to sustain the looses for
longer than the new entrant.
BARRIERS TO ENTRY
4. Anti Competitive Behaviour
MICROSOFT CASE STUDY
• In 2004, the European Union Commission fined Microsoft
€497 million for bundling a media player and messaging
technologies into its Windows operating system.
• The commission claimed that this prevented potential
competitors from reaching consumers.
• It ordered Microsoft to make public technical information
to allow other companies the ability to produce goods that
are compatible with Microsoft.
• In July 2006, the fine remained unpaid and Microsot
received an additional fine of €280.5 million for failure to
comply with 2004 fine.
BARRIERS TO ENTRY
4. Anti Competitive Behaviour
INTEL CASE STUDY
• In 2009 Intel, another company in the IT
industry, (with significant monopoly like
powers) was fined by the European
Commission for anti-competitive behaviour.
• This news item summarizes the key issues.
THE DEMAND CURVE AND THE PROFITMAXISMING LEVEL OF OUTPUT
• The monopolist is the industry and therefore the
monopolist’s demand curve is the industry
demand curve and is downward sloping.
• The monopolist can control either the level of
output or the price of the product, but not both.
• Some people wrongly assume, that monopolist
can charge whatever price they like and still some
their products. This is not the case. In order to
sell more they must lower their price.
DEMAND CURVE – MONOPOLIST
The monopolist has a
normal demand curve
with marginal revenue
below it, and it
maximises profit by
producing at the level
of output where
marginal cost is equal
to marginal revenue.
The monopolist sells a
quantity q at a price
per unit of P.
Possible Profit Situations in Monopoly
• If a monopolist is able to make abnormal
profits in the short run, and if the monopolist
has effective barriers to entry, then other
firms cannot enter the industry and compete
away the profits that are being earned.
ABNORMAL PROFITS IN MONOPOLY
The monopolist is able
to make abnormal
profits in the long run,
provided the barriers to
entry hold out. The
monopolist is
maximising profits and
is making abnormal
profits shown by the
shaded area PabC.
Without the entry of
new firms to the
industry, the situation
will continue.
Monopolies and Losses
• It is sometimes assumed that a monopolist will always
earn abnormal profits, but this is not always true.
• If the monopolist produces something for which there
is little demand, then it will not earn abnormal profits.
• If a monopolist were making losses in the short run,
then it would have the option of closing down
temporarily (if it was not covering it variable costs) or
continuing production for the time being.
• If normal profits cannot be earned in the long term,
the firm will have to close.
MONOPOLIST MAKING LOSSES
IN THE LONG RUN
In this diagram the firm is
not able to cover costs in
the long run, since the
average cost is greater
than the average revenue
at all levels of output.
Since there is nothing that
can done to rectify this
situation, this will be an
industry in which no firm
will be willing to produce.
There will be no industry.
Efficiency in Monopoly
• Unlike perfect competition, the monopolist
produces at the level of output, where there is
neither productive efficiency nor allocative
efficiency.
NO PRODUCTIVE AND
ALLOCATIVE EFFICIENCY
IN MONOPOLY
The monopolist is
producing at the profit
maximising level of
output, q. Output is
being restricted in order
to force up the price and
to maximise profits.
However, the most
efficient level of output,
q1 and the allocatively
efficient level of output,
q2 are not being
achieved.
Advantages of Monopoly in
comparison with Perfect Competition
• Monopolies may be able to achieve large
economies of scale simply because of their size.
• Monopolies do not have to be big, but is the
industry is big, then the monopolist should gain
substantial economies of scale.
• If this pushes the MC curve down, then it is
possible that the monopolist may produce at a
higher output and at a lower price than in perfect
competition.
• The idea of relative price and output in monopoly
and perfect competition is very debateable.
MONOPOLY VS PERFECT COMPETITION
In perfect competition, the equilibrium price and quantity will be where demand is
equal to supply. This means that the price will be P1 and the total output of Q1 will
be produced. However, if the industry is monopoly, with significant economies of
scale, then the MC curve, may well be substantially below the MC curve in perfect
competition, which is the industry supply curve. The monopolist will produce
where MC=MR maximising profits and producing a greater quantity than perfect
competition, Q2. at a lower price, P2.
Advantages of Monopoly in
comparison with Perfect Competition
• A second advantage may be that there will be
higher levels of investment in R&D in monopoly.
• Firms in perfect competition are, by definition,
relatively small and so may find it difficult to
invest in R&D.
• A monopolist making abnormal profits is in a
better situation to use some of those profits to
fund R&D.
• This in the long run will be benefit consumers.
Disadvantages of Monopoly in
comparison with Perfect Competition
• If significant economies of scale do not exist in
monopoly, then the monopoly may restrict
output and charge a higher price, than under
perfect competition.
MONOPOLY VS PERFECT COMPETITION WITHOUT ECONOMIES OF SCALE
In this graph there is no differences in costs for the monopolist and the
perfectly competitive market. If this is the case, then the monopolist will
produce Q2 at a price of P2 where MC=MR. The perfectly competitive market
will, however, produce Q 1 at a price of P1 where industry supply meets
industry demand. Thus higher prices and lower output could exist under
monopoly.
The Unfair Profits of Monopolists
• The high profits of monopolists may be
considered as unfair, especially by competitive
firms, or those on low incomes.
• The scale of the problem depends upon the
size and power of the monopoly.
• The monopoly profits of your local post office
may seem of little consequence when
compared to the profits of a giant national
company.
Summary
3 possible problems with monopolies
• They are productively and allocatively inefficient.
• They can charge a higher price for a lower level of
output.
• They can exercise anti-competitive behaviour to
keep their monopoly power.
These potential problems mean that monopolies
can act against the public interest. As a result, all
governments have laws and policies to limit
monopoly power.
EXAMINATION QUESTIONS
Short Response Questions
1.Explain the level of output at which a
monopoly firm will produce. (10 marks)
2.Using a diagram, explain the concept of a
natural monopoly. (10 marks)
3.Using appropriate diagrams, explain whether a
monopoly is likely to be more efficient or less
efficient than a firm in perfect competition.
(10 marks)
EXAMINATION QUESTIONS
Essay Question
1a. Explain three barriers to entry
that allow a firm to be a monopoly.
(10 marks)
1b. Evaluate the view that
governments should always
prevent firms from being
monopolies (15 marks)