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MONOPOLIES
causes of monopoly
How does a firm establish a monopoly position in a market? The fastest route for a business to
grow and take an increasing share of a particular market is through integration i.e. through
agreed mergers or contested take-overs.
Horizontal integration occurs when two businesses in same industry at the same stage of
production become one.
Vertical Integration involves acquiring a business in the same industry but at different stages of
the supply chain - for example an oil company owning drilling and extraction businesses
together with refining, distribution and retail subsidiaries.
Monopoly power also comes from the ownership of Patents and Copyright protection or the
exclusive ownership of assets (e.g. De Beers - diamonds).
The government may also give legal monopoly power to some business through nationalisation
or government awarded franchises and licences.
Monopoly power for existing firms within a business can come more organically through the
internal growth of a firm, taking advantage for example of internal economies of scale.
PRICE AND OUTPUT UNDER SINGLE PRICE, NON REGULATED MONOPOLY
linking prices and business objectives
Pricing objectives of businesses are generally related to satisfying one of the following five
common strategic objectives:
Objective: To maximise profits
Although the ‘maximisation of profits’ can have negative connotations for public interest, in
economic theory, one function of ‘profit’ is to attract new entrants to the market and the
additional suppliers keep prices at a reasonable level. By seeking to differentiate their product
from those of other suppliers, new entrants also expand the choice to consumers, and they may
vary prices as niche markets develop
Objective: To meet a specific target return on investment (or on net sales)
Assuming a standard volume operation (i.e. production and sales) target pricing is concerned
with determining the necessary mark-up (on cost) per unit sold, to achieve the overall target
profit goal.
Target return pricing is effective as an overall performance measure of the entire product line,
but for individual items within the line, certain strategic pricing considerations may require the
raising or lowering of the standard price.
Objective - To achieve a target sales level
Many businesses measure their success in terms of overall revenues. This is often a proxy for
market share. Pricing strategies with this objective in mind usually focus on setting price that
maximises the volumes sold.
Objective - To maintain or enhance market share
As an organisational goal, the achievement of a desired share of the market is generally linked
to increased profitability. An offensive market share strategy involves attaining increased
market share, by lowering prices in the short term. This can lead to increased sales, which in
the longer term can lead to lower costs (through benefits of scale and experience) and
ultimately to higher prices due to increased volume/market share.
Objective - To meet or prevent competition
Prices are set at a level that reflects the average industry price, with small adjustments made
for unique features of the company’s specific product(s). Firms that adopt this objective must
work ‘backwards’ from price and tailor costs to enable the desired margin to be delivered.
AN INCREASE IN DEMAND
GAIN IN MONOPOLY PROFIT
MONOPOLIES ARE NOT GUARANTEED PROFITS
THEY CAN MAKE ECONOMIC PROFITS IN THE LONG RUN BUT IT IS NOT
A CERTAINTY
MONOPOLY LOSSES
NATURAL MONOPOLY
price discrimination
A monopolist may be able to engage in a policy of price discrimination. This occurs when a firm
charges a different price to different groups of consumers for an identical good or service, for
reasons not associated with the costs of production. It is important to stress that charging
different prices for similar goods is not price discrimination. For example, price discrimination
does not does not occur when a rail company charges a higher price for a first class seat. This is
because the price premium over a second-class seat can be explained by differences in the cost
of providing the service.
CONDITIONS REQUIRED FOR PRICE DISCRIMINATION TO WORK
There are basically three main conditions required for price discrimination to take place.
Monopoly power
Firms must have some price setting power - so we don't see price discrimination in perfectly
competitive markets.
Elasticity of demand
There must be a different price elasticity of demand for the product from each group of
consumers. This allows the firm to extract consumer surplus by varying the price leading to
additional revenue and profit.
Separation of the market
The firm must be able to split the market into different sub-groups of consumers and then
prevent the good or service being resold between consumers. (For example a rail operator must
make it impossible for someone paying a "cheap fare" to resell to someone expected to pay a
higher fare. This is easier in the provision of services rather than goods.
The costs of separating the market and selling to different sub-groups (or market segments)
must not be prohibitive.
Examples of price discrimination
There are numerous good examples of discriminatory pricing policies. We must be careful to
distinguish between discrimination (based on consumer's willingness to pay) and product
differentiation - where price differences might also reflect a different quality or standard of
service.
Some examples worth considering include:




Cinemas and theatres cutting prices to attract younger and older audiences
Student discounts for rail travel, restaurant meals and holidays
Car rental firms cutting prices at weekends
Hotels offering cheap weekend breaks and winter discounts
The aims of price discrimination
It must be remembered that the main aim of price discrimination is to increase the total
revenue and/or profits of the supplier! It helps them to off-load excess capacity and can also
be used as a technique to take market share away from rival firms.
Some consumers do benefit from this type of pricing - they are "priced into the market" when
with one price they might not have been able to afford a product. For most consumers however
the price they pay reflects pretty closely what they are willing to pay. In this respect, price
discrimination seeks to extract consumer surplus and turn it into producer surplus (or
monopoly profit).
examples of price discrimination
Price discrimination involves market segmentation. A firm price discriminates when it charges
different prices to different consumers for reasons that do not reflect cost differences. Price
discrimination involves extracting consumer surplus from buyers and turning this into additional
revenue and profit
The key to price discrimination is to exploit the fact that different consumers have a different
willingness and ability to pay for goods and services
SINGLE PRICE MONOPOLIST
The single price monopolist aiming to maximise profits will choose an output Qm and Price Pm
as shown in the diagram above. This is the output where marginal revenue = marginal cost.
FIRST DEGREE PRICE DISCRIMINATION
This involves perfect segmentation of the market where every customer is charged his or her
“willingness to pay” so there is no consumer surplus in the transaction. The monopolists’
demand curve becomes the marginal revenue curve, i.e. you do not have to lower the price to
the higher value customers in order to sell more! More goods are sold; but price is higher to
some customers.
First degree discrimination takes place when bartering exists between buyers and sellers. The
bid and offer system in the housing market where potential home buyers put in an offer on an
individual property
Other
Negotiating
prices
with
Haggling
for
the
Dutch
Antiques fairs and car boot sales!
examples
dealers
price
for
of
second
a
hand
hotel
include:
cars
room
auctions
second degree price discrimination
Introduction
This type of price discrimination involves businesses selling off packages of excess capacity at
lower prices than the previously published/advertised price.
Examples of this can be found in the hotel and airline industries where spare rooms and seats
are sold on a last minute standby basis.
In these types of industry the fixed costs of production (the costs that do not vary with output)
are high. For example, the high costs of building a hotel or leasing a plane are clearly fixed. At
the same time the marginal or variable costs in these industries are small and predictable.
Marginal costs are the costs of providing an extra unit of output. If there are unsold airline
tickets or hotel rooms, it is often in the businesses best interest to offload spare capacity at
lower (discounted) prices, always providing that the cheaper price that adds to revenue covers
the marginal cost of each unit. The expansion of e-commerce by both well established
businesses and new entrants to online retailing has seen a further growth in second degree
price discrimination.
Examples of Second Degree Price Discrimination
In the autumn of 2001, most of the world’s main global airlines were left with a huge amount
of spare capacity following the terrorist attacks on the United States and a short term collapse
in demand for international travel. There followed several months of dramatic price-cutting
among airlines, desperate to maintain cash flow and increase occupancy rates on flights. The
low-cost airlines in Europe seemed to benefit greatly from this approach with price discounting
helping to maintain the strong growth of sales volumes.
Some of Britain’s long-established clothes retailers have also felt the squeeze of falling demand
and spare capacity in the wake of the successful entry of discounts retailers such as Matalan,
TK Maxx and Primark who have taken up to 15% of the UK clothing market.
The low cost airlines follow a different pricing strategy to the one outlined above. Customers
booking early with carriers such as EasyJet will normally find much lower prices if they are
prepared to commit themselves to a flight by booking early. Closer to the date and time of the
scheduled service, the price often rises, on the justification that consumer’s demand for a
particular flight becomes more inelastic the nearer to the time of the service.
THIRD DEGREE PRICE DISCRIMINATION
This is the most frequently found form of discrimination and involves charging different prices
for the same product in different segments of the market. The market is usually separated in
two ways: by time or by geography. Telephone and electricity companies separate markets by
time: There are three rates for telephone calls: a daytime peak rate and an off peak evening
rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak electricity
during the night. Markets can also be separated by geography. For example, exporters may
charge a higher price in overseas markets if demand is more inelastic than it is in home
markets.
Suppose that a firm has separated a market by time into a peak market with inelastic demand,
and an off-peak market with elastic demand. The demand and marginal revenue curves for the
peak market and off peak markets are labelled a and b respectively. This is illustrated in the
diagram below Assuming a constant marginal cost for supplying to each group of consumers,
the firm aims to charge a profit maximising price to each group. In the peak market the firm
will produce where MRa = MC and charge price Pa, and in the off-peak market the firm will
produce where MRb = MC and charge price Pb. Consumers with an inelastic demand for the
product will pay a higher price (Pa) than those with an elastic demand who will be charged Pb.
The monopolist seeks to sell additional output in the sub market where elasticity of demand is
high and extract some of the consumer surplus from consumers in the sub market where it is
thought the price elasticity of demand is lower.
Examples of Market Separation include
Discounts to Seniors / OAPs for entry to theatres, meals
rail
Different
prices
for
kids
and
adults
for
Gender pricing in some bars/clubs (lower prices for
EuroRail pass for student travel - compared to
Length of stay in airline tickets
in restaurants and travel on buses and
sporting
and
other
attractions
females entering some night clubs)
standard fares for business users
third degree (multi-market) price discrimination
Introduction
This is the most frequently found form of price discrimination and involves charging different
prices for the same product in different segments of the market. The market is usually
separated in two ways: by time or by geography. For example, exporters may charge a higher
price in overseas markets if demand is more inelastic than it is in home markets.
How it works
Suppose that a firm has separated a market by time into a peak market with inelastic demand,
and an off-peak market with elastic demand. The demand and marginal revenue curves for the
peak market and off peak markets are labelled a and b respectively. This is illustrated in the
diagram below. Assuming a constant marginal cost for supplying to each group of consumers,
the firm aims to charge a profit maximising price to each group.
In the peak market the firm will produce where MRa = MC and charge price Pa, and in the offpeak market the firm will produce where MRb = MC and charge price Pb. Consumers with an
inelastic demand for the product will pay a higher price (Pa) than those with an elastic demand
who will be charged Pb.
Two Part Pricing Tariffs
An alternative pricing policy common to industries with pricing power is to set a two-part
tariff for consumers. A fixed fee is charged (often with the justification of contributing to
the fixed costs of supply) and then a supplementary charge based on the number of units
consumed. There are plenty of examples of this including taxi fares; amusement park
entrance charges; and the ubiquitous fixed charges set by the utilities (gas, water and
electricity). Price discrimination can come from varying the fixed charge to different
segments of the market and in varying the charges on marginal units consumed (e.g.
discrimination by time)
price discrimination and economic efficiency
To what extent does price discrimination help to achieve a more efficient allocation of
resources?
There are arguments on both sides of the coin – indeed the overall impact of price
discrimination on economic welfare seems bound to be ambiguous.
• Consumer surplus is reduced in most cases - representing a loss of consumer welfare. For the
majority of consumers, the price charged is significantly above marginal cost. Those consumers
in segments of the market where demand is inelastic would probably prefer a return to uniform
pricing by firms with monopoly power!
• However some consumers who can buy the product at a lower price may benefit. Previously
they may have been excluded from consuming it. Low-income consumers may be “priced into
the market” if the supplier is willing and able to charge them a lower price. Good examples to
use here might include legal and medical services where charges are dependent on income
levels
• Price discrimination is clearly in the interests of businesses who achieve higher profits. A
discriminating monopoly is extracting consumer surplus and turning it into extra super normal
profit or producer surplus
• The profits made in one market may allow firms to cross-subsidise loss-making
activities/services that have important social benefits. For example profits made on commuter
rail or bus services may allow transport companies to support loss making rural or night-time
services. Without the ability to price discriminate these services may have to be with drawn
and employment might suffer. In many cases, aggressive price discrimination is seen as inimical
to business survival during an economic recession or sudden market downturn
• The premium prices paid by business purchases of software licences might allow a software
company to offer educational users a lower-price for similar or identical products
• An increase in total output resulting from selling extra units at a lower price might help a
monopoly supplier to exploit economies of scale thereby reducing long run average costs
potential benefits from monopoly
The debate about monopoly will never be settled! The consensus seems to be that the
economic case for and against monopoly needs to be judged on a case by case basis particularly when assessing the impact on economic welfare.
The standard economic case against monopoly is that, with the same cost structure, a
monopoly supplier will produce at a lower output and charge a higher price than a
competitive industry. This leads to a net loss of economic welfare and efficiency because price
is driven above marginal cost - leading to allocative inefficiency.
The diagram below shows how price and output differ between a competitive and a
monopolistic industry. We have assumed that the cost structure for both the competitive firm
and the monopoly is the same - indeed we have assumed that output can be supplied at a
constant marginal and average cost.
Assuming that the monopolist seeks to maximise profits and that they take the whole of the
market demand curve, then the price under monopoly will be higher and the output lower than
the competitive market equilibrium. This leads to a deadweight loss of consumer surplus and
therefore a loss of static economic efficiency.
CAN MONOPOLY BE DEFENDED?
Monopoly and Economies of Scale
Because monopoly producers are often supplying goods and services on a very large scale, they
may be better placed to take advantage of economies of scale - leading to a fall in the average
total costs of production. These reductions in costs will lead to an increase in monopoly profits
but some of the gains in productive efficiency might be passed onto consumers in the form of
lower prices. The effect of economies of scale is shown in the diagram above.
Economies of scale provide potential gains in economic welfare for both producers and
consumers.
Regulation of monopoly
Because of the potential economic welfare loss arising from the exploitation of monopoly
power, the Government regulates some monopolies. Regulators can control annual price
increases and introduce fresh competition into particular industries
Monopoly and Innovation (Research and Development)
How are the supernormal profits of monopoly used? Is consumer surplus of equal value to
producer surplus?
Are large-scale firms required to create a comparative advantage in global markets? Some
economists argue that large-scale firms are required to be competitive in international
markets.
An important issue is what happens to the monopoly profits both in the short run and the long
run. Undoubtedly some of the profits will be distributed to shareholders as dividends. This
raises questions of equity. Some low income consumers might be exploited by the monopolist
because of higher prices. And, some of their purchasing power might be transferred via
dividends to shareholders in the higher income brackets - thus making the overall distribution
of income more unequal.
However some of the supernormal profits might be used to invest in research and development
programmes that have the potential to bring dynamic efficiency gains to consumers in the
markets. There is a continuing debate about whether competitive or monopolistic markets
provide the best environment for high levels of research spending.
Price Discrimination
Are there potential welfare improvements from price discrimination? Some forms of price
discrimination benefit certain consumers.
Domestic monopoly but international competition
A firm may have substantial domestic monopoly power but face intensive competition from
overseas producers. This limits their market power and helps keep prices down for consumers.
A good example to use here would be the domestic steel industry. Corus produces most of the
steel manufactured inside the UK but faces intensive competition from overseas steel
producers.
Contestable markets!
Contestable market theory predicts that monopolists may still be competitive even if they
enjoy a dominant position in their market. Their price and output decisions will be affected by
the threat of "hit and run entry" from other firms if they allow their costs to rise and
inefficiencies to develop.