A Monopoly is when there is a dominant seller in the market. In other words there is one firm that has a very high market share.
A legal monopoly is sometimes considered to be when a firm has at least 25% market share. Firms can have “monopoly power” without necessarily having a monopoly. Monopoly power involves being able to raise the price to increase profits.
Examples of monopolies:
- Rail tracks – Network Rail.
- NHS in the market for healthcare in the UK.
- Google: approximately 90% of internet searches occur through Google.
Monopoly properties
Properties of monopoly markets include:
- One large firm.
- High barriers to entry
- Firms are price makers
- Supernormal profits.
The degree of monopoly power that a firm has depends on these factors. For example:
- The barriers to entry. The lower the barriers to entry, the easier it will be for a firm to enter and take a slice of any supernormal profits. This will disincentivise a firm from raising prices, knowing that other firms would enter and take their profits if they did so.
- The number of competitors, The more competitors, the easier for a consumer to switch to another product when one firm increases its price.
- Advertising – more brand loyalty may make it easier for firms to raise prices on consumers without consumers switching brands.
- The degree of product differentiation. The more unique the product, the greater power it has to raise prices (there are fewer alternatives).
Monopoly diagram
The diagram below shows the cost and revenue curves for a standard monopoly firm. The marginal revenue and average revenue lines are downward-sloping, reflecting the fact that the firm has the power to control prices.
The key point of the diagram: the firm is better off being a monopoly as it increases its profits, yet consumers lose out from higher prices and reduced quantity.
To maximise profits, the firm sets marginal cost equal to marginal revenue, resulting in quantity q being produced. By dotting up to the average revenue line, we get the monopoly price as p (note average revenue is the price per unit sold, so the average revenue line reflects the price). The red rectangle gives the level of supernormal profit the firm makes – the difference between price and average cost, multiplied by the quantity produced.
In an allocatively efficient market (one in which consumer and producer welfare together are maximised), the price will equal the marginal cost. This occurs at quantity q1 and price p1. Compared to this outcome, the monopoly firm has raised prices and reduced the quantity. In other words the monopoly is allocatively inefficient which creates a welfare shown by the blue area.
Natural monopoly diagram
A natural monopoly is a particular type of monopoly with significant economies of scale and high fixed costs.
For example, consider markets for utilities such as energy or water. There are high fixed costs to set up the pipes but once the pipe network is in place, it becomes very cheap to distribute the good among households.
In this case a monopoly might be more advantageous in comparison with a normal monopoly. If a firm can become large, it can achieve economies of scale, in other words lower (long-run) average costs. The firm may then pass on these cost reductions to the consumer in the form of lower prices. In contrast it could be very inefficient to have two firms set up separate networks of pipes for example.
The diagram below shows a natural monopoly. The key difference, in comparison with the previous diagram, is the downward sloping cost curves. This reflects the economies of scale in a natural monopoly. The firm maximises profits where MR=MC at quantity q and so sets the price p.
Suppose instead that, rather than one natural monopoly firm, there are two firms of equal size. Then each firm might produce half of the quantity at q2 for example. Then that would lead to a higher price at p2 compared with the monopoly price. So in this case, the natural monopoly means a lower price and higher quantity for consumers, increasing consumer surplus and making consumers better off..
Advantages of monopoly
Dynamic efficiency – advantage:
- As a monopolist the firm is making higher supernormal profits compared to firms in a more competitive market.
- This means there is dynamic efficiency: firms can reinvest supernormal profits over time to reduce costs or improve product quality.
- Hence consumers could see lower prices over time and improved quality.
Natural monopoly – advantage:
- High fixed costs and significant economies of scale (LRATC downward sloping and becomes nearly flat) define a natural monopoly.
- The larger the firm, the lower the long run average cost, so the price of the good should fall.
- If there were multiple firms, then LRATC would be higher in the market and consumers would face higher prices.
Disadvantages of monopoly
Welfare loss – disadvantage
- Monopoly raises the price and reduces the quantity, relative to perfectly competitive outcome.
- The firm produces where MR=MC and makes supernormal profit.
- But this outcome is productively inefficient and allocatively inefficient.
- Monopoly leads to a welfare loss.
Consumer welfare loss – disadvantage:
- Consumer surplus falls. Consumers face higher prices and reduced quantity.
- Less choice as only one main supplier of the good. In more competitive markets there would likely be more firms selling different varieties of the good.
- Worsen income inequality – poorer are hit hardest by higher prices.
Other evaluation points for monopoly
Whether a monopoly is desirable or undesirable may depend on any of the following factors:
- The monopoly may have other objectives e.g. market share/sales maximisation. This could be a better outcome for consumers compared to profit maximisation. Beyond that, it is even possible to have predatory pricing or temporary loss making even to maintain market power which could benefit consumers in the short term.
- How supernormal profits are used by the firm – the firm could use supernormal profits as dividends for shareholders, in which case there wouldn’t be reinvestment in product improvements or cost reductions.
- Extent of economies of scale. There could be diseconomies of scale in some industries. So having one large firm could be undesirable, as quality of service would worsen, with costs higher and hence prices also higher.
- Reason for monopoly position – the firm may have achieved its monopoly position because they provide highest quality service for lowest price. Then it may be best for consumers to keep that firm in its monopoly position.
- How contestable the market is – if the barriers to entry are not too high, then the market is more contestable. Firms would enter when there are supernomal profits available, reducing supernormal profits and reducing consumer prices.
- Degree of regulation. Regulation could prevent monopoly firms from abusing their market power by raising prices too much. In the UK the Competition and Markets Authority (CMA) is one regulatory body that investigates anti-competitive behaviour. For more information about the CMA, see the link here.
Why is there a welfare loss in monopoly?
Here are two methods to explain why there is a welfare loss (also known as a deadweight loss) in monopoly:
Method 1
To show there is welfare loss from monopoly, we need to compare two outcomes:
1. The monopoly profit-maximising outcome. The monopoly chooses its output level where MR=MC.
Then it prices on the average revenue curve.
2. The allocatively-efficient outcome where AR=MC. Allocative efficiency means social welfare (in this case, producer surplus plus consumer surplus) is maximised.
When moving from the allocatively efficient outcome to the profit maximising outcome, there is A) an increase in profits (so higher producer surplus).
But there is also B) a larger fall in consumer surplus (the price rise and the fall in output reduce consumer surplus).
As the fall in consumer surplus is larger than the increase in profits under monopoly, there is an overall welfare loss.
Method 2
Another way to think about this is as follows: start with the monopoly profit-maximising outcome.
The output level is set where MR=MC and the price is directly above that point on the average revenue curve.
The AR curve is also a demand curve – it shows consumers’ willingness to pay for goods and services.
The MC curve shows the cost of production of an extra unit. In a perfectly competitive market, if a firm was paid to cover its marginal cost, it would produce this one extra unit.
The AR curve is above the MC curve at the monopoly output level.
This means the consumer is willing to pay more (for one more unit) than the firm would be able to produce one more unit for.
Society would stand to benefit overall if that extra unit is produced. The extra benefit to the consumer outweighs the marginal cost to the producer.
Related pages
For more information on the CMA’s competition policy, view the link below:
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