Monopoly
I. Monopoly Structure
Market Power is when “a
company [has the] ability to manipulate price by influencing an item's supply,
demand or both. A company with market power would be able to affect price to
its benefit. Firms with market power are said to be "price makers" as
they are able to set the price for an item while maintaining market share.
Generally,
market power refers to the amount of influence that a firm has
on the industry in which it operates.”[1]
Market demand is the total
quantities of good or service people are willing and able to buy at alternative
prices in a given time period; the sum of individual demands.
Monopoly = industry
Monopolies arise when:
1. No
Close Substitute
a. If a good has a close substitute, even
though only one firm produces it, that firm effectively faces competition from
the producer of substitutes.
2. Barriers
to Entry
a.
Barrier to entry – It’s a natural or legal constraint that
protects a firm from competitors.
b.
Patent is a government grant of exclusive ownership of an innovation.
When we are faced with a monopoly, the firms
demand is equal to the market demand for that given product
Marginal
revenue is the change in
total revenue that results from a one-unit increase in quantity sold.
Q1 = 1 P1 = 10 TR1
= 10
Q2 = 2 P2 = 9 TR2
= 18 MR = 8
This process continues and when the MR stops
increasing it means that we have derived the price at which a firm obtains
maximum TR.
MR = 0
The marginal revenue curve lies below the
demand curve at every point but the first. The MR is less than P because when the P is
lowered to sell one more unit two opposing forces affect TR:
1. The lower P results in revenue loss.
2. The increase in Q sold results in a revenue
gain.
II. Monopolistic Behavior
Profit maximization rule stats that one will produce at the rate of output where marginal revenue is equal to marginal cost
MR = MC
Production decision is the
selection of the short run rate of output (with existing plant and equipment).
A
monopoly finds its Q m by making MR = MC. Then using this Q m it goes to the
demand curve and obtains the P m.
Below is how we determine price and quantity supplied in a monopoly:
·
The intersection of the MR = MC curves
establishes the profit maximizing rate of output.
·
The demand curve tells is the highest price
consumers are willing to pay for that specific quantity of output.
·
Only one price is compatible with the
profit-maximizing rate of output.
They are
higher than competitive market.
·
All they have to do is increase quantity and
price will drop.
·
This will reduce the profits available in the
market giving an economic discouragement.
Barriers to entry are obstacles
that make it difficult or impossible for would be producers to enter a
particular market.
·
Patent is a government grant of exclusive ownership of an innovation.
·
Copyright is an exclusive right granted to the author
or composer.
Other entry
barriers
There are two types of barrier to entry:
Natural
monopoly – It’s a monopoly that arises when technology
for producing a G or S enables one firm to meet the entire market demand at a
lower price than two or more firms could.
Legal
monopoly – It’s a market
in which competition and entry are restricted by the concentration of ownership
of a natural resource or by the granting of a public franchise, government
license patent, or copyright.
·
Legal
Harassment – Some companies
will harass smaller companies by suing them.
This makes the cost of entrance higher (think Russia on everything and
Apple computers’ OS system).
·
Exclusive
licensing – Some companies will
not allow for compatibility on the factors of production. As with legal harassment, this makes the cost
of entrance higher and prices of the product artificially high (think AT&T
with the iPhone)
·
Bundled
Products – Some companies force
consumers to purchase complementary products (the largest offender that I can
think of was Microsoft and their internet explorer).
·
Public Franchise is an exclusive right granted by the
government to a firm so they can supply G or S (think USPS).
·
Government license controls entry into particular occupations,
profession, and industries (Think commercial driver’s license, and emission or
tag agencies).
IV. Comparative
Outcomes
Competition
vs. Monopolies
|
Perfectly
competitive |
Monopoly |
|
Higher prices signal the need
for more supply |
Higher prices signal the need
for more supply |
|
Higher profits attracts new
suppliers |
Barriers to entry are erected to
exclude potential competition |
|
P = MC |
MR = MC |
|
More efficient |
Less efficient |
|
Lower prices |
Higher prices |
|
Higher quantities |
Lower quantities |
Near
Monopolies
Duopoly – It is a market with only two players (or
firms)
Oligopolies
The characteristics of Oligopolies are:
1. Small
Number of Firms – An
oligopoly consists of a small number of firms.
Each firm has a large share of the market, the firms are independent,
and they face temptation to collude.
2. Interdependence – With a small
number of firms in the market, each firm’s actions influence the profits of the
other firms.
a. Example:
if ith player reduces his prices, all other players in the market
will loose market share to him. This occurs if we assume the competitors do not
change their prices as well.
3.
Temptation
to Collude – When a small number of firms share a market, the can increase their
profits by forming a cartel and acting like a monopoly.
Cartel – It is a group of firms acting together to limit output; it raises
prices and increase economic profit.
4.
Barriers to Entry – Either natural or legal barriers to entry
can create oligopoly.
How many firms are in the market depends on
how many firms it takes to supply the demand for the given good.
A legal oligopoly arises when a legal barrier
to entry protects the small number of firms in a market.
When barriers to entry create an oligopoly,
firms cam make an economic profit in the LR without fear of triggering the
entry of additional firms.
The characteristics of Monopolistic
Competition are:
1.
Large Number of Firms – The
presence of a large number of firms has three implications for the firms in the
industries:
2.
Small
Market Share – While each firm can influence the price of its own
product, it has little power to influence the MKT P.
3.
No
Market Dominance – Each firm is sensitive to the avg. MKT P, but it
does not pay attention to any one individual competitor. Since they are all relatively small not one
firm can dictate the market.
4.
Collusion
Impossible – Firms try to profit from illegal agreements with other
firms to fix prices and not undercut each other, and this is impossible due to
the share number of players in the market.
5.
Product Differentiation – This implies that the product has close
substitutes, but not a perfect substitute.
Production
differentiation – It’s
making a product that is slightly different for the products of competing
firms.
6. Competing
on Quality, Price and Marketing – Product differentiation enables a firm to compete with other
firms in three areas:
a. Quality – the quality of a product
is the physical attributes that make it different from the products of the
others. It runs on a spectrum between high and low.
b. Price – because of product differentiation, a firm in monopolistic
competition faces a downward-sloping demand curve. So like a monopoly, the firm can set both its
P and Q. But there is a tradeoff between
P and quality.
c. Marketing – because of product
differentiation, a firm in monopolistic competition must market its
product.
Marginal cost pricing rule – It is the offer of goods at prices equal
to their MC.
The marginal cost pricing
rule is efficient, but it leaves the natural monopoly incurring an economic
loss; therefore, it is seldom used.
Average
cost pricing rule – It is a price rule for a natural monopoly that sets
the price equal to average cost and enables the firm to cover its costs and
earn a normal profit.
The main
reason why monopoly exists is that it has the potential advantages over a
competitive alternative. These
advantages arise from:
Invention leads to a wave of innovation as new knowledge is
applied to the production process. If a
firm invents in something that obtains a patent, the monopoly will hold
monopoly power for a period of time.
This does not imply that productivity will grow.
Economies of scale can lead to natural monopoly.
Economies of
scale – A condition in which, when a firm increases its plant size and
labor employed by the same percentage, its output increase by a larger
percentage and its average total cost decreases.
Where significant economies of scale exist, it would be
wasteful not to have a monopoly. Usually
they exist where the cost of providing a G or S is cheaper at higher quantities
produced.
Contestable
market is an imperfect competitive industry subject to potential entry
if prices or profits increase.
·
If entry is insurmountable competitors will be
locked out of the market.