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Monopolies & Oligopolies

Monopolies

Terms

Problems

Pure Monopolies and Natural Monopolies

Pure Monopolies

A pure monopoly is a firm that satisfies the following conditions:

  1. It is the only supplier in the market.
  2. There is no close substitute to the output good.
  3. There is no threat of competition.

In practice, pure monopolies are very rare. For instance, a supermarket may be the only food supplier in a particular town, but if it raises its prices and retains too much of a profit, a competitor may enter the space. Even the threat of serious competition entering the market forces the existing firm to act conscionably, and differently from how it would act otherwise. A train company may be the only carrier in a particular station, but if cars are also available in the area, there exists a close substitute to the output good.

Natural Monopoly

A natural monopoly is a firm with such extreme economies of scale that once it begins creating a certain level of output, it can produce more at a far lower cost than any smaller competitor. Natural monopolies exist far more frequently than pure monopolies, mainly because the requirements are not as stringent.

Natural monopolies occur when, for whatever reason, the average cost curves decline over a relevant span of output quantities. A firm with high fixed costs relative to its marginal costs will have declining average costs for a significant span of quantities. A firm with a decreasing marginal cost structure will also have declining average costs. For example, utilities and software are two industries where natural monopolies occur often.

An Example

A monopoly differs from competitive firms in that it is not a price taker. Because it is the only supplier in the market, it faces a downward sloping demand curve, the market demand curve. As a result, the monopoly is free to choose its price and quantity according to market demand.

Monopolies are still profit maximizing firms and are thus going to satisfy the profit maximizing condition that marginal cost equal marginal revenue. The key to understanding monopolies and monopoly power is the marginal revenue calculation. In a perfectly competitive market, there exists a market price. Marginal revenue is simply equal to price in this market; every additional unit that is sold brings the market price. In a monopoly, however, every quantity is associated with a different price. The marginal revenue is not simply the price.

For example, I may be able to sell 10 guitars at 100each, butinordertosell11guitars, Iwillhavetoofferapriceof 95. Unfortunately, it's very difficult to sell 10 guitars at 100andthensellthelastoneat 95. In our model of a monopoly, there can only be one price for a good. If I choose to sell 11 units, I make 95revenueonthe11thguitar, butIlose 5 revenue on each of the first 10 guitars. If it costs me 50toproduceaguitar, mymarginalrevenueisthen 95 - 50 = 45.

Let's generalize. Assume that a monopolistic firm faces a linear, downward- sloping market demand curve, described as follows:

Q = 100 - P
Let's further assume its marginal cost curve is constant at a value of 10.
MC = 10

Our firm naturally wants to maximize profits and will therefore aim to satisfy the profit maximizing condition, MC = MR . Marginal costs are constant at ten, so half of our equation is easy. To find our marginal revenue, we first look at the total revenue. Total revenue is simply:

R = P * Q

Because the monopolist faces the entire market demand curve, price and quantity have a one-to-one relationship. That is, P = 100 - Q . We can rewrite our total revenue as:

R = (100 - Q) * Q = 100 * Q - Q^2

The marginal revenue is simply the first derivative of the total revenue with respect to Q .

MR = 100 - 2 * Q

If you don't feel comfortable with derivatives, you can convince yourself this MR is correct by analyzing its components.

MR = (100 - Q) - Q

(100 - Q) is the price according to our market demand curve. This 100 - Q represents the marginal revenue brought in by selling the next unit. However, in order to sell the next unit, we had to lower the price by 1 for all units sold (the demand curve has a slope of -1, so the tradeoff between Q and P is 1 for 1). Therefore, on the margin, we lost 1 unit of revenue for all Q units sold. The marginal revenue is then (100 - Q) - Q = 100 - 2*Q .

To solve for the monopolistic equilibrium, we find the quantity at which MR = MC . Solving:

100 - 2 * Q = 10 => Q = 45

At this quantity, the market price would be 100 - 45 = 55 . Assuming no fixed costs, the profits for this firm would be 45*(55 - 10) = 2025 . Naturally, this is a vast improvement for the firm over the competitive outcome of zero profits.

Welfare Analysis

So what's wrong with making profits? Certainly, profits are good for the monopolistic firms. The consumers are willing to pay for the goods at the monopoly price. Nobody is being forced to do anything, so we have a system of mutually beneficial exchange with no coercion. I think it would be overstepping our bounds for SparkNotes to say there is something wrong with monopoly power, but the foundations for government intervention in monopolistic markets can be found in welfare analysis.

Let's identify the deadweight loss in the example from the previous section. Let Q m be the output quantity chosen by the monopolist, 45 in this market. Let Q * be the output quantity at which the marginal cost curve intersects the market demand curve. Q * = 90 in this market.

Q * is the socially optimal output quantity. Imagine the firm is trading at a quantity less than Q * . At this point, the marginal cost curve is below the demand curve. In other words, the marginal cost to society is less than the marginal benefit (the demand curve). The society stands to gain by trading at a higher quantity. The opposite is true at quantities greater than Q * (convince yourself of this).

Remember that Q m is no greater than, and most often less than, Q * . If Q m is less than Q * , it is suboptimal. The deadweight loss is the area between the demand curve and the marginal cost curve over the quantities between Q m and Q * . The marginal cost is the marginal cost to society, and the marginal benefit is the demand curve. Over these quantities, the marginal benefit is greater than the marginal cost, so the area between the curves represents social surplus unrealized at the monopolistic equilibrium.

The impact of monopolistic behavior on social welfare varies with the shape of the demand curve. For example, with a perfectly inelastic demand curve, the market cannot help but trade at the socially optimal quantity. However, the monopolist has the power to set prices as high as it pleases (for this reason, many of these industries are regulated, such as suppliers of insulin or water). Therefore, there exists no deadweight loss, but all social surplus is absorbed by the monopolistic firm.

A monopolist's power is determined by its ability to set prices, which relies completely on the demand curve a firm faces. In perfect competition, a firm sees a flat demand curve and therefore does not have a practical choice as to what price to offer. The monopolist's power comes from facing a downward sloping demand curve.

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