CHARACTERISTICS OF MONOPOLY

In theory, a monopoly exists when a single firm controls the entire output of the industry.

NUMBER OF BUYERS AND SELLERS

A pure monopoly is a theoretical model as it is unusual to find a single firm with 100% market share. In the
UK, the monopolies and mergers commission defines a monopoly as a single firm or inter-related group of
firms controlling 25% or more of the market (complex monopoly). The theory, however, focuses on a single
supplier of goods or services of which there is no close substitute.

THE NATURE OF THE PRODUCT

The monopolist sells a unique product. The cross-elasticity of demand between the pure monopolist products
and all other products is low. A rise in the price of the monopolist product leads to no significant increase in the
demand for any other product. There are no close substitutes.

THE DEGREE OF FREEDOM OF ENTRY AND EXIT

Entry into the market or industry is restricted.

NATURE OF TINFORMATION

The firm is the only one in the industry. So there are no competitors so therefore there is no need to find
information on competitors.

THE MONOPOLIST DEMAND CURVE

The firm is the industry so the demand curve is downward sloping. The demand curve tells the price at
which the producer can sell different levels of output.
TR = PxQ
AR =TR
Q therefore AR=P
The demand curve is the average revenue curve.

Fig1: REVENUE CURVES FOR MONOPOLY

PERFROMANCE OF FIRMS, PROFITS AND ECONOMIC EFFICIENCY
A profit maximizing monopolist will equate MC with MR as shown in fig 2 below.

Fig2: Equilibrium Position of a monopolist

In a monopoly there is no distinction between the short run because of the barriers that prevent the entry of
competitors. There is no economic incentive for the monopolist to move away from the profit maximizing point.

ECONOMIC EFFICIENCY FOR A MONOPOLIST

The monopolist is not allocatively efficient because P is greater than Marginal Cost. There is no productive
efficiency because the monopolist is not producing the output where average cost (AC) is at its minimum.

Fig1: The Welfare Loss Under Monopoly

Deadweight refers to the net fall in welfare as a result of the monopolist restriction of output. Producer surplus
is the area above the supply curve but below the price line consumer surplus is the area below the demand curve
and above the price line.

PERFORMANCE OF FIRMS (BARRIERS TO ENTRY)

A monopolist is able to maintain above normal profits in the long run because of barriers to entry of new firms.
These barriers include:

1) High entry cost- An existing monopolist producing a large volume of output may be benefiting from
economies of scale. A new competitor would probably be producing a low volume of output and higher
per unit production cost. The new firm would not be able to compete effectively in the market.
2) Legal monopolies- In some cases the state has created monopolies by law e.g. - the post office in the UK
in the past.
3) Patents and copyrights- A monopoly can result from the holding of a patent on an invention or
innovation. A patent covers sale production rights for a given time period on those who have invested in
research and development to enable them to earn a return on their investment. A copyright restricts the
reproduction of printed or recorded material in a similar way.

CONDUCT OF FIRMS IN A MONOPOLY

PRICING POLICY

Monopolies practice price discrimination to increase their profits. Price discrimination is a situation in
which a supplier charges different prices to different customers for the same or similar products. The price
differences do not reflect differences in cost of supplying the product or service to the consumer.

Some customers are willing to pay more than the single price. The monopolist aims to change
consumers surplus into producer surplus and make more abnormal profits.

There are three types of price discrimination

1. First Degree Price Discrimination (perfect price discrimination)-The producer charges

the highest price that the consumer is willing to pay for each unit sold.

Fig 1: First degree price discrimination

The monopolist extracts the whole of the consumer surplus. To do this the producer must be
able to prevent resale of the product by the individual consumers.

2. Second Degree Price Discrimination-This involves charging different prices for

different blocks of consumption. The aim of the monopolistic e.g. a public utility company
is to charge a relatively high price for the first block of consumption, a lower price for the
next block and so on. This is a common practice for electricity companies.
The monopolist charges price OP1 for units up to quantity OQ1. A charge of OP2 is placed on units
above OP1 up to OP2. For instance, if a consumer purchases quantity OP 2 his expenditure will be
equal to the rectangle OP1, AQ1 and Q1BCQ2.

3. Third Degree Price Discrimination- For third degree price discrimination the
monopolist is able to separate two or more markets with differing elasticities of demand
and charge different prices in the separate markets. The markets where the demand for
the product is inelastic will be charged a higher price than the markets where demand is
elastic.

A good example of third degree price discrimination is the telecommunications company

LIME. This is because LIME charges residential and commercial buildings different rates. The
households demand per land based phones is elastic since there are other options. Therefore
they are charged lower. On the other hand, the commercial buildings demand for the landline
based phone is inelastic therefore they are charged higher.

Advantages of price discrimination to a firm

(1) It allows the firm to earn higher revenue from any given level of sales.
(2) A firm that practices price discrimination may be able to use it to drive competitors out of business. If a
firm has a monopoly in one market (e.g the home market), it may be able to charge a high price due to
relatively inelastic demand and thus make high profits. If it is under oligopoly in another market (e.g the
export market) it may use the high profits in the first market thus forcing its competitors out of the
market.
The Consequences of Price Discrimination - Welfare and Efficiency Arguments

To what extent does price discrimination help to achieve a more efficient allocation of resources? There are
arguments on both sides.

The impact on consumer welfare

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 of production. Those consumers in segments
of the market where demand is inelastic would probably prefer a return to uniform pricing by firms with
monopoly power! Their welfare is reduced and monopoly pricing power is being exploited.

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. Greater access to these services may yield external
benefits (positive externalities) which then have implications for the overall level of social welfare and the
equity with which scarce resources are allocated.

Producer surplus and the use of profit

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 supernormal profit. Of course businesses
may not be driven solely by the aim of maximising profit. A company will maximise its revenues if it can
extract from each customer the maximum amount that person is willing to pay.

Price discrimination also might be used as a predatory pricing tactic i.e. setting prices below cost to certain
customers in order to harm competition at the suppliers level and thereby increase a firms market power. This
type of anti-competitive practice is difficult to prove, but would certainly come under the scrutiny of the UK
and European Union competition authorities.

A converse argument to this is that price discrimination may be a way of making a market more contestable in
the long run. The low cost airlines have been hugely successful partly on the back of extensive use of price
discrimination among consumers.

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 a recession or sudden market downturn.

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

A high market concentration (fewness of sellers) does not always signal the absence of competition; sometimes
it can reflect the success of leading firms in providing better quality products, more efficiently, than their
smaller rivals

It is important in essays and data questions when you are analyzing imperfectly competitive markets where the
concentration ratio is high to mention some of the potential advantages of suppliers having monopoly power.

One difficulty in assessing the welfare consequences of monopoly, duopoly or oligopoly lies in defining
precisely what a market actually constitutes! In nearly every industry the market is segmented into different
products, and the impact of globalisation makes it difficult to gauge the true degree of monopoly power that
might exist in an industry at any moment in time. Increasingly markets where a monopoly appears to exist are
actually becoming more contestable because of the effects of growing international competition.

So what are the main advantages of a market dominated by a few sellers?

Economies of Scale

A monopolist might be better positioned to exploit economies of scale leasing to an equilibrium which gives a
higher output and a lower price than under competitive conditions.

Monopoly Profits, Research and Development and Dynamic Efficiency

As firms are able to earn abnormal profits in the long run there may be a faster rate of technological
development that will reduce costs and produce better quality products for consumers. This is because the
monopolist will invest profits into research and development to promote dynamic efficiency.

Monopoly power can be good for innovation, according to research by Professor Federico Etro, published in the
April 2004 edition of the Economic Journal. Despite the fact that the market leadership of firms like Microsoft
is often criticised, their investments in research and development (R&D) can be beneficial to society because
they expand the technological frontier and open new ways to prosperity. Many technological innovations are
developed by firms with patents on the leading-edge technologies. These firms perpetuate their leadership and
their market power through innovations. Etro's research argues that providing that a market is characterised by
free entry, then the market leader will actually have more incentives than any other firm to invest in R&D.

Baumol Oligopoly and Innovation

William Baumol an economist from Princeton University in the USA published a book in 2002 The Free
Market Innovation Machine in which he analysed the conditions best suited for markets and countries to
achieve a faster pace of innovation. Baumol argues that the structure that fosters productive innovation best is
oligopoly. The Baumol hypothesis is that oligopolists compete by making their products differ slightly from
their rivals. Highly innovative firms are often quick to license new technology or to become members of
technology-sharing consortia.

Natural Monopoly

A natural monopoly occurs in an industry where LRAC falls over a wide range of output levels such that there
may be room only for one supplier to fully exploit all of the internal economies of scale, reach the minimum
efficient scale and therefore achieve productive efficiency.
The major utilities such as gas, electricity and water are often put forward as examples of industries with strong
"natural tendencies" towards being a natural monopoly in part because of the huge fixed costs of building and
maintaining nationwide networks of cables and pipes. In fact we can make an important distinction between the
supply and distribution of services such as gas and electricity. The retail market for the supply of gas and
electricity to homes and businesses is also fully competitive. However, the businesses which transport gas and
electricity to the final consumer are closer to being natural monopolies. The industry regulator Ofgem regulates
these companies through price controls and monitoring of quality of service.

The natural monopoly through the exploitation of economies of scale can in theory undercut any actual or
potential rivals purely on the grounds of cost. If the monopolist loses market share (for example by the
competition authorities acting to split up an existing monopoly) there is the risk that smaller-scale suppliers will
produce at higher average total cost which would represent a waste of scarce resources. Forcing such a company
to price at marginal cost would also inflict inevitable losses and threaten the long term financial viability of the
supplier.