Prices and Markets Chapter 9
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What is a monopoly?
A monopoly is a seller of a good or service that does not have a close substitute.
Barriers to entering the market must be so high no other firms can enter.
High barriers exist due to:
(1) government blocking the entry of more than one firm into a market,
(2) control over an input necessary to produce a product,
(3) important network externalities,
(4) economies of scale so large that one firm has a natural monopoly
How does a monopoly firm make profits?
A monopoly firm maximises profit by producing the quantity of output that makes marginal revenue equal to marginal cost. (MR = MC)
A monopoly firm’s demand curve is the same as the market demand curve for the product it sells.
If the monopolist’s price exceeds its average total cost at the output where marginal revenue equals marginal cost, it will earn an economic profit
Key characteristics of a monopoly
1. Monopolies can maintain super-normal profits in the long-run.
2. With no close substitutes, the monopolist can derive super-normal profits, area PABC.
3. A monopolist with no substitutes would be able to derive the greatest monopoly power.
The advantages of monopolies
They can benefit from economies of scale, and may be ‘natural’ monopolies, so it may be argued that it is best for them to remain monopolies to avoid the wasteful duplication of infrastructure that would happen if new firms were encouraged to build their own infrastructure.
Domestic monopolies can become dominant in their own territory and then penetrate overseas markets, earning a country valuable export revenues. This is certainly the case with Microsoft.
It has been consistently argued by some economists that monopoly power is required to generate dynamic efficiency, that is, technological progressiveness.
This is because:
a. High profit levels boost investment in R&D.
b. Innovation is more likely with large enterprises and this innovation can lead to lower costs than in competitive markets.
c. A firm needs a dominant position to bear the risks associated with innovation.
d. Firms need to be able to protect their intellectual property by establishing barriers to entry; otherwise, there will be a free rider problem.
e. Why spend large sums on R&D if ideas or designs are instantly copied by rivals who have not allocated funds to R&D?
f. However, monopolies are protected from competition by barriers to entry and this will generate high levels of supernormal profits.
g. If some of these profits are invested in new technology, costs are reduced via process innovation. This makes the monopolist’s supply curve to the right of the industry supply curve. The result is lower price and higher output in the long run.
Disadvantages of monopoly:
Monopolies can be criticised because of their potential negative effects on the consumer, including:
a. Restricting output onto the market.
b. Charging a higher price than in a more competitive market.
c. Reducing consumer surplus and economic welfare.
d. Restricting choice for consumers.
e. Reducing consumer sovereignty.
- *Consumer sovereignty
- Resources are allocated towards the satisfaction of the consumer, who is 'king' (sovereign) - firms can only survive if they consistently satisfy consumer demand. The more they satisfy the consumer, the greater their profits.
Higher prices, lower output and welfare loss
The area of economic welfare
under perfect competition is E, F, B.
- The loss of consumer surplus if the
- market is taken over by a monopoly is P P1 A B.
The new area of producer surplus
, at the higher price P1, is E, P1, A, C.
Thus, the overall (net) loss
of economic welfare is area A B C.
Remedies of a monopoly market
Monopoly power can be controlled, or reduced, in several ways, including price controls and prohibiting mergers. (Price capping, regulators to prevent mergers, nationalise the monopoly - public control, forcing firms to unbundle products, yardstick competition)
It is widely believed that the costs to society arising from the existence of monopolies and monopoly power are greater than the benefits and that monopolies should be regulated.
Price discrimination is the practice of charging a different price for the same good or service
- 1st degree
- 2nd degree
- 3rd degree
1st degree price discrimination
First-degree discrimination, alternatively known as perfect price discrimination, occurs when a firm charges a different price for every unit consumed
2nd degree price discrimination
Second-degree price discrimination means charging a different price for different quantities, such as quantity discounts for bulk purchases.
3rd degree price discrimination
Third-degree price discrimination means charging a different price to different consumer groups.
For example, rail and tube travellers can be subdivided into commuter and casual travellers, and cinema goers can be subdivide into adults and children. Splitting the market into peak and off peak use is very common and occurs with gas, electricity, and telephone supply, as well as gym membership and parking charges. Third-degree discrimination is the commonest type.
Necessary conditions for successful discrimination
The firm must be able to identify different market segments, such as domestic users and industrial users.
Different segments must have different price elasticities (PEDs).
Markets must be kept separate, either by time, physical distance and nature of use, such as Microsoft Office ‘Schools’ edition which is only available to educational institutions, at a lower price.
There must be no seepage between the two markets, which means that a consumer cannot purchase at the low price in the elastic sub-market, and then re-sell to other consumers in the inelastic sub-market, at a higher price.
The firm must have some degree of monopoly power.
4 main reasons firms become monopolies
1. Government blocks entry
2. Control of a key source
3. Network externalities
4. Economics of scale
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