What is Monoploy - Managerial Economics

Perfect monopoly lies at the opposite extreme from perfect competition on the market structure continuum. Monopoly exists when a single firm is the sole producer of a good that has no close substitutes; in other words, there is a single firm in the industry. Perfect monopoly, like perfect competition, is seldom observed.

Characteristics of Monopoly Markets

Monopoly exists when an individual producer has the ability to set market prices. Monopoly firms are price makers as opposed to price takers. Their control over price typically requires

Price, Cost, and Optimal Supply Decisions for a Firm Under Pure Competition

Price, Cost, and Optimal Supply Decisions for a Firm Under Pure Competition

  • A single seller. A single firm produces all industry output. The monopoly is the industry.
  • Unique product. Monopoly output is perceived by customers to be distinctive and preferable to its imperfect substitutes.
  • Blockaded entry and exit. Firms are heavily restricted from entering or leaving the industry.
  • Imperfect dissemination of information. Cost, price, and product quality information is withheld from uninformed buyers.

As in the case of perfect competition, these basic conditions are too restrictive for monopoly to be commonplace in actual markets. Few goods are produced by single producers, and fewer still are free from competition of close substitutes. Even public utilities are imperfect monopolies in most of their markets. Electric companies approach a perfect monopoly in the residential lighting market but face strong competition from gas and oil suppliers in the heating market. In all industrial and commercial power markets, electric utilities face competition from gas- and oil-powered private generators. Even though perfect monopoly rarely exists, it is still worthy of careful examination. Many of the economic relations found under monopoly can be used to estimate optimal firm behavior in the less precise, but more prevalent, partly competitive and partly monopolistic market structures that dominate the real world.

Price/Output Decision Under Monopoly

Under monopoly, the industry demand curve is identical to the firm demand curve. Because industry demand curves slope downward, monopolists also face a downward-sloping demand curve. In Figure, for example, 100 units can be sold at a price of $10 a unit. At an $8 price, quantity demanded rises to 150 units. If the firm decides to sell 100 units, it will receive $10 a unit; if it wishes to sell 150 units, it must accept an $8 price. The monopolist can set either price or quantity, but not both. Given one, the value of the other is determined along the demand curve.

A monopoly uses the same profit-maximization rule as does any other firm: It operates at the output level at which marginal revenue equals marginal cost. The monopoly demand curve is not horizontal, however, so marginal revenue does not coincide with price at any but the first unit of output. Marginal revenue is always less than price for output quantities greater than one because of the negatively sloped demand curve. Because the demand (average revenue) curve is negatively sloped and hence declining, the marginal revenue curve must lie below it.

Firm’s Demand Curve Under Monopoly

Firm’s Demand Curve Under Monopoly

When a monopoly equates marginal revenue and marginal cost, it simultaneously determines the output level and the market price for its product. This decision is illustrated in Figure. The firm produces Q units of output at a cost of C per unit and sells this output at price P. Profits, which equal (P - C) times Q, are represented by the area PP_C_C and are at a maximum. Remember, Q is an optimal short-run output level only because average revenue, or price, is greater than average variable cost, as shown in Figure 10.8. If price is below average variable cost, losses are minimized by shutting down. Thus, if P < AVC, optimal Q = 0.

Illustration of Price/Output Decisions in Monopoly Markets

To further illustrate price/output decisions under monopoly, the previous Hair Stylist, Ltd., example can be modified to reflect an assumption that the firm has a monopoly in the College Park market, perhaps because of restrictive licensing requirements. In the earlier example, each of 100 perfectly competitive firms had a profit-maximizing activity level of 750 hairstylings per month, for a total industry output of 75,000 hairstylings per month.

Price/Output Decision Under Monopoly

Price/Output Decision Under Monopoly

As a monopoly, the Hair Stylist provides all industry output. For simplicity, assume that the Hair Stylist operates a chain of salons and that the cost function for each shop is the same as in the previous example. By operating each shop at its average cost-minimizing activity level of 750 hairstylings per month, the Hair Stylist can operate with Marginal Cost = Average Cost = $20. Assume that industry demand and marginal revenue curves for hair stylings in the College Park market are

marginal revenue curves

The monopoly profit-maximizing activity level is obtained by setting marginal revenue equal to marginal cost, or marginal profit equal to zero (Mπ = 0), and solving for Q:

marginal profit

The optimal market price is

optimal market price

At the Q= 37,500 activity level, the Hair Stylist will operate a chain of 50 salons (= 37,500/750). Although each outlet produces Q = 750 hair stylings per month, a point of optimum efficiency, the benefits of this efficiency accrue to the company in the form of economic profits rather than to consumers in the form of lower prices. Economic profits from each shop are

Economic profits

With 50 shops, the Hair Stylist earns total economic profits of $1,125,000 per month. As a monopoly, the industry provides only 37,500 units of output, down from the 75,000 units provided in the case of a perfectly competitive industry. The new price of $50 per hairstyling is up substantially from the perfectly competitive price of $20. The effects of monopoly power are reflected in terms of higher consumer prices, reduced levels of output, and substantial economic profits for the Hair Stylist, Inc.

Long-Run Equilibrium Under Monopoly

In general, any industry characterized by monopoly sells less output at higher prices than would the same industry if it were perfectly competitive. From the perspective of the firm and its stockholders, the benefits of monopoly are measured in terms of the economic profits that are possible when competition is reduced or eliminated. From a broader social perspective, these private benefits must be weighed against the costs borne by consumers in the forms of higher prices and reduced availability of desired products. Employees and suppliers also suffer from the reduced employment opportunities associated with lower production in monopoly markets.

Monopolies have an incentive to underproduce and earn economic profits. Underproduction results when a monopoly curtails output to a level at which the value of resources employed, as measured by the marginal cost of production, is less than the social benefit derived, where social benefit is measured by the price that customers are willing to pay for additional output. Under monopoly, marginal cost is less than price at the profit-maximizing output level. Although resulting economic profits serve the useful functions of providing incentives and helping allocate resources, it is difficult to justify above-normal profits that result from market power rather than from exceptional performance.

As shown earlier, in equilibrium, perfectly competitive firms must operate at the minimum point on the LRAC curve. This requirement does not hold under monopoly. For example, again consider Figure 10.8 and assume that the ATC curve represents the long-run average cost curve for the firm. The monopolist will produce Q units of output at an average cost of C per unit, somewhat above the minimum point on the ATC curve.

In this case, the firm is called a natural monopoly, because the market-clearing price, where P = MC, occurs at a point at which long-run average costs are still declining. In other words, market demand is insufficient to justify full utilization of even one minimum efficient–scale plant. Asingle monopolist can produce the total market supply at a lower total cost than could any number of smaller firms, and competition naturally reduces the number of competitors until only a single monopoly supplier remains. Electric and local telephone utilities are classic examples of natural monopoly, because any duplication in production and distribution facilities would increase consumer costs.

Is Monopoly Always Bad?

Natural monopoly presents something of a dilemma. On the one hand, economic efficiency could be enhanced by restricting the number of producers to a single firm. On the other hand, monopolies have an incentive to underproduce and can generate unwarranted economic profits.

Nevertheless, it is important to recognize that monopoly is not always as socially harmful as sometimes indicated. In the case of Microsoft Corp., for example, the genius of Bill Gates and a multitude of research associates has created a dynamic computer software juggernaut. The tremendous stockholder value created through their efforts, including billions of dollars in personal wealth for Gates and his associates, can be viewed only as a partial index of their contribution to society in general. Other similar examples include the DeKalb Corporation (hybrid seeds), Kellogg Company (ready-to-eat cereal), Lotus Corporation (spreadsheet software), and the Reserve Fund (money market mutual funds), among others. In instances such as these, monopoly profits are the just rewards flowing from truly important contributions of unique firms and individuals.

It is also important to recognize that monopoly profits are often fleeting. Early profits earned by each of the firms mentioned previously attracted a host of competitors. For example, note the tremendous growth in the money market mutual fund business since the November 1971 birth of the Reserve Fund. Today the Reserve Fund is only one of roughly 500 money market mutual funds available, and it accounts for only a small fraction of the roughly $1 trillion in industry assets. Similarly, Lotus Corporation is now a footnote in the computer software industry.

The tremendous social value of invention and innovation often remains long after early monopoly profits have dissipated.

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