MONOPOLY Economics – Course Companion Blink and Dorton, 2007, Chapter 9, p105-113

Assumptions of Monopoly There is one firm producing the product, so the firm is the industry. Barriers to entry exist, which stop new firms from entering the industry and maintains the monopoly. As a consequence of barriers to entry, the monopolist may be able to make abnormal profits in the long run.

What firms are monopolies? Whether a firm really is a monopoly depends upon how narrowly we define the industry. While Microsoft may be the only producer of a particular kind of software, it does not have a monopoly on all software. The important question here is not whether the firm is a monopoly, but rather how much monopoly power the firm has.

The Extent of Monopoly Power Key Questions To what extent is the firm able to set its own prices without worrying about other firms? To what extent can it keep people out of the industry?

The Strength of Monopoly Power The strength of monopoly power possessed by a firm will really depend upon how many competing substitutes are available. For example, the underground railway in a city may have the monopoly of underground travel, but it will face competition from other industries, such as buses, taxis and private transport.

Sources of Monopoly Power Barriers to Entry A monopoly may continue to be the only producer in any industry if it is able to stop other firms from entering the industry in some way. These ways to preventing entry to the industry are known as barriers to entry as follows: Economies of Scale. Natural Monopoly. Legal Barriers. Brand Loyalty. Anti Competitive Behaviour.

BARRIERS TO ENTRY 1. Economies of Scale Firms gain average cost advantages as their size increases: - economies of scale. Specialization, division of labour, bulk-buying and financial economies may lead to cost savings and lower unit costs. If a monopoly is large, then they will be experiencing economies of scale. Any firm wishing to enter the industry, will probably have to start up in a relatively small way and so will not have the economies of scale that are enjoyed by the monopolist.

BARRIERS TO ENTRY 1. Economies of Scale Even if the new firm were able to start up with the same size as the monopolist, it would still not have the economies that come from expertise in the industry, such as managerial economies, promotional economies, and R&D (Research and Development)

BARRIERS TO ENTRY 1. Economies of Scale Without economies of scale, a would be entrant to the industry, knows that it would not be able to compete with the existing monopolist who would simply have to reduce the price to the level of normal profits. At this level the new entrant would be making looses, because the average costs would be higher, so the lack of economies of scale acts as a deterrent to firms that want to enter a monopoly industry.

BARRIERS TO ENTRY 2. Natural Monopoly Some industries are classified as natural monopolies. An industry is a natural monopoly if there is only enough economies of scale available in the market to support one firm.

NATURAL MONOPOLY In this graph, the monopolist is the industry and has a demand curve D1. The long run average cost curve faced by the monopolist is LRAC and its position and shape are set by the economies of scale the firm is experiencing. The monopolist is able to make abnormal profits by producing an output between q1 and q2, because the average revenue is greater than the average cost for that range of output. If another firm were to enter the industry, then the firm would take demand from the monopolist and monopolist’s demand curve would shift to the left, in this case to D2.

Two firms in a Monopoly Market leads to losses. If a second firm enters a market which is characteristic of a monopoly, the two firms would now be a position, where it is impossible for them to make even normal profits. Their LRACs would be above the AR at every level of output.

Abnormal Profits in a Monopoly Market The LRAC, which is shaped by the economies of scale experienced by the monopolist will only give an abnormal profit if the monopolist is able to satisfy all the demand in the market. The industry is a natural monopoly, because the market will only support one firm.

Examples of Natural Monopolies Examples of Natural monopolies include the industries that supplies utilities such as water, electricity and gas. However, in recent years, the electricity market has been deregulated in many developed countries, and consumers may have some choice between providers.

BARRIERS TO ENTRY 3. Legal Barriers In certain situations, a firm may have been given a legal right to be the only producer in an industry. This is the legal right to be a monopoly. This is the case with patents, which give a firm the right to be the only producer of product for a specific number of years, after it has been invented. When a patent expires, other producers will then be allowed to produce and sell the product.

BARRIERS TO ENTRY 3. Legal Barriers Why do patents exist? Patents exists as a means to encourage invention. If individuals or firms put time and money into inventions only to find that they were copied as soon as they were successful, then there would be little incentive to create the product. If a firm knows that it will be a protected monopoly for a number of years, then it is more likely to invest in R&D.

BARRIERS TO ENTRY 3. Legal Barriers Intellectual Property Rights Patents along with copyrights and trademarks, are examples of intellectual property rights. Intellectual property rights refer to creations of the minds. Just as private property rights allow people to own physical property, so patents guarantee the creators of ideas the rights to own their ideas. A very good and controversial example of patent protection is the pharmaceutical industry.

BARRIERS TO ENTRY 3. Legal Barriers Essential Services The government of a country may grant the right to produce a product or service to a single firm. Examples include the state Postal Service, and Public Transport.

BARRIERS TO ENTRY 4. Brand Loyalty It may be that a monopolist produces a product that has gained huge brand loyalty. The consumer thinks of the product as a brand. For example, in the early days of the vacuum cleaner, there was only one brand – Hoover. If the brand loyalty is so strong, then new firms may be put off from entering the industry.

BARRIERS TO ENTRY 4. Anti Competitive Behaviour A monopolist may also attempt to stop competition by adopting restrictive practices, which may be legal or illegal. Price War For example, an established monopoly should be in strong position to start a “price war” if another firm enters the industry. The monopoly can lower its price to a loss making level and should be able to sustain the looses for longer than the new entrant.

BARRIERS TO ENTRY 4. Anti Competitive Behaviour MICROSOFT CASE STUDY In 2004, the European Union Commission fined Microsoft €497 million for bundling a media player and messaging technologies into its Windows operating system. The commission claimed that this prevented potential competitors from reaching consumers. It ordered Microsoft to make public technical information to allow other companies the ability to produce goods that are compatible with Microsoft. In July 2006, the fine remained unpaid and Microsot received an additional fine of €280.5 million for failure to comply with 2004 fine.

BARRIERS TO ENTRY 4. Anti Competitive Behaviour INTEL CASE STUDY In 2009 Intel, another company in the IT industry, (with significant monopoly like powers) was fined by the European Commission for anti-competitive behaviour. This news item summarizes the key issues.

THE DEMAND CURVE AND THE PROFIT-MAXISMING LEVEL OF OUTPUT The monopolist is the industry and therefore the monopolist’s demand curve is the industry demand curve and is downward sloping. The monopolist can control either the level of output or the price of the product, but not both. Some people wrongly assume, that monopolist can charge whatever price they like and still some their products. This is not the case. In order to sell more they must lower their price.

DEMAND CURVE – MONOPOLIST The monopolist has a normal demand curve with marginal revenue below it, and it maximises profit by producing at the level of output where marginal cost is equal to marginal revenue. The monopolist sells a quantity q at a price per unit of P.

Possible Profit Situations in Monopoly If a monopolist is able to make abnormal profits in the short run, and if the monopolist has effective barriers to entry, then other firms cannot enter the industry and compete away the profits that are being earned.

ABNORMAL PROFITS IN MONOPOLY The monopolist is able to make abnormal profits in the long run, provided the barriers to entry hold out. The monopolist is maximising profits and is making abnormal profits shown by the shaded area PabC. Without the entry of new firms to the industry, the situation will continue.

Monopolies and Losses It is sometimes assumed that a monopolist will always earn abnormal profits, but this is not always true. If the monopolist produces something for which there is little demand, then it will not earn abnormal profits. If a monopolist were making losses in the short run, then it would have the option of closing down temporarily (if it was not covering it variable costs) or continuing production for the time being. If normal profits cannot be earned in the long term, the firm will have to close.

MONOPOLIST MAKING LOSSES IN THE LONG RUN In this diagram the firm is not able to cover costs in the long run, since the average cost is greater than the average revenue at all levels of output. Since there is nothing that can done to rectify this situation, this will be an industry in which no firm will be willing to produce. There will be no industry.

Efficiency in Monopoly Unlike perfect competition, the monopolist produces at the level of output, where there is neither productive efficiency nor allocative efficiency.

NO PRODUCTIVE AND ALLOCATIVE EFFICIENCY IN MONOPOLY The monopolist is producing at the profit maximising level of output, q. Output is being restricted in order to force up the price and to maximise profits. However, the most efficient level of output, q1 and the allocatively efficient level of output, q2 are not being achieved.

Advantages of Monopoly in comparison with Perfect Competition Monopolies may be able to achieve large economies of scale simply because of their size. Monopolies do not have to be big, but is the industry is big, then the monopolist should gain substantial economies of scale. If this pushes the MC curve down, then it is possible that the monopolist may produce at a higher output and at a lower price than in perfect competition. The idea of relative price and output in monopoly and perfect competition is very debateable.

MONOPOLY VS PERFECT COMPETITION In perfect competition, the equilibrium price and quantity will be where demand is equal to supply. This means that the price will be P1 and the total output of Q1 will be produced. However, if the industry is monopoly, with significant economies of scale, then the MC curve, may well be substantially below the MC curve in perfect competition, which is the industry supply curve. The monopolist will produce where MC=MR maximising profits and producing a greater quantity than perfect competition, Q2. at a lower price, P2.

Advantages of Monopoly in comparison with Perfect Competition A second advantage may be that there will be higher levels of investment in R&D in monopoly. Firms in perfect competition are, by definition, relatively small and so may find it difficult to invest in R&D. A monopolist making abnormal profits is in a better situation to use some of those profits to fund R&D. This in the long run will be benefit consumers.

Disadvantages of Monopoly in comparison with Perfect Competition If significant economies of scale do not exist in monopoly, then the monopoly may restrict output and charge a higher price, than under perfect competition.

MONOPOLY VS PERFECT COMPETITION WITHOUT ECONOMIES OF SCALE In this graph there is no differences in costs for the monopolist and the perfectly competitive market. If this is the case, then the monopolist will produce Q2 at a price of P2 where MC=MR. The perfectly competitive market will, however, produce Q 1 at a price of P1 where industry supply meets industry demand. Thus higher prices and lower output could exist under monopoly.

The Unfair Profits of Monopolists The high profits of monopolists may be considered as unfair, especially by competitive firms, or those on low incomes. The scale of the problem depends upon the size and power of the monopoly. The monopoly profits of your local post office may seem of little consequence when compared to the profits of a giant national company.

Summary 3 possible problems with monopolies They are productively and allocatively inefficient. They can charge a higher price for a lower level of output. They can exercise anti-competitive behaviour to keep their monopoly power. These potential problems mean that monopolies can act against the public interest. As a result, all governments have laws and policies to limit monopoly power.

EXAMINATION QUESTIONS Short Response Questions Explain the level of output at which a monopoly firm will produce. (10 marks) Using a diagram, explain the concept of a natural monopoly. (10 marks) Using appropriate diagrams, explain whether a monopoly is likely to be more efficient or less efficient than a firm in perfect competition. (10 marks)

EXAMINATION QUESTIONS Essay Question 1a. Explain three barriers to entry that allow a firm to be a monopoly. (10 marks) 1b. Evaluate the view that governments should always prevent firms from being monopolies (15 marks)