Monopoly Power

Characteristics of monopoly

A pure monopoly is a market that only contains one seller. Thus, one firm is the entire industry. In this market, the one firm owns all of the market share.

On the other hand, under a looser definition, a monopoly is the dominant firm in the market. This means that the firm owns almost all of the market share (over 90%), although still faces competition from other firms.

Characteristics of monopoly power

A pure monopoly is an example of a concentrated market.

As opposed to a pure monopoly, where only one seller owns the entire market, the existence of some degree of monopoly power is more common in industries. This means that there is one dominant firm in the industry that produces most of the output. Firms that have a certain degree of monopoly power (also referred to as market power) still face competition from the other firms in the market.

Competitive pressure can come from competition within the market, from available substitutes in the market, or from other firms that are trying to enter the market and compete directly with the monopoly. Monopoly power, however, is at its highest level when there is only one firm in the market.

There are different market factors that influence monopoly power. Let's explore them.

Barriers to entry

Barriers to entry prevent new firms from entering the market. These can either be natural, like economies of scale, or artificial, like strategic barriers. An example of a strategic barrier would be the existing firm owning a patent for the production of a certain good or service.

Number of competitors

Usually, in a monopolistic industry, one large firm dominates the market. However, in certain industries, the large firm and smaller niche firms coexist in the market, which somewhat limits monopoly power.

Product differentiation

Product differentiation can also influence monopoly power. This includes making a product different from another similar product through marketing, production, or usability. If the firm is really good at differentiating its product, it can increase its monopoly power.

Advertising

Persuasive advertising can reduce competition in the market. This type of advertising can captivate customers in a way that they would believe it is the best product on the market. As a result, they might be unwilling to purchase any other substitutes.

Sources of monopoly power

There are different sources of monopoly and monopoly power.

Natural monopoly

Natural monopoly occurs when the market only has room to accommodate one single firm. In other words, there is only one firm that can benefit from the existing economies of scale in the market.

Geographical monopoly

A pure monopoly can also take place when, for a geographical reason, a single country is the only possible supplier of raw materials or commodities. This could happen due to the climate, geology, or geographical layout of the country, as well as due to spatial factors.

Government-imposed monopoly

Governments can also create monopolies in certain industries which they do not think would benefit from competition. These industries can either be state-owned or private.

The government can also create a private monopoly, in order to encourage consumption of a good or service they deem beneficial to society or limit the consumption of a good or service they deem harmful to society.

Profit maximisation in monopoly

Before taking a look at profit maximisation, let's examine a pure monopoly demand curve. As there is only one firm in the market, the market demand curve is the demand curve of the monopolist's output. This means that the monopoly can either be a price maker or a quantity setter.

If the monopoly is the price maker, they set the price in the market. Therefore, the demand curve will show the maximum quantity of the good or service that can be sold. Taking a look at Figure 4 below, at P1, the maximum output that can be sold is Q1.

On the other hand, if the monopoly is the quantity setter, the demand curve in Figure 4 will show the maximum price at which the output can be sold on the market. At Q2 the maximum price the output can be sold for is P2.

This implies that the monopoly faces a trade-off between price and quantity. It can either set the price or the quantity, but not both.

Fig. 4 - Monopoly demand curve same as market demand curve

Now, let's take a look at the profit maximisation of a monopoly (Figure 5 below). The diagram for a monopoly's profit is considered to be the same in both the short and the long run due to barriers to entry that prevent new firms from entering the market.

If the monopoly aims to maximize its output, it will set its output level at the point where the marginal cost is equal to the marginal revenue (MC = MR in Figure 5). At the production level of QM, the demand curve shows the price the monopoly can set at PM. The average cost (AC) of producing each unit of the good is equal to ACM as shown in Figure 5 below.

The difference between the two price levels (PM and ACM) is the excess, or supernormal profit per unit. The total supernormal profit is represented by area A highlighted in green in Figure 5 below.

Fig. 5 - Monopoly profits

Due to the barriers to entry that protect the monopoly, no new firms can enter the market and there is no competition for the supernormal profit. This allows for the monopolist to keep the abnormal profits in both the short and long term.

As a result, the profit-maximising position illustrated in Figure 5 represents both the short-term and long-term equilibrium for the monopoly.

Monopoly inefficiencies

One of the main problems that cause inefficiencies with monopolies is that a monopoly can always set the price. A monopoly has the power to reduce market output in order to increase the price of the good or service they produce, and therefore maximise its profit.

Taking the diagram from Figure 4 (above) as an example, let's imagine that the monopoly could be producing quantity Q2 at a price P2. Using its market power, it can restrict its output to Q1 whilst setting the price to P1. The monopoly output may thus be less than the socially optimum quantity, whilst the price is higher, causing welfare loss. This can lead to market failure and the misallocation of resources, as the quantity produced decreases while the price increases.

Due to the high prices, consumers buy less of the goods than they would in a competitive market. The monopoly is, therefore, exploiting consumers in the market, reducing consumer surplus. This behavior is especially exploitative when the demand for the good or service is price inelastic, as consumers face the issue of not having any available substitutes.

Similarly, monopolies can also experience productive inefficiencies. As there are high barriers to entry into the industry, the pressure to reduce the costs of production is essentially nonexistent. Therefore, the monopoly is likely to operate at low output levels with high average costs of production.

Additionally, market failure and allocative inefficiencies are also drawbacks of a monopoly. The monopoly can restrict output leading to higher prices, which can therefore lead to the under-consumption of the goods or services that the monopoly produces.

Benefits of monopoly

A monopoly may also have its advantages. In certain cases, such as in natural monopolies, there are numerous economies of scale present in the industry which the monopoly can take advantage of. In this case, the monopoly taking advantage of all of them might end up producing a better economic result than under perfect competition.

Furthermore, monopolies might also benefit from dynamic efficiency, which is the overall increase of productive efficiency over time.

As monopolies make supernormal profits in both the short and long term, they can invest these profits into research and development or the process and product innovation. Eventually, this may lead to more efficient ways of production due to more advanced production means.