Monopoly

What is Monopoly?

Definition and Meaning:

Monopoly is from the Greek word meaning one seller. It is the polar opposite of perfect competition. Monopoly is a market structure in which one firm makes up the entire market. Monopoly and competition are at the two extremes. It is define as:


"Monopoly refers to a market where there is a single seller for a product and there is no close substitute of the commodity that is offered by the sole supplier to the buyers. The firm constitutes the entire industry".

Explanation:

Monopoly, therefore, indicates a case where:


(i) There is only a single seller of a product or service in the market.


(ii) The goods produced by a sole seller has not close substitutes.


(iii) The entry of new firms into the industry is effectively barred by legal or natural barriers.
             
(iv) The firm being the sole supplier of a product constitutes industry. Firm and industry thus have single identity. Or we can say monopoly is a single firm identity.
     
(v) The single seller affects no other seller by its own action in the market. The other sellers too cannot affect the price and output of the monopolist.
                              
(vi) The demand curve facing the monopolist is negatively sloped. The monopolist being the only seller of the commodity in the market can increase the total sale by lowering the price and if, he raises the price, he would not lose all his sale. The demand curve facing a monopolist is less than perfectly elastic, i.e., . it slopes downward from left to right.     


For the monopoly to exist, it is not necessary that the size of a firm should .be large. Even a small firm may have a monopoly. For instance, a local water company or a local electricity company, supplying water and electricity in the city possesses all the characteristics of a monopoly.

Monopolist:

Spencer has defined monopolist market in the following words:


"A monopolist market can be defined as one m which there is no perfect substitute for the product of an individual seller so that there is a separate demand curve for the product of each seller in the market".


Pure monopoly in its actual form does not exist in the real world. It is near monopolies which are very common. For example, railways face competition from road transport, electricity companies from oil and gas, telephone company from postal service, internet etc.

Conditions/Base of Monopoly Power:

Barriers to Entry:

The main conditions which give rise to monopoly are various. They are called collectively, "Barriers to Entry". These barriers block the entry of new firms into the industry and thus create monopoly. The main essentials of monopoly power are as follows:       

(i) Ownership of essential raw material. If a firm owns or controls the entire supply of an essential raw material used in the production of a commodity, it then creates a monopoly by keeping away the competitors out of the industry.

For example, 'De Bears Company' of South Africa has a monopoly over the supply of diamonds.

(ii) Patent and research. In order to encourage research for the creation of a new product, the government gives patent and copyrights to the inventors. The exclusive rights granted to an inventor to produce and control a product blocks the entry of new firms producing the same commodity. The inventor, thus, enjoys the monopoly position for the life of the patent.  

(iii) State ownership. If a government itself owns arid operates a business, a monopoly is then established. For instance; Railways, Electricity, are controlled and operated by the Government. State, thus, has monopoly in Electricity, Railways, etc.

(iv) Public utilities. In order to avoid cut throat competition and waste of resources, a government grants exclusive rights to a corporation to engage itself in public utility services. For instance; gas supply in the country, if given to more than one firms, will lead to unnecessary wastage of resources. So it is given to one firm to produce and distribute it to the consumers. The government, however, controls the prices and the rates to be charged by the company.
       
(v) Economies of scale. If a firm using modern technology and heavy investment enjoys the increasing returns to scale, it will produce goods at low unit cost. The new firms being unable to reap the economies enjoyed by the existing firm will not enter the industry. The big firm will continue controlling the entire supply of a commodity in the market.

(vi) Unfair competition. If a firm or a few firms form a unified business organization, they then possess sufficient economic power, to eliminate the entry of would be firms in the industry. The firm or some firms joining together adopt price cutting tactics, put pressure on resource, suppliers, pay higher wages to the skilled workers, etc., and thus try to bankrupt the competitors. If they are successful in their mission, unfair competition can give rise to monopoly.

Monopolies/Monopolist's Demand Curve:

Definition:

Under perfect competition, the demand curve which an individual seller has to face is perfectly elastic, i.e., it runs parallel to the base axis. The competitive seller being unable to affect the market price sells its output at prevailing market price. Hence marginal revenue, equals the price of the product. The average revenue is identical to its marginal revenue. Thus under perfect competition:

Formula:

 MR = AR = Price and the Three Curves Coincide and are Perfectly Elastic

This is, however, not the case under monopoly. The monopolist is the, sole supplier of a product in the market. He has full powers to make decisions about the pricing of his product. He is a Price Maker, if he lowers the unit price of his product, his sale is increased. If he raises the price, he will not lose all his sale. The demand curve facing the monopolist thus slope downward from left to right.

Explanation:

As the monopolist's demand curve is negatively sloped, the marginal revenue is here no longer equal to price or average revenue. It is less than the price (AR) at every level of output, except the first. The relation between marginal revenue and average revenue is explained with the help of a schedule and a diagram.

Schedule:

Price Per Meter in $	Quantity Output Meter	Total Revenue (TR) in $	Marginal Revenue (MR) in $	Average Revenue (AR) in $
100	1	100	100	100
80	2	160	60	80
60	3	180	20	60
45	4	180	0	45
35	5	175	-5	35

In the above schedule, it is shown that as the monopolist lowers price of his product from $100 per meter to $80 per meter in specified period of time, the sale increase from one unit to two units. The total revenue resulting from the sale of one more unit increases by $60 (MR); whereas the additional unit has been sold for $80 The reason for the total revenue not to increase by the same amount is that the price has been reduced for increasing the sale of the extra units. The price cut is applied to two units of output sold and not to the additional unit alone. Same is the case with the third, fourth and fifth units sold. The marginal revenue is less than the price ATR (AR) for all the units of commodity disposed off in the market.

MR = ΔTR

                                                                     ΔQ

Diagram/Curve:

As the marginal revenue is always less than price, the marginal revenue curve, therefore, remains below the average revenue curve or demand curve as is illustrated. In the figure (16.1) the demand curve which also represents average revenue curve has a downward slope. The demand curve is downward sloping because the monopolist can sell greater output only by reducing the price of units of output.

The marginal revenue curve of the monopolist always lies below the demand curve because the marginal revenue from the sale of additional unit of output is less than its price.
                   

Monopoly Price and Its Relationship to Elasticity of Demand:

The total revenue test can be applied for explaining the monopoly price and its relationship to price elasticity of demand. The total revenue test tells us that when demand is elastic, a decline in price will increase total revenue. When demand is inelastic, a decline in price of a good will decrease its revenue. Applying this test, a monopolist will fix the amount of his product at a level where the elasticity of his average revenue curve is greater than one (E > 1). It causes total revenue to increase. Here marginal revenue is positive. A monopolist does not push his produce to the point where the marginal revenue becomes negative. The monopolist choice of price when faced with varying degree of elasticities is now explained with the help of a linear average revenue function (price line) in fig 16.2.

At midpoint on the down sloping AR curve, elasticity of demand is equal to one, (E = 1). Above point P, elasticity is greater than one, (E > 1) and below less than one (E < 1). At price MP, marginal revenue is zero. At prices above than MP, MR is positive and below it marginal revenue is negative. The monopolist would not like to increase his safes up to a point where his MR becomes negative or his total revenue starts decreasing. The monopolist chooses the price quantity combination where the MR is positive and the elasticity of demand is more than one.

Short Run Equilibrium Price and Output Under Monopoly:

Short Run Equilibrium of the Monopoly Firm:

In the short period, the monopolist behaves like any other firm. A monopolist will maximize profit or minimize losses by producing that output for which marginal cost (MC) equals marginal revenue (MR). Whether a profit or loss is made or not depends upon the relation between price and average total cost (ATC). It may be made clear here that a monopolist does not necessarily makes profit. He may earn super profit or normal profit or even produce at a loss in the short ran.

Conditions for the Equilibrium of a Monopoly Firm:

         
There are two basic conditions for the equilibrium of the monopoly firm.

First Order Condition: MC = MR.
  
Second Order Condition: MC curve cuts MR curve from below.

Explanation:

(a) Short Run Monopoly Equilibrium With Positive Profit:

In the short period, if the demand for the product is high, a monopolist increase the price and the quantity of output. He can increase the, output by hiring more labor, using more raw material, increasing working hours etc. However, he cannot change his fixed plant and equipment. In case, the demand for the product falls, he then decreases the use of variable inputs, (like labor, material etc.).

As regards the price, the monopolist is a price maker. There is a greater tendency for the monopolist to have a price which earns positive profits. This can only be possible if the price (AR) is higher than average total cost (ATC). The short run profit earned by the monopolist is now explained with the help of the diagram (16.3) below.

Diagram/Curve: 

     
In this diagram, the monopoly firm is in equilibrium at point K where SMC = MR. The short run marginal cost (SMC) curve cuts MR from below. At point K both the equilibrium conditions are fulfilled. As a result, therefore, OE is monopoly price and OB, the monopoly output. At the monopoly output OB, the average total cost OF = BN. The profit per unit is FE. The short run monopoly profit is ETNF, It is represented by the area of shaded rectangle in figure 16.3.
  
At the output smaller than OB (say at point P) MR > SMC. Therefore, increased output up to B adds more to total receipts than to total costs. In case, the output is increased beyond OB, the MR < SMC. Hence, the increased outputs beyond OB adds more to total cost than to total receipts. This causes profits to decrease. So the best level of output for the monopolist firm is that where SMC curve cuts the MC curve from below.

(b) Short Run Equilibrium With Normal Profit Under Monopoly:

There is a false impression regarding the powers of a monopolist. It is said that the monopolistic entrepreneur always earns profits. The fact, however, is that there is no guarantee for the monopolist to earn profit in the short run. If a monopolist firm produces a new commodity and attempts to change the taste pattern of the consumers through advertising campaigns etc., then the firm may operate at normal profit or even produce at a loss minimizing price in the short run (Covering variable cost only). The normal profit short run equilibrium of the monopoly firm is explained, in brief, with the help of the diagrams.

In figure (16.4), a firm is in the short run equilibrium at point K, where SMC = MR. The price line is tangent to SAC at point C. The firm charges CB price per unit for units of output OB. The total revenue of the firm is equal to the area OPCB. The total cost of the firm is also equal to the area OPCB. The firm earns only normal profits and continues operating.

(c) Short Run Equilibrium With Losses Under Monopoly:

A monopolist also accepts short run losses provided the variable costs of the firm are fully covered. The loss minimizing short run equilibrium analysis is presented graphically.

In this figure (16.5), the best short run level of output is OB units which is given by the point L where MC = MR. A monopolist sells OB units of output at price CB. The total revenue of the firm is equal to OBCF. The total cost of producing OB units is OBHE. The monopoly firm suffers a net loss equal to the area FCHE. If the firm ceases production, it then has to bear to total fixed cost equal to GKHE. The firm in the short run prefers to operate and reduces its losses to FCHE only. In the long, if the loss continues, the firm shall have to close down.

Long Run Equilibrium Under Monopoly:

The monopolist creates barriers of entry for the new firms into the industry. The entry into the industry is blocked by having control over the raw materials needed for the production of goods or he may hold full rights to the production of a certain good (patent) or the market of the good may be limited. If new firms try to enter in the field, it lowers the price of the good to such on extent that it becomes unprofitable for new firms to continue production etc.

When there is no threat of the entry of new firms into the industry, the monopoly firm makes long run adjustments in the scale of plant. In case, the demand for the product is limited, the monopolist can afford to produce output at sub optimum scale. If the market size is large and permits to expand output, then the monopolist would build an optimum scale of plant and would produce goods at the minimum cost per unit. However, the monopolist would not stay in the business, if he makes losses in the long period. The long run equilibrium of a monopoly firm is now explained with the help of the following diagram.

Diagram/Curve:

                                     

In the long run, all the factors of production including the size of the plant are variable. A monopoly firm will maximize profit at that level of output for which long run marginal cost (MC) is equal to marginal revenue (MR) and the LMC curve intersects the MR curve from below. In the figure (16.6), the monopoly firm is in equilibrium at point E where LMC = MR and LMC cuts MR curve from below. QP is the equilibrium price and OQ is the equilibrium output.

At OQ level of output, the cost per unit is QH (LAC), whereas the price per unit of the good is QP. HP represents the per unit super normal profit. The total super normal profit is equal to KPHN. It may here be noted that at the equilibrium output OQ, the plant is not being fully utilized. The long run average cost (LAC) is not minimum at this level of output OQ. The firm will build an optimum scale of plant only if the demand for the product increases.

Threat of Entry of New Firms:

If there is a threat of entry of new firms into the market, the monopolist adopts price reduction strategy. He instead of charging QP price per unit, lowers the price to BR. Since the per unit price BR is equal to the cost per unit at R, the monopoly firm is earning only normal profit in the long run. The reduction in price and so in profits is adopted to prevent the entry of new firms in the market.

Summing up, if a monopoly firm is in a position to maintain its monopoly status, it can earn super normal profit in the long period. However, if there is an effective threat of the entry of potential firms in, the industry, then the firm can earn just normal profit by reducing the price. The reduction in price depends on how strong is the threat of potential entry into the industry.

Price and Output Determination Under Discrimination Monopoly:

Price discrimination takes place when a given product is sold by a monopolist at more than one price and these price differences are not justified by cost differences. The price discrimination is possible under the following conditions.

Conditions:

(1) Monopoly power. The seller of a good must be a monopolist.

(2) Segregation of market. The monopolist must be able to segregate buyers into separate classes with different price elasticities.

(3) No reselling. There should be no possibility of reselling the good from a tow price market to a high price market.

Purpose of Price Discrimination:

             
The purpose of price discrimination by a monopolist is two fold. Firstly, to increase his total revenue and profits and secondly, to produce a larger output than a non-practicing monopolist. Determination of price and output under monopolistic competition.
                  
Price discrimination is possible and profitable when the monopolist is able to control the amount and distribution of supply and the buyers can be separated into different classes having a demand curve with different elasticities. Let us assume that the monopolist sells his total product in two sub-markets A and B. Sub-market A has low price elastic demand for the product and the sub-market B has high price elasticity of demand. The discriminating monopolist will sell a greater quantity of his product by making a price reduction in market B. He sells lesser commodity in market A at a price higher than in market B. The monopolist will then earn maximum profit by price discriminating as is illustrated with the help of diagram given below.

Diagram:

In this figure (16.7) market A and Market B have different elasticity of demand for the product of the monopolist. The slopes of the AR and MR curves in each market are different depending upon the elasticity of demand for the commodity. In market A, the elasticity of demand is relatively inelastic. The rise in price does not cause a much fall in demand. In market B, the demand for the monopolist product is relatively elastic.

A reduction in price leads greater increase in the demand for the product and adds more to the revenue. In figure, the combined marginal cost curve (MC) of the total output of the monopolist intersects the combined marginal revenue curve of the two markets A and B from below at point P. The best levels of output of the monopolist is OT given by the point P where MC curve cuts the AR curve from below. The monopolist Is to distribute this equilibrium output OT between the two markets A and B in such a way that the MR in each market is OP.

In market A, MR equates MC at point F. The monopolist sells output OB at price KB. In market B, where the demand is more elastic, the monopolist maximizes profit by selling output OB² at price K²B² in market B, where the demand is more elastic, the price K²B² is lower than in market A, the profit of the monopolist is maximum when he sells output of OB at price KB in market A and output of OB² at price of K²B² in market B. The monopolist total profit is shown in the shaded area APE in figure 16.7c.

Summing up, a discriminating monopolist can maximize profits only when:
      
(1) It is profitable for him to sell the output in different markets.

(2) The price is charged in different markets in such a way that the last unit of the commodity sold in market gives the same marginal revenue.

(3) The marginal revenue is equal to the marginal cost of total output.