a) Characteristics of monopoly
Monopolies can be characterised as:
Profit maximisation – monopolist earns supernormal profits in both the short and long run
Sole seller in a market (a pure monopoly)
High barriers to entry
Price maker
Price discrimination
In UK, when one firm dominates the market with more than 25% market share (single supplier in the market), the firm has monopoly power
• E.g. Google dominates search engine market, with 90% share. The Sun has 30% of the market as Cadbury has 32%
Monopoly power gained when there are multiple suppliers
If two large firms in an oligopoly (several large sellers) have more than 25% market share, they have monopoly power
• E.g. Sainsbury’s and Asda have more than 25% market share combined – monopoly power
Very few examples of pure monopolies, but several firms have monopoly power
Monopolies can be formed if:
Firm has exclusive ownership of a scarce resource (Microsoft owning Windows) – has monopoly power over this resource, only firm that can exploit it
Govt can grant a firm monopoly status
• Like Post Office • Royal Mail lost its monopoly status in 2006, allowing competition
Producers may have patents over designs or copyright over ideas, characters, images, sound or names, giving them exclusive rights to sell a good or service
• E.g. a song writer having monopoly over their own material
A monopoly could be created following merger of two or more firms
• Reduces competition so mergers are subject to close regulation and may be prevented if two firms gain a combined share of 25% or more
Monopoly power is influenced by factors such as:
Barriers to entry: The higher the barriers to entry, the easier it is for firms to maintain monopoly power
Examples of barriers to entry which maintain monopoly power:
George Sigler (economist) defined an entry barrier as:
“A cost of producing (at some or every rate of output) which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry”
b) Profit maximising equilibrium
c) Diagrammatic analysis
Monopolies makes supernormal profits in the long run – profits are maximised when MC = MR
• Output is Q and Price is P • Price (AR) is above Ac at Q so supernormal profits are possible (area PABC)
With no close substitutes, the monopolist can derive supernormal profits (area PABC) and derive the greatest monopoly power
A monopolist earns supernormal profits in both the short and long run (MC = MR) so the monopolist produces an output of Q1 at the price of P1
Shaded rectangle shows area of supernormal profits
Firm is sole supplier in market so its cost and revenue curve is same as industry’s cost and revenue curve
Firms are price makers in a monopoly
P > MC in diagram, due to profit maximisation which occurs at MC = MR – so there is allocative inefficiency in a monopoly
AR > AC, so there are supernormal profits
Monopoly faces a downward sloping demand curve as it’s the whole industry
The only way to increase demand is to reduce price (AR)
At lower prices, consumers buy more –may also be imperfect substitutes
As monopolists reduce price to sell more units each unit yields less marginal revenue so MR will slope downwards and be below AR curve
A relationship exists between revenue and the degree of PED on the Demand Curve (AR)
• Revenue is maximised when MR is 0 and this corresponds to Unitary Price Elasticity
Diagrams in different situations
Normal Profit Output (AC=AR, State monopoly)
Nationalisation/State monopoly
The state is covering their opportunity cost
They are delivering for security
Increases consumer surplus as with a better price, it brings in more consumers
In theory, they produce a good at normal profit with an output for above a private monopoly, this is then a merit good
It is a positive externality as they are delivering more than the allocative efficiency which is the point of consumption
Allocatively Efficient Output (AR=MC):
Creation of regulatory bodies to regulate firms
They intervene, give targets, cap profits and inspect efficiency
Sales Maximisation:
They can flood the market and create market dominance – E.g. Netflix
Loss making:
Competes away competition in the short run by selling it at a loss
Cross subsidisation – they subsidise the loss making aspects through their profit making aspect
Defence mechanism
Over long run, they have massive SNP
d) Third degree price discrimination:
Necessary conditions and Diagrammatic analysis
Third degree price discrimination occurs in a monopoly or any firm with price setting (making) power – doesn’t occur in perfectly competitive markets
When the monopolist decides to charge different groups of consumers’ different prices for the same good or service
• E.g. higher price at peak times on trains is a form of third degree price discrimination because different groups of consumers (commuters) use trains at peak times, than at offpeak times • E.g. adults, students and children pay different prices to see the same film at a cinema – it costs the cinema the same to show the film but consumers have been divided into groups based on age
This isn’t for cost reasons
Market power enables organisations to price discriminate and in the process increase profit
The diagram shows demand curves of different price elasticities in a market existing with each group of consumers – usually this exists
This allows market to be split and means monopolist can charge different prices
It doesn’t cost monopolist much to split the market; otherwise, it won’t be financially worthwhile
A market with an elastic demand curve (second graph) will have a lower price
A market with an inelastic demand curve will have a high price (first graph)
Third graph shows firm’s costs and revenues – area of SNP is represented by yellow shaded rectangle
By charging different prices, the monopolist can maximise their overall profits
They can add output in elastic markets (lower price) and reduce in inelastic markets (increase price)
Conditions required
Firm must have price setting (making) power in at least one market
At least two consumer groups with different PED
Identify consumers in each group, set prices differently for consumers in these groups
The firm must prevent consumers in one group selling to consumers in the other
Costs and benefits to consumers and producers
Examples
Nurofen
Sell same product with different label for different prices
PED is more inelastic the more specific the pain is and it costs more
• For headaches it is more price elastic but finger pain is more price inelastic
Can offset surplus product to other stores for less
Cross-Channel ferry operations
Peak (price inelastic customers) and off-peak prices (price elastic customers)
How long before you buy a ticket?
• A year in advance – price elastic • Day in advance – price inelastic (more expensive)
If you spend longer – more price inelastic (more expensive)
Supermarkets cross subsidise ferry
Collude to stop consumers benefitting
Doctors discriminating between rich and poor consumers
) Costs and benefits of monopoly to
Higher Prices Explanation
Because of lack of competition, monopolist can charge higher price (P1) than in a more competitive market (at P)
Area of economic welfare under perfect competition is EFB
Loss of consumer surplus if market is taken over by a monopoly is PP1AB
New area of producer surplus, at higher price P1, is EP1AC so overall (net) loss of economic welfare is area ABC
Area of deadweight loss for a monopolist can also be shown in a more simple form, comparing perfect competition with monopoly
f) Natural monopoly
Natural monopoly is when there are high fixed costs – usually in infrastructure
Occurs in an industry where long-run average costs fall over a wide range of output levels
• E.g. Water and gas pipes, electricity cables and rail networks are expensive forms of infrastructure
In these industries, natural monopolies supply services
Costs of infrastructure are a form of sunk costs – costs aren’t recoverable if firm leaves market
Makes barriers of entry to and exit from the market high
Trying to increase competition by encouraging new entrants to market creates potential loss of efficiency
Efficiency loss to society exists if new entrant had to duplicate all fixed factors (infrastructure)
• Ineffective to duplicate – because resources would be wasted
Natural monopolies through exploitation of economies of scale can in theory undercut any actual or potential rivals purely on the grounds of costs
May only be room for one supplier to fully exploit economies of scale in the market and accrue productive efficiency
Economies of Scale
Economies of scale are very significant so minimum efficient scale isn’t reached until firm has become very large in relation to total size of the market
MES is lowest level of output at which all scale economies are exploited
When MES can only be achieved when one firm has exploited the majority of economies of scale available, then no more firms can enter the market
Utility companies
Natural monopolies are common in markets for ‘essential services’ requiring expensive infrastructure to deliver the good or service (water supply, electricity, and gas and other industries known as public utilities)
Because there’s potential to exploit monopoly power, governments tend to nationalise or heavily regulate them
Regulators
If public utilities are privately owned
• E.g. in UK since privatisation during 1980s
Usually have their own special regulator to ensure they don’t exploit their monopoly status
Regulators can cap prices or level of return gained
• E.g. regulators include, Ofcom, telecoms and media regulator
Railways as a natural monopoly
Railways are considered a natural monopoly
Very high costs of laying track, building a network and costs of buying or leasing the trains would prohibit or deter entry of a competitor
To society – costs associated with building and running a rival network would be wasteful
Avoiding wasteful duplication
To ensure competition without need to duplicate infrastructure is to allow new firms (train operators) to use existing infrastructure (track) so competition has been introduced
Opening-up infrastructure
Approach is adopted to deal with problem of natural monopolies and encouraging more competition
• E.g. Telecoms, the network is provided by BT
With natural monopoly ATC keeps falling because of continuous economies of scale – MC is below ATC over whole range of output
Profits
To maximise profits – natural monopolists would charge Q and make SNP
If they’re unregulated and privately owned – profits are likely to be excessive
Monopolist likely to be allocatively and productively inefficient
Losses
To achieve allocative efficiency – regulators impose excessive price-caps (P1)
Output needed to be allocatively efficient (Q1) is so high natural monopolists is forced to make losses as ATC is above AR at Q1
Allocative efficiency is achieved when price (AR) = marginal cost (MC) at A – at this price natural monopolists make a loss
Public utility’s losses could be dealt with in a number of ways, including:
• Subsidies from the government • Price discrimination, whereby additional revenue can be derived by splitting the market into two or more sub-groups, and charging different prices to each sub-group.