HL: Theory of the Firm: Monopoly
Definition: A pure monopoly exists when there is one sole supplier. In this case the
firm will be the industry. Barriers to entry exist, which prevent new firms from
entering the industry and maintains the monopoly. As a consequence of barriers to
entry a monopolist may be able to earn supernormal profits in the long run.
However, whether or not a firm really is a monopoly depends on how narrowly we define
the industry. So the Metro company may have a monopoly on the underground travel
industry but competes with bus companies in the Shanghai public transport market. So a
more important question is not if a firm is a monopoly but how much monopoly power
the firm has.
Assumptions of the monopoly model:
1. The monopolist has the power to determine either:
a) price at which it will sell the product
b) the quantity it wishes to sell
NOTE: a monopolist cannot determine both price and quantity because it cannot control
demand. The demand curve will give the quantity at a chosen price or the price at a
chosen quantity. As monopolists have the ability to control price and earn supernormal
profit they are known as PRICE ________________.
2. The monopolist’s power to influence price depends on two factors:
a) the availability of close substitutes
b) the power to restrict entry of new firms
Sources of monopoly power
How does a firm establish a monopoly position in a market? The fastest route for a
business to grow and take an increasing share of a particular market is through integration
i.e. through agreed mergers or contested take-overs.
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Horizontal integration occurs when two businesses in same industry at the same
stage of production become one for example Exxon & Mobil. Vertical integration
involves acquiring a business in the same industry but at different stages of the
supply chain - for example Shell owns drilling and extraction businesses together
with refining, distribution and retail subsidiaries. As a firm grows through
integration it will benefit from _____________ of _______. This will give it
significant cost advantages over potential entrants (see later)
Monopoly power also comes from the ownership of Patents and Copyright
protection or the exclusive ownership of assets.
The government may also give legal monopoly power to some business through
nationalisation or government awarded franchises and licenses. (The school gives
legal monopoly power to Sodexo on the school campus through a license)
Barriers to entry
Barriers to entry are designed to block potential entrants from entering a market
profitably. They seek to protect the monopoly power of existing (incumbent) firms in an
industry and therefore maintain supernormal (monopoly) profits in the long run. Barriers
to entry have the effect of making a market less contestable.
EXAMPLES OF BARRIERS TO ENTRY
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Patents: Giving the firm the legal protection to produce a patented product for a
number of years.
Cost advantages: Lower costs, perhaps through experience of being in the
market for some time, allows the existing monopolist to cut prices and win price
wars.
If the existing business has managed to exploit some of the
______________________________ that are available to firms in a particular
industry, it has developed a cost advantage over potential entrants. It might use
this advantage to cut prices if and when new suppliers enter the market, moving
away from short run profit maximisation objectives - but designed to inflict losses
on new firms and protect its market position in the long run.
Limit Pricing : Firms may adopt predatory pricing policies by lowering prices to
a level that would force any new entrants to operate at a loss
Advertising and marketing: Developing consumer loyalty by establishing
__________________ products can make successful entry into the market by new
firms much more expensive. This is particularly important in markets such as
cosmetics, confectionery and the motor car industry.
Research and Development expenditure: Heavy spending on research and
development can act as a strong deterrent to potential entrants to an industry.
Clearly much R&D spending goes on developing new products (see patents
above) but there are also important spill-over effects which allow firms to
improve their production processes and reduce unit costs. This makes the existing
firms more competitive in the market and gives them a structural advantage over
potential rival firms.
International trade restrictions: Trade restrictions such as tariffs and quotas
should also be considered as a barrier to the entry of international competition in
protected domestic markets.
Presence of sunk costs: Some industries have very high start-up costs or a high
ratio of fixed to variable costs. Some of these costs might be unrecoverable if an
entrant opts to leave the market. This acts as a disincentive to enter the industry.
Sunk Costs
Sunk Costs are costs that cannot be recovered if a business decides to leave an
industry. Examples include: Capital inputs that are specific to a particular industry and
which have little or no resale value (for example, telecommunication towers established
by mobile phone networks). Money spent on advertising / marketing / research which
cannot be carried forward into another market or industry. When sunk costs are high, a
market becomes less contestable. High sunk costs (including exit costs) act as a barrier to
entry of new firms (they risk making huge losses if they decide to leave a market).
Therefore sunk costs are often seen as a barrier to exit as well as entry.
Natural Monopolies
An industry is a natural monopoly if there are only enough economies of scale available
in the market to support one firm. Indeed the scale of production that achieves productive
efficiency may be a high percentage of the total market demand for the product in the
industry. Therefore it is more efficient if one firm serves the industry rather than two or
more.
If another firm where to enter the industry as shown above, then the new firm would take
demand from the monopolist and the monopolist’s demand curve would shift to the
_________, in this case D2. The two firms would now be in a position where it is
impossible for them both to earn normal profits. Their LRAC curves would be above
their AR curves at all output levels.
Natural monopolies tend to be associated with industries where there is a high ratio of
fixed to variable costs. For example, the fixed costs of establishing a national distribution
network for a product (electricity, water & sewerage) might be enormous, but the
marginal (variable) cost of supplying extra units of output may be very small. In this
case, the average total cost will continue to decline as the scale of production increase,
because fixed (or overhead) costs are being spread over higher and higher levels of
output.
The electricity generation and distribution industry has in the past been considered to
be a natural monopoly. Like railways and water provision, the existence of several
companies supplying the same area would result in an inefficient multiplication of cables,
transformers, pipelines etc.
THE MONOPOLISTS DEMAND CURVE- CONSTRAINTS ON MONOPOLY
Be careful of saying that "monopolies can charge any price they like" - this is wrong. It is
true that a firm with monopoly has price-setting power and will look to earn high levels
of profit. However the firm is constrained by the position of its demand curve. Ultimately
a monopoly cannot charge a price that the consumers in the market will not pay.
A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can
take the market demand curve as its own demand curve. A monopolist therefore faces a
downward sloping AR curve with a MR curve with twice the gradient of AR. The firm is
a price maker and has some power over the setting of price or output. It cannot, however,
charge a price that the consumers in the market will not bear. In this sense, the position
and the elasticity of the demand curve acts as a constraint on the pricing behaviour of the
monopolist. Assuming that the firm aims to maximise profits (where ___________) we
establish a short run equilibrium as shown in the diagram below.
The profit-maximising output can be sold at price P1 above the average cost ATC1 at
output Q1. The firm is making abnormal "monopoly" profits (or economic profits) shown
by the yellow shaded area. The area beneath ATC1 shows the total cost of producing
output Q1. Total costs equals average total cost multiplied by the output.
These supernormal profits can exist in the long run because of the existence of
barriers to entry/exit.