9 | Monopoly
• How Monopolies Form and Survive: Barriers to Entry
• How a Profit-Maximizing Monopoly Chooses Output and Price
• What are the Welfare Effects of a Monopoly
A pure monopoly is where one firm produces all of the
output in a market.
How Monopolies Form: Barriers to Entry
There are two types of monopoly, based on the types of barriers to entry they exploit. One is natural monopoly,
where the barriers to entry are something other than legal prohibition. The other is legal monopoly, where laws
prohibit (or severely limit) competition.
Barriers to entry are the legal, technological, or market forces that discourage or prevent potential competitors
from entering a market. Barriers to entry can range from the simple and easily surmountable, such as the cost
of renting retail space, to the extremely restrictive. For example, there are a finite number of radio frequencies
available for broadcasting. Once the rights to all of them have been purchased, no new competitors can enter
the market.
Newly entering firms find it difficult to match the low average costs of an existing (large firm). If LRAC has
a long slope to the right, then any firm that initially gets started in the market and builds sacle is likely to
become a natural monopoly
Note how that the small scale firm
depicted in the graph on the left is at a
clear disadvantage. With demand given
as in the graph, the profit maximizing
price for the large firm is very low and
to meet this price, the small firm will
likely suffer losses, perhaps more than
fixed costs, in which case it would
simply choose to shut down.
The small firm must find a way to
specialize itself and sell to its own
captured clientele. It must find a way to
segment the market and avoid
competition from the large firm. It can
do this by making a higher quality
product using a patented process. This
involves creating a legal monopoly for
itself through patent protection law.
A patent gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time; in the
United States, exclusive patent rights last for 20 years. The idea is to provide limited monopoly power so that
innovative firms can recoup their investment in R&D, but then to allow other firms to produce the product more
cheaply once the patent expires.
A trademark is an identifying symbol or name for a particular good, like Chiquita bananas, Chevrolet cars, or the
Nike “swoosh” that appears on shoes and athletic gear. Roughly 1.9 million trademarks are registered with the
U.S. government. A firm can renew a trademark over and over again, as long as it remains in active use.
A copyright, according to the U.S. Copyright Office, “is a form of protection provided by the laws of the United
States for ‘original works of authorship’ including literary, dramatic, musical, architectural, cartographic,
choreographic, pantomimic, pictorial, graphic, sculptural, and audiovisual creations.” No one can reproduce,
display, or perform a copyrighted work without permission of the author. Copyright protection ordinarily lasts
for the life of the author plus 70 years
Businesses have developed a number of schemes for creating barriers to entry by deterring potential competitors
from entering the market. One method is known as predatory pricing, in which a firm uses the threat of sharp price
cuts to discourage competition. Predatory pricing is a violation of U.S. antitrust law, but it is difficult to prove.
How a Profit-Maximizing Monopoly Chooses Output and Price
Can a Monopoly Go Bankrupt ?
Are there substitutes for monopoly products?
In almost all cases of consumer behavior, there is a set of alternative choices from which to select.
Very seldom do we have situations where people are forced to buy things (unless mandated by the
government) with no option to buy something else instead.
The most obvious substitute for any product being sold now is saving. One can always decide to buy
things later. Monopolies may be the only seller, but this doesn’t help if people decide to buy later
and not now. The demand we have been discussing in class is a demand for output NOW, not later.
In a very real sense, saving represents a risk for firms. If consumers decide to save a large portion of
their income, there is no reason to produce now. This includes previous purchased durable
products.
In addition, there is always foreign competitors. It may be that a company is the only domestic seller
of a product, but this may not be true internationally. Typically, foreign suppliers reduce the power
of domestic monopolies.
Finally, there is always a risk to monopolies of new products being offered. Bill Gates testified before
Congress and stated that an alternative to the Windows operating brand could be successfully
installed to every computer in a matter of hours over the entire world, if such a strong competitor
arose. This was when 95% of operating systems were Microsoft brands.
Welfare Aspects of Monopoly
Most people criticize monopolies because they charge too high a price, but in addition economists object
that monopolies do not supply enough output to be allocatively efficient.
To understand why a monopoly is inefficient, it is useful to compare it with the benchmark model of perfect
competition. Allocative efficiency is a social concept. It refers to producing the optimal quantity of some
output, the quantity where the marginal benefit to society of one more unit just equals the marginal cost.
The rule of profit maximization in a world of perfect competition was for each firm to produce the quantity
of output where P = MC, where the price (P) is a measure of how much buyers value the good and the
marginal cost (MC) is a measure of what marginal units cost society to produce.
Following this rule assures allocative efficiency. If P > MC, then the marginal benefit to society (as measured
by P) is greater than the marginal cost to society of producing additional units, and a greater quantity
should be produced. But in the case of monopoly, price is always greater than marginal cost at the profitmaximizing level of output. Thus, consumers will suffer from a monopoly because a lower quantity will be
sold in the market, at a higher price, than would have been the case in a perfectly competitive market.