A monopoly is a single producer of a product which does not have close substitute. A monopoly is characterized by barriers to entry. Sources of a monopoly include:
- Ownership/Control of a Key Resource - rainforests, rare minerals (DeBeers diamond monopoly).
- Exclusive Right Given by Government - patents, copyrights, franchises (pharmaceutical companies, research, authors).
- Falling Average Total Cost - making one company more efficient than others (also known as a natural monopoly), arising from economies of scale over the relevant range of output.
- Public Utilities - electricity, cable television. and water provision.
Pricing and Production Decisions
A monopoly is a large enough business to influence its own price, such that it is the price setter rather than taker, unlike a perfectly competitive market where each firm faces a perfectly elastic demand curve. A monopoly faces a downward-sloping demand curve and the market demand is the company’s demand. Monopolists are still constrained by the negative relationship between price and quantity demanded.
Revenue for a Monopoly
A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower its price. There are two effects on total revenue (profit x quantity):
- Output effect - gains more revenue because it sells more.
- Price effect - gains less revenue because it gets less from each unit sold because of the lower price.
Marginal revenue (MR) can even turn negative if price falls enough to reduce total revenue, even though the company sells more. What determines value of MR? It depends on whether the fall in price is larger than the increase in quantity. In other words, it depends on the elasticity of demand. Note that MR = P [1-1/abs. E].
When E > 1, MR > 0 because output effect > price effect
When E < 1, MR < 0 because price effect > output effect
When E = 1, MR = 0 because price effect = output effect
Therefore, the monopolist will never produce in the inelastic portion of the demand curve since MR < 0. A straight-line demand has elasticity that varies from zero to infinity. Assuming a linear demand curve P = a-bQ, the MR curve for a straight line will:
- be a straight line with the same intercept and;
- have twice the slope of the demand curve (i.e. it is zero at the halfway point of the demand curve).
Recall that the objective of a business is to maximize profits. As such, a company should produce where profit is at a maximum. In marginal terms,
- If MC < MR, producing 1 more unit will add more to TR than to TC, so the monopoly should increase quantity.
- If MC > MR, producing 1 more unit will add more to TC than to TR, so the monopoly should decrease quantity.
- Only when MR = MC (and MC cuts MR from below) is profit maximized.
A monopolist will generally produce less than a socially efficient level of output, and charge too high a price. Are the above normal profits of monopoly a social cost? Not usually, since profit is still part of surplus but has been transferred from consumers to producers. Social cost arises from inefficiently low output which leads to the dead weight loss. However, if the monopolist uses some of its normal profits to lobby in order to maintain a monopoly (rent seeking), then this can be a welfare cost to society.
Price discrimination is selling the same good to different customers/markets at different prices. Examples include movie tickets, airline tickets, and discount coupons. In order to practice price discrimination, there must be easy to separate customer into groups. These groups are determined based on their elasticities to demand. The company must also be able to prevent resales between groups, as well as arbitrage, which is buying where a good is cheap and selling where it is expensive.
Price Discrimination can increase the profit of monopolies, since they can charge a higher price to those with less elastic demand, and a lower price to those with more elastic demand. In this manner, a business does not have to lower prices to all buyers in order to sell more goods.