Monopoly is a situation in a market when one firm produces a good with no close substitutes and is protected by
barriers to entry into the industry by other firms. For example, closest examples to a monopoly are held by companies like
De Beers,
Microsoft and
ICBC.
This is a situation that is the complete opposite of that of
perfect competition in which the firm which controls the monopoly exercises a complete ability to influence the market price by varying the quantity. The firm is not a
price taker and exercises complete
market power.
As stated, in a monopoly, there are two main points:
1) There are no close substitutes
2)
Barriers to entry
Examples of items with no close substitutes is water. While for drinking, bottled water like
Evian might subside, nothing comes to public water when doing activities such as showering, and washing cars.
Barriers to entry are essential as they essentially eliminate competition by simply not allowing others into the field in question. This can either a
Legal monopoly or a
natural monopoly.
A
legal monopoly is a monopoly achieved by the restrictions of the government, which either hinder entrance or competition. Such activities are accomplished by such items like
legal licenses (lawyer licenses, medical licenses),
public franchises (US mail, Canada Post),
copyright, and
patents.
A
natural monopoly is achieved when natural
barriers to entry are imposed and generate a situation when one firm can generate a good or a service at a cost to the consumer which is less than if multiple firms do so. Such an instance is
BC Hydro.
Since monopolies can establish their own prices, they must use particular strategies to maximize profit. Two such instances are
single price monopoly and
price discrimination. With a
single price monopoly, since there are price differences, it may lead to resale by the low value customers.
Price discrimination on the other hand, is used more often as it does two things:
1) Makes it look like they're doing the consumer a favor by lowering its price to certain consumers, therefore increasing consumer satisfaction
2) Charging the highest possible price for each unit, therefore creating a situation of
rent seeking.
Using the
elasticity of demand, one can determine that monopolies only operate when the elasticities are higher than 1, or are elastic. This is because for any market to sell more of a quantity, they must lower the price. In a situation of elastic demand, the income lost due to a decrease in price is offset more by the increase in income by the quantity consumed by the public. When it is unit elastic or
elasticity of demand = 1, the marginal revenue is equivalent to zero and is the
maximum total revenue.
In turn, monopolies will generally produce at a quantity and price where
marginal revenue is equivalent to
marginal cost. In this situation, they maximized their economic profit, which is equivalent to their
total revenue -
total cost.
In comparison to a
perfect competition, a monopoly only involves one firm in a business. They have sheer
market power, which they exercise by limiting their output and therefore increasing economic profit. Also in the long run, monopolies generate
economic profit, while the
price takers in the
perfect competition only generate enough to cover their entrepreneural costs to stay in business. In addition, as a result of their limiting their production, they create an inefficiency, which in turn generates
deadweight loss.
With the self imposed restrictions on output by a monopoly, they generate inefficiency and
deadweight loss. But they also generate a redistribution of surplus, which offsets the social loss that is generated by
deadweight loss. In
rent seeking, monopolies attempt to capture as much of
consumer surplus,
producer surplus or
economic profit. Monopolies generally incur a greater
economic profit by diverting
consumer surplus to itself. They do this by either creating another monopoly or buying one. They are mainly able to
rent seeking by
price discrimination.
To properly
price discrimination, they must be able to identify each demographic consuming their good and their good must not be able to be resold. When they price discriminate properly, monopolies increase their economic profit by converting consumer surplus to economic profit. In situations of
perfect price discrimination, they extract all of the consumer surplus for themselves. Their marginal revenue curve becomes equivalent to the demand curve. In addition, only during
perfect price discrimination is there efficiency during a monopoly as there is no
deadweight loss, even though there is no consumer surplus]. The more closely a monopoly can emulate
perfect price discrimination, the more efficient the outcome.
While the power exercised by monopolies are considered by some as overwhelming, they do provide some advantages. One is that due to
economies of scale and
economies of scope,
natural monopolies can occur. Further more, they give a higher incentive to innovate and invent something different as a monopolistic power would allow them great economic profit.
Monopolies are not typically allowed to frolic on their own. They are usually regulated by government agencies (such as cases like
Microsoft). They either allow marginal cost pricing or average cost pricing. In marginal cost pricing, the monopoly incurs an economic loss, which they can either offset with a
subsidy. In most cases, they allow average cost pricing, where they allow the monopoly to make a normal profit. In that case, both consumers and producer gains more than compared to a profit maximizing or marginal cost pricing.