Monopoly, as compared to perfect competition, is the other extreme market setting where the entire market consist of only one firm. As such, the firm is a price-maker and consumers in the market do not have close substitutes for this good. The demand for the monopoly is the entire market demand.
Profit Maximisation for Monopoly
Unlike firms in perfect competition, since a monopoly is not a price-taker, it faces a downward sloping demand curve and as a result a downward sloping MR curve below the demand curve. The point of profit maximisation occurs at MC = MR, and at that quantity of production, price is higher than MC and MR.
As such, a monopoly is said to possess market power, which is the ability to charge P > MC, and the markup is therefore P – MC. Depending on the elasticity of demand, with less close substitutes for the good, the monopoly will possess more market power.
Without price discrimination, monopoly results in deadweight loss.
If price discrimination, which means that charging the good based on the individual’s willingness to pay, is carried out to the extreme, the monopoly can still maximise social welfare, but there will be zero consumer surplus and producer surplus will make up the entire social welfare. Extreme price discrimination however does not exist in reality, but firms do practice some form of price discrimination to increase producer surplus, and they do so by trying to find a signal of consumer’s willingness to pay and price their goods accordingly.
A typical example would be cinema ticket pricing. Afternoon shows are cheaper than night shows because the customers of afternoon shows are more price sensitive. They are typically the unemployed, the children, and the elderly who have less disposable income to spend on movie tickets. As the working adults have limited free time outside of their working hours, they have to watch movies during night time and they are less price sensitive due to their higher disposable income. The theatres can therefore charge a higher price.
Sources of Monopolies
Monopolies come about from two sources:
- Cost Advantages
Monopolies that come about from cost advantages are also known as natural monopolies. The nature of the market is such that one single firm will gain a cost advantage, and a new entrant will not be able to do so. For example, in a market with extremely high fixed costs, such as the market for supplying water, once the water pipes are laid, it does not make sense for a new entrant to lay another set of infrastructure over the existing one, as the new entrant will never be able to recover the sunk cost. This creates a barrier to entry, which is why monopolies occur naturally in such markets. Although it is not beneficial to society, a monopoly is the economically efficient outcome of such markets.
- Government Actions
Government actions can create monopolies to create markets that would otherwise not exist at all, in order to bring about more social welfare. For example, awarding patents for new drugs will provide incentive for firms to conduct research and innovate. Without the protection of patents, the enormous cost required to develop new drugs will not make sense to firms if any other competitors can simply free load on their research effort, and as a result the no firms will ever pursue research and innovation to benefit the society.
The success of patents benefiting the society depends on the level of innovation of the new good produced by the firms, which is difficult to determine by any government. In a scenario where the innovation truly creates new value, demand for the good will increase, causing demand curve to shift outwards. Therefore, even with a monopoly charging at a price above MC, total consumer surplus increases. However, in a scenario where the “innovation” is merely a superficial change to the original products, the patent will create a monopoly in place of a competitive market. With no change in demand, society will be worse off, due to less consumer surplus and an increase in deadweight loss.
Natural monopolies are examples of market failure, where the market had failed to naturally optimise the welfare of society, and this creates room for government intervention.
Government can attempt to fix prices charged by a monopoly at the social optimal level. The monopoly will no longer be a price maker and therefore the market will reach equilibrium at a point where MC = Demand = MR = Fixed Price. However, this is difficult to achieve as the government is unable to obtain accurate information to perform the price fixing, and it is in the monopoly’s best interest to blow up the cost. If the government underestimate the cost of a monopoly and fix the price below the social optimal, it may even result in a larger deadweight loss due to lower production and consumption.
A contestable market occurs when there is a natural monopoly but there is insufficient market power to deter other firms from entering the market.
An example is the airline industry in the U.S. Before 1970s, airline industry is a regulated natural monopoly as the government thinks no new entrants will be able to survive. However, it is in fact a contestable market as the firms actually lack market power. After 1970s, the airline industry was deregulated, and three things occurred:
- Prices fell enormously for some of the routes.
- New routes emerged as new entrants offered those services that were previously thought to be non-profitable.
- Drop in airline service quality. Previously, due to regulated pricing, firms had to compete using non-price factors, but with the deregulation, firms had done away with the frills to lower costs in order to compete using lower prices.
There was also an unintended consequence. The government overlooked the fact that although airline industry is a contestable market, the airports are monopolies as there are limited gates to house the airlines. Due to deregulation, certain smaller hubs dominated by one or two airlines are able to charge very high prices as the lack of gates created barrier to entry.
(Reference: MIT OCW Principles of Microeconomics)