Monopoly

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This article is about the economic term. For the board game, see Monopoly (game).

A monopoly (from Greek mono(μονό), alone or single + polο (πωλώ), to sell) is a persistent situation where there is only one provider of a product or service in a particular market. Monopolies are characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods. [1]

A Monopoly should be distinguished from monopsony, in which there is only one buyer of a product or service; a monopoly may also have monopsony control of a sector of a market. Likewise, a monopoly should be distinguished from a cartel (a form of oligopoly), in which several providers act together to coordinate services, prices or sale of goods.

A government-granted monopoly or legal monopoly is sanctioned by the state, often to provide an incentive to invest in a risky venture. The government may also reserve the venture for itself, thus forming a government monopoly.

It is argued in contemporary monopoly theory that if a monopoly is not protected from competition by government restrictions, then it is subject to potential competition and therefore is not able to gouge consumers without causing competitors to enter the field to take advantage of profit opportunities.

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[edit] Economic analysis

  • No close substitutes: A monopoly is not merely the state of having control over a product; it also means that there is no real alternative to the monopolized product.
  • A price maker: Because a single firm controls the total supply in a pure monopoly, it is able to exert a significant degree of control over the price by changing the quantity supplied.

Other common assumptions in modeling monopolies include the presence of multiple buyers (if a firm is the only buyer, it also has a monopsony), an identical price for all buyers, and asymmetric information.

The result of these conditions is that a company with a monopoly does not undergo price pressure from competitors, although it may face pricing pressure from potential competition. If a company raises prices too high, then others may enter the market if they are able to provide the same good, or a substitute, at a lower price. [2] The idea that monopolies in markets with easy entry need not be regulated against is known as the "revolution in monopoly theory".

[edit] Price setting for irregulated monopolies

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Surpluses and deadweight loss created by monopoly price setting
Surpluses and deadweight loss created by monopoly price setting

In economics, a firm is said to have monopoly power -- or at least a degree of market power --if it is not facing a horizontal demand curve (see supply and demand). This is in contrast to a price-taking firm which always faces a horizontal demand curve, and therefore sells little or nothing at prices above equilibrium. In contrast, a business with monopoly power can choose the price at which it wants to sell.

In most markets, falling demand associated with increased price is due partly to losing customers to other sellers and partly to customers who are no longer willing or able to buy the product. In a pure monopoly market, only the latter effect is at work. Therefore, the drop in sales as prices rise may be much less dramatic than one might expect, especially for necessary commodities such as medical care. However, unless the monopoly is a coercive monopoly, there is also the risk of competition arising if the firm sets its prices too high.

If a monopoly can set only one price, it will produce a quantity where marginal cost (MC) equals marginal revenue (MR), as seen on the diagram at right. The monopolist will then set the highest price at which that quantity can be sold. This, the optimal price according to supply and demand theory, is above the competitive price (Pc) and below the competitive quantity (Qc).

As long as the price elasticity of demand for most customers is less than one in absolute value, it is advantageous for a firm to increase its prices: it then receives more money for fewer goods. With a price increase, price elasticity tends to rise, and in the optimum case above it will be greater than one for most customers. The following formula gives the relation among price, marginal cost of production and demand elasticity that maximizes a monopoly profit: P(1+\frac1e) = MC where (e) is the negative elastic of demand. A monopoly's power is given by the vertical distance between the point at which the marginal cost curve (MC) intersects with the marginal revenue curve (MR) and the demand curve. The longer the vertical distance, (i.e., the more inelastic the demand curve) the greater the monopoly's power, and thus, the larger its profits.

The economy as a whole suffers when monopoly power is used in this way because the extra profit earned by the monopoly will be smaller than the loss in consumer surplus. This difference is known as a deadweight loss.

[edit] Calculating monopoly output

The single price monopoly profit maximization problem is as follows:

The monopoly's profit is its total revenue less its total cost. Let the price it sets as a market response be a function of the quantity it produces (Q) P(Q) and let its cost function be as a function of quantity C(Q). The monopoly's revenue is the product of the price and the quantity it produces. Hence its profit is:

\Pi\ = P(Q)\cdot Q - C(Q)

Taking the first order derivative with respect to quantity yields:

\frac{d \Pi\ }{dQ} = P'(Q)\cdot Q + P(Q) - C'(Q)

Setting this equal to zero for maximization:

\frac{d \Pi\ }{dQ} = P'(Q)\cdot Q + P(Q) - C'(Q)=0
\frac{d \Pi\ }{dQ} + C'(Q) = P'(Q)\cdot Q + P(Q)= C'(Q)

i.e. marginal revenue = marginal cost, provided

\frac{d^2 \Pi\ }{dQ^2} = P''(Q)\cdot Q + 2\cdot P'(Q) - C''(Q) < 0

(the rate of marginal revenue is less than the rate of marginal cost, for maximization).

This procedure assumes that the monopolist knows the exact demand function. [3]

[edit] Monopoly and efficiency

According to standard economic theory (see analysis above), a monopoly will sell a lower quantity of goods at a higher price than firms would in a purely competitive market. In this way the monopoly will secure monopoly profits by appropriating some or all of the consumer surplus: although the higher price deters some consumers from purchasing, most are willing to pay the higher price. Assuming that costs stay the same, this does not lead to an outcome that is inefficient in the sense of Pareto efficiency; no one could be made better off by shifting resources without making someone else worse off. However, overall social welfare declines, because some consumers must choose second-best products.

A monopoly can also achieve allocative efficiency if it price discriminates, if the monopoly achieves perfect price discrimination and sells off all its "blocks" to groups of consumers willing to pay at the different price levels it will in effect sell all its stock or "blocks" where Price= Marginal cost thus increasing its profit, increasing consumer surplus and reducing if not eradicating deadweight loss, now "everyone gets what they want" which is another definition of Allocative Efficiency". Arya Tabrizi.

[edit] Negative aspects

It is often argued that monopolies tend to become less efficient and innovative over time, becoming "complacent giants", because they do not have to be efficient or innovative to compete in the marketplace. Sometimes this very loss of efficiency can raise a potential competitor's value enough to overcome market entry barriers, or provide incentive for research and investment into new alternatives. The theory of contestable markets argues that in some circumstances (private) monopolies are forced to behave as if there were competition because of the risk of losing their monopoly to new entrants. This is likely to happen where a market's barriers to entry are low. It might also be because of the availability in the longer term of substitutes in other markets. For example, a canal monopoly, while worth a great deal in the late eighteenth century United Kingdom, was worth much less in the late nineteenth century because of the introduction of railways as a substitute.

[edit] Positive aspects

Some argue that it can be good to allow a firm to attempt to monopolize a market, since practices such as dumping can benefit consumers in the short term; and once the firm grows too big, it can be dealt with via regulation. When monopolies are not broken through the open market, often a government will step in, either to regulate the monopoly, turn it into a publicly owned monopoly, or forcibly break it up (see Antitrust law). Public utilities, often being natural monopolies and less susceptible to efficient breakup, are often strongly regulated or publicly owned. AT&T and Standard Oil are debatable examples of the breakup of a private monopoly. When AT&T was broken up into the "Baby Bell" components, MCI, Sprint, and other companies were able to compete effectively in the long distance phone market and began to take phone traffic from the less efficient AT&T.

[edit] Hotelling's law

Mathematician Harold Hotelling came up with Hotelling's law which showed that there exist cases where monopoly has advantages for the consumer. If there is a beach where customers are distributed evenly along it, an entrepreneur setting up an ice cream stand would naturally place it in the middle of the beach. A competing ice cream seller would do best to place his competing ice cream stand next to it to gain half the market share, but two stalls right next to each other is not an ideal situation for the people on the beach. A monopolist who owns both stalls on the other hand, would distribute his ice cream stalls some distance apart.[4]

[edit] The "natural monopoly" problem

A natural monopoly is defined as a situation in which production is characterized by falling long-run marginal cost throughout the relevant output range. In such situations, a policy of laissez-faire must result in a single seller. The conventional Paretian solution to market failure of this kind is public regulation (in the United States) or public enterprise (in the United Kingdom).

[edit] Historical monopolies

Common salt (sodium chloride) historically gave rise to natural monopolies. Until recently, a combination of strong sunshine and low humidity or an extension of peat marshes was necessary for winning salt from the sea, the most plentiful source. Changing sea levels periodically caused salt "famines" and communities were forced to depend upon those who controlled the scarce inland mines and salt springs, which were often in hostile areas (the Dead Sea, the Sahara desert) requiring well-organized security for transport, storage, and distribution. The "Gabelle", a notoriously high tax levied upon salt, played a role in the start of the French Revolution, when strict legal controls were in place over who was allowed to sell and distribute salt. Advocates of laissez-faire capitalism, such as the Austrian school, maintain that a salt monopoly would never develop without such government intervention. [citations needed]

[edit] Examples of alleged and legal monopolies

[edit] Notes and references

  1. ^ Blinder, Alan S; William J Baumol and Colton L Gale (June 2001). "11: Monopoly", Microeconomics: Principles and Policy (paperback) (in English), Thomson South-Western, 212. “A pure monopoly is an industry in which there is only one supplier of a product for which there are no close substitutes and in which is very difficult or impossible for another firm to coexist” 
  2. ^ Depken, Craig (23). "10", Microeconomics Demystified (in English). McGraw Hill, 170. ISBN 0071459111. 
  3. ^ For a discussion on a monopolist who does not know the demand function, see [1] where a free software is available as well.
  4. ^ Hotelling's Law Economyprofessor.com

[edit] Further reading

[edit] See also

Look up monopoly in Wiktionary, the free dictionary.

Market forms

Types

Proposed benefits

Monopolistic practices

General

[edit] External links

[edit] Criticism

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