Monopoly Monopoly: a market structure in which there is only one seller of a good or service that has no close substitutes and entry to the market is completely blocked. The single seller or firm referred to as a monopolist or monopolistic firm. Characteristics of a monopolistic industry Consists of a single firm: (ie the monopolistic firm is also the industry). This means that the demand for the product of the industry (or the market demand) is also the demand for the product of the single firm (or monopolist). They face a downward sloping demand curve and can fix the price at which it sells its product. Ie they can choose the point along the demand curve at which it wants to operate. However, once it decides on a price, the quantity sold depends on the market demand. A monopolist cannot set its sales and its price independently of each other. In other words, a monopolistic firm is always constrained by the demand for its product. This demand, however, might be highly price inelastic, thereby creating scope for the monopolist to exploit consumers by reducing the quantity supplied. Pure monopolies are a relatively rare occurrence. Most monopolies are actually nearmonopolies. Although there may be only one seller of a particular product in a market, that product may have substitutes. For example, there is only one railway system in South Africa, but that system has to compete with other modes of transport (air, road, sea). Whether or not an industry or market can be classified as a monopoly depends on how narrowly the industry or market is defined. There are global, national, regional and local markets. A monopoly does not require that there be only one supplier of the good or service in the whole country. A monopoly may pertain to a specific market area, such as a suburb, town, city or province, with transport costs often being an important determinant of the geographical size of the market. Moreover, services and retail outlets usually have narrower markets, geographically speaking, than manufactured goods. The advent of the Internet and online trading has widened some markets. Even if there is only one firm in the market, this fact alone is not sufficient to label it a pure monopolist. A single firm can only be classified as a monopolist if entry into the market is blocked. So, once again, why study the theory of pure monopoly if there are few, if any, actual examples of pure monopolies? The answer is basically the same as the one we gave in respect of perfect competition. The theory provides important insights into the behaviour of firms in markets which approximate conditions of monopoly. It also serves as a benchmark at the opposite extreme to perfect competition in the spectrum of market structures. As we shall see, many markets exhibit elements of competition and monopoly and we need theories of competition and monopoly to understand how these intermediate markets operate. Bishops Economics Department Page 1
The equilibrium (or profit-maximising) position of a monopolist We assume that the monopolistic firm aims to maximise profit. The monopolistic firm must consider its revenue and cost structures and follows the two basic rules explained previously. Like any other firm, a monopolist should produce where marginal revenue (MR) is equal to marginal cost (MC) (the profit-maximising rule) Provided that average revenue (AR) is greater than minimum average variable cost (AVC) in the short run or average total cost AC in the long run (the shut-down rule). For the moment we also assume that a monopolist is subject to the same basic technology and cost constraints as any other firm and we assume that its cost structure is no different to that of any other firm. Its revenue structure, however, is different to that of a perfectly competitive firm and we have to examine this more closely before we can determine the profit maximising position of a monopolist. Total, Average and Marginal Revenue Under Monopolistic Conditions Since a monopolist is the only supplier of the specific product, the demand curve for the product of a monopolistic firm is the market demand curve for the product of the industry. Because the market demand curve slopes downward, the monopolist can only sell an additional quantity of output if it lowers the price of its product. But the lower price will usually apply to all units of output, which means that the marginal revenue from the sale of an extra unit of output is less than the price at which all units of the product are sold. The relationship between a monopolist s average revenue (ie the price of the product) and its marginal revenue can be explained with the aid of a simple numerical example. This relationship applies to imperfect competitors as well. In the table on the left, prices and quantities for a hypothetical monopoly are shown. When the price of the product is R6 per unit, 3 units will be demanded and sold. TR = P Q (6 3 = 18) Average revenue is equal to the price of the product. The firm s marginal revenue (MR) is the change in total revenue when one extra unit of output is sold. This is shown in the last column. Except for the first unit sold, the firm s marginal revenue (MR) is always lower than the price of the product. Bishops Economics Department Page 2
The firm s total, average and marginal revenue are illustrated in the figures on the left. Because MR is the change in total revenue resulting from the sale of an extra unit of output, it applies to the movement from one unit to the next, rather than to a specific unit. The value of MR is therefore plotted between the two units concerned, rather than against one of them. MR is lower than AR at all levels of output. This is an important result which always holds when AR is downward sloping. If AR is a straight line, MR lies exactly halfway between AR and the price axis (ie the vertical axis). The firm s total revenue (TR) is shown in Figure 13-1(b) where TR rises, reaches a maximum and then falls. If you compare (a) and (b) of Figure 13-1 as long as MR is positive, TR rises where MR is zero, TR reaches a maximum when MR becomes negative, TR falls. Bishops Economics Department Page 3
The Short-Run Equilibrium of the Monopolistic Firm The short-run equilibrium position of a monopolistic firm is illustrated in Figure 13-2. The firm faces a downward-sloping demand curve (D) which is also its average revenue curve (AR). MR is lower than AR, & MR curve lies halfway between the AR curve and the price axis. The monopolist s MC & AC curves have the same shape as those of any other firm. To maximise profit (or minimise loss), the monopolist has to produce where MR = MC (point E at an in diagram output of Q1) At levels of output lower than Q 1 MR > MC and firm will add to its profit by expanding production. At Q 1 MR = MC and profit is maximised At levels of output greater than Q 1 MC > MR and total profit will therefore decline if the firm continues producing beyond Q 1. Like any other firm, a monopolist maximises profit by producing that quantity where MR = MC. At what price should that output be sold? The answer is quite simple. The monopolist sells its output at the price which consumers are willing to pay for that particular quantity, as indicated by the demand curve. In Figure 13-2 point M 1 is the price at which MR = MC. It shows that consumers are willing to pay a price of P 1 for a quantity of Q 1. Does the monopolist make a profit in equilibrium? To determine whether a firm makes an economic profit or a loss, we have to compare total revenue with total cost, or average revenue with average cost. Contrary to what many people believe, a monopolist can also make a loss. In Figure 13-2 the monopolist s average profit per unit of output is shown by the difference between AR and AC at a quantity Q 1 (M 1 and K 1 respectively). The firm s total economic profit is indicated by the shaded rectangle C 1 P 1 M 1 K 1. Bishops Economics Department Page 4
The Long-Run Equilibrium of the Monopolistic Firm Under perfect competition any short-run economic profit is competed away in the long run by the entry of new firms or the expansion of existing firms. Under monopoly, however, entry into the industry is blocked (by definition) and short-run economic profits therefore cannot be reduced by new competing firms entering the industry. The monopolistic firm can thus continue to earn economic profits (also called monopoly profits) in the long run, as long as the demand for its product remains intact. If the monopolistic firm should expand its plant size (to achieve economies of scale), its average cost curve will become flatter but for the rest the long-run position of a monopolist will be essentially the same as that illustrated in Figure 13-2, the only difference being that the firm will produce where MR = long-run MC. Absence of a Supply Curve Under Monopoly A monopolist does not have a supply curve showing the quantities that will be supplied at different prices of the product. Under perfect competition, the short-run supply curve of each individual firm is the rising (or upward-sloping) part of the marginal cost (MC) curve above the minimum average variable cost (AVC), and the market supply curve is obtained by adding all the individual supply curves horizontally. The monopolist, however, chooses the combination of price and output at which profit is maximised (or loss minimised), given the demand (or revenue) conditions and the cost conditions. Subject to the demand constraint, the monopolist is a price maker and does not move along a supply curve as the price of the product changes. Price discrimination Until now we have assumed that the monopolistic firm sells its product at a single price, irrespective of where or to whom it is sold. Sometimes, however, firms with market power find it profitable to sell the same product to different consumers or groups of consumers at different prices. This practice is called price discrimination. Price discrimination only occurs when price differences are based on different buyers valuations of the same product. If price differences are based on cost differences they are not discriminatory. In previous sections it was explained that consumers as a group benefit when a good or service is sold at a fixed price. If the demand curve slopes downward, a single price implies that all the quantities except the last one is sold at a lower price than consumers are willing and able to pay. This benefit is called the consumer surplus. The purpose of price discrimination is to capture all or part of the consumer surplus, or to increase sales, thereby increasing profits. Bishops Economics Department Page 5
However, not all firms are in a position to practice price discrimination. Two basic conditions have to be met 1. The firm must be a price maker or price setter. Under perfect competition, where all firms are price takers, price discrimination is impossible. 2. Consumers or markets must be independent. Consumers obtaining the product at a low price or in the low-priced market must not be able to resell the product at higher prices or in the high-priced market. The discriminating firm must thus be able to divide the market and keep the different parts separate. This is usually much easier for services than for goods. For example, one cannot resell the services of a hairdresser or a medical practitioner. Three main varieties of price discrimination can be distinguished 1. First-degree price discrimination (discrimination among units) This occurs when each consumer is charged the maximum price he or she is prepared to pay for each unit of the product. This is also what stall holders in a street market attempt to do when bargaining with their customers. Negotiation between sellers and buyers occurs at prices between that which the consumer is prepared to pay and that which the supplier is prepared to accept. The outcome will depend on the bargaining or negotiation skills of the two parties. The price-discriminating firm, however, will only practise price discrimination if it can obtain a higher price than the equilibrium market price. If the firm succeeds in capturing the total consumer surplus by charging each consumer the full amount she is willing and able to pay, the consumer surplus is eliminated and the demand curve becomes the firm s marginal revenue curve. This is called perfect price discrimination. 2. Second-degree price discrimination (discrimination among quantities) This occurs when the firm charges its customers different prices according to how much they purchase. It may, for example, charge a high price for the first so many units, a lower price for the next so many units and a lower price again for the next. With different prices being charged for different quantities or blocks of the same product consumers may be encouraged to consume more of the product. For example, if you purchase a six-pack of Coke you will pay less per can than if you buy fewer cans, and if you buy a case of 24 cans the unit price will be even lower. Likewise, if you subscribe to a magazine or newspaper for a certain period, you will pay less per copy than if you buy each one separately. 3. Third-degree price discrimination (discrimination among buyers) This occurs when consumers are grouped into two or more independent markets and a separate price is charged in each market. In this case the price elasticity of demand must differ between the different markets. The firm will charge the higher price in the market where demand is less price elastic, and thus less sensitive to an increase in price. By raising the price where demand is inelastic and reducing it where demand is elastic, revenue can be increased in both markets (or market segments). Third-degree price discrimination is practised fairly widely. Eskom, for example, sells electricity at different prices during peak periods and off-peak periods. Since electricity cannot be stored for later use, such discrimination is possible. South African Airways also practises price discrimination by charging different fares to different market segments and at different times of the day. Business travellers, whose fares are usually Bishops Economics Department Page 6
paid by their employers, demand for air travel is relatively price inelastic and an increase in their fares will tend to result in higher revenue. Other travellers, however, tend to have a higher price elasticity of demand and a reduction in the price of air travel (eg during off-peak periods or by booking well in advance or by staying over on weekends) will tend to attract additional passengers and raise revenue in this part of the market for air travel. There are many other examples of price discrimination, particularly as far as services are concerned. Hairdressers offering special low rates for pensioners at slack times, as do many golf clubs. Bus and train services charge different rates per trip for daily, weekly and monthly tickets. Many cinemas charge lower prices for children than for adults during daytime, or to everyone on relatively quiet days (eg Tuesdays). Children or students are also often charged lower prices on public transport or at sporting events. Doctors in private practice tend to charge their non-medical aid patients according to what they can afford. Natural monopoly Natural monopoly: a situation that arises where it is most cost efficient for a single firm to produce all the output in an industry or market. In the figure on the right, we see that average cost AC is still declining at the point where the quantity demanded reaches a maximum. Even if the price of the good or service is zero, market demand will still not be sufficient for the firm to achieve minimum AC (or maximum economies of scale). Thus, even where one firm supplies all the industry output, the firm will still not be operating at the minimum efficient scale. Clearly, if there were more than one firm sharing the output, the average cost of production of each firm would be higher. Natural monopolies typically arise in the case of public utilities such as the supply of electricity and water. Bishops Economics Department Page 7
Natural monopolies create a dilemma for government policy and regulation. Some form of government intervention is necessary, since a private firm would be able to produce at inefficient levels and earn large economic profits. Broadly speaking, there are two options 1. Government can produce the good itself 2. Production could be left to a private firm, which is then regulated by government in a variety of possible ways. Where production is left to a private firm, regulation can take the form of price control. But where should the price be set? Allocative efficiency requires that the price P be such that P = MC Productive efficiency is achieved where AC is at a minimum. In this case, the latter point cannot be reached and the logical conclusion is therefore that price should be equated with marginal cost to ensure allocative efficiency. This is called the marginal pricing rule. However, imposing the marginal pricing rule will result in economic losses see Figure 13-4. If price is equated to marginal cost, average revenue will be lower than average cost. What now? If the product is an essential one, like water or electricity, a solution needs to be found. At least four alternative strategies can be followed: 1. Government can supply the good or service itself and use tax revenue to compensate for the losses. A major problem with this strategy is that nonusers have to help pay for the good or service. 2. Government can leave production to a private firm and subsidise its losses. 3. An alternative pricing strategy can be followed, for example, average cost pricing (ie setting P = AC). The firm (which could be government-owned or a private company) would then earn a normal profit and no subsidisation would be necessary. Output (Q2 in Figure 13-4) will be lower than in the case of marginal cost pricing (Q3) but higher than that of an unregulated monopolist (Q1), which will produce where MR = MC and at a price (P1) corresponding to the demand (AR) curve. Bishops Economics Department Page 8
Theoretically, average cost pricing may seem a good option, but if firms are only allowed to earn normal profits they have no incentive to minimise costs. Higher costs (eg in the form of higher wages and salaries) will simply result in higher prices. This disadvantage is associated with the first two strategies as well. 4. The fourth option is price discrimination. As explained earlier, public utilities like Eskom tend to charge different rates for different market segments. Price discrimination enables the supplier to capture some of the consumer surplus in certain market segments which can then be used to subsidise consumers in other market segments. Bishops Economics Department Page 9