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Monopoly Power

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Economics

‘Control it all’ is one of the official slogans of the Monopoly board game. Similar to the board game, real monopolies can in fact ‘control it all’ when it comes to prices or output quantities.

The definition of a monopoly is quite relative. It can be defined under both stricter and looser terms.

A pure monopoly is a market owned by only one firm. In other words, one single firm produces all of the output in the market.

Defined under looser terms, a monopoly is a firm that dominates the market, although there are other firms in the same market.

Characteristics of monopoly

A pure monopoly is a market that only contains one seller. Thus, one firm is the entire industry. In this market, the one firm owns all of the market share.

On the other hand, under a looser definition, a monopoly is the dominant firm in the market. This means that the firm owns almost all of the market share (over 90%), although still faces competition from other firms.

Characteristics of monopoly power

A pure monopoly is an example of a concentrated market.

A concentrated market is one with very few firms. It can be interpreted as the opposite of perfect competition.

As opposed to a pure monopoly, where only one seller owns the entire market, the existence of some degree of monopoly power is more common in industries. This means that there is one dominant firm in the industry that produces most of the output. Firms that have a certain degree of monopoly power (also referred to as market power) still face competition from the other firms in the market.

Competitive pressure can come from competition within the market, from available substitutes in the market, or from other firms that are trying to enter the market and compete directly with the monopoly. Monopoly power, however, is at its highest level when there is only one firm in the market.

There are different market factors that influence monopoly power. Let's explore them.

Barriers to entry

Barriers to entry prevent new firms from entering the market. These can either be natural, like economies of scale, or artificial, like strategic barriers. An example of a strategic barrier would be the existing firm owning a patent for the production of a certain good or service.

Number of competitors

Usually, in a monopolistic industry, one large firm dominates the market. However, in certain industries, the large firm and smaller niche firms coexist in the market, which somewhat limits monopoly power.

Product differentiation

Product differentiation can also influence monopoly power. This includes making a product different from another similar product through marketing, production, or usability. If the firm is really good at differentiating its product, it can increase its monopoly power.

Advertising

Persuasive advertising can reduce competition in the market. This type of advertising can captivate customers in a way that they would believe it is the best product on the market. As a result, they might be unwilling to purchase any other substitutes.

Sources of monopoly power

There are different sources of monopoly and monopoly power.

Natural monopoly

Natural monopoly occurs when the market only has room to accommodate one single firm. In other words, there is only one firm that can benefit from the existing economies of scale in the market.

The National Rail in the UK is an example of a natural monopoly over the rail network. There are multiple economies of scale which come from having only one rail network operator.

Geographical monopoly

A pure monopoly can also take place when, for a geographical reason, a single country is the only possible supplier of raw materials or commodities. This could happen due to the climate, geology, or geographical layout of the country, as well as due to spatial factors.

A local market in a tiny village is the only supplier of groceries for its locals. This is not a case of pure monopoly, as the residents could always travel to a different town to buy their groceries. However, this can be expensive and inconvenient for them. It would also be difficult and unprofitable for another shop or firm to enter the market, as the village is too small, leading to the geographical monopoly of the local market.

Government-imposed monopoly

Governments can also create monopolies in certain industries which they do not think would benefit from competition. These industries can either be state-owned or private.

Certain industries, like the coal or steel industry, were government-owned monopolies in the UK.

The government can also create a private monopoly, in order to encourage consumption of a good or service they deem beneficial to society or limit the consumption of a good or service they deem harmful to society.

A patent is another example of a monopoly the government can create. Patents are used to entitle a creator or artist to their intellectual property for a certain period of time. These grant them the sole right to their intellectual property, creating a form of monopoly.

Profit maximisation in monopoly

Before taking a look at profit maximisation, let's examine a pure monopoly demand curve. As there is only one firm in the market, the market demand curve is the demand curve of the monopolist's output. This means that the monopoly can either be a price maker or a quantity setter.

If the monopoly is the price maker, they set the price in the market. Therefore, the demand curve will show the maximum quantity of the good or service that can be sold. Taking a look at Figure 1 below, at P1, the maximum output that can be sold is Q1.

On the other hand, if the monopoly is the quantity setter, the demand curve in Figure 1 will show the maximum price at which the output can be sold on the market. At Q2 the maximum price the output can be sold for is P2.

This implies that the monopoly faces a trade-off between price and quantity. It can either set the price or the quantity, but not both.

Monopoly and Monopoly Power, Profit maximization in monopoly, monopoly demand curve is the market demand curve, StudySmarterFigure 1. The monopoly demand curve is the market demand curve - StudySmarter Originals.

Now, let's take a look at the profit maximisation of a monopoly (Figure 2 below). The diagram for a monopoly's profit is considered to be the same in both the short and the long run due to barriers to entry that prevent new firms from entering the market.

If the monopoly aims to maximize its output, it will set its output level at the point where the marginal cost is equal to the marginal revenue (MC = MR in Figure 2). At the production level of QM, the demand curve shows the price the monopoly can set at PM. The average cost (AC) of producing each unit of the good is equal to ACM as shown in Figure 2 below.

The difference between the two price levels (PM and ACM) is the excess, or supernormal profit per unit. The total supernormal profit is represented by area A highlighted in green in Figure 2 below.

Monopoly and Monopoly Power, Profit Maximization in monopoly, monopoly profits, StudySmarterFigure 2. Monopoly profits - StudySmarter Originals.

Due to the barriers to entry that protect the monopoly, no new firms can enter the market and there is no competition for the supernormal profit. This allows for the monopolist to keep the abnormal profits in both the short and long term.

As a result, the profit-maximising position illustrated in Figure 2 represents both the short-term and long-term equilibrium for the monopoly.

Supernormal profit (also known as abnormal profit) is any profit over and above normal profit.

Perfect Competition

In the case of perfect competition, the presence of supernormal profits would signal to firms outside the market to enter the market, as supernormal profits can be made. Therefore, supernormal profits are only present in the short term under perfect competition. On the other hand, in a monopoly, they are present in both the short and long term due to the barriers to entry.

Monopoly inefficiencies

One of the main problems that cause inefficiencies with monopolies is that a monopoly can always set the price. A monopoly has the power to reduce market output in order to increase the price of the good or service they produce, and therefore maximise its profit.

Taking the diagram from Figure 1 (above) as an example, let's imagine that the monopoly could be producing quantity Q2 at a price P2. Using its market power, it can restrict its output to Q1 whilst setting the price to P1. The monopoly output may thus be less than the socially optimum quantity, whilst the price is higher, causing welfare loss. This can lead to market failure and the misallocation of resources, as the quantity produced decreases while the price increases.

Due to the high prices, consumers buy less of the goods than they would in a competitive market. The monopoly is, therefore, exploiting consumers in the market, reducing consumer surplus. This behavior is especially exploitative when the demand for the good or service is price inelastic, as consumers face the issue of not having any available substitutes.

Bear in mind that restricting output on certain products might be beneficial in some cases. For example, it could reduce the consumption of demerit goods like tobacco.

Similarly, monopolies can also experience productive inefficiencies. As there are high barriers to entry into the industry, the pressure to reduce the costs of production is essentially nonexistent. Therefore, the monopoly is likely to operate at low output levels with high average costs of production.

Additionally, market failure and allocative inefficiencies are also drawbacks of a monopoly. The monopoly can restrict output leading to higher prices, which can therefore lead to the under-consumption of the goods or services that the monopoly produces.

Benefits of monopoly

A monopoly may also have its advantages. In certain cases, such as in natural monopolies, there are numerous economies of scale present in the industry which the monopoly can take advantage of. In this case, the monopoly taking advantage of all of them might end up producing a better economic result than under perfect competition.

Furthermore, monopolies might also benefit from dynamic efficiency, which is the overall increase of productive efficiency over time.

Productive efficiency may increase over time due to technological advancements. A monopoly that is making supernormal profits might re-invest some of its profits in developing machinery that is more technologically advanced than the current one. As a result, the firm is able to produce goods a lot quicker and at a lower cost than before. This increases the overall productive efficiency of the monopoly.

As monopolies make supernormal profits in both the short and long term, they can invest these profits into research and development or the process and product innovation. Eventually, this may lead to more efficient ways of production due to more advanced production means.

Due to the lack of competitive pressure, monopolies might be disincentivised from innovating as they already experience the level of profit they desire.

Monopoly Power - Key takeaways

  • A pure monopoly is a market that only contains one seller. This seller owns all of the market share.
  • A pure monopolist has no competitors (does not face any competition) as they represent the entire industry.
  • As opposed to a pure monopoly, where only one seller owns the entire market, the existence of some degree of monopoly power is more common in industries. This means that there is one dominant firm in the industry that produces most of the output.
  • Market factors that influence monopoly power include:
    • Barriers to entry
    • Number of competitors
    • Product differentiation
    • Advertising
  • A natural monopoly is when the market only has room for one firm.
  • A geographical monopoly can occur when only one country has access to certain commodities or raw materials.
  • Governments can create monopolies in certain industries.
  • The monopoly can either be a price maker or a quantity setter.
  • The diagram for a monopoly's profit is considered to be the same in both the short and the long run.
  • Productive inefficiencies and exploitation are two of the main inefficiencies created by monopolies.
  • The advantages of a monopoly include economies of scale and dynamic efficiency.

Monopoly Power

As opposed to a pure monopoly, where only one seller owns the entire market, the existence of some degree of monopoly power is more common in industries. This means that there is one dominant firm in the industry that produces most of the output. Firms that have a certain degree of monopoly power (also referred to as market power) still face competition from the other firms in the market. 

Monopoly power is a firm's ability to control the prices or restrict output due to its dominance in the market.

A firm might experience monopoly power as a result of a geographical monopoly. For example, if a local market in a tiny village is the only supplier of groceries for locals. The market might face a certain level of competition from supermarkets elsewhere. However, locally it experiences high levels of monopoly power.

The sources of monopoly power include natural monopolies, geographical monopolies, and government-imposed monopolies.

You can calculate monopoly power by the extent to which the firm can set the price over marginal cost.

Final Monopoly Power Quiz

Question

What is a pure monopoly?

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Answer

A market that contains only one seller.

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What levels of competition do pure monopolists face?

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Answer

A pure monopolist has no competitors (does not face any competition) as they represent the entire industry. There are no other firms to compete within the market.

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What is a concentrated market?

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A concentrated market is one with very few firms present.

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What is monopoly power?

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Answer

Monopoly power can be characterised by a market that is dominated by one firm that produces most of the output in the industry.

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Question

Where does competitive pressure come from?

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Answer

Competitive pressure can come from:

  • Competition within the market
  • Available substitutes in the market
  • Firms that are trying to enter the market and compete directly with the monopoly position of the firm

Show question

Question

Market factors that influence monopoly power include:

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Answer

All are correct.

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Question

What are the two types of barriers to entry into a market?

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Answer

Natural and artificial.

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Name an example of a natural barrier to entry.

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Answer

Economies of scale.

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Name an example of an artificial barrier to entry.

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Strategic barriers.

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What is product differentiation?

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Product differentiation includes making a product different from another similar product through marketing, production, or usability.

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Name two sources of monopoly or monopoly power.

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Geographic disposition and the government.

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What is an example of a geographic monopoly?

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When a single country or region is the only possible supplier of raw materials or commodities. Also, when a region only has one supplier due to geographical reasons.

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Question

Explain the idea of a monopoly being a 'price maker'.

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If the monopoly is the price maker, they set the price in the market and the demand curve will show the maximum quantity of the good or service that can be sold. 

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How does the profit maximisation for a monopoly differ in the short and long-run?

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They do not differ.

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Name two disadvantages of monopolies.

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Productive inefficiencies and the exploitation of consumers.

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What is price discrimination?

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Price discrimination is the practice of charging different consumers different prices for the same product. 

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What is the main reason for price discrimination? 

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To capture consumer surplus and maximise the company's profits. 

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How many types of price discrimination are there? 


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1

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How is price discrimination classified?

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First degree, second degree, third degree.

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What is first-degree price discrimination?


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First-degree price discrimination is also known as perfect price discrimination. Producers charge the buyers with their maximum willingness to pay and thus capture the entire consumer surplus.

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Is first-degree price discrimination realistic? Why? 


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No, since it's hard to determine the maximum willingness to pay of each individual consumer. 

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What is third-degree price discrimination?


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Third-degree discrimination occurs when the company charges different prices for different groups of customers.

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Name an example of third-degree price discrimination.


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 Price of museum entrance for adults, seniors, and children. 

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When should firms price-discriminate? 


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Only when the profit from sub-markets is greater than the profit in the combined market should the company price discriminate. 

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What is the relationship between price discrimination and elasticity of demand? 


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Consumers with price inelastic demand can be charged higher prices that those with price elastic demand.

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What are some benefits of price discrimination? 


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It brings more revenues to the producer.

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What is not a disadvantage of price discrimination?


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A reduction in consumer surplus.

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What are the conditions for price discrimination?


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A certain level of monopoly.

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What is second-degree price discrimination?

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Second-degree discrimination happens when the company charges different prices depending on the amounts or quantities consumed.

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Name some examples of second-degree price discrimination.


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Bulk purchases, phone plans. 

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The green area A in the following diagram represents ___________   of a monopoly.

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supernormal profit

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A pure monopoly is a market that only contains one ___________ .


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seller

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A pure monopolist has no competitors.

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True

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Market factors that influence monopoly power include:

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Barriers to entry

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The monopoly can either be a price taker.  

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True

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The advantages of a monopoly include ___________ and dynamic efficiency.

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Answer

economies of scale 

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Productive efficiency may increase over time due to ___________ . 

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Answer

technological advancements 

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Monopolies might be disincentivised from innovating when there is a lack of ___________ .


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Answer

competitive pressure 

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Major drawbacks of a monopoly are market failure and  ___________ .

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allocative inefficiencies

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As the monopoly restricts output leading to higher prices, there might be an

___________ of the goods or services that the monopoly produces. 

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under-consumption 

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Governments can create monopolies in certain industries.

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True

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A geographical monopoly can occur when ___________  has/have access to certain commodities or raw materials.

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only one country

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A looser term for monopoly is a firm that dominates the market. 

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True

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A  pure monopoly means that one single firm produces all of the output in the market.  

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True

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Firms that have a certain degree of monopoly power does not face competition from the other firms in the market. 

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True

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Monopoly power is also referred to as ___________ .

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market power

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Competitive pressure can come from available ___________  in the market.

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substitutes  

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Economies of scale is a ___________   barrier to entry in a monopoly market. 


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natural  

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Suppose an existing firm own a patent for the production of a certain good or service. This can act as ___________ for newer firms. 

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an artificial barrier to entry

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Product differentiation that influence monopoly power can be achieved through ___________ , production, or usability. 

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marketing 

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