Monopoly

What comes to mind when you see the word "monopoly"? The game Monopoly? In that game, you are trying to own as many properties as possible - that gives you the power to charge more money from other players. So, that's one thing in common with the monopoly market structure that we're talking about here: it's about having the market power to charge consumers more money. Interested? Read on to find out more about how monopolists are able to do this!

Monopoly Monopoly

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Table of contents

    Monopoly Definition

    Before jumping into the definition of monopoly, let's consider why monopolies exist in the first place.

    A monopoly exists because it is very difficult for other firms to enter the market. This kind of difficulty is called barriers to entry. There are a number of different reasons why a high barrier to entry exists. It could be that one firm controls all the resources needed to produce that product. For example, if one firm controls all the diamond mines, it will have a monopoly on the diamond market.

    A monopoly is a market structure where a single firm supplies the entire market, and there are no close substitutes. Monopoly is the polar opposite of perfect competition.

    De Beers and the global diamond market1

    The diamond market was often cited as an example of a monopoly. One firm, De Beers, once controlled much of the global diamond market. De Beers not only owned a lot of diamond mines, but also got other suppliers of diamonds to sell them exclusively via De Beers. At its peak, De Beers once controlled almost 90% of the diamond market share. This level of market power meant that the company could effectively control the price of diamonds on the international market. When demand for diamonds was weak, De Beers would stockpile diamonds to limit supplies and stabilize the price; when demand was strong, the company would release that stockpile to the market (if the price becomes too high, people would turn away from buying diamonds). However, new diamond mines were eventually discovered in Russia, Australia, and Canada. Many of these new mines decided to sell diamonds directly to the market without going through De Beers. Eventually, De Beers lost its monopoly power over the diamond market.

    In some cases, the government can decide to only allow one firm (usually a state-owned company) to operate in a market. Another common reason for a monopoly is intellectual property protection. Think about Microsoft having a monopoly on the Windows operating system, or a drug company having a monopoly on patented drugs. A monopoly can also happen "naturally" when the fixed cost is simply too high for another company to enter the market.

    A natural monopoly occurs when long-run economies of scale exist for only one firm to serve the entire market. This means that there is a high fixed cost involved.

    Utility companies are common examples of natural monopolies. Think about it, it would be very expensive and not make much sense for another company to come in and build an entire electric grid again to compete with the existing electricity network grid provider.

    Monopoly Graph

    We have quite a few exciting graphs to show what's going on with a monopoly, so let's get started!

    Demand curve for monopoly

    What is the demand curve for a monopoly? Let's start from the very beginning!

    The biggest difference between a monopolist and a firm in a perfectly competitive market is the firm's ability to influence the price. In a perfectly competitive market, since there are many firms competing for consumer demand, any one firm is just a price-taker. As shown in Figure 1, the firm faces a flat demand curve at the market price Pm. If it charges a higher price than the market price, the consumers would go to the other suppliers, and the firm would lose all demand.

    To learn more about firms in the perfectly competitive market structure check our explanation - Perfect Competition.

    A monopolist is the only supplier in the market, by definition. The monopolist faces the market demand curve, which is downward-sloping, as shown in Figure 2.

    monopoly demand curve competitive market studysmarterFig. 1 - Demand curve faced by a firm in a perfectly competitive market

    monopoly demand curve faced by monopolist studysmarterFig. 2 - Demand curve faced by a monopolist

    Marginal revenue curve for monopoly

    The next element is the monopolist's marginal revenue curve.

    monopoly marginal revenue curve studysmarterFig. 3 - A monopolist's marginal revenue curve

    The thing to remember is that the monopolist's marginal revenue curve is below the demand curve, as shown in Figure 3. Why is the marginal revenue curve below the demand curve? Because the monopolist controls the market and the price. Let's look at the table below for an example of a software company that has monopoly power.

    To increase the quantity sold from 1 to 2, the company has to lower the price from $500 to $450; and to sell the third piece of software, it has to lower the price further to $400. You can see from the last column that the marginal revenue for each new unit sold is lower than that for the last unit. This is because the company has to lower its price on all units in order to sell more units. The revenue it loses from lowering prices on the previous units is the price effect. The revenue it gains from selling the additional unit is the quantity effect.

    \(\hbox{The price effect of selling the third unit}=(\$400-\$450)\times2=-\$100\)

    \(\hbox{The quantity effect of selling the third unit}=\$400\times(3-2)=\$400\)

    The marginal revenue of selling the third unit is the sum of the price and quantity effects, which is $300.

    If the monopolist cuts the price further, the marginal revenue will become negative as it loses more revenue from previous units than it gains from selling the additional unit (in this example, it happens at the 7th unit).

    A software monopoly
    Price ($)QuantityTotal Revenue ($)Marginal Revenue ($)
    5001500500
    4502900400
    40031200300
    35041400200
    30051500100
    250615000
    20071400-100

    Table 1. A software monopoly example

    Monopoly Profit Maximization

    Let's now explore monopoly profit maximization!

    How does a monopolist maximize profit?

    As in the case of firms in any market structure, the profit-maximizing point for a monopolist is where marginal revenue equals marginal cost. The difference for a monopolist is that its marginal revenue (MR) curve is below the demand curve. For a monopolist, the demand curve is also its average revenue (AR) curve because it supplies the entire market.

    Here in Figure 4, we assume that there is no fixed cost, and that marginal cost is constant. Because there is no fixed cost, the marginal cost (MC) curve is also the average total cost (ATC) curve. The monopolist will produce until point A, where the MR and MC curves intersect. It will charge the corresponding price on the demand curve at point B with price Pm. The orange area is the monopoly profit.

    monopoly profit maximization monopolist studysmarterFig. 4 - Profit maximization by a monopolist

    Monopoly Examples

    Let's explore some monopoly examples by looking at:

    • monopoly vs perfect competition
    • natural monopoly

    Monopoly vs perfect competition

    The difference between a firm in a perfectly competitive market and a monopolist is how much they can charge the consumers for their products. In perfect competition, a firm faces many other competitors and can only take the market price as given. If it charges a higher price, it loses all demand because the consumers will buy from the other firms.

    This is shown in Figure 5: the market price in perfect competition (Pc) is given by the marginal cost (MC) curve, and the firms will supply until point C, where the market demand curve intersects with the market price. The quantity produced under perfect competition (Qc) is also the socially optimal quantity. In a perfectly competitive market, the area of 1, 2, and 3 represent consumer surplus.

    Compare this to a monopoly, consumer surplus is only a much smaller area (area 2) because of the higher price and less quantity supplied. Area 1 is the profit that goes to the monopolist, and area 3 is the deadweight loss. As you can see from here, a monopoly leads to a higher price and less quantity produced than the social optimum.

    In short, P = MC in perfect competition; P > MC in a monopoly.

    monopoly vs perfect competition studysmarterFig. 5 - Monopoly vs perfect competition

    There are actually a few different ways to draw the monopoly graph. In Figure 5, we are assuming that there is no fixed cost, so MC = ATC. Take a look at the section below of natural monopoly graph and practice identifying the different areas (consumer surplus, monopoly profit, and deadweight loss).

    Calculating consumer surplus, monopoly profit, and deadweight loss

    Figure 6 is the same graph as Figure 5, but it has numbers, so we can do calculations of the different areas that we are interested in. Let's try to calculate the consumer surplus under perfect competition and the consumer surplus, monopoly profit, and deadweight loss under a monopoly.

    In a perfectly competitive market, the firms will supply 300 units of the product at the market price of $20.

    Consumer surplus (the combined triangular area of 1, 2, 3):

    \(\frac{1}{2}\times(\$50-\$20)\times300=\$4,500\)

    On the other hand, if a monopolist controls this market, the monopolist firm will supply only 100 units of the product at a price of $40.

    Consumer surplus is now only area 2:

    \(\frac{1}{2}\times(\$50-\$40)\times100=\$500\)

    Area 1 is the profit that goes to the monopolist:

    \((\$40-\$20)\times100=\$2,000\)

    The deadweight loss caused by the monopoly is area 3:

    \(\frac{1}{2}\times(\$40-\$20)\times(300-100)=\$2,000\)

    monopoly vs perfect competition numerical example studysmarterFig. 6 - A numerical example: monopoly vs perfect competition

    Natural monopoly

    A natural monopoly occurs when long-run economies of scale exist for just one firm to serve the entire market. In other words, there are large cost savings for a natural monopoly to exist in a market. Because of the high fixed cost involved, it would be too costly for another firm to enter the market. This is often the case for utility companies that require building a large infrastructure to serve the public.

    Figure 7 shows such a market where there is a high fixed cost. The average total cost (ATC) decreases as the quantity goes up.

    If the monopolist only cares about maximizing profit, it would supply until point A with price Pm. In this case, area 1 is consumer surplus, and area 2 is the monopoly profit. But this creates a large loss for society, so the government may step in and impose regulations on the natural monopolist.

    For example, the government can choose to cap the price at the monopolist's average cost at point C with price Pr. At this price, the natural monopolist is breaking even, after taking into account all of its costs. At this point, all of the shaded areas (1, 2, 3) are the consumer surplus. If the price is set at P=MC at point D, as it would have been in perfect competition, the monopolist would be making a loss and would require government subsidies to continue operating.

    monopoly natural monopoly studysmarterFig. 7 - A natural monopoly

    Monopoly - Key takeaways

    • A monopoly exists because it's difficult for other firms to enter the market.
    • Unlike a firm in a perfectly competitive market, a monopolist can charge a price higher than the marginal cost.
    • A monopolist's marginal revenue (MR) curve is below the demand curve, and the profit-maximizing quantity is where MR=MC.
    • A monopoly leads to a higher price, lower quantity supplied, and a deadweight loss compared to a perfectly competitive market.
    • A natural monopoly occurs when the long-run economies of scale make sense for one firm to supply the entire market (in other words, there are high fixed costs involved).

    Sources:

    1. "De Beers - Monopoly Broken." Australian Diamond Portfolio.

    Frequently Asked Questions about Monopoly

    How to find profit maximizing price for a monopoly?

    Find the intersection of the MC and MR curves. Read the price off the demand curve.

    What is a natural monopoly?

    A natural monopoly occurs when long-run economies of scale exist for just one firm to serve the entire market. In other words, there are large cost savings for a natural monopoly to exist in a market.

    Why do governments regulate natural monopolies?

    Governments regulate natural monopolies because if natural monopolies pursue profit maximization there will be a large cost to society.

    Why is marginal revenue less than price in a monopoly?

    Marginal revenue curve is always below the demand curve because the monopolist controls the market and the price. The price is read off the demand curve, therefore marginal revenue is always less than price in a monopoly.

    How do monopolies maximize profits?

    The profit-maximizing point for a monopolist is where marginal revenue equals marginal cost. The difference for a monopolist is that its marginal revenue (MR) curve is below the demand curve. For a monopolist, the demand curve is also its average revenue (AR) curve because it supplies the entire market.

    Test your knowledge with multiple choice flashcards

    A firm in a perfectly competitive market is a ____

    A monopolist's marginal revenue (MR) curve is ___ the demand curve

    The price that a monopolist charges is ___ than the marginal cost

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