Monopoly

We have seen that P-Competition has some remarkable results. As we have seen, P-competition defines an ideal market structure in two senses:

1) in P-competition, price competition dominates all other forms of competition and forces the price to the supply-and-demand equilibrium, and

2) at that price and the corresponding output, marginal benefit is equal to marginal cost, so the allocation of resources is efficient -- net benefits are maximized.

Now we consider the opposite extreme:

a monopoly.

By definition, a monopoly is the only seller of a product for which there is no close substitute.

Causes of Monopoly

Most economists regard monopoly as an exceptional case in a modern economy. Thus, we ask what might create the exception -- what might "cause" a monopoly. Most texts give four causes of monopoly, which I will also give and add a fifth.

We will discuss these five causes in turn.

Patents and Other Forms of Intellectual Property

Patent law is designed to increase the incentive to invent new methods of production and new goods. The inventor is granted a temporary monopoly on the use of the invention. The idea is that the patent makes the invention more profitable, during the term of the patent, and that these profits encourage inventors and so increase the rate of technical progress.

For example, the Polaroid company has owned the basic patents on instant cameras. When the Kodak company produced instant cameras in competition with Polaroid, a court found that this violated Polaroid's patent rights, and Kodak had to cease and desist and pay a penalty to Polaroid.

Other forms of "intellectual property" include copyrights on books and works of art and such, trade-marks, and trade secrets. Copyrights and trade-marks probably do not create monopolies in and of themselves.

Control of an Input Resource

Products which require a natural-resource input may be monopolized if one supplier can get control of all known supplies of the natural resource. For example, at one time all known supplies of nickel were controlled by a single company. Aluminum ore, too, was at one time controlled by a single supplier.

Decreasing Costs

Monopolies can come about because there are decreasing costs (increasing returns to scale) in the long run. In such a case, the long run average cost slopes downward, as shown in the picture:

In such a case, the largest producer can undersell the rest, and still make a bigger profit. Therefore, in an industry in which there are increasing returns to scale, we would not be surprised to find a monopoly, in the absence of any other causes. Such a case is called a "natural monopoly."

Crime

While economists usually limit themselves to discussion of legal activities, it is clear that criminal coercion can prevent competition and so create monopolies. This is probably most common in activities that are anyway illegal, such as gambling, which often seem to be local monopolies. (It's hard to be sure, for obvious reasons, and probably pretty changeable, too).

Once established in illegal activities, criminals may use their profits and means of coercion to monopolize businesses that are legal, in principle, such as small scale lending. (At monopoly rates, this is called "loan sharking.")

Monopoly Demand

The demand curve for a monopoly is different from that of a P-Competitive firm. As we recall, the P-competitive firm has a horizontal demand curve. The demand curve for the monopoly is the demand curve for the industry -- since the monopoly controls the output of the entire industry -- and the industry demand curve is downward sloping. So the monopoly's demand curve is downward sloping -- and that means the monopoly can push the price up by limiting output.

Monopoly Example 1

To illustrate what this means, let's "tell a story" about monopoly. In this story the monopoly will be created by legislation.

The story begins with a competitive industry consisting of many firms. As usual we will call it the "widget" industry -- think of it as a small manufactured good. Each firm operates under constant costs in the long run.

We recall that with constant costs in the long run, each firm's long run average cost is a horizontal line. We need two more facts about constant costs in the long run, and one more assumption.

Fact: with constant long run costs, the firm's long run marginal cost is also a horizontal line, identical with the LRAC curve.

Assumption: the firm cost curves remain the same as the number of firms in the industry increases.

Fact: when the assumption is true, the long run average cost, marginal cost, and supply curve of the industry are also the same horizontal line.

Monopoly Example 2

That simplifies things a lot. Here is a picture of long run supply and demand under these assumptions. In the picture, it is assumed that the constant average cost for the widget industry is $40 per unit.

Figure 1

As we see, the long run equilibrium output for the widget industry is 21,000 units of output at a price of $40.

Monopoly Example 3

Here are the numbers for the example.

P Q
100 0
97 1000
94 2000
89 4000
83 6000
77 8000
71 10000
66 12000
60 14000
54 16000
49 18000
43 20000
37 22000
31 24000
26 26000
20 28000
14 30000
9 32000
3 34000

Monopoly Example 4

Now we go on to the next stage of our story.

The national legislature passes a law limiting competition in the widget industry. All the small firms in the industry are consolidated into one large corporation. The owners of the old competitive firms are issued shares in the corporation proportionate to their ownership in the old firms. The corporation is now the only firm allowed to supply the widget industry.

The board of directors of the widget industry now meet to consider their policy, and they aim at maximizing profits. How will they go about this?

Marginal Revenue

We can define marginal revenue by a formula that should be familiar by now, at least in its broad outlines.

where R is revenue (that is, price times quantity sold) and Q is the quantity sold. As usual, this is an approximative formula, and the smaller the change in Q the better the approximation. We can interpret marginal revenue as (approximately) the increase in total revenue as a result of selling one more unit of output. Here's an example of calculation of the approximation: suppose output increases from 10000 to 11000 and revenue increases from 754286 to 714286. Then we have

Monopoly, P-Competition, and Marginal Revenue

Here is a difference between monopoly and P-competition. For the P-competitive firm, the marginal revenue is the same as the price, since each unit sold will add the price to revenue. For the monopoly, it is different. In order to sell one more unit, the monopoly has to drop its price a bit. The additional unit sold will add something to revenue, but the cut in price will decrease the revenue from the units the monopoly could have sold at the old price, without cutting. So the net addition to revenue will be less than the price at which the additional unit is sold, and could even be negative -- the lost revenue from the price cut could be more than the price for which the additional unit is sold.

Marginal Revenue Example: Table

Table 2

Output Price Marginal
Revenue
0 0
97
1000 97
89
3000 91
77
5000 86
66
7000 80
54
9000 74
43
11000 69
31
13000 63
20
15000 57
9
17000 51
-3
19000 46
-14
21000 40

A Picture of Demand and Marginal Revenue

Here is a picture of demand and marginal revenue for our example, based on the data in the previous table.

Monopoly Profit Maximization

The rule for monopoly profit maximization will come as no surprise. It is

MR=MC

That is, increase output up to the level where the marginal cost curve intersects the marginal revenue curve. The price charged is the corresponding price on the demand curve. The diagram is a little more complex. Here it is:

Monopoly Output Restriction

In the diagram, the monopoly maximizes its profits by selling Q'.

Now, let's get back to our story. Recall, the widget industry had been monopolized by an act of the legislature. Before it was monopolized, it had sold 21,000 units at a price of $40 -- to the right where demand crosses the marginal cost line. Now, we see the monopoly selling much less. In fact it will sell just half what the competitive industry sold -- 10,500 units, at a price of $70.

(It will not be this simple as a rule. Remember, we have made a lot of simplifying assumptions to get here. What we can be sure of in general is that a profit-maximizing monopoly will sell less than the supply-demand output, at a higher price).

Monopoly Profits

In our example, the widget industry started out in long run equilibrium, with zero economic profits. Once the monopoly has cut back to its long run equilibrium, at a higher price, it will have positive economic profits. In the picture below, profits are shown by the shaded area.

Monopoly Inefficiency 1

The restriction of output by the monopoly is inefficient. This inefficiency is shown in the following figure:

Monopoly Inefficiency 2

We can explain the inefficiency of monopoly by using the concept of consumers' surplus, using the diagram. There are three areas, the lightly (green) shaded area above the profit rectangle, the lightly (red) shaded area to its right, and the profit rectangle itself. Before the industry is monopolized, consumers buy 21,000 widgets at $40 per widget and their consumers' surplus is the sum of the three areas. After the monopolization, the consumers buy 11,500 widgets at $70, and their consumers' surplus is the area of the (green) upper triangle.

Monopoly Inefficiency 3

Let's add up the benefits of monopolization. After monopolization, the net benefits from widget production have two components: the profit rectangle plus the upper (green) consumers' surplus triangle. But the opportunity cost of monopolization is the consumers' surplus the consumers would have enjoyed if they had continued to buy at $40 -- the sum of the three areas. Thus, the benefits of monopolization are less than the costs, and the difference -- the excess cost -- is measured by the area of the (red) triangle to the right.

This loss of consumers' surplus is called the "deadweight loss" (meaning the monopoly profits are not enough to offset it) or the "welfare triangle" and is a measure of the waste due to monopoly restriction of output. In this very simplified example, it is half of the monopoly profits.

Monopoly in General

This is a pretty special example with, as I have said, a lot of simplifying assumptions. Can the conclusions be generalized? To some extent, they can. In general,
  • A monopoly will charge more than a competitive industry with the same cost conditions
  • The monopoly will sell less output
  • In long run equilibrium, the monopoly will receive economic profits
  • There will be a net loss of consumers' surplus relative to P-competitive equilibrium
  • This net loss is very roughly proportional to the monopoly profit.

Complications in the Theory of Monopoly

But there are still some complications we have not taken account of. So far we have been assuming that the monopoly has the same cost conditions that a competitive industry would have. The complications arise when the monopoly and a competitive industry cannot have the same cost conditions.

This could happen for two reasons.

The monopoly, lacking the spur of competition, wastes resources so that its cost curves are above those of a competitive industry. The term for this is "X-Inefficiency."
This is a deviation from the neoclassical assumption of absolute rationality, but perhaps a very important realistic deviation.
There are economies of scale, so the monopoly, operating on a larger scale, can achieve lower costs.
This is the case of natural monopoly.

"Natural" Monopoly 1

"Natural" monopoly creates a dilemma for neoclassical economics and (perhaps) for market economies.

Here is a picture-example of "natural" monopoly. The example assumes that there is one indivisible cost, but that once it is paid, the firm can produce an unlimited amount at a constant marginal cost. Thus, the Long Run Marginal Cost is horizontal, but the Long run Average Cost is downward- sloping

"Natural" Monopoly 2

The dilemma is that output Q1, where MC=price, is still the efficient output. But at that output, the monopoly cannot cover its total costs. On the other hand, a profit-maximizing monopoly will produce much less, at Q3, which covers costs but it inefficient.

In different countries and at different times, governments have dealt with this problem in three primary ways:

  • Government Ownership
  • Regulation
  • Deregulation

Government Ownership

Government ownership has been a pretty common response outside the United States, and there are cases of municipal ownership in the US.

Government ownership could, in principle, solve the problem, since the government could operate the monopoly and cover the losses out of tax revenues.

In practice, however, government monopolies usually seem to have been operated as "cash cows" for the government, and that's not a solution to the problem of natural monopoly!

In recent years, many of these government monopolies have been privatized.

Regulation

In the United States, for most of the 20th Century, the most common response has been regulation. In this system, a private monopoly is recognized and protected as such, on the condition that it keep its price down below the profit-maximizing level. The monopoly would be allowed to earn a "fair rate of return."

Over the years, this was more and more interpreted as meaning that the monopoly would operate at Q2, where the price just covers average cost. This is less efficient than Q1, but better than Q3. However, there are some other complications that led economists and regulators to question this interpretation by the 1960's. In recent years, the trend has been away from regulation.

Deregulation 1

Natural monopolies are complex businesses, with different lines of business and different cost conditions for the different lines of business, and changing technology may change the cost curves, making more competition possible. The telephone industry provides some examples. The Bell monopoly of the 1970's offered both long distance and local service, as well as some other lines of business. Microwave technology and other technical developments were making it possible for smaller firms to compete with Bell in long distance service. But, so long as Bell remained under "natural monopoly" regulations, all its lines of business were interdependent and had to be regulated in complicated ways.

Deregulation 2

This led some economists to argue that, even in natural monopoly conditions, it is best to rely more on market forces and less on government. Under the influence of those economists, US natural monopolies have increasingly been "deregulated." This began with the Jimmy Carter administration (1977-80) and has been continued since by all administrations, Republican or Democratic.

Deregulation has not meant that all regulations were eliminated, but their scope has been cut back a great deal. At a minimum, the companies have had more freedom to set their own prices, while in most cases they are no longer protected from new competition.

Summary on Monopoly

Monopoly provides an important example of an exception to the "fundamental theorem of microeconomics," in that there is not enough competition to push the price down to the supply-demand level. Indeed there is only one seller.

We have seen that a profit-maximizing monopoly will

  • produce less than a comparable P-competitive industry
  • charge a higher price
  • this output restriction is inefficient
However, if there are economies of scale, P-competition may simply not be possible, and the extreme case of "natural monopoly" leaves us with a choice of the least of three evils: public ownership, regulation, or deregulation.

Other Forms of Competition

In these other three market structures, which together are often called "imperfectly competitive" structures, there may just be less competition, or there may be other forms of competition, "nonprice competition."

Nonprice competition includes

  • Advertising
    • informational
    • persuasive
  • competition in the characteristics of the good
    • quality competition
    • differentiation

Informational Advertising

In a P-competitive market, there is no advertising, because there is no need to advertise -- the firm can sell its profit-maximizing output at the market price, so why should it spend on advertising? But in the real world, advertising is a very major competitive strategy.

When the aim of the advertising is to give people information about the availability, characteristics and prices of goods, we call it "informational advertising." This sort of advertising can contribute to the effectiveness of price competition, so (in some markets) it may complement price competition and bring the market closer to the supply-and-demand outcome than it otherwise would be. All the same, like other forms of nonprice competition, economists regard informational advertising as something of a mixed bag:

  • It gives people information they might lack, which is good, but
  • It can be overdone, spending too much on advertising and driving prices up, which is not so good.

Persuasive Advertising

The purpose of persuasive advertising is to shift the utility functions of the customers, thus to shift their demand curves in favor of the good being advertised. Since we judge consumers' benefits in terms of given consumer utility functions, it is hard to say if consumers benefit or lose -- so persuasive advertising looks like spending money without making consumers any better off, and many economists regard that as a negative.

We expect that both forms of advertising will be especially common in oligopolies and whenever products are differentiated, as in monopolistic competition. Monopolies, too, may find it profitable to advertise.

Product Differentiation

Products are differentiated when the products of different companies are not perfect substitutes -- instead, "every company has a monopoly of its own product." Nevertheless, companies may compete by changing the characteristics of the product they sell. The idea is not necessarily to make a better product than the competitor, just different -- to appeal to a different "market niche."

Again, economists (on the whole) regard this form of competition as a mixed bag:

  • It increases variety, but
  • It divides up the market, leading to higher prices and costs
This form of competition is definitive of "monopolistic competition" but is also observed in many oligopolies.

Competition in Quality

In some industries, there is a very hot competition to introduce a product that is superior to rival products. This form of competition has a good reputation but may be overrated -- it lends itself to "horse races," in which only the winner gets any profit at all, and recent research indicates that these "winner take all" competitions tend to lead to overinvestment and waste of resources. (The constant upgrading of computer software may be an example). On the other hand, quality improvement makes consumers better off in an obvious and probably pretty major way, so competition in quality is at worst a mixed bag.

The Economics of Garbage in Rose Valley

While the various forms of nonprice competition each seems to be a mixed bag -- some good, some bad consequences -- many economists feel that, on the whole, more competition in all these categories tends to be better than less competition.

My experience of garbage pickup in Rose Valley, Delaware County, seems an illustration. Rose Valley was incorporated as a Borough mainly to keep city conveniences out, and has no garbage collection services, public or privatized. Three haulers serve the individual homes by contract. This oligopoly competes somewhat in price and quality of the service, and my impression is that Rose Valleyans really do get better garbage service than other communities where, public or private, there is no competition at all.