Economic Analysis

Module 5. Concepts of market

Lesson 21
MONOPOLY

21.1 Introduction

If a firm can appreciably affect the market price of its output, the firm is classified as an “imperfect competitor.” Imperfect Competition prevails in an industry whenever individual sellers have some measure of control over the price of their output. Imperfect competition does not imply that a firm has absolute control over the price of its product.

21.2 Different Kinds of Imperfect Competition

The major kinds of imperfect competition are monopoly, oligopoly, and monopolistic competition. We shall see that for a given technology, prices are higher and outputs are lower under imperfect competition than under perfect competition. But imperfect competitors have virtues along with these vices. Large firms exploit economies of large-scale production and are responsible for much of the innovation that propels long-term economic growth. If you understand how imperfectly competitive markets work, you will have a much deeper understanding of modern industrial economies.

Fig. 21.1 Firm's demand curve under perfect and imperfect competition

The perfectly competitive firm can sell all it wants along its horizontal dd curve without depressing the market price. (b) But the imperfect competitor will find that its demand curve slopes downward as higher price drives sales down. And unless it is a sheltered monopolist, a cut in its rivals’ prices will appreciably shift its own demand curve leftward to d ¢ d ¢ .

We can also see the difference between perfect and imperfect competition in terms of price elasticity. For a perfect competition, demand is perfectly elastic; for an imperfect competitor, demand has a finite elasticity.

21.3 Monopoly

Monopoly is a single seller with complete control over an industry. It is the only firm producing in its industry, and there is no industry, and there is no industry producing a close substitute. Most monopolies persist because of some form of government regulation or protection. For example, a pharmaceutical company that discovers a new wonder drug may be granted a patent, which gives it monopoly control over that drug for a number of years. In such cases there is truly a single seller of a service with no close substitutes. A natural monopoly is a market in which the industry’s output can be efficiently produced only by a single firm. This occurs when the technology exhibits economies of scale over a range of output that is as large as the entire demand.

True monopolists are rare today. Most monopolies persist because of some form of government regulation or protection. For example, a pharmaceutical company that discovers a new wonder drug may be granted a patent, which gives it monopoly control over that drug for a number of years. But even monopolists must always be looking over their shoulders for potential competitors. The pharmaceutical company will find that a rival will produce a similar drug; telephone companies that were monopolists a decade ago now must reckon with cellular telephones. In the long run, no monopoly is completely secure from attack by competitors.

Fig. 21.2 Market structure under natural monopoly

When costs falls rapidly and indefinitely, as in the case of monopoly, one firm can expand in order to monopolize the industry.

Some important examples of natural monopolies are the local distribution in telephone, electricity, gas, and water as well as long-distance links in railroads, highways, and electrical transmission. Many of the most important natural monopolies are “network industries”. Similar trends in other markets, such as cable TV, are occurring as competitors invade them into hotly contested oligopolies. Technological advances, however, can undermine natural monopolies.

A final important case is natural monopoly. A natural monopoly is a market in which the industry’s output can be efficiently produced only by a single firm. This occurs when the technology exhibits economies of scale over a range of output that is as large as the entire demand. Fig. 2 shows the cost curves of a natural monopolist. The technology has perpetual increasing returns to scale, and average and marginal costs therefore fall forever. As output grows, the firm can charge lower and lower prices and still make a profit, since its average cost is falling. So peaceful competitive coexistence of thousands of perfect competitors will be quite impossible because one large firm is so much more efficient than a collection of small firms.

Some important examples of natural monopolies are the local distribution in telephone, electricity, gas, and water as well as long-distance links in railroads, highways, and electrical transmission. Many of the most important natural monopolies are “network industries”. Technological advances however can undermine natural monopolies. Most of the U.S. population is now served by two cellular telephone networks, which use radio waves instead of wires and are undermining the demand for landline telephone services. Similar trends in other markets, such as cable TV, are occurring as competitors invade these natural monopolies and are turning them into hotly contested oligopolies.

21.4 Barriers to Entry

Although cost differences are the most important factor behind market structure, barriers to entry can also prevent effective competition. Barriers to entry are factors that make it hard for new firms to enter an industry. When barriers are high, an industry may have few firms and limited pressure to compete. Economies of scale act as one common type of barrier to entry, but there are others, including legal restrictions, high cost of entry, advertising, and product differentiation.

21.5 Legal Restrictions

Governments sometimes restrict competition in certain industries. Important legal restrictions include patents, entry restrictions, and foreign-trade tariffs and quotas. A patent is granted to an inventor to allow temporary exclusive use of the product or process that is patented. For example, pharmaceutical companies are often granted valuable patents on new drags in which they have invested hundreds of millions of research and development dollars. Patents are one of the few forms of government-granted monopolies that are generally approved of by economists. Government grant patent monopoly patent protection, a company or a sole inventor might be unwilling to devote time and resource to devote time and resources to research and development. The temporarily high monopoly price and the resulting inefficiency is the price society pays for the invention.

Government also impose entry restrictions on many industries. Typically, utilities, such as telephone, electricity distribution, and water, are given franchise monopolies to serve an area. In these cases, the firm gets an exclusive right to provide a service, and in return the firm agrees to limit its profits and provide universal service in its region even when some customers might be unprofitable.

Historians who study the traffic have written, “The tariff is the mother of trusts.” This is because government-imposed imposed import restrictions have the effect of keeping out foreign competitors. It could be very well be that a single country’s market for a product is only big enough to support two or three firms in an industry, while the world market is big enough to support a large no of firms. Then a protectionist policy might change the industry structure. When markets are broadened by abolishing tariffs in a large free-trade area, vigorous and effective competition is encouraged and monopolies tend to lose their power. One of the most dramatic example of increased competition has come in the European Union , which has lowered tariff among member countries steadily over the last three decades and has benefited from larger markets for firms and lower concentration of industry.

21.6 High Cost of Entry

In addition to legally imposed barriers to entry , there are economic barriers as well. In some industries the price of entry simply may be very high. Take the commercial-aircraft industry, for example. The high cost of designing testing new airplanes serves to discourage potential entrants into the market. It is likely that only two companies – Boeing and Airbus – can afford the $10 to $15 billion that the next generation of aircraft will cost to develop.

In addition, companies build up intangible forms of investment, and such investments might be very expensive for any potential new entrant to match. Consider the software industry. Once a spreadsheet program or a word-processing program ( MS Word) has achieved wide acceptability, potential competitors find it difficult to make inroads into the market. Users, having learned one program, are reluctant to switch to another. Consequently, in order to get people to try a new program, any potential entrant will need to run a big promotional campaign, which would be expensive and may still result in failure to produce a profitable product.

21.7 Advertising and Product Differentiation

Sometimes it is possible for companies to create barriers to entry for potential rivals by using advertising and product differentiation. Advertising can create product awareness and loyalty to well-known brands. For example, Pepsi and Coca-Cola spend hundreds of millions of dollars per year advertising their brands, which makes it very expansive for any potential rivals to enter the cola market.

In addition, product differentiation can impose a barrier to entry and increase the market power of producers. In many industries- such as breakfast cereals, automobiles, household appliances, and cigarettes- it is common for a small number of manufacturers to produce a vast array of different brands, models, and products. In part, the variety appeals to the widest range of consumers. But the enormous number of differentiated products also serves to discourage potentials competitors. The demands for each of the individual differentiated products will be so small that they will not be able to support a large number of firms operating at the bottom of their U-shaped cost curves. The result is that perfect competition’s DD curve contracts so far to the left that it becomes like the demand curves of oligopoly or monopoly. Hence, differentiation, like tariff, produces greater concentration and more imperfect concentration and more imperfect competition.

21.8 Price Discrimination

Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets , where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However, product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to customers which have different supply costs.

21.8.1 Types of price discrimination

a) First degree price discrimination

In first degree price discrimination , price varies by customer's willingness or ability to pay. This arises from the fact that the value of goods is subjective. A customer with low price elasticity is less deterred by a higher price than a customer with high price elasticity of demand. This type of price discrimination is primarily theoretical because it requires the seller of a good or service to know the absolute maximum price that every consumer is willing to pay.

b) Second degree price discrimination

In second degree price discrimination , price varies according to quantity sold. Larger quantities are available at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts.

c) Third degree price discrimination

In third degree price discrimination , price varies by attributes such as location or by customer segment, or in the most extreme case, by the individual customer's identity; where the attribute in question is used as a proxy for ability or willingness to pay.

The purpose of price discrimination is generally to capture the market's consumer surplus. This surplus arises because, in a market with a single clearing price, some customers (the very low price elasticity segment) would have been prepared to pay more than the single market price. Price discrimination transfers some of this surplus from the consumer to the producer/marketer. Strictly, a consumer surplus need not exist, for example where some below-cost selling is beneficial due to fixed costs or economies of scale. An example is a high-speed internet connection shared by two consumers in a single building; if one is willing to pay less than half the cost, and the other willing to make up the rest but not to pay the entire cost, then price discrimination is necessary for the purchase to take place.

It can be proved mathematically that a firm facing a downward sloping demand curve that is convex to the origin will always obtain higher revenues under price discrimination than under a single price strategy. This can also be shown diagrammatically.

In the Fig. 3(A), a single price (P) is available to all customers. The amount of revenue is represented by area P, A, Q, O. The consumer surplus is the area above line segment P, A but below the demand curve (D).

With price discrimination, (Fig. 3(B)), the demand curve is divided into two segments (D1 and D2). A higher price (P1) is charged to the low elasticity segment, and a lower price (P2) is charged to the high elasticity segment. The total revenue from the first segment is equal to the area P1, B, Q1, O. The total revenue from the second segment is equal to the area E, C, Q2, Q1. The sum of these areas will always be greater than the area without discrimination assuming the demand curve resembles a rectangular hyperbola with unitary elasticity. The more prices that are introduced, the greater the sum of the revenue areas, and the more of the consumer surplus is captured by the producer.

Fig. 21.3 Sales revenue without and with Price Discrimination