THEORY OF MONOPOLY

A monopoly is a market structure where only one supplier of goods and services exist n the market.

A monopoly is characterized by the following:

1. Single supplier of a good: in a monopoly, there is only one supplier of goods in the market. In essence, the monopolist is the sole supplier in the industry.

2. The monopolist faces no competition: The monopolist firm is the industry, hence he faces no competition for his goods as they are no close substitutes for his goods.

3. Monopolist is a price searcher (price setter, price maker): The monopolist has market power because there are no close substitutes for his goods. He can increase his price above marginal cost.

4. Characterized by high barriers to entry and exit:  in a monopoly, it is very difficult to enter the market. As you would learn in this post, this barrier to entry keeps new firms from entering the market.

PRODUCTION DECISIONS IN MONOPOLY

Monopoly, as previously asserted, is a market structure where there is one supplier in a market.

As a result, the single firm has some form of control over price. In simple words, the monopolist is a price searcher

Like every other profit-maximizing firm, a monopoly will produce at the output where marginal cost equals marginal revenue.

For a perfectly competitive firm, the profit-maximizing output is where P=MR=MC. However, this is not exactly true for a monopolist

Why? 

The demand curve of a monopoly is different from its marginal revenue.

In a monopoly market, there is only one supplier in the market. In effect, the supplier's demand curve is the market demand curve. 

And as everyone knows, market demand curves are usually downward-sloping. Therefore, a monopolist demand curve is downward sloping.

A downward-sloping demand curve indicates an inverse relationship between price and quantity. 

So, this means the monopolist will have to reduce his price to sell an additional unit of his goods. 

What this means for marginal revenue is that: while the firm is earning additional revenue from selling additional units, it will be also losing some marginal revenue due to a reduction in the price of other units.

Therefore, at all output(apart from the first unit), the price received by a monopoly will be greater than its marginal revenue.

Because the price received by a monopoly is greater than its marginal revenue, the marginal revenue curve will always lie below the demand curve.

Remember, the demand curve relates price to the quantity and marginal revenue relates to marginal revenue to quantity.

Thus, the profit-maximizing point of a monopoly is the point where marginal revenue equals marginal cost(P>MR=MC), as opposed to a perfect competition where P=MR=MC

This is illustrated below.


The output where marginal revenue equals marginal cost may not necessarily be the profit-maximizing output, rather it might be the loss-minimizing output. 

The intuition for this is simple: 

If the price is greater than the average total cost, then the output where marginal revenue greater than marginal cost will be the profit-maximizing output. This is illustrated below.


If the price is lesser than the average total cost, then the output where MR=MC will be the loss-minimizing output.


But, why would a monopoly firm earn economic loss if it has market power?

A monopolist, without any doubt, is a price maker(price searcher), which means, he possess market power to raise price above marginal cost.

A monopolist's price-making power, is, however, restricted by his demand curve. This is because he can only fix prices as high as his demand curve allows him to charge. 

If the highest price allows by the demand curve is lesser than the average total cost, then the monopoly firm will be making a loss. 

Another reason why a monopolist earns an economic profit is that the revenue-maximizing point is not always the profit-maximizing point.

INEFFICIENCY IN MONOPOLY

A monopoly is a market structure that is less efficient and generates less surplus than perfect competition.

This is because the monopoly firm does not face any competition when producing goods or services.

Hence, he has incentives to charge high prices and produces less output.

This would mean the monopolist may not be allocatively efficient.

Allocative efficiency is a social concept that refers to producing the output most wanted by the consumer. 

It refers to producing at the socially optimum output, where price equals marginal cost.

Monopolists are not allocatively efficient. This is because the price received by a monopolist is usually greater than its marginal revenue. 

And you know that a profit-maximizing monopolist will produce the output where MR=MC. 

Therefore monopolists are not allocatively efficient as they would be producing at the point where the price is greater than marginal cost even at the equilibrium.

A monopoly also creates a deadweight loss by not supplying at the point where price equals marginal cost.

Deadweight loss or the loss of economic efficiency occurs when goods are not priced at their Pareto-optimum. 

Deadweight loss exists because consumers are paying higher prices than they would have paid in perfect competition.

Producers too are also losing surplus too, as they are not selling as much as they would have if it was perfect competition. Remember, you can only gain a surplus if you sell.

Therefore, we can say that less surplus and efficiency are achieved in a monopoly market structure than perfect competition. 

Price discriminating monopoly

So far, we have assumed that the monopoly sells all units of its product for a single price.

Monopoly, however, does price discriminate. Price discrimination occurs when a monopoly charges different prices for identical goods due to reasons not related to the cost of production.

In price discrimination, the monopoly split up its output and sell it at different prices to different buyers.

Just like everything else, price discrimination has its advantage and disadvantages.

Perfect Price discrimination helps monopolist increase their profit by converting consumer surplus into producer surplus. From a standpoint of welfare, this is disadvantageous to the consumer.

As an example, let's take a look at the accompanying diagram.


In the above figure, at the profit-maximizing output, the total revenue of a single-price monopoly is $3\times 40=120$ and the total cost is $3\times45=135$ and the company is sustaining a loss of $15$. 

However, if the monopoly decides to sell the goods at the price the consumer was willing to pay(Perfect price discrimination), then the total revenue would be $60+50+40=150$ and the firm will be earning a profit of $15$

So, the monopoly will effectively convert consumer surplus into producer surplus if it perfectly prices discriminated.

Another advantage of perfect price discrimination is that it results in an improvement of allocative efficiency.

Remember, allocative efficiency, in a specific sense, means producing where price equals marginal cost.

A perfect price discriminating monopolist, unlike its single-priced counterpart, does not lower its price to sell additional units of its product. 

Hence, marginal revenue(unit change in revenue) would be the same as its price.

If price equals marginal revenue, then the perfect price discriminating firm is allocatively efficient. 

Remember that a profit-maximizing firm will produce where marginal cost equals marginal revenue(which, in this case, equals price).

Related posts

That is all we got for now. For a recap, here are ten things you must remember about monopoly

1. A Monopoly firm is a price taker.

2. The first unit is the only unit where the price received by a monopolist will be the same as its marginal revenue

3. A perfect-price discriminating monopoly is allocatively efficient

4. A single-price monopoly is not allocative efficient.

5. High barrier to entry exists in a monopoly.

6. Even with market power, Monopoly does earn economic losses.

7. Deadweight loss is a feature of monopoly.

8. The point where Marginal revenue equals Marginal cost would be the loss-minimizing point if the average cost is greater than the price.

9. The demand curve faced by a monopolist is downward sloping.

10. In theory, monopoly faces no competition.

In this next post, we will be a contrasting monopoly and perfect competition.

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