1.4.4 Monopoly and monopoly power

AS: 3.1.4 Competitive and concentrated markets

Y1: 4.1.5 Perfect competition, imperfectly competitive markets and monopoly

What is the objective of a player in the game of monopoly?

What percentage of the board do you think you need to own to realistically win the game?

How many major players do you think there are in:• The supermarket industry• Banking• UK rail travel• Soft drinks industry?

1.4.4 MONOPOLY AND MONOPOLY POWER

The difference between pure monopoly and monopoly power

Monopoly power is influenced by factors such as barriers to entry, the number of competitors, advertising and the degree of product differentiation

Concentration ratios and how to calculate concentration ratios

The basic model of monopoly suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market

The potential benefits from monopoly, for example, economies of scale and possibly more invention and innovation

You should appreciate that there are few examples of pure monopoly but many firms have monopoly power

A formal diagrammatic analysis of monopoly is not required but you should be able to use a demand curve to illustrate that if a monopolist raises the market price above the competitive level, output will fall

You should also be able to use a long-run average cost curve to illustrate the benefits from economies of scale that may result from monopoly

You should appreciate the various factors which affect the behaviour and performance of firms in a variety of real-world markets

MONOPOLY - CHARACTERISTICS

A monopolist:

Is the only firm in the industry. Therefore, the firm is the industry

This means that the firm’s demand curve and the market demand curve are the same

The demand curve is also the average revenue curve

Aims to profit maximise

Makes supernormal profits as it produces where AR is greater than AC

Is a price maker i.e. it sets the price in the market

Barriers to entry stop other firms entering the industry

Monopoly can be seen as the opposite of perfect competition

The key characteristics are that there is only one firm in the industry and there is no entry into the market by other firms.

A pure monopoly has only one firm in the industry.

In the UK a monopoly is classed as any firm with 25% market share and a dominant monopoly as one with 40% market share.

MONOPOLY AND MARKET POWER

A monopoly occurs when there is only one producer in an industry

This provides the monopolist with market power leading to higher prices and supernormal profits

There will be allocative inefficiency and a misallocation of resources

Therefore, a monopoly is an example of market failure

A monopoly exists where there is only

one firm in the market. However,

the Government refer to any company that

has at least 25% market share as having monopoly

powers.

Market power is the ability of a firm to set price above marginal

cost.

Monopolies can exploit consumers by charging high prices.

Therefore, monopolies are

regulated in order to protect the customer.

How can monopolies use their power to exploit the customer? What role do governments play in regulating monopolies?

SOURCES OF MONOPOLY POWER

Sources of monopoly power are the factors that allow a firm to control price and output in a market

These sources protect the firm in the industry and lead to different behaviour by firms under conditions of monopoly and oligopoly than under that of perfect competition

The monopolist has an inelastic price elasticity of demand allowing it to set higher prices

There are no close substitutes for the monopolist’s product so consumers have no choice in where they buy from

Monopoly power exists in different market structures

The greater the degree of competition the less likely is a firm to have monopoly power

BARRIERS TO ENTRY

Barriers to entry exist in monopoly markets. These stop firms from entering the market

They include:

High costs to enter the market, especially high capital costs

Economies of scale experienced by large firms e.g. bulk buying

Intellectual property rights/legal barriers – patents, trademark and copyright restrict other firms from producing a good or service

Unfair competition e.g. predatory pricing attempting to force competitors out of a market e.g. selling products below cost price for a time period

Government regulation restricting firms from entering a market e.g. giving sole rights to one supplier

Barriers to entry are any factors that

stop a firm from entering a market. Some markets will have high barriers to entry e.g. the

cost of research and

development in hi-tech industries.

Can you identify an example of each of these

barriers to entry operating in UK

industries?

THE NUMBER OF COMPETITORS

The degree of concentration

within a market is the number of

firms that dominate the

market.

The degree of concentration within a market refers to the number of firms that dominate the market:

1. Monopoly – one firm dominates the market

2. Duopoly – two firms dominate the market

3. Oligopoly – a small number of firms are in the industry

4. Monopolistic Competition – many firms compete in the industry selling differentiated products

5. Perfect competition – many firms in the industry with no influence on market price

MONOPOLY DUOPOLY OLIGOPOLY MONOPOLISTICCOMPETITION

PERFECTCOMPETITION

THE NUMBER OF COMPETITORS

Monopoly ensures that there are no other firms in the market

This means that the monopolist can set both the price and the output of their product

In oligopoly there are only a few firms in the market, each firm is interdependent of each other

The concentration ratio tells us the number of firms that dominate the market

For example 3:75 means that 3 firms have 75% market share

Less competition enables the firm to behave more like a monopoly

How would you describe the UK energy market?

ADVERTISING

Firms invest heavily in advertising their products in order to create awareness and deter new entrants into the market

Advertising is in effect a form of product differentiation as it changes the perception of the product in the eyes of the consumer

Advertising will increase fixed costs and therefore increase the scale of production at which a firm needs to operate profitably

Effective advertising will lead to an increase in the level of profit for a monopolist

How effective is advertising in deterring new entrants and achieving product differentiation?

THE DEGREE OF PRODUCT DIFFERENTIATION

Product differentiation provides a competitive advantage to a firm and ensures a degree of monopoly power

Product differentiation includes:

Quality features that competitors’ products do not have

Functional and design features that competitors’ products do not have

Imperfect information where consumers are more aware of one firm’s products over those of the competition

Advertising creating perceived differences in the mind of the consumer

Location, where the product can only be bought geographically through one supplier

Product differentiation occurs

when firms try to make their product

different to the competition by

adapting the actual product in some way or by distinguishing the product through

advertising and branding.

This helps to provide a Unique Selling Point

(USP) - something that distinguishes the

product of one firm from those of its

competitors.

ADVANTAGES OF MONOPOLY

Economies of scale mean that monopolies can force down unit costs becoming more productively efficient

These lower costs can be passed on to the benefit of society

They have large research and development budgets allowing for the development of new products that can benefit society:

This creates dynamic efficiency as innovation leads to better processes lowering the LRAC curve further

Better quality products can be developed as monopolies can invest without the threat of competitors

This can lead to product invention and product innovation

Natural monopolies occur when it would be too expensive for a number of competing firms to provide the same product e.g. water and gas provision to households

In some cases no firms would supply the infrastructure for a market due to high costs so the government intervene

Product invention occurs when an

original product or process is created.

Product innovation occurs when a

product or process that already exists is

adapted.

Natural monopolies exist where the

nature of the industry means that there

would be high productive

inefficiency if more than one firm

supplied the product e.g. the water

industry.

PURE MONOPOLY

Costs

Output

LRAC

A pure monopoly is often highly regulated by the government as there is no competition. Consumer exploitation might occur if the industry was left to its own devices.

In conditions of pure monopoly we see continual returns to scale. This leads to an L-shaped LRAC curve where average costs are always falling.

This will give a firm the incentive to keep increasing the scale of production to reduce average costs further.

This leads to highly significant barriers to entry.

DISADVANTAGES OF MONOPOLY

A monopolist:

Removes competition due to barriers to entry

Makes supernormal profits in the long run by charging higher prices than would occur under competitive markets

This leads to the consumer being exploited

Is productively inefficient as it does not produce at the lowest point on its LRAC curve

Is allocatively inefficient as it does not produce at the point where P = MC

Is x-inefficient as no competition means less incentive to control costs

Can reduce choice and quality as there is no competition

A MARKET DEMAND CURVE SHOWING THE EFFECT ON PRICE

OF PRODUCING A LOWER OUTPUT

In a pure monopoly there is only one

supplier. Therefore, demand for the

monopolist's products is the demand for the whole of the market.

As the monopolist reduces output price

will increase. As it does not have to worry about the competition, the monopolist can

choose the price that will maximise profits.

Here, we can see that P1Q1 provides greater

total revenue than PQ.

Price

Quantity

D

P1

Q1

P

Q

The monopolist prices its product at P. At this point output is Q.

By reducing output to Q1 the monopolist is able to increase price to P1.

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TEST YOURSELF

1. With the use of a diagram explain how a monopoly can use its power to maximise profits?

2. State and briefly explain two barriers to entry.

3. What is meant by the term natural monopoly?