Monopoly and High Barriers to Entry

  1. Defining Monopoly
    1. Monopoly is a market structure characterized by:
      1. High Barriers to Entry
      2. A Single seller of a well-defined product for which there are no close substitutes.
    2. Three Factors are particularly important in creating high barriers to entry:
      1. Legal Barriers
        1. Patents--Government grants an exclusive right to use a specific process or produce a specific product for a period of time.
        2. License--Process by which one obtains permission from the government to enter a specific occupation or business.
        3. Legal Prohibition
      2. Economies of Scale--if per unit costs decline as the scale of the firm increases, then small scale firms will effectively be prevented from entering the industry.
      3. Control over Essential Resource--If a single firm has control over an essential resource it can eliminate competition by denying competitors access to the resource. This effectively limits entry into an industry.
        1. DeBeers
        2. Alcoa
  2. The Monopoly Model
    1. Marginal Revenue is Less than Selling Price

      For the monopolist, market demand and firm demand are the same. This occurs because the monopolist is the only seller of the product; he or she must lower the sales price if additional sales are wanted (provided market demand is downward sloping).

      Example: Take the following demand curve for Beers/Day

      $ Price Quantity Demanded Total Revenue Marginal Revenue
      8 2 $16 -
      7 3 $21 $5
      6 4 $24 $3
      5 5 $25 $1
      4 6 $24 -$1
      3 7 $21 -$3
      2 8 $16 -$5
      1 9 $9 -$7
      8 0 $0 -$9

    2. The marginal revenue curve of the monopolist will lie inside the firms demand curve.
    3. Like the pure competitor, the monopolist will expand output until marginal revenue equals marginal cost. The price it charges will be determined by the market demand curve.
    4. A monopolist is not assured of making economic profits.
  3. Price Discrimination

    Price discrimination is a practice whereby a seller charges different prices to different consumers of the same product or service. The difference in price is unrelated to differences in cost.

    1. For price discrimination of exist, three conditions must be met:
      1. The firm must confront a downward sloping demand curve for its product. (Seller need not be a pure monopolist to price discriminate.)
      2. There must be at least 2 identifiable groups of consumers whose price elasticities of demand for the firm's product differ.
      3. The seller must be able to prevent the consumer from reselling the product to other consumers.
    2. Winners and Losers
      1. Output will be higher with price discrimination than it would be without it.
      2. It tends to reduce allocative inefficiency.
      3. Because it increases the profits of the monopolist, it may enable a monopolist to remain in business.
  4. Problems of Monopoly
    1. Since Adam Smith's time (1776) monopoly has been considered a necessary evil. There are several reasons for this.
      1. Monopoly tends to limit options available to consumers.
      2. Monopoly results in allocative inefficiency--in other words, the monopoly price is higher than the marginal cost of production.
      3. Profits do not encourage entry into the industry. Hence, monopoly firms are not subject to the usual discipline inherent in competitive industries.
      4. When the government grants monopoly, rent seeking is encouraged.
    2. When can monopoly be made competitive?
      1. When economies of scale are unimportant a monopolized industry can be broken up and economic efficiency increased.
      2. In the absence of natural monopoly, competitive firms produce more and charge lower prices.
    3. If Economies of Scale ARE Important, larger firms will have lower unit costs than smaller firms.
  5. Policy Alternatives to Natural Monopoly
    1. It may be possible to regulate the monopolist in order to increase economic efficiency.
      1. Average Cost Pricing--Force monopolist to charge a price equal to ATC (productive efficiency)
      2. Marginal Cost Pricing--Force monopolist to charge a price equal to MC (Allocative efficiency). Requires a subsidy since monopolist incurs losses under this strategy.
    2. Why regulation goes astray.
      1. Lack of information--regulators have difficulty in determining what prices to impose. They don't know what the firm's costs are or what the demand for the product is.
      2. Cost shifting--little incentive for managers to contain costs under so-called "fair rate of return" regulation. Firms have an incentive to conceal costs from the regulators and to take profits in disguised forms.
      3. During inflations or periods of price instability, price information is inaccurate.
      4. Quality may suffer (or be too high).
      5. Special interest effect
    3. Government managed firm
      1. Decision-makers have little incentive to control costs.
      2. Mangers and employees of the bureaucracy often comprise a special interest group.
  6. Dynamic Change, Monopoly Power, and Resource Allocation
    1. Even the monopolist is not completely free from competitive forces. Charging exorbitant prices will encourage the development of substitutes.
    2. Monopolists may actually charge prices that are below those consistent with short-run profit maximization in order to discourage entry into the industry.
    3. The expectation of being able to form a monopoly may encourage product development.


Return to Notes Page

This page was last modified Tuesday, February 25, 1997.