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The model of monopoly

Monopoly, as a market form, is at the opposite end of the spectrum to perfect competition. In the literal sense, a monopoly exists when one single firm or a small group of firms acting together controls the entire market supply of a good or service for which there are no close substitutes. This is a situation of pure monopoly, which like the case of perfect competition, is rarely easy to identify in reality. Moreover, whether an industry can be classed as a monopoly will depend on how narrowly the industry is defined; for example, a city underground often has a monopoly on the supply of underground travel within the city, but does not have a monopoly on all forms of public transport within the city: people can also travel by bus or overground trains.

Thus in practice, less stringent definitions than 'single producer' tend to be used and economists focus instead on the degree of monopoly power which exists rather than absolute monopoly power. A firm may be regarded as being a monopolist if it controls 25 per cent or more of the total market supply of a particular good or service.

A market concentration ratio is used to measure the degree of concentration within a particular industry or group of industries. A commonly used ratio is the five firm concentration ratio which indicates the proportion of the industry's output produced by the five largest firms.

Theory of monopoly

The monopolist's demand curve

In our analysis of perfect competition, we showed how there is a distinction between the demand curve of the individual firm and that of the market as a whole - the existence of many firms each competing against each other means that each one has no influence over price, and has to take the price that is determined in the market through the intersection of the demand and supply curves. The demand curve for each firm is therefore horizontal: an infinite amount is demanded at one price, with nothing at all being demanded at a higher price and with the charging of a lower price being inconsistent with the goal of profit maximisation.

However, under monopoly there is only one firm in the industry; thus there is no difference between the demand curve for the industryand the demand curve for the firm. As the monopolist is subject to the normal law of demand, the monopolist's demand curve will be downward sloping so that to sell more, price would have to be lowered (see figure 1). In comparison to other types of market, the monopolist's demand curve is likely to be relatively inelastic as close substitutes may not be available if price is raised. Indeed, the availability or non-availability of close substitutes is one of the key factors determining the monopolist's power in the market.

Figure 1 Monopolist's demand curve

The demand curve shown in Figure 1 presents the monopolist with a choice. The monopolist can either choose to make the price or the quantity, but cannot do both; for example, if the monopolist chooses to set a price of OP1, the market dictates that only a quantity of OQ1 could be sold; however, if the monopolist chooses to set a quantity of OQ2 to be sold, clearly the demand curve tells us that this could only be achieved at a price of OP2.

Marginal revenue and average revenue under monopoly

The table below assumes that the monopolist faces a normal demand schedule, and from this the revenue curves are derived. Try calculating the figures for total, average and marginal revenue and once you have had a go, follow the link to check your answers.

Output Price Total revenue Marginal revenue Average revenue
1 20
2 18
3 16
4 14

Total, average and marginal revenue answers

From the table two points can be seen:

a) As price has to be lowered to increase sales, marginal revenue is not equal to price as in perfect competition: the additional revenue gained from each extra sale is always less than price or average revenue, and thus the MR curve will always be below the AR curve in monopoly.

b) As price is identical to average revenue, the demand curve is also the curve relating average revenue to the quantity produced.

The information in this table can now be shown in diagrammatic form to show the relationship between the average and marginal revenue curves (figure 2).

Figure 2 Marginal and average revenue curves

Monopoly equilibrium

Like the firm in perfect competition, the monopolist will maximise profits where marginal cost = marginal revenue (MC=MR). This indicates the best or profit maximising level of output.

When the average cost and average revenue curves are related to each other, they indicate the level of profit.

Figure 3 Equating MC with MR in monopoly

Figure 3 shows that there is no level of output better than OQ for the monopolist; for example, if the monopolist decides to stop producing at OQ1, then MR would be greater than MC by the distance AB, and output could be expanded with more being added to revenue than to cost; if the monopolist decides to produce beyond OQ, say to OQ2, then MC would be greater than MR by the distance CD, with more being added to cost than to revenue, and clearly this would not be worthwhile. The best output would therefore be where MC=MR.

In Figure 4, we add the average cost and average revenue curves to the previous diagram to show the monopolist's best output and level of profit at that output.

Figure 4 Monopoly equilibrium

As in figure 3, the best level of output is at OQ where MC=MR. To find the price or average revenue, a vertical line is taken from OQ to the demand curve (the monopolist 'charges what the market will bear'), and a horizontal line is drawn across to the revenue/cost axis. The price is therefore OP or QR. The level of profit is indicated by the amount by which AR exceeds AC: AR=QR; AC=QS; so RS is the profit per unit of output, and the total supernormal profit is given by the area CPRS.

Under perfect competition, supernormal profits can only exist in the short run, as in the long run new firms are attracted into the industry and the abnormal profits are competed away as the market supply curve shifts to the right and the market price falls. However, under monopoly new firms are unable to enter the market as there are various barriers to entry which are the very source of monopoly power. Thus a single firm may remain the only supplier, and supernormal profits may persist in both the short and long run; in monopoly, there is therefore no distinction between short and long run equilibrium.

Although the existence of such long run abnormal profits implies a considerable degree of market power, the fact that the monopolist cannot control both the supply of the good and its demand means that complete control does not exist. Corporations devote an enormous amount of time, money and effort trying to mould our demand to fit in with their long term corporate plans: a situation which might be described as producer sovereignty; however, providing the demand curve is not completely inelastic, some element of consumer sovereignty will still remain.

You should note that a monopolist will always produce at a point where demand is elastic, and will achieve this by restricting output to keep price in the upper price ranges (the elasticity of demand on a straight line demand curve varies from infinity at the top left section of the curve to nought at its bottom right section).Figure 4 shows that the marginal revenue curve falls continuously as price falls, eventually becoming negative. It can be seen, however, that although the marginal cost curve falls and rises, it is always positive as there will always be some cost involved in producing any economic good. It would therefore follow that where MC=MR and the firm is in profit maximising equilibrium, MR will be positive, and where this occurs demand is always elastic.