Monopoly is a market structure in which one firm supplies the entire market. The product supplied has no close substitutes. The market size can be large or small.
A firm in a monopoly market structure is called a monopolist.
Because there is only one firm in the market, the firm's demand curve is the same as the market demand curve. Unlike a firm in perfect competition, a monopolist is a price maker. It decides what price at which to sell its product. It also decides what quantity to offer for sale. A monopolist has market power.
How does a monopolist set a price and quantity? It is not true that a monopolist can continually raise its prices, with each price increase necessarily increasing the monopolist’s profits.
It is also not true that a monopolist always earns a profit. A monopolist has costs just like any other firm, and must earn revenue in excess of these costs in order to earn a profit.
The demand curve faced by a monopolist is downward sloping. This means that it can only increase output if it lowers its price. It cannot lower its price only on any additional output that it wishes to sell, however. It must lower its price on all units sold, including the units that it could sell at a higher price.
The exception to this is in the case of price discrimination, which will be discussed later in this section.
If a monopolist raises its price, the downward sloping demand curve means that it will sell fewer units. By having to lower the price on all units instead of just the additional units, the marginal revenue curve lies below the demand curve. Like any firm in any market structure, profits are maximized at the quantity of output where marginal revenue (MR) is equal to marginal cost (MC). With the marginal revenue curve below the demand curve, this quantity will be lower than the profit-maximizing quantity in perfect competition. Since the monopolist sets the quantity where MR=MC, supply is determined by marginal cost.
Also, unlike perfect competition, marginal revenue is not equal to price in a monopoly. Profits are maximized at the quantity where MR=MC, but the monopolist can charge the price where this quantity intersects the demand curve. Since the demand curve lies above the marginal revenue curve, this price will be higher than what would occur under perfect competition.
Since the price is set by the demand curve, and price also equals average revenue, the average revenue curve is the demand curve.
All else equal, then, the monopolist will sell a lower quantity at a higher price than what would occur under perfect competition.
With the output quantity determined by the marginal revenue curve, and the price determined by the demand curve (which lies above the marginal revenue curve), a monopolist doesn't really have a supply curve. It has a supply point. This is because only one point in a graph factors in price, quantity, demand, and marginal revenue.
A monopolist that sells a product with an inelastic demand can set a price higher than a monopolist that sells a product with an elastic demand, all else equal. This means that a monopoly for a product that is deemed to be a necessity is of special concern to the public and to policy makers.
A monopoly exists because the barriers to entry into the market are prohibitive. These barriers prevent other firms from entering the market. Since other firms are not able to enter the market to take advantage of profit potential, it is possible for a monopolist to earn economic profits in the long run.
These barriers to entry can be divided into three general classes: natural barriers, anti-competitive behavior, and government-created monopolies.
Economies of scale would be a natural barrier that would create a monopoly. If the entire market demand can be met on the downward sloping portion of the long run average total cost curve, then one firm can supply the entire market at a lower cost than two or more competing firms could. Splitting the market between firms would mean operating at a scale with higher costs.
Economies of scale typically involve high startup costs, high fixed costs, and lower variable costs per unit of output. An example of a monopoly due to economies of scale would be a plant that generates electricity for a local market.
A monopoly created by natural barriers is called a natural monopoly.
Economies of scale can offset the efficiency gains from a perfectly competitive market, which does not allow for economies of scale. This is why the discussion about a monopolist charging a higher price for a lower quantity included the disclaimer “all else equal”.
A firm that has gained market power may engage in activities that are designed to keep competition out of the market. For example, an established firm can afford to lower its price in the short run whenever a start-up firm threatens to take over some of the market share. A start-up firm would not have the resources needed to survive if it were forced to compete with prices that are substantially lower than costs. After the competition is eliminated, the monopolist will then raise its prices again to maximize profits.
A monopolist may be able to keep out competition by buying up a key resource. If nobody else has access to a key resource, then no competition can exist. For example, if a monopolist produces a product that can only be manufactured using a specific natural resource, the monopolist may attempt to buy all the land where this resource is known to exist.
Anti-competitive behavior is generally illegal under antitrust laws. However, small local monopolies can often “fly under the radar”, and avoid government scrutiny. For example, in a small town with only one restaurant, the restaurant may lower its prices or even raise wages in order to prevent a competing restaurant from being successful. The government may not be willing to use its resources to catch all such violators.
Government action can also create monopolies. Patent laws provide monopoly protection for the owners of patents for a period of time, which in the United States is currently 17 years.
Governments can also issue licenses for certain products that guarantee a monopoly.
Governments can also contract for services in which the government is the only buyer.
Because a monopolist sells a lower quantity at a higher price, all else equal, than a firm in perfect competition, the monopoly market structure is considered to be inefficient.
Recall from the discussion of perfect competition, which is considered to be the most efficient market structure, that efficiency is defined by total surplus. Total surplus is maximized under perfect competition, and includes the entire area left of the equilibrium point lying both below the demand curve and above the supply curve.
Consumer surplus is the portion of total surplus that lies above the market price. Producer surplus is the portion of total surplus that lies below the market price.
For a monopolist, the same graph would have the marginal cost curve substitute for the supply curve. This allows for comparison of surplus between the two market structures.
The monopolist would have a higher price and lower output. The area of total surplus is lower under a monopoly than under perfect competition by the area bordered by the monopolist's price and output point, the point where this quantity intersects the marginal cost curve, and the price and output point under perfect competition.
This triangular area represents loss of total efficiency, and is called deadweight loss.
Also, the area of the remaining total surplus under monopoly that lies between the monopolist's price and the price under perfect competition represents surplus that is transferred from the consumer to the producer.
The net result is that a monopoly market structure will have a lower consumer surplus (consumers are worse off), a higher producer surplus (sellers are better off), and a lower total surplus, resulting in less efficiency.
In general, a firm cannot lower its price on some units sold without lowering its price on all units sold, even the units that it could sell at a higher price. Otherwise, the customers that pay the lower price will simply sell the product to the customers who would be charged the higher price. This would prevent the firm from making sales at the higher price.
Under certain conditions, though, a monopolist may be able to charge different prices to different customers based on willingness to pay. It could increase revenue without increasing cost, and therefore increase profit by doing so.
If the monopolist can identify different classes of buyers, with different demand curves with different elasticities, and at the same time prevent the resale of its product, it can gain by using price discrimination.
Examples of price discrimination in the real world:
Airlines charge higher prices during the times and dates when business travel is highest. Business customers have a lower price elasticity of demand than other customers.
Restaurants, theaters, and other businesses often give senior citizen discounts to a class of customers that includes many people on a smaller budget (think fixed income) than the general population.
In-state tuition, grocery coupons, and lower prices for larger (bulk) purchases are other forms of price discrimination.