Economics Online Tutor
 Monopoly
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.

Why do monopolies exist?

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.

Natural barriers

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”.

Anti-competitive behavior

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-created monopolies

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.