The word ‘Monopoly’ means “alone to sell”. Monopoly is a situation in which there is a single seller of a product which has no close substitute. Pure monopoly is never found in practice. However, in public utilities such as transport, water and electricity, we generally find a monopoly form of market.
Features of Monopoly Market
The following are the major features of the monopoly market:
(1) Single seller of the product: In a monopoly market, there is only one firm producing or supplying a product. This single firm constitutes the industry and as such there is no distinction between firm and industry in a monopolistic market. Monopoly is characterized by an absence of competition.
(2) Barriers to Entry: In a monopolistic market, there are strong barriers to entry. The barriers to entry could be economic, institutional, legal or artificial.
(3) No close-substitutes: A monopoly firm has full control over the market supply of a product or service. A monopolist is a price maker and not a price taker. The monopolist generally sells a product which has no close substitutes. In such a case, the cross elasticity of demand for the monopolist’s product and any other product is zero or very small. The price elasticity of demand for monopolist’s product is also less than one. As a result, the monopolist faces a steep downward sloping demand curve.
(4) Market power: A monopoly firm has market power i.e. it has the ability to charge a price above marginal cost and earn a positive profit.
While to some extent all goods are substitutes for one other, there may be essential characteristics in a good or group of goods which give rise to gaps in the chain of substitution. If one producer can so exclude competition that he controls the supply of a good, he can be said to be ‘monopolist’ – a single seller.
How do monopolies arise?
The fundamental cause of monopoly is barriers to entry; in effect other arms cannot enter the market. A few reasons for occurrence and continuation of monopoly are:
1) Strategic control over a scarce resources, inputs or technology by a single firm limiting the access of other firms to these resources.
2) Through developing or acquiring control over a unique product that is dificult or costly for other companies to copy.
3) Governments granting exclusive rights to produce and sell a good or a service.
4) Patents and copyrights given by the government to protect intellectual property rights and to encourage innovation.
5) Business combinations or cartels (illegal in most countries) where former competitors cooperate on pricing or market share.
6) Extremely large start-up costs even to enter the market in a modest way and requirement of extraordinarily costly and sophisticated technical know-how discourage firms from entering the market.
7) Natural monopoly arises when there are very large economies of scale. A single firm can produce the industry’s whole output at a lower unit cost than two or more firms could. It is often wasteful (for consumers and the economy) to have more than one such supplier in a region because of the high costs of duplicating the infrastructure. For e.g. telephone service, natural gas supply and electrical power distribution.
8) Enormous goodwill enjoyed by a firm for a considerably long period create difficult barriers to entry.
9) Stringent legal and regulatory requirements effectively discourage entry of new firms without being specifically prohibited.
10) Firms use various anti-competitive practices often referred to as predatory tactics, such as limit pricing or predatory pricing intended to do away with existing or potential competition.
In real life, pure monopolies are not common because monopolies are either regulated or prohibited altogether. But, one producer may dominate the supply of a good or group of goods. Earlier, in public utilities, e.g. transport, water, electricity generation etc. monopolistic markets existed so as to reap the benefits of large scale production. But these markets have been deregulated and opened to competition over a period of time. In India, Indian Railways has monopoly in rail transportation. There is government monopoly over production of nuclear power.
Monopolist’s Revenue Curves
In the absence of government intervention, a monopolist is free to set any price it desires and will usually set the price that yields the largest possible profit. Since the monopolist firm is assumed to be the only producer of a particular product, its demand curve is identical with the market demand curve for the product. The market demand curve, which exhibits the total quantity of a product that buyers will offer to buy at each price, also shows the quantity that the monopolist will be able to sell at every price that he sets. If we assume that the monopolist sets a single price and supplies all buyers who wish to purchase at that price, we can easily find his average revenue and marginal revenue curves.
Fig. 23: A monopolist’s demand curve and marginal revenue curve
Suppose the straight line in Fig. 23 is the market demand curve for a particular product ‘A’. Suppose M/s. X and Co. is the only producer of the product A so that it faces the entire market demand. The firm faces a downward sloping demand curve, because if it wants to sell more it has to reduce the price of the product.
We have tabulated hypothetical values of price and quantity in Table 6 and have computed the amounts of average, total and marginal revenue corresponding to these levels.
Table 6 Average revenue, Total revenue and Marginal revenue for a Monopolist
|Quantity sold||Average Revenue (₹) (AR = P)||Total Revenue (₹) (TR)||Marginal Revenue (₹) MR|
If the seller wishes to charge ₹ 10 he cannot sell any unit as no buyer would be willing to buy at such a high price. Alternatively, if he wishes to sell 10 units, his price cannot be higher than ₹ 5. Because the seller charges a single price for all units he sells, average revenue per unit is identical with price, and thus the market demand curve is the average revenue curve for the monopolist.
In perfect competition, average and marginal revenue are identical, but this is not the case with monopoly since the monopolist knows that if he wishes to increase his sales he will have to reduce the price of the product. Consider the example given. If the seller wishes to sell 3 units, he will have to reduce the price from ₹ 9 to ₹ 8.50. The third unit is sold for ` 8.50 only. This adds ₹ 8.50 to the firm’s revenue. But, in order to sell the 3rd unit, the firm had to lower the price of all 3 units from ₹ 9 to ₹ 8.50. It thus receives ₹ .50 less on each of the 2 units it could have sold for ₹ 9. The marginal revenue over the interval from 2 to 3 units is thus ₹ 7.50 only. Again, if he wishes to sell 4 units, he will have to reduce the price from ₹ 8.50 to ₹ 8. The marginal revenue here will be ₹ 6.50 only. It must reduce price to sell additional output. So the marginal revenue on its additional unit sold is lower than the price, because it gets less revenue for previous units as well (it has to reduce price to the same amount for all units). The relationship between AR and MR of a monopoly firm can be stated as follows:
(i) AR and MR are both negatively by sloped (downward sloping) curves.
(ii) The slope of the MR curve is twice that of the AR curve. MR curve lies half-way between the AR curve and the Y axis. i.e. it cuts the horizontal line between Y axis and AR into two equal parts.
(iii) AR cannot be zero, but MR can be zero or even negative.
Monopolies are mainly of two types: Simple monopoly where the monopolist charges uniform price from all buyers and discriminating monopoly where the monopolist charges different prices from different buyers of the same good or service. We shall look into equilibrium of a simple monopolist.
Profit maximisation in a Monopolised Market: Equilibrium of the Monopoly Firm
Firms in a perfectly competitive market are price-takers so that they are only concerned about determination of output. But this is not the case with a monopolist. A monopolist has to determine not only his output but also the price of his product. As under perfect competition, monopolists’ decisions are based on profit maximisation hypothesis. Although cost conditions, i.e. AC and MC curves, in competitive and monopoly markets are generally identical, revenue conditions differ. Since a monopolist faces a downward sloping demand curve, if he raises the price of his product, his sales will go down. On the other hand, if he wants to increase his sales volume, he will have to be content with lower price. A monopolist will try to reach the level of output at which profits are maximum i.e. he will try to attain the equilibrium level of output. Since firm and industry are identical in a monopoly setting equilibrium of the monopoly firm signifies equilibrium of the industry. We shall discuss how a monopoly firm decides its output and price in the short run and in the long run.
Short run Equilibrium
Conditions for equilibrium: The twin conditions for equilibrium in a monopoly market are the same as that of a firm in a competitive industry. Graphically, we can depict these conditions in figure 24.
Fig. 24: Equilibrium of a monopolist (Short run)
The figure shows that MC curve cuts MR curve at E. That means, at E, the equilibrium output is OQ. The ordinate EQ extended to the demand curve (AR curve) gives the profit maximising equilibrium price OP. Thus the determination of output simultaneously determines the price which a monopolist can charge.
In order to know whether the monopolist is making profits or losses in the short run, we need to introduce the average total cost curve. The following gure shows two possibilities for a monopolist firm in the short run.
Fig. 25: Firm’s equilibrium under monopoly: Maximisation of profits
Figure 25 shows that MC cuts MR at E to give equilibrium output as OQ. At OQ, the price charged is OP. At output level OQ, the price per unit is QA (=OP) and the cost per unit is BQ. Therefore, the economic profit per unit given by AR – ATC is AB (AQ-BQ). The total profit is ABCP.
Can a monopolist incur losses? One of the misconceptions about a monopoly firm is that it makes profits at all times. It is to be noted that there is no certainty that a monopolist will always earn an economic or supernormal profit. It all depends upon his demand and cost conditions. If a monopolist faces a very low demand for his product and the cost conditions are such that ATC >AR, he will not be making profits, rather, he will incur losses. Figure 26 depicts this position.
Fig. 26: Equilibrium of the monopolist: Losses in the short run
In the above figure, MC cuts MR at E. Here E is the point of loss minimisation. At E, the equilibrium output is OQ and the equilibrium price is OP. The average total cost (SATC) corresponding to OQ is QA. Cost per unit of output i.e. QA is greater than revenue per unit which is BQ. Thus, the monopolist incurs losses to the extent of AB per unit or total loss is ABPC. Whether the monopolist stays in business in the short run depends upon whether he meets his average variable cost or not. If he covers his average variable cost and at least a part of fixed cost, he will not shut down because he contributes something towards fixed costs which are already incurred. If he is unable to meet his average variable cost even, he will shutdown.
Long Run Equilibrium: Long run is a period long enough to allow the monopolist to adjust his plant size or to use his existing plant at any level that maximizes his profit. In the absence of competition, the monopolist need not produce at the optimal level. He can produce at a sub-optimal scale also. In other words, he need not reach the minimum of LAC curve; he can stop at any point on the LAC where his profits are maximum.
Fig. 27: Long run equilibrium of a monopolist
However, one thing is certain, the monopolist will not continue if he makes losses in the long run. He will continue to make super normal profits even in the long run as entry of outside firms is blocked.