Monopoly

An effective monopoly must be able to exclude competitors from the market through barriers to entry. However, the closer the substitutes that competitors can produce, and the more elastic the demand curve facing the firm, the weaker the monopoly position. A monopoly is strongest when it produces an essential good for which there are no substitutes. Monopoly is likely to exist under the following circumstances:

Economies of scale. ……………………………………………………………………

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Public utility industries ……………………………………………………………….

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Other government-created monopolies. ………………………………………………………………

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Control of raw materials and market outlets ……………………………………….

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Advertising as a barrier to entry ……………………………………………………..

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Monopoly Equilibrium

Despite the likelihood of economies of scale in conditions of monopoly, for the time being we shall assume that we are investigating an industry with no economies or diseconomies of scale. It follows from this assumption that the lowest long-run average costs which a firm can achieve will be the same in conditions of perfect competition and monopoly. Nevertheless, the revenue curves will be different in the two market forms. Since the monopoly is the industry the monopolist’s demand curve and the industry demand curve are identical. There are two ways of looking at this. If we regard the monopolist as a price-maker, then when he sets the price he must be a quantity-taker. Alternatively, if the monopolist acts as a quantity-setter the demand curve determines the maximum price the monopolist can charge in order successfully to sell the chosen quantity. This is an example of a trade-off, an important economic concept which is closely related to opportunity cost. A problem of choice exists because the monopolist does not possess the freedom to set both price and quantity: if he acts as a price-maker, the demand curve determines the maximum output he can sell and vice versa.

Since the demand curve shows the price the monopolist charges for each level of output, it is also the monopolist’s average revenue curve. The demand curve is not the marginal revenue curve which must be below the average revenue curve.

The equilibrium output in conditions of monopoly is determined at point A, where MC = MR. It is worth repeating that the equilibrium condition MC = MR applies to any firm, whatever the market structure, as long as the firm is a profit-maximiser. You must avoid the temptation to read off the equilibrium price at point A: point B on the AR curve locates the monopolist’s equilibrium price.

 

As in the case of short-run equilibrium under perfect competition, the monopolist makes abnormal profits, represented by the shaded area. However, the existence of barriers to entry allows the abnormal profits to persist into the long run, whereas in perfect competition abnormal profits are essentially temporary.

 

Economic Efficiency

Some of the meanings which economists attach to the word efficiency:

Productive efficiency. This is often called technical efficiency, although in fact the two concepts are slightly different. Production is technically efficient when output is maximised from a given set of inputs (or when the inputs needed to produce a given level of output are minimised). To achieve productive efficiency, or cost efficiency, a firm must use the techniques which are available at the lowest possible cost. Productive efficiency is measured by the lowest point on a firm’s average cost curve.

Allocative efficiency. This rather abstract concept is of crucial importance to the understanding of economic efficiency. Allocative efficiency occurs when marginal cost is equated to price in all the industries in the economy. If all industries are perfectly competitive and if equilibrium prices prevail, allocative efficiency will automatically occur. In perfect competition P = MC. The price, P, indicates the value in consumption placed by buyers on an extra unit of output. At the same time, MC measures the value in production of the resources needed to produce the extra unit of output. Suppose P > MC, as is the case in monopoly: households will pay for an extra unit an amount greater than the cost of producing it. At this price the good will be under consumed. If in contrast P < MC, the value (P) placed on the last unit of the good by consumers will be less than the cost (MC) of the resources used to produce the extra unit. At this price the good will be overconsumed. Whenever P > MC or P < MC, allocative inefficiency will occur. For any given employment of resources, total consumer utility or welfare can be increased if resources are shifted out of industries where P < MC and into those where P > MC, until a state of allocative efficiency (P = MC) exists in all industries.