Monopoly is a type of market where there is only one firm (monopolist) that supplies the good. The firm is very large, and has control of the market price (has a lot of market power).
Sources of Market Power
A monopoly has market power (the ability to set the prices higher than the marginal cost) because it has no competitors. Consumers have to either buy from the monopolist, or not have the good at all. As a result, there will be demand for the good even if the price is set high.
To maintain its market power, a monopolist has to avoid having competitions; once it has competitors, customers will no longer be willing to buy the highly-priced goods that it supplies. But how can it prevent competitors? High barriers to entry:
- Economic barriers: economies of scale, superior technologies, and large initial investments are all things that benefit the existing firm, allowing it to produce more efficiently.
- Legal barriers: patents and copy rights ensure that the monopolist is the only firm producing a good. Property rights may grant one firm the exclusive access to a certain resource.
How does a monopolist maximize its profit? Well, obviously the monopolist is best off with a quantity where MC=MR, since that's the profit maximization point for any firm. However, how does MC relate to the market demand, and at what price should the firm sell its good at? Well, let's look at a graph for a monopoly:
Notice that the MR curve is different from the demand curve; it has a steeper slope. This is because that in order for the firm to sell more units, it must lower the prices. So even though total revenue goes up, the additional revenue for the most recent unit is lower; to sell that extra unit, the firm has had to lower the price of all the other units, thus the additional revenue is decreased.
Anyway, as mentioned just earlier, the monopolist is best off producing at the quantity where MC=MR. And, looking at the graph, we can see that at that quantity, the monopolist can charge as much as Pm, where the quantity meets the demand! Also, since the price is higher than the average cost curve, the firm is making positive economic profit.
Inefficiency of Monopoly
A monopoly is allocatively inefficient, since P>MC. There is a deadweight loss, which is the area of the triangle formed by the quantity, the marginal cost curve, and the demand curve.
Price Discrimination
Price discrimination means to charge different consumers differently, to try to charge each customer as much as possible.
First degree price discrimination, or perfect price discrimination, occurs when a firm varies the price of a good such that every consumer buys it at the maximize price that they are willing to pay. When this happens, the MC curve is no longer steeper than the demand curve and will instead become the same as the demand curve. This is because that to sell one extra unit, the monopolist no longer has to decrease the price for everyone customer; it can simply sell the most recent unit for a slightly lower price.
Natural Monopoly
A natural monopoly exists when it is most efficient for all the good to be supplied by one single firm. This is usually true for industries that have high fixed costs and low marginal costs, so that when output is very large, there can be economies of scale. Examples include the telecommunications and the electricity industry.
