BE/U4 Topic 7 Pricing under Monopoly
A market can be structured differently depending on the characteristics of competition within that market. At one extreme is perfect competition. In a perfectly competitive market, there are many producers and consumers, no barriers to enter and exit the market, perfectly homogeneous goods, perfect information, and well-defined property rights. This produces a system in which no individual economic actor can affect the price of a good – in other words, producers are price takers that can choose how much to produce, but not the price at which they can sell their output. In reality there are few industries that are truly perfectly competitive, but some come very close. For example, commodity markets (such as coal or copper) typically have many buyers and multiple sellers. There are few differences in quality between providers so goods can be easily substituted, and the goods are simple enough that both buyers and sellers have full information about the transaction. It is unlikely that a copper producer could raise their prices above the market rate and still find a buyer for their product, so sellers are price takers.
A monopoly, on the other hand, exists when there is only one producer and many consumers. Monopolies are characterized by a lack of economic competition to produce the good or service and a lack of viable substitute goods. As a result, the single producer has control over the price of a good – in other words, the producer is a price maker that can determine the price level by deciding what quantity of a good to produce. Public utility companies tend to be monopolies. In the case of electricity distribution, for example, the cost to put up power lines is so high it is inefficient to have more than one provider. There are no good substitutes for electricity delivery so consumers have few options. If the electricity distributor decided to raise their prices it is likely that most consumers would continue to purchase electricity, so the seller is a price maker.
Sources of Monopoly Power
Monopoly power comes from markets that have high barriers to entry. This can be caused by a variety of factors:
- Increasing returns to scale over a large range of production
- High capital requirements or large research and development costs
- Production requires control over natural resources
- Legal or regulatory barriers to entry
- The presence of a network externality – that is, the use of a product by a person increases the value of that product for other people
Monopoly vs. Perfect Competition
Monopoly and perfect competition mark the two extremes of market structures, but there are some similarities between firms in a perfectly competitive market and monopoly firms. Both face the same cost and production functions, and both seek to maximize profit. The shutdown decisions are the same, and both are assumed to have perfectly competitive factors markets.
However, there are several key distinctions. In a perfectly competitive market, price equals marginal cost and firms earn an economic profit of zero. In a monopoly, the price is set above marginal cost and the firm earns a positive economic profit. Perfect competition produces an equilibrium in which the price and quantity of a good is economically efficient. Monopolies produce an equilibrium at which the price of a good is higher, and the quantity lower, than is economically efficient. For this reason, governments often seek to regulate.
Price and output under a pure monopoly
- A monopolist can take market demand as its own demand curve
- The firm is a price maker but it cannot charge a price that the consumers will not bear
- A monopolist has market power which is the power to raise price above marginal cost without fear of losing supernormal profits to new entrants to a market
- In this sense, price elasticity of demand acts as a constraint on the pricing-power of the monopolist
- Assuming that the monopolist aims to maximise profits (where MR=MC), we establish a short run price and output equilibrium as shown in the diagram below