monopoly

Author: Louie Vogt
 * Monopoly Market Structure**

In economics, market structure describes the state of a market with respect to competition. From a managerial standpoint the practical application of market structure theory helps depict the factors that influence decision making including the number of firms competing in a market, the size of the firms, geographic market reach of a firm, demand conditions and the ease with which firms can enter or exit the industry. Market structure also drives competitive behavior and helps predict industry profitability. Ultimately market structure facilitates corporate and business level strategic decision making; particularly market entry or exit, vertical/horizontal integration, product scope, output, pricing, positioning and advertising and other forms of driving demand.

In its simplest form, a monopoly is a firm that is the sole producer of a good or service in a relevant market. Conceptually, where there is a single provider of a good or service, a firm has leverage in optimizing pricing and output quantities based on their marginal revenues and costs. Monopolies have similar characteristics:
 * __Concentration – single firm__
 * __High barriers to entry__
 * __No substitutes__
 * __Imperfect availability of information__

Monopoly power is often misinterpreted and misunderstood. High monopoly power does not guarantee high profitability. The most relevant consideration is whether there are firms selling close substitutes for a good or service in a given market. For example, a gas station located in a region where there does not exist another gas station for hundreds of miles is a monopolist in that respective region. The reason is because there is a single firm selling a product with no close substitutes.

There are 4 primary sources of monopoly power – one or more of these sources create a barrier to entry that prevents other firms from entering and competing.
 * __Economies of scale__ – exist whenever long-run average costs decline as output increases
 * __Economies of scope__ – exist when the total cost of producing two products within the same firm is lower than when the products are produced by separate firms
 * __Cost complementarities__ – exist when the marginal cost of producing one output is reduced when the output of another product is increased
 * __Patents and legal barriers__ – government may grant an individual or a firm a monopoly right or a patent may protect a new product or service for a given period of time

A monopolist does not have unlimited power, however. Although a monopolist is able to charge any price for the product, that does not mean the firm can sell as much as it wants at that price – ultimately consumers still control demand. This is because of the downward sloping demand curve and the principles of price and quantity demanded. Consumers will choose the price/quantity combination that meets their needs, or they may decide not to purchase anything at all. However, unlike perfect competition a monopolist may earn positive economic profits.


 * Maximizing Profits**

Marginal revenue is the change in total revenue attributable to the last unit of output; geometrically it is the slope of the total revenue curve. The relationship between marginal revenue and elasticity of demand can be described graphically (below). Recall that a linear demand curve is elastic at high prices and inelastic at low prices. The demand curve is elastic until marginal revenue equals zero, at which point it becomes unitary elastic (point Q0). Beyond this point, the demand becomes inelastic. The effect on total revenue is on the graph with the vertical axis labeled Ro = revenue. Revenue is maximized when marginal revenue equals zero. At any point before, the demand is elastic and there is revenue left to be earned in the market. At any point past, the demand is inelastic and a firm is losing money by increasing output. Revenues are one element in the profit function, costs are the other. The marginal revenue for a monopolist lies exactly half-way between the demand curve and the vertical axis. The reason marginal revenue is less than demand is because in order for a monopolist to sell more units, it must lower its price. Hence, marginal revenue is declining for each incremental unit of output. Where marginal revenue exceeds marginal cost, an increase in output will increase total revenue. When marginal costs exceed marginal revenue, a monopolist is better served by producing less output. The profit maximizing output is the point where marginal revenue equals marginal costs -- anything before that point leaves money on the table; anything after is costing more to make a unit of output than they can sell it for. The graph below highlights the point where profits are maximized (MR = MC). In this situation, the firm should produce Qm units for a price of Pm to maximize profits. The area marked by the diagonal lines is the quantity of profits, where price is greater than average total costs [Pm - ATC(Qm)] x Qm. You'll notice that there is no supply curve on this graph. That is because a monopolist determines how much to produce based on marginal revenue, which is less than price (P > MR = MC). The monopoly power a firm enjoys often signals a social cost to society. Since price exceeds marginal cost, a main insight that one can conclude is that monopolies tend to produce less output and charge more for it than would a benchmark perfectly competitive industry and that this type of equilibrium leads to a deadweight loss. The diagram below illustrates the loss of both producer surplus (B) and consumer surplus (A) resulting from the monopolists profit maximizing decision to produce less output and charge a higher price than would be the case under perfect competition. Essentially society would be willing to pay more for one more unit of output than it would cost to produce the unit, yet the monopolist won't produce the unit because it would reduce the firm's profitability.
 * Deadweight Loss of Monopoly**
 * Multiple Choice Questions:**

a. Produce outputs at the level of demand b. Produce outputs at the point where marginal revenue equals marginal cost c. Produce outputs at the point where marginal revenue is greatest relative to marginal cost
 * 1. Profit maximizing monopolists should:**

The answer is: b. If marginal revenue is greater than marginal costs, producing another unit of output would increase revenues more than it would increase costs. Conversely if marginal costs are greater than marginal revenue, producing one unit less of output would decrease costs more than it would decrease revenue. A profit maximizing manager is thus motivated to produce output where marginal revenue = marginal costs a. Is a characteristic of all market structures to some degree
 * 2. Deadweight loss reflects the welfare loss to society and:**

b. Can be minimized when marginal revenue equals marginal cost c. Is symptomatic of a monopoly market structure

The answer is: c. Society is willing to pay more for one more unit of output than it costs a firm to produce. Yet the monopolist refuses to produce the unit because it will decrease his/her profitability. a. Profits are maximized when demand is elastic b. Profits are maximized when demand is inelastic
 * 3. Profits and Elasticity of demand**

c. Profits are maximized when demand is unitary elastic

The answer is: c. When demand is unitary elastic, marginal revenue equals zero. If marginal revenue is positive, the firm would benefit by producing another unit of output. Conversely if marginal revenue is negative, the firm would benefit by producing one unit less. a. Slope of the total revenue curve b. Slope of the demand curve c.Slope of the average total cost curve
 * 4. Marginal revenue is geometrically equivalent to:**

The answer is: a.

a. Coca-Cola b. Delta Airlines c. Corn d. Utility Company
 * 5. Which of the following best represents a monopoly:**

The answer is: d. Utility companies are government regulated and there are really no close substitutes. There are hundreds of utility companies in the world, but the companies do not compete against one another for customers.


 * Answers:**

1. b 2. c 3. c 4. a 5. d


 * References:**

Skeath, Susan; Velenchik, Ann; Nichols, Len; and Case, Karl. Consistent Comparisons Between Monopoly and Perfect Competition. //Journal of Economic Education//. Summer 1992; p.255-261.

Grant, Robert. Contemporary Strategy Analysis, eight edition. Blackwell Publishing. MA. 2008. p. 337-342.

Baye, Michael. Managerial Economics and Business Strategy, fifth edition. McGraw-Hill/Irwin Publishing. 2006. p. 280-296.

http://en.wikipedia.org/wiki/Monopoly