Characteristics of monopoly
In theory a Monopoly occurs when there is only one single supplier of goods/services. This means that the firm will face no competition and therefore can set their prices without having to worry about competition undercutting this price. Although a theoretical Monopoly is when one firm owns 100% of the market share, in the UK a Monopoly is said to exist when one single firm has 25% or more of the market share. Past this point the competition commission is likely to intervene in order to prevent abusive of monopoly power.
High barriers to entry
Entry and exit barriers to monopoly market structures are high. Therefore, the problem of new entrants taking away long run supernormal profit within the market doesn’t exit. This allows the single supplier to set high prices and make large amounts of supernormal profit without the threat of new entrants.
The product that the monopoly makes is unique and therefore there are no similar products or direct substitutes that exit. As a result of this, monopolies have high levels of price making power.
There is imperfect information within the market which means that the firm may know more than the consumer and therefore are able to exploit them through extortionate prices.
The firm within a monopoly market structure produces at the point where marginal cost is equal to marginal revenue.
As shown from the diagram, the firm within a monopoly market structure operates at the profit maximization point, where marginal revenue is equal to marginal cost. This gives a price level of P1 and quantity level of Q1. Although a monopoly is able to fix the price level, they cannot fix the quantity levels. This is due to the fact that quantity is still constrained to the law of demand. Therefore, the higher price that they decide to charge, the lower the quantity demanded. As you can see from the diagram, the point of production (A) is greater than the average cost. This means that the firm makes a supernormal profit, represented by the box P1-A-B-C. Due to the high barriers to entry that exist within a monopoly, supernormal profits are maintained in the long-run. Therefore, the monopoly short-run diagram is the same as the monopoly long-run diagram.
As shown from the diagram, the single market supplier makes a supernormal profit in the long run and therefore has the potential to achieve dynamic efficiency. However, whether or not the firm does achieve this is dependent on what they decide to do with this supernormal profit. If they reinvest back into the company then they will achieve dynamic efficiency and if they don’t then they will not achieve dynamic efficiency.
Third degree price discrimination:
Third degree price discrimination occurs when a firm charges different prices for different segments of the market based on their differing price elasticities of demand. For example, in the transportation industry it is often cheaper for children to travel via bus than it is for an adult. The main reason for this is that adults are more likely to use the bus out of necessity e.g. to get to work, whereas children are more likely to use the bus out of leisure e.g. to go to the cinema. This is means that the price elasticity of demand for children is more likely to be elastic and the price elasticity of demand for adults is more likely to be inelastic. Given this, it is more profitable for the bus company to charge children lower prices and adult’s higher prices. This concept is shown on the diagram above where the average revenue and marginal revenue curve are drawn relatively inelastic for adults and relatively elastic for children. Overall, this leads to a higher price for adults (P1), and a lower price for children (P2).
Another example of third degree price discrimination is based on the differing prices for peak and off peak train travel. The peak time for trains usually occurs during the morning when people are going off to work and the evening when people are coming back from work. Therefore, their price elasticity of demand is inelastic as they are willing to pay a high price in order to get to work. On the other hand, off peak times usually occur during leisure travel times where commuting on the train is not essential. As a result of this, during off peak times consumers have a lower price elasticity of demand. This leads to peak travel being more expensive and off peak travel being cheaper.
Differences in price elasticity of demand
In order to be able to charge different segments of the market different prices, they have to have differing price elasticities of demand. If they don’t, the market segment that gets charged the higher price will have a substantially lower demand for the good/service than the market segment getting charge the lower price. This may lead to irregular sales e.g. low sales during peak travel times and lots of sales during off peak travel times, or more sales from children than adults etc. in addition to this, overall revenue is likely to decrease as prices will be set either too high or too low for that consumer groups price elasticity of demand e.g. a low price for consumers with relatively price inelastic demand.
Some degree of price making power
In order to set different prices firms must have some degree of price making power. This will be determined by the characteristics of the market structure that they operate in e.g. whether or not there are high barriers to entry.
Prevent market seepage
The firm must be able to stop the beneficiaries of the lower prices from selling their good/service at a higher price for those who have to pay extra. For example, if a child pays less for their train ticket than an adult, the train company has to prevent them from selling their tickets to adults at a higher price. One of the ways in which they do this is to print on the ticket whether it is an adult ticket or a child ticket. Therefore, a child ticket will be invalid if it is being used by an adult and doing so can also lead to a fine.
Distinguish different customer groups
In order to set different prices, firms must first identify a consumer group that may have a different price elasticity of demand from the rest. For example, adults may have a higher price elasticity of demand than children etc. This is essential due to the fact that the inability to do this may lead to the firm setting different prices for consumers with the same elasticities of demand, thus leading to a decrease in total revenue.
Costs and benefits of a monopoly to consumers and producers
Higher price and lower quantity
The main disadvantage of a monopoly is the lack of choice for consumers and the high prices that they have to pay. This can be seen on the diagram below where price level is Pm and quantity is Qm. In contrast to this, a competitive market would operate at the point of allocative efficiency which occurs at the point where marginal cost is equal to average revenue. By comparing the point of production in a monopoly market structure (MC=MR) to the point of production in a competitive market (MC=AR), the deadweight loss to the consumer can be shown (represented by the red area).
Lack of incentive for efficiency/Allocative and productive inefficiency
Due to the absence of competition, the firm within a monopoly has no incentive to work efficiently. As a result of this they don’t produce on the average cost curve. This causes wastage, increasing the price level for… Read more