What’s it: a monopoly is a market structure with only one seller and serving many buyers. The seller is called a monopolist.
Unlike in perfectly competitive markets, the monopolist has absolute control over market supply and prices.
Since there is only one company, individual supply is the same as the market supply. Likewise, the demand faced by the monopolist is effectively the same as market demand.
Monopolists maintain their dominance over time for several reasons. First, it is because of government policy.
Second, it is because of the low threat of new entrants due to the high barriers to entry.
Third, the monopolist does not face the threat of substitution.
Let’s discuss them one by one.
Monopoly vs. perfect competition
Monopoly is the extreme pole for market structure. It is the opposite of perfect competition.
Compared to perfect competition, the quantity sold by the monopolist is usually smaller. Therefore, the monopolist can charge a price higher than the price charged by firms in perfect competition.
A monopolist is a price maker, while a perfectly competitive firm is a price taker. As a price taker, the company only takes the market price as the selling price of its products.
Since the monopolist is the only seller of the product in the market, it does not have to worry about competitors. It can increase the price of a product without worrying about the actions of other competitors, the threat of substitution, or the threat of new entrants.
Conversely, in a perfectly competitive market, if the company unilaterally increases its price, it will only lose market share. Consumers immediately turn to competitors.
Examples of monopolies vary between countries. But, usually, it is for strategic industries such as electricity, telecommunication, and utilities.
A monopoly is a viable option for such an industry. Fixed costs are significant, so to achieve economies of scale and lower selling prices, the market needs only one firm.
In Indonesia, examples of monopolists are:
- PT Perusahaan Listrik Negara (PLN) in the electricity industry
- PT Kereta Api Indonesia (Persero) in the railway industry
- PT Pindad in the military products industry
In the United States, examples are:
- Carnegie Steel Company
- Standard Oil Company
- American Tobacco Company
In India, examples are:
- Indian Railway Catering and Tourism Corporation (IRCTC)
- Hindustan Aeronautics India Limited (HAL)
We can recognize the features of monopoly competition from various aspects, including:
- The number of sellers and buyers
- Barriers to entry
- Threats of substitution
- Firm market power.
Ok, the following are the characteristics of a monopoly:
- The market consists of one producer. Firm supply is the same as the market supply. Therefore, price and quantity depend on the monopolist’s strategy.
- Barriers to entry are high. It may come from economies of scale, regulatory constraints, or control of scarce resources. As a result, the threat from newcomers is low.
- The market has no substitutions. Consumers have no alternative products to buy.
- The monopolist has absolute market power. That’s because the company is the sole producer and doesn’t face threats from new entrants and product substitutions.
- The monopolist is the price maker. The company determines the market price for the products it sells.
- The monopolist has the power to discriminate against prices. Companies can set different prices to different consumers for the same product. It may be based on the buyer’s reservation price, purchase volume, or other aspects.
Causes of monopoly
The next question is how monopoly came about. There are various arguments for why monopoly power emerged, including:
- Control over critical and scarce production sources. For example, a diamond mining company.
- Legal barriers. Patents, copyrights, and licenses grant monopolistic rights to their owners to commercialize within a certain period. During that period, no one else may use or copy it.
- Economies of scale. A large company has significant economies of scale and can calm lower prices than its smaller competitors. It can set prices so low, at which competitors cannot compete and are forced to exit the market. The low price also acts as an entry barrier for new entrants.
- Network effect. An example is the Windows computer operating system by Microsoft. Many people use it. They become more familiar and challenging to switch to alternative products such as Linux. Various companies also use it. They don’t need to train employees because everyone knows how to use it.
- Authorization by the government. The government only allows one company to operate in the market as in most cases the natural monopoly in the electricity and railway industry.
- Non-price differentiation. That leads to the power of pricing. Companies produce unique and superior products, making consumers unwilling to switch to substitute products.
Profit maximization under a monopoly market
The monopolist faces a downward-sloped demand curve. Meanwhile, it does not have a well-defined supply function to determine optimal prices and output. Instead, it is determined by the entire demand curve it faces.
To maximize profit, the monopolist will produce at the quantity point where marginal revenue equals marginal cost. And, profit is not affected by changes in quantity.
Say the firm produces lower output where marginal revenue is higher than marginal cost. In this case, the company can get a higher profit by increasing output.
What is a natural monopoly? A natural monopoly is when costs fall if the market comprises fewer players, even just one firm. It happens because of significant fixed costs.
Thus, companies need higher economies of scale to lower average costs and selling prices. The higher the quantity sold, the lower the average cost.
If two or more companies operate, each must share market share and output. It is not sufficient to achieve higher economies of scale because of lower output, resulting in higher average costs.
For this reason, the government only allows one company to operate in the market. To avoid abuse of market power and avoid detrimental behavior for consumers, the government then regulates it, for example, by setting a limit on selling prices.
Price discrimination in the monopoly market
Because it has absolute market power, the monopolist will maximize its profits by discriminating against prices. Companies charge different prices to different consumers for the same product.
Three alternatives to price discrimination:
- First-degree price discrimination or perfect price discrimination. The monopolist sets the price according to the reservation price of each consumer, that is, the price they are willing and able to pay. In this case, the monopolist converts all consumer surplus into producer surplus.
- Second-degree price discrimination. The monopolist sets the price differently according to the volume purchased by each consumer. Purchase volume indicates whether the consumer highly appreciates the product or not.
- Third-degree price discrimination. The monopolist differentiates prices based on aspects other than reservation price and sales volume. It may be based on geographic variables or other characteristics.
Advantages and disadvantages of monopoly
In some cases, monopoly is desirable for several reasons, including:
First, it is essential to finance large-scale research and development projects. Companies can use their economic profit to innovate as a way to maintain dominance in the long run.
Second, the price of the product is lower. As in the case of natural monopolies, one firm can achieve higher economies of scale. The monopolist can produce at a low average cost, which cannot be achieved if two or more firms operate. It should also be supported by greater efficiency and innovation.
However, monopoly is also undesirable for several reasons:
Abuse of market power. The monopolist can produce a low quantity of output, of poor quality but sell it at a high price. There is no pressure to do so unless it is regulated by the government. If that happens, it only benefits the company and harms consumers.
Converting consumer surplus. By discriminating against prices, the monopolist converts the consumer surplus into its own.
That way, the total surplus will equal the producer surplus. But that’s hard to do in the real world.
X-inefficiency. Monopolists are reluctant to set prices at minimum average cost because there is no incentive to do so. I mean, there is no regulation or competitive pressure to force it to achieve minimum average costs.
Rent-seeking. The monopolist seeks to dominate and incurs costs such as lobbying and law to defend its privileges.