A Reason for a Monopoly - Essay Example

?Monopoly is a market where there is one firm catering to a large number of buyers. The firm sells a product which is unique and has no close substitutes. Monopoly markets have prohibitively high entry costs. The firm sets its price and quantities to maximize profits. Since to sell more units of its product the firm has to lower its prices, the firm faces a downward sloping demand curve (Ison & Stuart, 2006). Since each additional unit sells only at a lower price, the marginal revenue curve lies below the average revenue curve or the demand curve. The maximization of profits by a monopolist is shown in the diagram below. The necessary condition is that the marginal cost equals the marginal revenue and the sufficient condition is that the marginal cost curve has a greater slope than the marginal revenue curve at the intersection (Koutsoyiannis, 1975). Observe since the equilibrium price is higher than the average cost of production the equilibrium output, the monopolist makes a profit. This profit is shown as the shaded region in the diagram. Figure 1:Monopolist's equilibrium A typical reason for monopoly to occur is increasing returns to scale. If a particular firm has increasing returns to scale in any particular commodity, it has a natural advantage over any other firms in that market. This situation is known as natural monopoly. Monopoly can also occur through government regulation. There can be particular sectors in the economy that government run institutions run. Private entrepreneurship is not allowed. It may also be these industries require so high overhead costs private producers can’t afford it. The biggest disadvantage of monopoly is that it leads to exploitation of consumers. Particularly, this is true if the monopolist uses price discrimination to extract the entire consumers’ surplus. However, as first argued by Schumpeter (1950), the monopolist’s extraction of surplus is essential for economic growth. In competitive markets, the producers have to be content with zero profits. Investment returns are normal. Consequentially, the firm cannot invest in research and development which drives technological growth and innovation. However, since the monopolist is able to derive a surplus, it can invest this in research and development funds to attain technological competence. This is crucial for the monopolist or other big firms in order to retain their status as market leaders. And typically, technological innovation is what drives economic growth since it enables the resources of the economy to become more productive thereby breaking free of capacity constraints (Varian, 2006). Therefore, an economy can have benefits as well as damages if a monopolist is in charge of a particular market. Monopolistic competition however is a market which combines features of Monopoly as well as perfect competition. Monopolistic competition is a market comprising of numerous buyers and sellers. However, unlike perfect competition, here products are differentiated. Every seller thus is a monopolist for his own product (Ison & Stuart, 2006). The producers now are not mere price takers. They simultaneously set price and quantity to maximize prices. However, entry is costless and therefore as long as there are positive profits, new firms enter the industry. As a result, monopolistically competitive firms can only earn zero profits in the long run equilibrium (Varian, 2006). Typically, monopolistically competitive markets are what we observe the most in the real world (Koutsoyiannis, 1975). Markets start off with very few producers, but attracted by profits new firms enter. As competition intensifies, firms try to differentiate their products through advertising or introducing new varieties. The biggest advantage of monopolistic competition is that firms offer horizontally as well as vertically differentiated products and this results in better matches with consumer preferences. In the long run, there are no barriers to entering or exiting the market. As long as firms make supernormal profits, new firms may enter and reduce prices as well as increase factor demands and thus average costs through pushing up the factor prices. Thus in the long run, monopolistically competitive producers make only normal profits or zero profits (Ison & Stuart, 2006). In the short run however, there can be positive profits. The monopolistically competitive producers short run equilibrium is similar to the equilibrium of the monopolist. The necessary and sufficient conditions to maximize profits are the same. That is, at the optimal output and price combination, marginal costs equal marginal revenue and the marginal cost curve has a greater slope compared to the marginal revenue curve. So in the diagram, the MC curve intersects the MR curve from below. The long run equilibrium for a firm under monopolistic competition is however unique. As is shown in the diagram below, the long run equilibrium is characterized by a tangency of the market demand curve the firm faces with its long run average cost curve at the profit maximizing level of output. This ensures zero profits in the long run. Figure 2: LR equilibrium in monopolistic competition There are numerous firms in every Monopolistically Competitive group of products and numerous firms prepared to enter the market waiting on the side line (Ison & Stuart, 2006). The existence of numerous firms essentially allows each monopolistically competitive firm freedom to set individual quantities and prices without having to engage in strategic or inter-firm dependent decisions. This is true since there are numerous firms; each firm's individual actions have negligibly small impacts on the entire market. As a result, a firm operating in a monopolistically competitive industry could lower its prices and thereby enhance sales and not worry about possible retaliation from rivals is it would have worry under oligopoly markets (Koutsoyiannis, 1975). However, if a firm reduces its prices below average costs, the firm will make losses. Although this would increase its sales marginally compared to the aggregate sales of the market, other firms will not respond (Varian, 2006). This is shown in the diagram below. The firm charges a price that is lower than its average cost and as a result makes losses. The magnitude of the losses is shown in as the shaded area. Figure 3: Monopolistically Competitive firm charging price lower than average cost P1 is the lowered price and Q1 is the resulting amount sold. The average cost of producing Q1 is greater than the price charged. As a result, the firm makes losses. The loss is quantified as the output times the difference between the average cost of producing the output and the price charged. Since the firm makes losses, it cannot sustain this behavior in the long run. In the long run it will either have to charge price P* which is its profit maximizing price and make zero profits, or shutdown. Note that the firm will be indifferent between shutting down and zero profits as long as there are no fixed costs involved. If it has to pay fixed costs, then the firm will be strictly better off staying in the market and earning zero profits, since it will have to keep on paying fixed costs even if it shuts down. The firm can off course feasibly choose to sell of the plant and exit the market entirely. In that case the firm will not have to bear the fixed costs. Now consider the response from another firm competing in the same industry when this firm lowers its prices. The firm will know that its rival cannot sustain a price below its average costs. And therefore it will not deviate from its profit maximizing price-output combination (Varian, 2006). The number of firms in the long run depends upon how many firms the market structure can support in equilibrium. Factors such as the extent of product differentiation, fixed costs as well as scale economies all influence the number of firms that can be sustained in the equilibrium. Greater degrees of differentiation as well as higher fixed cost correspond to lower number of firms being operational in the long run equilibrium. On the other hand substantial scale economies will increase the number of firms that operate (Ison & Stuart, 2006). There are two sources of inefficiencies in the Monopolistically Competitive markets. First, the price at which profits are maximized are greater than the marginal costs. This results from the fact that due to product differentiation, the monopolistically competitive firm has some degree of market power. In figure 2, this is reflected by the fact that the firm faces a negatively sloped demand curve. Secondly, the output produced is less than the average cost minimizing output which is socially optimal. This is particularly obvious when a comparison is made between perfect competitive markets, which are socially optimal and monopolistically competitive markets which are not (Koutsoyiannis, 1975). This is shown in the diagram below. Figure 4: Comparing Monopolistically competitive and perfectly competitive long run equilibrium price and quantity In the diagram above, P_C represents the perfectly competitive price and Q_C represents the perfectly competitive output. Note that this is the level of output which minimizes the average cost and the price charged is equal to the minimum average cost. Evidently the price charged under monopolistically competitive market, P* is greater than P_C and the output under monopolistic competition Q* is lower than Q_C. An additional point to note is that since Q* is less than Q_C, this reflects that there is underutilized productive capacity for the firm under monopolistically competitive markets. That is to say, the firm produces at an output level where there are still increasing returns present. This is very similar to the situation of monopoly. However, the crucial point to note is that although monopolistically competitive markets are relatively inefficient compared to perfectly competitive markets, they are more efficient compared to monopoly. Further, since there are numerous substitutes available under monopolistically competitive markets, the market demands are relatively elastic. As a result, the price does not lie very high above the marginal cost. That is, the distance between the price and marginal cost is relatively small compared to monopoly (Varian, 2006). On the other hand, monopolistically competitive markets are characterized by the presence of a very large number of varieties of the same product which benefits the consumers. This benefit is missing from perfectly competitive markets. Therefore, while government intervention may be beneficial on the net for overall welfare, it may actually reduce welfare under monopolistically competitive markets since the improvement will not be very high. Taking away market power from monopolistically competitive producers will imply a forced perfectly competitive market with identical products. This may on the whole reduce the representative consumer’s as well as producer’s welfare. So, to conclude, we see that a Monopolistically Competitive market is a hybrid between a Monopoly and a Perfectly Competitive industry. While, like perfect competition, there are numerous buyers and sellers products are differentiated like a monopoly. Each individual seller is a monopolist for its particular variant of the product. The presence of numerous buyers and sellers implies each individual seller holds an insignificant share of the market, and so there is no strategic interdependence like oligopoly. However, because of product differentiation, the firm faces a downward sloping demand curve and the marginal revenue curve lies below the demand curve. Consequentially, the price charged in long run equilibrium is greater than the marginal cost of producing that output. This creates a source of inefficiency. Further, the output is lower than the average cost minimizing level. This is another source of inefficiency. However, since there are numerous substitutes available, the difference between price and marginal costs for the equilibrium output is not substantial enough to require government intervention. Because in its own a monopolistically competitive industry leads to a very high count of varieties of the same products available which enhances the welfare of the consumers, government intervention may result in reduced welfare on the net. References: Ison, S & Stuart Wall (2006) “Economics”, 4th edition, Prentice Hall Varian, H (2006) “Intermediate microeconomics: a modern approach”, 6th edition, AIPI Koutsoyiannis, A (1975) “Modern microeconomics”, WiIley Schumpeter, J A (1950) “Capitalism, Socialism and Democracy”, 3rd ed, New York: Harper-Collins. Read More