Introduction

Definition:

Pure monopoly exists when there is only one firm in an industry producing a unique product ( there are no close substitues).

Characteristics of Monopoly:

• There is only one firm in the industry.
• No close substitutes for the firm's product.
• The firm is a "price maker," it can control price by limiting supply
• There is no entry into the industry by other firms.
• A monopolist may or may not engage in nonprice competition, depending on the nature of its product; advertising may be done to increase demand.

Examples of monopoly include Public utilities (gas, electric, water, cable TV, and local telephone service companies), companies that control natural resources such as the DeBeers diamond syndicate which controls 70 percent of world's diamond supply, and professional sports leagues grant team monopolies to cities. There are also local monopolies that may be geographic such as a rural town with one gas station. In the United States monopolies produce about 5% of total output.

 

Reasons for Monopoly

1. Economies of scale are one cause of monopoly. In this case one large firm can produce at a significantly lower cost per unit than several small firms. Because large scale production is so efficient it is impossible for new firms start up. Public utilities are examples of such natural monopolies. The government usually grants one firm the right to operate a public utility in exchange for government regulation of its power.

2. Legal barriers to entry into a monopolistic industry also exist in the form of patents and licenses. Patents grant the inventor the exclusive right to produce or license a product for seventeen years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits. Licenses are another form of entry barrier. Radio and TV stations, taxi companies are examples of government granting licenses where only one or a few firms are allowed to offer the service.

3. Ownership or control of essential resources is another barrier to entry. Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication. International Nickel Co. of Canada controlled about 90 percent of the world's nickel reserves, and DeBeers of South Africa controls most of world's diamond supplies. Professional sports leagues control player contracts and leases on major city stadiums. Monopolists may use pricing or other strategic barriers such as advertising or excess capacity to dissuade firms from entering the industry.

Note:

Barriers to entry are rarely complete and often can be circumvented.
Monopolies may or may not be desirable-it depends on the impact on consumers and the economy.

Model

Since a monopoly means there is only one firm in the industry, the firm faces the industry or market demand curve which is downward sloping. This implies that price will always be greater than marginal revenue. This is because the monopolist has to lower price to increase sales. Since the monopolist must lower the price of all the units sold and not just the marginal unit the change in revenue will be the price of the last unit minus any reduction in price of the previous units.

 

The marginal-revenue curve is below the demand curve, and when it becomes negative, the total-revenue curve turns downward as total-revenue falls.

The monopolist is a price maker. The firm controls output and price but is not free of market forces, since the combination of output and price that can be sold depends on demand.

Price elasticity also plays a role in monopoly price setting. The total revenue test shows that the monopolist will avoid the inelastic segment of its demand schedule. As long as demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inelastic. At this point, total revenue falls as output expands, and since total costs rise with output, profits will decline as demand becomes inelastic. Therefore, the monopolist will expand output only in the elastic portion of its demand curve.