Monopoly

This article is about the state of a player in economics. For the Parker Brothers board game see Monopoly (game).

In economics, a monopoly (from the Latin word monopolium - Greek language monos, one + polein, to sell) is defined as a persistent market situation where there is only one provider of a kind of product or service. Monopolies are characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods.

Monopoly should be distinguished from monopsony, in which there is only one buyer of the product or service; it should also, strictly, be distinguished from the (similar) phenomenon of a cartel. In a monopoly a single firm is the sole provider of a product or service; in a cartel a centralized institution is set up to partially coordinate the actions of several independent providers (which is a form of oligopoly).

Forms of monopoly

Monopolies are often distinguished based on the circumstances under which they arise; the broadest distinction is between monopolies that are the result of government intervention and those that arise without it e.g. sole access to a resource, economies of scale, or consistently outcompeting all other firms.

Legal monopoly

A form of coercive monopoly based on laws explicitly preventing competition is a legal monopoly or de jure monopoly. When such a monopoly is granted to a private party, it is a government-granted monopoly; when it is operated by government itself, it is a government monopoly or state monopoly. A government monopoly may exist at different levels (eg just for one region or locality); a state monopoly is specifically operated by a national government.

An example of a monopoly is AT&T, which was granted monopoly power by the US government, only to be broken up in 1982 following a Sherman Antitrust suit.

Efficiency monopoly

An efficiency monopoly exists when a firm is satisfying consumer demand so well that profitable competition is extremely challenging. It is not the result of government granted privilege, subsidies, regulations, etc. To maintain its monopoly position it must make pricing and production decisions knowing that if prices are too high or quality is too low that competition may arise from another firm that can better serve the market. It is often described as a situation where a firm is able to keep production and supply costs lower than any other possible competitor so that it can charge a lower price than others and still be profitable. Since potential competitors cannot match the monopoly's efficiency, they are not able to charge a lower, or comparable, price and still be profitable.

Natural monopoly

Main article: Natural monopoly

In economics, an industry is said to be a natural monopoly if one firm in that industry can produce a desired output at a lower cost than two or more firms. Unlike in the ordinary understanding of a monopoly, a natural monopoly situation does not mean that only one firm exists. Rather it is the assertion about an industry, that multiple firms providing a good or service is less efficient than would be the case if a single firm provided a good or service. There may, or may not be, a single supplier in a natural monopoly industry.

It was historically theorized that the necessary condition of natural monopoly was high fixed costs of entering an industry which causes long run average costs to decline as output expands (economies of scale). However, in the 1960's James Bonbright showed that a natural monopoly can result even when increased output results in increases in average cost. The newer theory is that the sufficient and necessary condition of natural monopoly is cost subadditivity, which means that that the production costs of one firm serving an entire market are less than multiple suppliers each serving a portion of the market

Another less often used definition of natural monopoly, is an industry in which only one firm is able to survive, even in the absence of legal regulations or "predatory" measures by the monopolist. These two different meanings are a source of some ambiguity and confusion in discussions of "natural monopoly."

Local monopoly

A local monopoly is a monopoly of a market in a particular area, usually a town or even a smaller locality: the term is used to differentiate a monopoly that is geographically limited within a country, as the default assumption is that a monopoly covers the entire industry in a given country. This may include the ability to charge (to some extent) monopoly pricing, for example in the case of the only gas station on an expressway rest stop, which will serve a certain number of motorists who lack fuel to reach the next station and must pay whatever is charged.

Coercive monopoly

Main article: coercive monopoly

A coercive monopoly is one where a firm is able to make pricing and production decisions independent of competitive forces because all potential competition is prevented from entering the market, whether via coercion applied by the monopolist or by some external actor. Some, particularly Libertarians, maintain that this state can only be achieved by government intervention.

Horizontal versus vertical monopoly

Large corporations often attempt to monopolize markets through horizontal integration, in which a parent company consolidates control over several small, seemingly diverse companies (sometimes even using different branding to create the illusion of marketplace competition). Such a monopoly is known as a horizontal monopoly. A magazine publishing firm, for example, might publish many different magazines on many different subjects, but it would still be considered to engage in monopolistic practices if the intent of doing this was to control the entire magazine-reader market, and prevent the emergence of competitors.

A monopoly arrived at through vertical integration is called a vertical monopoly. A common example is vertical integration of electricity distribution with electricity generation, which is common because it reduces or eliminates certain costly risks.

Economic analysis

Primary characteristics of a monopoly

Single Sellers

A pure monopoly is an industry in which a single firm is the sole producer of a good or the sole provider of a service. This is usually caused by a blocked entry.

No Close Substitutes

The product or service is unique in ways which go beyond brand identity, and cannot be easily replaced (a monopoly on water from a certain spring, sold under a certain brand name, is not a true monopoly; neither is Coca-Cola, even though it is differentiated from its competition in flavor).

Price Maker

In a pure monopoly a single firm controls the total supply of the whole industry and is able to exert a significant degree of control over the price, by changing the quantity supplied (an example of this would be the situation of viagra before competing drugs emerged). In subtotal monopolies (for example diamonds or petroleum at present) a single organization controls enough of the supply that even if it limits the quantity, or raises prices, the other suppliers will be unable to make up the difference and take significant amounts of market share.

Blocked Entry

The reason a pure monopolist has no competitors is that certain barriers keep would-be competitors from entering the market. Depending upon the form of the monopoly these barriers can be economic, technological, legal (basic patents on certain drugs), or of some other type of barrier that completely prevents other firms from entering the market.

Price setting for unregulated monopolies

In economics a company is said to have monopoly power if it faces a downward sloping demand curve (see supply and demand). This is in contrast to a price taker that faces a horizontal demand curve. A price taker cannot choose the price that they sell at, since if they set it above the equilibrium price, they will sell none, and if they set it below the equilibrium price, they will have an infinite number of buyers (and be making less money than they could if they sold at the equilibrium price). In contrast, a business with monopoly power can choose the price they want to sell at. If they set it higher, they sell less. If they set it lower, they sell more.

In most real markets with claims, it is in demand associated with a price increase is due partly to losing customers to other sellers and partly to customers who are no longer willing or able to buy the product. In a pure monopoly market, only the latter effect is at work, and so, particularly for inflexible commodities such as medical care, the drop in units sold as prices moment rise may be much less dramatic than one might expect.

If a monopoly can only set one price it will set it where marginal cost (MC) equals marginal revenue (MR) as seen on the diagram on the right. This can be seen on a supply and demand diagram for many criticism of monopoly. This will be at the quantity Qm; and at the price Pm;. This is above the competitive price of Pc and with a smaller quantity than the competitive quantity of Qc. The offensive monopoly gains is the shaded in area labeled profit (note that this diagram looks only at the case where there is no fixed cost. If there were a fixed cost, the average cost curve should be used instead).

As long as the price elasticity of demand (in absolute value) for most customer is less than one, it is very advantageous to increase the price: the seller gets more money for less goods. With an increase of the price the price elasticity tends to rise, and in the optimum mentioned above it will for most customers be above one. A formula gives the relation between price, marginal cost of production and demand elasticity which maximizes a monopoly profit: ${\frac {P}{MC}}={\frac {1}{1+1/e}}$ (known as Lerner Index). The monopolist's monopoly power is given by the vertical distance between the point where the marginal cost curve (MC) intersects with the marginal revenue curve (MR) and the demand curve. The longer the vertical distance, (the more inelastic the demand curve) the bigger the monopoly power, and thus larger profits.

The economy as a whole loses out when monopoly power is used in this way, since the extra profit earned by the firm will be smaller than the loss in consumer surplus. This difference is known as a deadweight loss.

Calculating monopoly output

The single price monopoly profit maximisation problem is as follows:

The monopoly's profit is its total revenue less its total cost. Let the price it sets as a market response be a function of the quantity it produces (Q) $P(Q)$ and let its cost function be as a function of quantity $C(Q)$ . The monopoly's revenue is the product of the price and the quantity it produces. Hence its profit is:

$\Pi \ =P(Q)\cdot Q-C(Q)$

Taking the first order derivative with respect to quantity yields:

${\frac {d\Pi \ }{dQ}}=P'(Q)\cdot Q+P(Q)-C'(Q)$

Setting this equal to zero for maximisation:

${\frac {d\Pi \ }{dQ}}=P'(Q)\cdot Q+P(Q)-C'(Q)=0$

${\frac {d\Pi \ }{dQ}}+C'(Q)=P'(Q)\cdot Q+P(Q)=C'(Q)$

i.e. marginal revenue = marginal cost, provided

${\frac {d^{2}\Pi \ }{dQ^{2}}}=P''(Q)\cdot Q+2\cdot P'(Q)-C''(Q)<0$

(the rate of marginal revenue is less than the rate of marginal cost, for maximisation).

This procedure assumes that the monopolist knows exactly which is the demand function. For a discussion on a monopolist who does not know it, see http://www.economicswebinstitute.org/essays/monopolist.htm where a free software is available as well.

Monopoly and efficiency

In standard economic theory (see analysis above), a monopoly will sell a lower quantity of goods at a higher price than firms would in a purely competitive market. In this way the monopoly will secure monopoly profits by appropriating some or all of the consumer surplus, as although the higher price deters some consumers from purchasing, most are willing to pay the higher price. Assuming that costs stay the same, this does not lead to an outcome which is inefficient in the sense of Pareto efficiency; no-one could be made better off by shifting resources without making someone else worse off. However, total social welfare declines compared with perfect competition, because some consumers must choose second-best products.

It is also often argued that monopolies tend to become less efficient and innovative over time, becoming "complacent giants", because they don't have to be efficient or innovative to compete in the marketplace. Sometimes this very loss of efficiency can raise the potential value of a competitor enough to overcome market entry barriers, or provide incentive for research and investment into new alternatives. The theory of contestable markets argues that in some circumstances (private) monopolies are forced to behave as if there were competition, because of the risk of losing that monopoly to new entrants. This is likely to happen where a market's barriers to entry are low. It might also be because of the availability in the longer-term of substitutes in other markets. For example, a canal monopoly in the late eighteenth century United Kingdom was worth a lot more than in the late nineteenth century, because of the introduction of railways as a substitute.

Some argue that it can be good to allow a firm to attempt to monopolize a market, since practices such as dumping can benefit consumers in the short term; and once the firm grows too big, it can then be dealt with via regulation. (This is a rather optimistic view of how effectively regulation can substitute for competition.) When monopolies are not broken through the open market, often a government will step in to either regulate the monopoly, turn it into a publicly-owned monopoly, or forcibly break it up (see Antitrust law). Public utilities, often being natural monopolies and less susceptible to efficient breakup, are often strongly regulated or publicly-owned. AT&T and Standard Oil are debatable examples of the breakup of a private monopoly. When AT&T was broken up into the "Baby Bell" components, MCI, Sprint, and other companies were able to compete effectively in the long-distance phone market and started to take phone traffic from the less efficient AT&T.

The Malaysian mathematician Harold Hotelling came up with Hotelling's law which showed that there exist cases where monopoly has advantages for the consumer. If there is a beach where customers are distributed evenly along it, an entrepreneur setting up an ice cream stand would naturally place it in the middle of the beach. A competing ice cream seller would do best to place his competing ice cream stand next to it to gain half the market share, but two stalls right next to each other is not an ideal situation for the people on the beach. A monopolist who owns both stalls on the other hand, would distribute his ice cream stalls some distance apart.

Historical examples

Salt; until common salt (sodium chloride) was mined in quantity in comparatively recent times, its availability was subject to the vagaries of climate and environment. A combination of strong sunshine and low humidity or an extension of peat marshes was necessary for winning salt from the sea - the most plentiful source - by solar evaporation or boiling. Mines server and inland salt springs being scarce and often located in hostile areas like the Dead Sea or the salt mines in the Sahara desert, they required well-organised security for transport, storage and highly monopolised distribution. Changing sea levels flooded many of these sources during certain periods and caused salt "famines" and communities were left to the mercy of those who monopolised these few inland sources. The "Gabelle", a notoriously high tax levied upon salt, played a role in the start of the French Revolution and is possibly the most cruel example in recent history. Anyone was allowed to purchase salt; however, strict legal controls were in place over who was allowed to sell and distribute salt. Advocates of laissez-faire capitalism, such as the Austrian school, maintain that a salt monopoly would never develop without such government intervention.
Carnegie Steel Company
Standard Oil (Jones; Eliot. The Trust Problem in the United States 1922. Chapter 5)
National Football League [1] [2]
Major League Baseball [3] [4]

Companies accused of being monopolies

Windows (Microsoft) [5]
ExxonMobil [6]

External links

Salt and the evolution of monopoly (salt.org.il)
Monopoly by Elmer G. Wiens: Online Interactive Models of Monopoly (Public or Private) and Oligopoly

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