Chapter 8

“MONOPOLY, MONOPOLISTIC COMPETITION AND OLIGOPOLY”

Natural Monopoly

A natural monopoly occurs when the most efficient number of firms in the industry is
one.

A natural monopoly will typically have very high fixed costs meaning that it impractical to
have more than one firm producing the good.

An example of a natural monopoly is tap water. It makes sense to have just one
company providing a network of water pipes and sewers because there are very high capital
costs involved in setting up a national network of pipes and sewage systems. To have two
different companies offering water wouldn’t make sense as the average cost would be very high
compared to just one firm and one network. There would also be the inconvenience of having
two firms dig up the road to lay a duplicate set of water pipes.

Diagram of Natural Monopoly

 Suppose the industry demand is 10,000 units.

 If a firm produces 10,000 units, it will get the lowest possible average costs – £9.
 If there were three firms producing 3,000 units. The firms would have average costs of £17.
 Therefore, the optimal number of firms in the industry will be one (one firm producing all 10,000
units)
EXLUSIVE ACCESS TO RESOURCES

 A particular firm may have access to the only source of supply of the raw
materials necessary for the production of a certain commodity.

PRICE AND OUTPUT IN MONOPOLY

Suppose demand function for monopoly is Q = 200-0.4Q

Price function is P= 1000-10Q

Cost function is TC= 100 + 40Q + Q2

Maximum profit is achieved where MR=MC

To find MR, TR is derived.

TR= (1000-10Q) Q = 1000Q-10Q2

MR = ∆TR/∆Q= 1000 – 20Q

MC = ∆TC/∆Q = 40 + 2Q

MR = MC

1000 – 20Q = 40 + 2Q

Q = 43.63 (44 approx.) = Profit Maximizing Output

Profit maximizing price = 1000 – 20*44 = 120

Total maximum profit= TR-TC= (1000Q – 10Q2) – (100+ 40Q+Q2)

At Q = 44

Total maximum profit = Rs. 20844

WELFARE COST OF MONOPOLIES

A profit-maximizing firm in a perfectly competitive industry will produce at the

productively and allocate efficient level of output. The conventional argument against market
power is that monopolists can earn abnormal (supernormal) profits at the expense of efficiency
and the welfare of consumers and society.

The monopoly price is assumed to be higher than both marginal and average costs
leading to a loss of allocate efficiency and a failure of the market. The monopolist is extracting a
price from consumers that is above the cost of resources used in making the product and,
consumers’ needs and wants are not being satisfied, as the product is being under-consumed.

The higher average cost if there are inefficiencies in production means that the firm is
not making optimum use of scarce resources. Under these conditions, there may be a case for
government intervention for example through competition policy or market deregulation.

If the industry is taken over by a monopolist the profit-

maximizing point (MC=MR) is at price P mon and output
Q2. The monopolist is able to charge a higher price restrict
total output and thereby reduce welfare because the rise
in price to P mon reduces consumer surplus.

Some of this reduction in welfare is a pure transfer to the

producer through higher profits, but some of the loss is not
reassigned to any other agent. This is known as the
deadweight welfare loss or the social cost of monopoly and
is equal to the area ABC.

A monopolist might be better placed to exploit

increasing returns to scale leasing to an equilibrium that
gives a higher output and a lower price than under
competitive conditions. This is illustrated in the next
diagram, where we assume that the monopolist is able
to drive marginal costs lower in the long run, finding an
equilibrium output of Q2 and pricing below the
competitive price
PRICE DISCRIMINATION

A Monopolist can engage in price discrimination. Pricing strategy to set different prices
to different group of consumer for providing identical goods or services, for reasons not
associated with the cost of producing the goods or services. However, charging prices for
similar services is not price discrimination.

Price discrimination takes place on the following conditions:

1. Price Maker. Price discrimination does not take place in a perfect competition, only for
those firms that have the power to set the price, a price maker.
2. Elasticity of Demand. Different price elasticity demands of product from different
groups of costumers allow the firms to vary the price to earn additional profit by
extracting consumer surplus.
3. Market Niche. Monopolist must be able to create different market niche and at the same
time prevent the selling the goods or services between customers.

Monopolist engage in price discrimination to increase total revenue or profit, a technique

that can also distribute excess output in the market at the same time an approach to discourage
rival firms in entering the market. Consumer can also benefit from price discrimination by
allowing them to afford the product.in the market, buyers pay the price they are willing to pay,
prices discrimination creates consumer and producer surplus.

REGULATE MONOPOLY

The government may wish to regulate monopolies to protect the interests of consumers.
For example, monopolies have the market power to set prices higher than in competitive
markets. The government can regulate monopolies through price capping, yardstick competition
and preventing the growth of monopoly power.

Why the Government regulates monopolies

Prevent excess prices. Without government regulation, monopolies could put prices above the
competitive equilibrium. This would lead to allocate inefficiency and a decline in consumer
welfare.

Quality of service. If a firm has a monopoly over the provision of a particular service, it may
have little incentive to offer a good quality service. Government regulation can ensure the firm
meets minimum standards of service.

Monopsony power. A firm with monopoly selling power may also be in a position to exploit
monopsony buying power. For example, supermarkets may use their dominant market position
to squeeze profit margins of farmers.
Promote competition. In some industries, it is possible to encourage competition, and
therefore there will be less need for government regulation.

Natural Monopolies. Some industries are natural monopolies – due to high economies of
scale, the most efficient number of firms is one. Therefore, we cannot encourage competition,
and it is essential to regulate the firm to prevent the abuse of monopoly power.