Chapter 7: Monopoly and Imperfect Competition

Introduction

Even though producers are price takers, they may influence the market price in many markets such as monopoly and oligopoly.

Perfect competition and monopoly are two extreme forms of market structure. Most markets in the economy include elements of both of these cases and, therefore, are not completely described by either of them. Such markets that fall somewhere between the polar cases are called imperfect competition.

Oligopoly is one type of imperfectly competitive market. Another type of imperfectly competitive market is called monopolistic competition.

Monopoly

If a market is the only producer of a good or service and this good or service does not have close substitutes, it is a monopoly.

A monopoly exists in a market when there are barriers to entry. These barriers are:

• Government regulations,
• Ownership of a key resource,
• Natural monopoly.

The government may give one person or firm the exclusive right to sell some good or service.

A company may rarely have control of a key resource.

A natural monopoly occurs when economies of scale are so large that one firm can supply the entire market at a lower average cost than two or more firms.

In some markets, the usefulness of a product increases with the number of consumers who use it. This makes it difficult for other firms to enter into these markets and compete with existing firms with a large network of customers. This situation is network externalities.

Since the monopoly is the only producer in the market, it faces the market demand curve. It can sell at a higher price but a smaller quantity or sell a larger quantity but at a lower price. A monopolist on the other hand has to lower price to sell more and hence move down on the demand curve. When a monopoly increases the amount it sells, this action has two effects on the total revenue as the output effect and the price effect.

The output effect: More output is sold, so Q is higher, which tends to increase the total revenue.

The price effect: The price falls, so P is lower, this tends to decrease the total revenue.

A monopoly’s marginal revenue is less than its price because in order to increase its output by one unit, a monopoly must reduce the price it charges for every unit and this cut in price reduces the revenue on the units it was already selling.

The monopolist’s average revenue from sales equals to the price.

Unlike competitive firm, the demand curve the monopolist faces is the market demand curve and it is negatively sloped. The MR curve is also negative and it is smaller than the price.

As for profit maximization for a monopoly, profit of a firm is equal to the total revenue minus total cost. The difference between total revenues minus total costs is maximized when for the last unit produced, the marginal revenue of this last unit is exactly equal to its marginal cost. If marginal revenue of the last unit produced is more than its marginal cost, this means that marginal profit is positive. Therefore, the firm can increase its profits by increasing its quantity output.

A monopolist, just like a competitive firm, maximizes its profits at a quantity where the marginal revenue is equal to the marginal cost for the last unit produced. The difference is that a competitive firm is a small firm among many firms in the market. It takes the market price as given and can sell any quantity it wants at the market price. Hence, its marginal revenue is constant and equal to the market equilibrium price. A monopolist, on the other hand, is the only producer in the market. It faces the market demand curve and hence has to reduce price to sell more units. As a result, its marginal revenue from the last unit sold is less than the price of that unit.

The Welfare Cost of Monopolies

Although the high price is undesirable for consumers since it reduces their consumer surplus, the monopoly maximizes its profits by charging this high price.

A consumer’s willingness to pay the price for an additional unit is at most her marginal benefit from that unit. Hence, the demand curve is also the marginal benefit curve of consumers. Marginal benefit of the last unit is equal to its marginal cost at the quantity where demand and marginal cost curves intersect. This quantity is the socially efficient quantity that maximizes economic surplus.

A monopoly produces less than the socially efficient quantity of output and charges a relatively higher price; therefore, it creates a deadweight loss.

Types of Price Discrimination Under Monopoly

When consumers are charged the same for the same good or service, it is called uniform pricing. Nevertheless, firms may sell the same good to different customers at different prices, which is called price discrimination.

Each consumer, who values the good at more than the marginal cost of the production, buys the good and he/she is charged the price equal to his/her willingness to pay. The practice of charging the maximum price for each unit sold is called perfect price discrimination.

However, it eliminates the deadweight loss associated with uniform price monopoly since the price of the last unit sold is equal to the marginal cost of that unit. But it also eliminates consumer surplus since each consumer pays her exact maximum willingness to pay.

Oligopoly

Oligopoly is a market structure where there are only a few firms in the market due to barriers to entry. In oligopoly, large firms have an advantage over small firms and the industry is characterized with few large firms rather than many small firms.

Two possible outcomes in oligopoly are as follows:

1. Collusion, which is an agreement among firms to charge the same price or decide on quantities in cooperation with each other.
2. Competition, occurs when each producer maximizes its profits by choosing its own price or quantity without consulting other firms. Since there are only few firms, we cannot assume that each firm takes the market price as given as we have assumed in perfect competition. In oligopoly, each firm takes the other firm’s strategy as given and chooses the best response strategy. The best response strategy is a strategy that maximizes the firm’s profits given strategies chosen by other firms.

When each firm chooses the best response strategy given the strategies chosen by other firms, it is called Nash equilibrium.

Oligopolists may prefer to form cartels and earn monopoly profits; however, arguments among cartel members over how to divide the profits in the market can make such an agreement difficult.

Game theory is the study of how people, firms or countries make decisions in situations in which attaining their goals depends on their interactions with others, which are crucial in determining profitability in oligopolies. Three characteristics of the games are as follows:

1. Rules that determine which actions are allowable,
2. Strategies that players employ to attain their objectives in the game,
3. Payoffs that are the results of the interaction among the players’ strategies.

Regardless of the strategies other firms use, a dominant strategy is the best response strategy for a firm. When each firm has a dominant strategy, the only Nash equilibrium occurs when each firm chooses its dominant strategy.

When firms do not cooperate with each other and selfishly pursue their own interests, they end up at an outcome worse for them than the cartel/collusion outcome.

Monopolistic Competition

Monopolistic competition is a market structure in which there are many firms selling products that are similar but not identical.

As these firms are differentiated from each other according to different features, consumers do not perceive these firms as identical.

In such cases, price is not the only factor that determines consumers’ decisions. When consumers perceive a product as a unique product without perfect substitutes, demand facing its producer is no longer perfectly elastic (horizontal). In other words, demand is downward sloping similar to the demand curve facing a monopolist.

In perfect competition, there is no single market price. Moreover, quantity demanded drops to zero when a perfectly competitive firm sets a price slightly above the market price since products are identical and consumers can buy from another firm at the market price.

The quantity demanded decreases but it does not drop to zero when a firm increases the price of a good or service because there will still be some consumers willing to pay a higher price for that product.

Monopolistically competitive firms are similar to a monopoly in terms of profit maximization due to product differentiation. The firm maximizes its profits by choosing a quantity where marginal revenue of the last unit produced is exactly equal to its marginal cost.

However, unlike monopoly, monopolistically competitive market typically has many sellers because there are low barriers to entry in this market.

When monopolistically competitive firms enjoy positive profits, new firms enter into this profitable market. Therefore, the number of differentiated products in the market increases. This consumer behavior in turn decreases demand for old products.