Microeconomics - Monopoly

A Monopoly is a market situation where a single firm (or individual) is the sole producer and seller of a product or service in an entire market. It is characterized through a lack of competition. As a result the monopolist has the ability to affect market prices, which often results in an inefficient outcome for society. 

Monopolies typically emerge because entry into a particular market is restricted. Those restrictions may be effects of high entrance costs, government regulations, or other impediments. Due to the lack of competition, monopolies often cause higher prices, lower outputs and sometimes even inferior quality of the provided goods or services. Thus, to see why monopolies still persist in certain industries, we need to take a closer look.

Sources of Monopoly Power

As mentioned above, monopolies derive their market power from entry barriers to their markets. Those barriers can can be divided into four groups, according to their sources: specific resources, government regulations, natural monopolies, and deliberate actions.

Specific resourcesIf a company (or an individual) owns a specific and unique resource, it can already act as a monopolist. Imagine you live in a small village in the middle of the desert where there is just one well to provide water. If this well is owned by one individual, he (or she) can charge a lot of money, because there is no alternative supply and water is an absolute necessity. However, this source of monopoly power is not very relevant in practice, as resources can be traded worldwide today, which makes it easier for customers to find alternatives (even for seemingly unique products).Government regulationsIn many cases monopolies arise because of government regulations. This happens whenever the government grants a firm (or institution) the right to be the sole producer and seller of a certain good or service. Given that monopolies often cause inefficiencies, this may seem a little odd. However, government regulated monopolies are established specifically because they are viewed to be in the best public interest.Just think of copyright and patent laws. When a pharmaceutical company creates a new drug, it can apply for a patent (i.e. the right to be the sole producer and seller of this drug for a limited time). This is attractive for companies because they can generate high profits during the patent period. Hence, the firms are given an incentive to engage in research and development of pharmaceuticals, which is beneficial for society.Natural monopoliesSometimes it is more efficient for one producer to supply the entire market than for two or more suppliers. Natural monopolies often occur in industries with the need for large and expensive infrastructures. In those industries we often see economies of scale for the relevant output range, which means that an increase in output reduces the average cost of production for the supplier. In other words, if there is more than one supplier, the output for each of them is lower, which results in higher average production costs (per supplier). An example for a natural monopoly is the railway system. To provide railway services, a company needs a large infrastructure (tracks, power lines, etc.). If there are two competitors in the market, both of them need to pay the fixed costs related to this infrastructure. Hence, it is more efficient for them to merge and thereby reduce the fixed costs.Deliberate actionsLast but not least, some companies deliberately erect barriers to entry in their markets to prevent the entrance of new competitors. However, for this to be possible, the companies need to have a certain market power beforehand. As companies grow, they automatically become more powerful, since they control a bigger share of the market. The bigger (and more powerful) a firm becomes, the more the industry is at risk of limited competition.

Effects of Monopoly Power

Since a monopolist company is the sole supplier of its industry, it faces a downward sloping demand curve (unlike firms in a competitive market). As a result, the firm has to lower the price of its good or service to increase quantity sold. Therefore, a monopolist's marginal revenue (MR) is always less than the price (P) of its good or service. This is crucial for understanding monopolist behavior. 
To give an example, imagine you are the sole supplier of ice cream in your village. To keep things simple, assume you can sell 1 cone for a price of 1$, thus your revenue will be 1$. However, if you want to sell 2 cones, you have to reduce the price to 0.90$, which will result in a marginal revenue of 0.80$ and a total revenue of 1.80$. So, even though you can sell an additional ice cream cone, you earn 0.10$ less on each unit sold, therefore marginal revenue falls. 

The fact that marginal revenue is lower than the price of the good has several implications for the profit maximizing behavior of a monopolist. Those can be illustrated in a supply and demand diagram (see illustration 1).

Illustration 1: Profit maximization of a monopolist

As we just saw, a monopolist usually faces a downward sloping demand curve (D) and a marginal revenue curve (MR) that lies below the demand curve. In fact, whenever we face a linear demand curve (e.g. y= a*x - b), the marginal revenue curve will be twice as steep (e.g. y=a*x - 2b). Though, please note that this only applies to linear curves.

To maximize profits, the monopolist will produce up to the point where marginal revenue equals marginal cost (MR = MC). This results in an output quantity of QM, and a price of PM. In contrast, in a competitive market (where MR = D), the company would produce quantity QC, for a price of PC

Hence, monopoly output is lower than competitive output, but prices are still higher. This results in a welfare loss for society (deadweight loss) which can be quantified as the shaded triangle DWL. The deadweight loss is the reason why monopolies are often not in the best interest for society.

Government Policy towards Monopolies

To react to the inefficiencies caused by monopolies, the government has different options to chose from. The most relevant ones are the following: competition law, price regulations, nationalization, or doing nothing.Competition lawOne way to prevent monopolies from arising is through competition law. In this case, government institutions primarily control mergers and acquisitions to make sure they will not result in an impediment to the competitiveness of an industry. In addition, the institutions enact laws to prevent collusive behavior and other activities that could restrict competition.Price regulationsAlternatively, if a monopoly already exists, the government policy can confide itself to controlling the negative effects of monopoly power. Generally, this is done by prescribing the prices the monopolists are allowed to charge. However, it is rather difficult to set those prices appropriately, which makes it difficult to successfully implement this policy in reality. NationalizationA rather invasive option is the nationalization of existing monopolies. This allows the government to directly control the firm's behavior and thus minimize its negative effects on society. However, since this kind of policy is diametrically opposed to the idea of a free enterprise economy, it has become extremely rare in practice.Remain inactiveAs we have seen above, there are certain occasions where monopolies are socially desired or even encouraged by the government (e.g. patents, copyrights). Furthermore, it is possible that the inefficiencies caused by a possible intervention would be more harmful than the effects caused by the monopoly itself. In those cases the monopoly outcome is more desirable for society and the government will remain inactive and not interfere in the market.

In a nutshell

A Monopoly is a market situation where a single firm (or individual) is the sole producer and seller of a product or service in an entire market.Monopolies can arise because of specific resources, government regulations, costs of production, or deliberate actions. They are characterized through a lack of competition, which results in lower production outputs and higher prices. The government can react to monopolies by enacting competition law, imposing price regulations, nationalizing the monopolies or, if the inefficiency is acceptable (or even desirable) for society,by not doing anything at all