Introduction to Monopoly

In contrast to perfect competition where firms are price-takers, non-competitive markets are characterized by firms that possess market power, allowing them to influence the price of their product. This chapter explores market structures like monopoly, which arises when key conditions of perfect competition, particularly free entry and homogeneous products, are not met.

Defining Monopoly

A monopoly is a market structure characterized by a single seller of a commodity for which there are no close substitutes. This structure represents the opposite extreme of the market spectrum from perfect competition.

For a pure monopoly to exist and persist over time, three fundamental conditions must be met:

1. Single Producer/Seller: The entire market supply for a particular commodity is controlled by a single firm. The firm's individual supply curve is the market supply curve; the firm is the industry.
2. No Close Substitutes: The product sold by the monopolist is unique. Consumers have no acceptable alternative choices to satisfy their want for that product. This lack of substitutes is the source of the monopolist's market power and insulates it from competitive pressure.
3. Barriers to Entry: There must be significant restrictions or barriers that prevent any other firm from entering the market to compete with the monopolist. These barriers are crucial for the long-term survival of the monopoly. Barriers can be:
   • Natural: Control over a key natural resource (e.g., a single company owning all the mines for a specific mineral).
   • Technological: A patent or copyright that gives a firm the exclusive legal right to produce a good or use a particular process.
   • Legal/Governmental: A government license or franchise that grants a single firm the exclusive right to operate in a market (e.g., public utilities like electricity distribution).
   • Economic: Extremely high start-up costs or significant economies of scale that create a "natural monopoly," where a single firm can supply the entire market at a lower average cost than two or more firms could.

The key outcome of this structure is that the monopolist is a price-maker, not a price-taker.

Assumptions for the Simple Monopoly Model

To isolate and analyze the effects of a monopoly in a single commodity market, we make a few simplifying assumptions:

• All consumers are price takers.
• The markets for the inputs that the monopolist uses are themselves perfectly competitive.
• All other commodity markets in the economy are perfectly competitive.

Competitive Behaviour versus Competitive Structure

There is an interesting inverse relationship between the competitiveness of a market's structure and the competitive behaviour of the firms within it.

• Competitive Structure, Non-Competitive Behaviour: In a perfectly competitive market structure, there are so many firms that no single firm sees any other as a rival. An individual farmer, for example, does not strategize against a neighboring farmer. They simply take the market price as given and sell what they produce. The structure is highly competitive, but the behaviour is passive or non-competitive.
• Less Competitive Structure, Competitive Behaviour: In a less competitive market structure like an oligopoly (a few large firms), firms are highly aware of each other. The behaviour is intensely competitive and strategic. Firms like Coke and Pepsi engage in advertising wars, pricing strategies, and other forms of rivalry to gain market share from each other.

A monopoly is the extreme case. Since there is only one firm, there are no rivals to compete with. Therefore, a monopoly has the least competitive structure and exhibits zero competitive behaviour.

Market Demand Curve is the Average Revenue Curve

Since the monopolist is the sole seller in the market, the demand curve it faces is the entire market demand curve. The market demand curve is downward sloping, illustrating the inverse relationship between the price of the good and the quantity all consumers are willing to buy.

This has a crucial implication for the monopolist: it faces a trade-off. It cannot set both price and quantity independently.

• To sell a larger quantity, the monopolist must lower the price.
• To charge a higher price, the monopolist must be willing to sell a smaller quantity.

The monopolist can choose any price-quantity combination on the market demand curve. This power to choose its position on the demand curve is what makes the monopolist a "price-maker" or "quantity-setter".

Derivation: Demand Curve as the Average Revenue (AR) Curve

The demand curve also represents the firm's Average Revenue (AR) curve. Average Revenue is the revenue the firm receives per unit of output sold. The relationship is derived as follows:

By definition, Average Revenue (AR) is Total Revenue (TR) divided by quantity (q):

$AR = \frac{TR}{q}$

Total Revenue is Price (p) multiplied by quantity (q):

$TR = p \times q$

Substituting the expression for TR into the AR formula:

$AR = \frac{p \times q}{q} = p$

This result shows that Average Revenue is always equal to the price of the good. Since the demand curve shows the price consumers are willing to pay for each quantity, and the AR curve shows the revenue per unit (which is the price) for each quantity, the demand curve and the AR curve are identical for a monopolist.

Revenue Curves of a Monopolist

The downward-sloping demand curve faced by a monopolist dictates a unique and important relationship between its total, average, and marginal revenue. Unlike a perfectly competitive firm, a monopolist's revenue per unit (price) changes as it alters its output level.

Total Revenue (TR), Average Revenue (AR), and Marginal Revenue (MR)

To understand the interplay between these concepts, let's analyze them using a numerical example based on a linear demand curve. Suppose the demand function is given by the equation $q = 20 – 2p$. We can rewrite this in terms of price to get the inverse demand function: $p = 10 – 0.5q$.

1. Total Revenue (TR): Total Revenue is the product of price and quantity: $TR = p \times q$. Substituting the inverse demand function for 'p', we get:

   $TR = (10 – 0.5q) \times q = 10q – 0.5q^2$

   This is a quadratic equation, which represents an inverted U-shaped parabola. As the monopolist starts selling, TR increases. It reaches a maximum value and then begins to decline as further price cuts are needed to sell more units. This happens because the loss in revenue from selling all previous units at a lower price starts to outweigh the gain in revenue from selling the additional unit.

2. Average Revenue (AR): As established previously, Average Revenue is always equal to the price ($AR = p$). Therefore, the AR curve is identical to the downward-sloping demand curve ($p = 10 – 0.5q$).

3. Marginal Revenue (MR): Marginal Revenue is the change in total revenue from selling one additional unit ($MR = \Delta TR / \Delta q$). For a monopolist, to sell one more unit, the price must be lowered for all units sold. This means the revenue gained from the new unit (which is its price) is partially offset by the loss in revenue on all previous units (which are now sold at this new, lower price). Consequently, the marginal revenue is always less than the price (or average revenue). The MR curve must lie below the AR curve. For a linear demand curve like $p = a - bq$, the MR curve is given by $MR = a - 2bq$. In our example, the MR curve has the same vertical intercept (10) as the demand curve but is twice as steep (with a slope of -1 instead of -0.5).

The following table illustrates these relationships for our example:

The Relationship Between Average and Marginal Revenue Curves

The MR curve always lies below the AR curve when the demand curve is downward sloping. The steepness of the demand (AR) curve determines how far below the MR curve will be.

• Flatter AR Curve (More Elastic Demand): If the demand is highly elastic, a small price cut leads to a large increase in quantity. The loss in revenue on previous units is small compared to the gain from the new unit. Therefore, the MR is closer to the AR, and the vertical distance between the two curves is small.
• Steeper AR Curve (Less Elastic Demand): If demand is inelastic, a large price cut is needed to sell an additional unit. The loss in revenue on previous units is significant, causing the MR to be much lower than the AR. The vertical distance between the two curves is large.

Relationship between TR, MR, and Price Elasticity of Demand

The behavior of Total Revenue and Marginal Revenue is directly linked to the price elasticity of demand ($e_d$) at different points along the demand curve. This relationship is crucial for understanding a monopolist's pricing decisions.

*Note: The discrete calculation in the table shows MR as 0.5 at q=10. In a continuous model, MR would be exactly zero where TR is maximized.

• When demand is elastic ($|e_d| > 1$): A percentage decrease in price leads to a larger percentage increase in quantity sold. This causes Total Revenue to rise. In this range, Marginal Revenue is positive.
• When demand is unitary elastic ($|e_d| = 1$): A percentage decrease in price leads to an exactly equal percentage increase in quantity sold. Total Revenue is at its maximum and does not change. At this point, Marginal Revenue is zero.
• When demand is inelastic ($|e_d| < 1$): A percentage decrease in price leads to a smaller percentage increase in quantity sold. This causes Total Revenue to fall. In this range, Marginal Revenue is negative.

A profit-maximizing monopolist will never choose to produce an output level in the inelastic portion of its demand curve. This is because in that region, MR is negative. Producing an additional unit would decrease total revenue while increasing total cost, which would unambiguously reduce profit. A rational monopolist always operates on the elastic portion of its demand curve.

Short-Run Equilibrium of the Monopoly Firm

Like any firm aiming to maximize profit, a monopolist makes its production decisions by comparing the marginal benefits and marginal costs of its actions. The profit-maximizing level of output is found where the revenue from producing one more unit (Marginal Revenue) is exactly equal to the cost of producing that unit (Marginal Cost).

The Simple Case of Zero Cost

To build intuition, consider a highly simplified scenario of a monopolist with zero production costs. Imagine a remote village with a single well that provides all the water. The well is owned by one person who can sell the water but incurs no cost in doing so (the buyers draw the water themselves). In this case, the Total Cost (TC) is always zero.

The firm's profit is $\pi = TR - TC$. With TC = 0, the profit equation simplifies to $\pi = TR$.

Therefore, to maximize profit, the monopolist simply needs to maximize their Total Revenue. As we saw from the revenue curves, TR is maximized at the output level where Marginal Revenue (MR) is equal to zero.

• Equilibrium Quantity: The monopolist will produce 10 units of output, the quantity at which $MR=0$ and TR is at its maximum of $\text{₹} \ 50$.
• Equilibrium Price: To sell 10 units, the monopolist looks to the demand curve, which shows that consumers are willing to pay $\text{₹} \ 5$ per unit.
• Maximum Profit: The profit is equal to the total revenue, which is the area of the shaded rectangle: $p \times q = \text{₹} \ 5 \times 10 = \text{₹} \ 50$.

Comparison with Perfect Competition (Zero Cost Case)

What if the market had many wells (perfect competition)? Firms would compete by undercutting each other's prices. This competition would continue until the price was driven down to the marginal cost of production. Since the marginal cost is zero, the perfectly competitive price would be $p=MC=0$. At a price of zero, consumers would demand 20 units (from the demand equation $q=20-2p$). This comparison highlights that a competitive market results in a larger quantity ($20 > 10$) and a lower price (₹0 < ₹5) than a monopoly.

Introducing Positive Costs

In the more realistic scenario where production involves costs, the profit maximization decision involves both revenue and cost curves.

Analysis using Total Curves

Profit is the vertical distance between the Total Revenue (TR) and Total Cost (TC) curves ($\pi = TR - TC$). The monopolist seeks the level of output where this distance is the greatest.

• At output levels below $q_2$ and above $q_3$, the TC curve is above the TR curve, meaning the firm incurs losses.
• The firm earns a positive profit only between the breakeven points $q_2$ and $q_3$.
• The profit-maximizing output is $q_0$, where the vertical gap between TR and TC is at its maximum. The profit at this point is represented by the length of the line segment AB.

Graphical Analysis using Average and Marginal Curves

The standard and more precise method uses marginal curves to find the equilibrium.

The equilibrium for a monopolist occurs at the level of output ($q_0$) where two conditions are met:

1. $MR = MC$
2. The MC curve must be rising (or at least not falling) at the point of intersection.

The logic is that a firm will keep producing as long as an additional unit adds more to revenue than to cost ($MR>MC$). It will stop at the exact point where the last unit's revenue equals its cost ($MR=MC$).

The process to find the short-run equilibrium is as follows:

1. Identify the quantity ($q_0$) where the MR curve intersects the MC curve. This is the profit-maximizing output.
2. From $q_0$, draw a vertical line up to the demand curve (AR curve). The point where it hits the demand curve (point 'a') determines the equilibrium price ($p_0$).
3. At quantity $q_0$, find the Average Cost (AC) by looking at the corresponding point on the AC curve (point 'd').
4. Calculate the profit.
   • Total Revenue (TR) = $p_0 \times q_0$ = Area of rectangle $Oq_0ab$.
   • Total Cost (TC) = $AC(q_0) \times q_0$ = Area of rectangle $Oq_0dc$.
   • Supernormal Profit = $TR - TC$ = Area of the shaded rectangle $cdab$.

Comparison with Perfect Competition Again

If the same market were perfectly competitive, the equilibrium would occur where Price = Marginal Cost (since for a competitive firm, Price = AR = MR). In the diagram, the firm would produce where its demand curve (which would be a horizontal price line) intersects the MC curve. For the market as a whole, the equilibrium is where the market demand curve (the monopolist's AR curve) intersects the market supply curve (the monopolist's MC curve). This would be at point 'f' in the diagram.

• Quantity: A monopolist produces a lower quantity ($q_0$) compared to a perfectly competitive market ($q_c$).
• Price: A monopolist charges a higher price ($p_0$) compared to a perfectly competitive market ($p_c$).
• Profit: A monopolist can earn supernormal profits in the short run and long run, whereas competitive firms earn only normal profits in the long run.

This comparison shows that monopoly leads to a less efficient market outcome. It restricts output and charges a higher price, leading to a loss of welfare for consumers compared to a perfectly competitive market.

Monopoly in the Long Run

The distinction between the short run and the long run is less critical for a monopolist than for a competitive firm. The defining feature of a monopoly is the presence of strong barriers to entry. These barriers prevent new firms from entering the market, even if the monopolist is earning large supernormal profits.

Therefore, unlike in perfect competition where the entry of new firms erodes supernormal profits down to zero in the long run, a monopolist can continue to earn supernormal profits in the long run, provided the demand and cost conditions remain favorable. The monopolist will simply adjust its plant size in the long run to produce its chosen profit-maximizing output at the lowest possible cost.

Some Critical Views

While the standard model suggests monopolies are inefficient and exploitative, some economists offer a more nuanced perspective:

1. Pure Monopolies are Rare: It can be argued that true, pure monopolies rarely exist. In a broad sense, all commodities compete for the consumer's limited income, making them substitutes.
2. Competition is Dynamic: The economy is not static. New technologies constantly create new products that can act as close substitutes for a monopolist's product (a process Joseph Schumpeter called "creative destruction"). Therefore, even a monopolist faces potential competition in the long run, and the threat of this competition may moderate its pricing behavior even in the short run.
3. Potential for Innovation: The large, stable supernormal profits earned by monopolies can be a source of funds for significant investment in research and development (R&D). Small, perfectly competitive firms, which earn zero economic profit, lack the resources for major innovation. By investing in R&D, a monopolist may develop better quality products or more efficient production techniques, which can lead to lower costs and prices that may ultimately benefit society.

Monopolistic Competition

Monopolistic competition is a market structure that realistically describes many industries. It blends the characteristics of both monopoly and perfect competition, capturing a scenario where numerous firms compete, but each maintains a degree of market power through product differentiation.

Features of Monopolistic Competition

• Large Number of Firms: Similar to perfect competition, the market is populated by many firms. This has two main implications: (1) each firm has a small market share, so its actions have a negligible effect on its competitors, and (2) firms do not engage in strategic interaction, meaning they make decisions without worrying about how other specific firms will react.
• Free Entry and Exit: Like in perfect competition, there are no significant barriers preventing new firms from entering the market in the long run if profits are available, or stopping existing firms from leaving if they are incurring losses. This is a crucial feature that drives long-run profits to zero.
• Product Differentiation: This is the key feature that distinguishes monopolistic competition from perfect competition and gives it its "monopolistic" element. Each firm produces a product that is perceived by consumers as being different from the products of its competitors. This differentiation can be based on:
  • Physical Attributes: Differences in quality, design, features, or ingredients (e.g., different types of smartphones).
  • Branding and Packaging: Creating a unique brand identity through names, logos, and packaging (e.g., different brands of biscuits or soft drinks).
  • Location and Service: Differences in the location of the business or the level of customer service provided (e.g., a local restaurant versus a fast-food chain).
  Because of this differentiation, the products are close but not perfect substitutes.

The Firm's Demand Curve

Product differentiation gives each firm a small degree of monopoly power over its specific version of the product. Due to brand loyalty, if a firm raises its price, it will lose some, but not all, of its customers. Therefore, unlike a perfectly competitive firm, a monopolistically competitive firm faces a downward-sloping demand curve.

However, the presence of many close substitutes (from the large number of competing firms) makes this demand curve highly elastic. A small increase in price will cause a relatively large number of customers to switch to competing brands. Consequently, the firm's demand curve is much flatter than that of a pure monopolist. As with a monopoly, the firm's demand curve is also its Average Revenue (AR) curve, and its Marginal Revenue (MR) curve lies below the AR curve.

Short-Run Equilibrium

In the short run, a monopolistically competitive firm's decision-making process is virtually identical to that of a monopolist. To maximize profit, it will produce the quantity of output where its Marginal Revenue (MR) equals its Marginal Cost (MC). The price is then set based on the demand curve at that quantity.

In the short run, the firm can find itself in one of three situations:

• Supernormal Profit: If the price (AR) is greater than the Average Cost (AC) at the profit-maximizing output.
• Normal Profit: If the price is exactly equal to the Average Cost ($P = AC$).
• Loss: If the price is less than the Average Cost ($P < AC$). The firm will continue to produce as long as the price is above the Average Variable Cost ($P \ge AVC$).

Long-Run Equilibrium

The long-run equilibrium in monopolistic competition is driven by the free entry and exit of firms. This mechanism ensures that, in the long run, all firms in the industry will earn only normal profits (zero economic profit).

• Entry Eliminates Profits: If firms are earning supernormal profits in the short run, this will attract new firms to enter the industry. As new firms enter, the number of available close substitutes increases. This has two effects on the demand curve of each existing firm: (1) it shifts to the left as market share is lost to new entrants, and (2) it becomes more elastic as consumers have more alternatives to choose from. This process of entry continues until the demand curve for a typical firm has shifted to the left to the point where it is just tangent to the firm's Long-Run Average Cost (LRAC) curve.
• Exit Eliminates Losses: Conversely, if firms are incurring losses, some will exit the market. This reduces competition, causing the demand curve for the remaining firms to shift to the right until losses are eliminated and normal profits are restored.

The long-run equilibrium is characterized by two key conditions:

1. Profit Maximization ($MR = LRMC$): Firms produce at the output level where their long-run marginal cost equals their marginal revenue.
2. Zero Economic Profit ($P = LRAC$): The demand curve is tangent to the LRAC curve at the profit-maximizing output level.

Excess Capacity: A Key Inefficiency

A significant feature of the long-run equilibrium in monopolistic competition is the presence of excess capacity. Because the firm's demand curve is downward-sloping, the tangency point with the LRAC curve must occur on the downward-sloping portion of the LRAC curve, not at its minimum point.

• The output level that minimizes average cost is known as the efficient scale or optimal capacity.
• The long-run equilibrium output in monopolistic competition is less than this efficient scale.

This means that firms in monopolistic competition are not producing at the lowest possible average cost. They have "excess capacity" in the sense that they could increase their output and lower their average cost of production. This is considered a source of inefficiency compared to perfect competition, where firms are forced to operate at the minimum point of their LRAC in the long run. The trade-off for society is this inefficiency versus the benefit of product variety and consumer choice offered by monopolistic competition.

Oligopoly

An oligopoly is a market structure dominated by a small number of large firms. Because the number of sellers is few, each firm is a significant player in the market, and their decisions have a noticeable impact on both the market price and their competitors. A special case of an oligopoly with exactly two sellers is known as a duopoly. This market structure is common in industries with high barriers to entry, such as automobiles, airlines, telecommunications, and steel.

Key Feature: Strategic Interdependence

The single most important characteristic of an oligopoly is strategic interdependence. Unlike firms in other market structures, an oligopolistic firm cannot make decisions about its price or output in isolation. Its optimal strategy depends on the actions and, more importantly, the anticipated reactions of its rivals.

This creates a complex environment akin to a game of chess. Before making a move (e.g., lowering its price), a firm must ask:

• How will my competitors react?
• Will they match my price cut, leading to a price war?
• Will they ignore it, allowing me to gain market share?
• Will they retaliate with a massive advertising campaign?

This interdependence means there is no single, simple model to explain the behavior of firms in an oligopoly. The market outcome can vary widely depending on the assumptions made about how firms interact. The analysis of this strategic behavior is the domain of Game Theory.

How do Firms Behave in an Oligopoly?

The behavior of firms in an oligopoly can be placed on a spectrum, with two main extremes: perfect cooperation (collusion) and intense competition.

1. Collusion and Cartels (Cooperative Behaviour)

Firms may realize that competing aggressively is mutually destructive and can lead to lower profits for everyone. As an alternative, they might choose to collude, which is an explicit or implicit agreement among firms to limit competition by coordinating their actions.

The most formal and organized form of collusion is a cartel. A cartel is a group of firms that formally agree to act in unison, effectively behaving like a single monopolist. The cartel's objectives are typically to:

• Fix a high monopoly price for the industry.
• Restrict the total industry output to the monopoly level.
• Allocate production quotas or market shares among its members.

If a cartel is successful, it can maximize the collective profits of the industry, which can then be distributed among its members. The most famous example of an international cartel is the Organization of the Petroleum Exporting Countries (OPEC). However, cartels are notoriously unstable and difficult to maintain for two primary reasons:

1. Incentive to Cheat: Each individual member of the cartel has a powerful incentive to cheat on the agreement. By secretly producing more than its quota or offering a small discount on the fixed price, a single firm can capture a much larger market share and earn significantly higher profits, provided the other members stick to the agreement. If many members start to cheat, the cartel agreement collapses, and prices fall.
2. Illegality: In most countries, including India (under the Competition Act, 2002), explicit price-fixing and cartel agreements are illegal and subject to heavy fines.

2. Competition (Non-Cooperative Behaviour)

Alternatively, firms may decide to act independently and compete with each other. This non-cooperative behavior can take several forms:

• Price Competition (Price Wars): A firm might try to gain a competitive edge by lowering its price. However, due to interdependence, this action will likely provoke retaliation. Rivals will match or even exceed the price cut to protect their own market share. This can trigger a price war, where firms repeatedly undercut each other's prices. If this process continues to its logical conclusion, it can drive the market price down to the level of marginal cost, resulting in an outcome similar to perfect competition, where firms earn minimal profits.
• Non-Price Competition: Realizing that price wars are mutually destructive, oligopolistic firms often prefer to compete on dimensions other than price. Non-price competition aims to build brand loyalty and make demand for a firm's product less sensitive to price changes. Common methods include:
  • Advertising and Marketing: Creating a strong brand image.
  • Product Differentiation: Introducing new features, styles, or quality improvements.
  • Customer Service: Offering better after-sales service or warranties.

In practice, the equilibrium in an oligopolistic market often lies somewhere between the two extremes of monopoly and perfect competition. Firms are caught in a tension between the desire to cooperate and act like a monopolist (to earn high profits) and the incentive to compete and cheat on any agreement (to gain an individual advantage). This often leads to an outcome of price rigidity or "sticky prices," where firms are hesitant to change prices for fear of triggering a price war, leading to price stability even when costs change.

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