Q.
Define market structure of a monopoly and illustrate the equilibrium position in a short-run and in the long-run.
A.
Monopoly is defined as *being sole seller of a product without any close substitute.
* Mankiw, N Gregory. 2012. Principles of Economics. South-western Cengage Learning. Page 100.
The fundamental reason for the existence of a monopoly is "barrier to entry" which means other firms are not able to penetrate the market and compete with it. There is a certain structure of the business that defends the sole producer from outside threats of competition. In categorizing these factors, they are grouped under three broad aspects:-
1. Monopoly of resources. E.g. Water and electricity by the single firm within a big area.
2. Government regulation. E.g. Pattern or copyright laws or government incentive for heavy industries due to big initial capital outlay.
3. Production process. In other words, technological barrier. E.g. High-tech production steps, complicated and highly scientific research and development.
Equilibrium in Monopolies
Monopoly refers to a situation in which one firm is the only seller in a market. This usually results in very high prices, since there is no competition to keep prices in check. For example, Pepsi and Coke cost about the same amount of money. If Pepsi were to charge twice as much, most people would choose to buy Coke, and Pepsi would lose business and revenue. However, if Coke did not exist, and Pepsi were the only cola supplier in the market, Pepsi could charge twice as much; without any other options, people would buy Pepsi at the higher price, and Pepsi would have a huge profit margin.
In a competitive market, firms are price-takers, that is, they are too small to be able to set prices for the market to follow, so they cannot charge as much as they want, since their competitors can undercut them and win all of the customers. Monopolists, however, can set prices as they please, since they have no fear of competition.
Hence, in the short run (ie in the near future), the monopoly makes good profit, and increases its profit by selling more quantities. This profit can be sustained as there is no near competition.
However, in the long run (ie long term), the monopoly may need to adjust its price if there is no government protection (to ensure no competition), thus introduce some price reduction to attract more buyers, and fence out potential incoming competitors. As there is economic of scale by this time, it will be almost impossible for new competitor to come in as the initial cost barrier may be too huge to overcome. On the other hand, if there is special protection on this monopoly, price can still go up despite some loss of buyers. This loss of quantity is compensated by the price increase, and nothing can be done on this monopoly as there is no competitor.
Goods of this nature are like pattern protected highly specific medicines used in specific illness, for example cancer. A monopoly can increase its price in short or long run, without market responding too much to its quantity sold. In short, it is price inelastic. This is independent of the income level of the market, e.g. in a low income population, demand for such medicine can be very high (due to prevalence of disease), but the affordability is very low. Selling it cheaper does not increase quantity sold because only a small population can afford it. On the other hand, if the population is very rich, the demand may be low (due to disease prevalence very low), selling it in an expensive manner does not shy away the buyers. The price elasticity is very low. Thus, for a monopoly, a premium price mark up is usually maintained for profit, whether short-run or long-run.
Hence, in the short run (ie in the near future), the monopoly makes good profit, and increases its profit by selling more quantities. This profit can be sustained as there is no near competition.
However, in the long run (ie long term), the monopoly may need to adjust its price if there is no government protection (to ensure no competition), thus introduce some price reduction to attract more buyers, and fence out potential incoming competitors. As there is economic of scale by this time, it will be almost impossible for new competitor to come in as the initial cost barrier may be too huge to overcome. On the other hand, if there is special protection on this monopoly, price can still go up despite some loss of buyers. This loss of quantity is compensated by the price increase, and nothing can be done on this monopoly as there is no competitor.
Goods of this nature are like pattern protected highly specific medicines used in specific illness, for example cancer. A monopoly can increase its price in short or long run, without market responding too much to its quantity sold. In short, it is price inelastic. This is independent of the income level of the market, e.g. in a low income population, demand for such medicine can be very high (due to prevalence of disease), but the affordability is very low. Selling it cheaper does not increase quantity sold because only a small population can afford it. On the other hand, if the population is very rich, the demand may be low (due to disease prevalence very low), selling it in an expensive manner does not shy away the buyers. The price elasticity is very low. Thus, for a monopoly, a premium price mark up is usually maintained for profit, whether short-run or long-run.
You may recall that in a competitive market, firms decide how much output to produce by finding the point at which marginal revenue is equal to marginal cost. Since MR = P, they simply find the intersection of their MC curve and price. In competitive markets where firms are price-takers, the demand curve is horizontal along the price level, so that D = AR = MR = P:
Figure %: Demand for a Price-taking Firm
In noncompetitive markets, however, monopolists face our more familiar downward- sloping demand curve, which makes it more difficult to find the point where MR = MC. Here is where it gets a little tricky: competitive firms receive exactly the same amount of revenue (P) for each additional unit of product. They are price-takers, (as are households in a competitive market). A monopolist doesn't have this fixed marginal revenue. Let's take another look at Pepsi-as-a- monopolist: Pepsi could try selling its cola at $10000 a can. They might be able to sell one can. The marginal revenue on that first can is $10000. To sell two cans, however, Pepsi might have to lower its price to $7000 a can, to make a total of $14000. The marginal revenue on the second can is less than $10000. As Pepsi sells more and more cans of soda, the marginal revenue continues to drop.
Monopolists will find their profit-maximizing point by finding the intersection between their downward-sloping MR curve and their MC curve. Note that in a monopolist market, MR does not equal D, so the profit-maximizing point chosen by a monopolist results in higher prices and lower consumption than in a competitive market.
Figure %: Demand for a Monopolist
Monopolists are able to sell their products at well above their marginal cost, thereby earning much higher profits than competitive firms:
Figure %: Profits for a Monopolist
In certain markets there are natural monopolies, monopolies that will naturally occur in the market (as opposed to a monopoly that occurs because one firm pushes or buys other firms out). What kind of market would naturally lead to the formation of a monopoly? If there is a product that has a downward- sloping average cost curve (as opposed to the U-shaped curves we have been working with), then it is likely that a natural monopoly will form.
Figure %: Natural Monopoly
Why is this true? Let's say that in the market for computers, Eliot Computer Lab ("ECL") gets a head start on production, and has already made 1000 units before its competitors get started. At that point, ELC has a much lower average cost than the new firms, and therefore has a significant advantage over its competitors, since it can charge lower prices and make more profits. If it ever feels threatened by new firms, it can increase production and lower the price even more, so that the new firms cannot compete, since they are still further back on the cost curve. In such a case, ECL would have a natural monopoly in the computer market, and other firms would exit the market.
Ref:
SparkNotes, downloaded from http://www.sparknotes.com/economics/micro/supplydemand/equilibrium/section3.rhtml.