Question

2. Construct an economic model for the monopoly market structure.

Answer 1

Characteristics of a Monopoly Market Structure

The following are key features that are typically found in a monopoly market structure:

1. A Lack of Substitutes

One firm producing a good without close substitutes. The product is often unique. Ex: When Apple started producing the iPad, it arguably had a monopoly over the tablet market.

2. Barriers to Entry

There are significant barriers to entry set up by the monopolist. If new firms enter the industry, the monopolist will not have complete control of a firm on the supply. This implies that under monopoly there is no differ­ence between a firm and an industry.

3. Competition

There are no close competitors in the market for that product.

4. Price Maker

The monopolist decides the price of the product, since it has the market power. This makes the monopolist a price maker.

5. Profits

While a monopolist can maintain supernormal profits in the long run, it doesn’t necessarily make profits. A monopolist can be a loss making or revenue maximizing too. This is not possible under perfect competition. If abnormal profits are available in the long run, other firms will enter the competition with the result abnormal profits will be eliminated.

Advantages of a Monopoly

1. Stability of prices

In a monopoly market structure the prices are pretty stable. This is because there is only one firm involved in the market that sets the prices since there is no competing product. In other types of market structures prices are not stable and tend to be elastic as a result of the competition.

2. Economies of Scale

Since there is a single seller in the market it leads to economics of scale because big scale production which lowers the cost per unit for the seller. The seller may pass this benefit down to the consumer in terms of a lower price.

3. Research and Development

Since the monopolist is making abnormal or supernormal profits, the firm can invest that money into research and development. Customers may get better a quality product at reduced price leading to enhanced consumer surplus and satisfaction.

Disadvantages of a Monopoly

1. Higher prices

The monopolist could set a very high price for the product leading to exploitation of consumers as they have no option but to buy it from seller due to the lack of competition in the market.

2. Price discrimination

Monopolists can sometimes use price discrimination, where they charge different prices on the same product for different consumers. This depends on market conditions.

3. Inferior goods and services

The lack of competition may cause the monopoly firm to produce inferior goods and services because they know the goods will sell.

Revenue Curves for a Monopoly

Total Revenue

1. Marginal Revenue

Marginal revenue is the revenue earned by selling one more unit.

2. Average Revenue

Average Revenue is Total Revenue/Quantity.

Note:

• A monopolist can choose the level of output or the price, not both since it has a negatively sloped demand curve.
• The Marginal Revenue curve has double the slope of the Average Revenue curve.

A Profit Maximizing Monopolist

The Monopoly is a supernormal profit maker and using the profit maximization rule MC = MR, we can find the Quantity and the Price. After finding out where MC meets MR, draw a vertical line to the Demand curve, and the corresponding value on the vertical axis is the price. If it charges a higher price, then less quantity will be bought, but that won’t be maximum profit. This will continue in the long run, if barriers continue to exist, demand remains consistent and cost is maintained. The cost is found by drawing a vertical line from where Quantity meets the Average Cost curve to the price line.

Profit Maximizing Output is set at Marginal Cost (MC) = Marginal Revenue (MR)
Revenue Maximizing Output is set at Marginal Revenue (MR) = 0

A Revenue Maximizing Monopolist

When the firm wants to maximize revenue, it produces more units but charges a lower price. To find the quantity and price, draw a vertical line to the demand curve from where Marginal Revenue = 0. The price is found by drawing a horizontal line from the demand curve to the price axis (vertical). The cost is found by drawing a vertical line from where Quantity meets the Average Cost curve to the price line. The blue box represent supernormal profits and the red box, cost.

A Loss Making Monopolist

A monopolist can be a loss making one if the Average Cost lies above Average Revenue. In this case the firms costs are greater than its revenue so it makes a loss. The red and blue combined add up to cost. The red box represents revenue and the blue box, loss. The cost is found by drawing a vertical line from where Quantity meets the Average Cost curve to the price line.

What is an efficient output for society?

At output Q* and price P*, the Monopolistic firm is producing at a lower price but a higher output than a profit or revenue maximizing firm. This is the efficiency in monopolies.

Thus, there is a misallocation of resources because of monopoly power. Since monopolies aren’t forced to produce at minimum average cost, so there is productive inefficiency.