The Perfect Monopoly Market

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The Perfect Monopoly Market

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Monopoly Graph Review and Practice- Micro Topic 4.2

That is an essential aspect because it is the only market structure that can theoretically result in a socially optimal level of output. Probably the best example of a market with an almost perfect competition we can find in reality is the stock market. If you are looking for more information on perfect competition, you can also check our post on perfect competition vs. Monopolistic competition also refers to a market structure, where a large number of small firms compete against each other.

However, unlike in perfect competition, the firms in monopolistic competition sell similar but slightly differentiated products. That gives them a certain degree of market power, which allows them to charge higher prices within a specific range. Monopolistic competition builds on the following assumptions: 1 all firms maximize profits 2 there is free entry, and exit to the market, 3 firms sell differentiated products 4 consumers may prefer one product over the other.

Now, those assumptions are a bit closer to reality than the ones we looked at in perfect competition. However, this market structure no longer results in a socially optimal level of output because the firms have more power and can influence market prices to a certain degree. An example of monopolistic competition is the market for cereals. There is a vast number of different brands e. Most of them probably taste slightly different, but at the end of the day, they are all breakfast cereals.

An oligopoly describes a market structure that is dominated by only a small number of firms. That results in a state of limited competition. The firms can either compete against each other or collaborate see also Cournot vs. Bertrand Competition. By doing so, they can use their collective market power to drive up prices and earn more profit. The oligopolistic market structure builds on the following assumptions: 1 all firms maximize profits, 2 oligopolies can set prices, 3 barriers to entry and exit exist in the market, 4 products may be homogenous or differentiated, and 5 only a few firms dominate the market.

Both face the same cost and production functions, and both seek to maximize profit. The shutdown decisions are the same, and both are assumed to have perfectly competitive factors markets. However, there are several key distinctions. In a perfectly competitive market, price equals marginal cost and firms earn an economic profit of zero. In a monopoly, the price is set above marginal cost and the firm earns a positive economic profit. Perfect competition produces an equilibrium in which the price and quantity of a good is economically efficient.

Monopolies produce an equilibrium at which the price of a good is higher, and the quantity lower, than is economically efficient. For this reason, governments often seek to regulate monopolies and encourage increased competition. For monopolies, marginal cost curves are upward sloping and marginal revenues are downward sloping. In traditional economics, the goal of a firm is to maximize their profits. This means they want to maximize the difference between their earnings, i. To find the profit maximizing point, firms look at marginal revenue MR — the total additional revenue from selling one additional unit of output — and the marginal cost MC — the total additional cost of producing one additional unit of output. When the marginal revenue of selling a good is greater than the marginal cost of producing it, firms are making a profit on that product.

This leads directly into the marginal decision rule, which dictates that a given good should continue to be produced if the marginal revenue of one unit is greater than its marginal cost. Therefore, the maximizing solution involves setting marginal revenue equal to marginal cost. This is relatively straightforward for firms in perfectly competitive markets, in which marginal revenue is the same as price. Monopoly production, however, is complicated by the fact that monopolies have demand curves and MR curves that are distinct, causing price to differ from marginal revenue.

Monopoly : In a monopoly market, the marginal revenue curve and the demand curve are distinct and downward-sloping. Production occurs where marginal cost and marginal revenue intersect. Perfect Competition : In a perfectly competitive market, the marginal revenue curve is horizontal and equal to demand, or price. The marginal cost curves faced by monopolies are similar to those faced by perfectly competitive firms. Most will have low marginal costs at low levels of production, reflecting the fact that firms can take advantage of efficiency opportunities as they begin to grow. Marginal costs get higher as output increases. For example, a pizza restaurant can easily double production from one pizza per hour to two without hiring additional employees or buying more sophisticated equipment.

When production reaches 50 pizzas per hour, however, it may be difficult to grow without investing a lot of money in more skilled employees or more high-tech ovens. This trend is reflected in the upward-sloping portion of the marginal cost curve. The marginal revenue curve for monopolies, however, is quite different than the marginal revenue curve for competitive firms. Monopolies have much more power than firms normally would in competitive markets, but they still face limits determined by demand for a product. Higher prices except under the most extreme conditions mean lower sales. Therefore, monopolies must make a decision about where to set their price and the quantity of their supply to maximize profits.

They can either choose their price, or they can choose the quantity that they will produce and allow market demand to set the price. Since costs are a function of quantity, the formula for profit maximization is written in terms of quantity rather than in price. In this formula, p q is the price level at quantity q. The cost to the firm at quantity q is equal to c q. Since revenue is represented by pq and cost is c, profit is the difference between these two numbers. As a result, the first-order condition for maximizing profits at quantity q is represented by:.

Monopolies will produce at quantity q where marginal revenue equals marginal cost. Most economic textbooks follow the practice of carefully explaining the "perfect competition" model, mainly because this helps to understand departures from it the so-called "imperfect competition" models. The boundaries of what constitutes a market and what does not are relevant distinctions to make in economic analysis.

In a general equilibrium context, a good is a specific concept including geographical and time-related characteristics. Most studies of market structure relax a little their definition of a good, allowing for more flexibility in the identification of substitute goods. Monopolies derive their market power from barriers to entry — circumstances that prevent or greatly impede a potential competitor's ability to compete in a market. There are three major types of barriers to entry: economic, legal and deliberate. In addition to barriers to entry and competition, barriers to exit may be a source of market power. Barriers to exit are market conditions that make it difficult or expensive for a company to end its involvement with a market.

High liquidation costs are a primary barrier to exiting. The decision whether to shut down or operate is not affected by exit barriers. While monopoly and perfect competition mark the extremes of market structures [13] there is some similarity. The cost functions are the same. The shutdown decisions are the same. Both are assumed to have perfectly competitive factors markets.

There are distinctions, some of the most important distinctions are as follows:. The most significant distinction between a PC company and a monopoly is that the monopoly has a downward-sloping demand curve rather than the "perceived" perfectly elastic curve of the PC company. If there is a downward-sloping demand curve then by necessity there is a distinct marginal revenue curve. The implications of this fact are best made manifest with a linear demand curve. From this several things are evident. First, the marginal revenue curve has the same y intercept as the inverse demand curve. Second, the slope of the marginal revenue curve is twice that of the inverse demand curve.

Third, the x intercept of the marginal revenue curve is half that of the inverse demand curve. What is not quite so evident is that the marginal revenue curve is below the inverse demand curve at all points. The fact that a monopoly has a downward-sloping demand curve means that the relationship between total revenue and output for a monopoly is much different than that of competitive companies. A competitive company has a perfectly elastic demand curve meaning that total revenue is proportional to output. For a monopoly to increase sales it must reduce price. Thus the total revenue curve for a monopoly is a parabola that begins at the origin and reaches a maximum value then continuously decreases until total revenue is again zero.

The slope of the total revenue function is marginal revenue. Setting marginal revenue equal to zero we have. So the revenue maximizing quantity for the monopoly is A company with a monopoly does not experience price pressure from competitors, although it may experience pricing pressure from potential competition. If a company increases prices too much, then others may enter the market if they are able to provide the same good, or a substitute, at a lesser price. A monopolist can extract only one premium, [ clarification needed ] and getting into complementary markets does not pay.

That is, the total profits a monopolist could earn if it sought to leverage its monopoly in one market by monopolizing a complementary market are equal to the extra profits it could earn anyway by charging more for the monopoly product itself. However, the one monopoly profit theorem is not true if customers in the monopoly good are stranded or poorly informed, or if the tied good has high fixed costs. A pure monopoly has the same economic rationality of perfectly competitive companies, i. By the assumptions of increasing marginal costs, exogenous inputs' prices, and control concentrated on a single agent or entrepreneur, the optimal decision is to equate the marginal cost and marginal revenue of production. Nonetheless, a pure monopoly can — unlike a competitive company — alter the market price for its own convenience: a decrease of production results in a higher price.

In the economics' jargon, it is said that pure monopolies have "a downward-sloping demand". An important consequence of such behaviour is that typically a monopoly selects a higher price and lesser quantity of output than a price-taking company; again, less is available at a higher price. A monopoly chooses that price that maximizes the difference between total revenue and total cost. Market power is the ability to increase the product's price above marginal cost without losing all customers. All companies of a PC market are price takers.

The price is set by the interaction of demand and supply at the market or aggregate level. Individual companies simply take the price determined by the market and produce that quantity of output that maximizes the company's profits. If a PC company attempted to increase prices above the market level all its customers would abandon the company and purchase at the market price from other companies.

A monopoly has considerable although not unlimited market power. A monopoly has the power to set prices or quantities although not both. The two primary factors determining monopoly market power are the company's demand curve and its cost structure. Market power is the ability to affect the terms and conditions of exchange so that the price of a product is set by a single company price is not imposed by the market as in perfect competition. A monopoly has a negatively sloped demand curve, not a perfectly inelastic curve. Consequently, any price increase will result in the loss of some customers. Price discrimination allows a monopolist to increase its profit by charging higher prices for identical goods to those who are willing or able to pay more.

For example, most economic textbooks cost more in the United States than in developing countries like Ethiopia. In this case, the publisher is using its government-granted copyright monopoly to price discriminate between the generally wealthier American economics students and the generally poorer Ethiopian economics students. Similarly, most patented medications cost more in the U. Typically, a high general price is listed, and various market segments get varying discounts. This is an example of framing to make the process of charging some people higher prices more socially acceptable. This would allow the monopolist to extract all the consumer surplus of the market.

A domestic example would be the cost of airplane flights in relation to their takeoff time; the closer they are to flight, the higher the plane tickets will cost, discriminating against late planners and often business flyers. While such perfect price discrimination is a theoretical construct, advances in information technology and micromarketing may bring it closer to the realm of possibility. Partial price discrimination can cause some customers who are inappropriately pooled with high price customers to be excluded from the market. For example, a poor student in the U. Similarly, a wealthy student in Ethiopia may be able to or willing to buy at the U.

These are deadweight losses and decrease a monopolist's profits. Deadweight loss is considered detrimental to society and market participation. As such, monopolists have substantial economic interest in improving their market information and market segmenting. There is important information for one to remember when considering the monopoly model diagram and its associated conclusions displayed here. The result that monopoly prices are higher, and production output lesser, than a competitive company follow from a requirement that the monopoly not charge different prices for different customers. That is, the monopoly is restricted from engaging in price discrimination this is termed first degree price discrimination , such that all customers are charged the same amount.

If the monopoly were permitted to charge individualised prices this is termed third degree price discrimination , the quantity produced, and the price charged to the marginal customer, would be identical to that of a competitive company, thus eliminating the deadweight loss ; however, all gains from trade social welfare would accrue to the monopolist and none to the consumer. In essence, every consumer would be indifferent between going completely without the product or service and being able to purchase it from the monopolist. As long as the price elasticity of demand for most customers is less than one in absolute value , it is advantageous for a company to increase its prices: it receives more money for fewer goods.

With a price increase, price elasticity tends to increase, and in the optimum case above it will be greater than one for most customers. A company maximizes profit by selling where marginal revenue equals marginal cost. A price discrimination strategy is to charge less price sensitive buyers a higher price and the more price sensitive buyers a lower price. The basic problem is to identify customers by their willingness to pay. The purpose of price discrimination is to transfer consumer surplus to the producer. Market power is a company's ability to increase prices without losing all its customers.

Any company that has market power can engage in price discrimination. Perfect competition is the only market form in which price discrimination would be impossible a perfectly competitive company has a perfectly elastic demand curve and has no market power. There are three forms of price discrimination. First degree price discrimination charges each consumer the maximum price the consumer is willing to pay. Second degree price discrimination involves quantity discounts. Third degree price discrimination involves grouping consumers according to willingness to pay as measured by their price elasticities of demand and charging each group a different price.

Third degree price discrimination is the most prevalent type. There are three conditions that must be present for a company to engage in successful price discrimination. First, the company must have market power. A company must have some degree of market power to practice price discrimination. Without market power a company cannot charge more than the market price. A company wishing to practice price discrimination must be able to prevent middlemen or brokers from acquiring the consumer surplus for themselves. The company accomplishes this by preventing or limiting resale. Many methods are used to prevent resale. For instance, persons are required to show photographic identification and a boarding pass before boarding an airplane.

Most travelers assume that this practice is strictly a matter of security. However, a primary purpose in requesting photographic identification is to confirm that the ticket purchaser is the person about to board the airplane and not someone who has repurchased the ticket from a discount buyer. The inability to prevent resale is the largest obstacle to successful price discrimination. For example, universities require that students show identification before entering sporting events.

Governments may make it illegal to resell tickets or products. In Boston, Red Sox baseball tickets can only be resold legally to the team. The three basic forms of price discrimination are first, second and third degree price discrimination. In first degree price discrimination the company charges the maximum price each customer is willing to pay. The maximum price a consumer is willing to pay for a unit of the good is the reservation price.

Thus for each unit the seller tries to set the price equal to the consumer's reservation price. Sellers tend to rely on secondary information such as where a person lives postal codes ; for example, catalog retailers can use mail high-priced catalogs to high-income postal codes. For example, an accountant who has prepared a consumer's tax return has information that can be used to charge customers based on an estimate of their ability to pay. In second degree price discrimination or quantity discrimination customers are charged different prices based on how much they buy. There is a single price schedule for all consumers but the prices vary depending on the quantity of the good bought. Companies know that consumer's willingness to buy decreases as more units are purchased [ citation needed ].

The task for the seller is to identify these price points and to reduce the price once one is reached in the hope that a reduced price will trigger additional purchases from the consumer. For example, sell in unit blocks rather than individual units. In third degree price discrimination or multi-market price discrimination [55] the seller divides the consumers into different groups according to their willingness to pay as measured by their price elasticity of demand. Each group of consumers effectively becomes a separate market with its own demand curve and marginal revenue curve. Airlines charge higher prices to business travelers than to vacation travelers. The reasoning is that the demand curve for a vacation traveler is relatively elastic while the demand curve for a business traveler is relatively inelastic.

Any determinant of price elasticity of demand can be used to segment markets. For example, seniors have a more elastic demand for movies than do young adults because they generally have more free time. Thus theaters will offer discount tickets to seniors. The monopolist acquires all the consumer surplus and eliminates practically all the deadweight loss because he is willing to sell to anyone who is willing to pay at least the marginal cost. That is the monopolist behaving like a perfectly competitive company. Successful price discrimination requires that companies separate consumers according to their willingness to buy.

Determining a customer's willingness to buy a good is difficult. Asking consumers directly is fruitless: consumers don't know, and to the extent they do they are reluctant to share that information with marketers. The two main methods for determining willingness to buy are observation of personal characteristics and consumer actions. As noted information about where a person lives postal codes , how the person dresses, what kind of car he or she drives, occupation, and income and spending patterns can be helpful in classifying. The price of monopoly is upon every occasion the highest which can be got. The natural price, or the price of free competition, on the contrary, is the lowest which can be taken, not upon every occasion indeed, but for any considerable time together.

The one is upon every occasion the highest which can be squeezed out of the buyers, or which it is supposed they will consent to give; the other is the lowest which the sellers can commonly afford to take, and at the same time continue their business. Monopoly, besides, is a great enemy to good management. According to the standard model, in which a monopolist sets a single price for all consumers, the monopolist will sell a lesser quantity of goods at a higher price than would companies by perfect competition. Because the monopolist ultimately forgoes transactions with consumers who value the product or service more than its price, monopoly pricing creates a deadweight loss referring to potential gains that went neither to the monopolist nor to consumers.

Deadweight loss is the cost to society because the market isn't in equilibrium, it is inefficient. Given the presence of this deadweight loss, the combined surplus or wealth for the monopolist and consumers is necessarily less than the total surplus obtained by consumers by perfect competition. Where efficiency is defined by the total gains from trade, the monopoly setting is less efficient than perfect competition.

It is often argued that monopolies tend to become less efficient and less innovative over time, becoming "complacent", because they do not have to be efficient or innovative to compete in the marketplace. Sometimes this very loss of psychological efficiency can increase a potential competitor's value enough to overcome market entry barriers, or provide incentive for research and investment into new alternatives. The theory of contestable markets argues that in some circumstances private monopolies are forced to behave as if there were competition because of the risk of losing their monopoly to new entrants. This is likely to happen when a market's barriers to entry are low. It might also be because of the availability in the longer term of substitutes in other markets.

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