Monopoly Firms

A-level Economics

What they are. How they make Supernormal profits. Are they economically efficient?

What is a monopoly?

The purest sense of a monopoly is when there is only one firm in a market. In essence, the firm is the entire market.

However, a monopoly power is a firm which has monopoly-like behaviour, because they control over 25% of the market share.

[For example: Tesco is a monopoly power. As of October 2016, Tesco controlled 28.2% of market share, making them the market leader and a monopoly power in the supermarket industry.]

Features of a monopoly

A monopoly market has the following features:

1. High Barriers to Entry

2. Price Making Behaviour

3. No Close Substitutes for the consumer to choose

These features give the monopoly its power. Let's examine these in more detail below:

Barriers to Entry

High entry barriers make it difficult for new competition to join the market. The market might require extremely high start-up costs on entry, or a patent may be protecting the monopoly’s product from being copied. Also, the monopoly may be too popular with consumers and this might make it difficult for new firms to successfully penetrate the market. They may have access to millions of pounds worth of advertising budget which you do not have. These all act as entry barriers. For example, can you open up a new burger bar that will be as successful and well-known as McDonald’s?

Price Maker

Price making behaviour is when the firm is able to fully control its prices and remain in business. It’s able to increase the price or decrease the price at will. A monopoly has no or little competition so they are free to make prices up and remain in business/continue making profit.  If the market were competitive, they would not be able to do this because if they priced above market price, they would lose a large proportion of their customers and be kicked out of the market.

This can be shown on a diagram.

No Close Substitutes

Because there is little competition from other firms, the monopoly’s product will often be the only viable choice in the marketplace. This also gives the monopoly its power. The monopoly might have this power because its product is protected by a patent, or maybe its product has captured a large proportion of the industry already and customers cannot easily switch.

An example is Microsoft Windows. The majority of businesses and consumers use Microsoft Windows on their PCs and laptops. This is largely due to the popularity of Microsoft Windows in the 80s and 90s. It has meant that Windows has continued to be the operating system of choice because most people know how to use it and do not want to change. Other companies can make new operating systems and capture some market share, but it is too difficult. In the pie chart below, you can see most of the market is controlled by Windows products, with a small 3.96% market share attributed to Mac OS X.

The Monopoly Diagram: Achieving Supernormal Profits

The above means that monopolies can set their prices far above their marginal costs and make supernormal profits because people will simply pay it. Most firms’ main business objective is profit maximisation. The profit maximisation condition states that to maximise profits, MR = MC.

Monopolies and Efficiency

In general, a monopoly is considered to be less favourable than a perfectly competitive market. This is because it is usually less economically efficient.

Economic efficiency comes in 4 main flavours:

1. Allocative/Pareto

2. Productive

3. Technical

4. Dynamic

Let’s examine how efficient a monopoly is:

Allocative: To be allocatively efficient a firm must price at P=MC. On the diagram, have a look where the monopoly prices…..Did you see? The monopoly priced at MR=MC, which did not coincide with P=MC. At the price P1 on the diagram, the price is greater than what the MC is. So, P>MC, which means supernormal profits are being earned and this automatically means that the firm is being over-rewarded for its factors of production. They are getting too much money for what they are doing, essentially.

Productive: To be productively efficient a firm must price and output at the level where they are minimising their costs per unit with respect to maximising their output. This is at the minimum point on the AC curve, which happens to be AC=MC. In general, the monopoly's decision making is not based around minimising their average costs, so they are likely to be inefficient in this regard too. However, sometimes, they can be productively efficient by chance. For example, look at the diagram above and see that at the monopoly price, they happen to also be productively efficient.

A competitive firm, however, makes minimising their costs per unit one of their major priorities when running the business, because they are always trying to be as price competitive as possible. Monopolies do not have this incentive.

Technical: To be technically efficient a firm must be producing as many outputs as possible with the least amount of inputs as possible.

A monopoly is generally technically inefficient. This is because the monopoly has no incentive to improve its production process and make best use of its factor inputs. They are not concerned about ensuring that their inputs are getting them as much as possible in terms of output.

You might think that this is related to productive efficiency. You’d be right in thinking that but the key difference is productive efficiency is all about producing at the minimum possible cost per unit, whereas technical efficiency is more about making the best use of the factors themselves. In short, you need technical efficiency to achieve productive efficiency.

When a monopoly firm is not being technically efficient, they are sometimes also said to be X-inefficient. X-inefficiency occurs when the monopoly has a lack of competition so they become lazy and not concerned with minimising their costs or making best use their inputs.

Dynamic Efficiency: Now, a monopoly firm has this one last trick up its sleeve. Competitive markets would not be to achieve this sort of efficiency like a monopoly can. Dynamic efficiency is a result of the large supernormal profits that the monopoly has made in the past or the profits they expect to achieve. It is also to do with their huge size compared to any individual competitive firm.

Dynamic efficiency is the long-run welfare gains you get from being a big company and making supernormal profits. These welfare gains can be to seen in the production process or the level of innovation and quality of the products made. For example, the huge profits you make can be reinvested back into the company and what it can mean is that you achieve lower potential costs than a competitive firm. A competitive firm would not have the money a monopoly has to invest into better production processes, for example. Your huge production size can lead to economies of scale.

Another form dynamic efficiency is when a firm becomes more innovative due to the desire of making more and supernormal profit.

[For example, the money it makes can be invested into the creation of better quality and more desirable products. If the smartphone market, would completely competitive, do you think we would have the Apple iPhone and the Samsung Galaxy phones today? Apple introduced the first mass-produced and marketable touch screen smartphone in 2006. What drove Apple to make this smartphone do you think? The potential supernormal profits is what drove Steve Jobs to make the first iPhone. If you said to Steve Jobs that you can only sell the iPhone for a maximum of £150 do you think he would bother making it? So without supernormal profits, we have less innovation to drive the industry forward and make new, never-heard of products before. These welfare gains that we get are all a result of dynamic efficiency.]

Competitive markets on the other hand simply do not make enough money to innovate. They can only make normal profits, which is barely enough profit for them to survive. Their goal is survival and to do that they have to focus on being the cheapest in the market.  Huge innovation requires big investment, and a monopoly is more likely to achieve this because of the money that they have.

TIP: It is important you realise and use the dynamic efficiency argument for a monopoly because this is one of the only positive things you will have to say about a monopoly! Important for your essays because you need to make sure your argument is unbiased and two-sided.

In summary, what we have learned:

1. Definition of monopolies

2. What makes a monopoly stay in power

3. Monopoly diagrams

4. Monopoly and economic efficiency

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