"I Like a Little Competition"—J. P. Morgan by Art Young. Cartoon relating to the answer J. P. Morgan gave when asked whether he disliked competition at the Pujo Committee.
A monopoly (from Greek μόνος mónos ["alone" or "single"] and πωλεῖν pōleîn ["to sell"]) exists when a specific person or enterprise is the only supplier of a particular commodity. This contrasts with a monopsony which relates to a single entity's control of a market to purchase a good or service, and with oligopoly which consists of a few sellers dominating a market. Monopolies are thus characterized by a lack of economic competition to produce the good or service, a lack of viable substitute goods, and the possibility of a high monopoly price well above the seller's marginal cost that leads to a high monopoly profit. The verb monopolise or monopolize refers to the process
by which a company gains the ability to raise prices or exclude
competitors. In economics, a monopoly is a single seller. In law, a
monopoly is a business entity that has significant market power, that
is, the power to charge overly high prices.
Although monopolies may be big businesses, size is not a characteristic
of a monopoly. A small business may still have the power to raise
prices in a small industry (or market).
A monopoly is distinguished from a monopsony, in which there is only one buyer
of a product or service; a monopoly may also have monopsony control of a
sector of a market. Likewise, a monopoly should be distinguished from a
cartel
(a form of oligopoly), in which several providers act together to
coordinate services, prices or sale of goods. Monopolies, monopsonies
and oligopolies are all situations in which one or a few entities have market power and therefore interact with their customers (monopoly or oligopoly), or suppliers (monopsony) in ways that distort the market.
Monopolies can be established by a government, form naturally, or form by integration.
In many jurisdictions, competition laws
restrict monopolies. Holding a dominant position or a monopoly in a
market is often not illegal in itself, however certain categories of
behavior can be considered abusive and therefore incur legal sanctions
when business is dominant. A government-granted monopoly or legal monopoly, by contrast, is sanctioned by the state, often to provide an incentive to invest in a risky venture or enrich a domestic interest group. Patents, copyrights, and trademarks
are sometimes used as examples of government-granted monopolies. The
government may also reserve the venture for itself, thus forming a government monopoly.
Monopolies may be naturally occurring due to limited competition because the industry is resource intensive and requires substantial costs to operate.
Market structures
In
economics, the idea of monopoly is important in the study of management
structures, which directly concerns normative aspects of economic
competition, and provides the basis for topics such as industrial organization and economics of regulation. There are four basic types of market structures in traditional economic analysis: perfect competition, monopolistic competition,
oligopoly and monopoly. A monopoly is a structure in which a single
supplier produces and sells a given product. If there is a single seller
in a certain market and there are no close substitutes for the product,
then the market structure is that of a "pure monopoly". Sometimes,
there are many sellers in an industry and/or there exist many close
substitutes for the goods being produced, but nevertheless companies
retain some market power. This is termed monopolistic competition,
whereas in oligopoly the companies interact strategically.
In general, the main results from this theory compare
price-fixing methods across market structures, analyze the effect of a
certain structure on welfare, and vary technological/demand assumptions
in order to assess the consequences for an abstract model of society.
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 ("grapes sold during October 2009 in
Moscow" is a different good from "grapes sold during October 2009 in New
York"). Most studies of market structure relax a little their
definition of a good, allowing for more flexibility in the
identification of substitute goods.
Characteristics
- Profit Maximizer: Maximizes profits.
- Price Maker: Decides the price of the good or product to be sold, but does so by determining the quantity in order to demand the price desired by the firm.
- High Barriers: Other sellers are unable to enter the market of the monopoly.
- Single seller: In a monopoly, there is one seller of the good, who produces all the output. Therefore, the whole market is being served by a single company, and for practical purposes, the company is the same as the industry.
- Price Discrimination: A monopolist can change the price or quantity of the product. He or she sells higher quantities at a lower price in a very elastic market, and sells lower quantities at a higher price in a less elastic market.
Sources of monopoly power
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.
- Economic barriers:Economic barriers include economies of scale, capital requirements, cost advantages and technological superiority.
- Economies of scale: Decreasing unit costs for larger volumes of production. Decreasing costs coupled with large initial costs, If for example the industry is large enough to support one company of minimum efficient scale then other companies entering the industry will operate at a size that is less than MES, and so cannot produce at an average cost that is competitive with the dominant company. Finally, if long-term average cost is constantly decreasing, the least cost method to provide a good or service is by a single company.
- Capital requirements: Production processes that require large investments of capital, perhaps in the form of large research and development costs or substantial sunk costs, limit the number of companies in an industry: this is an example of economies of scale.
- Technological superiority: A monopoly may be better able to acquire, integrate and use the best possible technology in producing its goods while entrants either do not have the expertise or are unable to meet the large fixed costs (see above) needed for the most efficient technology. Thus one large company can often produce goods cheaper than several small companies.
- No substitute goods: A monopoly sells a good for which there is no close substitute. The absence of substitutes makes the demand for that good relatively inelastic, enabling monopolies to extract positive profits.
- Control of natural resources: A prime source of monopoly power is the control of resources (such as raw materials) that are critical to the production of a final good.
- Network externalities: The use of a product by a person can affect the value of that product to other people. This is the network effect. There is a direct relationship between the proportion of people using a product and the demand for that product. In other words, the more people who are using a product, the greater the probability that another individual will start to use the product. This reflects fads, fashion trends, social networks etc. It also can play a crucial role in the development or acquisition of market power. The most famous current example is the market dominance of the Microsoft office suite and operating system in personal computers.
- Legal barriers: Legal rights can provide opportunity to monopolise the market in a good. Intellectual property rights, including patents and copyrights, give a monopolist exclusive control of the production and selling of certain goods. Property rights may give a company exclusive control of the materials necessary to produce a good.
- Manipulation: A company wanting to monopolise a market may engage in various types of deliberate action to exclude competitors or eliminate competition. Such actions include collusion, lobbying governmental authorities, and force.
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.
Market exit and shutdown are sometimes separate events. The decision
whether to shut down or operate is not affected by exit barriers. A company will shut down if price falls below minimum average variable costs.
Monopoly versus competitive markets
While monopoly and perfect competition mark the extremes of market structures there is some similarity. The cost functions are the same.
Both monopolies and perfectly competitive (PC) companies minimize cost
and maximize profit. 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:
- Marginal revenue and price: In a perfectly competitive market, price equals marginal cost. In a monopolistic market, however, price is set above marginal cost.
- Product differentiation: There is zero product differentiation in a perfectly competitive market. Every product is perfectly homogeneous and a perfect substitute for any other. With a monopoly, there is great to absolute product differentiation in the sense that there is no available substitute for a monopolized good. The monopolist is the sole supplier of the good in question. A customer either buys from the monopolizing entity on its terms or does without.
- Number of competitors: PC markets are populated by an infinite number of buyers and sellers. Monopoly involves a single seller.
- Barriers to Entry: Barriers to entry are factors and circumstances that prevent entry into market by would-be competitors and limit new companies from operating and expanding within the market. PC markets have free entry and exit. There are no barriers to entry, or exit competition. Monopolies have relatively high barriers to entry. The barriers must be strong enough to prevent or discourage any potential competitor from entering the market
- Elasticity of Demand: The price elasticity of demand is the percentage change of demand caused by a one percent change of relative price. A successful monopoly would have a relatively inelastic demand curve. A low coefficient of elasticity is indicative of effective barriers to entry. A PC company has a perfectly elastic demand curve. The coefficient of elasticity for a perfectly competitive demand curve is infinite.
- Excess Profits: Excess or positive profits are profit more than the normal expected return on investment. A PC company can make excess profits in the short term but excess profits attract competitors, which can enter the market freely and decrease prices, eventually reducing excess profits to zero. A monopoly can preserve excess profits because barriers to entry prevent competitors from entering the market.
- Profit Maximization: A PC company maximizes profits by producing such that price equals marginal costs. A monopoly maximises profits by producing where marginal revenue equals marginal costs. The rules are not equivalent. The demand curve for a PC company is perfectly elastic – flat. The demand curve is identical to the average revenue curve and the price line. Since the average revenue curve is constant the marginal revenue curve is also constant and equals the demand curve, Average revenue is the same as price (AR = TR/Q = P x Q/Q = P). Thus the price line is also identical to the demand curve. In sum, D = AR = MR = P.
- P-Max quantity, price and profit: If a monopolist obtains control of a formerly perfectly competitive industry, the monopolist would increase prices, reduce production, and realise positive economic profits.
- Supply Curve: in a perfectly competitive market there is a well defined supply function with a one-to-one relationship between price and quantity supplied. In a monopolistic market no such supply relationship exists. A monopolist cannot trace a short term supply curve because for a given price there is not a unique quantity supplied. As Pindyck and Rubenfeld note, a change in demand "can lead to changes in prices with no change in output, changes in output with no change in price or both". Monopolies produce where marginal revenue equals marginal costs. For a specific demand curve the supply "curve" would be the price/quantity combination at the point where marginal revenue equals marginal cost. If the demand curve shifted the marginal revenue curve would shift as well and a new equilibrium and supply "point" would be established. The locus of these points would not be a supply curve in any conventional sense.
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.
Practically all the variations mentioned above relate to this fact. 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. Assume that the inverse demand
curve is of the form x = a − by. Then the total revenue curve is TR =
ay − by2 and the marginal revenue curve is thus MR = a −
2by. 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.
Since all companies maximise profits by equating MR and MC it must be
the case that at the profit-maximizing quantity MR and MC are less than
price, which further implies that a monopoly produces less quantity at a
higher price than if the market were perfectly competitive.
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.
Total revenue equals price times quantity. A competitive company has a
perfectly elastic demand curve meaning that total revenue is
proportional to output. Thus the total revenue curve for a competitive company is a ray with a slope equal to the market price.
A competitive company can sell all the output it desires at the market
price. 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.
Total revenue has its maximum value when the slope of the total revenue
function is zero. The slope of the total revenue function is marginal
revenue. So the revenue maximizing quantity and price occur when MR = 0.
For example, assume that the monopoly’s demand function is P = 50 − 2Q.
The total revenue function would be TR = 50Q − 2Q2 and marginal revenue would be 50 − 4Q. Setting marginal revenue equal to zero we have
So the revenue maximizing quantity for the monopoly is 12.5 units and the revenue maximizing price is 25.
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.
The idea that monopolies in markets with easy entry need not be
regulated against is known as the "revolution in monopoly theory".
A monopolist can extract only one premium,
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.e. to optimise a profit function given some
constraints. 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 worth noticing: 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.
The inverse elasticity rule
A
monopoly chooses that price that maximizes the difference between total
revenue and total cost. The basic markup rule (as measured by the Lerner index) can be expressed as
,
where is the price elasticity of demand the firm faces.
The markup rules indicate that the ratio between profit margin and the
price is inversely proportional to the price elasticity of demand. The implication of the rule is that the more elastic the demand for the product the less pricing power the monopoly has.
Market power
Market power is the ability to increase the product's price above marginal cost without losing all customers.
Perfectly competitive (PC) companies have zero market power when it
comes to setting prices. 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. A monopoly is a price maker. The monopoly is the market
and prices are set by the monopolist based on their circumstances and
not the interaction of demand and supply. 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).
Although a monopoly's market power is great it is still limited by the
demand side of the market. 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
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.S. than in other countries with a
(presumed) poorer customer base. 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.
Perfect price discrimination would allow the monopolist to charge each
customer the exact maximum amount he would be willing to pay. This would
allow the monopolist to extract all the consumer surplus of the market. While such perfect price discrimination is a theoretical construct, advances in information technology and micromarketing may bring it closer to the realm of possibility.
It is very important to realize that 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.S. might be excluded from purchasing an economics textbook at
the U.S. price, which the student may have been able to purchase at the
Ethiopian price'. Similarly, a wealthy student in Ethiopia may be able
to or willing to buy at the U.S. price, though naturally would hide such
a fact from the monopolist so as to pay the reduced third world price.
These are deadweight losses and decrease a monopolist's profits. 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 (1)
going completely without the product or service and (2) 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 company that does not engage in price
discrimination will charge the profit maximizing price, P*, to all its
customers. In such circumstances there are customers who would be
willing to pay a higher price than P* and those who will not pay P* but
would buy at a lower price. A price discrimination strategy is to charge
less price sensitive buyers a higher price and the more price sensitive
buyers a lower price. Thus additional revenue is generated from two sources. 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.
Consumer surplus is the difference between the value of a good to a
consumer and the price the consumer must pay in the market to purchase
it. Price discrimination is not limited to monopolies.
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 zero 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. Second, the company must be able to sort customers according to their willingness to pay for the good. Third, the firm must be able to prevent resell.
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.
Any market structure characterized by a downward sloping demand curve
has market power – monopoly, monopolistic competition and oligopoly. The only market structure that has no market power is perfect competition.
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 example, 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.
Companies have however developed numerous methods to prevent resale.
For example, universities require that students show identification
before entering sporting events. Governments may make it illegal to
resale 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.[49]
Direct information about a consumer’s willingness to pay is rarely
available. 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.
First degree price discrimination most frequently occurs in regard to
professional services or in transactions involving direct buyer/seller
negotiations. 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.
The theory of second degree price discrimination is a consumer is
willing to buy only a certain quantity of a good at a given price.
Companies know that consumer’s willingness to buy decreases as more
units are purchased.
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
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. The firm then attempts to maximize profits in each segment by equating MR and MC,
Generally the company charges a higher price to the group with a more
price inelastic demand and a relatively lesser price to the group with a
more elastic demand.
Examples of third degree price discrimination abound. 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.
Example
Assume
that by a uniform pricing system the monopolist would sell five units at
a price of $10 per unit. Assume that his marginal cost is $5 per unit.
Total revenue would be $50, total costs would be $25 and profits would
be $25. If the monopolist practiced price discrimination he would sell
the first unit for $50 the second unit for $40 and so on. Total revenue
would be $150, his total cost would be $25 and his profit would be
$125.00.
Several things are worth noting. 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.
Thus the price discrimination promotes efficiency. Secondly, by the
pricing scheme price = average revenue and equals marginal revenue. That
is the monopolist behaving like a perfectly competitive company. Thirdly, the discriminating monopolist produces a larger quantity than the monopolist operating by a uniform pricing scheme.
Classifying customers
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.
Monopoly and efficiency
Surpluses and deadweight loss created by monopoly price setting
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.
– Adam Smith (1776), The Wealth of Nations
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. 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. For example, a canal monopoly, while worth a great deal during the late 18th century United Kingdom, was worth much less during the late 19th century because of the introduction of railways as a substitute.
Contrary to common misconception,
monopolists do not try to sell items for the highest possible price,
nor do they try to maximize profit per unit, but rather they try to
maximize total profit.
Natural monopoly
A natural monopoly is an organization that experiences increasing returns to scale over the relevant range of output and relatively high fixed costs.
A natural monopoly occurs where the average cost of production
"declines throughout the relevant range of product demand". The relevant
range of product demand is where the average cost curve is below the
demand curve.
When this situation occurs, it is always cheaper for one large company
to supply the market than multiple smaller companies; in fact, absent
government intervention in such markets, will naturally evolve into a
monopoly. An early market entrant that takes advantage of the cost
structure and can expand rapidly can exclude smaller companies from
entering and can drive or buy out other companies. A natural monopoly
suffers from the same inefficiencies as any other monopoly. Left to its
own devices, a profit-seeking natural monopoly will produce where
marginal revenue equals marginal costs. Regulation of natural monopolies
is problematic.
Fragmenting such monopolies is by definition inefficient. The most
frequently used methods dealing with natural monopolies are government
regulations and public ownership. Government regulation generally
consists of regulatory commissions charged with the principal duty of
setting prices.
To reduce prices and increase output, regulators often use
average cost pricing. By average cost pricing, the price and quantity
are determined by the intersection of the average cost curve and the
demand curve.
This pricing scheme eliminates any positive economic profits since
price equals average cost. Average-cost pricing is not perfect.
Regulators must estimate average costs. Companies have a reduced
incentive to lower costs. Regulation of this type has not been limited
to natural monopolies.
Average-cost pricing does also have some disadvantages. By setting
price equal to the intersection of the demand curve and the average
total cost curve, the firm's output is allocatively inefficient as the
price is less than the marginal cost (which is the output quantity for a
perfectly competitive and allocatively efficient market).
Government-granted monopoly
A government-granted monopoly (also called a "de jure monopoly") is a form of coercive monopoly,
in which a government grants exclusive privilege to a private
individual or company to be the sole provider of a commodity. Monopoly
may be granted explicitly, as when potential competitors are excluded
from the market by a specific law, or implicitly, such as when the requirements of an administrative regulation can only be fulfilled by a single market player, or through some other legal or procedural mechanism, such as patents, trademarks, and copyright.
Monopolist shutdown rule
A monopolist should shut down when price is less than average variable cost for every output level – in other words where the demand curve is entirely below the average variable cost curve.
Under these circumstances at the profit maximum level of output (MR =
MC) average revenue would be less than average variable costs and the
monopolists would be better off shutting down in the short term.
Breaking up monopolies
In a free market, monopolies can be ended at any time by new
competition, breakaway businesses, or consumers seeking alternatives. In
a highly regulated market environment a government will often either
regulate the monopoly, convert it into a publicly owned monopoly
environment, or forcibly fragment it. Public utilities,
often being naturally efficient with only one operator and therefore
less susceptible to efficient breakup, are often strongly regulated or
publicly owned. American Telephone & Telegraph (AT&T) and Standard Oil
are often cited as examples of the breakup of a private monopoly by
government. Standard Oil never achieved monopoly status, a consequence
of existing in a market open to competition for the duration of its
existence. The Bell System, later AT&T, was protected from competition first by the Kingsbury Commitment,
and later by a series of agreements between AT&T and the Federal
Government. In 1984, decades after having been granted monopoly power
by force of law, AT&T was broken up into various components, MCI, Sprint, who were able to compete effectively in the long distance phone market.
Law
The law regulating dominance in the European Union is governed by
Article 102 of the Treaty on the Functioning of the European Union which
aims at enhancing the consumer’s welfare and also the efficiency of
allocation of resources by protecting competition on the downstream
market.
The existence of a very high market share does not always mean
consumers are paying excessive prices since the threat of new entrants
to the market can restrain a high-market-share company's price
increases. Competition law does not make merely having a monopoly
illegal, but rather abusing the power a monopoly may confer, for
instance through exclusionary practices (i.e. pricing high just because
you are the only one around.) It may also be noted that it is illegal to
try to obtain a monopoly, by practices of buying out the competition,
or equal practices. If one occurs naturally, such as a competitor going
out of business, or lack of competition, it is not illegal until such
time as the monopoly holder abuses the power.
Establishing Dominance
First
it is necessary to determine whether a company is dominant, or whether
it behaves "to an appreciable extent independently of its competitors,
customers and ultimately of its consumer". Establishing dominance is a
two stage test. The first thing to consider is market definition which
is one of the crucial factors of the test. It includes relevant product market and relevant geographic market.
Relevant Product Market
As
the definition of the market is of a matter of interchangeability, if
the goods or services are regarded as interchangeable then they are
within the same product market. For example, in the case of United Brands v Commission,
it was argued in this case that bananas and other fresh fruit were in
the same product market and later on dominance was found because the
special features of the banana made it could only be interchangeable
with other fresh fruits in a limited extent and other and is only
exposed to their competition in a way that is hardly perceptible. The
demand substitutability of the goods and services will help in defining
the product market and it can be access by the ‘hypothetical monopolist’
test or the ‘SSNIP’ test .
Relevant Geographic Market
It
is necessary to define it because some goods can only be supplied
within a narrow area due to technical, practical or legal reasons and
this may help to indicate which undertakings impose a competitive
constraint on the other undertakings in question. Since some goods are
too expensive to transport where it might not be economic to sell them
to distant markets in relation to their value, therefore the cost of
transporting is a crucial factor here. Other factors might be legal
controls which restricts an undertaking in a Member States from
exporting goods or services to another.
Market definition may be difficult to measure but is important
because if it is defined too broadly, the undertaking may be more likely
to be found dominant and if it is defined too narrowly, the less likely
that it will be found dominant.
As
with collusive conduct, market shares are determined with reference to
the particular market in which the company and product in question is
sold. It does not in itself determine whether an undertaking is dominant
but work as an indicator of the states of the existing competition
within the market. The Herfindahl-Hirschman Index
(HHI) is sometimes used to assess how competitive an industry is. It
sums up the squares of the individual market shares of all of the
competitors within the market. The lower the total, the less
concentrated the market and the higher the total, the more concentrated
the market. In the US, the merger guidelines state that a post-merger HHI below 1000 is viewed as not concentrated while HHIs above that will provoke further review.
By European Union law, very large market shares raise a
presumption that a company is dominant, which may be rebuttable. A
market share of 100% may be very rare but it is still possible to be
found and in fact it has been identified in some cases, for instance the
AAMS v Commission case.
Undertakings possessing market share that is lower than 100% but over
90% had also been found dominant, for example, Microsoft v Commission
case. In the AKZO v Commission case,
the undertaking is presumed to be dominant if it has a market share of
50%. There are also findings of dominance that are below a market share
of 50%, for instance, United Brands v Commission,
it only possessed a market share of 40% to 45% and still to be found
dominant with other factors. The lowest yet market share of a company
considered "dominant" in the EU was 39.7%.If a company has a dominant
position, then there is a special responsibility not to allow its
conduct to impair competition on the common market however these will
all falls away if it is not dominant.
When considering whether an undertaking is dominant, it involves a
combination of factors. Each of them cannot be taken separately as if
they are, they will not be as determinative as they are when they are
combined together.
Also, in cases where an undertaking has previously been found dominant,
it is still necessary to redefine the market and make a whole new
analysis of the conditions of competition based on the available
evidence at the appropriate time.
Other Related Factors
According
to the Guidance, there are three more issues that must be examined.
They are actual competitors that relates to the market position of the
dominant undertaking and its competitors, potential competitors that
concerns the expansion and entry and lastly the countervailing buyer
power.
- Actual Competitors
Market share may be a valuable source of information regarding the
market structure and the market position when it comes to accessing it.
The dynamics of the market and the extent to which the goods and
services differentiated are relevant in this area.
- Potential Competitors
It concerns with the competition that would come from other
undertakings which are not yet operating in the market but will enter it
in the future. So, market shares may not be useful in accessing the
competitive pressure that is exerted on an undertaking in this area. The
potential entry by new firms and expansions by an undertaking must be
taken into account, therefore the barriers to entry and barriers to expansion is an important factor here.
- Countervailing Buyer Power
Competitive Constraints may not always come from actual or potential
competitors. Sometimes, it may also come from powerful customers who
have sufficient bargaining strength which come from its size or its
commercial significance for a dominant firm.
Types of Abuses
There are three main types of abuses which are exploitative abuse, exclusionary abuse and single market abuse.
- Exploitative Abuse
It arises when a monopolist has such significant market power that it
can restrict its output while increasing the price above the
competitive level without losing customers. This type is less concerned by the Commission than other types.
- Exclusionary Abuse
This is most concerned about by the Commissions because it is capable
of causing long- term consumer damage and is more likely to prevent the
development of competition. An example of it is exclusive dealing agreements.
- Single Market Abuse
It arises when a dominant undertaking carrying out excess pricing
which would not only have an exploitative effect but also prevent
parallel imports and limits intra- brand competition.
Examples of Abuses
- Limiting supply
- Predatory pricing or undercutting
- Price discrimination
- Refusal to deal and exclusive dealing
- Tying (commerce) and product bundling
Despite wide agreement that the above constitute abusive practices,
there is some debate about whether there needs to be a causal connection
between the dominant position of a company and its actual abusive
conduct. Furthermore, there has been some consideration of what happens
when a company merely attempts to abuse its dominant position.
Historical monopolies
Origin
The term "monopoly" first appears in Aristotle's Politics. Aristotle describes Thales of Miletus's cornering of the market in olive presses as a monopoly (μονοπώλιον).
Another early reference to the concept of “monopoly” in a commercial sense appears in tractate Demai of the Mishna
(2nd century C.E.), regarding the purchasing of agricultural goods from
a dealer who has a monopoly on the produce (chapter 5; 4).
The meaning and understanding of the English word 'monopoly' has changed over the years.
Monopolies of resources
Salt
Vending of common salt (sodium chloride)
was historically a natural monopoly. Until recently, a combination of
strong sunshine and low humidity or an extension of peat marshes was
necessary for producing salt from the sea, the most plentiful source.
Changing sea levels periodically caused salt "famines"
and communities were forced to depend upon those who controlled the
scarce inland mines and salt springs, which were often in hostile areas
(e.g. the Sahara desert) requiring well-organised security for transport, storage, and distribution.
The Salt Commission was a legal monopoly in China. Formed in 758, the Commission controlled salt production and sales in order to raise tax revenue for the Tang Dynasty.
The "Gabelle" was a notoriously high tax levied upon salt in the Kingdom of France. The much-hated levy had a role in the beginning of the French Revolution,
when strict legal controls specified who was allowed to sell and
distribute salt. First instituted in 1286, the Gabelle was not
permanently abolished until 1945.
Coal
Robin Gollan argues in The Coalminers of New South Wales that anti-competitive practices developed in the coal industry of Australia's Newcastle as a result of the business cycle.
The monopoly was generated by formal meetings of the local management
of coal companies agreeing to fix a minimum price for sale at dock. This
collusion was known as "The Vend". The Vend ended and was reformed
repeatedly during the late 19th century, ending by recession in the
business cycle. "The Vend" was able to maintain its monopoly due to
trade union assistance, and material advantages (primarily coal
geography). During the early 20th century, as a result of comparable
monopolistic practices in the Australian coastal shipping business, the
Vend developed as an informal and illegal collusion between the
steamship owners and the coal industry, eventually resulting in the High
Court case Adelaide Steamship Co. Ltd v. R. & AG.
Petroleum
Standard Oil was an American oil producing, transporting, refining, and marketing company. Established in 1870, it became the largest oil refiner in the world. John D. Rockefeller was a founder, chairman and major shareholder. The company was an innovator in the development of the business trust. The Standard Oil trust streamlined production and logistics, lowered costs, and undercut competitors. "Trust-busting"
critics accused Standard Oil of using aggressive pricing to destroy
competitors and form a monopoly that threatened consumers. Its
controversial history as one of the world's first and largest multinational corporations ended in 1911, when the United States Supreme Court
ruled that Standard was an illegal monopoly. The Standard Oil trust was
dissolved into 33 smaller companies; two of its surviving "child"
companies are ExxonMobil and the Chevron Corporation.
Steel
U.S. Steel has been accused of being a monopoly. J. P. Morgan and Elbert H. Gary founded U.S. Steel in 1901 by combining Andrew Carnegie's Carnegie Steel Company with Gary's Federal Steel Company and William Henry "Judge" Moore's National Steel Company.
At one time, U.S. Steel was the largest steel producer and largest
corporation in the world. In its first full year of operation, U.S.
Steel made 67 percent of all the steel produced in the United States.
However, U.S. Steel's share of the expanding market slipped to 50
percent by 1911, and anti-trust prosecution that year failed.
Diamonds
De Beers
settled charges of price fixing in the diamond trade in the 2000s. De
Beers is well known for its monopoloid practices throughout the 20th
century, whereby it used its dominant position to manipulate the
international diamond market. The company used several methods to
exercise this control over the market. Firstly, it convinced independent
producers to join its single channel monopoly, it flooded the market
with diamonds similar to those of producers who refused to join the
cartel, and lastly, it purchased and stockpiled diamonds produced by
other manufacturers in order to control prices through limiting supply.
In 2000, the De Beers business model changed due to factors such
as the decision by producers in Russia, Canada and Australia to
distribute diamonds outside the De Beers channel, as well as rising
awareness of blood diamonds
that forced De Beers to "avoid the risk of bad publicity" by limiting
sales to its own mined products. De Beers' market share by value fell
from as high as 90% in the 1980s to less than 40% in 2012, having
resulted in a more fragmented diamond market with more transparency and
greater liquidity.
In November 2011 the Oppenheimer family announced its intention
to sell the entirety of its 40% stake in De Beers to Anglo American plc
thereby increasing Anglo American's ownership of the company to 85%.[30]
The transaction was worth £3.2 billion ($5.1 billion) in cash and ended
the Oppenheimer dynasty's 80-year ownership of De Beers.
Utilities
A public utility (or simply "utility") is an organization or company that maintains the infrastructure for a public service or provides a set of services for public consumption. Common examples of utilities are electricity, natural gas, water, sewage, cable television, and telephone. In the United States, public utilities are often natural monopolies
because the infrastructure required to produce and deliver a product
such as electricity or water is very expensive to build and maintain.
Western Union was criticized as a "price gouging" monopoly in the late 19th century.
American Telephone & Telegraph was a telecommunications giant. AT&T was broken up in 1984.
In the case of Telecom New Zealand, local loop unbundling was enforced by central government.
Telkom is a semi-privatised, part state-owned South African telecommunications company.
Deutsche Telekom
is a former state monopoly, still partially state owned. Deutsche
Telekom currently monopolizes high-speed VDSL broadband network.
The Long Island Power Authority (LIPA) provided electric service to over 1.1 million customers in Nassau and Suffolk counties of New York, and the Rockaway Peninsula in Queens.
The Comcast Corporation is the largest mass media and communications company in the world by revenue. It is the largest cable company and home Internet service provider in the United States, and the nation's third largest home telephone service provider. Comcast has a monopoly in Boston, Philadelphia, and many other small towns across the US.
Transportation
The United Aircraft and Transport Corporation was an aircraft manufacturer holding company that was forced to divest itself of airlines in 1934.
Iarnród Éireann, the Irish Railway authority, is a current monopoly as Ireland does not have the size for more companies.
The Long Island Rail Road (LIRR) was founded in 1834, and since the mid-1800s has provided train service between Long Island and New York City.
In the 1870s, LIRR became the sole railroad in that area through a
series of acquisitions and consolidations. In 2013, the LIRR's commuter rail system is the busiest commuter railroad in North America, serving nearly 335,000 passengers daily.
Foreign trade
Dutch East India Company was created as a legal trading monopoly in 1602. The Vereenigde Oost-Indische Compagnie enjoyed huge profits from its spice monopoly through most of the 17th century.
The British East India Company was created as a legal trading monopoly in 1600. The East India Company was formed for pursuing trade with the East Indies but ended up trading mainly with the Indian subcontinent, North-West Frontier Province, and Balochistan. The Company traded in basic commodities, which included cotton, silk, indigo dye, salt, saltpetre, tea and opium.
Professional sports
Major League Baseball survived U.S. anti-trust litigation in 1922, though its special status is still in dispute as of 2009.
The National Football League survived anti-trust lawsuit in the 1960s but was convicted of being an illegal monopoly in the 1980s.
Other examples of monopolies
- Microsoft has been the defendant in multiple anti-trust suits on strategy embrace, extend and extinguish. They settled anti-trust litigation in the U.S. in 2001. In 2004 Microsoft was fined 493 million euros by the European Commission which was upheld for the most part by the Court of First Instance of the European Communities in 2007. The fine was US$1.35 billion in 2008 for noncompliance with the 2004 rule.
- Monsanto has been sued by competitors for anti-trust and monopolistic practices. They have between 70% and 100% of the commercial GMO seed market in a small number of crops.
- AAFES has a monopoly on retail sales at overseas U.S. military installations.
- The Walt Disney Company seeks to acquire the large media company 21st Century Fox in 2017, despite the company owning numerous other firms related to animation, comics and media.
- The State retail alcohol monopolies of Norway (Vinmonopolet), Sweden (Systembolaget), Finland (Alko), Iceland (Vínbúð), Ontario (LCBO), Quebéc (SAQ), British Columbia (Liquor Distribution Branch), among others.
Countering monopolies
According to professor Milton Friedman, laws against monopolies cause more harm than good, but unnecessary monopolies should be countered by removing tariffs and other regulation that upholds monopolies.
A monopoly can seldom be established within a country without overt and covert government assistance in the form of a tariff or some other device. It is close to impossible to do so on a world scale. The De Beers diamond monopoly is the only one we know of that appears to have succeeded (and even De Beers are protected by various laws against so called "illicit" diamond trade). – In a world of free trade, international cartels would disappear even more quickly.
— Milton Friedman, Free to Choose, p. 53–54
However, professor Steve H. Hanke believes that although private
monopolies are more efficient than public ones, often by a factor of
two, sometimes private natural monopolies, such as local water
distribution, should be regulated (not prohibited) by, e.g., price
auctions.
Thomas DiLorenzo asserts, however, that during the early days of
utility companies where there was little regulation, there were no
natural monopolies and there was competition. Only when companies realized that they could gain power through government did monopolies begin to form.
Baten, Bianchi and Moser
find historical evidence that monopolies which are protected by patent
laws may have adverse effects on the creation of innovation in an
economy. They argue that under certain circumstances, compulsory
licensing – which allows governments to license patents without the
consent of patent-owners – may be effective in promoting invention by
increasing the threat of competition in fields with low pre-existing
levels of competition.
