Mono means “one” and a monopoly is the one and only company in a market, which means that company has total market power. And, given its market power, it can influence price by choosing how much quantity to supply. However, it cannot charge just any price because the monopolist is still bound by the laws of demand.
Figure 8-1 shows a diagram of a monopoly. It looks much the same as a regular market except for a new curve – marginal revenue (MR), which is the change in revenue given a change in quantity. Because the monopolist controls quantity, it also controls revenue. Remember that the demand curve is the locus of price/quantity pairs, so at each quantity the monopolist could charge the associated price. The monopolist wants to maximize its profits however, so it will not charge the highest price. The rule to maximize profit as a monopolist is to select the quantity associated with the point where marginal revenue equals marginal cost (at the yellow star). At that quantity (QM), the monopolist knows that willingness to pay is PM.
If there were many sellers, rather than one, the efficient market equilibrium would be where D = MC/Supply. This type of market structure is known as perfect competition because neither producers nor consumers can influence the price, and both producers and consumers can enter the market freely.
So where’s the market failure?
Price is higher than is socially efficient, quantity is lower than what would occur at e*, and MC ≠ P. The rule for efficiency is that the marginal cost should equal the price. But in plain English, what does this mean?
It comes down to producer and consumer surplus, and leaving value on the table. Let’s compare values between the equilibrium point, e* with the monopolist’s point of operation, m*. But first, try this:
- Redraw Figure 8-1.
- Identify under the perfect competition scenario:
- Consumer surplus
- Total value
- Producer surplus
- Identify under the monopolist scenario on the same graph:
- Consumer surplus
- Total value
- Producer surplus
Are consumers better off with the monopolist?
Is the monopolist better off than under competition?
Figure 8-2 illustrates changes in values using three coloured areas.
The answers to the questions above are that both consumer surplus and total value are smaller, meaning that consumers are worse off with the monopolist. The loss in total value is the area outlined in black. The loss to consumers is both the red triangle (lost because the monopolist produces a smaller quantity) and the blue rectangle, the latter of which was consumer surplus but is now revenue that goes to the monopolist. The monopolist loses the green triangle, which it makes up by gaining revenue that used to be consumer surplus (blue rectangle).
If we add the red and green area, we have something called “deadweight loss,” which is lost to society as a result of producing too little quantity and charging a price above that which would occur under perfect competition.
In Canada, monopolies are not against the law. However, there is a law regarding unfair competition as specified by the Competition Act 1889 (Bériault and Borgers 2004.) Additionally, there is something called a “natural monopoly,” whereby the best option is to have only one producer: there are not enough consumers to support more than one producer. In most cases, these businesses are utilities such as power, water, and energy that require extensive infrastructure to deliver the goods. If a second or third producer tried to enter the market, the outcome would be inefficient because the new company would have to duplicate power lines, railways, pipelines, grids, etc.
In the case of natural monopolies the government will often provide the service, or regulate the price. For example, SaskEnergy and SaskPower must justify and apply for permission to raise rates. In this way the government can ensure that such monopolies don’t take advantage of their market power by charging excessive prices. Check out the SaskPower news release asking for a rate hike.
In cases where monopolies might be trying to dissuade other entrants from competing, or competing unfairly by offering their goods at prices lower than cost, government regulation is required. Only the government has the power to force the monopolist to lower prices, or to break up the monopoly to prevent it from having so much market power.
Can you think of monopolies in the agriculture industry? Sometimes very large companies merge to make even larger companies and thus reduce competition. The article below by Gregston (2016) explains how fewer companies can lead to less choice in the market.
The government does however grant monopoly power in some cases. Research and development requires a tremendous amount of investment and not always do new products and methods succeed. So, to encourage innovation and research, companies register patents so that they have the exclusive right to produce and sell what they’ve invented for several years. Without this protection, there would be no incentive to invest. That’s why medicines, for example, are produced exclusively (and are more expensive) just after they’ve been developed. When the patent expires, the price drops because there are more choices given the production of generic brands.
Check out this link to Monsanto that explains what happens to farmers who save seeds.