aoooooooooooaoaooaaoo

Monopoly
By the end of this chapter, you should be able to:

ur

explain the assumptions of monopoly

xr- define, explain, and give examples of sources of monopoly power/

o
o

barriers to entry

xl

define, explain, and illustrate a natural monopoly

xr-

explain and illustrate the demand curve facing the monopolist

xl
rl

explain and illustrate possible profit situations in monopoly

explain, illustrate, and calculate the revenue maximizing level of

output and price

xl

explain and illustrate levels of efficiency in monopoly

Hr

compare monopoly and perfect competition.

l{t Assumptions of the model

In the theory of monopoly, we assume that:

.
o
.

There is only one firm producing the product so the firm is the

industry.
Barriers to entry exist, which stop new firms from entering the
industry and maintains the monopoly.
As a consequence of barriers to entry the monopolist may be able
to make abnormal profits in the long run.

However, whether a firm really is a monopoly depends upon how

narrowly we define the industry. For example, Microsoft may be the
only producer of a particular kind of software, but it does not have a
monopoly oI all software. The vegetable shop in your area may have
a monopoly of the sale of vegetables in that area, but it is not the
only seller of vegetables and if the area is widened then the shop
loses its monopoly.

The important question here is not whether or not a firm is a

monopoly, but rather how much monopoly power the firm has.
To what extent is the firm able to set its own prices without
worrying about other firms and to what extent can it keep people
out oI the industry? The strength of monopoly power possessed by
a lirm will really depend upon how many competing substitutes
are available. For example, the underground railway in a city may
have the monopoly of underground travel, but it will face
competition from other industries, such as buses, taxis, and private
transpoft.

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8.

A,4onopoly

Student workpoint 8.1

Be reflective-use your own experience
ln each case below, suggest which ones are
monopolies and also define the width of the industry
that you are assuming:

I
2

the canteen in your school

5
4

the local refuse disposal service

5
6

the national telephone service

your school

the national postal service.

=
d

your doctor

o
o
o

Sources of monopoly powe/barriers to entry

A monopoly may continue to be the only producer in an industry if
it is able to stop other fims from entering the industry in some way.
These \ryays of preventing entry to the industry are known as barriers
to entry. There are a number of possible barrie$ to entry as follows.

Economies of scale
As we have seen in Chapter 6, firms gain average cost advantages as
their size increases: these are known as economies of scale. Things
such as specialization, the division of labour, bull<-buying, and
financial economies may lead to cost savings and lower unit costs. If a
monopoly is large, then they will be experiencing economies of scale.
Any firm wishing to enter the industry wiLl probably have to start up
in a relatively small way and so will not have the economies of scale
that are enjoyed by the monopolist. Even if the new firm were able
to start up with the same size as the monopolist, it would still not
have the economies that come from expertise in the industry, such as
managerial economies, promotional economies, and research and
development.

Without equal economies of scale, a would-be entrant to the industry

knows that it would not be able to compete with the existing
monopolist, who would simply have to reduce price to the level of
normal profits. At this level the new entrant would be making losses,
because the average costs would be higher, so the lack of economies
of scale acts as a deterrent to firms that might want to enter a
monopoly industry.

Natural monoPoly

Some industries are classified as natural monopolies. An industry is a

natural monopoly if there are only enough economies of scale
available in the market to support one firm. This is best shown by
a diagram, such as Figure

8.I.

In this case, the monopolist is the industry and has the demand curve
Dr. The long-run average cost cuwe faced by the monopolist is LRAC
and its position and shape are set by the economies of scale that the
firm is experiencing. The monopolist is able to make abnormal profits
by producing an output between qr and qr, because the average
revenue is greater than the average cost for that range of output.

Quantity demanded

Figure 8.1 A natural monopolY

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8.

Monopoly

If another firm were to enter the industry, then the firm would take
demand from the monopolist and the monopolist,s demand curve
would shift to the left, in this case to D2. Since we can assume that
the situation will be the same for both Iirms, the two firms would
now be in a position where it is impossible for them to make even
normal profits. Their LRACs would be above AR at every level of
output.
F

In this industry, the LRAC, which is shaped by the economies of scale

experienced by the monopolist, will only give an abnormal profit if
the monopolist is able to satisfy all of the demand in the market. The
industry is a natural monopoly, because the market will only support
one firm. Examples of natural monopolies include the industdes that
supply utilities such as water, electdcity, and gas.

.9

3 Legal barriers
In certain situations, a firm may have been given a legal right to be
the only producer in an industry, i.e. rhe legal right to be a monopoly.
This is the case with patents, which give a firm the right to be the
only producer of a product for a certain number oI years after it has
been invented. Patents are usually valid for approximately 20 ycars.
When a patent expires other producers will then be allowed to
produce and sell the product. Patents exist as a means to encourage
invention. If individuals or firms put time and money into
inventions, only to find that they were copied as soon as they were
successful, then there would be little incentive to do so. However, if a
firm knows that, if its invention is successful, it will have a protected
monopoly for a number of years, then it is more likely to invest in

Congratllations! Yoer geerr of

exfentiye retear<h anl Jev<totrr,cnt
hav Paid sff. For 2c' geart, 9oq
sr;(t be the ontg ffoducer
NATtoNAL
?ATENT

Pernlttcl to
?rodoc

AurHoRl

research and development.

Patents, along wirh copyrights and trademarks, are examples of

intellectual property dghts. Intellectual property refers to the

creations of the mind. Just as pdvate property dghts allow people to
own physical property, so patents guarantee the creators of ideas rhe
rights to or.r.n their ideas. A very good example of patent protection is
found in the phamaceutical industry.

Another example oI legal barriers is where the government ol a

country grants the right to produce a product to a single firm. It may
do this by setting up a nationalised industry, such as a state postal
service, and then banning other firms from entering that industry, or
it may simply sell the right to be a sole supplier to a private firm, such
as the right to be the only network provider for mobile phones, once
again banning other firms.

114

Brand loyalty
It may be that a monopolist produces a product that has gained
huge brand loyalty. The consumers think of the product as the
brand. For example, in the early days of the vacuum cleaner they
were simply known by their brand name, Hoover. If the brand
loyalty is so strong then new firms may be put off from enrering the
industry, since they will feel that rhey are not able to produce a
product that will be sufliciently different in order to generate such
strong brand loyalty.

Student workpoint 8-2

Be reflective-use youl own

experience
Can you think of any other

products that dominate

the market so heavily that the
product is known by its brand
name rather than its product
name? Can you think of any
products that have lost this
market dominance to
competitors?

thi r

8.
Student workpoint

Monopoty

IIIE

8.!

Be reflective
Use the information below to explain the possible
advantages and disadvantages of pharmaceutical
patents for the different stakeholders involved.

and release it as
soon as the patent

Discoveries of new drugs have led to significant

improvements in health and longevity. None of this
would have been possible if pharmaceutical companles
hadn't had the incentlve to carry out the research,
development, and testing necessary to bring these drugs
onto the market. Estimates of the costs of developing
and testinS new drugs in the US range from $8oo
million to $2 billion and it can take anywhere from 12
to 15 years to bring a new drug onto the market.

Ceneric drugs are

Civen these figures, it is not surprising that drug

developers want to have some guarantee that they will
be able to be the exclusive providers so that they can
recover their costs and maximize their profits. This is
why patents are justified. ln fact, pharmaceutical
companies continually lobby governments to have
increased patent protection for their products.
As soon as the patent on a drug expires, other
pharmaceutical companies can produce and sell their
own version of the drug. These are commonly known
as generic drugs or simply generics. A generic drug is
exadly the same as its patented version in terms of
dosage, safety, strength, intended use, risks, and
benefits. They are said to be "bio-equivalent".
The producers of the generic drug can develop the drug
while the brand name drug is protected by its patent

expires.

vastly less expensive

than the brand name

drugs quite simply

because the pharmaceutical companies that produce

the generic drug do not have the huge development
and testing costs. The generics have to meet the
country's health and safety standards, but it takes much
less time and money than the original. With lower costs,
they can charge lower prices.

3.

Drug companies spend a lot of money on advertising to

try to make sure that the consumers of their druSs
maintain brand loyalry This is particularly important
when a drug is facing its patent expiry. They hope that
their consumers will stick with their drug even when
cheaper generics are on the market. lf the drug is a
prescription drug, the pharmaceutical comPanies may
find ways to convince doctors that they should keep
prescribing the brand name drugs.
There are deep ethical issues involved in the question
of patents on life-saving drugs. The fad that people die
from preventable diseases because they cannot afford
to buy the patented medicines, even though generic
drugs may be made available at a fraction of the price,
is currently under debate.

Anti-competitive behaviour

A monopolist may also attempt to stop competition by adopting

restrictive practices, which may be legal or illegal. For example, an
established monopoly should be in a strong position to start a "price
war" if another firm enters the industry. The monopoly can lower its
price to a loss-making level and should be able to sustain the losses for
a longer time than the new entrant, thus forcing the new firm out of
the industry. Indeed, knowledge of this possibility should be enough
to dissuade new firms from even attempting to enter the industry.

In 2004, the European Union Competition Commission filed

Microsoft 497 million for 'bundling' its windows Media Player
and messaging technologies into its Windows operating system. The
comrnission daimed that this prevented potential competitors from
reaching consumers. It also ordered Microsoft to make public technical
information to allow other companies the ability to produce goods that
are compatible with Microsoft to give Microsoft more competition
In 2006, Microsoft received an additional fine of 280.5 billion for
alleged failure to comply with the 2004 fine. Microsoft appealed the
fine, but lost the appeal in September 2007. Microsoft was fined

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!!!!!

8 o Monopoly

again in 2008 for failure to comply with the ruling, and was ordered
to pay 899 million Euros, the largest fine ever given by the
European Compe tition Con-lmission.
That is not the end of it, however. In 2009, the EU Competition
Commission again found Microsoft guilty of anti-competitive
practices, this time for bundling its Internet Explorer browser into
its Windows operating system. According to the commission:
E

"The evidence gathered during the investigation leads the Commission to believe
that the tying of Internet Explorer with Wnd.owL which makes Internet
Explorer available on 90% of the wo d's PCs, distofts competition on the
meits between competing web br1wsers insofar as it proides Intemet Exploret
with an artificial distribution advantage which other web browserc are
unable to match. The Commission is concerned that through the tying, Miffosoft
shields Internet Explorer from head to head competition with other browsers
which is detrime tal to the paee of proiluct innovation and to the
quality of produds which eonsumers ultimately obtain. In addition, the

Student workpolnt 8.4

Be an inquirer-conduct
researrh and assess the
outcomes

Commission is concet'ned that the ubiquity of Internet Explofer creates artifrcial

incentives for content proiders and sofiware developers to design websites or

an annotated time
line to briefly explain the
series of events and
decisions in the Microsoft
leSal baftle with the

N/lake

European Union

software primarily for Internet Explorer whi.ch ultimately risks undermining

Competition Commission.

competition and inn1vation in the provision of sentices to consumers."

Source: Europa press release, January l7th, 2009

What are the argumen6 for

and against the large fine?

The demand curve and the profit-maximizing level

of output in monopoly

As we know, the monopolist is the industry and so the monopolist's

demand curve is the industry demand curve and is downward
sloping. The monopolist can therefore control either the level ol

output or the price of the product, but not both. Students often
assume that monopolists can charge whatever price they like and still
sell their products, but this is not the case. In order to sell more they
must lower their price.

e9

:i

The demand curve facing a monopolist is shown in Figure 8.2. The

monopolist has a normal demand curve, with marginal revenue
below it, and maximizes profit by producing at the level of output
where marginai cost is equal to marginal revenue.

Oritput
FiSure 8.2 The demand curve facing a

We can see that, in this case, the monopolist sells a quantity q at a

price per unit of P

monopolist

Possible profit situations in monopoly

If a monopolist is able to make abnormal profits in the short run, and i{
the monopolist has effective barriers to entry, then other firms cannot
enter the industry and compete away the profits that are being eamed.
In this situatlon, the monopolist is able to make abnormal profits in the
long run, for as long as the barriers to entry hold out. This situation is
shown in Figure 8.3.

o"c

The monopolist is maximizing profits and is making abnormal profits

shown by the shaded area, PabC. Without the entry of new firms to

the industry this situalion will continue.

l:16

Output

Figure 8.3 Abnormal profits in the long

run in monopoly

8.
It is sometimes assumed that a monopolist will always eam abnormal
profits, but this is not true. If the monopolist produces something for
which there is little demand, then it will not eam abnormal profits. II
a monopolist were making losses in the short run, then it would have
the option of dosing down temporarily (iI it was not covering its
variable costs) or continuing production for the time being. However,
it would plan ahead in ttre long run to see whetber changes could be
made so that normal profits, at least, could be eamed. ff this were not
possible, then the rnonopolist would dose dovrm the firm and, since
the firm is the industry, the industry would cease to exist. This
situation is shown in Figure 8.4.
Here, the firrn is not able to cover costs in the long run, since the
average cost is greater than the average revenue at all levels oI output.
Since there is nothing that can be done to rectify the situation, this
will be an industry in which no firm will be willing to produce. Ttrere

Monopoly

'i

,gi:

6:

Output

Figure 8.4 A monopolist making losses

in the long run

will be no industry.

Revenue maximization in monopoly

It is possible that a monopolist may decide to maximise revenue
rather than profits. This situation is shown in Figure 8.5.
Instead of maximizing proiis, and producing where MC : MR, the
monopolist will produce where MR : 0 (see Chapter 6, Figure 6.I0
and explanation). This means that the monopolist will reduce price
from PpM to PRI{ and at the same time incease output foom q?M to qR!,r.
The revenue maximizing level of oulput is clear from a diagram,
since it is the level of output where the MR curve cuts the horizontal
axis. It can also be identilied from a set of revenue ligures such as the
ones in Table

8.I.

E
g

PPM
PRM

Output
Figure 8.5 Revenue maximizing as

opposed to profit maximilng in monopoly

?D

E?l

l!!!!

8.

i\,4onopory

Here we can clearly see that, if revenue is maximized where MR = 0,

then the revenue maximization level of output is between 50 and 60

units, i.e. 55 units.

Efficiency in monopoly
Unlike perfect comptition, the monopolist produces at the level ol
output where there is neither productive efficiency nor allocative
efficiency. This is shown in Figure 8.6.

o
o

The monopolist is producing at the profit-maximizing level of output, q.

Output is being restricted in order to force up the price and to maximize
profit. However, the most efficient level of output, q1 and the allocatively
eflicient level of output, q2, are not being achieved.

Advantages and disadvantages of monopoly in

comparison with perfect competition
Although they are both theoretical market forms, there has always
been much debate about the relatlve merits and demerits of perfect
competition and monopolies.
The advantages of monopoly in comparison with perfect

competition
Monopolies may be able to achieve large economies of scale simply
because of their size. Monopolies do not have to be big, but if rhe
industry is big, then the monopolist should gain substantial economies
of scale. If this pushes the MC curve down, then it is possible that the
monopolist may produce at a higher output and at a lower price than
in perfect competition. This idea of relative price and output in
monopoly and perfect competition is very debateable. The situation is
shown in Figure 8.7.

Output

Figure 8.7 Economies of scale in monopoly

In perfect competition, rhe equilibrium pdce and quantity will be

where demand is equal to supply. This means that the price will be
Pr and that a total output of Q, will be produced. However, if the
industry is a monopoly, with significant economies of scale, then the
MC cur-ve may well be substantially below the MC curve in pedect
competition, which is the industry supply cuwe.
8

If this is the case, then the monopolist will produce where MC:MR,
maximizing profits and producing a greater quantity than perfect
competition, Q2, at a lower price, Pr.

Output

Figure 8.6 Produdive and allocative

efficiency in monopoly

8.

N,4onopoly

IIIE

A second advantage may be that there will be higher levels oI

investment in research and development in monopolies. Firms in
perfect competition are, by definition, relatively small, and so may
find it difficult to invest in research and development. However, a
monopolist making abnormal profits is in a better situation to use
some of those prolits to fund research and development. This would,
in the long run, benefit consumers, who would have better products
and even more choice.

The disadvantages of monopoly in comparison with

o

perfect competition

l.

I{ significant economies of scale do not exist in a monopoly, then the

monopoly may restrict output and charge a higher price than under
perfect competition.

In Figure 8.8, there are no differences in costs for the monopolist

and the perfectly competitive market. If this is the case, then the
monopolist will produce Q2 at a price of Pr, where MC = MR. The
perfectly competitive market will, however, produce Q1 at a price of
P,, where industry supply meets industry demand. Thus higher prices
and lower output would exist under monopoly.
(= slrppy under pelfect competition)

.c
PJ

Output

Figure B.B l\/lonopoly versus perfect comPetition without economies of scale

The high profits of monopolists may be considered as unfair,

especially by competitive firms, or those on low incomes. The scale
of the problem depends upon the size and power of the monopoly.
The monopoly profits of your local post olIice may seem of little
consequence when compared to the profits of a giant national
company.
To summarize, there are three possible problems associated

with

monopolies in comparison with perfect competition.

o
o
o

They are productively and allocatively inefficient.

They can charge a higher price for a lower level of output.
They can exercise anti-competitive behaviour to keep their
monopoly power.

These potential problems mean that monopolies can act against the
public interest. As a result, all governments have laws and policies to

limit monopoly power. This will be developed in Chapter

12.

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!!!!!

8.

N,4onopoly

EXAMINATION QUESTIONS
Paper I, pail (a) questions

I
2
5

Explain

the level of output at which a monopoly firm will produce.

[10 norks]

Using a diagram, explain the concept of a natural monopoly.

[10 morks]

Using appropriate diagrams, explain whether a monopoly is likely to be more efficient or less

efficient than a firm in perfect competition.

[t0 norks]

Paper I, essay question

I a
b

Explain three barriers

to entry that allow

firm to be a monopoly.

Evaluate the view that governments should

Assessment odvice: essoy

[lo

a/roys prevent firms from being monopolies.

morks]

[15 moks]

wlting

ln essay question I (b) the word "always" is in italics.

This is a word that often appears in examination questions,
but if you see it on your exam, it won't be in italics. lt is in
italics here in order to draw your attention to it to let you
know that it is a key word. ln your evaluation, you are likely

to explain why governments should prevent firms from

being monopolies, but then discuss any circumstances
where they should not. That is, you will be arguing against
the view that they should o/woys do so.

Dato response exercise

Note: Data Response questions on your exam will be based mainly on lnternational and Development Economics.
However, they are good for learning and practice, so you should do them wherever they appear in this companion.
Read the article below and answer the questions that follow.

Bitter pill for pharmaceutical company Merck

Indian phamace utical companies

Ranbaxy and

Dr

Reddy's
Laboratories are expected to be
major beneficiaries to take
advantage of a multi-billion dollar
sales vacuum created by the patent
erpiry of two popular drugs in the
US. One of the drugs is a cholesterol-

cutting drug called Zocor and the

other is an antidepressant drug
named Zololt.
Merck eamed huge profits from
its sales of Zocor, \ /hose patent
expired on 23 June. Pfizer lost its

patent on l0 June. When

a compary
loses its exclusive patent for a

ability to create, manufacture, and

market generic drugs at low prices,

branded drug,

it is no longer a
monopoly in the market, and the

aided by the availabiJity of cheaper

market opens to generic drugmaken.

and skilled labour.

Ranbaxy is planning to produce
simvastatin, a genedc ve$ion of

This can lead to a drop of nearly

80o/o in the drug's price, resulting
in a major gain for consumers as
well as the makers of generic
versions of these drugs.
Indian companies are in good

zocor, after receiving tfre required

approval from the US Food and

Drug Administration.

Including those from India,

shape to gain from the patent expiries

billions of dollals' worth oI drugs

are scheduled to cdme off patent

in developed markets like the US

in 2006.

and Europe. They have

tremendous

Define the following terms, indicated in bold in the text:

a
b

120

patent

[2 morks]

monopoly.

[2 narks]

UsinS an appropriate diagram, explain why Merck was able to earn huge
profits from its sales of Zocor.

[4 morks]

Using an appropnate diagram, explain how cheaper labour allows lndia to

manufacture generic drugs at low p.i6g5.

[4

Using information from the text and your knowledge of economics, evaluate the effects
of the Zocor patent expjry on the market for cholesterolreducing medicines.

[8 mo*s]

nork]