Monopoly: Meaning, Characteristics and Equilibrium (Short-run & Long-run)

1 year ago

Atiqur Rahman

14 minutes

Introduction

Monopoly is rare and the extreme opposite of a perfectly competitive market structure. In a monopoly, there exists only a single seller where he/she sells the products to a large number of buyers. For this, he/she may charge a uniform price or may indulge in price discrimination. The main advantage to a monopolist is that it has no competitors or rivals in the market, and hence, it earns profits even in the long run.

Meaning of Monopoly:

Monopoly means the single seller of a product, but it is really a very rare condition to have a monopoly in a market structure, especially in the private sector. Since a monopolized industry is a single-firm industry, therefore, there is no distinction between a firm and an industry in a monopolistic market structure. Hence the demand curve of a monopolistic firm is the same as the market demand curve.

Characteristics of Monopoly:

(i) Single Seller and Many Buyers:

Under a monopoly, there is a single seller. He is the sole producer of the commodity. But there exists a large number of buyers in this market as well.

(ii) Firm is an Industry itself:

Under a monopoly, there is no difference between a firm and an industry. So firm’s output is the entire industry’s output, and the demand curve faced by a firm is also the market demand curve for the product.

(iii) No Close Substitutes:

As a monopolist is a sole producer, there are no close substitutes for the product it produces. If close substitutes are available, then the firm will not be able to enjoy a monopoly. Thus, the cross elasticity of demand for the monopolist’s product and other producer products is very small.

(iv) Full Control over Prices:

A monopolist is a single producer who has the sole authority to decide the price of the product that it produces. Unlike perfect competition, the monopolist is a price maker and not a price taker.

(v) Barriers to Entry:

For a monopoly to exist, there have to be barriers to entry. If entry is not restricted, then new firms would attract towards profit. More will be the firms; more will be the competition. But monopoly implies a complete absence of competition.

(vi) Profit Maximization:

The sole objective of the monopoly is profit maximisation. This is achieved by producing that level of output where addition to revenue is equal to addition to cost, i.e. marginal revenue is equal to marginal cost.

(vii) Perfect Knowledge:

The monopolist has full knowledge of market conditions. Any uncertainty about market conditions is completely ruled out.

(viii) Price Discrimination:

This is the most important feature of a monopoly. Under this, a monopolist charges different prices from different customers for the same product.

(ix) No Supply Curve:

Under a monopoly, there is no unique supply curve. So there is no one-to-one relationship between price and quantity supplied.

However, the main source of the emergence of monopoly is barriers to entry like legal restrictions, patent rights, sole control over scarce resources, efficiency etc.

Short-Run Equilibrium of Monopoly Firm:

The equilibrium of a firm is attained at a point where the firm earns a maximum profit. The short-run equilibrium of a monopolistic firm can be studied through two approaches:

TR – TC approach
MR – MC approach

TR – TC Approach:

According to the Total revenue (TR) and Total cost (TC) approach, a monopolistic firm is in equilibrium at the price and output where TR – TC = profit is maximum. For instance, in the following figure, the firm faces a cubic TC function TC = F + bQ − cQ² + dQ³ (where F = fixed cost) and the demand function Q = a − bP.

When we graph the TC function, then we get a Total cost curve as follows. Similarly, from the demand curve, we can get a revenue function by multiplying it by price, and hence when we plot it, then we get the following TR curve.

Equilibrium of monopoly through TR – TC approach

As can be seen from the above figure that till OQ1 and after OQ3, a monopolistic firm faces loss as its TC>TR. Hence a monopolistic firm earns positive profits only between OQ1 and OQ3.

Now the main question is that at which point or output does it maximize its profit in this range? This question can be answered in two ways. First is that the point or output where the vertical distance between the TR and TC is maximum is the point or output where the monopolist earns a maximum profit.

Another way of finding out the maximum profit is through the tangency points on TR and TC. As it can be seen from the above figure, if we draw two parallel lines both at TR and TC then the parallel lines are tangent on TR at point P and at TC at point M.

Now if we analyze this then this is the same point where the distance between the TR and TC is maximum too. Hence the corresponding output at this point corresponds to maximum profit. Hence, a profit-maximizing monopoly reaches its equilibrium at output OQ2.

MR – MC Approach:

As we know, Marginal revenue (MR) is the slope of TR, and Marginal cost (MC) is the slope of TC; therefore, this approach is, in turn, an extension of the previous approach. The equilibrium under this approach is shown in the following diagram:

The Average revenue (AR) curve of a monopolist is downward sloping like a demand curve and is also the demand curve for the monopolist firm because TR = P*Q

AR = P*Q/Q = Q

Hence AR is the demand curve of the monopolist firm. Correspondingly the MR is also downward sloping and has twice the slope of the AR; therefore, it cuts the x-axis at exactly half of the AR. SMC is the short-run marginal cost of the firm, which is U- shaped because, in the short run, some factors are fixed, and some are variable and when we increase the production then, the cost initially reduces because of economies of scale, but after reaching a minimum point of cost when the production is gain increased then the cost also increases due to diseconomies of scale.

Hence SMC is U- shaped. Moreover, SMC is the differentiation of TC, so when we plot this on a graph, we get the SMC curve as above. Similarly, SAC is the Short run average cost curve of the monopolistic firm, which is again U- shaped, but it is below the SMC, because SMC cuts SAC from below, and SAC is the combination of short-run average fixed cost and short-run average variable cost, i.e. AC = AVC + AFC.

Now in order to be in equilibrium, a firm has to fulfil the following two conditions:

MR = MC
Slope of MR > slope of MC, i.e. MR should cut MC from below.

Looking at the above figure, MR = MC at point N, correspondingly the profit-maximizing point or the equilibrium point of the firm is N, where a monopolistic firm produces OQ quantity and sells it at OP1 price and thus maximizes its profit.

Now in order to find out whether, at this point, the monopolistic firm earns a positive profit or a normal profit or a loss, we draw SAC and the point where it cuts PQ line, i.e. at point M, shows the cost of producing OQ output. So as per this, the price of selling OQ output is OP, and the cost of producing OQ is OM.

In other way, the total revenue from selling OQ output is OP1PQ, and the corresponding cost of producing this output is OP2MQ. Here, clearly, the cost of producing the output is much less than the revenue which the monopolist earns after selling it to its consumers. Hence the rectangle P2P1PM is the positive profit or the super normal profit which a monopolistic firm earns in the short run.

The next question which arises at this point is that “Does a monopoly firm always make positive profit in the short run?” the answer of this is NO, because there is no pure certainty that a monopoly firm will always earn positive profits in the short run.

Actually, it depends upon the cost which it bears for the production of its output, and, correspondingly, the cost curve, i.e. the curvature of the SAC, determines whether the monopoly firm will earn a normal profit, positive profit or loss. Hence, given the level of output, the three possibilities can be:

If AR > AC, there is economic profit for the firms,
If AR = AC, the firm earns only normal profit and
If AR < AC, the firm makes losses: a theoretical possibility in the short run.

Diagrammatically:

No Supply Curve of a Monopoly Firm:

Economists have found out that a monopoly firm does not face a certain or unique supply curve because a monopolist has the power to discriminate price, i.e. he can sell the same quantity of output at different prices and can sell a different quantity of output at the same price.

In order to show this, let us draw a diagram depicting a monopolist selling the same quantity at two different prices.

Monopolist selling same quantity at different prices

As we know that a supply curve shows a unique relationship between the price and the output and a monopoly firm, the equilibrium output is attained at a point where MR = MC and P>MC. Therefore under this condition, it becomes really very difficult to trace a unique relationship between the Price (AR=P) and the quantity supplied.

Now, suppose a monopoly firm faces two demand curves for its product as D1 and D2, then correspondingly, it will face two MR also. Since the cost of production is the same, therefore, it faces a single MC, which is upward-sloping as usual.

Now MC cuts both MR at the same point at E, depicting the same OQ level of quantity to produce, but when we stretch this point to their respective AR curves, then we can see that the price for the same quantity is coming out to be different. The consumers whose demand curve is D1, get the same quantity at price OP1, and those facing D2 get it for OP2.

Hence the monopolist can sell the same quantity of goods to different users having different demand curves at different prices.

Similarly, he can sell different output at the same price as follows:

Monopolist charging same price for different quantity

In the above case also, the monopolist sells different quantities, i.e. OQ1 (to the people having D1 demand curve) and OQ2 (to the people having demand curve D2) at the same price OP.

Hence in both cases, a monopoly firm finds it very difficult to get a unique relationship between the price and output of the firm; hence it has no certain supply curve.

Long-Run Equilibrium of Monopoly Firm:

The long-run equilibrium condition of a monopoly firm is quite different as compared to the other types of the market structure; as in a monopoly, there is no free entry or exit of the firms and hence has barriers to entry and exit like patent, economies of scale, legal protection etc., whereas, in other competitive markets, new firms can easily enter and exit in case of super normal profits or losses.

A monopolist always has the option to close down in the long run if he incurs losses in the short run and can continue production in case of profits. If SAC> AR, then the monopolist makes losses in the short run and will go out of business in the long run if the market size is so small that no plant size can ensure pure profits in the long run.

However, if AR> SAC, then it earns a short-run profit given by Q1 output in the following diagram, then the monopolist will continue production and can even expand in order to maximize its profits.

As shown in the above diagram, AR, MR, SAC, and SMC shows the short-run conditions of a monopoly firm, and LAC and LMC show the long-run conditions. The intersection point of LMC and MR curves determines the equilibrium output at Q2. Given the AR curve, the price is determined at P2Q2, which is also the long-run equilibrium of the monopolist firm as the monopolist maximizes its long-run profits at this point.

However, the total long-run profit is shown by the area LMSP2. Note that P1Q1 price and OQ1 output is the short-run equilibrium where its short-run profit is shown by the smaller shaded area.

Monopoly: Meaning, Characteristics and Equilibrium (Short-run & Long-run)

Introduction

Meaning of Monopoly: