Monopoly (Business)

Why monopolies exist What market power does a monopoly have Explain giving examples?

Answer

Wiki User
10/28/2008

Monopoly is a term used by economists to refer to the situation in which there is a single seller of a product (i.e., a good or service) for which there are no close substitutes.

Governmental policy with regard to monopolies (e.g., permitting, prohibiting or regulating them) can have major effects not only on specific businesses and industries but also on the economy and society as a whole.

Two Extreme Cases

It can be useful when thinking about monopoly to look at two extreme cases. One is a pure monopoly, in which one company has complete control over the supply or sales of a product for which there are no good substitutes. The other is pure competition or perfect competition, a situation in which there are many sellers of identical, or virtually identical, products.

There are various degrees of monopoly, and rarely does anything approaching pure monopoly exist. Thus, the term is generally used in a relative sense rather than an absolute one. For example, a company can still be considered a monopoly even if it faces competition from (1) a few relatively small scale suppliers of the same or similar product(s) or (2) somewhat different goods or services that can to some limited extent be substituted for the product(s) supplied by the monopolist. A business that produces multiple products can be considered a monopoly even if it has a monopoly with regard to only one of the products.

A company with a product that is just slightly different from other companies' products (e.g., a unique brand of food or clothing) could be considered to have a monopoly for that narrow range of product (assuming that it could not be copied due to protection by a patent, copyright, trademark, etc.). However, it might have very little monopoly power within the broader product category that includes both its and its competitors' products (e.g., food or clothing as a whole). In contrast, a company with exclusive rights to sell a product for which there are few if any good substitutes (e.g., steel or table salt1) would have tremendous monopoly power.

For a product characterized by perfect competition (or nearly perfect competition), each supplier or seller must set its price equal to (or very close to) those of its competitors. This equilibrium price tends to be close to the cost of producing the product due to price competition among its many sellers. It is difficult for any seller to charge a higher price than its competitors because it would be easy for buyers to purchase from other sellers instead. It is likewise difficult for a seller to charge a lower price, because profit margins (i.e., revenue minus cost) are already thin2.

Naturally, all businesses, regardless of their degree of monopoly power, generally want to be as successful as possible, and thus they attempt to maximize their profits. However, it is much easier for a monopolist to make large profits through profit maximizing behavior than it is for a firm in a highly competitive industry. The reason is that the former has much greater flexibility in setting prices than does the latter, which has little if any control over prices.

The monopolist has this flexibility because there is little or no direct competition to force the price down close to the cost of production. Of course, the monopolist will be acutely aware of the fact that the higher the price it charges, the smaller will be the number of units sold (what economists refer to as the law of demand 3). This is because at higher prices some purchasers will just decide to buy fewer units or no units at all. A reduction in the number of units sold will eventually occur when the price rises to a sufficiently high level, regardless of how much buyers think they want the product, because buyers are ultimately limited by their incomes and savings.

Assuming (unrealistically, but for the sake of simplification) that a monopolist could only charge a single price for a product, it would find the unique price that maximizes its profits. Raising the price above that level would reduce profits because the negative effect of the reduction in the number of units sold due to the higher price would more than offset the positive effect from the higher price. This profit maximizing price would generally be substantially higher than the product's cost of production, and it would thus also be substantially higher than the equilibrium price that would exist for the product if it were instead supplied by a number of competitive firms. Likewise, the volume of output and sales would be substantially lower than in a competitive situation.

The monopoly power of a company for a product is commonly thought of in terms of its market share for that product. However, it can also be measured by the ability that a company has to set the price for the product. In fact, this is the measure of monopoly used by some government agencies when studying competition in various industries.

WHY Monopoly

Monopolies have existed throughout much of human history. This is because powerful forces exist both for the creation and maintenance of monopolies6. At the root of these forces is the natural human desire for wealth and power together with the fact that monopolies can be immensely profitable and provide their owners with tremendous financial, political and social power.

-government has monopoly over oil exploration, as this is considered as a national sovereign resource.

-government has monopoly over railways, as the infrastructure needs a huge investment and

the payoff period is a long one.

Monopolies can arise in some circumstances as the result of normal business practices that are characteristic of firms in a highly competitive industry. Or they can arise as a consequence of what economists term anti-competitive practices, that is, behavior that is intended to destroy competition through means other than competing on the basis on price and quality (including the quality of services associated with the product).

More specifically, monopolies can arise in any of the following, non-mutually exclusive, ways:

1) By developing or acquiring control over a unique product that is difficult or costly for other companies to copy. This can occur as a result of a purchase, merger or research and development. An example is pharmaceuticals, which can be extremely expensive and risky to develop (and which are also protected by patents), thereby locking out all but a few large, well funded companies with ample talent. Closely related to this is control over a unique input for a product, such as a unique natural resource.

(2) By having a lower production cost than competitors. This can result from having a more efficient (i.e., more output per unit of input) production technique or from having access to a unique source of low cost inputs (e.g., a mine containing exceptionally high grade ore). In some cases, a greater efficiency is the result of economies of scale, which means that the production cost per unit of product declines as the volume of output increases due to the ability to use some resource more intensively (e.g., a steel mill or railroad with lots of excess capacity).

This category includes natural monopolies. A natural monopoly exists for a product for which there are sufficient economies of scale such that the product can be produced or supplied by a single company at lower cost than by multiple, competing companies. Examples include utilities such as railroads, pipelines, electric power transmission systems and wired telephone systems. It is often wasteful (for consumers and the economy) to have more than one such supplier in a region because of the high costs of duplicating the infrastructure (e.g., parallel railroad networks in a region or two sets of telephone wires to every house).

(3) By using various legal and/or illegal tactics, often referred to as predatory tactics , aimed specifically at eliminating existing or potential competition, such as

- (a) buying out or merging with competitors,

-(b) temporarily charging prices below cost to drive competitors out of business (often referred to as predatory pricing or dumping),

-(c) using a monopoly in one product to create a monopoly with regard to another product (sometimes referred to as the bundling or tying of products),

-(d) taking control of suppliers of inputs required by competitors or conspiring with them to raise their prices (or lower their quality of service, etc.) to competitors

-(e) taking control of, or conspiring with, suppliers of other products used by competitors' customers,

-(f) threatening costly litigation (e.g., regarding allegations of patent or copyright infringements regardless of the legal merits of such claims), which large companies can easily afford but small companies often cannot and

-(g) using blackmail or threats of violence.

Horizontal integration is the gaining of control by one company over other producers or sellers of the same product. The acquired companies can appear to be quite diverse. Often the acquisition of control is not publicized, and sometimes different branding is used to create the illusion of competition. For example, a broadcasting company might acquire various radio and/or television channels each with a different focus in order to gain control of most of the entire listener or viewer market in a region and thereby prevent the emergence of competitors.

Such seeming diversity can also offer offer other benefits to a monopolist. In particular, it can be valuable in separating markets, thereby allowing the monopolist to charge separate, profit maximizing prices in each. It can also make the existence of a monopoly less conspicuous and less of a target for public criticism, government intervention and the emergence of new competitors.

(4) By controlling a platform and using vendor lock-in. A platform is a standardized specification for a product that allows its providers and users and their products to interoperate without special arrangement. This reduces the overall costs of conducting transactions by removing some of the costs of matching up products with buyers. Lock-in is the practice of designing a product that cannot interoperate with products made by other companies in order to make it difficult and/or costly for users to switch to competing systems. Lock-in is also used so that replacement parts or add-on enhancements must be purchased from the same manufacturer. Examples would include a computer operating system or a portable music storage/replay device that is controlled by a single company.

(5) By receiving a government grant of monopoly status, i.e., becoming a government-granted monopoly. Today this is usually accomplished through the acquisition of a license, patent, copyright, trademark or franchise. Common examples include a franchise for cable television for a certain city or region, a trademark for a popular brand, copyrights on certain cartoon characters or a patent for a unique product or production technique.

As governments usually have the final authority regarding the creation, maintenance and extension of monopolies, public relations, particularly lobbying and advertising, are important tools for monopolists for convincing politicians to ignore, approve or even bless anti-competitive acquisitions, mergers, etc. Among the arguments typically made by monopolists are that such acquisition or merger is in the public interest because it would allow them to

-(1) spend more money on research and development in order to develop new and improved products,

-(2) standardize what would otherwise be a chaotic market (i.e., vigorous competition) and

-(3) reduce costs, and thus prices, through (a) the reduction of redundant production facilities and employees, (b) concentrating production at the most efficient production facilities and (c) obtaining greater economies of scale. Monopolists also frequently support such requests with the claim that they are model corporate citizens and that they are great contributors to charitable and educational causes.

The term barriers to entry is used by economists to refer to obstacles to businesses or to individuals wanting to enter a given field. Some of these barriers occur naturally, whereas others are erected or strengthened by monopolies in order to maintain or enhance their monopoly positions. Examples include the extremely high cost of developing new drugs, limited sources for a low cost input, a dominant platform for software or other products, patent protection of a low cost production technique, the difficulty of trying to compete with famous brands and air transport agreements that make it difficult for new airlines to obtain landing slots at popular airports.

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