Market Power: Monopoly and Oligopoly
Monopoly
Definition: A market structure where a single firm dominates the industry.
Assumptions:
Only one firm produces the product; the firm is the industry.
Barriers to entry prevent new firms from entering and maintain the monopoly.
The monopolist can make abnormal profits in the long run due to barriers to entry.
The degree of market power depends on the availability of competing substitutes.
Barriers to Entry
Economies of Scale:
Significant average cost advantages are gained as a firm's size increases.
Decreases in average costs in the long run when a firm alters all factors of production to increase output.
Types of economies of scale:
Specialization: Management specializes in areas of expertise, increasing efficiency.
Division of Labor: Breaking down production into small, efficient activities.
Bulk Buying: Negotiating discounts with suppliers, reducing input costs.
Financial Economies: Large firms can raise capital more cheaply due to lower risk.
Transport Economies: Lower delivery costs for bulk orders, or having own transport fleet.
Large Machines: Utilizing large machinery that small producers cannot afford.
Promotional Economies: Promotion costs do not increase proportionally with output, reducing unit costs.
Natural Monopoly:
An industry where economies of scale allow only one firm to operate efficiently. A natural monopoly occurs when the long-run average cost curve (LRAC) gives an abnormal profit only if the monopolist is able to satisfy all of the demand in the market.
Examples: Utilities like water, electricity, and gas.
If another firm enters, both firms would be unable to make even normal profits, so the market will only support one firm.
Graph:
The graph typically shows a downward-sloping LRAC curve, indicating decreasing average costs as output increases. The curve remains downward sloping even at high levels of output, illustrating that a single firm can produce at a lower cost than multiple firms.
Legal Barriers:
Patents: Exclusive rights to produce a product for a certain period (e.g., 20 years) to encourage invention.
Copyrights and Trademarks: Examples of intellectual property rights.
Government-granted monopolies: Nationalized industries or sole supplier rights.
Brand Loyalty:
Strong consumer preference for a particular brand, deterring new entrants.
Anti-Competitive Behavior:
Restrictive practices, such as price wars, to eliminate competition. For instance, predatory pricing, where an established monopoly lowers prices to loss-making levels to force new entrants out of the industry.
Graph:
Graphs demonstrating anti-competitive behavior typically illustrate a firm lowering prices below cost to drive out competitors. These graphs would show the original price and quantity, then the artificially low price imposed by the monopoly, leading to losses for new entrants.
Market Power in Monopoly
The monopolist's demand curve is the industry demand curve.
The monopolist can control output or price, but not both.
Profit maximization occurs where marginal cost (MC) equals marginal revenue (MR).
Monopolists can restrict quantity to increase price.
Graph:
The graph of a monopolist's market power typically shows a downward-sloping demand curve (Average Revenue) and a Marginal Revenue curve below it. The profit-maximizing point is where MC intersects MR, and the monopolist sets the price based on the demand curve at that quantity. This results in a higher price and lower quantity compared to a competitive market.
Profit Situations
Abnormal Profits: Monopolists can sustain abnormal profits in the long run due to barriers to entry.
Losses: If demand is too low, a monopolist may make losses and eventually exit the industry.
Graph:
A graph illustrating abnormal profits shows the Average Total Cost (ATC) curve below the Average Revenue (AR) curve at the profit-maximizing output level. The area between AR and ATC represents the abnormal profit. If the ATC curve is above the AR curve, the monopolist is making losses.
Efficiency in Monopoly
Inefficiency: Monopolies do not achieve productive or allocative efficiency.
Output is restricted to maximize profit, not to achieve efficient levels.
Advantages of Monopoly:
Economies of scale may lead to higher output and lower prices compared to perfect competition.
Potential for higher investment in research and development (R&D).
Disadvantages of Monopoly:
Potential restriction of output and higher prices if economies of scale are not significant.
Productive and allocative inefficiency.
Anti-competitive behavior.
High profits may be considered unfair.
Market Failure in Monopoly
Allocative inefficiency occurs due to profit maximization.
Potential advantages of monopoly (economies of scale, R&D) may outweigh the market failure.
Graph:
The graph illustrating market failure in monopoly shows a deadweight loss triangle, representing the loss of economic efficiency due to the monopolist's restriction of output. The allocatively efficient level of output is where Marginal Cost equals Average Revenue, which is higher than the monopolist's output level.
Oligopoly
Definition: A market structure dominated by a few firms.
A common indicator of concentration in an industry is known as the concentration ratio. Concentration ratios are expressed in the form CRX where X represents the number of the largest firms. For example, a CR4 would show the percentage of market share (or output) held by the largest four firms in the industry.
Assumptions:
A large proportion of the industry's output is shared by a small number of firms.
Examples of oligopolistic industries producing:
Almost identical products (e.g., petrol).
Highly differentiated products (e.g., motor cars).
Slightly differentiated products (e.g., shampoo).
Barriers to entry exist due to large-scale production or strong branding, but this is not always the case.
Interdependence: Firms must consider each other's actions.
Collusive vs. Non-Collusive Oligopoly
Collusive Oligopoly: Firms collude to charge the same prices, acting as a monopoly.
Formal Collusion: Open agreement on prices, market share, or marketing expenditure (e.g., cartels like OPEC).
Tacit Collusion: Firms charge the same prices without formal agreement.
Non-Collusive Oligopoly: Firms do not collude and must be aware of rivals' reactions.
Strategic Behavior: Developing strategies that consider all possible actions of rivals; using game theory.
Graph:
A common graph to illustrate this is the kinked demand curve model. In this model, firms assume that if they raise prices, competitors will not follow, leading to a significant decrease in demand. However, if they lower prices, competitors will also lower prices, resulting in a smaller increase in demand. This leads to a "kink" in the demand curve and a discontinuous marginal revenue curve, which explains why prices tend to be stable in oligopolistic markets.
Game Theory
Analyzing optimum strategies considering different decisions by rival firms.
Duopoly: A market with only two firms. Use the payoff matrix to determine the best strategy and possible profits for firms A and B with different possible price combinations.
Maximin Strategy: Maximizing minimum profit options (least worst outcome).
Maximax Strategy: Trying to make the maximum profit available (best possible scenario).
The Prisoner's Dilemma: Two individuals acting in their own self-interests do not produce the optimal outcome.
Graph:
A payoff matrix is used to represent the outcomes of different strategies chosen by two firms. The matrix shows the profits each firm can expect based on the other firm's actions. This helps in determining the Nash equilibrium, where neither firm can improve its outcome by unilaterally changing its strategy.
Competition in Oligopoly
Non-Price Competition:
Brand names, packaging, special features, advertising, sales promotion, personal selling, publicity, sponsorship deals, and special distribution features (e.g., free delivery, after-sales service).
Large advertising and marketing expenditures to develop brand loyalty.
Graph:
Graphs illustrating non-price competition often show the increase in demand due to successful branding or advertising campaigns. These graphs would show a shift in the demand curve to the right, indicating that at any given price, more consumers are willing to buy the product due to non-price factors.
Market Failure in Oligopoly
Firms do not produce at the allocatively efficient level of output if they are maximizing profits.
Collusive oligopolies behave like monopolies, restricting output and raising prices.
Government Intervention
Governments intervene to restrict the abuse of market power, potentially through:
Restriction of output, higher prices and distorted resource allocation - creating a loss of consumer surplus.
Lower consumer choice.
Productive inefficiency where production does not take place at the lowest possible unit cost, leading to a waste of resources.
Allocative inefficiency where there will be an underallocation of resources to the product in question.
Abnormal profits and inequity where the higher prices in an oligopoly or monopoly may exploit low income consumers and their purchasing power might be transferred to the owners of firms, entrepreneurs or shareholders, in the form of higher profits leading to more unequal distribution of income.
Actions of Competition Authorities:
Restricting mergers or takeovers that reduce competition.
Passing laws against price fixing and collusion.
Preventing firms from insisting that retailers charge certain prices or refusing to supply to certain