Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. They are very desirable from the point of view of a company and, usually, not very desirable for consumers. Three characteristics define pure monopoly:
1. There is a single seller.
2. There are no close substitutes for the firm’s product.
3. There are barriers to entry.
Whereas the perfectly competitive firm was a price taker, the monopolistic firm is a price maker. That is, it has control over the price.
Examples of monopoly are public utilities such as gas, electric, water, cable TV, and local telephone service companies, professional sports teams, DeBeers, and Alcoa. Also, monopolies may exist at the local level because of geographic location. Barriers to entry are the main line of defense for incumbent monopolies and may be of different types. Economies of scale constitute one major barrier. They occur where decreases in unit costs depend on output size. In this case, because a large firm with a large market share is most efficient, new firms cannot afford to enter the market and gain market shares. Public utilities are known as natural monopolies because they possess such economies of scale. Barriers to entry also exist in legal forms as patents or licenses. Patents grant the inventor the exclusive right to produce a product for 20 years (new worldwide patent period established with a 1995 GATT agreement). Licenses are granted by the government and allow only one or few firms to operate in a given market. Finally, barriers to entry may arise from the exclusive ownership or control of essential resources.
Since there is only one company, the monopolist is a price maker. That is, the company controls output or price – though not both. Even the monopolist has to deal with its market context. Ultimately, its profits depend on its ability to sell, that is, on the market demand for its product. How does a monopolist decide how much to produce and at what price to sell? As for perfect competition, crucial information is summarized by the demand curve. Since there is only one firm, in the case of the monopolist, the market and the company’s demand curves are identical. A monopoly demand is the industry (market) demand and is, therefore, illustrated by a downward sloping curve.
As in perfect competition, the profit maximizing solution for the monopolist is obtained when MC = MR. Unlike perfect competition, however, monopoly price exceeds marginal revenue because the monopolist must lower its price in order to increase sales. For each price cut, revenue increases by an amount equal to the price of the last unit sold minus the sum of the price cuts which must be taken on all prior units of output. Everything works in reverse if we consider a price increase. The trade-off between price and sales is the reason why the marginal revenue is always below the demand curve. Finally, since the monopolist produces where MR = MC and P > MR, then P > MC is also true. A monopolist charges a higher price than would competitive producers selling in the same market. Figure 1 illustrates profit maximization under monopoly.
Clearly, the price elasticity of demand plays a crucial role in monopoly price setting. As long as demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inelastic. Therefore, the monopolist will expand output only in the elastic portion of its demand curve.
A monopolist, like any other company, does not care about charging the highest price it can get, it cares about selling as close as possible to the quantity of output that maximize its profits. Finally, remember that, in monopoly, losses can occur. They are, in fact, relatively common in regulated monopoly where the government subsidizes low per unit prices (e.g. utilities). If monopoly creates substantial economic inefficiency and appears to be long-lasting, antitrust laws can be used to break up the monopoly. Figure 2 illustrates loss minimization under monopoly.