It should be noted that for a monopolist, MR is not equal to price. As stated above, if a monopolist wants to increase output, it must lower price as it faces a downward sloping demand curve. This fall in price is for all units sold and consequently, if output is increased by a single unit, the rise in revenue is by a smaller quantity than MR.
The profit of the firm is represented by the shaded rectangle in the diagram above; this is the difference between total revenues and total costs.
Where a market is dominated by a monopolist, the firm uses its advantage to raise its producer surplus and reduce consumer surplus. As a consequence, there are potential abnormal profits to be made, as well as a welfare loss to society. The welfare loss is known as the deadweight loss and is represented by the shaded triangle on the diagram. This comes about due to the monopolist being allocatively inefficient as they produce at the point where MC=MR. However, AR, the price, is above this so the price is higher than MC. Often they are also productively inefficient too, as they are not producing at the lowest point on the average cost curve.
Under normal circumstances, a monopoly would be expected to make a profit; however, if the average costs are sufficiently high, then a loss will be made.
There are certain benefits to society of their being a monopoly. Given that the monopolist is the only supplier in the market, it can use its power to achieve economies of scale by producing on a greater scale than if it had competition in the market. This allows lower average costs to be reached, which could be of benefit to the consumer.
A monopolist can also use its power to price discriminate. By doing so, it charges different people different prices for the same good according to what each person is willing to pay. This allows the monopolist to get around the problem whereby increasing output leads to a fall in revenue (because the price would fall for all goods sold – this is the problem of P being less than MR as stated previously)
The magnitude of the monopolist’s power is largely determined by the factors that are making that particular market a monopoly. The more likely the market is to remain a monopoly, the greater the power of the monopolist.
In a statutory monopoly or a monopoly caused by a patent, the inventors have an exclusive right to benefit for the invention for a certain time period without competition. In both of these cases, the status of the market is legally guaranteed, this gives the monopoly extra power, as it knows for certain that for a certain period there will be no competition in the market.
Markets with excessively high barriers to entry, for example high sunk costs through advertising, are also prone to monopolies, and thus give the monopolist a degree of power as they are aware that competition is unlikely. Where the demand for a good is small in comparison to the minimum efficient scale (the output at which average costs are minimised) then one can expect a monopoly to develop. Any firm who wishes to enter the market may be put off by the high set up costs, or sunk costs involved. This maintains the firm’s position as the sole supplier.
Natural monopolies involve very large fixed costs; an example is the electricity market. A new entrant to this market would have to invest in pylons and the distribution network of the electricity. In this industry, the marginal cost of an extra unit of electricity service is small, but the fixed costs are high. As MC is small, and set up costs are high, long run average costs are always falling. In fact, it is beneficial to society for there to be a sole supplier in the market as average costs are lowered.
In markets where the costs are not high enough to deter potential new firms to the market, a monopolist is more vulnerable and thus has less power. To maintain its status as a monopolist, the firm may lower its price to discourage new entrants. This is known as limit pricing and is only of benefit to consumers in the short run. In the long run, it prevents competition which would lower the price further still.
