Understanding Monopolies: Causes, Profit Maximization, and Inefficiency

Posted on Feb 19, 2025 in Economics

What Causes Monopolies?

  1. A legal fiat (e.g., US Postal Service)
  2. A patent with legal power (e.g., a new drug)
  3. Sole ownership of a resource (e.g., toll highway)
  4. Formation of a cartel (e.g., OPEC)
  5. Large economies of scale, where AVC decreases as y increases (e.g., local utility companies)
  6. Legal monopoly power, with certification such as a doctor or professor.

Profit Maximization for Monopolies

If a monopoly wants to maximize profits:

ProfitM = p(y) · y – c(y)

Max ProfitM = d(p(y).y)/dy – dc(y)/dy = 0 à d(p(y).y)/dy = dc(y)/dy à MR = MC

d(p(y).y)/dy = p(y) + y · dp(y)/dy

p(y) + y · dp(y)/dy < p(y) à MC = MR < PIC à increase price to increase production

Point nº1 is the Marginal Revenue, because it is the derivative of Total Revenue, where the slope is equal to 0.

While, point nº2 is the Marginal Cost, because it is the derivative of the Total Cost, where the slope is equal to 0.

So, at the profit maximization output level (y*), the slopes of the revenue and cost are equal à MR = MC

Inefficiency of Monopoly

A market is Pareto efficient if it achieves the maximum possible total gains-to-trade. But, otherwise, a market is Pareto inefficient. For example, a perfectly competitive market is Pareto efficient, while a monopolist market is not.

In a perfectly competitive market, P = MC, so the total gains-to-trade is maximized. In the graph, we can see how all the surplus is covered, for the consumers and producers.

While, in a monopolist market, P > MC, so the total gains-to-trade is not maximized. There is the deadweight loss, which is social welfare lost.

Natural Monopoly

NATURAL MONOPOLY: (electricity grid, gas network)

A natural monopoly arises when the firm’s technology has economies-of-scale large enough for it to supply the whole market at a lower average total production cost than is possible with more than one firm in the market.

A natural monopoly prevents the entry of other firms by threatening predatory pricing against an entrant.

A predatory price is a low price set by the firm when another firm tries to enter, causing the entrant’s economic profits to be negative and inducing its exit.

Even if we make the natural monopoly produce the efficient amount of output, there will still be some efficiency loss (not deadweight loss). Because at the efficient output (ye) à ATC (ye) > p (ye), so the firm makes an economic loss.

So, a natural monopoly can’t be forced to use marginal cost pricing. Doing so makes the firm exit, destroying the market. So, it is not possible to regulate a natural monopoly.

Oligopoly

  • A monopoly is a market with one single firm.
  • A duopoly is a market with just two firms.
  • An oligopoly is a market with a few firms. Particularly, each firm’s own price or output decisions affect its competitors’ profits.

In an oligopoly, an equilibrium is when each firm’s output level is a best response to the other firm’s output level, at this point neither wants to deviate from its output level. A pair of output levels (y1*, y2*) is a Cournot-Nash equilibrium if: y1* = R1(y2*) and y2* = R2(y1*) à so that both output levels depend on the output of the other firm.

There are other output level pairs that give higher profits to both firms. That’s why sometimes firms make a collusion. à There are profit incentives for both firms to cooperate by lowering their output levels. Firms that collude are said to have formed a cartel.