BUSINESS ECONOMICS

Session 11: Market Structure Analysis II: Monopoly and Discriminating Monopoly
1. 1.1 Pre-Work Introduction A comparison of the Competitive and Monopoly market structures has indicated that the firms in Monopoly Market Structures tend to earn and retain economic profits. This happens because given a demand curve, a Monopolist under produces (thereby can charge higher price) and is able to preserve the market share due to high entry barriers that prevents the emergence of competitors or potential competitors. Given these operating characteristics of a Monopoly market, it is generally believed that a Monopolist will always earn economic profit. However, it was discussed that the Monopolists profit margin is largely determined by the cost structure. The lower the cost structure, the higher are the profit margins earned by a Monopolist. Thus, even though the absence of competitors may induce a monopolist to underproduce (and charge higher prices), the possibility of higher profit margins can also induce a Monopolist to improve on the cost structure. The changes in the demand and supply conditions can also influence the profit maximizing behaviour of a Monopolist. Consider the following example. DeBeers, the Worlds largest diamond company,

controls about 80% of the world production of diamonds and has a significant market share. Inspite of this, DeBeers spends large amounts on advertisements. Considering that DeBeers is an effective Monopoly, why does it need to advertise? Similarly, consider a situation where the

government imposes additional taxes on the company. By virtue of being

a Monopolist, can the company shift the burden of additional tax on to the consumer? This session aims to analyse the implications of the changes in the demand and supply conditions on the profit maximizing behaviour of a Monopolist. The session also analyses how a monopolist can increase profits by practicing price discrimination i.e. charging different prices for the same product in various market segments.

1.2

Sources of Monopoly Market First, industries tend to have fewer sellers when there are significant economies of large-scale production and decreasing costs. Under these conditions, large firms can simply produce more cheaply and then undersell small firms, which cannot survive. Second, markets tend toward imperfect competition when there are barriers to entry that make it difficult for new competitors to enter an industry. In some cases, the barriers may arise from government laws or regulations which limit the number of factors that make it expensive for a new competitor to break into a market. And third, when a single firm has an ownership of a key resource, then this becomes a potential case for a monopoly.

1.3

Economies of Scale & Monopoly When economies of scale prevail, one or a few firms expand their outputs to the point where they produce most of the industrys total output. The industry then becomes imperfectly competitive.

Many industries enjoy increasing returns to scale-Numerous detailed econometric and engineering studies confirm that many

monagricultural industries show declining average long-run costs. For example, Table 9-2 shows the results of one study of six U.S. industries. It suggests that in many industries the point of minimum average cost occurs at a large fraction of industry output-10 or 20 or even 50 per cent. These industries will tend to be oligopolistic, since they can support only a few large producers.

A natural monopoly is a market in which the industrys output can be efficiently produced only by a single firm. This occurs when the

technology exhibits economies of scale over a range of output that is as large as the entire demand.

Some important examples of natural monopolies are the local distribution in telephone, electricity, gas, and water as well as longdistance links in rail-roads, highways, and electrical transmission. Many of the most important natural monopolies are network industries. Technological advances, however, can undermine natural monopolies.

1.4

Barriers to Entry Although cost differences are the most important factor behind market structures, barriers to entry can also prevent effective competition. Barriers to entry are factors that make it hard for new firms to enter an industry. When barriers are high, an industry may have few firms and limited pressure to compete. Economies of scale act as one common type of barrier to entry, but there are others, including legal restrictions, high cost of entry, advertising, and product differentiation.

1.5

Legal Restrictions Governments sometimes restrict competition in certain industries. Important legal restrictions include patents, entry restrictions, and foreign-trade tariffs and quotas. A patent is granted to an inventor to allow temporary exclusive use (or monopoly) of the product or process that is patented. Without the prospect of monopoly patent protection, a company or a sole inventor might be unwilling to devote time and resources to research and development. The temporarily high monopoly price and the resulting inefficiency is the price society pays for the invention.

Governments also impose entry restrictions on many industries. Typically, utilities, such as telephone, electricity distribution, and water, are given franchise monopolies to serve an area. In these cases, the firm gets an exclusive right to provide a service, and in return the firm agrees to limit its profits and provide universal service in its region even when some customers might be unprofitable.

1.6

High Cost of Entry In addition to legally imposed barriers to entry, there are economic barriers as well. In some industries the price of entry simply may be very high. Take the commercial aircraft industry, for example. The high cost of designing and testing new airplanes serves to discourage potential entrants into the market.

1.7

Advertising and Product Differentiation Sometimes it is possible for companies to create barriers to entry for potential rivals by using advertising and product differentiation. Advertising can create product awareness and loyalty to well-known brands. For example, Pepsi and Coca-Cola spend hundreds of millions of dollars per year advertising their brands, which makes it very expensive for any potential rivals to enter the cola market.

In addition, product differentiation can impose a barrier to entry and increase the market power of producers. In many industries-such as breakfast cereals, automobiles, household appliances, and cigarettes-it is common for a small number of manufacturers to produce a vast array of different brands, models, and products.

1.8

Learning Activity Coffee Export Curbs (For class discussion) (i) Define the nature of demand curve in Domestic Market (ii) International Market

What are the decision issues for Coffee Board? ***