Monopoly

What is a Monopoly?

A monopoly is a market with a single seller (called the monopolist) but with many buyers. In a perfectly competitive market, which comprises a large number of both sellers and buyers, no single buyer or seller can influence the price of a commodity. Unlike sellers in a perfectly competitive market, a monopolist exercises substantial control over the market price of a commodity.

The quantity sold by the monopolist is usually less than the quantity that would be sold in a perfectly competitive firm and the price charged by the monopolist is usually more than the price that would be charged by a perfectly competitive firm. While a perfectly competitive firm is a “price taker,” a monopolist is a “price maker.” Similar to a monopoly is a monopsony, which is a market with many sellers but only one buyer.

Understanding Monopoly

A monopolist can raise the price of a product without worrying about the actions of competitors. In a perfectly competitive market, if a firm raises the price of its products, it will usually lose market share as buyers move to other sellers. Key to understanding the concept of monopoly is understanding this simple statement: The monopolist is the market maker and controls the amount of a commodity/product available in the market.

However, in reality, a profit-maximizing monopolist can’t just charge any price it wants. Consider the following example: Company ABC holds a monopoly over the market for wooden tables and can charge any price it wants. However, Company ABC realizes that if it charged $10,000 per wooden table, no one would buy any and the company would have to shut down. It is because consumers would substitute other commodities such as iron tables or plastic tables for wooden tables.

Thus, Company ABC will charge the price that enables it to make the maximum profit possible. In order to do so, the monopolist must first determine the characteristics of market demand.

Understanding a Monopolist’s Decision

Consider the following example. Company ABC is the sole seller of wooden tables in a small town. The table above shows the demand curve faced by Company ABC, as well as the revenue it can earn by selling wooden tables.

The first two columns show the demand curve faced by the monopolist. If the monopolist supplies only one wooden table to the market, it can sell that table for $10. If the monopolist produces and supplies two wooden tables to the market and wants to sell both, it must lower the price to $9. Similarly, if the monopolist produces and supplies three wooden tables, it must lower the price to $8 to sell all of them.

The third column shows the total revenue the monopolist can earn by selling varying quantities of wooden tables. The fifth column shows the monopolist’s marginal revenue. It is the additional revenue earned by the monopolist when it increases the quantity sold in the market by one unit.

For a monopolist, the marginal revenue is always less than or equal to the price of the commodity. This arises because the monopolist is the only seller in the market and, thus, faces a market demand curve that is downward sloping. For example, if Company ABC raises production and supply from three wooden tables to four wooden tables, its total revenue will increase by only $4, even though it charges $7 per wooden table.

The costs faced by the monopolist depend on the nature of the production process. Consider the example of a monopolist who wants to expand production. The commodity produced by the monopolist requires a large quantity of skilled labor for its production, and skilled labor is in short supply.

Thus, as the monopolist raises output, it must pay more for skilled labor (as skilled labor gets scarcer, it charges a higher price). It results in the monopolist facing an upward rising marginal cost curve as shown below.

The monopolist produces that quantity of the commodity that reflects the equilibrium point of marginal revenue and marginal cost. The marginal cost is the change in the total cost of production when production is increased by one unit. The price charged by the monopolist depends on the market demand curve.

Source: Principles of Economics by N. Gregor Mankiw

Measuring Monopoly Power – Lerner’s Index

A common measure of monopoly power in a market is provided by Lerner’s Index.

L: Lerner’s Index

P: Price of the commodity

MC: Marginal cost of the commodity

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)® certification program, designed to help anyone become a world-class financial analyst. To continue learning and advance your career, see the following free CFI resources:

• Market Economy
• Command Economy
• Law of Supply
• Inelastic Demand
• See all economics resources