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12. Monopoly 1. Structure

There is only one seller and the firm is the whole industry.

There are no close substitutes for the product or imports.

Considerable barriers to entry must exist. These may include:

a patent

a license that limits the number of firms to one

control or ownership of raw materials

extremely high infrastructure or capital costs

government restrictions for essential services

Natural monopolies will form where infrastructure costs are high.

Natural Monopoly Argument: Where the capital cost associated with

running a business is extremely high then it can be argued that a monopoly

should operate in this industry so as the gain maximum economies of scale

and avoid the cost of duplicating expensive infrastructure. Monopolies often

operate in industries where capital costs are extremely high. ie

Telecommunications.

2. Conduct

Monopolies tend to restrict output or raise price. This is called monopolisation and results in supernormal profits.

A monopolist can set the price in the industry and is a price maker. It is not possible to control both price and output. A monopolist will choose to

control one or the other. Either way a monopolist will make a

supernormal profit.

There is no need for advertising or product differentiation. Product differentiation means to make your product different to that of your

competitors. In monopoly there are no competitors.

A monopolist will only undertake research & development if it can reduce their costs or increase profits. Product improvements that are

unprofitable will not be implemented.

Price discrimination may occur where a monopolist is able to segregate the market into groups with a different willingness to pay. A monopolist

has no competition and if consumers are unable to resell the product or

service then the monopolist can make some consumers pay more than

others. For example a monopolist phone company could charge daytime

business users more than night-time casual users. An electricity company

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could charge users more in the early hours of the evening when

customers are using hot water and cooking their dinner.

3. Performance

Monopolies make supernormal profits in the long run. New firms that may be attracted by these large profits are unable to enter the industry

because of the barriers to entry. This means that monopolies can make

supernormal profits in the long run. Consumers are paying for these

profits in the form of higher prices. The average revenue in a monopoly

is usually much higher than in other markets.

As a result of the fact that a monopolist restricts output by producing at the profit maximising level of output, productive efficiency is not

achieved and the full benefits of economies of scale are not passed on to

the consumer. The firm does not produce at the point where MC = ATC.

For the same reason a monopolist will not achieve allocative efficiency. A monopolist that restricts output forces the consumer to pay a higher

price (higher up the demand curve) than what would be paid if resources

were allocated efficiently. A monopolist does not produce at the point

where P = MC.

A monopolist has the money to spend on research & development but will only do so if there is an improvement in profitability. This means

that a monopolist will only partially achieve dynamic efficiency.

Monopoly Supernormal Profit

Output ATC MC D = AR MR

1 260 90 300 230

2 200 80 275 175

3 150 70 250 115

4 115 65 225 65

5 96 66 200 15

6 84 70 175

7 80 80 150

8 84 105 125

9 96 140 100

10 115 185 75

11 150 240 50

12 200 310

13 260 350

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Monopoly - Supernormal Profit

0

50

100

150

200

250

300

350

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Output

Re

ve

nu

e &

Co

st

All firms produce at the profit maximising level of output where MC = MR.

For the monopolist in the above diagram this occurs at 4 units of output. In

the above table both MC and MR are equal to 65 at 4 units of output. At this

point the monopolist makes a supernormal profit because AR > AC. At 4

units of output AR = 225 and AC = 115 which means that the monopolists profit margin is 225 115 = 110. If the firm produces 4 units of output then the supernormal profit is 110 x 4 = 440.

Examples of Monopoly in Australia

It is difficult to find examples of monopolies because government policy has

introduced competition in many industries. Monopolies have only been

allowed to exist in industries where the natural monopoly argument has

justified their existence.

In the pay television industry it was argued that the cost of digitalization and

providing content could only be justified if there were only one operator.

Foxtel recently upgraded its service to digital and introduced a number of

new channels. Foxtel is now the only pay TV operator in Australia.

There is only one international airport in Sydney because of the difficulty of

finding suitable land and the noise problem than an airport can generate.

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Sydney is expected to have one international airport for the next twenty

years according to recent government policy statements. This airport is

operated by the Sydney Airports Corporation which naturally has a

monopoly. When airlines negotiate landing slots (times) and landing fees

they are negotiating with a monopoly operator. Airlines may not be able to

fly to Sydney because they are unable to obtain landing slots. Cathay Pacific

was recently granted more landing slots in Sydney and Dragon Air will be

allowed to fly to Sydney next year.

Telstra is a large phone company that is 50% owned by the government. It

still has monopoly power in the local phone industry because it owns the

copper wire phone network. This monopoly is weakening because of the use

of mobile phones and the Internet. VOIP (voice over Internet protocol)

allows local phone calls to be placed over the Internet thus avoiding the

copper wire network. Telstra still has a dominant position in

telecommunications but the market has changed in some service areas to

duopoly or oligopoly.

Australia Post has a monopoly in the delivery of mail and letters. This

business is still owned by the government and it has evolved over a number

of decades. With the need for post boxes, postcodes and post offices in all

areas of Australia it is logical that one operator would be more efficient in

this industry. Australia Post has competition in the delivery of parcels and

airfreight. This monopoly has been created by a government license.

The State Rail Authority as the name suggests is a government rail

operator. The high cost of providing train tracks in Sydney and the impact

on local residents in terms of noise and disruption to roads, makes it logical

that only one train operator would exist in Sydney.

4. Government Policies for Monopoly

Regulation of Monopoly

Monopolies will not operate in the public interest unless they are regulated

by government. Regulation refers to any action by the government that is

intended to influence the conduct of industries or firms. Regulation can be

used to achieve efficient performance and fair conduct. Regulation aims to

achieve workable competition, which occurs when all firms operate near

their optimal scale. The concept of workable competition is based on what

would occur in a perfectly competitive market.

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Regulation of monopolies may include any of the following:

A regulation requiring a minimum standard of service. For example Telstra has a Universal Service Obligation that requires that all

Australian households can have a phone service if they require it.

Regulations requiring a minimum standard of service may have the effect of increasing output of the product beyond the profit maximising level

thus improving both productive and allocative efficiency.

Attaching conditions to licenses requiring a certain conduct.

The imposition of government legislation such as prescribed maximum fee scales for some professions eg Real-estate agents.

Competition Policy & Monopoly

Under the Trade practices Act it is illegal to practice monopolisation.

Section 46 of the Trade Practices Act makes it illegal for a firm to take

advantage of market power for predatory purposes. A firm shall not take

advantage of market power to eliminate a competitor, prevent entry of a

competitor into the industry, or prevent another firm from engaging in

competitive activities. It applies to any situation in which a firm attempts to

limit competition or engages in conduct to prevent competitors from

entering an industry. Using pricing or output policies to drive competitors

out of an industry so as to maintain market dominance would be an example

of conduct which is targeted by this law.

Section 49 of the Trade Practices Act deals with price discrimination. This

section makes it illegal for a corporation to discriminate between suppliers in

regard to: the price charged for goods, discounts, allowances or credits and

in the provision of services in respect of those goods, if the discrimination is

not cost-justified and is of a magnitude that it would lessen competition.

Governments are able to operate business enterprises. It is possible to

run Government Business Enterprises GBE in some industries to compete

against monopolies. Such government businesses could be operated at a loss

or normal profit and could force prices down and reduce supernormal

profits. This could improve allocative and productive efficiency. Some

arguments against this might be that the GBE is inefficient and this approach

may require the duplication of expensive capital equipment.

The Australian government could pass Antitrust laws like the Sherman

Act in the United States and then break up monopolies into smaller

competing firms as was done in that country. A major telephone company

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called Bell Corporation was broken up into the baby bells: Bell North, Bell South, Bell Atlantic etc. These baby bells compete against each other and so the original monopoly has been broken up. There is much talk about

the use of operational separation in the case of Telstra. This would involve

splitting the company into retail and wholesale components. This proposal

has arisen because of concerns of unfair trading practices and anti

competitive behavior used by Telstra.

In Australia we declared the telephone network a public asset forced Telstra

(a 50% government owned phone monopoly) to allow Optus to have access

to the telephone lines. It was proving to be too expensive for Optus to build

its own network and the only way to gain competition was to open the

access to the telephone network. Mobile phone companies are providing

some competition to Telstra however Telstra is also dominant in this market.

Tariff reductions may also be used to increase foreign competition in some

industries. Tariffs protect local producers. Some of these producers may be

monopolies. A good example of the impact of tariff reductions in Australia

is the steel industry and BHP, which had a monopoly in steel for many

years. As steel tariffs fell BHP was forced to become more competitive and

lost its market dominance. We now have three steel producers, a major

upgrade in steel making technology and much lower steel prices. Lower

steel prices have made Australian businesses that use steel much more

internationally competitive.

Deregulation & Monopoly

The term deregulation refers to the process of removing government

regulation from industry in the belief that it will perform more efficiently

without them. This may be particularly relevant in the case of a monopoly

that has been protected by a government license or restriction. Deregulation

will create much needed competition which could improve efficiency.

Currently the NSW State Government is considering competition against

Sydney Water (a State Government monopoly). Private operators claim that

they could run aspects of the sewerage and water system more efficiently.

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Cross Subsidisation & Natural Monopolies

Natural monopolies occur where there are large economies of scale in the

industry and having only one producer is more efficient. Such natural

monopolies are created by government legislation or licenses which act as

barriers to entry for potential competitors. These natural monopolies serve

the whole community at the lowest possible cost and often charge subsidised

prices. However the cost of providing the service may be higher in one

region compared to another. In a normal commercial situation these

consumers would pay higher prices. Natural monopolies often spread this

cost over the whole community which means that some consumers pay more

than they should and others pay less. This is called cross subsidisation.

The recent decision by the NSW State Government to build a desalination

plant is an example of cross subsidisation. Sydney has experienced drought

conditions and water restrictions for several years. To ensure that Sydney

has an adequate water supply the NSW State Government has decided to use

sea water. Only the residents in the eastern suburbs of Sydney will use

desalinated water but all water users in Greater Sydney will be paying an

additional amount on their water bills to cover the cost of the plant.

Microeconomic Reform & Monopoly

Microeconomic reform (MER) involves a selection of strategies to improve

the efficiency of Australias public and private sectors. MER aims to make our products more competitive on world markets by making factor and

product markets work more efficiently.

Many of these reforms have been targeted at utilities and natural monopolies

especially where they provide essential business services and have a major

impact on the cost of production of Australian firms. An example of these

reforms has been the introduction of competition by allowing the gas utilities

like AGL to sell electricity and the electricity utilities like Energy Australia

to sell gas. This has increased competition in these natural monopolies in the

hope of forcing companies to charge lower prices.

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Exam Questions

Multiple Choice Questions

1. A typical barrier to entry in a monopoly would be:

a) Advertising.

b) Economies of scale.

c) A license.

d) Product differentiation.

2. Workable competition attempts to develop a realistic model based on

which market structure?

a) Perfect Competition.

b) Monopoly.

c) Oligopoly.

d) Monopolistic Competition.

3. Public utilities usually operate as:

a) Duopolies.

b) Oligopolies.

c) Monopolies.

d) Perfect competitors.

4. The demand curve faced by a monopolist is:

a) Relatively elastic.

b) Perfectly elastic.

c) Relatively inelastic.

d) Perfectly inelastic.

5. The growth of natural monopolies requires:

a) Economies of scale.

b) Cross subsidisation.

c) Profitable production.

d) Microeconomic reform.

6. Monopolisation means to:

a) Restrict output.

b) Raise the price.

c) Restrict output and raise the price.

d) Restrict output or raise the price.

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Short Answer

1. Why must there be no close substitutes in a monopoly?

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2. Why do monopolies always have high barriers to entry?

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3. Why is there no need for product differentiation in monopoly?

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4. What is meant by the term monopolisation?

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5. What is price discrimination? Why is it likely to occur in monopoly?

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6. Why is a monopolist unlikely to achieve allocative or productive

efficiency?

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7. Why do monopolists make supernormal profits in the long run?

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8. Why do monopolies require regulation?

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9. What has the Australian government done in terms of competition policy

to improve the operation of industries dominated by monopolies?

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10. How could deregulation be used to increase competition in a monopoly?

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Extended Response

What are the structure, conduct and performance of a monopoly?

Rule 1: Define the terms in the question: Monopoly, structure, conduct and

performance.

Rule 2: Identify & define related concepts: Barriers to entry, substitutes,

patents, monopolisation, price discrimination and price maker.

Rule 3: Link introduced terms to the question: There is only one seller in a

monopoly because barriers to entry prevent new firms entering the market.

Rule 5: Draw relevant diagrams: Monopoly SNP

Rule 6: Text reference to diagram in your answer: A monopolist will make a

supernormal profit in the long run.

Rule 7: Use examples to communicate additional meaning: A mathematical

example of supernormal profit.

Rule 4: Draw logical conclusions: A monopolist will always make a

supernormal profit. By producing at the profit maximising level of output a

monopolist will never achieve allocative and productive efficiency.