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Economics: Defining Monopoly Power

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About this Lesson

  • Type: Video Tutorial
  • Length: 10:11
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 109 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Other Market Models (14 lessons, $26.73)
Economics: Monopolies (5 lessons, $10.89)

This video lesson will define the concept of monopoly power for you. It will also explain why its important and how it stands out in the study of economics. Taught by Professor Tomlinson, this video lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Thinkwell
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Suppose you're a firm that has a highly desirable product and you're the only one that offers it. How would you price your product? How much would you sell? The more you sell, the lower the price would be according to the law of demand. But, the higher you raise your price, the less of the product people will buy. How do you as a firm, who has market power make the decision about how to price your product? We're going to be studying this problem in the coming lessons, and we will begin this lecture by introducing the concept of market power and talking about an extreme case, the case of the single seller, a monopoly. Let me begin by defining market power. A firm is said to have market power, if it is able to influence the market price of its good or service, that is, if it has the power to set a price for its product, rather than take the price as given in the market. Market power is a contrast to a competitive firm; a firm that is competitive is a price taker. A firm with market power has the ability then to set its price. An extreme case of the firm with market power is a monopolist. A monopoly is a single seller of a good or service. Now, you may be hard pressed to come up with an idea quickly of a firm that really exists in the real world that's a true monopoly. In fact, monopolies are quite rare and monopolies usually arise due to one of three factors.
The first factor that can create a monopoly is a firm that has sole ownership of a particular resource that is important to the production of a good or service. An example of this would be the case of the market for diamonds. There was a time when the DeBeers Diamond Cartel owned almost eighty percent of the world's diamonds. Many of the competitive diamonds were in the Soviet Union and were not available on the market at the time. Because one single company owns so many of the diamond mines, they were able to have considerable influence over the price that was charged for diamonds. So, one thing that can create a monopoly is if the company has sole ownership of a particular resource that is important in the production of the good. Another example would be if we were at an airport, for example, and one company had sole ownership over the space that was available for selling concessions. If they owned that space, they would then be the only restaurant in the airport and would, therefore, be a monopoly.
This brings us to the second situation that can create a monopoly and this is monopoly that is created by government action. Government action meaning patents, copyrights, and in some cases special licenses. In these cases, the government creates a situation whereby entry into an industry is prohibited. For example, one of the important driving forces in the pharmaceutical market is company's desire to obtain a patent for a new effective drug to treat a certain kind of illness or condition. The company that developed the new drug first, will be granted a patent, and with this patent, they will have the sole right to produce and sell this drug in the United States for a period usually as long as fourteen years. In this case, a drug patent grants a monopoly to a company allowing it to have sole right to sell this product, and because there are not competitors, at least while the patent is in effect unless the company wants to license production to other companies. While this company has the patent, they have the right to be a monopolist, and being a monopolist allows them to earn extra profit and thereby recover the costs that they sank into developing this new drug. Other things that can give companies patent granted by the government, or other things that can give companies monopolies granted by the government, are called sole licenses. It has been the case throughout history that governments have granted single licenses to particular companies to provide particular types of service. For example, the Hudson Bay Company, which was licensed by the King of England to develop trade in the New World, had a monopoly right to, on behalf of England, go and provide imports and exports to the New World.
A third case in which we get a monopoly is what we call a natural monopoly. A natural monopoly arises because of the interaction between the size of the market and the efficient scale of operation of a single firm. Let's look at a picture that will make the idea of natural monopoly a littler clearer. You'll recall from our earlier discussions that the bottom point of the long run average cost curve determined the efficient scale of operation or the right size for a firm in a long run in this market. Firms that want to be competitive in the long run will be operating at the bottom their long run average cost; that is, they will be minimizing the average cost of production and thereby maximizing their profits. If it's a competitive market, firms will continue to enter until the price of the good drops down to the bottom of the average cost curve. Now, if the long run average cost curve is relatively close to the axis, that is, if the long run average cost curve points to a point of efficient scale that is small, relative to the amount of the product that the market wants to buy, that is, if the demand curve is way out here and the point of efficient scale is way back here, then there's room for a lot of other firms to enter this market. We'll get several of these blue curves fitting in adding up to the total amount of the product that the market is actually buying. That is, if the efficient scale of operation is small, relative to the size of the market, it takes a lot of firms to meet demand at this minimum average cost. However, if scale economies are very great, if the economies of scale are large, relative to the size of the market, then we can get a situation like this, with a long run average cost curve for each of its minimum point at a point that might actually be on its intersection with the demand curve. In this case it only takes one firm to meet the entire market's demand for this product at minimum average cost. If we look at the point here at minimum average cost, it's beyond the demand curve; this firm can produce everything that the market wants to buy at a price equal to minimum average cost. This is a case when an industry has very, very great economies of scale. Where the opportunities for teamwork and specialization, increasing returns to scale, and diminishing average cost go on for a long time, that is the economy or the industry grows very, very large before it runs into problems with management and communication, all of those other things that lead to decreasing returns to scale. When the economy has a lot of scale economies, when the firm has a lot of scale economies relative to the amount of the good that people want to buy, then we have what we call a natural monopoly. When the point of efficient scale is enough to provide all of the goods that the market wants to buy, from a single firm producing it, then we have a situation of natural monopoly. Some examples of this that have been sited in the past were electrical utilities. Electrical utilities provided power to your house by stringing up electrical wires that led to a large generating plant that used coal or water power to produce electricity that has been wired to your house, and there was really no need for competition in this market because one utility taking care of the wires and the generation could provide all the power that a particular market might want to buy. So, we have a situation of natural monopoly. The alternative would be for another power company to come in, build a large tower plant and string their wire to your house so you could then choose whose electricity you wanted to buy. As long as we think of power generation as coming from utilities that then send the power to your house through electrical wires, it really seems that it is a natural monopoly. We don't want a lot of firms out there stringing their own wires and building their own plants. Now, we are going to talk more about electrical utilities a little bit later when we talk about the possibility that monopolies might be deregulated, but for now, let me summarize.
The three things that create monopolies are, first of all, sole ownership of some strategic resources, as in the case of the Diamond's Cartel. The second is government action, usually in the granting of patents or special licenses, and finally, natural monopolies which occur when there are a lot of economies of scale in an industry so that the point of efficient scale has a lot of production relative to the demand in the market when all the demand in the market can be met at very low cost or a diminishing cost by a single firm. Given what we have in the monopoly or supposing that we have a monopoly. How then will this monopoly behave? Will it charge high prices and sell little out put, or will it charge lower prices and sell more output? In the next lesson, we take up the question then of the monopolist's problem. How to make the trade off between higher prices and larger sales.
Other Market Models
Monopolies
Defining Monopoly Power Page [2 of 2]

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