Overview of a Monopoly
A monopoly is a market structure comprising of a single seller (also known as the Monopolist). The monopolist has significant advantages – such as better technology, knowledge, connections, and resources – that allows it to retain its dominant market position. Very often, the monopolist erect significant entry barriers to limit new firms from entering the market to compete. Unlike the perfect competition, the monopoly demand curve is downward slopping. In addition, it is able to earn supernormal profit in the long run.
Characteristics of a Monopoly
#1 A single producer
- No other firm competing directly with monopoly.
#2 No substitutes
- The goods and services produced by the monopoly are not easily substitutable.
#3 Barriers to entry
#4 Market power (or “price setter”)
- The monopoly has the power to influence prices and hence is able to price discriminate or charge higher prices for their goods or services.
#5 Imperfect knowledge
- Other firms do not have the skills and technology of how to produce the goods or services.
Understanding the demand curve of a monopoly
In monopoly, there is only a single seller known as the monopolist.
Unlike the case of perfect competition where firms are price taker, the monopolist is the price setter, since it is the only provider of a particular good in the market. Hence, the Law of Demand applies. Meaning that if the monopolist wishes to sell more, it must reduce the price. Hence, it has a downward sloping demand curve.
Graphically, the maximum total revenue is where the marginal revenue (MR) of producing that good is zero. However, it does not mean that the monopolist will produce the product at the price (P) and quantity (Q) to maximise revenue. Rather, the monopolist will rather produce at some level that can maximise its profit.
Understanding why a monopoly is able to earn supernormal profit
To maximise profit, a monopolist will produce at an output level (Qm) where its marginal revenue (MR) is equal to its marginal cost (MC).
Since it has a downward sloping demand curve (i.e. the Average Revenue (AR) curve), the price that it can charge based on that level of optimal output will be Pm.
Note that at output Qm, the price based on the average revenue is higher than the average cost. This means that a monopolist is able to earn a supernormal profit (as shown in the blue rectangular area in the diagram).