monopoly profit

In

economics

, a

monopoly

is a firm that lacks any viable competition and is the sole producer of the Product (business), industry's product.Bradley R. Chiller, "Essentials of Economics", New York: McGraw-Hill, Inc., 1991.Edwin Mansfield, "Micro-Economics Theory and Applications, 3rd Edition", New York and London: W.W. Norton and Company, 1979.Roger LeRoy Miller, ''Intermediate Microeconomics: Theory Issues Applications'', Third Edition, New York: McGraw-Hill, Inc, 1982.Tirole, Jean, ''The Theory of Industrial Organization'', Cambridge, Massachusetts: The MIT Press, 1988.John Black, ''Oxford Dictionary of Economics'', New York: Oxford University Press, 2003. In a normal competitive situation, no firm can charge a price that is significantly higher than the Marginal cost, marginal Economic cost, economic cost of producing the product; if any firm doing business within a competitive situation tries to raise prices significantly higher than the marginal cost of producing the product, it will lose all of its customers to either other existing firms that charge lower prices or to a new firm that will find it profitable to use a lower price closer to the product's marginal cost to bring customers away from the firm charging the higher price. But since the monopoly firm does not have to worry about losing customers to competitors, it can set a monopoly price that is significantly higher than its marginal cost, enabling an economic profit that is significantly higher than the normal profit that is typically found in a perfect competition, perfectly competitive industry. This high economic profit obtained by a monopoly firm is referred to as monopoly profit.

The existence of a monopoly, and therefore the existence of a monopoly price and monopoly profit, depends on the existence of Barrier to entry, barriers to entry. Barriers to entry stop other firms from entering into the industry and sapping away profits.

Basic classical and neoclassical theory

According to Classical economics, classical and Neoclassical economics, neoclassical economic thought, firms in a perfectly competitive market are price takers (rather than price makers) because no firm can charge a price that is different from the Economic equilibrium, equilibrium price set within the entire industry's perfectly competitive market. Since a competitive market has many competing firms, a customer can easily buy Widget (economics), widgets from any of the competing firms. Because of this tight competition, competing firms in a market each have their own ''horizontal'' demand curve that is fixed at a single price established by market equilibrium for the entire industry as a whole. Each firm in a competitive market will have buyers for its product as long as the firm charges 'no more than' the single price. Since firms cannot control the activities of other firms that produce the same widget sold within the market, a firm that charges a price that is higher than the industry's market equilibrium price would lose ''all'' business; customers would simply respond by buying their widgets from other competing firms that charge the lower market equilibrium price. This makes deviation from the market equilibrium price impossible.

Perfect competition is commonly characterized by an idealized situation in which all firms within the industry produce ''exactly'' comparable goods that are Substitute good#Perfect substitutes, perfect substitutes. With the exception of commodity markets, this idealized situation does not typically exist in many actual markets. However, in many cases, there exist similar products which are Marginal rate of substitution, easily interchangeable because they are close Substitute good, substitutes (for example, butter and margarine).Henderson, James M., and Richard E. Quandt, "Micro Economic Theory, A Mathematical Approach. 3rd Edition", New York: McGraw-Hill Book Company, 1980. Glenview, Illinois: Scott, Foresmand and Company, 1988. A significant rise in a product's price will tend to cause customers to switch from this good to a lower priced close substitute.Roger LeRoy Miller, "Intermediate Microeconomics Theory Issues Applications, Third Edition", New York: McGraw-Hill, Inc, 1982.
See Reference to "Price Elasticity" as it relates to "substitutability", as well as the "Marginal Rate of Technical Substitution" In some cases, firms that produce differing but similar goods have similar production processes; this makes it relatively easy for these one-good firms to Marginal rate of technical substitution, switch their manufacturing processes to produce the other differing but similar good. This would be the case when the cost of changing the firm's manufacturing process to produce the similar good can be somewhat immaterial in relationship to the firm's overall profit and cost. Since consumers will tend to replace goods whose prices are high with cheaper close substitutes and the existence of close substitutes whose manufacturing processes are similar allows a firm producing a low-priced good to easily switch over to producing the other higher priced good, the competition model will still accurately explain why the existence of different similar goods form competitive forces that deny any single firm the ability to establish a monopoly in their product. This effect is observable in a high profit and production cost industry, such as the car industry, and other industries facing competition from imports.Drake Bennett, "BusinessWeek"
"GM, Ford, and Chrysler: The Detroit Three Are Back, Right?"
April 4, 2013.

Drake Bennett, "BusinessWeek"

''The Debate Room'', April 4, 2013.

By contrast, the lack of competition in a market ensures the firm (monopoly) has a downward sloping demand curve. Although raising prices causes the monopoly to lose some business, some sales can be made at higher prices. Though monopolists are constrained by consumer demand, they are not "price takers" because they can influence price through their production decisions. The monopolist can either have a ''target level of output'' that will ensure the monopoly price as the given consumer demand in the industry's market reacts to the fixed and limited market supply, or it can set a fixed monopoly price at the onset and adjust Output (economics), output until it can ensure no excess Inventory control, inventories occurs at the final output level chosen. At each price, the firm must accept the level of output as determined by the market's consumer demand, and every output quantity is identified with a price that is determined by the market's consumer demand. The price and output are co-determined by consumer demand and the firm's Industrial engineering, production cost structure.

A firm with monopoly power sets a monopoly price that maximizes the monopoly profit. The most ''profitable'' price for the monopoly occurs when output level ensures the marginal cost (MC) equals the marginal revenue (MR)) associated with the demand curve. Under normal market conditions for a monopolist, this monopoly price will be higher than the marginal (economic) cost of producing the product, thereby indicating the price paid by the consumer, which is equal to the marginal benefit for the consumer, is above the firm's marginal cost. In the chart below the shaded area represents the profits of the monopolist, such that MR = MC for the case of monopoly. The lower half represents the normal profits that would go to a competitive firm (ignoring output losses). The upper half represents the additional economic profit going to the monopolist.

Persistence

In the ''absence of'' Barrier to entry, barriers to entry and collusion in a market, the existence of a monopoly, and therefore monopoly profit, cannot persist in the long run. Normally, when economic profit exists within an Industry (economics), industry, economic agents rush to form new firms in the industry in an effort to obtain at least a portion of the existing economic profit. As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying (they compete for customers). Since consumers will flock toward the lowest price (in search of a bargain), older firms within the industry actually face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average economic cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to entering the industry, supply of the product stops increasing, and the price charged for the product stabilizes. Essentially, a competitive situation always leads to an equilibrium solution.

Normally, a firm that introduces a brand new product can initially secure a monopoly for a short while. At this stage, the initial price the consumer must pay for the product is high, and the demand for, as well as the availability of the product in the market, will be limited. In the long run, however, when the profitability of the product is well established, the number of firms that produce this product will increase until the available supply of the product eventually becomes relatively large, the price of the product shrinks down to the level of the average economic cost of producing the product. When this finally occurs, all monopoly associated with producing and selling the product disappears, and the initial monopoly turns into a (perfectly) competitive industry.

When consumers have full information about the prices available in the market and the quality of the products sold by the various firms, there cannot be a persistent monopolistic situation in the absence of barriers to entry and collusion.Steven M. Sheffrin, "Rational Expectations", New York: Cambridge University Press, 1987. John Black, "Oxford Dictionary of Economics", New York: Oxford University Press, 2003. Various barriers to entry include patent rights and monopolization of a natural resource needed to produce a product. The American firm Alcoa, Alcoa Aluminum is a historical example of a monopoly due to natural resource control; their control of "practically every source of bauxite in the United States" (bauxite is used to produce aluminum) was one key reason that "Alcoa was, for a long time, the sole producer of aluminum in the United States".

A barrier to entry can exist in a market situation that is characterized by a combination of high fixed costs in Production (economics), production and a relatively small demand within the firm's product market. Since a high fixed cost will result in a higher product market unit costs at lower production levels, and lower unit costs at higher production levels, the combination of a small product market demand for the firm's product, and the high revenue levels the firm needs to cover the high fixed costs it faces, indicate this product market will be dominated by a single large firm that uses economies of scale to minimize both its unit cost and its product price.The combination of high fixed costs and a small product market Demand ensures any reduction in a firm's Market share will significantly raise its unit costs. If entry of additional firms into the industry indicates total Production (economics), industrial production increases, a decline in the price charged for the Product (business), product would have to occur in order to accommodate the Demand, sale of the additional quantity that is Production (economics), produced for the product market. Even a small rise in the number of firms within the industry can quickly cause a large drop in profitability because of the double-whammy of rising unit costs and a falling price. This would tend to discourage the entry of new firms into the industry.

See: Bradley R. Chiller's "Essentials of Economics"(1991), pages 143–144,

Henderson and Quandt, Microeconomic Theory A Mathematical Approach, pages 193–195

New firms would be reticent to enter such a product market if an apparent slim economic profit can turn into an immediate economic loss for all firms upon a new entry. However, since the qualities of most economic markets make them Contestable market, contestable markets, there may be a greater magnitude of product differentiation within this overall market structure, making it similar to a monopolistic competition structure.

Government intervention

Competition law, Antitrust (competition) laws were created to prevent powerful firms from using their economic power to artificially create the barriers to entry they need to protect their monopoly profits. This includes the use of predatory pricing toward smaller competitors. In the United States, Microsoft Corporation was initially convicted of breaking the antitrust laws and engaging in anti-competitive behavior in order to form one such barrier in ''United States v. Microsoft''; after a successful appeal on technical grounds, Microsoft agreed to a settlement with the Department of Justice in which they were faced with stringent oversight procedures and explicit requirements"United States of America, Plaintiff, v. Microsoft Corporation, Defendant", Final Judgement
Civil Action No. 98-1232, November 12, 2002. designed to prevent this predatory behavior. Microsoft was successfully convicted of similar anti-competitive behavior in the European Economic Community's second highest court, the Luxembourg-based Court of First Instance, in 2007.Andy Reinhardt, "BusinessWeek"
"Microsoft's Day in European Court"
April 24, 2006.



Jennifer L. Schenker, "BusinessWeek"
"Microsoft in Europe: The Real Stakes"
September 14, 2007.


Jennifer L. Schenker, "BusinessWeek"
"Endgame for Europe's Microsoft Case"
October 22, 2007.
If firms in an industry collude they can also limit production, thereby restricting supply to ensure the price of the product remains high enough to ensure all of the firms in the industry achieve an economic profit.

The diagram to the right depicts an industry that initially starts out with a single firm that enjoys a monopoly and the initial monopoly profit that comes with it. Later, a second firm enters into the industry, lowering its price to obtain customers that usually do not purchase the product at the high monopoly price. As the initial monopoly firm loses customers, it is forced to lower its price to retain profitability. In the competition for sales to customers, the firms lower their prices even further, which increases the consumer demand for the product, and thereby entices the firms to raise production and which then increases the industry's total production and sales. Finally, the price and production in the industry stabilizes into its "competitive equilibrium"; the price paid by the consumers are just high enough to cover the average economic cost of producing the product, and the available quantity of the product doubles from its initial sales (under the monopoly).

If a government feels it is impractical to have a competitive market, it will sometimes try to regulate the monopoly by controlling the price the monopoly charges for its product. The old AT&T (regulated) monopoly, which existed before the courts United States v. AT&T, ordered its breakup and tried to force competition in the market, had to get government approval to raise its prices. The government examined the monopoly's costs, and determined whether or not the monopoly should be able raise its price and if the government felt that the cost did not justify a higher price, it rejected the monopoly's application for a higher price. Though a regulated monopoly will not have a monopoly profit that is high as it would be in an unregulated situation, it still can have an economic profit that is still well above a competitive firm has in a truly competitive market.

The government examines the marginal cost associated with raising the production level up to its presently desirable quantity, and allows the regulated monopoly to charge a price that is no greater than this marginal cost. Though the monopoly's profit is less than an unregulated situation, it can still make a positive economic profit.

Footnotes

References

*Kahana, Nava and Katz, Eliakim. "Monopoly, Price Discrimination, and Rent-Seeking". ''Journal Public Choice''. 64:1 (January 1990).
*Langbein, Laura and Wilson, Len. "Grounded Beefs: monopoly prices, Minority Business, and the price of Hamburgers at U.S. Airports". ''Public Administration Review''. 1994.
*von Mises, Ludwig. "Monopoly Prices". ''Quarterly Journal of Austrian Economics'' 1:2 (June 1998).
*Edwin Mansfield, "Micro-Economics Theory & Applications, 3rd Edition", New York and London:W.W. Norton and Company, 1979.
*Roger LeRoy Miller, "Intermediate Microeconomics Theory Issues Applications, Third Edition", New York: McGraw-Hill, Inc, 1982.
*Henderson, James M., and Richard E. Quandt, "Micro Economic Theory, A Mathematical Approach. 3rd Edition", New York: McGraw-Hill Book Company, 1980. Glenview, Illinois: Scott, Foresmand and Company, 1988,
*Binger, Brian R., and Elizabeth Hoffman. "Micro Economics with Calculus", Glenview, Illinois: Scott, Foresmand and Company, 1988.

{{DEFAULTSORT:Monopoly Profit
Market failure
Monopoly (economics)
Profit
Renting