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14.
Monopoly
Monopoly price and output
A pure monopolist can take market demand as its own demand curve. The firm is a price maker but a
monopoly cannot charge a price that the consumers in the market will not bear. In this sense, the elasticity
of the demand curve acts as a constraint on the pricing-power of the monopolist. Assuming that the firm
aims to maximise profits (where MR=MC), we establish a short run equilibrium as shown in the diagram
below.
The profit-maximising level of output is at Q1 at a price P1. This will generate total revenue equal to
OP1aQ1, but the total cost will be OAC1aQ. As total revenue exceeds total costs the firm makes abnormal
(supernormal) profits equal to P1baAC1.
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The effect of a rise in costs
The rise in price from p1 to p2 helps in part the monopolist to offset some of the rise in costs, but the net
effect is still a reduction in total profits and a contraction in output. The extent to which a business with
monopoly power can pass on a rise in costs depends in part on the price elasticity of demand – pricing
power is greatest when demand is price inelastic.
Barriers to entry – protecting monopoly power
Barriers to entry are designed to block potential entrants from entering a market profitably. They seek to
protect the power of existing firms and maintain supernormal profits / increase producer surplus. These
barriers have the effect of making a market less contestable - they are also important because they
determine the extent to which established firms can price above marginal and average cost in the long run.
The Nobel Prize winning economist George Stigler defined an entry barrier as “A cost of producing which
must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry”.
Another Economist, George Bain defined entry barriers in a slightly different way “The extent to which
established firms can elevate their selling prices above the minimal average costs of production without
inducing potential entrants to enter an industry”.
This emphasises the asymmetry in costs that often exists between the incumbent firm (i.e. the business
with market power already inside the market) and the potential entrant. If the existing businesses have
managed to exploit internal economies of scale and therefore developed a cost advantage over potential
entrants. This advantage might be used to cut prices if and when new suppliers enter the market. This
involves a decision to move away from short run profit maximisation objectives – but is designed to inflict
losses on new firms and protect market position in the long run.
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Different types of entry barriers exist:
o
Structural barriers (innocent entry barriers) – arising from differences in production costs
o
Strategic barriers (see the notes below on strategic entry deterrence)
o
Statutory barriers - entry barriers given force of law (e.g. patent protection of franchises such as
the National Lottery or television and radio broadcasting licences)
Entry barriers exist when costs are higher for an entrant than for the incumbent(s) firms. This is shown in
the next diagram:
In the previous diagram we assume that the incumbent monopolist has achieved economies of scale so that
that its own LRAC and LRMC are lower than that of a potential entrant. If the monopolist maintains a profit
maximising price of P1, a market entrant could achieve economic profits since its costs are lower than the
prevailing price. At any price below Pe the potential entrant will make a loss – and entry can be blockaded.
Barriers to Exit - Sunk Costs
Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:
o
Capital inputs that are specific to an industry and which have little or no resale value
o
Money spent on advertising, marketing and research and development projects which cannot be
carried forward into another market or industry
When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier to entry of
new firms (they risk making huge losses if they decide to leave a market). In contrast, markets such as fastfood restaurants, sandwich bars, hairdressing salons and local antiques markets have low sunk costs so the
barriers to exit are low.
The frequent market entry and failure of firms in many service and retail trade industries is evidence of
insubstantial entry barriers.
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Case Study in Exit costs – Coca Cola withdraws Dasani from the UK market
March 2004 was a bad month for Coca-Cola - the world’s largest soft-drinks maker. It had to withdraw its
Dasani bottled water from retail shelves in the UK just two months after it launched because the product did
not meet safety standards. This was a damaging and costly blow for Coca-Cola as it attempts to diversify
away from its traditional products into the faster-growing bottled water market. It demonstrates the
financial costs incurred when a business is either forced or chooses to withdraw a product from a market.
The product withdrawal was required because of strict consumer safety regulation in Britain. Under UK law,
bottled or tap water should contain no more than 10 micrograms per litre of bromate, a chemical that has
the potential to increase the risk of cancer. Coca-Cola’s analysis revealed levels in some samples of the
bottled water of up to 25 micrograms per litre.
So the Dasani bottles had to be withdrawn from sale as quickly as possible. There were over 500,000 bottles
on sale when the decision was taken. Coca-Cola was left pondering the effectiveness of the £2 million it had
already spent launching the product - part of a total promotional campaign worth £7 million which it had
budgeted to make the launch of Dasani the same kind of success in the UK as it has enjoyed in Europe.
Coca-Cola, which gets more than two-thirds of its revenue from outside the U.S., is relying more on sales of
water and juices to counter slower demand for soft drinks in North America. The Dasani recall’s negative
publicity may make it more difficult for Coca-Cola to compete against bottled water makers such as Nestle
SA in other parts of Europe as well.
Strategic Entry Deterrence
Strategic entry deterrence involves any move by existing firms to reinforce their position against other firms
of potential rivals. This might involve:
o
Hostile takeovers and acquisitions
o
Product differentiation through brand proliferation (i.e. investment in developing new products
and heavy spending on marketing and advertising)
o
Capacity expansion to achieve lower unit costs from exploiting economies of scale
o
Predatory pricing: Incumbent businesses may offer price cuts to customers who identify lower price
entrants.
Strategic barriers may be deemed anti-competitive by the British and EU competition authorities - The
EU Competition Commissioner Mario Monti has been active in recent years in building cases against
European businesses that have engaged in anti-competitive practices including price fixing cartels.
Nonetheless we often do witness the entry of new suppliers into markets and industries where one or more
firms have a clear position of market power. Entry can occur in a variety of ways:
1. A takeover from outside the industry (sometimes known as the “Trojan-horse route” to by-pass
any structural entry barriers that might exist within an industry)
2. The widening of a product range from a firm outside a specific market but with a state of
technology sufficient to challenge existing firms
3. A transfer of brand names from one sector of the economy to another (for example the
diversification practiced by both EasyGroup and Virgin in recent years)
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4. Increasing competition from overseas - perhaps stimulated by fluctuations in the exchange rate
of the development of a competitive advantage by foreign businesses
5. Growing markets – if demand is increasing, market prices might be expected to rise and through
the working of the price mechanism, higher prices offer increased potential profits for new entrants
even if their initial production costs are higher than the incumbent firms
6. Existing firms may be content to control the flow of new firms coming into a market rather than
engaging in strategies designed to block the entry of any new firm outright.
Barriers to Exit
For many businesses, there are also barriers to exit which increase the intensity of competition in an
industry because existing firms have little choice but to “stay and fight” when market conditions have
deteriorated. There are several costs associated with exiting an industry.
o
Asset-write-offs – e.g. the expense associated with writing-off items of plant and machinery,
stocks and the goodwill of a brand
o
Closure costs including redundancy costs, contract contingencies with suppliers and the penalty
costs from ending leasing arrangements for property
o
The loss of business reputation and consumer goodwill - a decision to leave a market can
seriously affect goodwill among previous customers, not least those who have bought a product
which is then withdrawn and for which replacement parts become difficult or impossible to obtain.
o
A market downturn may be perceived as temporary and could be overcome when the economic or
business cycle turns and conditions become more favourable
The importance of market share
An important piece of research in the 1960’s provided the basis for understanding the importance of market
share – and emphasised the implications for marketing and business strategy.
The Profit Impact of Market Strategy (“PIMS”) analysis was developed at General Electric in the 1960’s and
is now maintained by the Strategic Planning Institute. The PIMS database provides evidence of the impact
of various marketing strategies on business success. The most important factor to emerge from the PIMS
data is the link between profitability and relative market share. PIMS found (and continues to find) a link
between market share and the return a business makes on its investment. The higher the market share –
the higher is the return on capital investment. This is probably as a result of economies of scale. Economies
of scale due to increasing market share are particularly evident in purchasing and the utilisation of fixed
assets.
An accurate measure of market share is dependent on several factors:
o
A satisfactory definition of the market: This would answer questions such as which products to
include, which geographical areas, which means of distribution?
o
The availability of reliable, up-to-date information
o
Agreement on which measures of share are most relevant: For example, should market share be
calculated on the basis of sales revenues, profits, units produced or some other measure that
competitors in the market generally recognise as valid.
Unit 4: Industrial Economics
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Edexcel A2 Economics Toolkit 2005