Monopoly Power

Monopoly power (also called market power) refers to a firm’s ability to charge a price higher than its marginal cost. Monopoly power typically exists where the there is low elasticity of demand and significant barriers to entry.

Why is it that a firm in perfect competition is a price-taker while a monopoly can set any price it deems fit? The answer lies in the nature of the demand curve facing each firm. In a perfect competition, no firm has any market power because they face a horizontal demand curve. They must supply at the prevailing market price or sell nothing. A monopoly, on the other hand, need not worry about any competition. Since a monopolist is the only firm in the market, if the elasticity of demand for its product is low, he determines the market price. In other words, a monopolist has infinite monopoly power.

The most popular measure of monopoly power is Lerner Index which measures the difference between a firm's marginal cost and the price it charges as a proportion of the price.

Sources of Monopoly Power

Important determinants/sources of monopoly power include elasticity of demand of the product, existence of economies of scale, control of a key resource, existence of legal barriers, etc.

Elasticity of Demand

If the elasticity of demand is low, a firm is in a better position to charge a price higher than its marginal cost. If close substitutes exist and hence the elasticity of demand is high, even a single firm can’t increase price beyond some reasonable range. For example, if people could switch to other word processors easily, elasticity of demand for Microsoft Word would be low and Microsoft wouldn’t enjoy a near-monopoly in the market.

Since a monopolist faces a downward-sloping demand curve, its marginal revenue is given by the following equation:

$$ MR=P+Q\times\frac{\Delta P}{\Delta Q} $$

It shows that in order to increase its revenue by one unit, a monopolist must reduce its market price. The first factor on the right-hand side of the equation i.e. P represents the revenue from additional unit sold and the second factor (Q × ∆P/∆Q) represents the loss in revenue from reduction in market price.

Multiplying and dividing the right-hand side by P, we get a relationship between a firm’s elasticity of demand and its marginal revenue.

$$ MR=P+Q\times\frac{P}{P}\times\frac{\Delta P}{\Delta Q}=P+P\times \frac{Q}{P}\times \frac{\Delta P}{\Delta Q} $$

But Q/P multiplied by ∆P/∆Q equals elasticity of demand Ed, we can get the following equation:

$$ MR=P+P\times E_d $$

Economies of Scale

A firm’s production function and cost structure are also important determinants of whether positive economic profit is possible in the long-run.

If the cost structure of an industry is such that economies of scale matter a lot, a single large firm might be able to produce at a significantly lower cost than other small and medium-sized firms. This enables the largest player to price other firms out of the market. Many utility companies are able to monopolize a market owing to economies of scale. Such a monopoly is called a natural monopoly. Similarly, existence of increasing returns to scale means that as the size of a firm gets larger, its productivity (i.e. output per unit) increases and he can supply the product at increasingly lower prices.

Existence of economies of scale and increasing returns to scale means that the industry’s minimum efficient scale is high, and this restricts entry by new firms because they must start big to stand a change and not many firms may have the capital needed to start at such a scale.

Legal Barriers

Third source of monopoly power is the existence of legal entry barriers including patents, copyrights, licenses, etc.

In many instances, a monopoly is created and enforced by a government through its intellectual property rights laws. For example, Microsoft has monopoly in Windows-based operating systems because no one else can copy and sell Windows. Similarly, many pharmaceutical companies have monopoly in specific drugs due to existence of patents.

Access to Critical Natural Resource

Monopolies also arise when one firm has control over certain important physical and natural resource. The firm controlling the resource can restrict supply of the resource to other firms thereby controlling the ultimate market price.

For example, De Beers has monopoly in diamonds because it owns and controls all major diamond mines.

Written by Obaidullah Jan, ACA, CFA and last modified on