A firm has market power if it can profitably charge a price that is above its marginal cost.
A monopoly market is a market with a single seller; an oligopoly market has a few (but not many) sellers.
In situations in which market power exists, economists define the market to include products that are close substitutes for one another but to exclude more distant substitutes.
Monopoly pricing
A monopolist's marginal revenue is determined by both output expansion and price reduction effects. Because of the price reduction effect, a monopolist's marginal revenue is less than his price, except when his sales quantity is zero, where it equals the price.
If the monopolist's profit-maximizing sales quantity is positive, it occurs at a point where marginal revenue equals marginal cost. The monopolist can find the profit-maximizing sales quantity by first identifying the most profitable positive sales quantity at which marginal revenue equals marginal cost (the quantity rule) and then checking whether that sales quantity results in a greater profit than does shutting down (the shut-down rule).
At the profit-maximizing price, a monopolist's markup (or price-cost margin, or Lerner Index), (P - MC)/P, is equal to the reciprocal of the elasticity of market demand, times negative one.
Welfare effects of monopoly pricing
By raising the price above marginal cost, a monopolist increases profit but reduces consumers' well-being.
Monopoly pricing results in a deadweight loss, because aggregate surplus fails to achieve its maximum possible level. Put differently, the harm to consumers from monopoly pricing is greater than the monopolist's gain in profit.
Distinguishing monopoly from perfect competition
A monopolist responds to changes in demand and cost differently from firms in a perfectly competitive industry. This can provide ways to tell if a group of firms is competing vigorously or is instead colluding and acting just like a monopolist.
A monopolist's price depends on the elasticity of demand, while the price in a perfectly competitive market depends on the level of demand. As a result, a rotation of the demand curve through the initial price and sales quantity will change the monopolist's price, but not the price in a perfectly competitive market.
In a perfectly competitive market, an increase in marginal cost never increases the price by more than the increase in marginal cost. A monopolist's price may increase by more than the increase in marginal cost.
Nonprice effects of monopoly
When all consumers value an increase in a product's quality by the same amount, a monopolist will produce the level of quality that maximizes aggregate surplus.
If some consumers value increases in quality more than others, the monopolist will not necessarily provide the quality level that maximizes aggregate surplus.
A monopolist's incentive to advertise depends on both the amount by which the price exceeds the marginal cost (which depends on the price elasticity of demand) and the responsiveness of demand to advertising.
Investments that are made with the aim of becoming a monopolist can be either socially beneficial or wasteful (through rent seeking).
Monopsony
Sometimes the buyers in a market enjoy market power, so that they need not take the price at which a good is sold as given. In extreme cases, there may be only a single buyer for a good, known as a monopsonist.
The analysis of monopsony parallels the analysis of monopoly. Monopsonists can reduce the amount that they pay for a good by reducing the quantity they buy.
A monopsonist's marginal expenditure is determined by input expansion and price increase effects. The price increase effect makes a monopsonist's marginal expenditure greater than the input price, except when the monopsonist's purchase of the input is zero, where it equals the input price.
The optimal purchase quantity for the monopsonist, if positive, equates the marginal benefi t from the good to the marginal expenditure.
The monopsonist buys less of a good than the amount that would maximize aggregate surplus, leading to a deadweight loss.
Regulation of monopolies
In response to concerns about monopoly pricing, governments may decide to regulate monopolies. Some monopolies arise because the market can be profitable for only one firm. Others are created by the government. Governments sometimes create monopolies in natural monopoly markets, in which the entry of a second firm would lead to inefficient production.
Ideally, government regulators would set the monopolist's price at the "competitive price," which would maximize aggregate surplus. In practice, however, that price would often cause the regulated firm to lose money. In that case, they may implement second-best price regulation, which involves setting the price so as to maximize aggregate surplus, subject to the constraint that the firm not lose money.
In practice, price regulation can cause other problems, such as discouraging efforts at cost reduction, allowing regulators to pursue aims other than economic efficiency, and permitting regulatory capture.
Sometimes concern over monopoly pricing leads to government ownership, which can eliminate some problems of regulation (such as elaborate rate hearings), but may lead to other problems (such as elimination of the profit motive).
Multiproduct monopoly
When a monopolist sells products that are complements or substitutes, the profit-maximizing price of any given product takes account of the effects on sales of other products.
If a monopolist sells one product (say, popcorn) at a price above its marginal cost and it is a complement to another product (say, a movie ticket) the monopolist also sells, the monopolist will have an incentive to set a lower price for the second product (the movie ticket) because doing so will increase sales of the first product (popcorn).If instead the first product is a substitute for the second, the monopolist will have an incentive to set a higher price for the second product because, with substitutes, doing so increases sales of the first product.
