Sources of Monopoly Power

Why do some firms have considerable monopoly power while other firms have little or none? Remember that monopoly power is the ability to set price above marginal cost and that the amount by which price exceeds marginal cost depends inversely on the elasticity of demand facing the firm. As equation (10.4) shows, the less elastic its demand curve, the more monopoly power a firm has. The ultimate determinant of monopoly power is therefore the firm’s elasticity of demand. Thus we should rephrase our question: Why do some firms (e.g., a supermar- ket chain) face demand curves that are more elastic than those faced by others (e.g., a producer of designer clothing)?

Three factors determine a firm’s elasticity of demand.

1. The elasticity of market demand. Because the firm’s own demand will be at least as elastic as market demand, the elasticity of market demand limits the potential for monopoly power.
2. The number of firms in the market. If there are many firms, it is unlikely that any one firm will be able to affect price significantly.
3. The interaction among firms. Even if only two or three firms are in the market, each firm will be unable to profitably raise price very much if the rivalry among them is aggressive, with each firm trying to capture as much of the market as it can.

Let’s examine each of these three determinants of monopoly power.

1. The Elasticity of Market Demand

If there is only one firm—a pure monopolist—its demand curve is the mar- ket demand curve. In this case, the firm’s degree of monopoly power depends completely on the elasticity of market demand. More often, however, several firms compete with one another; then the elasticity of market demand sets a lower limit on the magnitude of the elasticity of demand for each firm. Recall our example of the toothbrush producers illustrated in Figure 10.7 (page 370). The market demand for toothbrushes might not be very elastic, but each firm’s demand will be more elastic. (In Figure 10.7, the elasticity of market demand is −1.5, and the elasticity of demand for each firm is −6.) A particular firm’s elasticity depends on how the firms compete with one another. But no matter how they compete, the elasticity of demand for each firm could never become smaller in magnitude than −1.5.

Because the demand for oil is fairly inelastic (at least in the short run), OPEC could raise oil prices far above marginal production cost during the 1970s and early 1980s. Because the demands for such commodities as coffee, cocoa, tin, and copper are much more elastic, attempts by producers to cartelize these mar- kets and raise prices have largely failed. In each case, the elasticity of market demand limits the potential monopoly power of individual producers.

2. The Number of Firms

The second determinant of a firm’s demand curve—and thus of its monopoly power—is the number of firms in its market. Other things being equal, the monopoly power of each firm will fall as the number of firms increases: As more and more firms compete, each firm will find it harder to raise prices and avoid losing sales to other firms.

What matters, of course, is not just the total number of firms, but the number of “major players”—firms with significant market share. For example, if only two large firms account for 90 percent of sales in a market, with another 20 firms accounting for the remaining 10 percent, the two large firms might have consid- erable monopoly power. When only a few firms account for most of the sales in a market, we say that the market is highly concentrated.10

It is sometimes said (not always jokingly) that the greatest fear of American business is competition. That may or may not be true. But we would certainly expect that when only a few firms are in a market, their managers will prefer that no new firms enter. An increase in the number of firms can only reduce the monopoly power of each incumbent firm. An important aspect of competitive strategy (discussed in detail in Chapter 13) is finding ways to create barriers to entry—conditions that deter entry by new competitors.

Sometimes there are natural barriers to entry. For example, one firm may have a patent on the technology needed to produce a particular product. This makes it impossible for other firms to enter the market, at least until the patent expires. Other legally created rights work in the same way—a copyright can limit the sale of a book, music, or a computer software program to a single company, and the need for a government license can prevent new firms from entering the markets for telephone service, television broadcasting, or interstate trucking. Finally, economies of scale may make it too costly for more than a few firms to supply the entire market. In some cases, economies of scale may be so large that it is most efficient for a single firm—a natural monopoly—to supply the entire market. We will discuss scale economies and natural monopoly in more detail shortly.

3. The Interaction Among Firms

The ways in which competing firms interact is also an important—and some- times the most important—determinant of monopoly power. Suppose there are four firms in a market. They might compete aggressively, undercutting one another ’s prices to capture more market share. This could drive prices down to nearly competitive levels. Each firm will fear that if it raises its price it will be undercut and lose market share. As a result, it will have little monopoly power.

On the other hand, the firms might not compete much. They might even col- lude (in violation of the antitrust laws), agreeing to limit output and raise prices. Because raising prices in concert rather than individually is more likely to be profitable, collusion can generate substantial monopoly power.

We will discuss the interaction among firms in detail in Chapters 12 and 13. Now we simply want to point out that, other things being equal, monopoly power is smaller when firms compete aggressively and is larger when they cooperate.

Remember that a firm’s monopoly power often changes over time, as its operating conditions (market demand and cost), its behavior, and the behav- ior of its competitors change. Monopoly power must therefore be thought of in a dynamic context. For example, the market demand curve might be very inelastic in the short run but much more elastic in the long run. (Because this is the case with oil, the OPEC cartel enjoyed considerable short-run but much less long-run monopoly power.) Furthermore, real or potential monopoly power in the short run can make an industry more competitive in the long run: Large short-run profits can induce new firms to enter an industry, thereby reducing monopoly power over the longer term.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.