The purpose of this essay is to explore the concept of monopoly power and the way abuse of monopoly power can lead to market failure. However, to fully understand how a Monopoly works I will explain certain key factors that determine a monopolistic market. Following that, I will explain how a monopoly will abuse its power to maximise its profits and how this causes market failure. Consequently, this will lead us to the second part which is to evaluate what the government can do to regulate the problem and how it should be addressed, as well as what the effect and side effects of regulation can be.
Market failure is when misallocation of resources happens while at least one individual could be better off without making the other worse off. (Paredo Inefficient) The main feature of a Monopoly Market is the lack of competition in the Market as well as the ability of a single firm to determine the market price. The lack of competition exists due to high barriers to entry. These are obstacles faced by firms who want to enter the market, as they see that the monopoly is enjoying abnormal profits. Some examples of barriers to entry are economies of scale, ownership of unique resources, high costs of setting up and brand loyalty which are mainly found in natural monopolies. On the other hand, there are also artificial barriers to entry which include predatory pricing, advertising, and patents (CorporateFinanceInstitute, N.D.). As a result of lack of competition, the monopolist is able to determine the price with it’s only limiting factor being demand.
With that being said, the monopolist will determine the price at which it will maximize profits with its only limiting factor to profits being demand. One of the determining factors of how a monopoly seek to maximize profits is Marginal Revenue, that is the additional revenue of producing 1 more unit. This can be easily calculated as it always has a slope which is double the slope of the Demand curve. It’s also important to note that Marginal Revenue follows the law of Marginal Diminishing Returns which means that eventually as we increase production, revenue will start to decrease. The next key factor is Marginal To do so, a rational monopolist, just like any other entrepreneur will choose to produce at the quantity Q1. That is where Marginal and Marginal Revenue are equal, however, in contrast to a competitive market, price will not be equal to marginal costs, it can sell this quantity at a price P2 such that P>MC.
This will result in a fall of consumer surplus, which is the difference between WTP and market price as well as a fall in producer surplus. This is marked by the triangle on the graph also known as Dead Weight loss and it represents all the additional units that could have been potentially produced and sold. These are not produced at all by the monopolist so that they can increase price and maximise profits.