Monopoly

Monopoly is the condition under which a single seller sets prices in a market. This condition opposes that of perfect competition, where sellers have no pricing power.

Monopolistic sellers can exercise maximum feasible pricing power. However, this power is less than conventional wisdom frequently identifies. In short, a monopolist cannot just charge any price for its goods or services. Rather, it sets prices subject to consumers’ willingness to pay.

[Page 372]Competitive firms are “atomistic” in the sense that their production decisions negligibly affect the aggregate level of output available to consumers. As a result, competitive firms are “price takers”; that is, they can sell all their output at a fixed market price.

Monopolistic firms, in contrast, are “price makers.” Unlike their competitive counterparts, monopolists significantly affect aggregate output by altering their own output. Indeed, a monopolist' output not only contributes to aggregate output, it is aggregate output (at least for the market in which it operates). Consequently, rather than being able to sell all its output at a fixed price, the monopolist must lower its price to sell additional quantities.

To understand this necessity, suppose a monopolist sells soft drinks. A consumer might be willing to purchase a single drink for, say, $1.00. A second, less thirsty, consumer may only be willing to pay, say, $0.75. To the extent that the monopolist cannot price-discriminate (charge different prices to different consumers), it must choose in the present example between selling a single unit for $1.00 or two units for $1.50 ($0.75 each).

This example illustrates the more general phenomenon that, because consumers vary in their willingness to pay for goods and services (and because individual consumers often value additional units at lower marginal values), monopolists face “downward sloping demand curves.” Should a monopolist want to supply more units to the market, it must do so at a lower price. To maximize profits, monopolists do not maximize price. Rather, they strategically trade off increased profit from increasing their output against decreased profit from lowering their price at higher output levels.

Although this tradeoff maximizes the monopolist' profit, it can constrain output to a less than socially optimal level. This adverse welfare consequence occurs because there exist consumers who are willing to pay more than the monopolist' marginal cost of production, but the monopo-list is unwilling to sell to those customers because doing so would lower the price it charges to previous customers.

Monopolistic power can also create benefits, however. Consider the case of pharmaceutical innovations. Although monopolistic power has “natural” origins (such as that associated with first-mover advantages), it also has legal or regulatory origins. One such origin is patent law, which essentially confers monopoly power on those who create innovations in general and pharmaceutical companies in particular.

Absent this power, pharmaceutical companies would be reluctant to sink real resources into research and development efforts. Doing so would create significant costs while leaving consequent benefits for expropriation by other firms and consumers. No firm can invest for long in such an environment. Monopolistic power can thus offset, and perhaps overwhelm, associated welfare-decreasing effects (that is, constraining output) by, for example, encouraging potentially productive activity such as research and development.

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