Monopoly Power, Price Rigidity, and Economies of Scale in Microeconomics

Posted on Aug 3, 2024 in Economy

Price Rigidity in Non-Collusive Oligopolies

There are many ways to explain why non-collusive oligopoly is characterized by price rigidity. One explanation is the use of game theory. This theory considers the optimum strategy that a firm could undertake in light of different situations between firms. It is useful when there are few firms in the market; otherwise, it is impossible to accurately predict outcomes. In general terms, it is used when firms that have the same costs, identical products, and share the market wish to change their prices and so work out the best “good outcome” and the best “worst outcome”. However, most of the time, the price is maintained. If all firms lower their prices, it would employ losses or less revenue than before, so they would have been better off leaving prices unchanged or if they had colluded.

The kinked demand curve also explains price rigidity in non-colluded oligopolies. Firms are afraid to raise prices above the current market price since other firms will likely maintain prices, leading to relatively elastic demand above the market price (a small increase in price leads to a larger fall in quantity demanded), losing trade, sales, and profit. Firms are afraid of lowering their prices below the market price since other firms will follow, undercutting them and leading to more inelastic demand (a decrease in price won’t lead to a greater increase in quantity demanded) and thus creating a price war that may harm all firms. The shape of the marginal revenue (MR) curve means that if marginal cost (MC) were to rise, then it is possible that MC would still equal MR, and so the firms, being profit maximizers, would not change their prices or output.

Diagram: Point A is located at the current market price. Above A, demand is more elastic; below A, demand is more inelastic. MR is twice as downward-sloping than average revenue (AR) in points CB due to the inelasticity.

Long-Run Average Cost (LRAC) Curve

The long run is the period in which all factors of production (FOPs) are variable, but the state of technology is fixed. All planning takes place in the long run. The effects on costs when all FOPs are increased to increase output are what is analyzed. LRAC contains infinite numbers of short-run average cost (SRAC) curves.

Diagram: The firm is producing an output of q1 at C3 cost per unit and operating at SRAC1. C3 is the lowest possible cost of producing the output since it’s the point that limits with the LRAC. If demand increases and the firm wishes to produce q2, it can do so in the short run by increasing its variable factors, moving along the SRAC1, until q2 is produced at C* cost per unit, which implies higher costs. So the firm will plan to change all of its FOPs in the long run to lower costs. q2 will then be produced at C2 cost per unit. SRAC curves are U-shaped due to the diminishing returns hypothesis (eventually diminishing average returns), while the LRAC curves are U-shaped due to the existence of economies of scale and diseconomies of scale.

When the long-run unit costs fall as output increases, the firm is experiencing increasing returns to scale. When the LRAC is constant as output increases, the firm is experiencing constant returns to scale. When the LRAC rises as output rises, the firm is experiencing decreasing returns to scale.

Normal Profits in Long-Run Perfect Competition

At the industry level, there are normal demand and supply curves, and producers wish to supply more at higher prices, and consumers would demand less at higher prices. Demand is downward sloping while supply is upward sloping. At the firm level, producers will face perfectly elastic demand curves since they are “price takers” of the industry price. They can also sell as much as they want since it won’t affect the industry supply curve because of that P=D=AR=MR.

In the long run, firms in perfect competition will make normal profits since, even if they are making short-run abnormal profits/losses, the industry will adjust with firms entering or leaving the industry until a normal profit situation is reached. In that situation, there is no incentive for firms to enter or leave the industry, and so equilibrium will persist until there is a change in either the industry demand curve or the costs that firms face, and so firms will be making short-run abnormal profits/losses again, and the industry will once more adjust, with firms entering or leaving. This is also due to the assumption of perfect knowledge and no barriers in the market.

Economies of Scale

Economies of scale are any decrease in long-run average costs that come about when a firm alters all of its FOPs to increase its scale of output. They lead to the firm experiencing increasing returns to scale.

Different Types of Economies of Scale:

Specialization: In small firms, there are few, if any, managers that take on many different roles, often roles for which they are not the best candidates. This leads to higher unit costs. As firms grow, they can have their management specialize in individual areas of expertise and therefore be more efficient.
Division of Labor: Breaking a production process into small activities that workers can perform repeatedly and efficiently. As firms get bigger and demand increases, they often break down their production processes, use the division of labor, and reduce their unit costs.
Bulk Buying: As firms increase in scale, they can often negotiate discounts with their suppliers that they would not have received when they were smaller. The cost of their inputs is then reduced, which will reduce their unit costs of production.
Financial Economies: Large firms can raise financial capital more cheaply than small firms. Banks tend to charge a lower interest rate to larger firms since they are considered less risky than smaller firms and are unlikely to fail to repay.
Transport Economies: Large firms making bulk orders may be charged less for delivery costs than smaller firms, or they may be able to have their transport fleet, which implies less cost.
Large Machines: Some machinery is too large to be owned and used by a small producer, so they’ll hire the equipment. But as producers grow, they can have their equipment, reducing the unit costs of production.
Promotional Economies: Most firms want to promote their products using ads, sales promotion, personal selling, or publicity. The cost of promotion doesn’t increase proportionally as output. If a firm doubles its output, it won’t double its expenditure on promotion methods. Therefore the cost of promotion per unit of output falls; it’s a fixed cost.

Diseconomies of Scale

Diseconomies of scale are any increases in long-run average costs resulting from a firm altering all of its FOPs to increase its scale of output. It leads to the firm experiencing decreasing returns to scale.

Different diseconomies of scale may afflict a firm as it increases the scale of output:

Control and Communication Problems: As firms grow in scale, management will find it harder to control and coordinate the firm’s activities, which may lead to inefficiency and increase the unit costs of production. Also, greater size leads to communication breakdowns that increase unit costs, so an increase in the need for effective communication is needed.
Alienation and Loss of Identity: As firms grow, workers and managers may begin to feel useless inside the big organization, losing their sense of belonging and loyalty. If this happens, workers and managers might not work as hard or productively as before, forcing up the unit costs of production.

Economies and diseconomies of scale relate to the unit cost decreases or increases that might be encountered by a single firm, known as internal economies and diseconomies of scale.

External economies and diseconomies of scale are those that come about when the industry’s size increases and affects the unit costs of individual firms.

Sources of Monopoly Power/Barriers to Entry

A monopoly may survive if it can stop other firms from entering the industry with several barriers:

Economies of Scale: The lack of economies of scale acts as a barrier to firms that might want to enter a monopoly industry. Firms gain average cost advantages as they grow. Things such as specialization, division of labor, bulk-buying, etc., lead to cost savings and lower unit costs. A firm trying to enter the industry will start up in a small way and won’t have the economies of scale enjoyed by the monopolists. Even if the new firm starts up with the same size, it would still not have the expertise in the industry, such as managerial economies or research and development. Without equal economies of scale, a firm trying to enter the industry won’t be able to compete with the monopolist, who would reduce the price to the level of normal profits, where the new entrant would be making losses since the average costs would be higher.
Natural Monopoly: If there are only enough economies of scale available in the market to support one firm.
Legal Barriers: A firm may have been given a legal right to be the only producer in an industry, such as patents. This kind of barrier is set to encourage inventions. Patents, copyrights, and trademarks are intellectual property rights. Another legal barrier is where the government grants the right to produce a product to a single firm, such as a nationalized firm like the postal service or a private firm like electricity.
Brand Loyalty: It may be that a monopolist produces a product that has gained brand loyalty. Consumers think of the product as the brand. New firms may be put off since they will feel they can’t produce a product sufficiently different to generate such strong brand loyalty.
Anti-competitive Behavior: A monopolist may also attempt to stop competition by adopting restrictive practices, which may be legal or illegal. A monopoly can start a price war, lowering its price to a loss-making level and should be able to sustain the losses for a longer time than the new entrant, forcing the new firm out of the industry.

Possible Profit Situation in Monopoly

If it can make abnormal profits in the short run and if it has effective barriers to entry, other firms can’t enter the industry and compete away the profits earned. So monopolists can make abnormal profits in the long run as long as the barriers to entry hold out.

Monopolies won’t always make abnormal profits. If the monopoly of a product has little demand, they won’t make abnormal profits. If a monopoly made losses in the short run, it could close temporarily (if it wasn’t covering variable costs) or continue production in the short run. If there’s no planning towards making at least a normal profit, the firm would close, and since the firm was the industry, it would cease to exist.

Advantages and Disadvantages of Monopoly in Comparison with Perfect Competition

Advantages:

Monopolists may achieve large economies of scale without being big. If the industry is big enough, the monopolist would gain great economies of scale. If this pushes the MC curve down, the monopolist may produce at a higher output and a lower price than in perfect competition.
There will be higher investment levels in R&D in monopolies. Firms in perfect competition are relatively small and find it difficult to invest in R&D. Monopolies making abnormal profits have a better situation to invest in R&D, which in the long run would benefit consumers, with better products and more choice.

Disadvantages:

If there are not enough economies of scale, the monopoly may restrict output and charge a higher price than under perfect competition.
The high profits of monopolists may be considered unfair, especially by competitive firms or those with low incomes. The disadvantage increases with the power and size of the monopoly.
Productively and allocatively inefficient.
They can exercise anti-competitive behavior to keep monopoly power.