TOPIC 8 ► MONOPOLY MARKET

8.1 CHARACTERISTICS OF A MONOPOLY MARKET

SELF-CHECK 8.1

In your opinion, why is there only one firm that controls the production of a particular good or service?

The main characteristics that differentiate a monopoly from a perfectly competitive market are as shown in Figure 8.1:

Figure 8.1: The features of a monopoly market

8.1.1 No Close Substitutes

Goods produced by a monopoly do not have close substitutes in terms of the consumption of the good. In Malaysia, Tenaga Nasional Berhad (TNB) is the best example of a monopoly. Electricity supplied by TNB cannot be substituted with other forms of energy. Even though there might be other goods that can substitute the use of electricity, the good may still be limited in terms of its use and nature.
Candles, for example, can be used to provide light and substitute electricity power during blackouts, but its use is limited. It cannot be used to receive television or radio programmes, or to turn on an electric fan.

8.1.2 Barriers to Entry into Industry

Unlike the perfectly competitive market, monopoly has the power to restrict the entry of other firms into the industry. This restriction is due to several reasons such as:

1. License given by the government;
2. Control over production resources; and
3. Having the benefits of economies of scale and others.

This will create monopoly power in a particular industry. Monopoly power will be explained in the following section of this chapter.

8.1.3 Firm as the Price Maker

As mentioned from the beginning, a monopoly market consists of only one firm that controls the whole market. This enables the monopolist to solely determine the price of goods or services provided.

ACTIVITY 8.1

In your opinion, why can similar goods or services be sold at different prices to two different consumers?

8.2 POWER SOURCE OF MONOPOLY

SELF-CHECK 8.2

Before proceeding with your readings, determine which of these are considered a monopoly?

1. Tenaga Nasional Berhad
2. Celcom (M) Berhad
3. Perbadanan Urus Air Selangor (PUAS)
4. Malaysian Airline System (MAS)
5. Sistem Televisyen Malaysia Berhad (TV3)

There are several sources that cause monopoly power:

1. Control over certain production resources;
2. Economies of scale; and
3. Legal barriers.

8.2.1 Control over Certain Production Resources

A monopoly can occur when a particular firm is able to control a large portion or the entire supply of raw material that cannot be afforded by other firms. Telekom Malaysia Berhad is one of the businesses attempting to control a large portion of  telecommunication resources by taking over several other telecommunication companies such as Celcom and thus, becoming the monopoly in this industry.
De Beers is a common example that exemplifies world monopoly of the mining of precious gems. Almost all of the world’s precious gem mining is controlled by De Beers.

8.2.2 Economies of Scale

Economies of scale means a firm can produce output with a low average cost due to the large quantities produced. The output produced is able to accommodate almost all the demand in the market. This prevents new firms from entering the market because of the long time period needed to achieve economic scale.
If a new firm intends to enter the market, it needs to sell its output at a price as low as the price of the firm experiencing economies of scale; this will probably result in a loss and the new firm will soon have to leave the market.

8.2.3 Legal Barriers

The government creates regulatory barriers to protect the interests of the monopoly. The regulatory barriers can be in the form of licenses, patents and copyrights. Figure 8.2 illustrates the legal barriers present.

Figure 8.2: Regulatory barriers in the economy

1. License Public license is a legal right granted by the state government or the local government by imposing a certain amount of payment onto the business owner. Without this license, the business operated is considered illegal and legal action can be taken towards it.
   
   Any business such as the medical, food and other industries, will need to have a license. How can a license create monopoly power? A license can create monopoly power because not all businesses will be granted a license by the government.
   
   However, the granting of license seldom leads to monopoly power. In most situations, it will only reduce competition. The government will only provide licenses to a particular business which is considered to be more viable than other competitors. Any firm without a license will be restricted from doing business.
2. Patent Patent is a form of special right given by the government to inventors or creators, with regard to their inventions or creations. This patent restricts other individuals from producing an output similar to the invention that has been granted the patent right. Patent is vital in protecting new inventions and creations since it involves a very high cost. In the United States, a patent for an invention is granted for a period of at least seventeen years.

ACTIVITY 8.2

In Malaysia, it is said that the awareness regarding patent choice of a particular invention by individuals is still low. In your opinion, what are the necessary measures that should be taken in order to increase awareness regarding this matter?

3. Copyrights Copyright is also a patent that protects inventors from imitations. Copyright differs from patent as it is given to writings and publication of books, and song writing. Copyright only allows the particular writer to publish the particular book or song. Any unauthorised publication will be legally dealt with.

ACTIVITY 8.3

Describe the reasons why monopoly power exists.

8.3 DEMAND, AVERAGE REVENUE AND MARGINAL REVENUE

Before proceeding into further discussion about maximisation of monopoly profit, we first have to know the basic matters related to it. Here, we will look at the relationship between demand curve (D), total revenue curve (TR), and marginal revenue curve (MR) of a monopoly market.

8.3.1 Relationship between the Demand Curve and the Total Revenue Curve

SELF-CHECK 8.3

How do you obtain total revenue?

Total revenue can be obtained by multiplying price with the quantity of output sold.

Figure 8.3(a) illustrates the demand curve of a monopoly, while Figure 8.3(b) shows its total revenue curve.

Figure 8.3: Relationship between demand curve and total revenue curve

The total revenue curve of a monopoly is similar to the total revenue curve of a perfectly competitive market, which begins at the origin indicating that no revenue is gained when there is no output produced.
From the figure, we are able to see how total revenue experiences increase in value until the maximum level is achieved then decreases continuously.
Its relationship with the demand curve is at the section where a demand curve is more elastic. When there is more output being produced due to a decrease in price, total revenue will increase.

Total revenue is maximum at the section where the demand curve is unitary elastic. After that particular point, the total revenue will decrease when more quantities are being produced. This is one of the reasons why a monopolist will not produce output at the section where the demand curve is inelastic.

8.3.2 Total Revenue Curve, Total Costs Curve and Monopoly Profit

SELF-CHECK 8.4

In your opinion, how do we calculate the economic profit based on Figure 8.3?

Economic profit is calculated based on the biggest difference in distance between total costs curve (TC) and total revenue curve (TR). Figure 8.4 illustrates that the biggest distance is when output is equivalent to 150 units.
Observe that, in that condition, the gradients of both curves are equal. Any output between 50 to 290 units will still give an economic profit to a monopolist but the total profit is not maximal.
Profit will only be maximal at the output level of 150 units. Meanwhile, an output level that is less than 50 units, or more than 290 units, will bring loss since the total costs curve is above the total revenue curve, meaning that cost is higher than revenue for every unit of output. This can be seen in Figure 8.4.

Figure 8.4: Total revenue curve, total costs curve and monopoly profit

8.3.3 The Relationship between Demand Curve and Marginal Revenue Curve

The marginal revenue curve of a monopoly has a similar intersection as its demand curve at the vertical axis (price axis), that is when price is at RM80. However, its value of slope at the horizontal axis is different; the intersection of the demand curve is twice the intersection of its marginal revenue curve.
Figure 8.5 shows that the marginal revenue curve intersects the horizontal axis at the output level of 400 units, while the demand curve intersects the axis at the output level of 800 units. This also means that the sloping or gradient of the marginal revenue curve is twice the gradient of the demand curve of a monopoly.
For example, if given the demand function of monopoly is:

P = 24 –  6Q

Hence, the marginal revenue function is:

MR = 24 – 12Q

We can see here that the gradient for the demand function is 6, while the gradient for the marginal revenue function is 12.
Why does the marginal revenue curve intersect the X-axis at half the value of the demand curve intersection on the same axis? This is because, marginal revenue is maximum at the point where demand curve is unitary elastic, that is, in the middle of the demand curve. After that point, the value of marginal revenue becomes negative.

Figure 8.5: The relationship between demand curve and marginal revenue curve

8.3.4 Marginal Revenue

SELF-CHECK 8.5

After going through the previous topic, in your opinion, what is marginal revenue?

Marginal revenue is the gradient of the total revenue curve (TR), while marginal cost is the gradient of the total costs curve (TC).

Based on this definition, we can state that a monopolist will choose the output level where total revenue is equivalent to total costs.
Marginal revenue of a monopoly can be obtained from the differentiating method towards the total revenue function. In function,

Given that the profit function is

In order to gain maximum profit, we need to differentiate the profit function against output and equating it to zero.

This rule must also be followed as with the rule fixed in the perfectly competitive market, that is, the marginal revenue curve must intersect the marginal costs curve from above.
Rationally, this condition is when all firms want to produce their output at the condition where marginal revenue exceeds marginal cost. Thus, marginal revenue must be above the marginal cost before the intersection (crossing).

Figure 8.6: Maximisation of monopoly profit

Based on Figure 8.6, we can see the condition where the marginal costs curve intersects the marginal revenue curve. Intersection takes place at two points, that is when output is at Q₁ and Q* units of output.
However, the output chosen is the output that maximises profit because at this point, the marginal cost curve intersects the marginal revenue curve from the top and after the intersection, the marginal costs curve is at the bottom of the marginal revenue curve.
This means that when the production of output is between Q₁ and Q*, the average cost of output is still very much lower compared to its average revenue. Meanwhile, after Q* unit of output, an increase in the subsequent output will result in a bigger increase in cost compared to the increase in revenue.
Only at Q* unit, output produced will give a marginal revenue that is equivalent to the marginal cost, and this is the output that can maximise the monopoly profit. Q₁ is the output produced when the firm achieves the condition of capital break even.

8.3.5 Monopoly and Supply Curve

What is a supply curve? A supply curve of a perfectly competitive market is its own marginal cost curve (MC) with a condition that the curve is situated above the minimum point of its average variable costs. In a monopoly, its marginal costs curve cannot be considered as the supply curve. This is because the supply curve of each good indicates the relationship between price level and the quantity of good supplied.
This means, for every price level, there will be one level of good. But for a monopoly, one level of output can have different prices. Figure 8.7 will validate this condition.

Figure 8.7: Monopoly and supply curve

Curves D₀ and MR₀ are the initial demand curve and marginal revenue curve respectively, and the MC curve is the marginal costs curve for the monopoly. Since the rule of maximising monopoly profit is at the point where marginal revenue is equivalent to marginal cost, Q₀ is the output that maximises monopoly profit with the imposed price of P₀.
When we assume that demand decreases and the D₀ curve shifts to D₁, hence curve MR₁ is produced. With the assumption that the production costs remain unchanged, the MC curve is also unchanged. Since Q₀ is the level of output identified as the output that maximises profit, the monopolist must produce at that particular level of output.
Since the demand curve has declined from the initial demand curve, the new price formed at that particular output is P₁ which is much lower than the initial price of P₀. Here we are able to see clearly how a monopoly can impose two different prices at one level of output (Q₀).
Therefore, the marginal costs curve of a monopoly cannot be considered as its supply curve because it can give two different levels of price at the same level of output.

8.4 SHORT-RUN EQUILIBRIUM OF MONOPOLY

Short-run equilibrium of a monopoly is achieved when the marginal revenue curve intersects with the short-run marginal costs curve.
The output and price at that point of intersection is the output and price that will maximise profit of the firm in the short-run. In other words, equilibrium is achieved in the short-run when marginal costs is equivalent to marginal revenue (MC = MR).
Figure 8.8 illustrates the condition of short-run equilibrium of a monopoly with Q* and P* as the level of output and price that maximises profit respectively. The area P*bca is the total profit gained by the monopoly, that is, the difference between price and average costs in the short-run.

Figure 8.8: Short-run equilibrium of a monopoly

Like any other firms, a monopolist can also face a loss in the short-run. The monopolist will experience loss in the short-run if the short-run average costs curve (SAC) is situated above its demand curve (which is also its average revenue curve).
Figure 8.9 below illustrates the condition where a monopoly faces loss in the short-run. Based on the diagram, we are able to see clearly that price per unit of output is lower than the production cost per unit of output. Q* is the output level that maximises profit of this monopoly.

Figure 8.9: Loss in the short-run

The total revenue for Q* unit of output is P*cQ*0, while the cost of producing Q* unit of output is abQ*0. Here, we can compare how the total revenue is lower than the total production.
This condition brings about loss to the monopolist. If this condition prolongs into the long-run, the monopolist has to shut down its operations. The area abcP* represents the loss faced by the monopolist.

8.4.1 Price and Output that Maximises Profit: A Special Case

If we want to determine the output and price that maximises monopoly profit in special cases, the rule or condition needed is similar to the other normal cases. Special case here refers to the horizontal shape of the marginal costs curve. The marginal costs curve bears that shape due to the constant value of marginal cost throughout the production process. This can be seen in Figure 8.10.

Figure 8.10: Monopoly with a constant marginal costs curve

An example of special case as in Figure 8.10 is:
Given the respective demand function and cost function of a monopoly as below:

P	=	200 – 10Q
TC	=	320 + 20Q

This condition will produce a marginal cost function of MC = 20.
From the figure above, we find that even though the marginal cost function of monopoly differs from the normal, U-shapedmarginal cost function of monopoly, it still gives the same condition in determining the output and price that maximises profit. The output of four units and price of RM160 is the output and price that will maximise the profit of that particular firm.

8.5 THE MONOPOLY FIRM SHUT DOWN IN THE SHORT-RUN

SELF-CHECK 8.6

When does a monopoly firm have to close/shut down its operations?

The situation of shut down of a monopoly is similar to the perfectly competitive market, that is, the firm will shut down its operations when the equilibrium price is much lower than the average variable costs. The price is also considered as the average revenue of monopoly.
If the average revenue of output cannot accommodate the average production cost of the output then it is best that the monopoly firm shuts down its operations. This is because at a price less than the average variable cost, not only is the fixed cost is unbearable but also the variable costs.
Therefore, it is best that the firm closes down its production operations in such condition. When operations close down, the firm is able to minimise its loss by only bearing its fixed costs.
Figure 8.11 illustrates how a monopoly is forced to shut down its operations in the short-run. Based on the rule of profit maximisation, Q* and P* are the output and price that maximises the monopoly profit respectively.

Figure 8.11: Monopoly firm shut down in the short-run

However, from this diagram we find that when Q* is produced, the firm faces loss because the price is much lower than its average variable cost. The average variable cost in the production of Q* units of output is denoted by C*.
This will force the firm to close its operations since the firm can no longer bear its fixed costs and also its variable costs.

8.6 LONG-RUN EQUILIBRIUM OF MONOPOLY

Long-run is a particular time period in which the firm is able to change all its inputs, or in other words, all inputs are variable inputs.

In the short-run, output equilibrium is achieved when the marginal costs curve crosses the marginal revenue curve, but in the long-run, the output that maximises profit is when the long-run marginal costs curve (LMC) intersects with the marginal revenue curve of that monopoly.

Figure 8.12: Long-run equilibrium of a monopoly

Figure 8.12 illustrates how the long-run equilibrium of a monopoly is achieved. Observe that in the long-run, the monopolist is still able to gain supernormal profit. This condition occurs for firms that obtain monopoly power through the granting of license by the government.
Pressure towards profit does not occur. This causes the supernormal profit enjoyed to remain even in the long-run. From the diagram above, it is clearly shown that the continuous long-run average costs curve faces decline. This means that the monopolist obtains cost advantage compared to its competitors.
In the long-run as well, the monopoly firm can experience normal profit or decrease in profit. Competitors might create substitute inputs for the input controlled by the monopolist.
Competing firms supplying outputs that have similar use as the output supplied by the monopolist can also emerge in the long-run. This causes the profit gained by the monopolist to decline.

8.7 PRICE DISCRIMINATION

Up to the previous section, we have discussed  monopoly with the assumption that the monopoly supplies output at only one price to every buyer or consumer who purchases their goods. In this section, we will discuss on how monopolists have the ability to supply their output at different prices to each of its buyers. This condition is referred to as price discrimination.

Price discrimination means that monopolist imposes different prices on the same good to different consumers.

When price discrimination takes place, it means that the monopolist is able to transfer consumer surplus and transform them into their own profit instead.

8.7.1 Conditions for the Occurrence of Price Discrimination

There are a few matters which have been identified in ensuring the success of price discrimination. Among the conditions or rules for price discriminations are:

1. No Feasible Reallocation of Goods Price discrimination will not succeed if goods sold in market with a lower price can be easily reallocated to the market that imposes a higher price. In other words, there is no possibility of reselling for that particular good in a different market.
   
   If reallocation or reselling of goods ever occur, this will cause the price received by the firm to be unequal to the price fixed, and there might be a possibility for the price in both markets to be equal. When this condition takes place, price discrimination cannot be carried out.
2. Geographically Segmented Markets When two markets are segmented geographically, the possibility of reallocation of goods is low; if goods can be reallocated, this will result in change of the production costs. Production costs of firms imposing price discriminations are the same. Hence, when costs differ, price discrimination will not succeed.
3. Different Elasticity and Demand Characteristics in Both Markets A higher price will be imposed in the market with low elasticity of demand compared to the market with higher price elasticity (more elastic). When both markets have the same elasticity, monopoly will not be able to differentiate the price for both markets, hence price discrimination will not take place.

8.7.2 Sales in Segmented Markets

One of the rules or conditions that enables discrimination to be carried out is that the monopolist can segment their output market. Assuming that the firm is the one and only producer of that particular good, it can impose different prices for both of its markets.
Even when selling takes place in two different markets, the monopolist faces the same total costs curve. This results in the same marginal costs for both markets.
Figure 8.13 illustrates the demand curve and marginal revenue curve for a monopolist that sells their output in two different markets. Observe that the marginal revenue curve of two firms selling at different markets is the horizontal summation of the marginal revenue curves of each market.

Figure 8.13: Monopoly and sales in different markets

From Figure 8.13, it is found that the overall output that is able to maximise monopoly profit is 20 units, where 8 units are produced for Market 1 while the remaining 12 units are produced for Market 2.
We can conclude here, that even the marginal revenue for both markets are the same at the time of production and the price imposed at each market is different. This is because both markets have different demand curves.

8.7.3 Profit Maximisation: Equilibrium Price and Output of a Monopoly Conducting Price Discrimination

In this section, we will look at how a monopolist determines the price and output that are able to maximise profit in the discrimination condition. Even when conducting discrimination, the monopolist is still tied to the rule of profit maximisation as before, that is, the marginal cost is equivalent to marginal revenue.
A monopolist will determine the output needed to be produced, the allocation of output for each market, and the price at each market. In order to determine these matters, the monopolist will carry out these following actions:

1. The monopolist has to determine beforehand the output level that can maximise profit by equating the marginal cost with its marginal revenue in both markets; and
2. The output will then be distributed to each market segment and the total output allocated is different for each market. When outputs have been identified, the equivalent price for that particular output can be determined, that is, based on the demand curve of each market.

As stated before, for the market with a low elasticity of demand, a smaller number of outputs are distributed for that market compared to the output allocated for the market with a higher elasticity of demand. The opposite happens for price where a lower price is imposed on the market with a higher elasticity of demand.
Previously, Figure 8.13 illustrated how output is allocated for both markets. The marginal revenue curve of a monopoly selling at two different markets is the horizontal summation of the marginal revenue curves of each market. Output that maximises profit is determined when the marginal costs curve intersects the marginal revenue curve.
From the diagram, we also found that the equilibrium output is 20 units of which 8 units were distributed to Market 1 while the remaining 12 units to Market 2. Prices in the respective markets are different where price in Market 2 is higher compared to the price in Market 1.

8.7.4 Degrees of Price Discrimination

There are three degrees of price discrimination, namely the first, second, and third degree discrimination.

1. First Degree Price Discrimination
   First degree price discrimination is also referred to as perfect price discrimination. Perfect price discrimination means the monopolist imposes different prices for every unit of output sold.
   
   In this case, the monopolist knows perfectly about the willingness to pay of each buyer. Therefore, in first degree price discrimination, the monopolist is able to obtain the entire consumer surplus available in the market. In this first degree price discrimination, the demand curve of the monopoly is also its marginal revenue curve.
   
   Figure 8.14 illustrates how the monopolist imposes different prices for each unit of output sold. This results in an area covering aP4b to indicate the profit or producer surplus of the monopoly and there is no consumer surplus in this case.
   
   

   

   Figure 8.14: First degree price discrimination

   How does a monopolist determine the output that is able to maximise its profit? The condition that determines the output that maximises profit of a monopolist practising price discrimination is marginal revenue (MR) equals marginal cost (MC).
   

   

   Figure 8.15: Price discrimination and equilibrium

   Figure 8.15 illustrates how a monopolist determines the output that maximises their profit. From the diagram, Q* is the output that maximises profit for this monopolist. At this point, the marginal costs curve intersects the marginal revenue curve, which is also the demand curve of monopoly.
   For every unit of output from 0 to the Q* unit, the monopolist imposes different prices to the buyers. Prices imposed by the monopolist are between a and b for every unit of output 0 to Q*. All consumer surpluses go to the monopolist as profit.
   This first degree price discrimination seldom occurs because:
   
   1. The difficulty for the monopolist to know the true amount each potential customer is willing to pay for a particular good; and
   2. The possibility of reselling to occur is high.
2. Second Degree Price Discrimination The second degree price discrimination occurs more often compared to the first degree. In the case of second degree price discrimination, the price of good declines with the increase in the quantity of the good purchased. The monopoly determines different prices for every usage group of different units of output. Unlike perfect price discrimination, the second degree price discrimination only takes up a portion of consumer surpluses and not the whole of it.Figure 8.16 illustrates how a monopolist determines the price for consumers using their products. For every first Q1 units of output, the price imposed is P₁ per unit. Addition of output is subsequently imposed with the price of P₂ for every unit of that particular output.
   

   

   Figure 8.16: Second degree price discrimination

   It is the same for the following additional units of Q₂Q₃.  Price that has to be paid for each unit of output is P₃. Area 1, 2, and 3 which are the areas with consumer surplus, are converted into profit for the monopoly.
   Note: Second degree price discrimination is effective when the market for the particular good is very wide, with a large number of buyers, different preferences, different levels of income, and different conditions.
   For example:
   A firm that practices second degree price discrimination is Tenaga Nasional Berhad (TNB). For example, TNB will impose a high price for the first 300 kilowatts of output. For the following 300 units, it will impose a lower price, and so on.
3. Third Degree Price Discrimination Third degree price discrimination occurs when the monopoly differentiates price according to groups or classes of consumers, based on their level of income, or their willingness to pay. Each consumer group has their own demand curves.
   Consumer groups that often obtain low prices are student groups and senior citizens group. Transportation companies often practice this type of discrimination.
   How is the output determined in this third degree price discrimination? There are several steps implemented by the firms involved.
   Firstly, once the output that maximises profit has been identified, that output will be allocated to the relevant groups of consumer.
   Assuming there are two consumer groups and the marginal revenue for the first group exceeds the marginal revenue of the second group, it is better for the firm to reallocate output from the second market to the first market.
   Reallocation of output is carried out by lowering the price for the first group and increasing the price for the second group. Whichever price imposed on both markets, marginal revenue for both groups are the same.
   Secondly, we know that the total output that maximises profit is obtained when marginal revenue for each group of buyers is equivalent to the marginal cost of production. However, if this condition does not take place, the firm can increase profit by increasing output (decreasing the total output) and reducing (increasing) price for both markets.
   Example:
   When the marginal revenue for each group are equal but exceeds the marginal production cost, hence the firm can increase profit by increasing output.
   Price will be reduced for both groups of buyers resulting in a decrease in their marginal revenue (but marginal revenue are still the same for each consumer groups) until it is equivalent to the marginal cost. This condition can be proved using algebra, which is:
   
   
   where Q_T is the overall total market output. P₁Q₁ and P₂Q₂ are the prices and output for market one and market two respectively.
   The firm will increase sales in both groups until the profit increase for the final unit sold is equivalent to zero.
   
   
   As marginal costs for both groups of consumers are the same, hence it is found that the rule of maximising profit for a firm practicing third degree price discrimination is:
   
   

8.8 SOCIAL COSTS OF MONOPOLY

In economics, only the perfectly competitive market operates efficiently, that is, when it produces output at the point where price is equivalent to marginal costs (P = MC). Efficiency here refers to the valuation of buyers towards the final unit of output is equivalent to the market value of the production resources used in producing the particular output.
Efficiency also means there is no possibility for the occurrence of increase in profit or interests due to substitution in the market. Monopoly is said to be inefficient because output production is carried out when price exceeds marginal cost (P > MC).

Figure 8.17: Monopoly and social costs

Figure 8.17 illustrates how inefficiency in monopoly causes a loss in social welfare. LMC and LAC are the long-run average costs curve and long-run marginal costs curve of a monopoly respectively. A monopoly that does not implement price discrimination will impose a price of P_m and produce Q_m units of output.
 
A perfectly competitive market operating under similar cost conditions will produce at Q_c unit of output and impose a price of P_c. When compared to the perfectly competitive market, the monopoly will cause a loss in consumer surpluses.
The area aP_cb is the area of consumer surplus of a perfectly competitive market. However, in a monopoly, consumer surplus has diminished to only aP_mc (area 1). Meanwhile, the area of P_mP_cdc is consumer surplus that has become the producer surplus (profit) for the monopoly (area 2).
Area cdb (area 3) is the area of consumer surplus, that is lost from the perfectly competitive market but also not gained by the monopoly and it is referred to as the social costs of society and also known as the deadweight loss from the monopoly.

8.8.1 Natural Monopoly

Natural monopoly is the monopoly that enjoys a large economic scale in production. Generally, a firm can choose between large scale and small scale production.
Natural monopoly is the monopoly that produces public goods such as electricity and water supply, which needs a very large economic scale in its production.
Figure 8.18 illustrates that a large scale plant (scale two) can produce 250,000 units of output at an average cost of RM1.00. If the industry is restructured into five firms, each firm will produce in small scale (scale 1); the industry can still produce the same amount (50,000 for each firm) but with a higher cost per unit (RM5.00).

Figure 8.18: Natural monopoly

8.8.2 Control and Natural Monopoly

Figure 8.19: Control and natural monopoly

Figure 8.19 illustrates the structure of a natural monopoly. Assume that the firm faces a declining average cost curve (AC) when more output is produced. Meanwhile, the marginal cost (MC) faced is also very low and constant.
From the diagram above, P_m and Q_m are the price and quantity produced by a monopoly which is not controlled by the government. This results in a high price being imposed and the production of too little output which does not fulfil the overall market demand.  
Profit gained by the firm covers the area of P_mP_sba. This condition causes a loss to consumers because the price is much higher than the production cost. The government can control the firm so as to increase production so that it can accommodate more demand in the market while imposing the price when P = MC.
When this condition occurs, the output produced is at Q_c units and the price imposed is P_c. But at that price, the firm will face a loss since the price is much lower than the average costs (AC), and if this condition prolongs into the long-run, the firm has to shut down its operation.
Through price control, there are two matters that can be imposed by the government, namely:

1. Setting a Ceiling Price Ceiling price is the maximum price that can be imposed by a particular firm for their products. However, by imposing a ceiling price, the government has to give subsidies to the firm.
2. Imposing a Price at P = AC When this condition takes place, the firm will not face any loss even in the long-run. Profit gained will reduce to an extent the firm will only gain normal profit. While for consumers, with this kind of control, more of their demand can be fulfilled and at the same time, the price is much lower compared to when firms are not controlled by the government.

ACTIVITY 8.4

Explain the terms:

1. Social Costs of Monopoly; and
2. Natural Monopoly

SUMMARY

Up to this point, you have learnt about the concept of a monopoly market. In short, monopoly market can be elaborated as in the following mind map:

• Monopoly is a type of market that consists of only one firm producing output for the entire society. A few factors have been identified as the source of monopoly power such as control towards input, economies of scale, patents, and licenses granted by the government.
• Unlike the perfectly competitive market, a monopoly faces a demand curve that is sloping downwards from left to right.
• This allows a monopoly to be only able to control either its price or output, but not both simultaneously. If the monopoly wishes to increase the sales of its output, it has no choice but to reduce the price.
• If a monopoly is able to sell in two different markets, it will keep producing output until the marginal revenue of both markets are equal.
• Monopoly is considered as an inefficient market structure because it causes a loss of consumer welfare.
• This can be proven when we compare the perfectly competitive market to a monopoly. Only the perfectly competitive market is considered efficient in production because it produces output at the point where price is equivalent to marginal costs.
• This means that for every additional unit of output produced by the monopoly will give more value compared to the production cost of that output. This inefficiency results in the monopoly being controlled by the goverment through several suitable methods.