What Monopolists Do

Why did Rhodes want to consolidate South African diamond producers into a single company? What difference did it make to the world diamond market?

Figure 13-2 offers a preliminary view of the effects of monopoly. It shows an industry in which the supply curve under perfect competition intersects the demand curve at C, leading to the price PC and the output QC.

What a Monopolist Does Under perfect competition, the price and quantity are determined by supply and demand. Here, the competitive equilibrium is at C, where the price is PC and the quantity is QC. A monopolist reduces the quantity supplied to QM and moves up the demand curve from C to M, raising the price to PM.

Suppose that this industry is consolidated into a monopoly. The monopolist moves up the demand curve by reducing quantity supplied to a point like M, at which the quantity produced, QM, is lower, and the price, PM, is higher than under perfect competition.

Market power is the ability of a firm to raise prices.

The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power. And market power is what monopoly is all about. A wheat farmer who is one of 100,000 wheat farmers has no market power: he or she must sell wheat at the going market price. Your local water utility company, though, does have market power: it can raise prices and still keep many (though not all) of its customers, because they have nowhere else to go. In short, it’s a monopolist.

The reason a monopolist reduces output and raises price compared to the perfectly competitive industry levels is to increase profit. Cecil Rhodes consolidated the diamond producers into De Beers because he realized that the whole would be worth more than the sum of its parts—the monopoly would generate more profit than the sum of the profits of the individual competitive firms. As we saw in Chapter 12, under perfect competition economic profits normally vanish in the long run as competitors enter the market. Under monopoly the profits don’t go away—a monopolist is able to continue earning economic profits in the long run.

In fact, monopolists are not the only types of firms that possess market power. In the next chapter we will study oligopolists, firms that can have market power as well. Under certain conditions, oligopolists can earn positive economic profits in the long run by restricting output like monopolists do.

But why don’t profits get competed away? What allows monopolists to be monopolists?