. How does Monopoly creates the highest Market Power among the other market structures
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A monopoly exists when a single provider serves the entire market demand. Even though there are several concepts of natural monopoly, they possess a common thread, namely, that rivalry in a particular market cannot be sustained and perhaps is even inefficient.
One idea of natural monopoly is that in some situations competition self-destructs, resulting in a single firm supplying the entire market demand. This idea led to the cost-based definition of natural monopoly, which states that a firm is a natural monopoly if it is able to serve the entire market demand at a lower cost than any combination of two or more smaller, more specialized firms. If the monopoly firm serves a single market, then economies of scale are sufficient for the firm to be a natural monopoly, although other cost characteristics may also result in a single-product firm being considered a natural monopoly. Economies of scale imply that the firm’s average cost declines as the firm increases output. If the firm is a monopoly in several markets, more complex cost concepts, such as economies of scope and cost subadditivity come into play. Economies of scope exist when it is less costly for a single firm to provide two or more products jointly than for multiple firms to provide the products separately. Cost subadditivity exists when a single firm is able to satisfy the entire market demand(s) for its product(s) at a lower cost than two or more smaller, more specialized firms.2 The most recent definition of natural monopoly states that a firm is a natural monopoly in a market if no more than one firm can serve the market and receive non-negative profits.
Operators providing utility services have certain cost characteristics that sometimes make some portion of their service a natural monopoly or at least make competition difficult to sustain at any appreciable level.3 For example, operators tend to have high capital costs relative to firms in other sectors. Sometimes capital costs constitute a sunk cost, which means the cost is unrecoverable if the operator decides to exit the market. Sunk costs are a barrier to entry, which means that they make it less likely for firms to enter the market. Some portion of the utility operations may also have high fixed costs, which are costs that do not vary with the output of the firm. High fixed costs can lead to economies of scale, which may lead to natural monopoly.
If an operator in a market is a natural monopoly – in the sense that a single firm can serve the entire market demand at a lower cost than two or more smaller firms – then the operator cannot recover all of its costs if its prices are set at incremental cost. Left unregulated and without a threat of government intervention, a profit maximizing monopoly operator would limit output to receive monopoly profits, which results in what economists call a deadweight loss. If the natural monopoly operator were regulated, the regulator would need to allow prices to exceed incremental cost for the operator to be commercially viable.
If a firm has economies of scale, economies of scope, or both, it may be difficult to develop prices that encourage allocative efficiency. Allocative efficiency means that the optimal mix of outputs is provided. This form of economic efficiency is said to exist when the price that customers pay for each product is equal to that product’s marginal cost. Marginal cost is the cost of increasing output by one unit. Setting prices equal to marginal cost is difficult when there are economies of scale because such prices would not result in sufficient revenue to cover the firm’s total cost.
Likewise, with economies of scope, if prices for each product cover only the incremental cost of producing that product, the firm would not receive sufficient revenue to cover its common costs. Incremental cost in this context is the additional cost of producing the entire amount of a product, given that the firm is already producing all of his other products. Common costs in this context are the costs that are necessary for the firm to produce its n products, but that are unaffected by the dropping up to n – 1 of its products.4 Tariff Design examines possible solutions to this pricing problem.
Even if the operator is not a monopoly, it may not be subject to significant competitive pressure. In this situation, the firm is said to have market power or significant market power because the firm is able to receive profits above its cost of capital by limiting output.