Chapter 10
Monopoly
© 2004 Thomson Learning/South-Western
Monopoly

A market is described as a monopoly if there is
only one producer.
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–
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2
This single firm faces the entire market demand
curve.
The monopoly must make the decision of how much
to produce.
The monopoly’s output decision will completely
determine the good’s price.
Causes of Monopoly


Barriers to entry which are factors that
prevent new firms from entering a market are
the source of all monopoly power.
There are two general types of barriers to entry
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3
Technical barriers
Legal barriers
Technical Barriers to Entry

A primary technical barrier is when the firm is a
natural monopoly because it exhibits
diminishing average cost over a broad range of
output levels.
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4
Hence, a large-scale firm is more efficient than a
small scale firm.
A large firm could drive out competitors by
price cutting.
Technical Barriers to Entry

Other technical barriers to entry.
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5
Special knowledge of a low-cost method of
production.
Ownership of a unique resource.
Possession of unique managerial talents.
Legal Barriers to Entry

Pure monopolies can be created by law.
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The basic technology for a product can be assigned
to only one firm through a patent.

–
The government can award an exclusive franchise
or license to serve a market.
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6
The rational is that it makes innovation profitable and
encourages technical advancement.
This may make it possible to ensure quality standards
APPLICATION 10.1: Should You Need a
License to Shampoo a Dog?


State governments license many occupations
and impose penalties for those who run a
business without a license.
Specific examples include:
–
Dry Cleaning in California
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7
Perspective dry-cleaners must take a licensing exam
which may require attending a school.
Profits are higher than in other states.
Existing firms are staunch defenders of the law.
APPLICATION 10.1: Should You Need a
License to Shampoo a Dog?
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Liquor Stores


Currently 16 states operate liquor-store monopolies.
In 34 other states, liquor stores are licensed and subject to
restrictions on pricing and advertising.
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States with licenses have higher prices.
– Existing owners are most stringent supporters.
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Taxicabs
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8
Many cities limit number of taxicabs.
In Toronto, prices are about 225 percent higher.
New York city taxi medallions cost about $250,000.
Profit Maximization


To maximize profits, a monopoly will chose the
output at which marginal revenue equals
marginal costs.
The demand curve is downward-sloping so
marginal revenue is less than price.
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9
To sell more, the firm must lower its price on all units
to be sold in order to generate the extra demand.
A Graphic Treatment


A monopoly will produce an output level in
which price exceeds marginal cost.
Q* is the profit maximizing output level in
Figure 10.1.
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10
If a firm produced less than Q*, the loss in revenue
(MR) will exceed the reduction in costs (MC) so
profits would decline.
FIGURE 10.1: Profit Maximization and Price
Determination in a Monopoly Market
MC
Price
AC
E
P*
A
C
D
MR
0
11
Q*
Quantity
per week
A Graphical Treatment
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–
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12
The increase in costs (MC)would exceed the gain in
revenue (MR) if output exceeds Q*.
Hence, profits are maximized when MR = MC.
Given output level Q*, the firm chooses P* on
the demand curve because that is what
consumers are willing to pay for Q*.
The market equilibrium is P*, Q*.
Monopoly Supply Curve


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13
With a fixed market demand curve, the supply
“curve” for a monopoly is the one point where
MR = MC (point E in Figure 10.1.)
If the demand curve shifts, the marginal
revenue curve will also shift and a new profit
maximizing output will be chosen.
Unlike perfect competition, these output, price
points do not represent a supply curve.
Monopoly Profits


Monopoly profits are shown as the area of the
rectangle P*EAC in Figure 10.1.
Profits equal (P - AC)Q*,
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–
14
If price exceeds average cost at Q* > 0, profits will
be positive.
Since entry is prohibited, these profits can exits in
the long run.
Monopoly Rents

Monopoly rents are the profits a monopolist
earns in the long run.
–
These profits are a return to the factor that forms the
basis of the monopoly.
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15
Patent, favorable location, license, etc..
Others might be willing to pay up to the amount
of this rent to operate the monopoly to obtain
its profits.
What’s Wrong with Monopoly?

Profitability
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16
Monopoly power is the ability to raise price above
marginal cost.
Profits are the difference between price and
average cost.
In Figure 10.2, one firm earns positive
economic profits (a) while the other (b) earns
zero economic profits.
FIGURE 10.2: Monopoly Profits Depend on the Relationship
between the Demand and Average Cost Curves
Price
Price
MC AC
MC
AC
P*
P*=AC
AC
D
D
MR
0
Q*
Quantity
per week
(a) Monopoly with Large Profits
17
MR
0
Q*
Quantity
per week
(b) Zero-Profit Monopoly
What’s Wrong with Monopoly?
–

People may also be concerned that economic
profits go to the wealthy.
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18
If monopoly rents accrue to inputs, the monopoly
may appear to not earn a profit.
However, as with the Navajo blanket monopoly, the
profits of the low-income Navajo are coming from
the more wealthy tourists.
APPLICATION 10.2: Who Makes Money
at Casinos?
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
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19
U.S. casinos take in about $50 billion each year in
gross revenues.
In some markets, casinos operate quite
competitively…there are so many casinos in Las
Vegas that it is unlikely that any one of them has
much power to set prices monopolistically.
However, many other locales have adopted such
restrictions on the numbers and sizes of casinos that
owners of these casinos are able to capture
substantial monopoly profits.
Riverboat Gambling
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
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20
A number of states on the Mississippi River
permit casino gambling only in riverboats.
One clear impact of the way that riverboat
gambling is regulated is to provide monopoly
rents to a number of different parties.
States are the primary beneficiaries – they
usually tax net profits from riverboats at more
than 30 percent.
The owners of riverboats also make monopoly
profits.
Indian Gaming

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21
The Indian Gaming Regulatory Act of 1988 clarified
the relationship between state and the Indian tribes
living within their borders.
The Act made it possible for these tribes to offer
casino gambling under certain circumstances.
Since the passage of the Act, more than 120 tribes
have adopted some form of legalized gambling.
The distributional consequences of Indian gaming are
generally beneficial.
What’s Wrong with Monopoly

Distortion of Resource Allocation
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Monopolists restrict their production to maximize
profits.
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22
Since price exceeds marginal cost, consumers are willing
to pay more for extra output than it costs to produce it.
From societies point of view, output is too low as
some mutually beneficial transactions are missed.
Distortion of Resource Allocation

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23
In Figure 10.3 the monopolist is assumed to
produce under conditions of constant marginal
cost.
Further, it is assumed that if the good where
produced by a perfectly competitive industry,
the long-run cost curve would be the same as
the monopolist’s.
Distortion of Resource Allocation
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24
In this situation, a perfectly competitive industry
would produce Q* where demand equals longrun supply.
A monopolist produces at Q** where marginal
revenue equals marginal cost.
The restriction in output (Q* - Q**) is a
measure of the harm done by a monopoly.
FIGURE 10.3: Allocational and
Distributional Effects of Monopoly
Price D
MR
B
P**
MC ( =AC)
A
25
0
Q**
Quantity per week
Monopolistic Distortions and
Transfers of Welfare

The competitive output level (Q* in Figure 10.3)
is produced at price P*.
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–
26
The total value to consumers is the area DEQ*0
Consumers’ pay P*EQ*0.
Consumer surplus is DEP*.
FIGURE 10.3: Allocational and
Distributional Effects of Monopoly
Price
D
MR
B
P**
P*
27
E
A
MC ( =AC)
0
Q**
Q*
Quantity per week
Allocational Effects

A monopolist would product Q** at price P**.
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28
Total value to the consumer is reduced by the area
BEQ*Q**.
However, the area AEQ*Q** is money freed for
consumers to spend elsewhere.
The loss of consumer surplus is BEA which is often
called the deadweight loss from monopoly.
FIGURE 10.3: Allocational and
Distributional Effects of Monopoly
Price D
MR
B
P**
P*
29
E
A
MC ( =AC)
Value of
transferred
inputs
0
Q**
Q*
Quantity per week
Distributional Effects

In Figure 10.3 monopoly profits equal the
area P**BAP*.
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30
This would be consumer surplus under perfect
competition.
It does not necessarily represent a loss of social
welfare.
This is the redistributional effects of monopoly
that may or may not be desirable.
FIGURE 10.3: Allocational and
Distributional Effects of Monopoly
Price D
P**
P*
31
MR
B
Transfer
from
consumers
to firm
E
A
MC ( =AC)
Value of
transferred
inputs
0
Q**
Q*
Quantity per week
FIGURE 10.3: Allocational and
Distributional Effects of Monopoly
Price D
MR
B
P**
Transfer
from
consumers
to firm
P*
32
Deadweight
loss
A
E
MC ( =AC)
Value of
transferred
inputs
0
Q**
Q*
Quantity per week
Monopolists’ Costs

Monopolists costs may be higher due to:
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33
Resources spent to achieve monopoly profits such
as ways to erect barriers to entry.
Monopolists may expend resources for lobbying or
legal fees to seek special favors from the
government such as restrictions on entry through
licensing or favorable treatment from regulatory
agencies.
Monopolists’ Costs


The possibility that costs may be higher for
monopolists complicates the comparison of
monopoly with perfect competition.
Studies that have attempted to measure
welfare losses from monopoly find estimates
are sensitive to assumptions.
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34
Estimates range from as little as 0.5 percent of GDP
to as much as 5 percent of GDP.
APPLICATION 10.3: Pricing Problems
in Dallas
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35
“People in the same trade seldom meet
together even for merriment and diversion but
the conversation ends … in some contrivance
to raise prices” (Adam Smith)
The CEO of American Airlines was taped in a
conversation where he suggested that if Braniff
Airway would raise prices, American Airlines
would follow.
APPLICATION 10.3: Pricing Problems
in Dallas

Later, American Airlines was accused of
predatory pricing.
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36
It was accused of lowering prices to drive small
carriers out of the market and then raise prices after
the small firms leave.
Unless prices are below average variable cost
(a “shutdown standard”), this pricing behavior
is not necessarily illegal.
A Numerical Illustration of
Deadweight Loss


Table 10.1 repeats the information about the
cassette tape market used as an illustration in
previous chapters.
If tapes have a $3 marginal cost, this would be
the price under perfect competition.
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37
As shown in the Table, this would result in consumer
surplus equal to $21.
TABLE 10.1: Effects of Monopolization on the
Market for Cassette Tapes
Demand Conditions
Quantity
(Tapes
per
Total
Marginal
Price Week)
Revenue Revenue
$9
1
$9
$9
8
2
16
7
7
3
21
5
6
4
24
3
5
5
25
1
4
6
24
-1
3
7
21
-3
2
8
16
-5
1
9
9
-7
0
10
0
-9
38
Competitive Equilibrium: (P = MC)
Consumer Surplus
Average
and
Marginal
Cost
$3
3
3
3
3
3
3
3
3
3
Totals
Under
Perfect
Competition
$6
5
4
3
2
1
0
---$21
Under
Monopoly
$3
2
1
0
------$6
Monopoly equilibrium: (MR = MC)
Monopoly
Profits
$3
3
3
3
------$12
A Numerical Illustration of
Deadweight Loss

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39
If the industry were a monopoly the firm would
produce where marginal revenue equals
marginal cost, an output of 4 units.
As shown in the Table, this would result in $12
of monopoly profits and $6 of consumer
surplus which totals $18.
The deadweight loss is the difference between
the $21 and the $18 or $3.
Price Discrimination


Price discrimination occurs if identical units
of output are sold at different prices.
If the monopolist could sell its product at
different prices to different customers, new
opportunities exits as shown in Figure 10.4.
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40
Some consumer surplus still exists (area DBP**).
The possibility of mutually beneficial trades exist as
represented by the area BEA.
FIGURE 10.4: Targets for Price
Discrimination
Price D
MR
B
P**
E
P*
41
MC ( =AC)
A
0
Q**
Q*
Quantity
per week
Perfect Price Discrimination

Perfect price discrimination is selling each
unit of output for the highest price obtainable.
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42
The firm would sell the first unit at slightly below 0D
(Figure 10.4), the next for slightly less, and so on
until the firm reaches Q*, where a lower price would
result in less profit.
All consumer surplus (area P*DE) would be
monopoly profit.
Perfect Price Discrimination

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43
Since the monopolist would produce and sell
Q* units of output, which is the competitive
equilibrium.
This pricing scheme requires a way to
determine what each consumer would be
willing to pay, and
The monopolist must be able to stop
consumers from selling to each other.
APPLICATION 10.4: Financial Aid at
Private Colleges

Prior to the 1990s the U.S. government
proposed a formula to determine a student’s
need, and schools would offer such aid.
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44
Because the formula differed among colleges, the
net price (family contribution) differed.
The Overlap Group (23 prestigious colleges)
negotiated the differences so that each college
offered the same net price.
APPLICATION 10.3: Financial Aid at
Private Colleges

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45
The U.S. Justice Department challenged this
pricing scheme as price fixing.
Although the schools signed a consent decree,
they were exempted from the antitrust laws by
the Higher Education Act of 1992.
APPLICATION 10.3: Financial Aid at
Private Colleges

Several innovative pricing schemes were put
forth by schools in the 1990s.
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46
Several schools adopted sophisticated statistical
models used to offer the lowest price necessary to
get a particular student to accept an offer of
admission.
Schools using this approach come very close
to perfect price discrimination.
Quantity Discounts

Quantity discounts allow some sales at the
monopolist’s price (P** in Figure 10.4), and
sales beyond Q** at a lower price which
increases profits.
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47
Examples include a second pizza for a lower price
and supermarket coupons.
The monopolist must keep customers who
buy at lower prices to sell to customers at a
price less than P**.
Two-Part Tariffs


In this pricing scheme, customers must pay
an entry fee for the right to purchase a good.
A classic example is the pricing of movie
popcorn.
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48
The entry fee, which should be set to obtain as
much of the consumer surplus as possible, is the
price of movie itself.
Popcorn is then priced to maximize admission so
long as the price exceeds cost.
APPLICATION 10.4: Pricing at the
Magic Kingdom


49
During the 1960s Disneyland patrons had to
purchase a “passport” containing a ticket for
admission to the rides (see Table 1 for the
structure of a typical passport).
Because of higher labor costs, Disney switched
to an entry fee with zero marginal prices for all
rides.
TABLE 1: Structure of a Typical
Disneyland Passport
Item
Admission
“A” ride
“B” ride
“C” ride
“D” ride
“E” ride
50
Example
-Shooting Gallery
Dumbo, train
Peter Pan’s Flight
Autopia
Space Mountain
Number of
Tickets
in Passport
1
2
3
3
2
5
Price of
Extra
Ticket
$4.00
.25
.50
.75
1.00
1.50
APPLICATION 10.4: Pricing at the
Magic Kingdom
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
51
Disney could also use other price
discrimination practices such as reduced prices
for multiday tickets.
With ever-growing attractions and newer ticket
technology (especially optical scanners) has
allowed Disney to again price discriminate in a
manner similar to their practices in the 1960s.
Market Separation


If the market can be separated into two or
more categories may be able to chare different
prices.
Figure 10.5 shows the separation into two
markets.
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52
The profit-maximizing decision is to sell Q1* in the
first market and Q2* in the second market where, in
both cases, MR = MC.
FIGURE 10.5: Separated Markets Raise the
Possibility of Price Discrimination
Price
P1
P2
D2
MC
D1
MR1
Quantity in market 1 Q*
1
53
MR
0
Q*
2
2
Quantity in market 2
Market Separation

The two market prices will be P1and P2
respectively.
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54
As shown in Figure 10.5, the price-discriminating
monopolist will charge a higher price in the market
with the more inelastic demand.
Examples include book publishers charging higher
prices in the U.S. or charging different prices for a
movie in the day than at night.
Pricing for Multiproduct
Monopolies

If a firm has pricing power in markets for
several related products, other strategies can
be used.
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
55
Firms can require users of one product to also buy a
related product such as coffee filters bought with
coffee machines.
Firms can also create pricing bundles such as
option packages on cars or computers.
APPLICATION 10.6: Bundling of Satellite
TV Offerings

Theory of Program Bundling
–
Four consumer’s willingness to pay for either sports
or movie programming is shown in Figure 1.

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56
Two, A and D, are willing to pay $20 per month for sports
(A) or movies (D).
B want sports but some movies and C wants movies with
some sports.
FIGURE 1: Willingness to Pay for
Cable TV Options
Movies
20 D
C
15
B
A
8
57
15
20
Sports
APPLICATION 10.6: Bundling of Satellite
TV Offerings
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–
–
58
Charging $15 per each package would yield $60
from these customers.
A bundling scheme that charges $20 per package, if
purchased individually, or $23 if both are bought,
would yield $86.
Thus, revenue can be increased by the proper
choice of pricing bundles of services.
APPLICATION 10.6: Bundling of Satellite
TV Offerings

Bundling by Direct TV, Inc.
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59
Bundling prices are shown in Table 1, where the
incremental costs help to demonstrate the bundling
price scheme.
Notice adding sports costs $10 extra, but the full
movie package adds $43 ($15 for Showtime and
$28 for HBO/STARZ).
Both packages together ($51) offers a minor
savings over buying the separate packages.
TABLE 1: Sample Direct TV Program
Options
Package
Total Choice Plus
TCP + 1 option
TCP + 3 options
TCP + 5 options
Total Choice Premium
60
Cost
Incremental
$/Month
Cost
35.99
47.99
66.99
81.99
81.99
-12.00
31.00
46.00
46.00
Marginal Cost Pricing Regulation and
the Natural Monopoly Dilemma


By marginal cost pricing the deadweight loss
from monopolies is minimized.
However, this would require a natural
monopoly to operate at a loss.
–
61
A unregulated monopoly would produce QA at price
PA in Figure 10.6, yielding a profit of PAABC.
FIGURE 10.6: Price Regulation for a
Natural Monopoly
Price
P
A
A
B
C
AC
MC
MR
62
0
QA
D
QR
Quantity
per week
Marginal Cost Pricing Regulation and
the Natural Monopoly Dilemma
–

63
Marginal cost pricing of PR which results in QR
demanded would generate an a loss equal to the
area GFEPR because PR < AC.
Either marginal cost pricing must be
abandoned or the government must subsidize
the monopoly.
FIGURE 10.6: Price Regulation for a
Natural Monopoly
Price
P
A
A
B
C
P
64
F
H
G
E
R
J
0
QA
MR
AC
MC
D
QR
Quantity
per week
Two-Tier Pricing Systems



65
Under this system the monopoly is permitted to
charge some users a high price and charge
“marginal” users a low price.
The regulatory commission might allow the
monopoly to charge PA and sell QA to one class
of buyers.
Other users would pay PR and would demand
QR - QA.
Two-Tier Pricing Systems



66
At total output of QR average costs are 0G.
Under this system, monopoly profits (area
PAAHG) balance the losses (area HFEJ).
Here the “marginal user” pays marginal cost
and is subsidized by the “intramarginal” user.
APPLICATION 10.7: Can Anyone
Understand Telephone Pricing?


67
In January 1, 1984 AT& T formally divested
itself of its seven local Bell Operating
Companies as the result of a 1974 Department
of Justice antitrust suit.
The goal of the restructuring was to improve
the performance and competitiveness of the
U.S. telephone industry.
APPLICATION 10.7: Can Anyone
Understand Telephone Pricing?

Subsidization of Local Phone Service
–
–
–
68
Prior to the breakup, regulators forced AT&T to
subsidize local residential phone services.
They covered these losses by charging aboveaverage costs on long distance calls.
Residential services cost an average of $28 per
month but the typical charge was $11.
APPLICATION 10.7: Can Anyone
Understand Telephone Pricing?

After the breakup regulators had to choose
between implementing huge increases in
residential telephone rates or continuing
subsidies.
–
69
The politically expedient choice was to force AT&T
and other to continue to subsidize local residential
rates.
APPLICATION 10.7: Can Anyone
Understand Telephone Pricing?

The Telecommunications Act of 1996
–
–
–
70
The government used this act to increase entry into
the local phone market to try to reduce the
monopoly power of local providers.
This was attempted by specifying specific conditions
under which these local companies could offer long
distance service.
To obtain this right, local companies had to sell
services to potential entrants into their market.
Rate of Return Regulation


71
Regulators may permit a monopoly to charge a
price above average cost that will earn a “fair”
rate of return on investment.
If the allowed rate exceeds that an owner might
earn under competitive circumstances, the firm
has an incentive to use relatively more capital
input than needed to minimize costs.