CHAPTER
6
Monopoly
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Monopoly
A
monopoly is a market served
by a single firm.
A
monopoly occurs when
there is only one firm and a
barrier preventing other
firms from entering the
market.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
2
Barriers to Entry
Possible barriers to entry include:

A patent, granted by the government,
gives an inventor the exclusive right to
sell a new product for some period of time

A franchise, or licensing scheme, in
which the government designates a single
firm to sell a particular product

A natural monopoly, in which large
economies of scale in production allow only
one firm to be profitable
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
3
The Monopolist’s Output Decision

Like other firms, the monopoly’s
objective is to produce the output
level that will maximize profit.

The firm faces the same laws of
production and cost in the short
run, associated with diminishing
returns.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
4
The Monopolist’s Demand Curve

Since the monopoly
is the only firm in the
market, it faces the
entire market
demand for its
product.

A downwardsloping demand
curve is associated
with particular
revenue
characteristics for
the monopoly firm.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
5
TR and MR for the Monopolist


In order to increase
the quantity sold,
the monopolist must
decrease price for all
units sold.
When the monopolist
decreases price in
order to increase
quantity sold, there is
good news and bad
news regarding
additional revenue.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
6
Demand, TR and MR for the Monopolist



Marginal revenue is
defined as the
change in TR that
results from selling
one more unit of
output
The good news is
that the firm sells
more output, so it
collects more
revenue from new
customers.
The bad news is that the firm loses revenue from
selling at a lower price to all customers combined.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
7
Demand and MR for the Monopolist

The combined good
and bad news
yields the value of
marginal revenue
for the monopolist.

When the bad news
outweighs the good
news, marginal
revenue becomes
negative.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
8
TR and MR for the Monopolist
Information from the
demand curve (price and
quantity sold) can be used to
derive the total and marginal
revenue curves.
Total Revenue
32
C o s t in $

24
16
8
0
Total
Marginal
Revenue Revenue
($)
($)
Price
($)
Quantity
Sold
P
Q
TR
0
1
2
3
4
5
6
(PxQ)
0
14
24
30
32
30
24
16
14
12
10
8
6
4
© 2005 Prentice Hall Business Publishing
MR
 TR
Q
14
10
6
2
-2
-6
Survey of Economics, 2/e
P ric e a n d m a rg in a l re v e n u e
0
1
2
3
4
Quantity sold
5
6
Demand and Marginal Revenue
14
12
10
8
6
4
2
0
-2
-4
-6
0
1
2
3
4
5
6
Quantity sold
Demand
O’Sullivan & Sheffrin
Marginal Revenue
9
The Marginal Principle and the Output Decision

To decide how much output to produce
and what price to charge, the monopolist
can use the marginal principle.
Marginal PRINCIPLE
Increase the level of an activity if its
marginal benefit exceeds its marginal cost,
but reduce the level if the marginal cost
exceeds the marginal benefit. If possible,
pick the level at which the marginal benefit
equals the marginal cost.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
10
The Marginal Rule for Profit Maximization
A firm maximizes profit by
following the marginal
principle—by setting
marginal revenue equal to
marginal cost;
MR = MC
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
11
Computing Maximum Profit
ATC
Profit
(Total
Approach
Profit
Per
Unit
Profit Per
Unit
Approach
Price
Q
MR
TR
Revenue
per Unit
$18
600
$12
$10,800
$18
$5,710
$4
$9.52
$5,090
$8
$5,090
17
700
$11
$11,900
$17
$6,140
$4
$8.77
$5,760
$8
$5,760
16
800
$9
$12,800
$16
$6,635
$5
$8.29
$6,165
$8
$6,165
15
900
$7
$13,500
$15
$7,20
$6
$8.00
$6,300
$7
$6,300
14
1000
$5
$14,000
$14
$7,835
$6
$7.84
$6,165
$6
$6,165
13
1100
$3
$14,300
$13
$8,560
$7
$7.78
$5,740
$5
$5,740
12
1200
$1
$14,400
$12
$9,400
$8
$7.83
$5,000
$4
$5,000

TC
MC
Marginal revenue is closest to marginal
cost at 900 units of output.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
12
$
The Output Decision
When the gap
between total
revenue and total
cost is greatest,
marginal revenue
is roughly equal
to marginal cost.
The monopolist
maximizes profit
when it produces
900 units of
output.
© 2005 Prentice Hall Business Publishing
MC
15
m
AC
8
c
6
n
D
900
MR
Doses of Drug per hour
Survey of Economics, 2/e
O’Sullivan & Sheffrin
13
The Costs of Monopoly


What are the trade-offs? The costs
& benefits of monopoly to society as
a whole?
In many cases monopoly results
from government policy;
 If
the costs exceed the benefits , it may
be sensible to remove barriers to
entry;
 The benefits to consumers are
measured by Consumer Surplus.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
14
The demand Curve & Consumer Surplus

Consumer Surplus: The difference
between the maximum amount a
consumer is willing to pay for a product
and the price that he/she actually pays.
The consumer surplus is the area under the
demand curve and above the market price.
It is what consumers gain from their
Purchases after deducting the cost.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
15
The demand Curve & Consumer Surplus
Juan is willing to pay $22, so if the
actual price is $10, his consumer
surplus is $12
Price ($ per lawn)
$25
$22
Forest is willing to pay $13,his consumer
surplus is $12
Juan
Tupak
$19
Thurl
$16
Fivola is willing to pay $10,her
consumer surplus is $0
Forest
$13
Fivola
$10
$7
Price
Siggy
D
4
1
2
3
Number of Lawns cut per week
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
5
Siggy is willing to
pay $7,he doesn’t
get his lawn cut
6
Total market Consumer surplus =
$12+$9+$6+$3+$0=$30
O’Sullivan & Sheffrin
16
The Costs of Monopoly

To examine the social costs of monopoly, we
start with a perfectly competitive market and
then switch to a monopoly …
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
17
Monopoly Versus perfect Competition
Monopoly price is $18 and consumer surplus associated with
this price is shown by triangle C. Switching from perfect
competition to monopoly decreases consumer surplus by the
areas R and D.
$
Perfectly competitive price is
$8, so the consumer surplus is
shown by triangles C and D
and rectangle R
C
$18
R
D
Only part of consumers’ loss is
LRAC
recovered by producers (Rectangle
Demand R). The net loss to consumers &
$8
200
400
Doses of Drug per hour
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
society is triangle D (deadweight
loss)
O’Sullivan & Sheffrin
18
Rent Seeking

Rent seeking is a term used to describe the efforts by a
monopoly to persuade government to erect barriers to
entry.

If rent seeking exists,
the monopoly may
spend some of its
potential profit on
rent-seeking activity,
and the net loss to
society would be areas
R and D, not just area
D.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
19
The Costs and Benefits of Monopoly


Costs: a monopoly produces less
output than a perfectly competitive
market, and people waste resources
trying to get and keep monopoly
power.
Benefits: a patent or license
increases the payoff from research
and development, thus encourages
innovation.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
20
Natural Monopoly

A natural monopoly is a firm that
serves the entire market at a lower cost
than two or more firms can.

Examples of natural monopolies:


Public utilities (sewerage, water, and
electricity generation)
Transportation services (railroad
freight and mass transit)
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
21
Natural Monopoly


The long-run
average cost of
electricity
generation is
negatively sloped,
reflecting large
economies of scale.
As long as the longrun average cost
decreases, the longrun marginal cost
must lie below it.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
22
Natural Monopoly

Given the structure of
demand and marginal
revenue, the
monopoly maximizes
profit by generating 3
thousand kilowatt
hours.

Left alone, the
monopoly will charge
$8.20 and earn a profit
of ($8.20-$6.20) = $2
per kilowatt hour
(distance between
points c and m).
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
23
Natural Monopoly

Total profit equals
(price – average
cost) x quantity
produced and sold
(the green area).

Profit is possible
only if there is one
firm, unregulated,
serving the entire
market demand.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
24
Natural Monopoly

Suppose that the
monopoly shared the
market demand and
output sold with a
second firm, and that
each firm produced
half of the market
output (1.5 kw/h).

The cost of producing
1.5 kw/h would exceed
the price the firms can
receive, thus they
would suffer losses.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
25
Price Controls for a Natural Monopoly

Under an average-cost
pricing policy, the
government picks a
price equal to the
average cost of
production, or $5.20.

But regulation gives the
utility no incentive to
control costs, so costs
rise. Price after
regulation decreases by
less than anticipated.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
26