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© 2011 Thomson South-Western
© 2011 Thomson South-Western
Monopoly
• A firm is considered a monopoly if . . .
– it is the sole seller of its product.
– its product does not have close substitutes.
• While a competitive firm is a price taker, a
monopoly firm is a price maker.
• All this means that a monopoly has market
power
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WHY MONOPOLIES ARISE
• The fundamental cause of monopoly is
barriers to entry.
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WHY MONOPOLIES ARISE
• Barriers to entry have three sources:
– Ownership of a key resource.
– The government gives a single firm the exclusive
right to produce some good.
– Costs of production make a single producer more
efficient than a large number of producers.
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Monopoly Resources
• Although exclusive ownership of a key
resource is a potential source of monopoly, in
practice monopolies rarely arise for this reason.
• E.g., DeBeers owns most of the world’s
diamond mines
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Government-Created Monopolies
• Governments may restrict entry by giving a
single firm the exclusive right to sell a
particular good in certain markets.
• Patent and copyright laws are two important
examples of how government creates a
monopoly to serve the public interest.
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Natural Monopolies
• An industry is a natural monopoly when a
single firm can supply a good or service to an
entire market at a smaller cost than could two or
more firms.
• A natural monopoly arises when there are
economies of scale over the relevant range of
output.
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Natural monopolies
Example: 1000 homes
need electricity.
ATC is lower if
one firm services
all 1000 homes
than if two firms
each service
500 homes.
Cost
Electricity
Economies of
scale due to
huge FC
$80
$50
ATC
500
1000
Q
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HOW MONOPOLIES MAKE PRODUCTION
AND PRICING DECISIONS
Monopoly
vs.
Competitive Firm
Is the sole producer
Is one of many producers
Is a price maker
Is a price taker
Faces a downward-sloping
demand curve
Faces a horizontal demand
curve
Reduces price to increase
sales
Sells as much or as little at
the same price
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Monopoly vs. Competition: Demand Curves
In a competitive market, the
market demand curve slopes
downward.
but the demand curve
for any individual firm’s
product is horizontal
at the market price.
The firm can increase Q
without lowering P,
P
A competitive firm’s
demand curve
D
so MR = P for the
competitive firm.
Q
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Monopoly vs. Competition: Demand Curves
A monopolist is the only
seller, so it faces the market
demand curve.
To sell a larger Q,
the firm must reduce P.
P
A monopolist’s
demand curve
Thus, MR ≠ P.
D
Q
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ACTIVE LEARNING
1:
A Monopoly’s revenue
Moonbucks is
the only seller of
cappuccinos in town.
The table shows the
market demand for
cappuccinos.
Fill in the missing
spaces of the table.
What is the relation
between P and AR?
Between P and MR?
Q
P
0
$4.50
1
4.00
2
3.50
3
3.00
4
2.50
5
2.00
6
1.50
TR
AR
MR
n.a.
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ACTIVE LEARNING
1:
Answers
Here, P = AR,
same as for a
competitive firm.
Here, MR < P,
whereas MR = P
for a competitive firm.
Q
P
TR
AR
0
$4.50
$0
n.a.
1
4.00
4
$4.00
2
3.50
7
3.50
3
3.00
9
3.00
4
2.50
10
2.50
5
2.00
10
2.00
6
1.50
9
1.50
MR
$4
3
2
1
0
–1
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Moonbuck’s D and MR Curves
P, MR
$5
4
3
2
1
0
-1
-2
-3
0
Demand curve (P)
MR
1
2
3
4
5
6
7
Q
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A Monopoly’s Revenue
• A Monopoly’s Marginal Revenue
• A monopolist’s marginal revenue is always less
than the price of its good.
• The demand curve is downward sloping.
• When a monopoly drops the price to sell one more unit,
the revenue received from previously sold units also
decreases.
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A Monopoly’s Revenue
• A Monopoly’s Marginal Revenue
• When a monopoly increases the amount it sells, it
has two effects on total revenue (P  Q).
• The output effect:
More output is sold, which raises revenue
• The price effect:
The price falls, which lowers revenue
• This happens because the monopolist is subject to
the Law of Demand.
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A Monopoly’s Revenue
• To sell a larger Q, the monopolist must reduce
the price on all the units it sells.
• Hence, MR < P
• MR could even be negative if the price effect
exceeds the output effect
(e.g., when Moonbucks increases Q from 5 to 6).
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Figure 3 Demand and Marginal-Revenue Curves for a Monopoly
Price
$11
10
9
8
7
6
5
4
3
2
1
0
–1
–2
–3
–4
If a monopoly wants to sell
more, it must lower price.
Price falls for ALL units sold.
This is why MR is < P.
Demand
(average
revenue)
Marginal
revenue
1
2
3
4
5
6
7
8
Quantity
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Profit Maximization
• Step 1: A monopoly maximizes profit by
producing the quantity at which MR = MC.
• Step 2: It then uses the demand curve to find
the price that will induce consumers to buy that
quantity.
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Figure 4 Profit Maximization for a Monopoly
Costs and
Revenue
2. . . . and then the demand
curve shows the price
consistent with this quantity.
B
Monopoly
price
1. The intersection of the
marginal-revenue curve
and the marginal-cost
curve determines the
profit-maximizing
quantity . . .
Average total cost
A
Demand
Marginal
cost
Marginal revenue
0
Q
QMAX
Q
Quantity
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Profit Maximization
• Comparing Monopoly and Competition
• For a competitive firm, price equals marginal cost.
• P = MR = MC
• For a monopoly firm, price exceeds marginal cost.
• P > MR = MC
• Remember, all profit-maximizing firms set
MR = MC.
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A Monopoly’s Profit
• Profit equals total revenue minus total costs.
• Profit = TR – TC
• Profit = (TR/Q – TC/Q)  Q
• Profit = (P – ATC)  Q
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Figure 5 The Monopolist’s Profit
Costs and
Revenue
Marginal cost
Monopoly E
price
B
Monopoly
profit
Average
total D
cost
Average total cost
C
Demand
Marginal revenue
0
QMAX
Quantity
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A Monopolist’s Profit
• The monopolist will receive economic profits
as long as price is greater than average total
cost.
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Case Study: Monopoly vs. Generic Drugs
Patents on new drugs
Price
give a temporary
monopoly to the seller.
The market for
a typical drug
PM
When the
patent expires,
PC = MC
the market
becomes competitive,
generics appear.
D
MR
QM
Quantity
QC
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THE WELFARE COST OF
MONOPOLY
• In contrast to a competitive firm, the monopoly
charges a price above the marginal cost.
• From the standpoint of consumers, this high
price makes monopoly undesirable.
• However, from the standpoint of the owners of
the firm, the high price makes monopoly very
desirable.
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The Welfare Cost of Monopoly
• Recall: In a competitive market equilibrium,
P = MC and total surplus is maximized.
• In the monopoly eq’m, P > MR = MC
• The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to
produce that unit (MC).
• The monopoly Q is too low –
could increase total surplus with a larger Q.
• Thus, monopoly results in a deadweight loss.
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Figure 7 The Efficient Level of Output
Price
Marginal cost
Value
to
buyers
Cost
to
monopolist
Value
to
buyers
Cost
to
monopolist
Demand
(value to buyers)
Quantity
0
Value to buyers
is greater than
cost to seller.
Efficient
quantity
Value to buyers
is less than
cost to seller.
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The Deadweight Loss
• Because a monopoly sets its price above
marginal cost, it places a wedge between the
consumer’s willingness to pay and the
producer’s cost.
• This wedge causes the quantity sold to fall short of
the social optimum.
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The Inefficiency of Monopoly
Competitive eq’m:
quantity = QE
P = MC
total surplus is
maximized
Monopoly eq’m:
quantity = QM
P > MC
deadweight loss
Price
Deadweight
MC
loss
P
P = MC
MC
D
MR
Q M QE
Quantity
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The Deadweight Loss
• The Inefficiency of Monopoly
• The monopolist produces less than the socially
efficient quantity of output.
• What about the Monopolist’s profit?
• This is not a loss to society since this adds to
Producer Surplus.
• This is similar to the example of taxes, except
instead of government revenue the surplus goes to
the Monopolist.
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PUBLIC POLICY TOWARD MONOPOLIES
Government responds to the problem of
monopoly in one of four ways:
– Making monopolized industries more competitive.
• Increasing competition with Antitrust Laws.
– Regulating the behavior of monopolies.
• Will talk a little about this
– Turning some private monopolies into public
enterprises.
• USPS is an example
– Doing nothing at all.
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Regulation
• Government may regulate the prices that the
monopoly charges.
• The allocation of resources will be efficient if price
is set to equal marginal cost.
• For natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
• If so, regulators might subsidize the monopolist or
set P = ATC for zero economic profit.
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Figure 9 Marginal-Cost Pricing for a Natural Monopoly
Price
If regulators set P = MC, the
natural monopoly will lose money.
Average total
cost
Regulated
price
Loss
Average total cost
Marginal cost
Demand
0
Quantity
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Regulation
• In practice, regulators will allow monopolists to
keep some of the benefits from lower costs in
the form of higher profit, a practice that
requires some departure from marginal-cost
pricing.
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PRICE DISCRIMINATION
• Price discrimination is the business practice
of:
– selling the same good at different prices to
different customers,
– even though the costs for producing for the two
customers are the same.
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The Analytics of Price Discrimination
• Price discrimination is not possible when a
good is sold in a competitive market;
• Since there are many firms all selling at the market
price.
• In order to price discriminate, the firm must
have some market power.
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The Analytics of Price Discrimination
• Perfect Price Discrimination
• Perfect price discrimination refers to the situation
when the monopolist knows exactly the willingness
to pay of each customer and can charge each
customer a different price.
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The Analytics of Price Discrimination
• Two important effects of price discrimination:
• It can increase the monopolist’s profits.
• It can reduce deadweight loss.
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Figure 10 Welfare with and without Price Discrimination
(a) Monopolist with Single Price
Price
Consumer
surplus
Deadweight
loss
Monopoly
price
Profit
Marginal cost
Marginal
revenue
0
Quantity sold
Demand
Quantity
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Figure 10 Welfare with and without Price Discrimination
(b) Monopolist with Perfect Price Discrimination
Price Consumer surplus and
deadweight loss have both Every consumer gets charged a
been converted into profit. different price -- the highest price
they are willing to pay -- so in this
special case, the demand curve is
also MR!
Profit
Marginal cost
Demand
Marginal revenue
0
Quantity sold
Quantity
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Price Discrimination in the Real World
• In the real world, perfect price discrimination is
not possible:
• no firm knows every buyer’s WTP
• buyers do not announce it to sellers
• So, firms divide customers into groups
based on some observable trait
that is likely related to WTP, such as age.
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Examples of Price Discrimination
Movie tickets
Discounts for seniors, students, and people
who can attend during weekday afternoons. They are
all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices
Discounts for Saturday-night stayovers help
distinguish business travelers, who usually have higher
WTP, from more price-sensitive leisure travelers.
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Examples of Price Discrimination
Discount coupons
People who have time to clip and organize coupons are
more likely to have lower income and lower WTP than
others.
Need-based financial aid
Low income families have lower WTP for their
children’s college education.
Schools price-discriminate by offering need-based aid
to low income families.
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Examples of Price Discrimination
Quantity discounts
A buyer’s WTP often declines with additional units, so
firms charge less per unit for large quantities than
small ones.
Example: A movie theater charges $4 for
a small popcorn and $5 for a large one that’s twice as
big.
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CONCLUSION: The Prevalence of Monopoly
• In the real world, pure monopoly is rare.
• Yet, many firms have market power, due to
• selling a unique variety of a product
• having a large market share and few significant
competitors
• In many such cases, most of the results from
this chapter apply, including
• markup of price over marginal cost
• deadweight loss
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