Chapter 15
Monopoly
Ratna K. Shrestha
Microsoft’s Windows System



When Microsoft designed “Windows” it received a
copyright, an exclusive right to sell, from the
government.
Unlike in a Competitive market where many firms sell
identical products, in “windows’ market, Microsoft is a
sole seller.
The MC of producing a copy of “Windows” CD is just a
few $$ and yet its price is well over the MC, Why??
Airline Price Discrimination
The airlines sort their
customers according to their
willingness to pay by
offering a maze of advancepurchase and stopover
restrictions that attract pricesensitive leisure but not by
business travelers.
Would it bother you to
know what I paid for this
seat?
Overview





Why Monopolies Arise?
Production and Pricing Decisions
Welfare Cost of Monopoly
Public Policy and Monopoly
Price Discrimination
Monopoly

A firm is considered a monopoly if:
– it is the sole seller of its product
– its product does not have close substitutes
– it has some ability to influence the market price of
its product or is a price maker

A Pure Monopoly exists when a single firm is the only
producer or seller of a product that has no close
substitutes.
Why Learn About Monopolies?


It is estimated that about 5% of domestic output is
supplied under monopoly conditions.
It helps to understand more common market
structures such as monopolistic competition and
oligopoly.
Why Monopolies Arise?
The fundamental cause of a monopoly is
Barriers to Entry.
Ownership of Key Resource
Legal Barriers By Government
Large Economies of Scale
Ownership of Key Resources
A single owner of an
important resource that
cannot be readily
duplicated, as with some
natural resources.
Example: De Beers, a
South African Diamond
Company, which controls
about 80% of world’s
diamond production.
Government-Created Monopolies


Governments also restrict entry by giving a single firm
the exclusive right to sell a particular good in certain
markets.
– E.g., Local cable television
– ICBC in basic auto insurance market. ICBC was
created by NDP government to give a monopoly to
the government owned company (so that US
insurance firms cannot enter the market.
Patent and copyright laws give a firm or an individual
exclusive rights to sell a product.
– Certain new pharmaceutical drugs
– a book.
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 in production.
ATC is smaller when produced by a single large firm
than smaller many firms.
 e.g. BC Hydro, Coast Mountain Transportation,
Telus, Terasen.
Economies of Scale: Cause of Monopoly
Cost
ATC
MC
0
Quantity of Output
Monopoly Behavior
Monopoly vs. Competitive Firm
Monopoly
 Sole Producer
 Downward Sloping
Demand Curve. The
monopolist faces the
whole market demand.
 Price Setter
 Reduces Price to
Increase Sales
 Marginal Revenue curve
below demand
Monopoly Behavior
Competitive Firm vs. Monopoly
Competitive Firm
 One of many producers
 Horizontal Demand Curve: the firm sells all of its
products at that same market price determined by
the market. So the demand facing the competitive
firm is a horizontal line at that market price.
 Price Taker
 Sells a lot or a little at the same price
 Marginal Revenue curve is horizontal and
coincides with D curve.
Demand Curves for Competitive and
Monopoly Firms..
Price
(a) A Competitive Firm’s
Demand Curve
Price
(b) A Monopolist’s
Demand Curve
Demand
Demand
0
Quantity of
Output
0
Quantity of
Output
Monopoly’s Revenue





Total Revenue: TR = Q x P
Average Revenue: AR =TR/Q
Marginal Revenue: MR = DTR/DQ
A monopolist’s MR < P.
The Marginal Revenue curve lies below its demand
curve.
A Monopoly’s Total, Average, and Marginal
Revenue
Quantity
(Q)
0
1
2
3
4
5
6
7
8
Price
(P)
$11.00
$10.00
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00
Total Revenue
(TR=PxQ)
$0.00
$10.00
$18.00
$24.00
$28.00
$30.00
$30.00
$28.00
$24.00
Average
Revenue
(AR=TR/Q)
Marginal Revenue
(MR= DTR / DQ )
$10.00
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
-$2.00
-$4.00
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. As a result MR < P.
 When a monopoly increases the amount it sells, it has
two effects on total revenue.
 The output effect—more output is sold, so Q is higher.
 The price effect—price falls, so P is lower.
 So what happens to R (=PQ) is ambiguous; it
depends on the elasticity of demand.
Demand and Marginal Revenue
Curves for a Monopoly...
Price
$11
10
9
8
7
6
5
4
3
2
1
0
-1
-2
-3
Demand
(average revenue)
Marginal
revenue
1
2
3
4
5
6
7
8
Quantity of Water
Profit Maximization of a Monopoly



A monopoly maximizes profit by producing the quantity
at which MR = MC.
If MR > MC, profits can be increased by producing
more. When MR = MC, there is no more opportunities
to further increase profits.
It then uses the demand curve to find the price that will
induce consumers to buy that quantity. At this reduced
quantity, consumers are willing to pay more and as a
result P > MC.
Profit-Maximization for a Monopoly..
2. ...and then the
demand curve shows
the price consistent
with this quantity.
Costs and
Revenue
B
Monopoly
price
1. The intersection of
MR curve and the MC
curve determines the
profit-maximizing
quantity...
Average total cost
A
Demand
Marginal
cost
0
Marginal revenue
QMAX
Quantity
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
Profit = TR – TC = (P - ATC) x Q
As long as PM > ATC, economic profits will be
earned.
Monopolist’s Profit...
Costs and
Revenue
Marginal cost
Monopoly E
price
B
Average total cost
Average
total cost D
C
Demand
Marginal revenue
0
QMAX
Quantity
Case Study: Monopoly Drug Vs.
Generic Drugs

When a firm discovers
a drug, patent laws
give it a monopoly over
the sales of that drug.

But eventually, the
firm’s patent runs out
and the market
switches to competitive
one.
Case Study: Monopoly Drug Vs.
Generic Drugs
Costs and
Revenue
Price
during
patent life
Price after
patent
expires
MC
MR
0
QM
Demand
QC
Quantity
The Welfare Cost of Monopoly




At monopoly prices, some potential consumers value
the good at more than its MC but less than the
monopolist’s price.
These consumers do not end up buying the good.
Monopoly pricing prevents some mutually beneficial
trades from taking place  deadweight loss.
Because a monopoly sets price above MC it places a
wedge, similar to a tax. As in the case of tax, the wedge
causes the quantity sold (QM) to fall short of the social
optimum (QC).
The Efficient Level of Output...
Marginal cost
Price
PM
Goods in between QC and
QM are not traded even if
Value to Buyers > Costs
to Sellers
Demand
(value to buyers)
0
QM
QC
Value to buyers is greater
than cost to seller.
Quantity
Monopoly’s Deadweight Loss
Price
MC = Supply
Monopoly
DWL
PM
Efficient
Quantity Q*!
D
QM
MR
Quantity
Monopoly Deadweight Loss
 The
deadweight loss caused by a monopoly is similar
to the deadweight loss caused by a tax.
 The difference between the two cases is that the
government gets the revenue from a tax, whereas a
private firm gets the monopoly profit.
 Monopoly charges a higher price and consumers pay
that higher price.
 The extra profits/producer surplus the monopolist
make (over the competitive market situation) is less
than the loss in consumer surplus—the source of
deadweight loss.
Public Policy Toward Monopoly
Government may intervene by. . .
 Creating a competitive market
 Implement/Enforce competition laws
 Regulating the behavior of monopolies
 Price control and regulation
 Public Ownership
 Government runs the monopoly itself
 Doing Nothing
1. Competition with Antitrust Laws
 In the United States, the competition laws are called
antitrust laws; in Canada we call them competition laws.
 Antitrust (or competition) laws are a collection of
statutes aimed at curbing monopoly power.
 Antitrust laws give government various ways to promote
competition.
 They allow government to prevent mergers.
 They allow government to break up companies (e.g.,
in 1975 US govt. broke AT&T into 15 “baby bells.”)
 They prevent companies from performing activities
which make markets less competitive.
Antitrust Laws in Canada


First Antitrust Law in Canada (1889)
 Reduced the market power of the large and
powerful “trusts” of that time.
Recent Acts (1986):
 Competition Act
 Competition Tribunal Act.
 These acts are enforced by Competition Bureau,
which is under Industry Canada.
Antitrust Laws in Practice


In 1990, the merger of Imperial Oil and Texaco was
blocked.
Similarly, in 1998 the merger of RB and BMO; and
that of CIBC and TD was blocked.
 Benefits from merger: Reduced Cost of operation
such as overhead/administrative costs.
 Social Cost of merger: Monopoly power and
resulting deadweight loss.
2. Regulation
Government may regulate the prices that the monopoly
charges.
 The allocation of resources will be efficient if P =
MC.
In
the case of Natural Monopoly, If price is regulated to
be equal to MC, P < ATC and the monopolist will incur
loss.
 In this case, the govt. can allow a natural monopolist to
charge P = ATC. Or the govt. can enforce P = MC and
cover the loss by providing a subsidy.
MC Pricing for a Natural Monopoly...
Price
Average
total cost
Regulated
price
Average total cost
Loss
Marginal cost
Demand
0
Quantity
3. Public Ownership
Rather than regulating a natural monopoly that is
run by a private firm, the government can run the
monopoly itself.
e.g.
(1)
(2)
Federal Corporations: Canada Post, CBC.
BC crown corporations: BC Hydro, ICBC, BC Tel,
etc.
In this case what is possible is the government can
have P = MC to avoid DWL and cover the loss from
general taxation.
4. Doing Nothing
Government can do nothing at all if the market failure
due to Monopoly (measured in terms of DWL) is deemed
small compared to the imperfections of public policies
(regulation).
Regulation itself can sometimes cause more welfare
loss than no regulation especially when the government
has no (or imperfect) knowledge on the market demand
and supply curve and hence the efficient point.
Price Discrimination


The practice of charging different prices for different
units of the same product, to different customers.
Conditions required for price discrimination:
– Is not possible in a competitive market.
– In order to price discriminate, the firm must have
some market power.
– There should be no opportunities for arbitrage—
a practice of buying at a cheaper price at one
location and resell it at a higher price at another
location.
Examples: Price Discrimination








Quantity Discounts: Long distance telephone rates:
different rate for first minute and subsequent minutes.
Airline Tickets: first class vs. economy class, one-way vs.
round-trip.
Discount Coupons: target group is price sensitive
consumers who are more likely to use coupons.
Financial Aid: Needy vs. wealthy students.
Two-part tariff: Cell-phone plans: subscription fee/month
and then extra price for each minute of call.
Block Pricing: one price for the fist 100 L of water then
after higher price.
Peak-load Pricing: higher energy price during winter.
Movie Tickets: Adult, Children, Senior rates.
Examples
1. Perfect Price Discrimination
Perfect or first-degree 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, according to his/her
willingness to pay.
 Perfect price discrimination is difficult in practice. Some
of the close examples are:
Car dealerships: they charge different price
depending on your bargaining power (or willingness to
pay)
Ticket Scalping: the scalper charges different prices
depending on customers willingness to pay.
Welfare Without Price Discrimination
(a) Monopolist with Single Price
Price
Consumer
surplus
Monopoly
price
Deadweight
loss
Profit
Marginal cost
Marginal
revenue
0
Quantity sold
Demand
Quantity
Welfare With Price Discrimination...
Price
(b) With perfect price
discrimination DWL = 0.
Monopolist extracts all the
Consumer Surplus.
PS
Marginal cost
Demand
0
Quantity sold
Quantity
2. Second-Degree Price
Discrimination
Examples:
 Quantity discounts
– Buying in bulk like at Sam’s Club
 Block pricing – the practice of charging different
prices for different quantities of “blocks” of a good
– Electric power companies charge different prices
for a consumer purchasing a set block of electricity
3. Third-Degree Price Discrimination


Practice of dividing consumers into two or more
groups depending upon their demand (curves)
and charging different prices to each group.
Most common examples:
– Airlines’ economy and business class fares,
premium vs. non-premium liquor, discounts to
students and senior citizens, frozen vs. canned
vegetables.
– Coupons.
Example: Economics of
Coupons and Rebates



Those consumers who are more price elastic will
tend to use the coupon/rebate more often when
they purchase the product than those consumers
with a less elastic demand.
Thus, coupons and rebate programs allow firms to
price discriminate based on their demand
elasticities.
Price sensitive consumers end up paying lower
prices whereas other non-price sensitive
consumers pay regular prices.
How to Price a Best Selling Novel?



Publisher must divide consumers into two groups:
– Those willing to buy more expensive hard back
– Those willing to wait for cheaper paperback
Have to be strategic about when to release
paperback after hardback
– Publishers typically wait 12 to 18 months
So this kind of publisher’s practice is an example of
third-degree price discrimination.
4. The Two-Part Tariff



Form of pricing in which consumers are charged an
entry fee and usage fee as well.
– EX: amusement park, golf course, telephone
service, cell phone service.
A fee is charged upfront for right to use/buy the
product.
An additional fee is charged for each unit the
consumer wishes to consume
– Pay a fee to play golf and then pay another fee for
each game you play.
Two-Part Tariff with a Single
Consumer
$/Q
T*
P*
Usage price = P* is set equal to MC.
Entry price = T*, the entire consumer
surplus.
Firm captures all consumer surplus as
profit.
MC
D
Quantity
5. Bundling
Gone with the Wind
Getting Gertie’s Garter
Theater A
$12,000
$3,000
Theater B
$10,000
$4,000


Renting the movies separately would result in
each theater paying the lowest reservation price
for each movie:
– Maximum price for Wind = $10,000
– Maximum price for Gertie = $3,000
Total Revenue = $26,000
Bundling




If the movies are bundled:
– Theater A will pay $15,000 for both
– Theater B will pay $14,000 for both
If each were charged the lower of the two prices, total
revenue will be $28,000.
The movie company will gain $2000 more revenue by
bundling the movie (than selling separately).
More profitable to bundle because relative valuation
of two films are reversed. That is, demands are
negatively correlated.
– A pays more for Wind ($12,000) than B ($10,000).
– B pays more for Gertie ($4,000) than A ($3,000).
Bundling: Relative Valuations

If the demands were positively correlated (Theater A
would pay more for both films as shown) bundling
would not result in an increase in revenue.
Gone with the Wind
Getting Gertie’s Garter
Theater A
$12,000
$4,000
Theater B
$10,000
$3,000
Bundling



If the movies are bundled:
– The most Theater A would pay = $16,000
– The most Theater B would pay = $13,000
The maximum price that could be charged if
bundled = $13,000.
Thus, total revenue will be $26,000, the same as by
selling the films separately.
Price Discrimination


Two Important Effects of Price Discrimination:
–
Can increase the monopolist’s profits.
–
Can reduce deadweight loss by increasing the
producer surplus, and not the consumer surplus.
Monopoly power is common. Most firms have some
control over prices because of differentiated products.
 Baskin - Robins Ice Cream vs. Breyer’s
 Designer’s clothes vs. No-Name brands
– However, firms with substantial monopoly power are
rare because few goods are truly unique.