Monopoly
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Monopoly
• “Monopoly” is as close as economics comes
to a dirty word
– Negative reputation of monopoly is in many
ways deserved
– At the same time a mythology has developed
around monopolies
– This negative characterization goes too far
• We do better by managing monopoly problem, rather
than eliminating it
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What Is A Monopoly?
• A monopoly firm is the only seller of a good or service with
no close substitutes
– Market in which the monopoly firm operates is called a monopoly
market
• Key concept is notion of substitutability
• Definition of monopoly firm or market may seem precise
– But in real world, definition is not always so clear-cut
• Because we all have different tastes and characteristics,
we can have different opinions about what is, and what is
not, a “close” substitute
– As a result, we can have different ideas about how broadly or how
narrowly we should define a market when trying to decide if it is a
monopoly
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The Sources of Monopoly
• Existence of a monopoly means that something is
causing other firms to stay out of the market
– Rather than enter and compete with firm already there
• What barrier prevents additional firms from
entering the market?
– Several possible answers
• Economies of scale
• Legal barriers
• Network externalities
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Economies of Scale
• If economies of scale persist to the point where a
single firm is producing for entire market, the
market is a natural monopoly
– Market in which, due to economies of scale, one firm
can operate at lower average cost than can two or more
firms
• Unless government intervenes, only one seller
would survive—market would naturally become a
monopoly
• Small local monopolies are often natural
monopolies
– Because they continue to enjoy economies of scale up
to point at which they are serving entire market
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Figure 1: A Natural Monopoly
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Legal Barriers
• Sometimes public interest is best served by
having a single seller in a market
• Many monopolies arise because of legal barriers
including
– Protection of intellectual property
– Government franchise
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Protection of Intellectual Property
• The words you are reading right now are an example of intellectual
property, which includes literary, artistic and musical works, and
scientific inventions
• In dealing with intellectual property government strikes a compromise
– Allows creators of intellectual property to enjoy a monopoly and earn
economic profit, but only for a limited period of time
– Once time is up, other sellers are allowed to enter the market, and it is
hoped that competition among them will bring down prices
• Most important kinds of legal protection for intellectual property are
– Patents
• Temporary grant of monopoly rights over a new product or scientific discovery
– Copyrights
• Grant of exclusive rights to sell a literary, musical, or artistic work
• Copyrights and patents are often sold to another person or firm, but
this does not change monopoly status of the market, since there is still
just one seller
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Government Franchise
• Large firms we usually think of as monopolies
have their monopoly status guaranteed through
government franchise
– Grant of exclusive rights over a product
• Barrier to entry is
– Any other firm that enters the market will be prosecuted
• Governments usually grant franchises when they
think market is a natural monopoly
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Network Externalities
• Exist when an increase in network’s membership
increases its value to current and potential
members
• When network externalities are present, joining a
large network is more beneficial than joining a
small network
– Even if product in larger network is somewhat inferior to
product in smaller one
• In addition to advantages of joining a larger
network
– Advantage in not leaving it once you’ve joined
• Avoiding switching costs
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Network Externalities
• All of this clearly applies to the market for computer
operating systems
– When you buy a computer already loaded with Microsoft Windows,
you benefit
• By having a large number of people with whom you can easily share
documents
• Huge number of computers everywhere you can easily operate
– You gain access to many more software programs, like Microsoft
Word, Excel, or Outlook, since many more programs are designed
for Windows than for the few alternatives
– You can save time by just calling knowledgeable friends or
coworkers
• Rather than attempting to contact technical support
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Monopoly Goals And Constraints
• Goal of a monopoly—like that of any firm—is to
earn highest profit possible
• However, a monopolist faces constraints
– Constraint on monopoly’s cost
• For any level of output it might produce, total cost is determined
by
– Technology of production
– Price it must pay for its inputs
– Demand constraint
• Monopolist’s demand curve tells us maximum price monopolist
can charge to sell any given quantity of output
• And for any level of output it might produce, maximum price it
can charge is determined by market demand curve for its
product
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Monopoly Price or Output Decision
• Noncompetitive firms—such as monopolies—do not make
two separate decisions about price and quantity, but rather
one decision
– Once firm determines its output level, it has also determined its
price
• When any firm—including a monopoly—faces a downward
sloping demand curve, marginal revenue is less than price
of output
– Therefore, marginal revenue curve will lie below demand curve
• Monopoly will always produce at an output level where
marginal revenue is positive
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Figure 2: Demand and Marginal
Revenue
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The Profit-Maximizing Output Level
• To maximize profit, the firm should produce
level of output where MC = MR and
– MC curve crosses MR curve from below
• For a monopoly, price and output are not
independent decisions
– But different ways of expressing the same
decision
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Figure 3: Monopoly Price and
Output Determination
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Profit And Loss
• A monopoly earns a profit whenever P > ATC
– Its total profit at best output level equals area of a
rectangle
• Height equal to distance between P and ATC
• Width equal to level of output
• A monopoly suffers a loss whenever P < ATC
– Its total loss at best output level equals area of a
rectangle
• Height equal to distance between ATC and P
• Width equal to level of output
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Figure 4: Monopoly Profit and Loss
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Equilibrium in Monopoly Markets
• A monopoly market is in equilibrium when
the only firm in market
– The monopoly firm is maximizing profit
• For monopoly—as for perfect competition—
we have different expectations about
equilibrium in short-run and equilibrium in
long-run
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Short-Run Equilibrium
• Monopoly may earn an economic profit or suffer
an economic loss
• What if a monopoly suffers a loss in short-run?
– Any firm should shut down if P < AVC at output level
where MR = MC
• If monopoly suddenly finds that P < AVC,
government will usually not allow it to shut down,
– Instead use tax revenue to make up for firm’s losses
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Long-Run Equilibrium
• Important insights of previous chapter—
perfectly competitive firms cannot earn a
profit in long-run equilibrium
• However, monopolies may earn economic
profit in long-run
• A privately owned monopoly suffering an
economic loss in long-run will exit the
industry
– Should not find privately owned monopolies
suffering economic losses in long-run
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Comparing Monopoly to Perfect
Competition
• In perfect competition, economic profit is relentlessly
reduced to zero by entry of other firms
– In monopoly, economic profit can continue indefinitely
• But monopoly differs from perfect competition in another
way
– Can expect a monopoly market to have a higher price and lower
output than an otherwise similar perfectly competitive market
• By raising price and restricting output, new monopoly
earns economic profit
• Consumers lose in two ways
– Pay more for output they buy
– Due to higher prices they buy less output
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Figure 5: Comparing Monopoly and
Perfect Competition
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Comparing Monopoly to Perfect
Competition
• Changeover from perfect competition to monopoly benefits
owners of monopoly and harms consumers of the product
– Important proviso concerning this result
• In comparing monopoly and perfect competition, price is higher and
output is lower under monopoly if all else is equal
• General conclusion
– Monopolization of a competitive industry leads to two opposing
effects
• For any given technology of production, monopolization leads to
higher prices and lower output
• Changes in technology of production made possible under monopoly
may lead to lower prices and higher output
– Ultimate effect on price and quantity depends on relative strengths
of two effects
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Why Monopolies Often Earn Zero
Economic Profit
• Forces tending to cut monopoly profits
– Government regulation
– Rent-seeking activity
• Any costly action a firm undertakes to establish or maintain its monopoly
status is called rent-seeking activity
• In countries with corrupt bureaucracies, rent-seeking activity includes
bribes to government officials
– In less corrupt governments, it includes time and money spent lobbying
legislators and public for favorable polices
• Rent-seeking activity that helps establish or maintain a firm’s monopoly
position is part of firm’s costs
– As a result, rent-seeking activity can reduce economic profit of a monopoly
• May even reduce it to zero
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What Happens When Things
Change?
• Once a monopoly is maximizing profit, it has no
incentive to change its price or its level of output
– Unless something that affects these decisions changes
• Possible events
– Change in demand for monopolist’s product
– Change in its costs
• What might cause a monopolist to experience a
shift in demand?
– Possible causes are the same as for perfect
competition
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An Increase in Demand and a CostSaving Technological Advance
• Monopolist will react to an increase in demand by
– Producing more output
– Charging a higher price
– Earning a larger profit
• It will react to a decrease of demand by
– Reducing output
– Lowering price
– Suffering a reduction in profit
• In general, monopoly will pass to consumers only part of benefits from
a cost-saving technological change
– After change in technology, monopoly’s profits will be higher
• In general, a monopoly will pass only part of a cost increase onto
consumers in form of a higher price
– After its cost increase, monopoly’s profits will be lower
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Figure 6: A Change in Demand
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Figure 7: Monopoly Profit and Loss
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Price Discrimination
• Single-price monopoly
– Firm that is limited to changing same price for each unit
of output sold
• Price discrimination occurs when a firm charges
different prices to different customers for reasons
other than differences in costs
• Price-discriminating monopoly does not
discriminate based on prejudice, stereotypes, or
ill-will toward any person or group
– Rather, it divides its customers into different categories
based on their willingness to pay for good
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Requirements for Price
Discrimination
• Although every firm would like to practice price
discrimination, not all of them can
• To successfully price discriminate, three
conditions must be satisfied
– Must be a downward-sloping demand curve for the
firm’s output
– Firm must be able to identify consumers willing to pay
more
– Firm must be able to prevent low-price customers from
reselling to high-price customers
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Price Discrimination That Harms
Consumers
• Price discrimination always benefits owners
of a firm
– Can use this ability to increase its profit
• When price discrimination raises price for
some consumer above price they would pay
under a single-price policy it harms
consumers
– Additional profit for the firm is equal to
monetary loss of consumers
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Figure 8: Price Discrimination
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Price Discrimination That Benefits
Consumers
• Price discrimination benefits monopoly at
the same time it benefits a group of
consumers
• Since no one’s price is raised, no one is
harmed by this policy
– When price discrimination lowers price for
some consumers below what they would pay
under a single-price policy, it benefits
consumers as well as firm
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Perfect Price Discrimination
• Suppose a firm could somehow find out maximum price
customers would be willing to pay for each unit of output it
sells
• It could increase profits even further by practicing perfect
price discrimination
– Firm charges each customer the most the customer would be willing
to pay for each unit he or she buys
– Increases profit at expense of consumers
• Perfect price discrimination is very difficult to practice in the
real world
– Would require firm to read its customers’ minds
• Marginal revenue is equal to price of additional unit sold
– Firm’s MR curve is same as its demand curve
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Figure 9: Perfect Price
Discrimination
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The Decline of Monopoly?
• Past century was not kind to monopolies
• Today, monopolies face a different threat
– Relentless advance of technology
• The world of monopolies is changing rapidly
– But monopolies in many forms will be with us
for some time
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Using the Theory: Price Discrimination
at Colleges and Universities
• Most colleges and universities give some kind of financial
aid to a large proportion of their students
• Financial aid has been used as an effective method of
price discrimination
– Designed to increase revenue of the college
• Colleges have long been in an especially good position to
benefit from price discrimination, because they satisfy all
three requirements
– Face downward-sloping demand curves
– Able to identify consumers willing to pay more
– Able to prevent low-price customers from reselling to high-price
customers
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Using the Theory: Price Discrimination
at Colleges and Universities
• Most colleges have been active price discriminators for
decades
• Under newer systems, those who can signal a lower
willingness to pay have benefited from reduced prices
– While those signaling greater willingness to pay have suffered a
price increase
• Result is vastly different prices for different students
– Highly correlated to their families’ willingness to pay
• Increased price discrimination at colleges, like so many
other economic issues, is a matter of tradeoffs
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