Market Structures: Monopoly
Monopoly
Assumptions
• One seller and many buyers
– Implication: The seller is a price maker and the buyers
are price takers.
• Barriers to Entry
– Ownership of a unique resource (Diamonds)
– Government granted rights for exclusive production
(e.g. patents, copyrights, licenses, concessions)
– Economies of scale and declining long-run average
costs
– Implication: Monopolist faces the entire market
demand curve and profits can persist in the short and
long-run.
Limits to Monopoly
• Size of the market (Pavarotti versus Joe,
uncongested bridge)
• Definition of market and close substitutes
(ornamental versus industrial diamonds,
bottled water).
• Potential competition
Production Decisions
• Monopolist versus competitive firm.
– CF is a price taker who faces a perfectly elastic demand
curve  MR=P
– M is a price maker who faces the entire market demand
curve  MR<P
• Intuitive proof – to sell another unit the monopolist must lower
the price. This means lowering the price not only on the extra
unit sold, but also all the other units the monopolist was
selling. So MR = Price of the additional unit – the sum of the
decreases in all the units previously sold ( e.g. selling 4 units
@$100, to sell the 5 unit the price must be lowered to $90, so
the monopolist’s MR = $90 – 4X$10=$50)
• Tabular proof – see next table and handout
• Graphical proof
A Monopoly’s Revenue
• Total Revenue
P  Q = TR
• Average Revenue
TR/Q = AR = P
• Marginal Revenue
DTR/DQ = MR
Table 1 A Monopoly’s Total, Average,
and Marginal Revenue
Copyright©2004 South-Western
Figure 2 Demand Curves for Competitive and
Monopoly Firms
(a) A Competitive Firm’s Demand Curve
Price
(b) A Monopolist’s Demand Curve
Price
Demand
Demand
0
Quantity of Output
0
Quantity of Output
Copyright © 2004 South-Western
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
Demand
(average
revenue)
Marginal
revenue
1
2
3
4
5
6
7
8
Quantity of Water
Copyright © 2004 South-Western
Profit Maximization
• A monopoly maximizes profit by producing
the quantity at which marginal revenue
equals marginal cost.
• It then uses the demand curve to find the
price that will induce consumers to buy that
quantity.
• Profit Maximization –
– Set MR = MC to find Q that maximizes profits.
– Use the market demand curve to find the P that the Q
brings
– Find ATC and AVC cost to determine profits, losses, or
shutdown.
• Difference between the monopolist decision and
the competitive firms decision
– The monopolist does not have a supply curve like the
CF, rather they pick a single price and quantity
– Monopolists produce where P>MR and P>MCversus
CFs who produce where P=MR and P=MC.
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
Copyright © 2004 South-Western
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
Copyright © 2004 South-Western
Figure 6 The Market for Drugs
Costs and
Revenue
Price
during
patent life
Price after
patent
expires
Marginal
cost
Marginal
revenue
0
Monopoly
quantity
Competitive
quantity
Demand
Quantity
Copyright © 2004 South-Western
Welfare Costs of Monopoly
• In competitive markets, firms produce where
P=MC
And since
P=MB=willingness to bud
And
MC=willingness to sell
P=MC  MB=MC or
Maximum total surplus
• In monopoly,
P>MR so
P>MC
Or
MB>MC
Output falls short of the efficient amount 
Deadweight Welfare Loss
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.
Value to buyers
is less than
cost to seller.
Efficient
quantity
Copyright © 2004 South-Western
Figure 8 The Inefficiency of Monopoly
Price
Deadweight
loss
Marginal cost
Monopoly
price
Marginal
revenue
0
Monopoly Efficient
quantity quantity
Demand
Quantity
Copyright © 2004 South-Western
• Monopoly profit is not usually a social cost
but a transfer of surplus from consumer to
producer.
• Profit can be a social cost if extra costs are
incurred to maintain it, such as political
lobbying, or if the lack of competition leads
to costs not being minimized (Xinefficiency again!)
Public Policy and Monopolies
Working towards P=MC
• Attempts to increase competition through antitrust legislation
– Sherman Antitrust Act of 1890
– Examples: Breakup of Standard Oil and turning MA
Bell into Baby Bells
• Regulation – Natural Monopolies
– P=MC doesn’t work with extensive economies of scale
– Regulated forms have little incentive to minimize costs
• Public Ownership
– Public utilities and the Postal Service
• Hands-off Approach
Price-Discriminating Monopolist
• Price discrimination occurs when different prices
are charged to different consumer that do no
reflect differences in the cost of providing th good
• Perfect Price Discrimination – charging each
customer their maximum willingness to pay.
• Imperfect Price Discrimination – segmenting the
market into different consumer groups.
– Parable – Hardcopy versus paperback copy
– Allows firms to increase profits
– Requires separating customers into different groups and
minimize arbitrage
– Results in greater economic welfare than single-pricing
monopolists.
Basis for Price Descrimination
• Different consumers have different willingness to pay 
different price elasticities of demand
• Rule: segment the market according to price elasticity of
demand and charge the consumers will less elastic demand
more than those with more elastic demand
• Examples: (remember the smaller the % of income or the
greater the number of close substitutes the less price elastic
the demand,)
–
–
–
–
–
Movie Tickets
Airline Tickets
Discount Coupons
Financial Aid
Quantity Discounts
Summary
• Monopolies contribute to inefficiency because:
– P>MC  DWWL
– Less than the socially optimal level of output is
produced
– Incentives for cost reduction may diminish
– Too many resources may be spent on political
protection
• However, discriminating monopolist can help
reduce DWWL.
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
Copyright © 2004 South-Western
Figure 10 Welfare with and without Price
Discrimination
(b) Monopolist with Perfect Price Discrimination
Price
Profit
Marginal cost
Demand
0
Quantity sold
Quantity
Copyright © 2004 South-Western
Price Maker – Profit Taker
http://www.youtube.com/watch?v=ZcSBurP8yLs&feature=re
lated Queue 51
You’re a Price Maker
Price Maker Money Taker
Price Maker Profit Taker
Don’t you mess around with me
You’re a Price Maker
Price Maker Money Taker
Price Maker Profit Taker
Don’t you mess around with me, no no. no!