Monopoly
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Introduction
 Monopoly
 A firm that is the sole seller of a product without
close substitutes
 Has market power
 The ability to influence the market price of the
product it sells
 A competitive firm has no market power
 Arise due to barriers to entry
 Other firms cannot enter the market to compete
with it
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Three Barriers to Entry
1. Monopoly resources
 A single firm owns a key resource.
 E.g., DeBeers owns most of the world’s
diamond mines
2. Government regulation
 The government gives a single firm the
exclusive right to produce the good.
 E.g., patents, copyright laws
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Three Barriers to Entry
3. The production process
 Natural monopoly: a single firm can
produce the entire market Q at lower cost
than could several firms
Example: 1000 homes
need electricity.
ATC is lower if one firm
services all 1000 homes
than if two firms each
service 500 homes.
Cost
$80
Electricity
ATC slopes
downward due
to huge FC and
small MC
$50
ATC
500
1000
Q
3
Monopoly vs. Competition: Demand
A monopolist’s
P A competitive firm’s Curves
P
demand curve
demand curve
D
D
Q
Q
 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, so MR = P for the competitive firm.
 A monopolist is the only seller, so it faces the market demand
curve. To sell a larger Q, the firm must reduce P. Thus, MR ≠
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P.
Active Learning 1
A monopoly’s
revenue
Common Grounds 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?
5
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
n.a.
MR
Active Learning 1
 P = AR,
same as for a
competitive firm.
 MR < P, whereas
MR = P for a
competitive firm.
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Answers
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
Common Grounds’ D and MR
P,Curves
MR
Q
P
0 $4.50
1
4.00
2
3.50
3
3.00
4
2.50
5
2.00
6
1.50
MR
$4
3
2
1
0
–1
$5
4
3
2
1
0
-1
-2
-3
Demand curve (P)
MR
0
1
2
3
4
5
6
7
Q
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Understanding the Monopolist’s MR
 Increasing Q has two effects on revenue:
 Output effect: higher output raises revenue
 Price effect: lower price reduces revenue
 Marginal revenue, MR < P
 To sell a larger Q, the monopolist must reduce the
price on all the units it sells
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Profit-Maximization
 Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR = MC
 Sets the highest price consumers are willing to
pay for that quantity
 It finds this price from the D curve
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Profit-Maximization
Costs and
Revenue
The profitmaximizing Q is
where MR = MC.
Find P from the
demand curve at
this Q.
MC
P
D
MR
Q
Quantity
Profit-maximizing output
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The Monopolist’s Profit
As with a
competitive firm,
the monopolist’s
profit equals
Costs and
Revenue
MC
P
ATC
ATC
D
(P – ATC) x Q
MR
Q
Quantity
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A Monopoly Does Not Have an S Curve
 A competitive firm takes P as given
 Has a supply curve that shows how its Q
depends on P
 A monopoly firm is a “price-maker”
 Q does not depend on P
 Q and P are jointly determined by MC, MR, and
the demand curve
 Hence, no supply curve for monopoly.
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The Welfare Cost of Monopoly
 Recall:
 Competitive market equilibrium: P = MC and total
surplus is maximized
 Monopoly equilibrium, 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.
 Monopoly results in a deadweight loss
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The Welfare Cost of Monopoly
Competitive equilibrium:
• quantity = QC
• P = MC
• total surplus is
maximized
Price
Deadweight
MC
loss
P
P = MC
MC
D
Monopoly equilibrium:
• quantity = QM
• P > MC
• deadweight loss
MR
QM QC
Quantity
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Price Discrimination
 Price discrimination:
 Sell the same good at different prices to different
buyers
 A firm can increase profit by charging a higher
price to buyers with higher willingness to pay
 Requires the ability to separate customers
according to their willingness to pay
 Can raise economic welfare
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Price Discrimination in the Real World
 Perfect price discrimination
 Not possible in the real world
 No firm knows every buyer’s WTP
 Buyers do not reveal it to sellers
 Price discrimination
 Firms divide customers into groups
based on some observable trait
that is likely related to willingness to pay (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.
 Lower WTP than people who pay full price on
Friday night
 Airline prices
 Discounts for Saturday-night stayovers
 Business travelers (higher WTP) vs. more pricesensitive 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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Topic: Oligopoly
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Measuring Market Concentration
 Concentration ratio: the percentage of the
market’s total output supplied by its four largest
firms.
 The higher the concentration ratio,
the less competition.
 This chapter focuses on oligopoly,
a market structure with high concentration ratios.
OLIGOPOLY
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Concentration Ratios in Selected U.S. Industries
Industry
Video game consoles
Tennis balls
Credit cards
Batteries
Soft drinks
Web search engines
Breakfast cereal
Cigarettes
Greeting cards
Beer
Cell phone service
Autos
Concentration ratio
100%
100%
99%
94%
93%
92%
92%
89%
88%
85%
82%
79%
Oligopoly
 Oligopoly: a market structure in which only a
few sellers offer similar or identical products.
 Strategic behavior in oligopoly:
A firm’s decisions about P or Q can affect other
firms and cause them to react. The firm will
consider these reactions when making decisions.
 Game theory: the study of how people behave
in strategic situations.
OLIGOPOLY
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EXAMPLE: Cell Phone Duopoly in Smalltown
 Smalltown has 140 residents
P
Q
$0
140
5
130
10
120
15
110
20
100
25
90
30
80
(duopoly: an oligopoly with two firms)
35
70
 Each firm’s costs: FC = $0, MC = $10
40
60
45
50
OLIGOPOLY
 The “good”:
cell phone service with unlimited
anytime minutes and free phone
 Smalltown’s demand schedule
 Two firms: T-Mobile, Verizon
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EXAMPLE: Cell Phone Duopoly in Smalltown
P
Q
$0
140
5
130
650
1,300
–650
10
120
1,200
1,200
0
15
110
1,650
1,100
550
20
100
2,000
1,000
1,000
25
90
2,250
900
1,350
30
80
2,400
800
1,600
35
70
2,450
700
1,750
40
60
2,400
600
1,800
45
50
2,250
500
1,750
OLIGOPOLY
Revenue
Cost
Profit
$0 $1,400 –1,400
Competitive
outcome:
P = MC = $10
Q = 120
Profit = $0
Monopoly
outcome:
P = $40
Q = 60
Profit = $1,800
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EXAMPLE: Cell Phone Duopoly in Smalltown
 One possible duopoly outcome: collusion
 Collusion: an agreement among firms in a
market about quantities to produce or prices to
charge
 T-Mobile and Verizon could agree to each produce
half of the monopoly output:
 For each firm: Q = 30, P = $40, profits = $900
 Cartel: a group of firms acting in unison,
e.g., T-Mobile and Verizon in the outcome with
collusion
OLIGOPOLY
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Collusion vs. Self-Interest
 Both firms would be better off if both stick to the
cartel agreement.
 But each firm has incentive to renege on the
agreement.
 Lesson:
It is difficult for oligopoly firms to form cartels and
honor their agreements.
OLIGOPOLY
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The Equilibrium for an Oligopoly
 Nash equilibrium: a situation in which
economic participants interacting with one another
each choose their best strategy given the strategies
that all the others have chosen
 Our duopoly example has a Nash equilibrium
in which each firm produces Q = 40.
 Given that Verizon produces Q = 40,
T-Mobile’s best move is to produce Q = 40.
 Given that T-Mobile produces Q = 40,
Verizon’s best move is to produce Q = 40.
OLIGOPOLY
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A Comparison of Market Outcomes
When firms in an oligopoly individually choose
production to maximize profit,
 oligopoly Q is greater than monopoly Q
but smaller than competitive Q.
 oligopoly P is greater than competitive P
but less than monopoly P.
OLIGOPOLY
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The Output & Price Effects
 Increasing output has two effects on a firm’s profits:
 Output effect:
If P > MC, selling more output raises profits.
 Price effect:
Raising production increases market quantity,
which reduces market price and reduces profit
on all units sold.
 If output effect > price effect,
the firm increases production.
 If price effect > output effect,
the firm reduces production.
OLIGOPOLY
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The Size of the Oligopoly
 As the number of firms in the market increases,
 the price effect becomes smaller
 the oligopoly looks more and more like a
competitive market
 P approaches MC
 the market quantity approaches the socially
efficient quantity
Another benefit of international trade:
Trade increases the number of firms competing,
increases Q, brings P closer to marginal cost
OLIGOPOLY
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Game Theory
 Game theory helps us understand oligopoly and
other situations where “players” interact and
behave strategically.
 Dominant strategy: a strategy that is best
for a player in a game regardless of the
strategies chosen by the other players
 Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial
OLIGOPOLY
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Example: Negative Campaign Ads
 Election with two candidates, “R” and “D.”
 If R runs a negative ad attacking D,
3000 fewer people will vote for D:
1000 of these people vote for R, the rest abstain.
 If D runs a negative ad attacking R,
R loses 3000 votes, D gains 1000, 2000 abstain.
 R and D agree to refrain from running attack ads.
Will each one stick to the agreement?
OLIGOPOLY
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Example: Negative Campaign Ads
Each candidate’s
dominant strategy:
run attack ads.
R’s decision
Do not run attack
ads (cooperate)
Do not run
attack ads
(cooperate)
D’s decision
Run
attack ads
(defect)
OLIGOPOLY
no votes lost
or gained
no votes
lost or gained
Run attack ads
(defect)
R gains 1000
votes
D loses
3000 votes
R loses 3000
votes
D gains
1000 votes
R loses
2000 votes
D loses
2000 votes
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Another Example: Negative Campaign Ads
 Nash eq’m: both candidates run attack ads.
 Effects on election outcome: NONE.
Each side’s ads cancel out the effects of the
other side’s ads.
 Effects on society: NEGATIVE.
Lower voter turnout, higher apathy about politics,
less voter scrutiny of elected officials’ actions.
OLIGOPOLY
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