natural monopoly - Porterville College

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Economics
Combined Version
Edwin G. Dolan
Best Value Textbooks
4th edition
Chapter 10
Theory of Monopoly
What is a Monopoly?
 A monopoly is a market structure in which there is a
single supplier of a product.
 The monopolist:
 May be small or large.
 Must be the ONLY supplier of the product.
 Sells a product for which there are NO close substitutes. (The
greater the number of close substitutes for a firm’s products,
the less likely it is that the firm can exercise monopoly power.
 Monopolies are fairly common: U.S. Postal Service, local
utility companies, local cable providers, etc.
2
The Creation of Monopolies
 Monopolies often arise as a result of barriers to entry.
 Barrier to entry: anything that impedes the ability of firms to
begin a new business in an industry in which existing firms
are earning positive economic profits. There are three general
classes of barriers to entry:
 Natural barriers, the most common being economies of
scale
 Network effects
 Actions by firms to keep other firms out
 Government (legal) barriers
3
Economies of Scale
 In some industries, the larger the scale of
production, the lower the costs of production.
 Entrants are not usually able to enter the market
assured of or capable of a very large volume of
production and sales.
 This gives incumbent firms a significant
advantage.
 Examples are electric power companies and other
similar utility providers.
4
Monopoly based on
Economies of Scale
5
Actions by Firms
 Entry is barred when one firm owns an essential
resource.
 Examples are inventions, discoveries, recipes, and
specific materials.
 Microsoft owns Windows, and has been
challenged by the U.S. Dept. of Justice as a
monopolist.
6
Government
 Governments often provide barriers, creating
monopolies.
 As incentives to innovation, governments often
grant patents, providing firms with legal
monopolies on their products or the use of their
inventions or discoveries for a period of 17 years.
7
Types of Monopolies (Alt. Text)
 Natural monopoly: A monopoly that arises from
economies of scale. The economies of scale arise from
natural supply and demand conditions, and not from
government actions.
 Local monopoly: a monopoly that exists in a limited geographic
area.
 Regulated monopoly: a monopoly firm whose behavior
is overseen by a government entity.
 Monopoly power: market power, the power to set prices.
 Monopolization: an attempt by a firm to dominate a
market or become a monopoly.
8
Kinds of Monopoly (Dolan Text)
 A closed monopoly is protected by legal restrictions
on competition. For example, state law in
Washington prevents anyone from offering
competing car ferry service to islands served by the
Washington State Ferry System.
 A natural monopoly is an industry in which longrun average cost is minimized when just one firm
serves the entire market. Distribution of natural gas
to residential customers is an example.
 3. An open monopoly is a case in which a firm
becomes, at least for a time, the sole supplier of a
product without having the special protections
against competition that is enjoyed by a closed or
natural monopoly. An example is Sony’s first home
video cassette recorder.
Washington State Ferry at Lopez Island
Picture by E. Dolan
The Demand Curve
Facing a Monopoly Firm
 In any market, the industry demand curve is downward-
sloping. This is the result of the law of demand.
 In Monopoly the monopolist
IS the industry
because it is the sole producer.
 Therefore the monopolist faces a downward-sloping
demand curve. The industry demand curve is the firm’s
demand curve.
10
Marginal Revenue
 Marginal Revenue (MR) is:
TR
MR 
Q
 MR is less than price for a monopoly firm.
 The MR is less than price and declines as output
increases because the monopolist must lower the price in
order to sell more units (because the demand curve
slopes downward).
11
Demand Curve
for a Monopolist
Q
Price
TR
MR
1
$1,700 $ 1,700
$1,700
2
$1,650 $ 3,300
$1,600
3
$1,600 $ 4,800
$1,500
4
$1,550 $ 6,200
$1,400
5
$1,500 $ 7,500
$1,300
6
$1,450 $ 8,700
$1,200
7
$1,400 $ 9,800
$1,100
8
$1,350 $10,800
$1,000
9
$1,300 $11,700
$ 900
12
From the text but not very useful
Average Revenue
 Whenever MR is greater than AR, AR rises.
 Whenever MR is less than AR, AR falls.
 Average revenue is:
P Q
AR 
P
Q
 Note that the AR is the same as price. In fact, the AR curve is the
demand curve.
 With a downward-sloping demand curve, prices fall as output
increases. This means that AR falls.
 MR must always be less than AR.
13
For A Monopolist: Marginal
Revenue IS NOT Price
The MR Curve for a downward
sloping, linear demand curve:
Is always below the demand
curve
Sits half-way between the
demand curve and the Y axis
In other words it is half-way
between the quantity on the
Demand curve and a quantity of
Zero
14
Demand and Revenue
for the Monopolist
Monopoly firms NEVER chose to
produce in the inelastic range of
their demand curve.
Monopoly firms will always
withhold product to keep their
sales in the Elastic or Unit
Elastic range of their demand
curve.
15
Profit Maximization
 The monopolist will not set the price arbitrarily high.
 For the monopolist, the profit-maximizing price still
corresponds to the point where MR=MC.
 The monopolist’s market power will allow the firm to
achieve above-normal profits.
Unlike Perfect Competition, in Monopoly:
MR < Price & MR < Demand Curve
16
Profit Maximizing Monopoly
Monopoly Firms pick their
profit maximizing quantity
where:
MR=MC
The price is determined by
the Demand Curve at that
Quantity
D
Monopoly Profit Solution
Price is the intersection
of the Monopoly
Quantity with the
Demand Curve
Cost
Cost is found at the
intersection of the
quantity with the firm’s
Average Total Cost
Curve at the selected
quantity
Profit Maximization
Price is the intersection of the Monopoly Quantity with the Demand Curve
Cost is found at the intersection of the quantity with the firm’s Average Total
Cost Curve at the selected quantity
19
Price Discrimination
Under certain
conditions, a firm
with market power is
able to charge
different customers
different prices. This
is called price
discrimination.
20
Necessary Conditions
for Price Discrimination
 For price discrimination to work, the firm must be able
to set the price.
 The firm cannot be a price taker.
 The firm must be able to “segment the market”. That is,
the firm must be able to:
 Separate the customers
 Prevent resale of the product
21
Price Discrimination in Action
22
Monopoly and Perfect Competition:
Comparison
23
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