Chapter 12 Monopoly
I.
Market Power
A. Market power and competition are the two forces that influence the market structure of most
markets.
1.
Market power is the ability to influence the market, and in particular the market price,
by influencing the total quantity offered for sale.
2.
A monopoly is a firm that produces a good or service for which no close substitute
exists and which is protected by a barrier that prevents other firms from selling that good
or service.
B. How a Monopoly Arises
1.
A monopoly market has two key features:
a) No close substitutes. The absence of any firms making close substitute goods or
services allows the monopolist to avoid competition in the market.
b) Barriers to entry. Legal or natural constraints that protect a firm from potential
competitors are called barriers to entry.
2.
There are two types of barriers to entry:
a)
Legal barriers to entry create a legal monopoly—a market in which competition
and entry are restricted by the granting of a public franchise, a government license, a
patent, or a copyright.
i)
A public franchise exists when an exclusive right is granted to a firm to
supply a good or service. For example, the U.S. Postal Service has a public
franchise to deliver first-class mail.
ii) A government license exists when the government controls entry into
particular occupations, professions and industries. For example, a license is
required to practice law. Licensing doesn’t always create a monopoly, but
it does restrict competition.
iii) A patent is an exclusive right granted to the inventor of a product or
service, and a copyright is an exclusive right granted to the author or
composer of a literary, musical, dramatic, or artistic work. Patents and
copyrights don’t always create a monopoly, but because these rights can be
sold, they do restrict competition.
b) Natural barriers to entry create a
natural monopoly, which is an
industry in which one firm can
supply the entire market at a lower
price than two or more firms can.
Figure 12.1 shows the LRAC curve
for an electrical power company that
is a natural monopoly.
C. Monopoly Price-Setting Strategies
1.
Monopolies face a tradeoff between the
price it charges and the quantity it can
sell. For a monopoly firm to determine the quantity it sells, it uses its market power to
choose the appropriate price.
2.
There are two types of monopoly price-setting strategies:
a) Price discrimination is the practice of selling different units of a good or service
for different prices. Many firms price discriminate, but not all of them are monopoly
firms.
b) A single-price monopoly is a firm that must sell each unit of its output for the
same price to all its customers.
3.
Although the practice of price discrimination appears to be for the benefit some
consumers, it is really an attempt by the firm to receive the maximize price for each unit
sold to maximize its economic profit.
II. A Single-Price Monopoly’s Output and Price Decision
A. Price and Marginal Revenue
1.
The demand curve facing a monopoly firm is the entire market demand curve.
2.
This demand curve relates the market price at which the monopoly firm can sell the
corresponding quantity of output.
a) Total revenue, TR, is the
price, P, multiplied by the
quantity sold, Q.
b) Marginal revenue, MR, is the
change in total revenue
resulting from a one-unit
increase in the quantity sold.
The key feature of a singleprice monopoly is that at
each level of output,
marginal revenue is less than
the price, that is, MR < P.
c) MR < P at every level of
output because the single–
price monopoly firm must
lower its price on all units
sold to sell an additional unit
of output. This fact means
that the extra revenue
received equals the price of
the additional unit sold
minus the decrease in price
for each of the previous units
it would have sold at the
higher price. As a result, the
net increase to firm’s
revenue, that is, its MR, is
less than the price of the last
unit sold.
d) Figure 12.2 uses a demand curve to show how these offsetting influences on total
revenues.
B. Marginal Revenue and Elasticity
1.
A single-price monopoly’s MR is related to the elasticity of demand for its good.
a) If demand is elastic, a fall in price brings an increase in total revenue. The rise in
revenue from the increase in quantity sold outweighs the fall in revenue from the
lower price per unit, and so the MR is positive.
b) If demand is inelastic, a fall in price brings a decrease in total revenue. The rise in
revenue from the increase in quantity sold is outweighed by the fall in revenue from
the lower price per unit, and so the MR is negative.
c) If demand is unit elastic, a fall in price does not change the firm’s total revenues.
The rise in revenue from the increase in quantity sold equals the fall in revenue from
the lower price per unit, and so the MR is zero.
2. Figure 12.3 shows the
relationship between elasticity of
demand and total revenues for all
three cases.
3. A single-price monopoly will
never produce at an output for
which demand is inelastic. If it
did so, the firm could decrease
output, increase total revenue
while decreasing total cost, and
thereby enjoy higher economic
profits. So a single price
monopoly will always maximize
its economic profit by producing
in the elastic range of its demand.
C. Price and Output Decisions
1.
The monopoly faces the same
types of technology and cost
constraints as does a competitive
firm, so its costs behave the same
as the costs of a perfectly
competitive firm. But the
monopoly faces a different type of
market constraint.
a) The monopoly selects the
profit-maximizing level of
output in the same manner as
a competitive firm, choosing
the level of output where:
MR = MC.
b) The monopoly sets its price
at the highest level at which it
can sell the profitmaximizing quantity. Table 12.1 uses a numerical example to illustrate the
monopoly firm’s output and price decision.
2.
The monopoly might earn an
economic profit—even in the long
run—because the barriers to entry
protect the firm from market entry
by competitor firms.
a) Figure 12.4 illustrates the
profit-maximizing choices of a
single-price monopolist.
b) A monopoly is not guaranteed
an economic profit. An
economic profit is received
only when P > ATC.
III. Single-Price Monopoly and Competition Compared
A. Comparing the same industry under perfect competition and monopoly reveals the significant
differences in these two types of markets.
B. Comparing Output and Price
1. Figure 12.5 shows the market
outcomes under perfect competition
and under monopoly.
2. The market demand curve, D, in
perfect competition is the same
demand curve that the firm faces in
monopoly.
3. The market supply curve, S, in
perfect competition is the horizontal
sum of the individual firm’s marginal
cost curves (S = sum of MC for each
firm). This supply curve is also the
monopoly’s marginal cost curve.
4.
Equilibrium in perfect competition
occurs where the quantity demanded
equals the quantity supplied at quantity QC and market price PC.
5.
The profit-maximizing equilibrium output for a monopoly QM occurs where MR = MC.
Equilibrium price for the monopoly, PM, is obtained from the demand curve, at the profitmaximizing quantity.
6.
The monopoly firm produces less output and charges a higher price than a perfectly
competitive market.
B. Efficiency and Comparison
1.
The monopoly output decision is
inefficient. Figure 12.6 shows why this
result is so.
a) The demand curve, D, is the
marginal benefit curve for society,
MB, and the competitive market
supply curve, S, is the marginal
cost curve for society, MC. So
competitive equilibrium is efficient
because output is produced where
MB = MC.
b) Monopoly is inefficient because
output occurs where MB > MC.
c)
For all output levels at which MB >
MC, a deadweight loss is incurred.
So, an increase in output would
generate additional MB for society
that would exceed the additional
MC to society.
C. Redistribution of Surpluses
Monopoly redistributes a portion of
consumer surplus by changing it to producer
surplus.
D. Rent Seeking
1.
The social cost of monopoly may
exceed the deadweight loss through an
activity called rent seeking, which is
any attempt to capture a consumer
surplus, a producer surplus, or an
economic profit. Rent seeking is not
confined to a monopoly.
2.
There are two forms of rent seeking:
a) Buy a monopoly—expend resources by seeking out the opportunity to buy monopoly
rights for a price below the value of the economic profit earned by the monopoly.
Example: The buying of taxi cab medallions (a government license) in New York
City.
b) Create a monopoly—expend resources seeking political influence, such as lobbying
legislators to provide preferential market status by restricting domestic competition
or enacting tariffs on imports. Example: U.S. steel firms successfully seeking large
tariffs placed against imported steel from foreign firms.
E. Rent-Seeking Equilibrium
1. There are no barriers to entry in the activity of rent seeking. This fact means that the
resources used up in rent seeking are costs which can exhaust the monopoly’s potential
economic profit and leave the monopoly owner with only a normal profit.
2.
However, the outcome is still not
efficient, because output does not
occur where MB = MC. Figure 12.7
shows the normal profit outcome that
results from rent seeking.
IV. Price Discrimination
A. Price discrimination is the selling of
different units of a good or service for
different prices.
1.
To be able to price discriminate, a firm
must:
a) Identify and separate different
buyer types
b) Sell a product that cannot be resold
2.
Price discrimination occurs because of different consumer’s willingness to pay for the
good.
a)
Price discrimination does not occur because of cost differences between units
produced.
b) Not all observed price differences are the result of price discrimination.
B. Price Discrimination and Consumer Surplus
1.
Price discrimination converts consumer surplus into economic profit.
2.
A monopoly firm can price discriminate in different ways:
a)
Monopoly firms can charge the same buyer a different price for each unit sold.
Quantity discounts are an example. However, quantity discounts that reflect lower
costs at higher volumes are not price discrimination.
b) Monopoly firms can charge different buyers different prices for the same good or
service. Giving a lower price on advance purchase airline tickets is an example of
this form of price discrimination.
C. Profiting by Price Discriminating
Figure 12.8 and Figure 12.9 show the same market with a single price monopoly firm and
monopoly firm practicing price discrimination, respectively. Comparing these two diagrams
shows how price discrimination converts consumer surplus into economic profit for the firm.
D. Perfect Price Discrimination
1.
Perfect price discrimination
occurs if a firm is able to sell each
unit of output for the highest price
anyone is willing to pay for it. The
outcome of perfect price
discrimination is characterized by:
a) Economic profit increases above
that earned by a single-price
monopoly firm.
b) Output increases to the quantity
at which P = MC.
c) Deadweight loss is eliminated.
2. Figure 12.10 shows the outcome of
perfect price discrimination.
E. Efficiency and Rent Seeking with Price
Discrimination
1.
The more perfectly a monopoly can price discriminate, the closer its output gets to the
competitive output where P = MC and the outcome is more efficient.
2.
However, this outcome differs from the outcome of perfect competition in two important
ways:
a) The monopoly firm captures the entire consumer surplus.
b) The increase in economic profit attracts even more rent-seeking activity that leads to
an inefficient use of resources for society.
V. Monopoly Policy Issues
A. Gains from Monopoly
1.
Monopolies create inefficiency:
a)
Both single-price and price-discriminating monopolies create deadweight loss. And
a price discriminating monopoly converts consumer surplus into producer surplus
and economic profit.
b) Both types of monopoly also encourage rent-seeking activity, which wastes
resources.
2.
However, monopoly also brings benefits to society:
a) Patents and copyrights provide protection from competition, which lets the
monopoly enjoy the profits stemming from product innovation for a longer period of
time. This encourages more expenditures on researching/developing new products.
b) When production technology exhibits potential for economies of scale or economies
of scope, a monopoly firm can produce goods at a lower ATC than what a large
number of competitive firms could achieve. (However, because of the deadweight
loss, this lower cost of production cannot be fully experienced by society unless the
monopoly firm sells the good at a competitive market price.)
B. Regulating Natural Monopoly
1.
Where demand and cost conditions
create a natural monopoly, a federal,
state, or local government agency
usually steps in to regulate the price of
the monopoly.
a. Figure 12.11 shows a the output
decisions of a natural monopoly
firm and compares two types of
outcomes with government
regulation with the outcome of no
regulation.
b. Left alone, the natural monopoly
will charge a price and produce at
a quantity where MR = MC. Under
this outcome, P > MC and the
quantity produced is less than the
efficient level of output under
perfect competition.
2. Regulating a natural monopoly in the public interest sets firm output where MB = MC
and P = MC. Setting price equal to marginal cost is called the marginal cost pricing
rule, and it results in an efficient use of resources.
a) With output occurring where P = MC, the firm’s ATC > P and the monopoly incurs
an economic loss. If the monopoly receives a subsidy from the government equal to
its economic loss, then taxes must be imposed on some other economic activity. This
tax creates deadweight loss in the allocation of resources in the taxed market.
b) Where possible, a regulated natural monopoly might be permitted to price
discriminate to cover the loss from marginal cost pricing.
3. Another alternative is to produce the quantity at which P = ATC. Setting the price equal
to the average total cost is called the average cost pricing rule.
a)
Output occurs where P > MC, which means that resources are not allocated as
efficiently as with a perfectly competitive market.
b) However, the inefficiency is less than the unregulated market outcome.