Pure Monopoly
CHAPTER 11
PURE MONOPOLY
CHAPTER OVERVIEW
This chapter is divided into six basic sections: the characteristics of pure monopoly; the barriers to entry
that create and protect monopolies; price and output determination under monopoly; the economic
effects of monopoly; price discrimination under monopoly; and the regulation of monopolies.
The discussion of barriers to entry states at the outset that these barriers may occur to some extent in
any form of imperfect competition, not just in a pure monopoly. The concept of a natural monopoly is
addressed in this section.
Building on the analysis of the preceding chapter, the discussion of price-output decision making by
monopoly firms points out that the marginal-revenue—marginal-cost rule still applies. Emphasis here is
on the major difference between the determination of marginal revenue in pure competition and in pure
monopoly. The misconceptions about monopoly pricing behavior are presented as well as a comparison
of efficiency in pure competition and pure monopoly. This section ends with a discussion of effects of
monopoly power in the U.S. economy and some policy alternatives.
The case of price discrimination and its effects are discussed along with the conditions necessary for it to
occur. At the end of the chapter, the basic issues involved in the regulation of public service monopolies
are reviewed.
WHAT’S NEW
The theoretical material remains intact, but the examples have been revised, especially as they pertain to
developments in the Microsoft legal battles.
A “Consider This” box on price discrimination has been added. It appeared previously in the “Analogies,
Anecdotes, and Insights” section of the website.
A new end-of-chapter question on price discrimination has been added.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. List the five characteristics of pure monopoly.
2. Explain the difference between a “pure” monopoly and a “near” monopoly.
3. List and give examples of the four barriers to entry.
4. Describe the demand curve facing a pure monopoly and how it differs from that facing a firm in a
purely competitive market.
5. Compute marginal revenue when given a monopoly demand schedule.
6. Explain why the marginal revenue is equal to the price in pure competition but not in monopoly.
7. Determine the price and output level the monopoly will choose given demand and cost information
in both table and graphic form.
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8. Discuss the economic effects of pure monopoly on price, quantity of product produced, allocation
of resources, distribution of income, and technological progress.
9. Give examples of how new technology has lessened monopoly power.
10. List three conditions necessary for price discrimination.
11. Explain why profits and output will be higher for a discriminating monopoly as compared to nondiscriminating monopoly.
12. Identify two pricing strategies of monopoly regulation and explain the dilemma the regulators face
in utilizing these strategies.
13. Define and identify terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Ask students to list products that they believe are provided by a “pure” monopoly, or at least by
firms with a high degree of monopoly power. Then ask them to list substitutes for the products
sold by each of these “monopolies.” Demonstrate how the relative “closeness” of the substitutes
they listed determines, to a large degree, effective limits to the monopoly power of these firms.
2. Review what is meant by a firm versus an industry in pure competition and compare this with pure
monopoly where the firm is the industry.
3. In addition to the example of patents discussed in the text, note how licenses, product safety
requirements, zoning laws, environmental impact statements, price controls, etc.—all of which are
enforced by various levels of government—can serve as barriers to entry in different situations.
4. Stress that the price-output decision is an either-or-decision, i.e., the monopolist can sell one unit
at $162 or two units at $152. Ask how much of an increase in total revenue will occur if the
second unit (one unit) is sold for $152: answer $152. Now ask how much total revenue will
decrease if the price of the first unit is decreased from $162 to $152.
5. The ability to engage in price discrimination is based on differing price elasticities and demand
among customers. There are many good examples given in this chapter. Telephone service, air
travel, and electricity are all sold at various prices taking into account the customer’s sensitivity to
price. The more substitutes available to the buyer, the more elastic the demand. This is a good
opportunity to review price elasticity and demonstrate the many applications of this measure.
6. Electrical utilities and telephone service were regulated monopolies for many years. Deregulation
in both industries is a topic worthy of class discussion and student research. In addition to the
basic dilemma facing regulators of natural monopolies covered in the text, discuss problems that
result when regulators are not well intentioned and attempt to maximize their own gains from such
an elected or appointed position. The difficulty in finding impartial, yet knowledgeable, people to
serve on regulatory commissions is a good topic for discussion, especially if there are any related
issues affecting your community, such as an environmental or consumer group that may be
challenging a ruling by a regulatory commission. Refer to the relevant summary of this material in
Chapter 32.
7. The Last Word in this chapter highlights the fact that monopolies do not necessarily last forever.
STUDENT STUMBLING BLOCK
In Chapter 23 the students learned that firms operating in a purely competitive setting equate marginal
revenue to price. Now students learn that marginal revenue under imperfect competition is less than
price. Students seem to grasp this initially, but because they first learned the identity of marginal revenue
and price in a competitive setting, it is sometimes hard to unlearn that when analyzing other market
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structures. Some instructors avoid this problem by teaching the imperfect competition models first.
Students learn to equate marginal revenue and marginal cost in seeking the profit-maximizing output
level. Then they can use this rule in studying pure competition and treat the equality of price and
marginal revenue as a special case. If you choose to present the material with Chapter 24 coming before
Chapter 23, discuss the models in Table 23-1 before assigning this chapter on the monopoly model.
LECTURE NOTES
I.
Pure Monopoly: An Introduction
A. Definition: A pure monopoly exists when a single firm is the sole producer of a product for
which there are no close substitutes.
B. There are a number of products where the producers have a substantial amount of monopoly
power and are called “near” monopolies.
C. There are several characteristics that distinguish pure monopoly.
1. There is a single seller so the firm and industry are synonymous.
2. There are no close substitutes for the firm’s product.
3. The firm is a “price maker,” that is, the firm has considerable control over the price
because it can control the quantity supplied.
4. Entry into the industry by other firms is blocked.
5. A monopolist may or may not engage in nonprice competition. Depending on the nature
of its product, a monopolist may advertise to increase demand.
C. Examples of pure monopolies and “near monopolies.”
1. Public utilities—gas, electric, water, cable TV, and local telephone service companies—
are pure monopolies.
2. First Data Resources (Western Union), Wham-o (Frisbees) and the DeBeers diamond
syndicate are examples of “near” monopolies. (See Last Word.)
3. Manufacturing monopolies are virtually nonexistent in nationwide U.S. manufacturing
industries.
4. Professional sports leagues grant team monopolies to cities.
5. Monopolies may be geographic. A small town may have only one airline, bank, etc.
D. Analysis of monopolies yields insights concerning monopolistic competition and oligopoly,
the more common types of market situations. (See Chapter 25.)
II.
Barriers to Entry Limiting Competition
A. Economies of scale constitute one major barrier. This occurs where the lowest unit costs
and, therefore, lowest unit prices for consumers depend on the existence of a small number
of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm
with a large market share is most efficient, new firms cannot afford to start up in industries
with economies of scale. (See Figure 22-9b and Figure 24-1.)
1. Public utilities are known as natural monopolies because they have economies of scale in
the extreme case where one firm is most efficient in satisfying existing demand.
2. Government usually gives one firm the right to operate a public utility industry in
exchange for government regulation of its power.
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3. The explanation of why more than one firm would be inefficient involves the description
of the maze of pipes or wires that would result if there were competition among water
companies, electric utility companies, etc.
B. Legal barriers to entry into a monopolistic industry also exist in the form of patents and
licenses.
1. Patents grant the inventor the exclusive right to produce or license a product for
seventeen years; this exclusive right can earn profits for future research, which results in
more patents and monopoly profits.
2. Licenses are another form of entry barrier. Radio and TV stations, and taxi companies
are examples of government granting licenses where only one or a few firms are allowed
to offer the service.
C. Ownership or control of essential resources is another barrier to entry.
1. International Nickel Co. of Canada (now called Inco) controlled about 90 percent of the
world’s nickel reserves, and DeBeers of South Africa controls most of world’s diamond
supplies (see Last Word).
2. Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore
used in aluminum fabrication.
3. Professional sports leagues control player contracts and leases on major city stadiums.
D. Monopolists may use pricing or other strategic barriers such as selective price cutting and
advertising.
1. Dentsply, manufacturer of false teeth, controlled about 70 percent of the market. In 1999
the U.S. Justice Department accused Dentsply of illegally preventing distributors from
carrying competing brands.
2. Microsoft charged higher prices for its Windows operating system to computer
manufacturers featuring Netscape Navigator instead of Microsoft’s Internet Explorer.
U.S. courts ruled this action illegal.
III.
Monopoly demand is the industry (market) demand and is therefore downward sloping.
A. Our analysis of monopoly demand makes three assumptions.
1. The monopoly is secured by patents, economies of scale, or resource ownership.
2. The firm is not regulated by any unit of government.
3. The firm is a single-price monopolist; it charges the same price for all units of output.
B. Price will exceed marginal revenue because the monopolist must lower the price to sell the
additional unit. The added revenue will be the price of the last unit less the sum of the price
cuts that must be taken on all prior units of output (Table 24-1 and Figure 24-2).
1. Figure 24-3 shows the relationship between demand, marginal-revenue, and
total-revenue curves.
2. The marginal-revenue curve is below the demand curve, and when it becomes negative,
the total-revenue curve turns downward as total revenue falls.
C. The monopolist is a price maker. The firm controls output and price but is not free of market
forces, since the combination of output and price that can be sold depends on demand. For
example, Table 24-1 shows that at $162 only 1 unit will be sold, at $152 only 2 units will be
sold, etc.
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D. Price elasticity also plays a role in monopoly price setting. The total revenue test shows that
the monopolist will avoid the inelastic segment of its demand schedule. As long as demand
is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true
when demand becomes inelastic. At this point, total revenue falls as output expands, and
since total costs rise with output, profits will decline as demand becomes inelastic.
Therefore, the monopolist will expand output only in the elastic portion of its demand curve.
(Key Question 4)
IV.
Output and Price Determination
A. Cost data is based on hiring resources in competitive markets, so the cost data of Chapters 22
and 23 can be used in this chapter as well. The costs in Table 24-1 restate the data of Table
22-2.
B. The MR = MC rule will tell the monopolist where to find its profit-maximizing output level.
This can be seen in Table 24-1 and Figure 24-4. The same outcome can be determined by
comparing total revenue and total costs incurred at each level of production. (Key Question
5)
C. The pure monopolist has no supply curve because there is no unique relationship between
price and quantity supplied. The price and quantity supplied will always depend on the
location of the demand curve.
D. There are several misconceptions about monopoly prices.
1. A monopolist cannot charge the highest price it can get, because it will maximize profits
where total revenue minus total cost is greatest. This depends on quantity sold as well as
on price and will never be the highest price possible.
2. Total, not unit, profits is the goal of the monopolist. Table 24-1 has an example of this,
in which unit profits are $32 at 4 units of output compared with $28 at the
profit-maximizing output of 5 units. Once again, quantity must be considered as well as
unit profit.
3. Unlike the purely competitive firm, the pure monopolist can continue to receive
economic profits in the long run. Although losses can occur in a pure monopoly in the
short run (P > AVC), the less-than-profitable monopolist will shutdown in the long run
(P > ATC). Figure 24-5 shows a short-run loss situation for a monopoly firm.
V.
Evaluation of the Economic Effects of a Monopoly
A. Price, output, and efficiency of resource allocation should be considered.
1. Monopolies will sell a smaller output and charge a higher price than would competitive
producers selling in the same market, i.e., assuming similar costs.
2. Monopoly price will exceed marginal cost, because it exceeds marginal revenue and the
monopolist produces where marginal revenue and marginal cost are equal. The
monopolist charges the price that consumers will pay for that output level.
3. Allocative efficiency is not achieved because price (what a product is worth to
consumers) is above marginal cost (opportunity cost of product). Ideally, output should
expand to a level where price = marginal revenue = marginal cost, but this will occur
only under pure competitive conditions where price = marginal revenue. (See Figure 246)
4. Productive efficiency is not achieved because the monopolist’s output is less than the
output at which average total cost is minimum.
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B. Income distribution is more unequal than it would be under a more competitive situation.
The effect of the monopoly power is to transfer income from consumers to business owners.
This will result in a redistribution of income in favor of higher-income business owners,
unless the buyers of monopoly products are wealthier than the monopoly owners.
C. Cost complications may lead to other conclusions.
1. Economies of scale may result in one or two firms operating in an industry experiencing
lower ATC than many competitive firms. These economies of scale may be the result of
spreading large initial capital cost over a large number of units of output (natural
monopoly) or, more recently, spreading product development costs over units of output,
and a greater specialization of inputs.
2. X-inefficiency may occur in monopoly since there is no competitive pressure to produce
at the minimum possible costs.
3. Rent-seeking behavior often occurs as monopolies seek to acquire or maintain
government-granted monopoly privileges. Such rent seeking may entail substantial costs
(lobbying, legal fees, public relations advertising, etc.), which are inefficient.
D. Technological progress and dynamic efficiency may occur in some monopolistic industries
but not in others. The evidence is mixed.
1. Some monopolies have shown little interest in technological progress.
2. On the other hand, research can lead to lower unit costs, which help monopolies as much
as any other type of firm. Also, research can help the monopoly maintain its barriers to
entry against new firms.
E. Assessment and policy options.
1. Although there are legitimate concerns about the effects of monopoly power on the
economy, monopoly power is not widespread. While research and technology may
strengthen monopoly power, over time it is likely to destroy a monopoly position.
2. When monopoly power is resulting in an adverse effect upon the economy, the
government may choose to intervene on a case-by-case basis.
VI.
Price discrimination occurs when a given product is sold at more than one price and the
price differences are not based on cost differences.
A. Conditions needed for successful price discrimination.
1. Monopoly power is needed with the ability to control output and price.
2. The firm must have the ability to segregate the market, to divide buyers into separate
classes that have a different willingness or ability to pay for the product (usually based
on differing elasticities of demand).
3. Buyers must be unable to resell the original product or service.
B. Examples of price discrimination.
1. Airlines charge higher fares to executive travelers (inelastic demand) than to vacation
travelers (elastic demand).
2. Electric utilities frequently segment their markets by end uses, such as lighting and
heating. (Lack of substitutes for lighting makes this demand inelastic).
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3. Long-distance phone service has higher rates during the day, when businesses must make
their calls (inelastic demand), and lower rates at night and on weekends, when less
important calls are made.
4. Movie theaters and golf courses vary their charges on the basis of time and age.
5. Discount coupons are a form of price discrimination, allowing firms to offer a discount
to price-sensitive customers.
6. International trade has examples of firms selling at different prices to customers in
different countries.
7. CONSIDER THIS … Price Discrimination at the Ballpark
C. Outcomes of price discrimination.
1. More profits can be earned by the seller, since the price charged is what each buyer is
willing to pay in perfect discrimination. The marginal revenue will be equal to price in
the perfect discrimination case. (See Figure 24-8.)
2. More production will occur with discrimination because as output expands, the reduced
price applies only to the additional unit sold and not to prior units. Marginal revenue can
now be equated to marginal cost to find the profit-maximizing level of output, and price
of the last unit sold will equal that marginal revenue. End-of-chapter questions 5 and 6
allow comparison of the outcomes in nondiscriminating and discriminating cases.
VII.
Regulated Monopoly
A. This occurs where a natural monopoly or economies of scale make having one firm desirable.
B. As a result of changes in technology and deregulation in the local telephone and the
electricity-providers industry, some states are allowing new entrants to compete in previously
regulated markets.
C. In those markets that are still regulated, a regulatory commission may attempt to establish the
legal price for the monopolist that is equal to marginal cost at the quantity of output chosen.
This is called the “socially optimal price.”
C. However, setting price equal to marginal cost may cause losses, because public utilities must
invest in enough fixed plant to handle peak loads. Much of this fixed plant goes unused most
of the time, and a price = marginal cost would be below average total cost. Regulators often
choose a price equal to average cost rather than marginal cost, so that the monopoly firm can
achieve a “fair return” and avoid losses. (Recall that average-total cost includes an
allowance for a normal or “fair” profit.)
D. The dilemma for regulators is whether to choose a socially optimal price, where P = MC, or a
fair-return price, where P = AC. P = MC is most efficient but may result in losses for the
monopoly firm, and government then would have to subsidize the firm for it to survive. P =
AC does not achieve allocative efficiency, but does ensure a fair return (normal profit) for
the firm. (Key Question 11)
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