Why Are There Monopolies?
Q: What about a market causes there to be only one firm in operation?
A: Several possible factors. First, a firm could control a key resource needed for the production of a good.
For example, there can be only one dam at any point along a river, so whoever owns the dam will have a
monopoly on the production of hydroelectric power there. Second, the government could mandate that only
one firm will operate in a market. This is true with respect to mail delivery. Only the U.S. Postal Service (a
government monopoly) can deliver mail into your mailbox. Other firms can deliver packages to your door,
but not to your mailbox. Finally, economies of scale in production may dictate that one large firm is the most
efficient way to provide a product. This situation is called natural monopoly.
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The Monopolist's Demand Curve
A monopoly is a firm that is the only seller of a product with no close substitutes. Because of this, the
demand curve for a monopolist's product is the same as the entire market demand curve for the product.
Therefore, when economists depict a monopoly firm in a graph, the demand curve will be downward sloping,
and will look just like the entire market demand curve for the product.
Contrast the monopolist's demand curve with the demand curve facing the firm selling in a competitive
market. Competitive firms exist in a market with many firms selling products that are very close substitutes
for each other. As such, competitive firms are price takers. Because of this, economists draw the demand
curve for a competitive firm's product as a horizontal line at the market price.
The demand curves for monopolies and competitive firms are shown in the figure below.
Monopoly Profit Maximization
Q: How do monopolists maximize profits?
A: By producing where MR = MC.
As with competitive firms, the monopolist will maximize its profit by producing where MR = MC (shown in
bold in Table 1). What is different in a monopoly market is that there is no entry or exit of firms to drive
away economic profits in the long run. The situation from Table 1 is depicted in the figure below. Notice that
the monopolist is making economic profits (profits above the firm's ATC curve). Because there is no
competition in the market, the monopolist will continue to make these profits in the long run.
Notice in the figure below that the size of the gray area (profits) is equal to $10. The height of the area is $2.5
($13 - $10.5) and the base is 4 units. $2.5/unit times 4 units is equal to the $10 profit from Table 1.
Social Costs of Monopoly
Because of the market power of monopolists, the equilibrium in a monopoly market yields less output of the
product, which is sold at a higher price than in a competitive market. In the graph of the monopoly
equilibrium (see above), the equilibrium for a competitive market is also shown. You can find the competitive
equilibrium where the marginal cost (MC) curve intersects both the average total cost (ATC) curve and the
demand curve. This is the only point on the MC curve where the competitive firms will make zero economic
profits.
Q: What are the costs to society of having a monopoly firm?
A: The deadweight loss (shown in red in the graph above) is the cost to society. The red area represents
consumer and producer surplus that exists in the competitive equilibrium, but is not gained by anybody since
the monopolist restricts its output to only four units.
Public Policy and Monopoly
Public policy towards monopoly is geared towards making the monopolist produce the socially desirable
quantity of output. Your textbook details four possible policies:
1.
Antitrust laws – antitrust law outlaws business activities that restrain trade and reduce competition
in the market place. If monopolists behave in uncompetitive ways, the government can take the
monopolist to court and force the firm to act competitively. Further, the government can use
antitrust law in deciding whether or not to allow mergers between large firms in the same industry.
2.
Regulation – Regulation is a common solution to the problem of natural monopolies, where it is
normally not efficient to create competition among many small firms (recall that natural monopoly
3.
4.
results from economies of scale in production). In the case of regulation, the government (or a
regulatory agency) tells the monopolist what price they can charge. There are two primary options for
regulatory pricing:
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Marginal cost pricing – if the government forces the firm to produce where P = MC, the firm
will produce the socially desirable quantity of output with no deadweight loss. There is,
however one problem, which is illustrated in Figure 15-9 in your textbook. Because natural
monopolies have declining average costs, marginal cost pricing will force the firm to lose
money. As a result, the firm will either have to be subsidized or allowed to charge a price
slightly above marginal cost (but this leads to a deadweight loss).
*
Average cost pricing – the government could force the firm to produce where P = AC, and the
firm will break even. However, since MC < AC for a natural monopoly (again, see Figure 159 in your textbook), the firm will not produce the socially desirable quantity of output.
Public ownership – the government could choose to take over the firm and run the firm itself. This
is the case with the U.S. Postal Service. An obvious downside to public ownership of monopolies is
that government bureaucrats may not have the same incentives for running an efficient firm that
private, profit-maximizing owners have.
Do nothing – the government can choose to do nothing about the monopoly. Since each of the first
three options have their own drawbacks, doing nothing may be the best choice for society.
Monopolists and Price Discrimination
Price discrimination is the business practice of selling the same good at different prices to different
customers. If monopolists could charge every customer a price equal to the customer's willingness to pay,
consumer surplus could be reduced to zero, and the monopolist would make the largest possible profit (this
is depicted in your textbook in Figure 15-10).
Q: Why do monopolists price discriminate?
A: Because they make larger profits if they do.
Q: What does price discrimination do to economic welfare?
A: Perfect price discrimination (as depicted in Figure 15-10) reduces consumer surplus to zero, but is also
socially optimal - total surplus is maximized. Imperfect price discrimination (which is quite common) can
either raise or lower total surplus in a market, but it definitely increases the monopolists profit. If it didn't
increase profits, the monopolist would not do it. Movie tickets, airline prices, discount coupons, financial aid,
and quantity discounts are examples of price discrimination in our economy.