Monopoly
ECO 230
J.F. O’Connor
Market Structure
• Perfect Competition
– participants act as price takers and cannot by
individual behavior affect market outcome
• Imperfect Competition
– An individual firm has some degree of control
over the price for its good
– If it increases price, it does not lose all its
customers
Forms of Imperfect
Competition
• Monopoly
– A firm that’s the only supplier of a unique product with
no close substitutes
• Oligopolist
– A firm that produces a product for which only a few
rival firms produce close substitutes
• Monopolistically competitive firm
– One of a large number of firms that produce slightly
differentiated products that are reasonably close
substitutes for one another
Understanding Monopoly
•
•
•
•
•
Bases for monopoly
Profit maximization for a monopolist
Social efficiency of monopoly
Regulation of monopoly
Pricing strategies
Bases for Monopoly
• Economies to scale relative to the size of the
market
• Transmission and transportation networks
• Control of an input
• Patent
• Copyright
• Exclusive franchise from government
• Legal cartel
Examples of Monopoly
• One grocery store, one bakery or a funeral
home in a small town
• Telephone, electricity, water firm
• Alcoa, Picasso,
• Drugs, Roundup
• Stephen King
• Pepsi on campus
• Baseball
Returns to Scale
• Constant returns to scale
– When all inputs are changed by a given
proportion and output changes by the same
proportion
• Increasing returns to scale
– When all inputs are changed by a given
proportion and output changes by a higher
proportion
– Also know as Economies of Scale
Economies of Scale
• With Economies of Scale
– Average total cost of production falls as output
increases
– There are high start-up costs
– There are low marginal costs
Profit Maximization
• Key is to understand that under simple
monopoly, where there is one price for all
units, selling an additional unit requires
lowering the price of all units sold.
Therefore, marginal revenue (MB of selling
another unit) is less than the price received
for the unit. A monopolist faces the market
demand curve.
Profit Maximization
• AK Water Co. has a monopoly on the
supply in a region
• Fixed cost is $20
• Average variable cost is $4 per unit and
therefore, MC =$4
• Problem is to decide on the profit
maximizing level of output
Revenue,Cost, & Profit
Price Quantity
20
0
18
1
16
2
14
3
12
4
10
5
8
6
6
7
4
8
2
9
0
10
TR(Q) TVC(Q)
0
0
18
4
32
8
42
12
48
16
50
20
48
24
42
28
32
32
18
36
0
40
FCTC(Q) Profit
20
20
-20
20
24
-6
20
28
4
20
32
10
20
36
12
20
40
10
20
44
4
20
48
-6
20
52
-20
20
56
-38
20
60
-60
Profit Maximizing Output
• Looking at the table, TR is price time
quantity, TC is Total Variable Cost + FC,
and Profit is TR – TC.
• At output of 4, profit is a maximum, $12.
• Total revenue and total cost are are graphed
in the next slide. Profit at any given level of
output is the vertical difference between the
two, which is greatest at output of 4.
Total Revenue and Cost
60
TC
50
40
Dollars
TR
30
20
10
0
0
1
2
3
4
5
Quantity
6
7
8
9
10
Marginal Analysis
• Instead of looking at total revenue and total
cost, one can look at profit maximization in
per unit terms.
• Compare addition to revenue (MR) with
addition to cost (MC) from changing output.
Per Unit Data
Q
0
1
2
3
4
5
6
7
8
9
10
AR(Q)
20
18
16
14
12
10
8
6
4
2
0
TR(Q)
0
18
32
42
48
50
48
42
32
18
0
MR(Q)
18
14
10
6
2
-2
-6
-10
-14
-18
MR'
20
16
12
8
4
0
-4
-8
-12
-16
AVC=MC ATC(Q)
4
4
24.00
4
14.00
4
10.67
4
9.00
4
8.00
4
7.33
4
6.86
4
6.50
4
6.22
4
6.00
Average and Marginal Revenue
20
18
AR
16
14
12
$/unit
10
MR
8
6
4
2
0
-2
-4
0
1
2
3
4
5
Quantity
6
7
8
9
10
Unit Curves
20
18
16
ATC
14
12
AR
$/unit
10
8
6
MC=AVC
4
2
0
-2
-4
0
1
2
3
4
5
Quantity
MR
6
7
8
9
10
Profit Maximizing Conditions
• Find the output at which
marginal revenue = marginal cost
• On the demand curve, find the price at
which the output can be sold.
• Check to see that P is greater than AVC
• Compute economic profit, [P-ATC(q)]q
Some Comments
• Having a monopoly allows you to set price
but not quantity. Buyers decide on quantity.
• A monopoly does not guarantee an
economic profit or even covering of
variable costs. Note that many patents have
never been exercised.
• Some monopolists have positively sloped
marginal cost curves (see text)
Social Inefficiency of Monopoly
• One condition for an efficient allocation of
resources is that the valuation of the
marginal unit to the consumer (price) equal
the opportunity cost of producing it
(marginal cost)
• Under monopoly, P> MR=MC. Hence the
allocation is socially inefficient. In our
example, the value of the marginal unit is
$12 while the marginal cost is only $4.
The Social Cost of Monopoly
• We can use our graph to measure the social
cost or deadweight loss because of
monopoly
• The socially efficient outcome is 8 units at a
price of $4, Price = MC
• The social cost is the area under the demand
curve from 4 to 8 units and above the MC,
namely, .5(12-4)(8-4) = $16
Measuring the Social Cost of
Monopoly
20
18
16
ATC
14
12
AR
$/unit
10
8
6
MC=AVC
4
2
0
-2
-4
0
1
2
3
4
5
Quantity
MR
6
7
8
9
10
Why Do We Grant Monopoly?
• To take advantage of economies of scale
• To encourage innovation in art, science, and
literature
• In return for granting a monopoly that takes
advantage of economies to scale, society
reserves the right to regulate the price
charged by the monopolist.
Regulation of Monopoly
• Socially Efficient Regulation
– Set a price ceiling at AR=MC and pay a lumpsum subsidy to the monopolist to ensure zero
economic profit.
• Fair Rate of Return Regulation
– Set a price ceiling where AR=ATC. This
ensures zero economic profit but output is less
than socially efficient. It may be close enough.
• Public Ownership
Current Developments
• Electricity, natural gas, telephone, cable
• Airlines
• Privatization of state monopolies
Price Discrimination
• A monopolist can sometimes increase profit
by charging different prices to different
customers or for different units.
• Charging different prices for the same good
is called price discrimination.
• Price discrimination is illegal in the U.S.!
Kinds of Price Discrimination
• Third degree – separate buyers into two or
more markets. E.g. movie theaters, ailines
• Quantity discounts – electric utility
• Perfect or first degree price discrimination –
charge the reservation price for each unit -
Third Degree
• Firm produces a product with essentially
zero marginal cost
• Two possible markets, one high priced, one
low priced
One Price
Market 1
Price
Quantity
40
35
30
25
20
15
10
5
0
0
500
1000
1500
2000
2500
3000
3500
4000
Market 2
Price
10
5
0
Quantity
0
2000
4000
TR
0
17500
30000
37500
40000
37500
30000
27500
0
• If the firm charges one price for all units, it
will maximize total revenue, and in this
case, profit by selling 2,000 units at $20 per
unit.
• Note that it does not sell in the second
market.
• If the buyers can be separated, it could sell
another 2,000 in the second market at $5
and add $10,000 to revenue and profit.