8
Monopoly
Definition of Monopoly


Market: A monopoly is an industry in which
there is only one firm (seller).
Firm: A firm is considered a monopolist if . . .


it is the only seller of its product.
its product does not have close substitutes.
Why Do Monopolies Arise?

Why is there only one firm in the market?
Because there are barriers to entry in the
market.
Why Do Monopolies Arise?

Barriers to entry have three sources:
1.
Government restricts entry by giving a
single firm the exclusive right to sell a
particular good, service, idea


Land phone service is given to Türk Telekom, postal
services given to PTT, natural gas given to İGDAŞ,
tap water to İSKİ in İstanbul.
Patents, copyrights, intellectual property rights.
Government-Created Monopolies


Patents, copyrights and intellectual property
rights laws creates a monopoly to increase social
welfare. Purpose is to encourage research and
development. If there were no such laws, then it
would be free to copy inventions (ideas, films,
books, formulas...), then nobody does research &
development.
Ex: Aspirin is patented to Bayer for 5 years and no
other firm can use the same formula without
purchasing patent rights during 5 years. After 5
years, “generic drugs” can sell the same formula.
Why Do Monopolies Arise?
2.
Natural Monopoly:


Cost structure of production make a single producer
more efficient than multiple producers.
Natural monopolies arise when there are very large
fixed costs but low marginal costs.
Ex: High technology products, research&
development, inventions (Ex:light bulb,
microwave oven), software, energy, telecom,
etc.
“İSKİ” and tap water production, Türk Telekom
(Cable TV & Land Phones), Tüpraş, İGDAŞ
(Natural Gas Distributor), etc.
Natural Monopolies

An industry is a natural monopoly when a
single firm can supply a good or service to an
entire market at a smaller average cost than
can two or more firms. (i.e. when there are
economies of scale over the entire market
size)
Figure 1 Economies of Scale as a Cause of Monopoly
Cost
Average
total
cost
0
Quantity of Output
Copyright © 2004 South-Western
Why Do Monopolies Arise?
3.
Ownership of a key resource:
Diamonds (De Beers), Hazelnuts & Boraks
(Turkey as a country), İGDAŞ (Natural Gas
Distributor), etc.
How Does a Monopolist Choose its Quantity
and its Price?

Monopoly versus Competition

Monopoly




Is the sole producer
Faces a downward-sloping demand curve
Has market power (power to choose the price).
Competitive Firm



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Is one of many producers
Faces a horizontal demand curve
Is a price taker
Can sell much or little at the same price
Property of a Monopoly

While a competitive firm is a price taker, a
monopoly firm is a price maker. Monopolist
can choose its own price. Does this mean
that it chooses the maximum possible price?
No.
Figure 2 Demand Curves for Competitive and Monopoly Firms
(a) A Competitive Firm’s Demand Curve
Price
(b) A Monopolist’s Demand Curve
Price
Demand
Demand
0
Quantity of Output
0
Quantity of Output
Copyright © 2004 South-Western
A Monopoly’s Revenue



Total Revenue
P  Q = TR
Average Revenue
TR/Q = AR = P
Marginal Revenue
DTR/DQ = MR
Table 1 A Monopoly’s Total, Average,
and Marginal Revenue
Copyright©2004 South-Western
Figure 3 Demand and Marginal-Revenue Curves for a Monopoly
Price
$11
10
9
8
7
6
5
4
3
2
1
0
–1
–2
–3
–4
Demand
(average
revenue)
Marginal
revenue
1
2
3
4
5
6
7
8
Quantity of Water
Copyright © 2004 South-Western
A Monopoly’s Revenue

A Monopoly’s Marginal Revenue

A monopolist’s marginal revenue is always less
than the price of its good.


The demand curve is downward sloping.
When a monopoly drops the price to sell one more unit,
the revenue received from all previously sold units also
decreases.
How Does a Monopolist Choose its
Quantity and its Price?


A monopolist maximizes profit by producing
the quantity at which marginal revenue
equals marginal cost.
After choosing optimal qty, monopolist uses
the demand curve to find the price of the
good. At that price, consumers will buy the
optimal quantity that maximizes firm’s profit.
Figure 4 Profit Maximization for a Monopoly
Costs and
Revenue
2. . . . and then the demand
curve shows the price
consistent with this quantity.
B
Monopoly
price
1. The intersection of the
marginal-revenue curve
and the marginal-cost
curve determines the
profit-maximizing
quantity . . .
Average total cost
A
Demand
Marginal
cost
Marginal revenue
0
Q
QMAX
Q
Quantity
Copyright © 2004 South-Western
How Does a Monopolist Choose its Quantity
and its Price?

Comparing Monopoly and Competition


For a competitive firm, price equals marginal cost.
P = MR = MC
For a monopoly firm, price exceeds marginal cost.
P > MR = MC
A Monopoly’s Profit

Profit equals total revenue minus total costs.



Profit = TR - TC
Profit = (TR/Q - TC/Q)  Q
Profit = (P - ATC)  Q
Figure 5 The Monopolist’s Profit
Costs and
Revenue
Marginal cost
Monopoly E
price
B
Monopoly
profit
Average
total D
cost
Average total cost
C
Demand
Marginal revenue
0
QMAX
Quantity
Copyright © 2004 South-Western
A Monopolist’s Profit

The monopolist will receive economic profits
as long as price is greater than average total
cost.
Figure 6 The Market for Drugs
Costs and
Revenue
Price
during
patent life
Price after
patent
expires
Marginal
cost
Marginal
revenue
0
Monopoly
quantity
Competitive
quantity
Demand
Quantity
Copyright © 2004 South-Western
THE WELFARE COST OF
MONOPOLY


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In contrast to a competitive firm, the
monopoly charges a price above the marginal
cost.
From the perspective of consumers, this high
price makes monopoly undesirable.
However, from the perspective of the firm, the
high price makes monopoly very desirable.
Figure 7 The Efficient Level of Output
Price
Marginal cost
Value
to
buyers
Cost
to
monopolist
Value
to
buyers
Cost
to
monopolist
Demand
(value to buyers)
Quantity
0
Value to buyers
is greater than
cost to seller.
Value to buyers
is less than
cost to seller.
Efficient
quantity
Copyright © 2004 South-Western
The Deadweight Loss

Because a monopoly sets its price above
marginal cost, it places a difference between
the consumer’s marginal benefit and the
producer’s marginal cost.

This difference causes the quantity sold to be less
than the socially optimal qty where MB=MC.
Figure 8 The Inefficiency of Monopoly
Price
Deadweight
loss
Marginal cost
Monopoly
price
Marginal
revenue
0
Monopoly Efficient
quantity quantity
Demand
Quantity
Copyright © 2004 South-Western
The Deadweight Loss of Monopoly

The Inefficiency of Monopoly


The monopolist produces less than the socially
efficient quantity of output AND
Charges a price that is greater than socially
efficient MC.
PUBLIC POLICY TOWARD
MONOPOLIES

Government responds to the problem of
monopoly in one of four ways.


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Making monopolized industries more competitive.
Regulating the behavior of monopolies: control
price.
Turning some private monopolies into public
enterprises.
Doing nothing at all.
Increasing Competition with Antitrust Laws


Antitrust laws aim to decrease monopoly power.
Antitrust laws give government various ways to
increase competition. If necessary,
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They allow government to prevent mergers.
They allow government to break up companies.
They prevent companies from performing activities that
make markets less competitive:
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Predatory pricing. Large firm prevents other firms from
entering the market by setting a very low price.
Collusion: firms get together and arrange prices and share the
market. Ex: OPEC, intercity travel companies.
Regulation

Government may regulate the prices that the
monopoly charges.

The allocation of resources will be efficient if price
is set to equal marginal cost.
Figure 9 Marginal-Cost Pricing for a Natural Monopoly
Price
Average total
cost
Regulated
price
Loss
Average total cost
Marginal cost
Demand
0
Quantity
Copyright © 2004 South-Western
Govt. Policy Against Monopoly


In practice, regulators allow monopolists to
make some positive profits by allowing
price>MC. This is because if price is forced to
be equal to MC in a natural monopoly, profit
is always negative and the firm cannot
survive.
Ex: research & development, new ideas.
Price of Stata is $500 but MC is only $20, but
initial research effort is $1million.
Public Ownership

Rather than regulating a natural monopoly
that is run by a private firm, the government
can run the monopoly itself (Ex: in the US
and in Turkey, government runs the Postal
Service. In Turkey, government runs the
distribution of natural gas).
PRICE DISCRIMINATION

Price discrimination is the business practice
of selling the same good at different prices to
different customers, even though the costs
for producing for the two customers are the
same.
PRICE DISCRIMINATION

Price discrimination is not possible when a good
is sold in a competitive market since there are
many firms all selling at the market price. In
order to price discriminate, the firm must have
some market power.

Perfect Price Discrimination

Perfect price discrimination takes place when the
monopolist knows exactly the marginal benefit
(willingness to pay) of each customer and can
charge each buyer a different price equal to that
buyer’s willingness to pay.
PRICE DISCRIMINATION

Three important effects of price
discrimination: Show on graph:



It increases the monopolist’s producer surplus.
It decreases consumer surplus.
It decreases deadweight loss, therefore increases
total surplus of the society.
PRICE DISCRIMINATION

Examples of Price Discrimination

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Movie tickets
Airline prices
Discount coupons
New publications: novels, films, etc.
Financial aid
Quantity discounts
CONCLUSION: THE
PREVALENCE OF MONOPOLY

How prevalent are the problems of
monopolies?

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Monopolies are common.
Most firms have some control over their prices
because of differentiated products.
Firms with substantial monopoly power are rare.
Few goods are truly unique. There are usually
substitutes, but they may be poor substitutes. Ex:
natural gas. Substitute?