The Economics of Monopoly Power
 The US justice department filed antitrust charges against
Microsoft. In 2000 the court declared that Microsoft was a
monopoly.
 In 2008, the European Commission sent Intel Corp. a new set
of antitrust charges for abuse of dominant position with the
goal of excluding its main rival from the x86 central processing
units market
 Antitrust charges against Starbucks for lease agreement that
excludes competitors from occupying the same building
 Antitrust charges have been filed against big corporations like
Wal-Mart, Toys R Us, Apple and AT&T
 A significant percentage of innovations produced by
firms with monopoly power.
 Regulation of big firms imposes costs on society
 Diminished incentives to innovate
 Big governments
Objective
Develop an economic basis for
analyzing
O The economic performance of businesses with
monopoly power
O Prices in monopoly markets vs. perfect
competitive markets
O Welfare implications of monopoly behavior
Economics of Monopoly Power
 Monopoly market: is a market where there is a single seller of a good or a
service that has no close substitute
 Monopoly power of a firm refers to the extent of its control over the supply
of the product produced by the industry
 The larger the output of the firm relative to the industry’s, the greater its monopoly power
 Relative not absolute size
Monopoly Power
Price
• Assume 4 firms
• If one firm reduces its output,
it can raise the market price
• Max price P3
• Only if own output is zero
• If 100 firms instead, the power
to raise price would be much
less
P3
P4
Demand
0
Q3
Q4
Quantity
Market Concentration
 Economists use concentration ratios to measure the degree of monopoly
power in imperfect competitive markets.
 Four-firm concentration ratio measures the percentage of total output
produced by the largest four firms.
Quantifying Market Power
Industry
Concentration Ratio
Cigarettes
97.8
Breweries
89.5
Primary Aluminum
85.3
Cereal Breakfast Food
80.4
Aircraft
74.3
Automobile
67.6
Soap and Other Detergent
67.1
Snack Foods
53.2
Cement
40.8
Output and Prices: PC markets
 A Competitive Firm
Is one of many producers
Faces a horizontal demand curve
Is a price taker
Sells as much or as little at same price
 The firm has no control over the market price
Output and Prices: PC markets
(a) An individual Firm
(b) Market Supply
Price
Price
S
MC
ATC
P*
D
0
q
Quantity (firm)
0
Quantity (market)
Q*
(=n x q)
Welfare Implications: Allocative Efficiency
Is Q* Efficient?
(b) Market Supply
Price
 The
PC market
produces a quantity
where MSB equals
MSC.
 The PC market
achieves allocative
Efficiency.
S
MSC
D
MSB
0
Quantity (market)
Q*
(=n x q)
Welfare Implications: Production Efficiency
Is Q* Efficient?
(a) An individual Firm
 Firms
are making zero
economic profit.
Price
MC
 Firms
produce at the
lowest possible unit cost,
i.e. firms are operating at
their efficient scale.
ATC
P*
0
 PC
market achieves
production efficiency
q
Quantity (firm)
Output and Prices: Monopoly markets
 A Monopoly Firm
Is a single seller in the market
Has no close substitute to its product
Faces a downward sloping demand curve
Is a price maker
Can lower or raise price by changing the amount it
sells
Monopoly:
Output
and
Price
Price
MC
Monopoly
price
Marginal
Revenue
(MPB)
0
Monopoly
quantity
Demand
(MSB)
Quantity
ThePriceInefficiency of Monopoly
Deadweight
loss
MSC
Monopoly
price
Allocative
Efficiency
Marginal
Revenue
(MPB)
0
Monopoly Efficient
quantity quantity
Demand
MSB
Quantity
PRICE DISCRIMINATION
 Price discrimination is the practice of charging different prices to different
customers for essentially the same good or service
 In order to price discriminate, the firm must have some market power.
The Analytics of Price Discrimination
 Two important effects of price discrimination:
 It can increase the monopolist’s profits.
 It can reduce deadweight loss.
Perfect Price Discrimination
 Perfect (first degree) Price Discrimination
 The monopolist knows the willingness to pay of each buyer
 identical goods are sold at different prices to each buyer based on his willingness to pay.
Welfare with and without Price Discrimination
(a) Monopolist with Single Price
Price
Consumer
surplus
Deadweight
loss
Monopoly
price
Profit
Marginal cost
Marginal
revenue
0
Quantity sold
Demand
Quantity
Welfare with and without Price Discrimination
(b) Monopolist with Perfect Price Discrimination
Price
Every consumer gets charged a different
price -- the highest price they are willing
to pay -- so in this special case, the
demand curve is also MR!
Consumer surplus and
deadweight loss have both been
converted into profit.
Profit
Marginal cost
Demand
Marginal revenue
0
Quantity sold
Quantity
Examples of Perfect Price Discrimination
You can see this type of price discrimination in
the sale of both new and used cars. People will
pay different prices for cars with identical
features, and the salesperson must attempt to
gauge the maximum price at which the car can
be sold.
 This type of price discrimination
often includes a bargaining
aspect, where the consumer
attempts to negotiate the price.

Second-degree price discrimination

In many situations the firm
 does not know the willingness to pay of
each buyer, and
 cannot sell identical units of the good at
different prices
Second-degree price discrimination
Hurdle Pricing:
 Firm puts a “hurdle” to sort the different types
of consumers
 Self selection: a certain type of consumers will
go through the hurdle. Ideally that is the low
willingness to pay type.
 Those who go through the hurdle get the
lowest price
Examples of Second-Degree Price
Discrimination
Bulk discounts: a reduced price may be offered
if you buy two t-shirts instead of just one. (e.g.,
1/$6.99 or 2/$10)
 Small vs. Large cup of coffee
 Airline Tickets
 Discount coupons

8 oz
$1.5
16 oz
$1.79
Are profits higher with price discrimination?
 A bookseller knows that there are two groups of people willing
to buy a given book.
 high demand group is willing to pay $50, low demand group
is willing to pay $20
 There are 100 people in each group
 The cost of each book is zero (for simplicity)
 What pricing strategy (single pricing vs. price
discriminations)? What hurdle? Higher Profits? Efficiency?
Third Degree Price Discrimination
 Different groups of consumers that are easily identifiable
 Seller can identify which group the consumer belongs to
 The seller knows the demand of each group but not the WTP of each
individual
Third Degree Price Discrimination in the Market
for Movie Tickets
(b) Demand by people below age 60
(b) Senior citizen demand
Pric
e
P1
The relative prices charged
will depend on the price
elasticity of demand in
each market: P 1  1 
1
P2

2
1 1
1
P2
Marginal cost
Demand
Demand
M
R
MR
Q1
Q2
Entry Barriers
 As an industry realizes economic profit, new firms
enter the market hoping to realize the above average
rate of return.
 Entry helps to allocate resources among industries
 Attempts to deter entry or exit in an industry would
create a misallocation of resources.
Entry Barriers
 Sometimes the process of entry is impeded resulting in imperfect
competitive market structures
 The impediments may be raised by firms already in the market who have an
interest in keeping prices high
Private Barriers
Arise from the nature of the market or the actions of participant:
 Ownership of a key resource
 The threat to fight new entrants by lowering prices
Private Barriers
Arise from the nature of the market or the actions of participant:
 Product differentiation and offering a large variety
 Network economies: value of the product is enhanced by increased adoption
 Economies of scale: average cost decline with production. A single producer is more
efficient than a large number of producers.
Government-Created Monopolies
 Governments may restrict entry by giving a single firm the exclusive right to
sell a particular good in certain markets.
 Patent and copyright laws are two important examples of how government
creates a monopoly to serve the public interest.
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 cost than could two or more firms.
 A natural monopoly arises when there are economies of scale over the
relevant range of output.
 Examples: water services and electricity. It is very expensive to build
transmission networks (water/gas pipelines, electricity and telephone lines),
therefore it is unlikely that a potential competitor would be willing to make
the capital investment needed to even enter the monopolists market
Natural Monopoly: One is Better than Two!
Cost
With two firms, each produces 20
units and average cost rises to
$7/unit
Suppose 40 units can be sold. A
monopoly firm produces 40 units at
a cost of $5/unit
7
5
Average
total
cost
0
20
40
Quantity of Output
Natural Monopoly:…But One is A Monopoly!
Cost
While it is desirable to have a
single firm, the monopolist
does not produce the socially
optimum output level since
P>MR=MC
ATC
MR
0
Q monopoly
P
Q optimum
MC
Quantity
Natural Monopoly
Cost
Regulation: Requiring the
firm to produce the optimum
output level results in losses
since ATC>MC=P
ATC
P
0
20
Q optimum
MC
Quantity
The Exception: Natural Monopoly
 Since economies of scale exist, it is not socially desirable to promote
competition
 Requiring a firm to produce the socially optimal amount results in economic
losses
 However, the free operation of the market with a monopoly firm does not
result in the socially optimal level of output
How can the government regulate this market?