Lecture 11: Monopoly
Readings: Chapter 13
Monopoly
 Q: How realistic is the perfectly competitive
model of supply?
 A: Very few industries have firms that resemble
the price taking small producers of the perfect
competitive model.
 Q: Is the model of perfect competition wrong?
 A: All models are wrong in the literal sense. The
important question is whether the model is
useful.
Monopoly
 Q: In what sense is the model of supply under
perfect competition useful?
 A: There are a number of general insights:

Firms maximize profits by setting output
strategies where the MR=MC.

Losses cause exit and shift the supply
curve to the left over the long run.

Profits cause entry and shift supply to the
right over the long run.
Monopoly
 Q: Does the model of perfect competition fail?
 A: The model does not explain:

Pricing strategies in industries with few
competitors?

Non-price strategies (advertising, product
differentiation, R&D, etc.)

Strategic interdependence between firms.
Monopoly
 Q: How can we get a better understanding of
pricing strategies?
 A: The simplest model that investigates pricing
strategy is the model of a monopoly supplier.
 Monopoly will be our starting point from which
we will proceed to a more detailed and complete
understanding of the theory of supply.
Monopoly
 Q: What is a monopoly?
 A: A Monopoly is an industry with one supplier of a
product with no close substitutes.
 Q: When do monopolies occur?
 A: Whenever there are barriers to entry.

Legal Monopolies (public franchise,
government license, patent, or copyright)

Natural Monopoly (IRS)
The Theory of Supply - Monopoly
 Q: What is the simplest type of monopoly?
 A: A Single-price monopoly charges same price
for every unit of output.
 Q: How is the single price monopoly’s problem
different from the perfectly competitive firm’s
problem?
 A: In addition to deciding how much to produce,
the single price monopoly must decide what
price to charge for its good.
continued
The Theory of Supply - Monopoly
 Q: Why can’t a firm in a perfectly industry
choose the price it sells its good for?
 A: Because suppliers in a competitive industry
can sell as much as they want at the market
price, but cannot sell even one unit at any price
above the market price. (eg. Wheat farmer)
 For a firm in a competitive industry, P = MR = AR
= firm’s demand curve.
 A monopolist can choose the price it sells at.
Monopoly
 Q: What is the monopolist’s MR?
 A: Consider the problem of selling one more unit.
To do so, the monopolist must lower the price on
all units. This creates two impacts on revenue:

For those goods already being sold revenue
falls because of the lower price per unit.

The lower price also increases sales which
increases revenue.
 The total impact is illustrated in the next diagram.
Monopoly
 Figure 13.2 illustrates
the relationship
between price and
marginal revenue and
derives the marginal
revenue curve.
 Suppose the monopoly
sets a price of $16 and
sells 2 units.
Monopoly

Now suppose the firm cuts the
price to $14 to sell 3 units.

It loses $4 of total revenue
on the 2 units it was selling
at $16 each.

And it gains $14 of total
revenue on the 3rd unit.

So total revenue
increases by $10, which is
marginal revenue.
Monopoly
 The marginal revenue
curve, MR, passes
through the red dot
midway between 2 and
3 units and at $10.
 Notice that MR < P at
each quantity.
Monopoly
 A single-price
monopoly’s marginal
revenue is related to
the elasticity of
demand for its good:
 If demand is elastic, a
fall in price brings an
increase in total
revenue.
Monopoly

The increase in revenue
from the increase in
quantity sold outweighs the
decrease in revenue from
the lower price per unit, and
MR is positive.

As the price falls, total
revenue increases.
Monopoly

If demand is inelastic, a fall
in price brings a decrease in
total revenue.

The rise in revenue from the
increase in quantity sold is
outweighed by the fall in
revenue from the lower price
per unit, and MR is negative.
Monopoly
 As the price falls,
total revenue
decreases.
Monopoly

If demand is unit elastic, a fall
in price does not change total
revenue.

The rise in revenue from the
increase in quantity sold
equals the fall in revenue
from the lower price per unit,
and MR = 0.

Total revenue is maximized
when MR = 0.
Monopoly
 Surprising Implication: A Monopoly will
always choose an output strategy where
Demand Is Elastic

A single-price monopoly never produces an
output at which demand is inelastic.

If it did produce such an output, the firm
could increase total revenue, decrease total
cost, and increase economic profit by
decreasing output.
Monopoly
 Q: Does the monopoly choose a price that
maximizes revenue for the firm?
 A: No! The monopoly must maximize profits to
satisfy its owners.
 Q: What is the profit maximizing monopolist’s
best strategy?
 A: Choose Q where π = TR - TC, and then set
the maximum price that will sell precisely this
many units of their output.
Monopoly
 The profit-maximizing
choice of a single-price
monopoly is Q=3,
where total revenue
minus total cost is
maximized
Monopoly
 Q: What if the managers of monopoly do not
know the TR or TC curves. What will they do?
 A: Follow the marginal algorithm for finding the
optimal strategy.

Increase Q if MR>MC

Decrease Q if MR<MC

Q is best when MR = MC
Monopoly
 Q: What does such a strategy look like?
 A: We can merge the market demand curve with
the firm’s average and total cost curves.

This is possible because a monopoly firm’s
demand is the full market demand.
Monopoly
 The firm chooses Q=3 where MR = MC and sets
the price at which it can sell that quantity.
 The ATC curve tells us
the average total cost.
 Economic profit is the
profit per unit
multiplied by the
quantity produced—
the blue rectangle.
Monopoly
TC
TR
TR,
(a) Total revenue TC
42
and total cost
Economic
profit $12
30
(b) Demand,
P
marginal revenue,
marginal cost, and
average cost
0
20
Q
3
MC
Economic
ATC profit $12
14
10
0
Copyright © 1997 Addison-Wesley Publishers Ltd.
MR
3
D
Q
Textbook p. 266
Monopoly
 Q: What does this model tell us about monopoly
supply behaviour?
 A: There are several interesting characteristics
of monopoly supply:

A monopoly never operates in the inelastic
range of the demand curve.

A monopoly has no supply curve.

Monopolistic firms make economic profits,
even in long run, because barriers prevent
entry new firms.
Monopoly
 Q: What is missing from this analysis of
monopoly supply behaviour?
 A: Monopolists only rarely charge a single price
for there product. It is more usual for
monopolists to price discriminate.
 Q: What is price discrimination?
 A: Charging different customers different prices,
for the same good.
Monopoly
 Q: Why price discrimination?
 A: Price discrimination increasing profits by
identifying who will pay more than the current
monopoly price, and charging them a higher
price. It isn’t just monopolists who benefit from
price discrimination. Examples include:

Airline ticket pricing

Declining block pricing for electricity.

Long-Distance Telephone rates.
 Next Page: Three groups identified , three prices
continued
Figure 12.4b A Monopoly’s Output and Price: Demand
and Marginal Revenue and Cost Curves
P
20
MC
14
ATC
10
MR
0
Copyright © 1997 Addison-Wesley Publishers Ltd.
3
D
Q
Textbook p. 266
Monopoly
 Q: What is the most profitable price discrimination
strategy?
 A: Perfect price discrimination - Charge each
customer the maximum price they are willing to pay
(P= maximum willingness to pay)
 Q: How much will a perfect price discriminating
monopoly choose to supply?
 A: It will depend on what the MR looks like under
perfect price discrimination. Once we know what MR
curve is, the most profitable Q is where MR=MC.
Monopoly
 If perfect price discrimination is possible, then
there is no need to reduce the price for all goods
sold if the monopoly wants to sell more. The
monopoly simply reduces the price to the new
consumers, while keeping the price to his
existing consumers unchanged.
 Implications:

1. MR curve same as demand curve

2. Q is same as under perfect competition
Monopoly

Perfect price
discrimination occurs if a
firm is able to sell each
unit of output for the
highest price anyone is
willing to pay.

Marginal revenue now
equals price and the
demand curve is also the
marginal revenue curve.
Monopoly

With perfect price
discrimination: The profitmaximizing output
increases to the quantity at
which price equals marginal
cost.

Economic profit increases
above that made by a singleprice monopoly.
Monopoly
 Q: Is perfect price discrimination a viable
strategy option?
 A: No. It requires the firm to know what each
person is willing to pay for the good. The
consumer is unlikely to tell the monopolist this
information.
 Q: What is a viable strategy option?
 A: Identify a few groups, and develop a separate
monopoly strategy for each group.
Monopoly
 Consider the case of an airline monopoly that
has identified two traveling groups:
 Business
 Tourist
 Suppose the profit maximizing strategy for the
single price monopoly is to charge $1500.
 If Business and Tourist travelers have a different
price elasticity of demand at this price then
profits can be increased by charging a different
price to each group.
Monopoly
 Q: How should the price strategy be changed?
 A: Revenue will increase if you increase the
price for customers who inelastically demand
airline trips, while revenue can also rise if you
drop the price for customers who elastically
demand airline trips.

Business travelers are known to
inelastically demand the good at this price

Tourist travelers are known to elastically
demand
Monopoly
 But airlines are not revenue maximizers, they
are profit maximizers.
 Q: What price should each group be charged if
the airline is to maximize profits?
 A: For each group find where the MR curve
intersects the MC curve, supply that many seats
to that group, then go up to the demand curve to
find the maximum price that will sell all the
seats. (in following example MC is constant)
Figure 12.6a Price Discrimination: Business Travellers
P
No price
discrimination
profit $3m
2,000
1,700
1,500
$3.5m
1,000
MC
Decrease
in quantity
demanded
0
Copyright © 1997 Addison-Wesley Publishers Ltd.
DB
MRB
56
Q
Textbook p. 269
Figure 12.6b Price Discrimination: Vacation Travellers
P
No price
discrimination
profit $2m
2,000
1,500
1,350
$2.45 m
1,000
MC
Increase in
quantity
demanded
DV
MRV
0
4
Copyright © 1997 Addison-Wesley Publishers Ltd.
7
Q
Textbook p. 269
Monopoly
 Q: Is that all the airline has to do to increase
profits by price discrimination?
 A: No! The monopolist must make it impossible
for the low price consumers to sell to the high
price consumers.

Airlines do this by putting the customers
name on the ticket
 Without prevention of resale, the strategy would
be destroyed by arbitraging (ie ticket scalping)
Monopoly
 Q: How does a monopoly compare to a perfectly
competitive industry?
 A: For a single price monopolist:

Price is higher

Quantity supplied is lower

Consumer Surplus is lower

Deadweight Loss
Monopoly

Compared to
perfect
competition,
monopoly
produces a
smaller output
and charges a
higher price.
Monopoly

Perfect Competition produces
more output at a lower price
→ Perfect Competition is
more efficient.

Recall: The market demand
curve is the marginal social
benefit curve, MSB, and the
market supply curve is the
marginal social cost curve,
MSC.

At competitive equilibrium
MSB = MSC, and so the
competitive market is
efficient.
Monopoly
 Consumer surplus is the area below the demand
curve and above the price.
 Producer surplus is the
area below the price
and above the supply
curve.
 Total surplus, the sum of
the two surpluses, is
maximized and the
quantity produced is
efficient.
Monopoly
 Monopoly produces
less at a higher price.
 Because price exceeds
marginal social cost,
marginal social benefit
exceeds marginal social
cost,
 and a deadweight
loss arises.
Monopoly
 Q: What happens
to the surpluses?
 CS ↓
 PS ↑
 some surplus
disappears
completely (DWL)
Monopoly
 Q: Should price discrimination be allowed?
 A: If possible, price discrimination can be
expected to:

Increase monopoly profits

Reduce consumer surplus for some,
increase for others.

Increase QS towards perfect competition
output level.

Deadweight Loss is lower
 Exercise: Prove these at home.
Monopoly
 Q: Is Monopoly really that bad?
 A: It may be worse than we have shown:

The lure of monopoly creates wasteful rent
seeking behavior.

Surplus is transferred from consumers to a
small number of monopoly owners, which
reduces the fairness of the market.

Monopoly creates inequality which can lead
to wasteful social unrest.
Monopoly
 Q: What can be done?
 A: There are two things governments can do:

Regulate prices when monopoly is
unavoidable (Natural Monopoly).

Deregulate when government regulations
have created un-necessary monopoly, or
when government regulation has reduced
competition.
End of Lecture 11