Chapter 13
Monopoly
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
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Market Power
How a Firm Uses Market Power to Maximize Profit
The Costs of Monopoly: Deadweight Loss
The Costs of Monopoly: Corruption and Inefficiency
The Benefits of Monopoly: Incentives for Research
and Development
 Economies of Scale and the Regulation of Monopoly
 Other Sources of Market Power
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Introduction
 Since 1981 AIDS has
killed over 36 million
people.
 In the U.S., deaths from
AIDS dropped 50% due
to drugs like Combivir.
 A Combivir pill costs $0.50 to produce, but sells
for 25 times higher - $12.50. Why?
INGRAM PUBLISHING/VETTA/GETTY IMAGES
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Definition
Market power:
The power to raise price above marginal cost
without fear that other firms will enter the market.
Monopoly:
A firm with market power. Normally thought of as a
single seller in a market
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Market Power
 GlaxoSmithKline owns the patent on Combivir.
 A patent gives exclusive rights to make, use, or
sell the product.
 GSK’s patent prevents competition.
 This gives GSK market power.
 India does not recognize the Combivir patent.
 In India, an equivalent drug sells for $0.50, or
the marginal cost.
 Market Power = “lack of substitutes”
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Definition
Marginal revenue (MR):
the change in total revenue from selling
an additional unit.
Marginal cost (MC):
the change in total cost from selling an
additional unit.
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Self-Check
Market power allows a firm to raise price:
a. Above average cost.
b. Above marginal cost.
c. Above marginal revenue.
Answer: b – market power allows a firm to raise
price above marginal cost, without fear that other
firms will enter the market.
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Market Power
 To maximize profit, firms produce at the level of
output where:
MC = MR
 A firm with market power faces a downward
sloping demand curve.
 It must lower price to sell an additional unit.
 The additional revenue per unit < current price,
or:
MR < P
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Marginal Revenue
 When price ↓ from
$16 to $14,
quantity ↑ from 2
to 3 units
 Total revenue ↑
from $32 to $42.
 MR, or the change
in total revenue, is
$10.
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Marginal Revenue
Price
$20
Revenue loss
$2 x 2 = $4
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16
Price ↓ $16 to $14
14
12
10
Revenue gain
14 x $1 = $14
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6
Demand
MR =
$10
4
2
1
2
3
4
5
6
MR
7
Quantity
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Short-Cut for Finding MR
 MR begins at same point on the vertical axis as demand.
 MR has twice the slope (assuming linear demand curve).
Price
a
Demand: P = a – b x Q
2b
1
b
1
a/2b
MR = a – 2b x Q
Quantity
a/b
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Self-Check
For a firm with market power, marginal revenue
is:
a. Higher than price.
b. Equal to price.
c. Lower than price.
Answer: c – A firm with market power must drop
its price to sell more units, so the marginal
(additional) revenue is lower than price.
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Profit Maximization for Monopoly
Just like for firms in a competitive industry:
Profit maximization consists of two steps:
1.Choosing a Quantity
Rule: choose Q where MR = MC
2.Choosing a Price
Choose the highest price you can get away with…
which is the highest price consumers will pay
for that Quantity
Rule: once you’ve picked your Quantity, then
follow the graph to the Demand curve,
which shows you how much consumers
will pay (price).
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Using Market Power to Maximize Profit
Price
($/pill)
Demand
Profit maximizing output:
MR = MC at 80 million pills
Profit maximizing price = $12.50
Profit per pill = $10.00
Total profit = $10 x 80 = $800 m
$12.50
Profit
2.50
//
AC
MC
0.50
80
MR
Quantity
(millions of pills)
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Elasticity of Demand and Markup
 Two effects make demand for pharmaceuticals
inelastic:
• The “you can’t take it with you” effect:
 People with serious illnesses are relatively
insensitive to the price of life saving drugs.
• The “other people’s money” effect:
 If third parties are paying for the medicine,
people are less sensitive to price.
 The more inelastic the demand curve, the more
a monopolist will raise price above MC.
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Elasticity of Demand and Markup
Price
Price
Relatively elastic demand
→ small markup
Relatively inelastic demand
→ big markup
P
Demand
P
MC
MC
Demand
QE
MR
Quantity
Q
MR
Quantity
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Costs of Monopoly: Deadweight Loss
 Monopolies charge a higher price and produce
less than competitive firms.
 Monopolies reduce total surplus (consumer
surplus + producer surplus).
 This implies a deadweight loss - sales that do
not occur because the monopoly price is above
the competitive price.
 The real cost of monopoly is the lost gains from
trade or DWL.
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Costs of Monopoly: Deadweight Loss
P
P
Consumers get this
Consumers
get this
Monopolist gets this
PM
PC
No one gets this
(deadweight loss)
Supply
MC = AC
Demand
Demand
MR
QC
Competition: P = MC
Q
QM
Q
QC
Monopoly: P > MR
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Self-Check
A monopolist’s price is:
a. Lower than a competitive firm’s.
b. Higher than a competitive firm’s.
c. The same as a competitive firm’s.
Answer: b – a monopolist’s price is higher than a
competitive firm’s.
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Costs of Monopoly: Corruption and
Inefficiency
 Many monopolies are the result of government
corruption.
 Tommy Suharto, the Indonesian president’s son,
was given the clove monopoly.
 He bought the
Lamborghini company
with the monopoly
profits.
In these cases, self-interest is channeled toward social
destruction through poor institutions, instead of
towards social prosperity through good institutions. 20
Costs of Monopoly: Corruption and
Inefficiency
 Monopolies are especially harmful if they control a
good that is used to produce other goods.
 In Algeria a dozen or so army generals each
control a key good
• People refer to these men as General wheat,
General tire….
• Each general tries to get a larger share of the
economic pie.
 The result is greater deadweight loss, and the
“pie” shrinks.
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Benefits of Monopoly: Incentives for R&D
 Drug prices are lower in India and Canada.
• India does not offer strong patent protection.
• Canada’s government controls drug prices.
 It costs $1 billion to develop a new drug.
 Patents are one way of rewarding research and
development (R&D).
 Without patents firms would not spend on R&D,
fewer new drugs would be developed.
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Benefits of Monopoly: Incentives for R&D
 Prizes can reward research and development
without creating monopolies.
 Patent Buyouts
• If the government were to compensate patent holders
the value of their patents (and then allow competition),
prices could be driven down - eliminating the
deadweight loss without eliminating the incentive to
innovate.
 Reduce price without reducing R&D.
 Must raise taxes to pay for the patent.
 May be difficult to determine a price.
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Definition
Economies of Scale:
the advantages of large-scale
production that reduce average cost as
quantity increases.
Natural Monopoly:
when a single firm can supply the entire
market at a lower cost than two or more
firms.
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Natural Monopoly
 Monopolies can arise naturally when economies of
scale allow a single firm to produce at lower cost than
many small firm.
 Utilities such as water, natural gas, and cable
television are often natural monopolies.
• The largest firm will be able to produce its goods at
a lower per unit cost than smaller firms, so only
one firm tends to exist.
 If economies of scale are large enough, price can be
lower under natural monopoly than under competition.
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Natural Monopoly
P
Average costs
for small firms
Competitive
price PC
It is possible for PM < PC
If economies of scale are
large enough
Monopoly
price PM
AC
MC
Demand
Competitive
Quantity QC
Monopoly
Quantity QM MR
Q
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Self-Check
Which of the following is most likely to be a
natural monopoly:
a. A home builder.
b. A restaurant.
c. A railroad company.
Answer: c – a railroad company is most likely to
be a natural monopoly, due to economies of scale
and the high cost of duplicating tracks.
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Price Control and Natural Monopoly
 A price control can increase output.
 Price = MC is the optimal level of output.
 At P = MC, P < AC.
 The firm is operating at a loss and will exit
the industry.
 Price = AC is the lowest price the firm will accept.
 Firm is earning zero (normal) profit.
 Output is higher than at monopoly price.
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Price Control and Natural Monopoly
Price
• PM and QM are set where MR = MC
• Optimal quantity is where P = MC
• At optimal Q, firm suffers a loss
Monopoly
price PM
P = MC
AC
Loss (P < AC)
QM
Monopoly
quantity
Optimal
quantity
MC
Demand
Quantity
MR
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Price Control and Natural Monopoly
Price
• At P = AC, firm has normal profit
• Results in some deadweight loss
Monopoly
price PM
Deadweight Loss
P = AC
AC
P = MC
QM
Monopoly
quantity
Optimal
quantity
MC
Demand
Quantity
MR
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Natural Monopoly - Regulation
 Government Regulation or ownership can solve
the Natural Monopoly problem.
 California deregulated electricity prices with
disastrous results.
• High demand pushed generators to capacity
• Utilities’ demand for electricity is inelastic when supply
is critically low.
• System was designed for regulation, not competition
• Social cost of an outage – at least $10,000/Mwh if not
higher
• “Electricity is damn useful stuff”
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Natural Monopoly - Regulation
• Firms that generated electricity found a way to
increase profit by shutting down some of their
generators “for maintenance and repair.”
 When supply decreased, the price rose rapidly.
 Enron and others “gamed” the system for their benefit
• California put wholesale price controls in place
• Deregulation, ultimately caused PG&E to file for
bankruptcy, and added $50,000,000,000 to total
power costs in the region
• Other Western States would up charging as
much as $5000/Mwh (normal - $40/Mwh)
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More On Regulation
• Many assume that market failure can be
corrected via regulation
• Implicitly presume that regulation is done
competently if not perfectly
• “Nirvana” fallacy - the fallacy of comparing
actual things with unrealistic, idealized
alternatives. It can also refer to the
tendency to assume that there is a perfect
solution to a particular problem.
•
Example: using political, not economic criteria
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More On Regulation
 Sometimes regulatory actions are hardly
“solutions” (i.e. Calif electric “deregulation”)
 Many believe Dodd-Frank Financial
Regulation bill has made things worse
 What matters is the effectiveness of the
regulation in terms of costs/benefits,
including potential opportunity costs
 i.e. over-regulation can stifle market forces
for cost reduction and/or innovation
 “Power does not equate to wisdom”
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Self-Check
A monopolist will have normal profit when its
price is set equal to:
a. Marginal cost.
b. Average cost.
c. Total cost.
Answer: a – a monopolist will have normal profit
when P = AC.
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Definition
Barriers to entry:
factors that increase the cost to new
firms of entering an industry.
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Other Sources of Monopoly Power
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Numerical Example - Monopoly
A monopolist's demand curve is described by the equation Q = 50 – 0.5P. The marginal revenue
curve is described by the equation MR = 50 – Q. Marginal cost per unit is constant at $5, and
there are no fixed costs to be considered here. What is the monopolist's profit-maximizing
quantity and profit level? Show all your calculations.
MC = 5, MR = 50 – Q, FC = 0
MC = MR is profit max Quantity
so 50 – Q so Q = 45, Q = 45
Solve for P using demand equation:
Q = 50 - .5P
45 = 50 - .5P (solve for P)
5/.5 yields P = 10
Profit = TR – TC
(45)*(10) – ($5)*45 = 450-225
Profit = $225
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Takeaway
 For a monopolist, marginal revenue is less than
market price (MR < P).
 Monopolies:
• Charge a higher price than competitive firms.
• Reduce total.
• Create a deadweight loss.
• Use market power to earn above normal profits.
 The markup of price over marginal cost is larger
the more inelastic the demand.
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Takeaway
 Patent monopolies involve a trade-off between
deadweight loss and innovation,
 Natural monopolies involve a trade-off between
deadweight loss and economies of scale.
 Outcomes can be improved by:
• Opening the industry up to competition.
• Regulating the monopolist.
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