22
Pure Monopoly
22-1
Copyright 2008 The McGraw-Hill Companies
Learning objectives
• In this chapter students will learn:
A. The characteristics of pure monopoly.
B. How a pure monopoly sets its profit-maximizing output
and price.
C. About the economic effects of monopoly.
D. Why a monopolist might prefer to charge different prices
in different markets.
22-2
Copyright 2008 The McGraw-Hill Companies
Pure Monopoly: An Introduction
Definition: Pure monopoly exists when a single firm is the sole
producer of a product for which there are no close substitutes.
• There are a number of products where the producers have a
substantial amount of monopoly power and are called “near”
monopolies.
• There are several characteristics that distinguish pure
monopoly:
1. There is a single seller so the firm and industry are
synonymous (the same).
2. There are no close substitutes for the firm’s product.
3. The firm is a “price maker” that is, the firm has considerable
control over the price because it can control the quantity
supplied.
4. Entry into the industry by other firms is blocked.
5. A monopolist may or may not engage in nonprice competition.
Depending on the nature of its product, a monopolist may
advertise to increase demand.
22-3
Copyright 2008 The McGraw-Hill Companies
Barriers to Entry Limiting Competition:
1. Economies of scale constitute one major barrier. This
occurs where the lowest unit costs and, therefore, lowest
unit prices for consumers depend on the existence of a
small number of large firms or, in the case of a pure
monopoly, only one firm. Because a very large firm with a
large market share is most efficient, new firms cannot
afford to start up in industries with economies of scale
2. Public utilities are often natural monopolies because they
have economies of scale in the extreme case where one
firm is most efficient in satisfying existing demand (two or
more firms will lead to higher ATC).
• Government usually gives one firm the right to operate a
public utility industry in exchange for government regulation
of its power.
22-4
Copyright 2008 The McGraw-Hill Companies
Average Total Cost
THE NATURAL MONOPOLY CASE
$20
15
10
If ATC declines over extended output,
least-cost production is realized only if
there is one producer - a natural
monopoly
0
22-5
ATC
50
Copyright 2008 The McGraw-Hill Companies
100
Quantity
200
•
The explanation of why more than one firm would be
inefficient involves the description of the maze of pipes or
wires that would result if there were competition among
water companies, electric utility companies, etc.
3. Legal barriers to entry into a monopolistic industry also
exist in the form of patents and licenses.
a) Patents grant the inventor the exclusive right to produce or
license a product for twenty years; this exclusive right can
earn profits for future research, which results in more
patents and monopoly profits.
b) Licenses are another form of entry barrier. Radio and TV
stations are examples of government granting licenses
where only one or a few firms are allowed to offer the
service.
22-6
Copyright 2008 The McGraw-Hill Companies
c)
•
•
•
•
•
Ownership or control of essential resources is another
barrier to entry.
International Nickel Co. of Canada (now called Inco)
controlled about 90 percent of the world’s nickel reserves,
and DeBeers of South Africa controls most of the world’s
diamond supplies.
Aluminum Co. of America (Alcoa) once controlled all basic
sources of bauxite, the ore used in aluminum fabrication.
Monopolists may use pricing or other strategic barriers
such as selective price-cutting and advertising.
Dentsply, manufacturer of false teeth, controlled about 70
percent of the market. In 2005 Dentsply was found to have
illegally prevented distributors from carrying competing
brands.
Microsoft charged higher prices for its Windows operating
system to computer manufacturers featuring Netscape
Navigator instead of Microsoft’s Internet Explorer. U.S. courts
ruled
22-7 this action illegal.
Copyright 2008 The McGraw-Hill Companies
•
Monopoly demand is the industry (market) demand and is
therefore downward sloping.
• Our analysis of monopoly demand makes three
assumptions:
1. The monopoly is secured by patents, economies of scale,
or resource ownership.
2. The firm is not regulated by any unit of government.
3. The firm is a single-price monopolist; it charges the same
price for all units of output.
•
•
Price will exceed marginal revenue because the
monopolist must lower the price to sell the additional unit.
The added revenue (MR) will be the price of the last unit
less the sum of the price cuts which must be taken on all
prior units of output.
The marginal-revenue curve is below the demand curve,
and when it becomes negative, the total-revenue curve
turns downward as total-revenue falls.
22-8
Copyright 2008 The McGraw-Hill Companies
Price and Marginal Revenue
Marginal Revenue is Less Than Price
• A Monopolist is
Selling 3 Units at
$142
• To Sell More (4), $142
Price Must Be
132
Lowered to $132
122
• All Customers
Must Pay the Same 112
Price
102
• TR Increases $132
92
Minus $30 (3x$10)
Loss = $30
D
Gain = $132
82
0
22-9
Copyright 2008 The McGraw-Hill Companies
1
2
3
4
5
6
Price and Marginal Revenue
Marginal Revenue is Less Than Price
• A Monopolist is
Selling 3 Units at
$142
• To Sell More (4), $142
Price Must Be
132
Lowered to $132
122
• All Customers
Must Pay the Same 112
Price
102
• TR Increases $132
92
Minus $30 (3x$10)
82
• $102 Becomes a
Point on the MR
Curve
• Try Other Prices to
Determine Other
0
MR Points
Loss = $30
D
Gain = $132
MR
1
2
3
4
5
6
The Constructed Marginal Revenue Curve
Must Always Be Less Than the Price
22-10
Copyright 2008 The McGraw-Hill Companies
•
The monopolist is a price maker. The firm controls output
and price but is not free of market forces, since the
combination of output and price that can be sold depends
on demand. For example, Table 22.1 shows that at $162
only 1 unit will be sold, at $152 only 2 units will be sold, etc.
•
Price elasticity also plays a role in monopoly price setting.
The total revenue test shows that the monopolist will avoid
the inelastic segment of its demand schedule. As long as
demand is elastic, total revenue will rise when the
monopoly lowers its price, but this will not be true when
demand becomes inelastic. At this point, total revenue falls
as output expands, and since total costs rise with output,
profits will decline as demand becomes inelastic. Therefore,
the monopolist will expand output only in the elastic portion
of its demand curve.
22-11
Copyright 2008 The McGraw-Hill Companies
• Output and Price Determination
• Cost data is based on hiring resources in competitive
markets, so the cost data of Chapters 20 and 21 can be
used in this chapter as well.
• The MR = MC rule will tell the monopolist where to find its
profit-maximizing output level. The same result can be found
by comparing total revenue and total costs incurred at each
level of production.
• The pure monopolist has no supply curve because there is
no unique relationship between price and quantity supplied.
The price and quantity supplied will always depend on
location of the demand curve.
22-12
Copyright 2008 The McGraw-Hill Companies
Monopoly Revenue and Costs
Revenue and Cost Data of a Pure Monopolist
Cost Data
Revenue Data
(2)
Price
(1)
Quantity (Average
Of Output Revenue)
0
1
2
3
4
5
6
7
8
9
10
$172
162
152
142
132
122
112
102
92
82
72
(3)
Total
Revenue
(1) X (2)
$0 ]
162 ]
304 ]
426 ]
528 ]
610 ]
672 ]
714 ]
736 ]
738 ]
720
(4)
Marginal
Revenue
$162
142
122
102
82
62
42
22
2
-18
(5)
(6)
(7)
(8)
Average Total Cost Marginal Profit (+)
Total Cost (1) X (5)
Cost
or Loss (-)
$190.00
135.00
113.33
100.00
94.00
91.67
91.43
93.75
97.78
103.00
$100 ]
190 ]
270 ]
340 ]
400 ]
470 ]
550 ]
640 ]
750 ]
880 ]
1030
$90
80
70
60
70
80
90
110
130
150
$-100
-28
+34
+86
+128
+140
+122
+74
-14
-142
-310
Can you See Profit Maximization?
22-13
Copyright 2008 The McGraw-Hill Companies
Monopoly Revenue and Costs
Demand, Marginal Revenue, and Total Revenue for a Pure
Monopolist
$200
Demand and Marginal Revenue Curves
Elastic
Inelastic
Price
150
100
50
D
MR
0
2
4
Total Revenue
$750
8
10
12
Total-Revenue Curve
14
16
18
500
250
0
22-14
6
TR
2
Copyright 2008 The McGraw-Hill Companies
4
6
8
10
12
14
16
18
Profit Maximization
By A Pure Monopolist
Price, Costs, and Revenue
$200
175
MC
150
Pm=$122
125
100
75
Economic
Profit
ATC
A=$94
D
MR=MC
50
25
0
MR
1
2
3
4
5
6
Quantity
22-15
Copyright 2008 The McGraw-Hill Companies
7
8
9
10
Loss Minimization
Price, Costs, and Revenue
By A Pure Monopolist
MC
A
Pm
ATC
Loss
AVC
V
D
MR=MC
MR
0
Qm
Quantity
22-16
Copyright 2008 The McGraw-Hill Companies
•
There are several misconceptions about monopoly
prices.
1.
Monopolist cannot charge the highest price it can get,
because it will maximize profits where total revenue minus
total cost is greatest. This depends on quantity sold as
well as on price and will never be the highest price
possible.
2.
Total, not unit, profits is the goal of the monopolist. Once
again, quantity must be considered as well as unit profit.
3.
Unlike the purely competitive firm, the pure monopolist can
continue to receive economic profits in the long run.
Although losses can occur in a pure monopoly in the short
run (P>AVC), the less-than-profitable monopolist will
shutdown in the long run (P>ATC).
22-17
Copyright 2008 The McGraw-Hill Companies
Evaluation of the Economic Effects of a Monopoly
• Price, output, and efficiency of resource allocation should be
considered.
• Monopolies will sell a smaller output and charge a higher
price than would competitive producers selling in the same
market, i.e., assuming similar costs.
• Monopoly price will exceed marginal cost, because it
exceeds marginal revenue and the monopolist produces
where marginal revenue and marginal cost are equal. The
monopolist charges the price that consumers will pay for that
output level.
• Allocative efficiency is not achieved because price (what
product is worth to consumers) is above marginal cost
(opportunity cost of product). Ideally, output should expand
to a level where price = marginal revenue = marginal cost,
but this will occur only under pure competitive conditions
where price = marginal revenue. (See Figure 22.6)
22-18
Copyright 2008 The McGraw-Hill Companies
Economic Effects of Monopoly
Price, Output, and Efficiency
Pure
Monopoly
Purely
Competitive
Market
S=MC
MC
Pm
P=MC=
Minimum
ATC
Pc
b
c
Pc
a
D
D
MR
Qc
P = MC
Qm
Qc
P > MC
Pure Competition is Efficient. Monopoly Price is Greater
Than MC And Is Therefore Inefficient
22-19
Copyright 2008 The McGraw-Hill Companies
• Productive efficiency is not achieved because the
monopolist’s output is less than the output at which average
total cost is minimum.
• The efficiency (or deadweight) loss is also reflected in the
sum of consumer and producer surplus equaling less than
the maximum possible value.
• Income distribution is more unequal than it would be under a
more competitive situation. The effect of the monopoly
power is to transfer income from the consumers to the
business owners. This will result in a redistribution of income
in favor of higher-income business owners, unless the
buyers of monopoly products are wealthier than the
monopoly owners.
22-20
Copyright 2008 The McGraw-Hill Companies
Assessment and policy options:
• Although there are legitimate concerns of the effects of
monopoly power on the economy, monopoly power is not
widespread. While research and technology may strengthen
monopoly power, overtime it is likely to destroy monopoly
position.
• When monopoly power is resulting in an adverse effect upon
the economy, the government may choose to intervene on a
case-by-case basis
Price discrimination
• occurs when a given product is sold at more than one price
and the price differences are not based on cost differences.
Price discrimination can take three forms:
1. Charging each customer in a single market the maximum
price he or she is willing to pay.
2. Charging each customer one price for the first set of units
purchased, and a lower price for subsequent units.
3. Charging one group of customers one price, and another
group
a different price.
22-21
Copyright 2008 The McGraw-Hill Companies
Conditions needed for successful price discrimination:
1. Monopoly power is needed with the ability to control output
and price.
2. The firm must have the ability to segregate the market, to
divide buyers into separate classes that have a different
willingness or ability to pay for the product (usually based on
differing elasticities of demand).
3. Buyers must be unable to resell the original product or
service.
Examples of price discrimination:
1. Airlines charge high fares to executive travelers (inelastic
demand) than vacation travelers (elastic demand).
2. Electric utilities frequently segment their markets by end
uses, such as lighting and heating. (Lack of substitutes for
lighting makes this demand inelastic).
3. Long-distance phone service has higher rates during the
day, when businesses must make their calls (inelastic
demand), and lower rates at night and on week-ends, when
less
important calls are made.
22-22
Copyright 2008 The McGraw-Hill Companies
4. Discount coupons are a form of price discrimination,
allowing firms to offer a discount to price-sensitive
customers.
5. International trade has examples of firms selling at different
prices to customers in different countries.
Regulated Monopoly
• This occurs where a natural monopoly or economies of
scale make one firm desirable.
• As a result of changes in technology and deregulation in the
local telephone and the electricity-providers industry, some
states are allowing new entrants to compete in previously
regulated markets.
• In those markets that are still regulated, a regulatory
commission may attempt to establish the legal price for the
monopolist that is equal to marginal cost at the quantity of
output chosen. This is called the “socially optimal price.
22-23
Copyright 2008 The McGraw-Hill Companies
Regulated Monopoly
Dilemma of Regulation
Price and Costs (Dollars)
Monopoly
Price
Pm
Fair-Return
Price
f
Pf a
Socially
Optimal
Price
ATC
Pr
r
MR
0
Qm Quantity
22-24
Copyright 2008 The McGraw-Hill Companies
MC
D
b
Qf
Qr
• However, setting price equal to marginal cost may cause
losses, because public utilities must invest in enough fixed
plant to handle peak loads. Much of this fixed plant goes
unused most of the time, and a price = marginal cost would
be below average total cost. Regulators often choose a
price equal to average cost rather than marginal cost, so that
the monopoly firm can achieve a “fair return” and avoid
losses. (Recall that average-total cost includes an
allowance for a normal or “fair” profit)
• The dilemma for regulators is whether to choose a socially
optimal price, where P = MC, or a fair-return price, where P
= AC. P = MC is most efficient but may result in losses for
the monopoly firm, and government then would have to
subsidize the firm for it to survive. P = AC does not achieve
allocative efficiency, but does insure a fair return (normal
profit) for the firm.
22-25
Copyright 2008 The McGraw-Hill Companies
• LAST WORD: De Beers’ Diamonds: Are Monopolies
Forever?
• De Beers Consolidated Mines of South Africa has been one
of the world’s strongest and most enduring monopolies. It
produces about 45 percent of all rough-cut diamonds in the
world and buys for resale many of the diamonds produced
elsewhere, for a total of about 55 percent of the world’s
diamonds.
• Its behavior and results fit the monopoly model portrayed in
Figure 22.4. It sells a limited quantity of diamonds that will
yield an “appropriate” monopoly price.
• The “appropriate” price is well over production costs and has
earned substantial economic profits.
• How has De Beers controlled the production of mines it
doesn’t own?
1. It convinces producers that “single-channel” monopoly
marketing is in their best interests
22-26
Copyright 2008 The McGraw-Hill Companies
2. Mines that don’t use De Beers may find the market flooded
from De Beers stockpiles of the particular kind of diamond
they produce, which causes price declines and loss of
profits.
3. Finally, De Beers purchases and stockpiles diamonds
produced by independents
Threats and problems face De Beers’ monopoly power.
1. New diamond discoveries have resulted in more diamonds
outside their control.
2. Russia, which has been a part of De Beers’ monopoly, has
agreed to sell progressively larger quantities directly to the
world market rather than through De Beers.
• In mid-2000, De Beers abandoned its attempt to control the
supply of diamonds.
• The company is transforming itself into a company that sells
“premium” diamonds and luxury goods under the De Beers
label.
• De Beers plans to reduce its stockpile of diamonds and
increase the demand for diamonds through advertising.
22-27
Copyright 2008 The McGraw-Hill Companies
Key Terms
•
•
•
•
•
•
•
•
•
pure monopoly
barriers to entry
simultaneous consumption
network effects
X-inefficiency
rent-seeking behavior
price discrimination
socially optimal price
fair-return price
22-28
Copyright 2008 The McGraw-Hill Companies
Next Chapter Preview…
Monopolistic
Competition
and Oligopoly
22-29
Copyright 2008 The McGraw-Hill Companies
22-30
Copyright 2008 The McGraw-Hill Companies