Chap14 Monopoly

Monopoly
14
Main Theme
The third topic in a sequence dealing with firm behavior and the
organization of industry.
Chapter 12 developed the cost curves on which firm behavior is based.
In Chapter 13, we employed these cost curves to show how a competitive firm
responds to changes in market conditions.
In the present lecture, these cost curves are employed to show how a
monopolistic firm chooses the quantity to produce and the price to
charge.
A monopolist is the sole seller of a product without close substitutes.
It has market power because it can influence the price of its output.
While a competitive firm is a price taker, a monopoly firm is a price maker.
The purpose of this lectures is to examine:

the production and pricing decisions of monopolists,
the social implications of their market power, and
the ways in which governments might respond to the problems caused by
monopolists.
Copyright 2004 South-Western
Definition
A firm is considered a monopoly if . . .
it is the sole seller of its product.
its product does not have close substitutes.
WHY MONOPOLIES ARISE
The fundamental cause of monopoly is barriers to

entry.
WHY MONOPOLIES ARISE

Barriers to entry have three sources:
Ownership of a key resource.
The government gives a single firm the exclusive right to
produce some good.
Costs of production make a single producer more
efficient than a large number of producers.
Monopoly Resources
Although exclusive ownership of a key resource is a
potential source of monopoly, in practice
monopolies rarely arise for this reason.
DeBeers
A diamond monopoly which controls about 80 percent of
the diamonds in the world.
Government-Created Monopolies
Governments may restrict entry by giving a single
firm the exclusive right to sell a particular good in
certain markets.
Main examples of how government creates a
monopoly to serve the public interest:
Patents
issued by the government to give firms the exclusive right to
produce a product for several years.
Copyright laws
Protection of the intellectual property of creative artists
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.
Average total cost falls as the firm's scale becomes larger.
Figure 1
Figure 1 Economies of Scale as a Cause of Monopoly
Cost
Average
total
cost
0
Quantity of Output
Monopoly versus Competition:

Key differences.
Monopoly
Is the sole producer
Faces a downward-sloping demand curve
If a monopoly wants to sell more output, it must lower the price of its product.
Is a price maker
Reduces price to increase sales
Competitive Firm
Is one of many producers
Faces a horizontal (a perfectly elastic) demand curve.
The firm can sell all that it wants to at this price.
Is a price taker
Sells as much or as little at same price
Figure 2 Demand Curves for Competitive and Monopoly

Firms
The key difference between a competitive firm and a monopoly is
the monopoly's ability to control price.
(a) A Competitive Firms Demand Curve
Price
(b) A Monopolists Demand Curve

Price
Demand
Demand
Quantity of Output
Quantity of Output
A Monopolys Revenue
Total Revenue
P Q = TR
Average Revenue
TR/Q = AR = P
Marginal Revenue
DTR/DQ = MR
The change in total revenue when output increases by
one unit.
A sole producer of water:

Total, Average, and Marginal Revenue
Monopoly's
marginal
revenue is
always less
than the
price of the
good.
Why?
A Monopolys Marginal Revenue

Why the monopolists 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 previously sold units also
decreases.
A Monopolys Marginal Revenue

When a monopoly increases the amount it sells, it
has two effects on total revenue (P Q).
The output effectmore output is sold, so Q is higher.
The price effectif the monopolist sells one more unit,
he must lower the price, so P is lower.
Figure 3 Demand and Marginal-Revenue Curves for a

Monopoly
The firm's demand and marginal revenue
curve always start at the same point
because P = MR for the first unit sold.
For every other level of output, marginal
revenue lies below the demand curve
because MR < P.
Price
$11
10
9
8
7
6
5
4
3
2
1
0
1
2
3
4
Demand
(average
revenue)
Marginal
revenue
1
Quantity of
Water
Recall that demand tends to be elastic along the upper portion of the demand curve => a decrease in price
causes total revenue to increase => marginal revenue is greater than zero.
Further down the demand curve, the demand is inelastic => a decrease in price results in a drop in total
revenue => implying that marginal revenue is now less than zero.
An Example
The Whatsa Widget Company has a monopoly in the sale of widgets.
The demand the firm faces can be shown by the following schedule:
Quantity
Price ($)
Total Revenue
($)
Marginal
Revenue ($)
0
1
2
3
4
5
15
14
13
12
11
10
0
14
-14
26
36
12
10
44
50
6
Profit Maximization
A monopoly maximizes profit by producing the
quantity at which marginal revenue equals marginal
cost.
If MR > MC, profit can be increased by raising the level
of output.
If MR < MC, profit can be increased by lowering the
level of output.
The monopoly then uses the demand curve to find

the price that will induce consumers to buy that
quantity.
Figure 4.
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
QMAX
Quantity
Comparing Profit Maximization for Monopoly

and for Competition
Even though MR = MC is the profit-maximizing
rule for both competitive firms and monopolies,
there is one important difference:
For a competitive firm, price equals marginal cost.
P = MR = MC
For a monopoly firm, price exceeds marginal cost.
P > MR = MC
A Monopolys Profit
Profit equals total revenue minus total costs.
Profit = TR - TC
Profit = (TR/Q - TC/Q) Q
Profit = (P - ATC) Q
The monopolist will receive economic profits as

long as price is greater than average total cost.
Figure 5 The Monopolists Profit

Costs and
Revenue
Marginal cost
Monopoly E
price
Monopoly
profit
Average
total D
cost
Average total cost
Demand
Marginal revenue
0
QMAX
Quantity
A company has a monopoly on bottled water sales in California. Assume that the price increases
as a result of the demand shift. What is the change in the companys profit-maximizing levels of
output, price and profit?
Costs and
Revenue
P2
Marginal cost
F
E
P1
Average total cost
AC2
AC1
D2
C
MR2
D1
MR1
Quantity
An Example
What is the profit-maximizing level of output?
Use the information on total revenue and total cost to calculate the
level of maximum profit.
Quantity
Price ($)
0
1
2
3
4
5
15
14
13
12
11
10
TR ($)
MR ($)
Total Marginal
Cost ($) Cost ($)
0
14
-14
8
11
26
36
44
50
12
10
8
6
16
26
39
57
3
5
10
13
18
Why a Monopoly Does Not Have a

Supply Curve
A supply curve tells us the quantity that a firm
chooses to supply at any given price.
But a monopolistic firm is a price maker;
The firm sets the price at the same time it chooses the
quantity to supply.
It is the market demand curve that tells us how much

the monopolist will supply
because the shape of the demand curve determines the
shape of the marginal revenue curve (which in turn
determines the profit-maximizing level of output).
The Market for Drugs

The market for pharmaceutical drugs takes on both:
monopoly characteristics and
competitive characteristics.
When a firm discovers a new drug, patent laws give

the firm a monopoly on the sale of that drug.
However, the patent eventually expires and any firm can
make the drug, which causes the market to become
competitive.
Figure 6
Figure 6 The Market for Drugs

Analysis of the pharmaceutical industry has shown us that prices of drugs fall
after patents expire and new firms begin production of that drug.
Costs and
Revenue
Price
during
patent life
Price after
patent
expires
Marginal
cost
Marginal
revenue
Monopoly
quantity
Competitive
quantity
Demand
Quantity
CNN Video: Mobile Phone Numbers

Now Mobile
In 2001, Hong Kong launched mobile phone number
portability
up to 5,000 of the city's 3 million mobile phone users can change
networks each day without having to change their numbers.
This has led to a price and perks war cellular service providers.
A legislator states that portability is good for competition.
However, a business representative worries that profits will
decline and new investment in network expansion will be
hampered.
How does mobile phone number portability increase
competition and affect the price elasticity of demand curve for
mobile phone contracts?
Why might profits and investment in network infrastructure be
reduced in the new environment?
THE WELFARE COST OF

MONOPOLY
In contrast to a competitive firm, the monopoly
charges a price above the marginal cost.
From the standpoint of consumers, this high price
makes monopoly undesirable.
However, from the standpoint of the producers, 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)
A monopoly sets its price

above the marginal cost,
=>it puts a wedge between
the consumers willingness
to pay and the producers
cost.
This wedge causes the
quantity sold to fall short of
the social optimum.
Quantity
0
Value to buyers
is greater than
cost to seller.
Efficient
quantity
Value to buyers
is less than
cost to seller.
The Inefficiency of Monopoly

The monopolist produces less than the socially
efficient quantity of output.
Figure 8
The deadweight loss caused by a monopoly is similar to
the deadweight loss caused by a tax.
The difference between the two cases is that the
government gets the revenue from a tax, whereas a
private firm gets the monopoly profit.
The deadweight loss caused by a monopoly is similar to the deadweight

loss caused by a tax.
The difference between the two cases is that the government gets the
revenue from a tax, whereas a private firm gets the monopoly profit.
Price
Deadweight
loss
Marginal cost
Monopoly
price
Marginal
revenue
Monopoly Efficient
quantity quantity
Demand
Quantity
PUBLIC POLICY TOWARD

MONOPOLIES
Government responds to the problem of monopoly
in one of four ways.
Making monopolized industries more competitive.

Regulating the behavior of monopolies.
Turning some private monopolies into public enterprises.
Doing nothing at all.
Increasing Competition with Antitrust Laws

Antitrust laws are a collection of statutes aimed at
curbing monopoly power.
Antitrust laws give the government various ways to
promote competition.
They allow the government to prevent mergers.
They allow the government to break up companies.
They prevent companies from performing activities that
make markets less competitive.
Increasing Competition with Antitrust Laws

Two Important Antitrust Laws
Sherman Antitrust Act (1890)
Reduced the market power of the large and powerful trusts of
that time period.
Clayton Act (1914)

Strengthened the governments ability to curb monopoly power
and authorized private lawsuits.
Break up of AT&T in 1984

Antitrust laws also impose costs on society.
Some mergers may provide synergies, which occur when
the costs fall because of joint operations.
Figure 9 Marginal-Cost Pricing for a Natural Monopoly
Price
Average total
cost
Regulated
price
Loss
Average total cost

Marginal cost
Demand
0
Quantity
Public Ownership
Rather than regulating a natural monopoly that is run by a
private firm, the government can run the monopoly itself
e.g. in the United States, the government runs the Postal Service.
However, economists generally prefer private ownership of

natural monopolies than public ownership.
Private owners have an incentive to keep costs down to earn higher
profits.
If government bureaucrats do a bad job running a monopoly, the
political system is the taxpayers only recourse.
Doing Nothing
Government can do nothing at all if the market
failure is deemed small compared to the
imperfections of public policies.
Sometimes the costs of government regulation outweigh
the benefits
costs of maintaining a large bureaucracy.
Therefore, some economists believe that it is best for the

government to leave monopolies alone.
PRICE DISCRIMINATION
Price discrimination is the business practice of selling the
same good at different prices to different customers.
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.
Two important effects of price discrimination:
It can increase the monopolists profits.
It can reduce the deadweight loss.
How? Consider an example

Example: Readalot Publishing Company

The firm pays an author $2 million for the right to publish a book. (Fixed
cost)
The cost of printing the book is zero. (Constant Marginal Cost = 0)
The firm knows that there are two types of readers.
100,000 die-hard fans of the author willing to pay up to $30 for the book.
400,000 other readers who will be willing to pay up to $5 for the book.
How should the firm set its price?

If P = $30, it will sell 100,000 copies of the book, receive total revenue of $3
million, and earn $1 million in profit.
If P = $5, it will sell 500,000 copies, receive total revenue of $2.5 million, and
earn only $500,000 in profit.
=> the firm chooses P = $30 and sells 100,000 books => there is a DWL
because there are 400,000 other customers willing to pay P = $5 > MC =$0.
If there was a way to prevent those who buy the book for $5 from
reselling it to the readers willing to pay $30, the company could make
even more profit:
by selling 100,000 copies to the die-hard fans at $30 each, and then selling
400,000 copies to the other readers for $5 each.
The total revenue from selling 100,000 copies at $30 each is $3 million.
The total revenue from selling 400,000 copies at $5 each is $2 million.
Since the firm's costs are $2 million, profit will be $3 million.
The Moral of the Readalot Story

By charging different prices to different customers,
a monopoly firm can increase its profit.
To price discriminate, a firm must be able to
separate customers by their willingness to pay.
Arbitrage will limit a monopolist's ability to price
discriminate.
the process of buying a good in one market at a low price
and then selling it in another market at a higher price
Price discrimination can increase economic welfare.

There is no deadweight loss in this situation.
Perfect Price Discrimination

Perfect price discrimination:
the monopolist knows exactly the willingness to pay of each
customer and can charge each customer a different price.
Without price discrimination, a firms output level is lower

than the socially efficient level.
If a firm perfectly price discriminates, each customer who
values the good at more than its marginal cost will purchase
the good and be charged his or her willingness to pay.
There is no deadweight loss in this situation.
Because consumers pay a price exactly equal to their willingness to
pay, all surplus in this market will belong to the producer.
Figure 10 Welfare with and without Price Discrimination

Without price discrimination, a firm produces an output level that
is lower than the socially efficient level.
(a) Monopolist with Single Price
Price
Consumer
surplus
Deadweight
loss
Monopoly
price
Profit
Marginal cost
Marginal
revenue
Quantity sold
Demand
Quantity
Figure 10 Welfare with and without Price Discrimination

If a firm perfectly price discriminates, each customer who values the
good at more than its marginal cost will purchase the good and be
charged his or her willingness to pay.
(b) Monopolist with Perfect Price Discrimination
Price
There is no deadweight
loss in this situation.
Profit
Marginal cost
Demand
Quantity sold
Quantity
Because consumers pay

prices exactly equal to
their willingness to pay,
all surplus in this market
will be taken by the
producer
PRICE DISCRIMINATION
Examples of Price Discrimination
Movie tickets
Airline prices
Discount coupons
Financial aid
Quantity discounts
CONCLUSION: THE
PREVALENCE OF MONOPOLY
How prevalent are the problems of monopolies?
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.
Summary
A monopoly is a firm that is the sole seller in its
market.
It faces a downward-sloping demand curve for its
product.
A monopolys marginal revenue is always below the
price of its good.
Summary
Like a competitive firm, a monopoly maximizes
profit by producing the quantity at which marginal
cost and marginal revenue are equal.
Unlike a competitive firm, its price exceeds its
marginal revenue, so its price exceeds marginal cost.
Summary
A monopolists profit-maximizing level of output is
below the level that maximizes the sum of consumer
and producer surplus.
A monopoly causes deadweight losses similar to the
deadweight losses caused by taxes.
Summary
Policymakers can respond to the inefficiencies of
monopoly behavior with antitrust laws, regulation of
prices, or by turning the monopoly into a
government-run enterprise.
If the market failure is deemed small, policymakers
may decide to do nothing at all.
Summary
Monopolists can raise their profits by charging
different prices to different buyers based on their
willingness to pay.
Price discrimination can raise economic welfare and
lessen deadweight losses.

Chap14 Monopoly

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Chap14 Monopoly

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Monopoly

The purpose of this lectures is to examine:

Copyright 2004 South-Western

WHY MONOPOLIES ARISE

The fundamental cause of monopoly is barriers to

Copyright 2004 South-Western

WHY MONOPOLIES ARISE

Copyright 2004 South-Western

Copyright 2004 South-Western

Copyright 2004 South-Western

Figure 1 Economies of Scale as a Cause of Monopoly

Monopoly versus Competition:

Figure 2 Demand Curves for Competitive and Monopoly

(b) A Monopolists Demand Curve

Copyright 2004 South-Western

A sole producer of water:

A Monopolys Marginal Revenue

Copyright 2004 South-Western

A Monopolys Marginal Revenue

Copyright 2004 South-Western

Figure 3 Demand and Marginal-Revenue Curves for a

The monopoly then uses the demand curve to find

Figure 4 Profit Maximization for a Monopoly

2. . . . and then the demand

1. The intersection of the

Average total cost

Comparing Profit Maximization for Monopoly

Copyright 2004 South-Western

The monopolist will receive economic profits as

Copyright 2004 South-Western

Figure 5 The Monopolists Profit

Average total cost

Copyright 2004 South-Western

Copyright 2004 South-Western

Why a Monopoly Does Not Have a

It is the market demand curve that tells us how much

The Market for Drugs

When a firm discovers a new drug, patent laws give

Figure 6 The Market for Drugs

CNN Video: Mobile Phone Numbers

THE WELFARE COST OF

Copyright 2004 South-Western

Figure 7 The Efficient Level of Output

A monopoly sets its price

The Inefficiency of Monopoly

Copyright 2004 South-Western

The deadweight loss caused by a monopoly is similar to the deadweight

PUBLIC POLICY TOWARD

Making monopolized industries more competitive.

Copyright 2004 South-Western

Increasing Competition with Antitrust Laws

Copyright 2004 South-Western

Increasing Competition with Antitrust Laws

Clayton Act (1914)

Break up of AT&T in 1984

Figure 9 Marginal-Cost Pricing for a Natural Monopoly

Average total cost

However, economists generally prefer private ownership of

Copyright 2004 South-Western

Therefore, some economists believe that it is best for the

Copyright 2004 South-Western

How? Consider an example

Example: Readalot Publishing Company

How should the firm set its price?