Monopoly

Chapter 12
 The Theory of Monopoly

• A firm is a monopoly if . . .

• There is one seller

• The single seller sells a product for which
there is no close substitute
• There are extremely high barriers to entry
 WHY MONOPOLIES ARISE……
Barriers To Entry
• Legal Barriers: a Public Franchise is a right granted to a
firm by government that permits the firm to provide a
particular good or service and excludes all others from
doing the same.
• Economies of Scale: In some industries, low average
total costs are only obtained through large scale
production. If only one firm can survive in that
industry, the firm is called a Natural Monopoly.
• Exclusive Ownership of a Necessary Resource: Existing
firms may be protected from entry of new firms by the
exclusive or near-exclusive ownership of a resource
needed to enter the industry.
• Consumer lock-in
– Potential entrants can be deterred if they believe high
switching costs will keep them from inducing many
consumers to change brands

• Network externalities
– Occur when value of a product increases as more
consumers buy & use it
– Make it difficult for new firms to enter markets where
firms have established a large network of buyers

• Brand loyalties
– Strong customer allegiance to existing firms may keep
new firms from finding enough buyers to make entry
worthwhile
 Government Monopolies Vs. Market
Monopolies
Some economists use the term government monopoly to
refer to monopolies that are legally protected from
competition and the term market monopoly to refer to
monopolies that are not legally protected from
competition.

• An industry is a natural monopoly when one firm can

supply a good or service to an entire market at a smaller
cost than could two or more firms.
– Example: delivery of electricity, phone service, tap
water, etc.
 Competition v. Monopoly

CHAPTER 15 MONOPOLY 6
 Comparing Monopoly and Competition
• For a competitive firm, price equals marginal cost.
P = MR = MC
• For a monopoly firm, price exceeds marginal cost.
P > MR = MC
• Note that the monopolist does not have a supply curve
– The monopolist is a price maker; it chooses what price to
charge
– A perfectly competitive firm is a price taker; it responds to
whatever the market price happens to be and chooses what
quantity to produce at that price
– This is why there is a supply curve in perfect competition,
but not in monopoly.
– This is why the theory of supply and demand (chapter 4)
works only under perfect competition

7
 Figure 2 Demand Curves for Competitive and Monopoly Firms

(a) A Competitive ’s Demand (b) A Monopolist’s Demand

Firm Curve Curve
Pric Pric
e e

Deman
d

Deman
d

0 Quantity of Output 0 Quantity of Output

8
Recap from Ch 14: Profit

• Profit equals total revenue minus total costs.

– Profit = TR – TC
– Profit/Q = TR/Q – TC/Q
– Profit = (TR/Q – TC/Q) × Q
– Profit = (P – ATC) × Q

9
Recap from Ch 14: A Firm’s Revenue

• Total Revenue
TR = P × Q
• Average Revenue
AR = TR/Q = P
• Marginal Revenue
MR = ΔTR/ΔQ

10
Table 1 A Monopoly’s Total, Average,
and Marginal Revenue

Note that P = AR > MR.

Recall that, in perfect

competition, P = AR =
MR.

11
 Figure 3 Demand and Marginal-Revenue Curves for a Monopoly

Price
$11 Note that P = AR > MR
10 at all quantities.
9
8
7
6
5
4
3 Demand
2 Marginal (average
1 revenue revenue)
0
–1 1 2 3 4 5 6 7 8 Quantity of Water
–2
–3
–4
12
 Monopoly Pricing and Output
Decisions
• A monopolist is a price searcher; that is, it is a seller
that has the ability to control to some degree the price
of the product it sells.
• In the theory of monopoly, the monopoly firm is the
industry and the industry is the monopoly firm. They
are the same.
 Figure 4 Profit Maximization for a Monopoly
Costs
and
Revenu 2. . . . and then the demand 1. The intersection of the
e curve shows the price marginal-revenue
consistent with this quantity. curve
and the marginal-cost
curve determines the
B profit-maximizin
Monopol g
quantity . . .
y pric
e 3. Note that P > MR = MC in equilibrium.

Average total cost

MC A

Margina Deman
l cost d

Marginal
revenue
0 Q QMAX Q Quantity

4. Recall that in perfect competition P = MR = MC in equilibrium. Can you pinpoint the

perfect competition outcome in this diagram?14
 Figure 5 The Monopolist’s Profit

Costs
and
Revenu
e

Marginal
cost
Monopol E B
y pric
e
Monopol Average total cost
y profit

Averag
e total D C
cost
Deman
d

Marginal
revenue
0 QMAX Quantity
15
A Monopolist’s Profit

• Recall that profit = (P – ATC) × Q

• Therefore, the monopolist will stay in business
as long as price (P) is greater than average
total cost (ATC).

CHAPTER 15 MONOPOLY 16
 For Monopolists:
• Note that the price of the good being sold is greater than the
marginal revenue. P>MR
• To sell an additional unit of a good (per time period), the
monopolist must lower price.
• The monopolist gains and loses by lowering price.
• The gain equals the price of the product times one.
• The loss equals the difference between the new lower price
and the old higher price times the units of output sold
before the price was lowered.
• Marginal revenue can be defined as revenue gained minus
revenue lost
• P=Revenue gained, MR=Revenue Gained – revenue lost, and
revenue lost is >0. Therefore, P>MR
The Dual Effects of a Price Reduction
on Total Revenue

To sell an additional unit of

the good, a monopolist
needs to lower price. This
price reduction both gains
revenue and loses revenue
for the monopolist. In the
exhibit, the revenue gained
and revenue lost are shaded
and labeled. Marginal
revenue is equal to the
larger shaded area minus the
smaller.
 Monopolist Demand and Marginal
Revenue Curves

In monopoly, the
firm’s demand curve
is not the same as its
marginal revenue
curve. The
monopolist’s
demand curve lies
above its marginal
revenue curve.
 Maximizing Profit, Monopolist Style
• Maximizing revenues is the same as maximizing
profits only when a firm has no variable costs. It is
unlikely, though, that a firm will be without variable
costs.
• The monopolist that seeks to maximize profits
produces the quantity of output at which MR=MC
and charges the highest price per unit at which this
quantity of output can be sold.
 The Monopolist’s Profit-Maximizing Price and
Quantity of Output

The monopolist produces

the quantity of output (Q1)
at which MR=MC, and
charges the highest price
per unit at which the
quantity of output can be
sold (P1). Notice that at
the profit maximizing
quantity of output, price is
greater than marginal cost,
P>MC.
 Competition Vs. Monopoly

• For the perfectly competitive firm, P=MR; for the

monopolist, P>MR. The perfectly competitive
firm’s demand curve is its marginal revenue curve;
the monopolist’s demand curve lies above its
marginal revenue curve
• The perfectly competitive firm charges a price
equal to marginal cost; the monopolist charges a
price greater than marginal cost.
• A monopoly firm differs from a perfectly
competitive firm in terms of how much consumers’
surplus buyers receive.
 Figure 6 The Market for Drugs (Pharmaceutical)

Costs and
Revenue

P > MC;
monopoly

Price
during
P = MC; perfect
patent life
competition

Price after
Marginal
patent
cost
expires
Marginal Demand
revenue

0 Monopoly Competitive Quantity

quantity quantity
24
 The Case Against Monopoly
• The Deadweight Loss of Monopoly: Greater output is
produced under perfect competition than under
monopoly. The net value of the difference in these
two output levels is said to be the deadweight loss of
monopoly. This is the amount buyers value the
additional output over and above the opportunity
costs of producing the additional output.
• Rent Seeking: If firm A tries to get the government to
transfer “income” or consumers’ surplus from buyers
to itself it is undertaking a transfer seeking activity. In
economics, these activities are usually called Rent
Seeking.
 Deadweight Loss and Rent Seeking
as Costs of Monopoly
The monopolist produces
QM, and the perfectly
competitive firm produces
the higher output level
QPC. The deadweight loss
of the monopoly is the
triangle (DCB) between
these two levels of output.
Rent seeking is a socially
wasteful activity because
resources are expended to
affect a transfer and not to
produce goods and
services.
 X-Inefficiency
Refers to The increase in costs when monopolists
are operating at higher than lowest possible costs,
and to the organizational slack that is directly tied
to this.
 Price Discrimination
– Price discrimination occurs when the seller charges different
prices for the product it sells, and the price differences do not
reflect costs. Example: Movie tickets, Airline tickets ,Discount
coupons, Financial aid Quantity discounts

• Perfect Price Discrimination: sells each unit separately and

charges the highest price each consumer would be willing to pay
for the product.
• Second Degree Discrimination: it charges a uniform price per unit
for one specific quantity, a lower price for an additional quantity,
and so on.
• Third Degree Discrimination: it charges a different price in
different markets or charges a different price to different
segments of the buying population
 Why Price Discrimination?
• For the monopolist who practices perfect price
discrimination, price equals marginal revenue.
• Conditions of Price Discrimination:
– The seller must exercise some control over price; it must
be a price searcher.
– The seller must be able to distinguish among buyers who
would be willing to pay different prices.
– It must be impossible or too costly for one buyer to resell
the good at other buyers. The possibility of arbitrage, or
“buying low and selling high” must not exist.
• The perfectly price discriminating monopolist and
the perfectly competitive firm both exhibit resource
allocative efficiency.
 Price Discrimination
• The perfectly price-discriminating monopolist
tries to get the highest price for each
customer, irrespective of what other
customers pay.
• One of the uses of the cents-off coupon is to
make it possible for the seller to charge a
higher price to one group of customers than
to another group.
By price discriminating,
the firm can increase its
profit.
In doing so, it converts
consumer surplus into
economic profit.