ECON 201

CHAPTER 15 MONOPOLY
A monopoly is a firm that is the sole seller of a product without close substitutes.
A monopoly firm has market power, the ability to influence the market price of the
product it sells. A competitive firm has no market power.
Sources of Monopoly Power
The main cause of monopolies is barriers to entry other firms cannot enter the market.
Three sources of barriers to entry:
1.

A single firm owns a key resource.

E.g., DeBeers owns most of the worlds diamond mines

2.

The government gives a single firm the exclusive right to produce the good.
E.g., patents, copyright laws

3.
Natural Monopoly: A single firm can produce the entire market Q at lower cost
than could several firms (economies of scale over the relevant range of output).
E.g., distribution of water or electricity
Monopoly versus Competition
In a competitive market, the market demand curve slopes downward. But the demand
curve for any individual firms product is horizontal at the market price.
The firm can increase Q without lowering P, so MR = P for the competitive firm.
A monopolist is the only seller, so it faces the market demand curve.
To sell a larger Q, the firm must reduce P (thus, MR P). Note that the monopolist can
choose a point along the market demand curve (combination of price and quantity) but
cannot choose a point off (above) the market demand curve.

Monopolysts Revenue
For a monopolist MR<P always because the monopolist faces a downward sloping
demand curve.
Increasing Q has two effects on revenue:

Output effect: higher output raises revenue

Price effect: lower price reduces revenue

To sell a larger Q, the monopolist must reduce the price on all the units it sells.
The MR and the demand curves start at the same intercept on the vertical axis because the
marginal revenue of the first unit sold equals the price of the good. However, the
monopolists marginal revenue on all units after the first is less than the price of the good.
Therefore, MR < P and the marginal revenue curve lies below its demand curve.
MR could even be negative if the price effect exceeds the output effect.
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A Simple Numerical Example (Table 1 page 305 of your book):

Profit Maximization
A firm will continue to produce as long as the marginal revenue obtained from the
production of one extra unit is greater than the marginal cost that it faces to produce that
extra unit.
If MR > MC increase production
If MC > MR produce less
To maximize profit the monopolist produces quantity where MR=MC (intersection of the
marginal-revenue curve and the marginal-cost curve)
Once the monopolist identifies the quantity where MR=MC, he sets the highest price
consumers are willing to pay for that quantity. The monopolist finds this price from the D
curve.
A monopolys Profit = TR TC = (P ATC) Q

Monopolized versus Competitive Markets The Case of Generic Drugs

Note the difference between perfect competition and monopoly:
In perfect competition: P=MR=MC (Price equals Marginal Cost)
A competitive firm takes P as given and has a supply curve that shows how its Q depends
on P.
In monopoly: P>MR=MC (Price exceeds Marginal Cost)
A monopoly firm is a price-maker, not a price-taker. Q does not depend on P;
rather, Q and P are jointly determined by MC, MR, and the demand curve.
So there is no supply curve for monopoly.
Patents on new drugs give a temporary monopoly to the seller. When the patent expires,
the market becomes competitive, generic drugs appear.
New drug, patent laws monopoly
Produce Q where MR=MC
P>MC
Generic drugs competitive market
Produce Q where MR=MC
And P=MC
The price of the competitively produced generic drug is below the price that the
monopolist was able to charge due to the patent.

The Welfare Cost of Monopolies

A monopolist produces a quantity such that MC = MR. This quantity is less than the
socially efficient quantity of output and corresponds to a price P>MC.
Monopoly pricing prevents some mutual beneficial trades from taking place. There are in
fact some consumers that value the good at more than the monopolists marginal cost but
less than the monopolists price.
The deadweight loss is the triangle between the demand curve and the MC curve.

Its not the profit earned by the monopolist the problem in terms of social welfare, but
rather the inefficiently low quantity of output.

Price Discrimination
In competitive markets many firms sell the same good; therefore if one firm charges any
consumer or group of consumers a higher price, it would not be able to sell the good.
However, if a firm is a monopolist, it can try to sell the good to different customers at
different prices.
The characteristic used in price discrimination is willingness to pay: a firm can increase
profit by charging a higher price to buyers with higher willingness to pay.
When the monopolist charges the same price to all buyers he obtains profits, however
there is also a consumer surplus and a deadweight loss. The consumer surplus is due to
the fact that some consumers would have been willing to pay a higher price that the price
set by the monopolist. The deadweight loss is instead due to the fact that some consumers
were willing to pay a price smaller than the price set by the monopolist, but still greater
than the marginal cost for the monopolist.
If the monopolist can perfectly price discriminate, he will charge each customer exactly
the price that the customer is willing to pay. Therefore the entire surplus goes to the
monopolist and there is no consumer surplus and no deadweight loss.

In the real world, perfect price discrimination is not possible because firms dont know
every buyers willingness to pay. Therefore firms divide customers into groups based on
some observable trait that is likely related to their willingness to pay, such as age.
Examples of Price Discrimination
Movie tickets: discounts for students, seniors and matinees.
Airline Prices: discounts for non-business travelers (Saturday stays over)
Discount Coupons: people who have time to clip and organize coupons are more likely to
have lower income and lower willingness to pay than others.
Need-based financial aid: low income families have lower willingness to pay for their
childrens college education. Schools price-discriminate by offering need-based aid to
low income families.
Quantity discounts: a buyers willingness to pay often declines with additional units, so
firms charge less per unit for large quantities than small ones.
Public Policies toward Monopolies
Monopolies, in contrast to perfectly competitive markets, fail to allocate resources
efficiently. Moreover, the monopoly related losses may be greater than just the
deadweight losses as potential monopolies may spend resources on lobbying/lawyers and
politicians and this implies that resources are not being spent on productive activities but
being spent on increasing the probability of getting a monopoly position. This kind of
expenditure is sometimes referred to as rent-seeking expenditure.1
The basic objective of public policy in this context is to increase and encourage
competition.
a) Anti-trust Laws: The government can intervene directly and break up monopolies,
prevent collusive behavior and prevent mergers.
Mergers result in reduced competition and this can potentially increase prices. However
mergers may also result in increased cost efficiencies which result in lower prices. If the
first negative effect is estimated to be stronger, then the government will not approve the
merger.
b) Price Regulation: The government can try and directly regulate the prices of natural
monopolies such as Electricity Companies, Water Companies, Postal Systems etc. The
1

Note however that although monopoly results in deadweight losses for the economy, the potential for
positive economic profits creates an incentive for firms to invest and R&D and improve the quality of
existing products or come up with new products.

ideal situation from the efficiency perspective is to enforce marginal cost pricing.
Because these are situations of natural monopoly, the long run average total cost curve is
downward sloping and the MC is below the Average cost. So if the price is restricted to
be equal to MC then the price will be below the average cost and the firm will face
losses. The firm then will exit the industry and there would be no provider for the service.

One way to solve the problem is to subsidize the natural monopolist.

An alternative policy may be to enforce average cost pricing. In this case there will still
be deadweight losses and the quantity produced will be below the socially efficient level.
However in both policies the firm does not make profits and has no incentive to reduce
costs.
c) Public Ownership: The government can take over the ownership of the monopoly and
make it a public enterprise (U.S. Postal Service). Public ownership is usually less
efficient since there is no incentive to minimize costs
d) Doing Nothing: The government can choose to do nothing and let the market forces
dictate the outcome.

Conclusion
In the real world, pure monopoly is rare. Yet, many firms have market power, due to
selling a unique variety of a product or having a large market share and few significant
competitors.
In many such cases, most of the results that we have studied apply, including markup of
price over marginal cost and deadweight loss.
Competitive versus Monopoly Markets in Synthesis

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