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Monopoly

CHAPTER

© 2003 South-Western/Thomson Learning


1
Barriers to Entry
A monopoly is the sole supplier of a
product with no close substitutes
The most important characteristic of
a monopolized market is barriers to
entry  new firms cannot profitably
enter the market
Barriers to entry are restrictions on
the entry of new firms into an
industry
Legal restrictions
Economies of scale
Control of an essential resource

2
Legal Restrictions

One way to prevent new firms from


entering a market is to make entry
illegal

Patents, licenses, and other legal


restrictions imposed by the
government provide some
producers with legal protection
against competition

3
Patent and Invention Incentives
A patent awards an inventor the
exclusive right to produce a good
or service for 20 years

Patent laws
Encourage inventors to invest the time
and money required to discover and
develop new products and processes
Also provide the stimulus to turn an
invention into a marketable product, a
process called innovation

4
Licenses and other Entry Restrictions
Governments often confer
monopoly status by awarding a
single firm the exclusive right to
supply a particular good or service

Broadcast TV and radio rights

State licensing of hospitals

Cable TV and electricity on local level

5
Economies of Scale
A monopoly sometimes emerges
naturally when a firm experiences
economies of scale as reflected by
the downward-sloping, long-run
average cost curve

In these situations, a single firm


can sometimes supply market
demand at a lower average cost per
unit than could two or more firms
at smaller rates of output

6
Exhibit 1: Economies of Scale as a Barrier to Entry

$
Put another way, market
demand is not great enough to
permit more than one firm to
achieve sufficient economies
of scale  a single firm will
emerge from the competitive
Cost per unit

process as the sole seller in


the market.

Long-run
average cost

Quantity per period


7
Natural Monopoly
Because such a monopoly emerges
from the nature of costs, it is called
a natural monopoly

A new entrant cannot sell enough


output to experience the
economies of scale enjoyed by an
established natural monopolist 
entry into the market is naturally
blocked

8
Control of Essential Resources
Another source of monopoly power is a
firm’s control over some nonreproducible
resource critical to production
Professional sports teams try to block the
formation of competing leagues by signing the
best athletes to long-term contracts
Alcoa was the sole U.S. maker of aluminum for a
long period of time because it controlled the
supply of bauxite
China is the monopoly supplier of pandas
DeBeers controls the world’s diamond trade

9
Local Monopolies
Local monopolies are more common
that national or international
monopolies

Numerous natural monopolies for


products sold in local markets

However, as a rule long-lasting


monopolies are rare because, as we
will see, a profitable monopoly
attracts competitors
10
Revenue for the Monopolist
Because a monopoly, by definition, supplies
the entire market, the demand for goods or
services produced by a monopolist is also
the market demand

The demand curve for the monopolist’s


output therefore slopes downward,
reflecting the law of demand

As seen in the following discussion this has


important implications for revenues

11
Demand, Average and Marginal Revenue
Suppose De Beers controls the entire
diamond market and suppose they can
sell three diamonds a day at $7,000
each  total revenue of $21,000

Total revenue divided by quantity is


the average revenue per diamond
which is also $7,000

Thus, the monopolist’s price equals


the average revenue per diamond

12
Demand, Average and Marginal Revenue
To sell a fourth diamond, De Beers
must lower the price to $6,750 
total revenue for 4 diamonds is
$27,000 and average revenue is again
$6,750

The marginal revenue from selling the


fourth diamond is $6,000  marginal
revenue is less than the price or
average revenue

Recall that these were equal for the


perfectly competitive firm
13
Exhibit 2: Loss or Gain from Selling
One More Unit
By selling another diamond, De Beers gains
the revenue from that sale, $6,750 from the
$7,00 4th diamond as shown by the blue-shaded
0 LOSS
6,750 vertical rectangle marked gain.
However, to sell that 4th unit, De Beers must
Price per sell all four diamonds for $6,750 each  it
Diamond must sacrifice $250 on each of the first three
diamonds which could have sold for $7,000
G D = Average each.
revenue
A
I The loss in revenue from the first three units,
N $750, is shown by the red shaded horizontal
rectangle marked Loss.

The net change in total revenue from selling


the 4th diamond equals the gain minus the
loss  $6,750 - $750 = $6,000.
0 3 4 1 - carat diamonds per day 14
Exhibit 3: Revenue Schedule
Revenue for De Beers, a Monopolist The first two columns contain the
1-Carat Price pertinent price and quantity information.
diamonds (average Total Marginal
per day revenue) revenue revenue
Total revenue (quantity times price) is
(Q) (p) (TR = Q x p) (MR = TR /
Q) provided in the third column. As De
(1) (2) (3) =(1) x (2) (4) Beers expands output, total revenue
increases until quantity reaches 15
0 $7,750 0 - diamonds when total revenue tops out.
1 7,500 $7,500 $7,500
2 7,250 14,500 7,000
3 7,000 21,000 6,500
4 6,750 27,000 6,000 Marginal revenue (the change in total
5 6,500 32,500 5,500 revenue from selling one more diamond)
6 6,250 37,500 5,000 appears in the fourth column. Note that for
7 6,000 42,000 4,500 all units of output except the first, marginal
8 5,750 46,000 4,000 revenue is less than the price, and the gap
9 5,500 49,500 3,500
10 5,250 52,500 3,000
between the two widens as the price
11 5,000 55,000 2,500 declines because the loss from selling all
12 4,750 57,000 2,000 diamonds at this lower price increases.
13 4,500 58,500 1,500
14 4,250 59,500 1,000 Exhibit 4 depicts this information
15 4,000 60,000 500 graphically.
16 3,750 60,000 0
17 3,500 59,500 -500
15
Exhibit 3: Monopoly Demand and Marginal and
Total Revenue
(a) Demand and Marginal Revenue
Demand and marginal revenue are
shown in the upper panel and total
revenue is in the lower panel. Elastic

Dollars per diamond


Unit elastic
$3,750
Note that the marginal revenue curve
is below the demand curve and total Inelastic

revenue is at a maximum when


0
marginal revenue equals zero. Marginal revenue
D = Average revenue

16 32 1-carat diamonds per day


(b) Total Revenue
Notice also that when demand is
elastic, a decrease in price increases
$60,000
total revenue  marginal revenue is
positive. Conversely, when demand
Total dollars

is inelastic, a decrease in price


Total revenue
reduces total revenue  marginal
revenue is negative

16
0 16 32 1-carat diamonds per day
Firm’s Costs and Profit Maximization

The monopolist can choose either


the price or the quantity, but
choosing one determines the other

Because the monopolist can select


the price that maximizes profit, we
say the monopolist is a price maker

More generally, any firm that has


some control over what price to
charge is a price maker
17
Profit Maximization
Exhibits 5 and 6 repeat the revenue
data from the previous exhibits and
also include short-run cost data

The cost data are similar to those


already introduced in the preceding
chapters

The key issue is which price-


quantity combination should De
Beers select to maximize profits
18
Exhibit 5: Short-Run Revenues and Costs for the
Monopolist

Short-run Costs and Revenue for a Monopolist


The profit-
Price Marginal Marginal Average Total
Diamonds (average Total Revenue Total Cost Total Cost Profit or maximizing
per day revenue) revenue (MR = Cost ( MC = (ACT = Loss = monopolist employs
the same decision
(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC
(1) (2) (3) =(1) x (2) (4) (5) (6) (7) rule as the
(8) competitive firm 
the monopolist
0 $7,750 0 - $15,000 - - -
$15,000 produces that
1 7,500 $7,500 $7,500 19,750 4,750 $19,750 quantity where total
-12,250
revenue exceeds
2 7,250 14,500 7,000 23,500 3,750 11,750
9,000 total cost by the
3 7,000 21,000 6,500 26,500 3,000 8,830 greatest amount 
-5,500
$12,500 per day
4 6,750 27,000 6,000 29,000 2,500 7,750
-2,000 when output is 10
5 6,500 32,500 5,500 31,000 2,000 6,200 units per day. Total
1,500
revenue is $52,500
6 6,250 37,500 5,000 32,500 1,500 5,420
5,000 and total cost is
7 6,000 42,000 4,500 33,750 1,250 4,820 $40,000
8,250
8 5,750 46,000 4,000 35,250 1,500 4,410
10,750
9 5,500 49,500 3,500 37,250 2,000 4,140 19
Exhibit 5: Short-Run Revenues and Costs for the
Monopolist

Short-run Costs and Revenue for a Monopolist Applying the


Price Marginal Marginal Average Total marginal rule would
Diamonds (average Total Revenue Total Cost Total Cost Profit or imply that the
per day revenue) revenue (MR = Cost ( MC = (ACT = Loss = monopolist increases
(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC output as long as
(1) (2) (3) =(1) x (2) (4) (5) (6) (7) selling additional
(8) diamonds adds more
0 $7,750 0 - $15,000 - - - to total revenue than
$15,000 to total cost. Again
1 7,500 $7,500 $7,500 19,750 4,750 $19,750 profit is maximized
-12,250
2 7,250 14,500 7,000 23,500 3,750 11,750 at $12,500 when
9,000 output is 10
3 7,000 21,000 6,500 26,500 3,000 8,830 diamonds per day,
-5,500
4 6,750 27,000 6,000 29,000 2,500 7,750 per unit costs are
-2,000 $4,000 and the price
5 6,500 32,500 5,500 31,000 2,000 6,200 is $5,250. Exhibit 6
1,500
6 6,250 37,500 5,000 32,500 1,500 5,420 provides a graphical
5,000 illustration of this
7 6,000 42,000 4,500 33,750 1,250 4,820 process.
8,250
8 5,750 46,000 4,000 35,250 1,500 4,410
10,750
9 5,500 49,500 3,500 37,250 2,000 4,140 20
Exhibit 6: Monopoly Costs and Revenue
(a) Per-Unit Cost and Revenue
The intersection of the two marginal curves at
point e in panel (a) indicates that profit is Marginal cost
maximized when 10 diamonds are sold. At Average total cost
this rate of output, we move up to the demand

Dollars per unit


a
$5,250
curve to find the profit-maximizing price of Profit b
$5,250. The average total cost of $4,000 is 4,000
identified by point b  the average profit per e
diamond equals the price of $5,250 minus the
D  Average revenue
average total cost of $4,000  $1,250  MR
economic profit is the equal to $1,250 * 10 0 10 16 32 Diamonds per day
units sold  $12,500 as shown by the blue (b) Total Cost and Revenue
shaded area.
Total cost
Maximum
profit
In panel (b), the firm’s profit or loss is $52,500
measured by the vertical distance between
Total dollars

the total revenue and total cost curves  40,000


again profit is maximized where De Beers
produces 10 diamonds per day
Total revenue
15,000

0 10 16 32 Diamonds per day


21
Short-Run Losses and the Shutdown Decision

A monopolist is not assured of profit


The demand for the monopolists good or
service may not be great enough to
generate economic profit in either the
short run or the long run
In the short run, the loss-minimizing
monopolist must decide whether to
produce or to shut down
If the price covers average variable cost,
the firm will produce
If not, the firm will shut down, at least in
the short run

22
Exhibit 7: The Monopolist Minimizes Losses in the
Short Run
Recall that average variable cost and
average fixed cost sum to average total Marginal cost
cost .

Loss minimization occurs at point


e, where the marginal revenue a Average total cost
curve intersects the marginal cost
Loss
curve  Q and p are the loss p b
minimization quantity and price, Average variable cost
respectively.
c
Dollars per unit

Notice that at point b, the firm is


covering its average variable cost  e
it is making some contribution to its
fixed costs. However, it is not
covering all of its costs. The Demand  Average revenue
average loss per unit, measured by Marginal revenue
ab, is identified by the yellow Quantity per period
0 Q
shaded area.
23
Monopolist’s Supply Curve

The intersection of a monopolist’s


marginal revenue and marginal
cost curve identifies the profit
maximizing quantity, but the price
is found on the demand curve

Thus, there is no curve that shows


both price and quantity supplied 
there is no monopolist supply curve

24
Long-Run Profit Maximization
For a monopoly, the distinction
between the long and short run is
not as important

If a monopoly is insulated from


competition by high barriers that
block new entry, economic profit
can persist in the long run

However, short-run profit is no


guarantee of long-run profit
25
Long-Run Profit Maximization
A monopolist that earns economic
profit in the short-run may find that
profit can be increased in the long
run by adjusting the scale of the firm

Conversely, a monopoly that suffers


a loss in the short run may be able to
eliminate that loss in the long run by
adjusting to a more efficient size

26
Price and Output Comparison
Purpose here is to compare monopoly
using the benchmark established in our
discussion of perfect competition

When there is only one firm in the


industry, the industry demand curve
becomes the monopolist’s demand curve
 the price the monopolist charges
determines how much gets sold

Exhibit 8 provides our comparison

27
Exhibit 8: Perfect Competition and Monopoly
The horizontal supply curve is a
based on the assumption of a
constant-cost industry.
Equilibrium in perfect competition m
p'm

Dollars per unit


is at point c, where market demand
and supply intersect to yield price
pc and quantity Qc. b c
pc Sc = MC = ATC

The monopolist maximizes


D = AR
profit by equating marginal
revenue with marginal cost  MRm
point b  equilibrium price
pm and output Qm. 0 Quantity per period
Q'm Q'c
The price shows the consumers’ marginal benefit at that output rate, point m, which exceeds
the marginal cost, point b. Because the marginal benefit consumers attach to additional
units exceeds the marginal cost of producing those additional units, society would be better
off if output were expanded beyond Qm  the monopolist restricts output below the level
that maximizes social welfare  consumer surplus is shown by the yellow triangle ampm
28
Exhibit 8: Perfect Competition and Monopoly

Consumer surplus under perfect a


competition is the large triangle acpc
while under monopoly it shrinks to the
m
p'm

Dollars per unit


smaller triangle ampm

The monopolist earns economic


b c
profit equal to the shaded rectangle pc Sc = MC = ATC
 a transfer from consumer surplus
to monopoly profit  this amount D = AR
is not lost to society and so is not
MRm
considered a welfare loss from
monopoly.
0 Quantity per period
Q'm Q'c
Notice that consumer surplus has been reduced by more than the profit triangle. Consumers
have also lost the triangle mcb which was part of the consumer surplus under perfect
competition  the deadweight loss of monopoly because it is a loss to consumers but a gain
to nobody. This loss results from the allocative inefficiency arising from the higher price
and reduced output.
29
Why the Welfare Loss Might Be Lower

If economies of scale are extensive


enough, a monopolist may be able
to produce output at a lower cost
per unit than could competitive
firms

If this is true, the price or at least


the cost of production could be
lower under monopoly than under
competition

30
Why the Welfare Loss Might Be Lower
The welfare loss shown in Exhibit 8
may also overstate the true cost of
monopoly because monopolists
may, in response to public scrutiny
and political pressure, keep prices
below what the market could bear

Finally, a monopolist may keep the


price below the profit maximizing
level to avoid attracting new
competitors

31
Why the Welfare Loss Might Be Higher
Another line of thought suggests
that the welfare loss of monopoly
may, in fact, be greater than shown
in our example

If resources must be devoted to


securing and maintaining a
monopoly position, monopolies may
involve more of a welfare loss that
simple models suggest

32
Why the Welfare Loss Might Be Higher

Consider, for example, radio and TV


broadcasting rights confer on the
recipient the exclusive right to use a
particular band of the scarce broadcast
spectrum

In the past, these rights have been given


away by government agencies to the
applicants deemed most deserving

33
Why the Welfare Loss Might Be Higher
Because these rights are so
valuable, numerous applicants
spend millions on lawyers’ fees,
lobbying expenses, and other costs
associated with making themselves
appear the most deserving

The efforts devoted to securing and


maintaining a monopoly position are
largely a social waste because they
use up scarce resources but add not
unit to output
34
Why the Welfare Loss Might Be Higher

Activities undertaken by individuals


or firms to influence public policy in
a way that will directly or indirectly
redistribute income to them are
referred to as rent seeking

Second, monopolists insulated from


the rigors of competition in the
marketplace, may also become
efficient

35
Why the Welfare Loss Might Be Higher

Finally, monopolists have also been


criticized for being slow to adopt
the latest production techniques, to
develop new products, and
generally lacking innovativeness

36
Price Discrimination
A monopolist can sometimes increase
economic profit by charging higher
prices to customers who value the
product more

The practice of charging difference


prices to different customers when
the price differences are not justified
by differences in cost is called price
discrimination

37
Conditions for Price Discrimination
Conditions
The demand curve for the firm’s product
must slope downward  the firm has some
market power and control over price
There are at least two groups of consumers
for the product, each with a different price
elasticity of demand
The producer must be able, at little cost, to
charge each group a different price for
essentially the same product
The producer must be able to prevent those
who pay the lower price from reselling the
product to those who pay the higher price

38
Model of Price Discrimination

Exhibit 9 shows the effects of price


discrimination

Consumers are divided into two


groups with different demands

39
Exhibit 9: Price Discrimination
(a) (b)

Dollars per unit


Do llars per u nit

$3.00

$1.50
1.00 LRAC, MC 1.00 LRAC, MC
D'
MR D MR'
0 400 Quantity per period 0 500 Quantity per period
At a given price, the price elasticity of demand in panel b(elastic) is greater than in panel a (inelastic). For
simplicity, assume the firm produces at a constant long-run average and marginal cost of $1. This firm
maximizes profits by finding the price in each market that equates marginal revenue with marginal cost 
consumers with the lower price elasticity pay $3 and those with the higher price elasticity pay $1.50 in
markets with elastic demand the price will be lower than in markets where demand is inelastic.
40
Examples of Price Discrimination
Because businesspeople face
unpredictable yet urgent demands
for travel and communication, and
because employers pay such
expenses, businesspeople are less
sensitive to price than householders

Telephone companies are able to


sort out their customers by charging
different rates based on the time of
day

41
Perfect Price Discrimination
If a monopolist could charge a
different price for each unit sold, the
firm’s marginal revenue curve from
selling one more unit would equal the
price of that unit  the demand curve
would become the marginal revenue
curve

A perfectly discriminating monopolist


charges a different price for each unit
of the good

Exhibit 10 provides our example


42
Exhibit10: Perfect Price Discrimination
A perfectly discriminating
a monopolist would maximize
profits at point e where marginal
revenue equals marginal cost 
price set at point e
D o l la r s p e r u n i t

Profit
Long-run
e average cost
c
= marginal cost

D = Marginal
revenue

0 Q 43
Quantity per period
Perfect Price Discrimination
Perfect price discrimination gets high
marks based on allocative efficiency

Because such a monopolist does not


have to lower price to all customers
when output expands, there is no reason
to restrict output

In fact, because this is a constant-cost


industry, Q is the same quantity
produced in perfect competition

44
Perfect Price Discrimination
As in perfect competition, the marginal
benefit of the final unit of output
produced just equals its marginal cost

And although perfect price discrimination


yields no consumer surplus, the total
benefits consumers derive just equal the
total amount they pay for the good

Since the monopolist does not restrict


output, there is no deadweight loss

45