MONOPOLY

Objectives

After studying this chapter, you will able to

 Explain how monopoly arises and distinguish between
single-price monopoly and price-discriminating monopoly
 Explain how a single-price monopoly determines its
output and price
 Compare the performance and efficiency of single-price
monopoly and competition
Objectives

After studying this chapter, you will able to

 Define rent seeking and explain why it arises
 Explain how price discrimination increases profit
 Explain how monopoly regulation influences output,
price, economic profit, and efficiency
The Profits of Generosity

Most of us use Microsoft Windows to run our computers.

Microsoft isn’t a price taker like the firms in perfect
competition.
How does a firm like Microsoft decide the quantity to
produce and the price to charge?
Students get lots of price breaks—at the movies,
hairdresser, and on the airlines.
Why?
How can it be profit maximizing to offer lower prices to
some customers?
Market Power

Market power and competition are the two forces that

operate in most markets.
Market power is the ability to influence the market, and in
particular the market price, by influencing the total quantity
offered for sale.
A monopoly is an industry that produces a good or
service for which no close substitute exists and in which
there is one supplier that is protected from competition by
a barrier preventing the entry of new firms.
Market Power

How Monopoly Arises

A monopoly has two key features:
 No close substitutes
 Barriers to entry
Legal or natural constraints that protect a firm from
potential competitors are called barriers to entry.
Market Power

There are two types of barriers to entry: legal and natural.

Legal barriers to entry create a legal monopoly, a market
in which competition and entry are restricted by the
granting of a:
 Public franchise
 Government license (like a license to practice law or
medicine)
 Patent and copyright
Market Power

Natural barriers to entry

create a natural
monopoly, which is an
industry in which one firm
can supply the entire
market at a lower price
than two or more firms
can.
Figure 12.1 illustrates a
natural monopoly.
Market Power

One firm can produce 4

units of output at 5 cents
per unit.
Two firms can produce 4
units—2 units each—at 10
cents per unit.
Four firms can produce 4
units—1 unit each—at 15
cents per unit.
Market Power

In a natural monopoly,
economies of scale are so
powerful that they are still
being achieved even when
the entire market demand
is met.
The ATC curve is still
sloping downward when it
meets the demand curve.
Market Power

Monopoly Price-Setting Strategies

For a monopoly firm to determine the quantity it sells, it
must choose the appropriate price.
There are two types of monopoly price-setting strategies:
Price discrimination is the practice of selling different
units of a good or service for different prices. Many firms
price discriminate, but not all of them are monopoly firms.
A single-price monopoly is a firm that must sell each unit
of its output for the same price to all its customers.
A Single-Price Monopoly’s Output and
Price Decision

Price and Marginal Revenue

A monopoly is a price setter, not a price taker like a firm in
perfect competition.
The reason is that the demand curve for the monopoly’s
output is the market demand curve.
To sell a larger output, a monopoly must set a lower price.
A Single-Price Monopoly’s Output and
Price Decision

Total revenue, TR, is the price, P, multiplied by the

quantity sold, Q.
Marginal revenue, MR, is the change in total revenue that
results from a one-unit increase in the quantity sold.
For a single-price monopoly, marginal revenue is less than
the price at each level of output. That is,

MR < P
A Single-Price Monopoly’s Output and
Price Decision

Figure 12.2 illustrates the

relationship between price
and marginal revenue and
derives the marginal
revenue curve.
Suppose the monopoly
sets a price of $16 and
sells 2 units.
A Single-Price Monopoly’s Output and
Price Decision

Now suppose the firm

cuts the price to $14 to
sell 3 units.
It loses $4 of total revenue
on the 2 units it was
selling at $16 each.
And it gains $14 of total
revenue on the 3rd unit.
So total revenue
increases by $10, which is
marginal revenue.
A Single-Price Monopoly’s Output and
Price Decision

The marginal revenue

curve, MR, passes
through the red dot
midway between 2 and 3
units and at $10.
You can see that MR < P
at each quantity.
A Single-Price Monopoly’s
Output and Price Decision
Marginal Revenue and Elasticity
A single-price monopoly’s marginal
revenue is related to the elasticity of
demand for its good.
If demand is elastic, a fall in price
brings an increase in total revenue.
The rise in revenue from the
increase in quantity sold outweighs
the fall in revenue from the lower
price per unit, and MR is positive.
A Single-Price Monopoly’s
Output and Price Decision

If demand is inelastic, a fall in price

brings a decrease in total revenue.
The rise in revenue from the
increase in quantity sold is
outweighed by the fall in revenue
from the lower price per unit, and
MR is negative.
A Single-Price Monopoly’s
Output and Price Decision

If demand is unit elastic, a fall in

price does not change total
revenue.
The rise in revenue from the
increase in quantity sold equals the
fall in revenue from the lower price
per unit, and MR = 0.
A Single-Price Monopoly’s
Output and Price Decision

Total revenue is maximized when

marginal revenue is zero.
A single-price monopoly never
produces an output at which
demand is inelastic.
If it did produce such an output, the
firm could increase total revenue,
decrease total cost, and increase
economic profit by decreasing
output.
A Single-Price Monopoly’s Output and
Price Decision

Output and Price Decisions

The monopoly faces the same types of technology
constraints as the competitive firm, but the monopoly
faces a different market constraint.
The monopoly selects the profit-maximizing level of output
in the same manner as a competitive firm, where MR =
MC.
A Single-Price Monopoly’s Output and
Price Decision

The monopoly sets its price at the highest level at which it

can sell the profit-maximizing quantity.
Table 12.1 on page 262 provides a numerical example to
illustrate the profit-maximizing output and price decision.
The monopoly may earn an economic profit, even in the
long run, because the barriers to entry protect the firm
from market entry by competitor firms.
A Single-Price Monopoly’s Output and
Price Decision

Figure 12.4 illustrates the

profit-maximizing choices
of a single-price
monopolist.
In part (a), the monopoly
sets the quantity produced
at the level that
maximizes total revenue
minus total cost.
A Single-Price Monopoly’s Output and
Price Decision
In part (b), the firm
produces the output at
which MR = MC and sets
the price to sell that
quantity.

The ATC curve tells us the

average cost.
Economic profit is the
profit per unit multiplied by
the quantity produced—
the blue rectangle.
Single-Price Monopoly and Competition
Compared

Comparing Output and

Price
Figure 12.5 compares the
price and quantity in perfect
competition and monopoly.
The market demand curve,
D, in perfect competition is
the demand curve that the
firm faces in monopoly.
Single-Price Monopoly and Competition
Compared

The market supply curve in

perfect competition is the
horizontal sum of the
individual firm’s marginal
cost curves, S = MC.
This curve is the
monopoly’s marginal cost
curve.
Single-Price Monopoly and Competition
Compared

Equilibrium in perfect
competition occurs where
the quantity demanded
equals the quantity
supplied at quantity QC
and price PC.
Single-Price Monopoly and Competition
Compared

Equilibrium output for a

monopoly, QM, occurs
where marginal revenue
equals marginal cost, MR
= MC.
Equilibrium price for a
monopoly, PM, occurs on
the demand curve at the
profit-maximizing quantity.
Single-Price Monopoly and Competition
Compared

Because marginal
revenue is less than price
at each output level, QM <
QC and PM > PC.
Compared to perfect
competition, monopoly
restricts output and
charges a higher price.
Single-Price Monopoly and Competition
Compared

Efficiency Comparison
Monopoly is inefficient, and
Figure 12.6 shows why.
The demand curve is the
marginal benefit curve, MB,
and the competitive market
supply curve is the
marginal cost curve, MC.
So competitive equilibrium
is efficient: MB = MC.
Single-Price Monopoly and Competition
Compared

Consumer surplus is the

area below the demand
curve and above the price.

Producer surplus is the

area below the price and
above the marginal cost
curve.
The sum of the two
surpluses is maximized
and the efficient quantity
is produced.
Single-Price Monopoly and Competition
Compared

Monopoly is inefficient
because price exceeds
marginal cost so marginal
benefit exceeds marginal
cost.

On all output levels for

which marginal benefit
exceeds marginal cost, a
deadweight loss is
incurred.
Single-Price Monopoly and Competition
Compared

Redistribution of
Surpluses
Monopoly redistributes a
portion of consumer
surplus by changing it to
producer surplus.
Single-Price Monopoly and Competition
Compared

Rent Seeking
The social cost of monopoly may exceed the deadweight
loss through an activity called rent seeking, which is any
attempt to capture consumer surplus, producer surplus, or
economic profit.
Rent seeking is not confined to a monopoly. There are two
forms of rent seeking activity to pursue monopoly:
Buy a monopoly—transfers rent to creator of monopoly.
Create a monopoly—uses resources in political activity.
Single-Price Monopoly and Competition
Compared

Rent-Seeking Equilibrium
The resources used in rent
seeking can exhaust the
monopoly’s economic profit
and leave the monopoly
owner with only normal
profit.
Figure 12.7 shows the
normal profit that results
from rent seeking.
Single-Price Monopoly and Competition
Compared

A potential profit shown by

the blue area gets used up
in rent seeking.
Average total cost
increases and the profits
disappear to become part
of the enlarged deadweight
loss from rent seeking.
Price Discrimination

Price discrimination is the practice of selling different units

of a good or service for different prices.
To be able to price discriminate, a monopoly must:
 Identify and separate different buyer types
 Sell a product that cannot be resold
Price differences that arise from cost differences are not
price discrimination.
Price Discrimination

Price Discrimination and Consumer Surplus

Price discrimination converts consumer surplus into
economic profit.
A monopoly can discriminate
Among units of a good. Quantity discounts are an
example. (But quantity discounts that reflect lower costs at
higher volumes are not price discrimination.)
Among groups of buyers. (Advance purchase and other
restrictions on airline tickets are an example.)
Price Discrimination

Profiting by Price
Discriminating
Figures 12.8 and 12.9
show the same market
with a single price and
price discrimination and
show how price
discrimination converts
consumer surplus into
economic profit.
Price Discrimination

As a single-price
monopolist, this firm
maximized profit by
producing 8 units, where
MR = MC and selling them
for $1,200 each.
Price Discrimination

By price discriminating, the

firm can increase its profit.
In doing so, it converts
consumer surplus into
economic profit.
 Price Discrimination

Perfect Price Discrimination

Perfect price discrimination
extracts the entire potential
consumer surplus and
converts it to economic profit.
Price Discrimination

With perfect price

discrimination:
Output increases to the
quantity at which price
equals marginal cost.
Economic profit increases
above that earned by a
single-price monopoly.
Deadweight loss is
eliminated.
Price Discrimination

Efficiency and Rent Seeking with Price Discrimination

The more perfectly a monopoly can price discriminate, the
closer its output gets to the competitive output (P = MC)
and the more efficient is the outcome.
But this outcome differs from the outcome of perfect
competition in two ways:
 The monopoly captures the entire consumer surplus.
 The increase in economic profit attracts even more rent-
seeking activity that leads to an inefficient use of
resources.
Monopoly Policy Issues

Gains from Monopoly

A single-price monopoly creates inefficiency and price
discriminating monopoly captures consumer surplus and
converts it into producer surplus and economic profit.
And monopoly encourages rent-seeking, which wastes
resources.
But monopoly brings benefits.
Monopoly Policy Issues

Product innovation
Patents and copyrights provide protection from
competition and let the monopoly enjoy the profits
stemming from innovation for a longer period of time.
Economies of scale and scope
Where economies of scale or scope exist, a monopoly can
produce at a lower average total cost than a large number
of competitive firms could achieve.
Monopoly Policy Issues

Regulating Natural
Monopoly
When demand and cost
conditions create natural
monopoly, government
agencies regulate the
monopoly.
Figure 12.11 shows how a
natural monopoly might be
regulated.
Monopoly Policy Issues

With no regulation, the

monopoly maximizes profit.
It produces the quantity at
which marginal revenue
equals marginal cost.
Monopoly Policy Issues

Regulating a natural
monopoly in the public
interest sets output where
MB = MC and the price
equal to marginal cost.
This regulation is the
marginal cost pricing rule,
and it results in an efficient
use of resources.
Monopoly Policy Issues

With price equal to marginal

cost, ATC exceeds price and
the monopoly incurs an
economic loss.
If the monopoly receives a
subsidy to cover its loss,
taxes must be imposed on
other economic activity,
which create deadweight
loss.
Monopoly Policy Issues

Where possible, a regulated

natural monopoly might be
permitted to price
discriminate to cover the loss
from marginal cost pricing.
Another alternative is to
produce the quantity at which
price equals average total
cost and to set the price
equal to average total cost—
the average cost pricing
rule.
MONOPOLY
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