MONASH

BUSINESS
SCHOOL

ECF1100 Microeconomics

Week 10 – Monopoly and monopolistic competition

Dr. George Rivers
We are up to week 10

Week Topic Reading/

Reference
1 Introduction to economics Chapters 1, 2 and 3
2 The market forces of supply and demand Chapter 4
3 Elasticity and its application Chapter 5
4 Supply, demand and government policies, market Chapters 6,7,and 8
efficiency and costs of taxation
Applications of supply and demand: international trade Chapters 9 and 19
5 and labour markets (pages 422 to 435 and
pages 438 to 439)
6 Market failure and government intervention (Chapters 10 and 11)
7 MID SEMESTER TEST (to be held during the lecture:
you must attend the lecture you are allocated to)
8 Costs of production Chapter 13
9 Firms in competitive markets Chapter 14
10 Monopoly and Monopolistic competition Chapters 15 and 16

MONASH
!2 BUSINESS
SCHOOL
Learning objectives

1. Define monopoly.
2. Explain the four main reasons why monopolies arise.
3. Explain how a monopoly determines price and output.
4. Use a graph to illustrate how a monopoly affects surplus.
5. Discuss government policies towards monopolies.
6. Explain why a monopolistically competitive firm has a downward-
sloping demand curve.
7. Explain how a monopolistically competitive firm decides the quantity
to produce and the price to charge.
8. Analyse the situation of a monopolistically competitive firm in the long
run.
9. Compare the efficiency of monopolistic competition and perfect
competition.

MONASH
!3 BUSINESS
SCHOOL
Monopoly: The only
seller of a good or
service that does not
have a close
substitute.

MONASH
!4 BUSINESS
SCHOOL
 DeBeers
Presently produces about 45% by
value of the total annual global
diamond production

Controls over 80% of diamond sales

through the Diamond Trading
Company (DTC)

MONASH
!5 BUSINESS
SCHOOL
Sources of Monopoly

▪ Exclusive ownership of a key resource: (e.g. Alcoa, De

Beers)
▪ Government-created monopolies: Patent, copyright
laws, regulation (e.g. Australia Post, utility companies)
▪ Network economies: Value to customers increases in the
number of customers (e.g. communications services
(phone, fax), software, Internet portal, Facebook)
▪ Natural monopoly: A situation in which economies of
scale are so large that one firm can supply the entire
market at a lower average total cost than can two or more
firms.

MONASH
!6 BUSINESS
SCHOOL
Monopoly Vs Competition

• The key difference between a competitive firm and a

monopoly is the monopoly’s ability to influence the price of
its output.

• A competitive firm is small relative to the market in which it

operates and, therefore, takes the price of its output as
given by market conditions.

MONASH
!7 BUSINESS
SCHOOL
Demand curves for competitive and monopoly firms

MONASH
!8 BUSINESS
SCHOOL
A monopoly’s total, average and marginal revenue

MONASH
!9 BUSINESS
SCHOOL
A monopolist’s marginal revenue

• The marginal revenue and demand curves always start at

the same point on the vertical axis because the marginal
revenue of the first unit sold equals the price of the good.

• The monopolist’s marginal revenue on all units after the

first is less than the price of the good.

• Thus, a monopoly’s marginal revenue curve lies below its

demand curve.

MONASH
!10 BUSINESS
SCHOOL
Demand (average revenue) and marginal revenue functions for a monopoly


MONASH
!11 BUSINESS
SCHOOL
Profit maximisation for a monopoly

MONASH
!12 BUSINESS
SCHOOL
Profit maximisation for a monoploy

• At a low level of output, such as Q1, marginal cost is less

than marginal revenue. If the firm increased production by
one unit, the additional revenue would exceed the
additional costs, and profit would rise.

• At high level of output, such as Q2, marginal cost is

greater than marginal revenue. If the firm reduced
production by one unit, the costs saved would exceed the
revenue lost.

MONASH
!13 BUSINESS
SCHOOL
Profit maximisation for a monoploy

• After the monopoly firm chooses the quantity of output, it

uses the demand curve to find the price consistent with
that quantity.

• In competitive markets, price equals marginal cost; in

monopolised markets, price exceeds marginal cost.

MONASH
!14 BUSINESS
SCHOOL
The monopolisit’s profit

MONASH
!15 BUSINESS
SCHOOL
Welfare cost under monopoly

• What quantity would a benevolent social planner want the

monopoly to produce?

• The demand curve reflects the value of the good to

buyers, as measured by their willingness to pay for it.

• The marginal cost curve reflects the costs of the

monopolist.

MONASH
!16 BUSINESS
SCHOOL
Allocative inefficiency under a monopoly

MONASH
!17 BUSINESS
SCHOOL
Is a monopolist’s profit a social cost?

• A monopolist’s profit is not in itself necessarily a problem

for society. After all, producer surplus is a part of the total
surplus.
• Suppose, however, that a monopoly firm has to incur
additional costs to maintain its monopoly position.
• For example, a firm with a government created monopoly
might need to hire lobbyists to convince politicians to
continue its monopoly. If the monopoly uses up some of
its monopoly profits paying for these additional costs, then
these costs are a part of the social loss from monopoly.

MONASH
!18 BUSINESS
SCHOOL
Monopolistic competiton

▪ Monopolistic competition has the following attributes:

– Many sellers: there are many firms competing for the
same group of customers.
– Product differentiation: each firm produces a product
that is at least slightly different from those of other
firms. Rather than being a price taker, each firm faces
a downward-sloping demand curve.

MONASH
!19 BUSINESS
SCHOOL
There are many sellers under monopolistic competition

MONASH
!20 BUSINESS
SCHOOL
Product differentiation

• Each seller sells a differentiated product

• The greater the differentiation the greater the switching

costs – the less sensitive consumers will be to prices

• Prices set above marginal cost

MONASH
!21 BUSINESS
SCHOOL
Monopolistic competition

• Because its product is different from those offered by

other firms, each firm in a monopolistically competitive
market faces a downward sloping demand curve.

• The profit-maximising quantity is found at the intersection

of the marginal revenue and marginal cost curves.

• In this case, price exceeds average total cost, so the firm

makes a profit.

MONASH
!22 BUSINESS
SCHOOL
Short term profit under monopolistic competition

MONASH
!23 BUSINESS
SCHOOL
Monopolistic competition and long run equilibrium

• When firms are making profits, new firms have an

incentive to enter the market. Entry increases the number
of products from which customers can choose and,
therefore, reduces the demand faced by each firm
already in the market.

• Conversely, when firms are making losses, firms in the

market have an incentive to exit. Customers have fewer
products from which to choose, which expands the
demand faced by those firms that remain in the market.

MONASH
!24 BUSINESS
SCHOOL
Monopolistic competition and long run equilibrium

▪ Because of these shifts in demand, a monopolistically

competitive firm eventually finds itself in the long-run
equilibrium where price equals average total cost and the
firm earns zero profit.

MONASH
!25 BUSINESS
SCHOOL
Monopolistic competitor in the long run

MONASH
!26 BUSINESS
SCHOOL
Monopolistic competitor in the long run

• In the long run equilibrium, price equals average total cost

and the firm earns zero profit.

• Notice that the demand curve just barely touches the

average total cost curve. The two curves are tangential to
each other.

• Also note that this point of tangency occurs at the same

quantity where marginal revenue equals marginal cost.

MONASH
!27 BUSINESS
SCHOOL
Monopolistic competition versus perfect competition

MONASH
!28 BUSINESS
SCHOOL
Allocative and productive inefficiency under monopolistic competition

• Allocative inefficiency: mark-up of price over marginal

cost. Buyers who value the good at more than the
marginal cost of production, but less than the price, will be
deterred from buying it, creating a deadweight loss.
• Productively inefficient in the long run (i.e. equilibrium
level of output is less than minimum efficient scale).
• However, it is more efficient in terms of dynamic
efficiency. Consumers are able to purchase a product
that is differentiated and more closely suited to their
tastes.

MONASH
!29 BUSINESS
SCHOOL