Market Structures

Monopoly

Dr. Mudenda
 Outline

 Definition issues Monopoly

 Sources of Monopoly
 The Monopolist’s Supply Decision
 A Comparison of Monopoly and Perfect Competition
 Can Anything Good Be Said About Monopoly?
 Price Discrimination Under Monopoly

Dr. Mudenda
 Definition

 Monopoly: Just one seller that determines the quantity

supplied/the market-clearing price.
 In the strictest sense a firm is considered a pure monopoly if . . .
it is the sole seller of its product.
 its product does not have close substitutes.

 Some reason why entry and survival of a competing firm is

unlikely.
 Pure monopolies are rare in real world because most firms face
competition from firms producing substitutes.
 E.g., sole provider of hydro electricity in a city is not a pure
monopoly, since other firms provide substitutes like gas and
solar electricity.
 if there is only one railroad, it still competes with bus lines,
trucking companies, and airlines

Dr. Mudenda
Sources of Monopoly Power: Barriers to Entry

1. Legal restrictions: Monopolies are established if

government which prevents other firms from entering
the industry.
Governments may restrict entry by giving a single firm the
exclusive right to sell a particular good in certain markets
● E.g., licensing mobile phone provider or cable TV supplier
or right to operate a food stand in a public stadium or
right to operate landlines
2. Patents and Copy Rights: To encourage innovation,
government gives exclusive production rights for a
period of time to product's inventors

Dr. Mudenda
Sources of Monopoly Power: Barriers to Entry

 This to enable them recoup the cost of research and

development. It prevents the production of printed or recorded
materials Monopoly is protected as long as its patent remains
in effect.
3. Control of a scarce resource or input: If a good is
produced with a rare input, a Co. that gains control of
that input can establish a monopoly.
● E.g., DeBeers diamond syndicate controls S of highest
quality diamonds in the world.
4. Deliberately erected entry barriers: An incumbent firm
can make it difficult for potential rivals to enter.
● E.g., Spending huge amounts on advertising forces any potential
entrant to match that expenditure to obtain customers. Intel has
used its "Intel Inside" marketing campaign to ward off
competition
Dr. Mudenda
Sources of Monopoly Power: Barriers to Entry

5. Large entry/sunk costs: Entry into an industry is risky if

it requires a large sunk I. Most important type of
"naturally imposed" barrier to entry.
● E.g., Boeing was the only supplier of top-end airplanes for
many years after intro of its 747. Airbus receives gov.
subsidies so it can afford the high I costs
6. Technical Superiority: A firm whose technological
expertise vastly exceeds that of any potential competitor
can maintain a monopoly for a period of time.
● E.g., For many years, IBM had little competition in
PC business because of its superior technology.
7. Economies of scale: If the size of a firm gives a cost
advantage over a smaller rival, it may be impossible for
anyone to compete with largest firm in the industry.
Dr. Mudenda
Sources of Monopoly Power: Barriers to Entry

 Natural monopoly is an industry where advantages of large

scale production makes it possible for a single firm to S
entire market output at a lower AC than a larger number of
firms producing smaller Q.
 Once a firm is big enough, its natural cost advantage will drive
competition out of business
8. Network Economies There are important network
externalities in supplying the good or service.
 These exist when the usefulness of a product increases with the
number of consumers who use it.
 Network externalities can set off a virtuous cycle: if a firm can
attract enough customers initially, it can then attract more
customers, which attracts even more customers, and so on.
 Example: microsoft’s windows operating system
Dr. Mudenda
 Total and Marginal Revenue of monopolist

 In a perfectly competitive Qty Price Total MR

market, each individual firm Revenue
faces a horizontal demand 1 25 25 -
curve, even though the 2 23 46 21
demand curve for the market 3 21 63 17
as a whole slopes downward 4 19 76 13
 This is because each firm is 5 17 85 9
assumed to be too small for 6 15 90 5
its production decisions to 7 13 91 1
affect the market price. It
8 11 88 -3
can sell as much as it wants
at the market price 9 9 81 -7

 if it tries to charge more, it will 10 7 70 -11

be undercut by competitors and
won’t be able to sell anything
Dr. Mudenda
 Total and Marginal Revenue of monopolist

 In contrast, as the only Qty Price Total MR

producer in the market, a Revenue
monopolist faces the 1 25 25 -
downward sloping market 2 23 46 21
demand curve 3 21 63 17
 The monopolist can choose to 4 19 76 13
sell at any price it wants 5 17 85 9
without fear of being undercut, 6 15 90 5
because there are no other 7 13 91 1
firms to do the undercutting. 8 11 88 -3
 However, it is still constrained 9 9 81 -7
by market demand i.e., can 10 7 70 -11
customers buy at any price

Dr. Mudenda
 Total and Marginal Revenue of monopolist

 Naturally, it would love to sell a Qty Price Total MR

huge quantity of goods at a high Revenue
price. But how would consumers 1 25 25 -
respond to a high price? 2 23 46 21
 Recall -the law of demand says 3 21 63 17
that, all else equal, quantity
4 19 76 13
demanded falls as price rises.
5 17 85 9
 The monopoly can choose any
price-quantity combination on the 6 15 90 5
demand curve, but is unable to 7 13 91 1
choose points that are not on the 8 11 88 -3
curve. 9 9 81 -7
 Thus, the demand curve for a
10 7 70 -11
monopolist is downward sloping

Dr. Mudenda
 Total and Marginal Revenue of monopolist

 The total revenue that a Qty Price Total MR

monopolist could earn at each Revenue
price is simply price times 1 25 25 -
quantity sold, which is the 2 23 46 21
amount shown in column 3. 3 21 63 17
 Profit equals total revenue 4 19 76 13
minus total costs. 5 17 85 9
 Profit = TR - TC 6 15 90 5
 Profit = (TR/Q - TC/Q)  Q 7 13 91 1
 Profit = (P - ATC)  Q 8 11 88 -3

 Monopolist’s MR is not equal 9 9 81 -7

to price. Marginal revenue is 10 7 70 -11
the revenue generated by
selling each additional unit
Dr. Mudenda
 Total and Marginal Revenue of monopolist
Qty Price Total MR
Revenue
1 25 25 -
2 23 46 21
3 21 63 17
4 19 76 13
5 17 85 9
6 15 90 5
7 13 91 1
8 11 88 -3

 The graph shows that revenue 9 9 81 -7

falls at very high prices 10 7 70 -11
 If for ex. He charges a price of Profit maximising monopolist will not produce
Where MR is negative unless MC were also
K11, the MR is negative
negative
Dr. Mudenda
 Price and To sell more, the price must
revenue be lowered. The MR curve
will be below the DD curve.
Monopoly is a price maker.
It does not face a horizontal
demand curve and profits are
not competed away by entry
of new firms

The firm is the industry and

faces an industry demand
curve
Marginal
Demand = average
revenue
revenue
0
Quantity

• The monopolist can choose to charge a higher or lower price

and still sell some quantity of goods.
• However, the pricing decision affects the quantity demanded.

Dr. Mudenda
 Profit-maximising quantity and price for a monopolist:

Price and cost

To maximise profit a monopolist
60 MC
should sell up to the point where the
MR from selling the last output equals
Profit- its MC (MR=MC)
maximising
price 42 B In this case the MR from selling
the sixth unit and the marginal cost
are both K27
27 A
D =AR The firm maximises profit by
selling six units per month
MR and charging a price of K42
0
6 Quantity at (B)
Profit-maximising
For a monopoly firm, price exceeds marginal cost.
quantity
P > MR = MC. The monopolist will receive
economic profits as long as price is greater than
average total cost
Dr. Mudenda
 Profits for a monopolist
Price and
cost • In the graph, the monopolist
K60 Profit
is producing 6 units and
MC
selling at K42 (P > MR = MC)
Profit-maxi • The total revenue which is
price
P2 B represented by OP2BQ
exceed the cost (OCVQ)
ATC
• Profit that the monopolist is
C V making is presented by
A D=AR
shaded rectangle CVBP2
• The monopolist therefore
MR
0 makes above-normal profits
Q Quantity
Profit-maximising
quantity
• The excess of price over
marginal cost is a measure of
monopoly power
 Does monopoly reduce economic efficiency?
Perfectly competitive Market Monopoly

 We know that equilibrium in a perfectly competitive market results in the

greatest amount of economic surplus, or total benefit to society, from the
production of a good or service
 Perfect competition equil. intersection of SS (marginal cost) and DD, at point C
in panel A. At any higher quantity, total surplus is reduced, because the increase
in consumer surplus is less than the decrease in producer surplus.
 Does monopoly reduce economic efficiency?
Perfectly competitive Industry Monopoly

 At any lower quantity, total surplus is also reduced— the decrease in

consumer surplus is greater than the increase in producer surplus
 However, a monopoly will produce less and charge a higher price
than would a perfectly competitive industry producing the same good.
 Does monopoly reduce economic efficiency?
Perfectly competitive firm Panel A Monopoly Panel B

R’

 This quantity is lower under monopoly than the efficient quantity that
would prevail in a competitive market, which tells us that total surplus
is not maximized
 Monopolies earn profit, while consumers lose surplus. Panel B
represents the loss of total surplus as a deadweight loss areas ArR’
 Does monopoly reduce economic efficiency?
Perfectly competitive firm Panel A Monopoly Panel B

R’

 The deadweight loss areas ArR’ is lost to both producers and consumers.
 Because a monopoly exerts its market power by charging a price above
MC, it places a similar wedge. The wedge causes the quantity sold to fall
short of the social optimum.
 Does monopoly reduce economic efficiency?
Monopoly Panel B
The higher price reduces consumer
surplus by the area equal to
rectangle A and triangle B. Some of
the reduction in consumer surplus
is captured by the monopoly as
producer surplus and some becomes
deadweight loss, which is the area
equal to triangles B and C
The effects of monopoly can be summarised
as follows:

a) Monopoly causes a reduction in consumer surplus.

b) Monopoly causes an increase in producer surplus.
c) Monopoly causes a deadweight loss, which represents a reduction
in economic efficiency; (allocative inefficiency occurs).
At an output below the efficient level, the deadweight loss shows the loss of
social surplus.
Deadweight loss under Monopoly Discrimination
(a) Monopolist with Single Price

Price

Consumer
surplus

Monopoly Deadweight
price loss
Profit
Marginal cost

Marginal Demand
revenue

0 Quantity sold Quantity

Copyright © 2004 South-Western

 PUBLIC POLICY TOWARD MONOPOLIES

 Government responds to the problem of monopoly in one of four

ways
1. Increasing Competition with Antitrust Laws
 Antitrust laws are a collection of statutes or laws aimed at
curbing monopoly power
 Antitrust laws give government various ways to promote
competition
a. They allow government to prevent mergers.
b. They allow government to break up companies.
c. They prevent companies from performing activities that make
markets less competitive
2. Regulation
 PUBLIC POLICY TOWARD MONOPOLIES
 Government responds to the problem of monopoly in one of four
ways
2. Regulation
Government may regulate the prices that the monopoly charges.
 The allocation of resources will be efficient if price is set to
equal marginal cost
 In practice, regulators will allow monopolists to keep some of
the benefits from lower costs in the form of higher profit, a
practice that requires some departure from marginal-cost
pricing
 In short - many governments allow private monopolies to
exist in the supply of electricity, tap water, or natural gas, but
cap the price these companies can charge.
 PUBLIC POLICY TOWARD MONOPOLIES

3. Public Ownership
 Natural monopolies pose a particular problem for policy-
makers. On the one hand, the monopolist is able to achieve
lower costs of production than multiple competing producers
would.
 On the other hand, even a natural monopoly chooses to
produce at a price that is higher than marginal cost, causing
deadweight loss
 Rather than regulating a natural monopoly that is run by a
private firm, the government can run the monopoly as public
agencies. Examples – post office in Zambia
 PUBLIC POLICY TOWARD MONOPOLIES

4. Doing Nothing: Government can do nothing at all if the

market failure is deemed small compared to the
imperfections of public policies
 When the pros and cons of various interventions in monopoly
markets are considered, some economists conclude that the
best response to a monopoly is sometimes no response at all.
 Doing nothing might be preferable if regulation is too difficult
to create or manage effectively. If government interventions in
the market are subject to corruption or political mishandling, it
might be better not to act
 Can Monopolies be Good?

1. Monopoly may aid innovation:

 Monopolies are shielded from competition, so
any innovation that ↓costs → ↑profits.
 Monopolies may have more incentive to invest in
research and development (R&D)
 In SR, ↑AC with R&D spending, but in LR, ↓AC
with use of new technologies or production
processes
 Can Monopolies be Good?

2. Natural monopoly:
↓AC as ↑Q
Costs of production would be higher if a natural
monopoly were broken up into many smaller firms.
Society benefits from monopolist’s ↓AC (or IRTS).
Must be regulated for consumers to receive lower
P.
 PRICE DISCRIMINATION

 Price discrimination is the business practice of selling the same

good at different prices to different customers, even though the
costs for producing for the two customers are the same
 Charging different customers different prices when cost of
supplying them is the same
 It involves “discriminating” between customers on the basis
of their willingness to pay.
 Price discrimination is not possible when a good is sold in a
competitive market since there are many firms all selling at
the market price.
 In order to price discriminate, the firm must have some
market power.
 PRICE DISCRIMINATION

 Price discrimination occurs in many industries, but it is

easier to accomplish if firm is sole producer of a good.
 Price discrimination → more profitable to sell to 1 group
than another.
 With competition, firms enter and steal profitable
customers away by charging them slightly lower Price
 Two important effects of price discrimination:
 It can increase the monopolist’s profits.

 It can reduce deadweight loss.

 PRICE DISCRIMINATION

 There are three requirements for successful price

discrimination:
a. A firm must possess a market power.
b. The firm must know what different consumers are willing to
pay
c. The firm must be able to divide (segment) the market for the
product
d. It must be impossible (or very difficult) for a group that buys the
product as lower price to resale it.
For example airlines
• Business travellers - more price inelastic
• Holiday travellers - more price elastic
• Economy, business and first class
 Three Types of price discrimination

1. Perfect or 1st Degree

price discrimination
 Perfect price discrimination
describes a situation in
which the monopolist knows
exactly the willingness to pay
of each customer and can
charge each customer a
different price  There is no deadweight loss, and
 In this case, the monopolist the entire surplus derived from
charges each customer the market goes to the monopoly
exactly his willingness to pay, producer in the form of profit
and the monopolist gets the  Without price discrimination, part
entire surplus in every of the profit would have gone to
transaction consumers and deadweight loss
 Three Types of price discrimination
2. Quantity or 2nd Degree price discrimination
 Situation in which a firm charges a different price for large
quantities than for small quantities but all customers who buy
a given quantity pay the same price
 Here the price varies only with quantity: All customers pay the
same price for a given quantity. hence Its called block pricing
 Many utilities use block-pricing schedules, by which they charge
one price for the first few units (a block) of usage and a different
price for subsequent blocks. For example ZESCO, they charge a
lower rate for units below 200 watts and subsequently increase
the price –this change in tariff rates has nothing to do with the
cost of producing the units of electricity in each block
 Both declining-block and increasing-block pricing are common
 Three Types of price discrimination
2. Third Degree/Multi-Market price discrimination
 the firm charges different groups of customers different prices,
but it charges a given customer the same price for every unit of
output sold.
 The strategy in 3rd degree PD is fairly straightforward; the firm
charges higher prices to types with more inelastic demand.
 Typically we think about as “high type” consumer with high
willingness to pay and a “low type” consumer with low
willingness to pay; the equilibrium price to the high type will
be higher than for the low type
 For example: ZESCO can charge high tariffs for industry and
low tariffs for households. Among household, the tariffs can
be high in Kabulonga and Lower in Kalingalinga compound
because of the willingness to pay.