ECONOMICS 102

Chapter 10 Monopoly
Transcript

[slide 3] Monopoly
⚫ A market is described as a monopoly if there is only one producer.
– This single firm faces the entire market demand curve.
– The monopoly must make the decision of how much to produce.
⚫ The monopoly’s output decision will completely determine the good’s price.

[slide 4] Causes of Monopoly

⚫ Barriers to entry which are factors that prevent new firms from entering a market are the source of
all monopoly power.
⚫ There are two general types of barriers to entry
– Technical barriers
– Legal barriers

[slide 5, 6] Technical Barriers to Entry

⚫ A primary technical barrier is when the firm is a natural monopoly because it exhibits diminishing
average cost over a broad range of output levels.
– Hence, a large-scale firm is more efficient than a small scale firm.
⚫ A large firm could drive out competitors by price cutting.
⚫ Other technical barriers to entry.
– Special knowledge of a low-cost method of production.
– Ownership of a unique resource.
– Possession of unique managerial talents.

[slide 7] Legal Barriers to Entry

⚫ Pure monopolies can be created by law.
– The basic technology for a product can be assigned to only one firm through a patent.
⚫ The rational is that it makes innovation profitable and encourages technical
advancement.
– The government can award an exclusive franchise or license to serve a market.
⚫ This may make it possible to ensure quality standards

[slide 8] Profit Maximization

⚫ To maximize profits, a monopoly will chose the output at which marginal revenue equals marginal
costs.
⚫ The demand curve is downward-sloping so marginal revenue is less than price.
– To sell more, the firm must lower its price on all units to be sold in order to generate the
extra demand.

[slide 9, 11] A Graphic Treatment

⚫ A monopoly will produce an output level in which price exceeds marginal cost.
⚫ Q* is the profit maximizing output level in Figure 10.1.
– If a firm produced less than Q*, the loss in revenue (MR) will exceed the reduction in costs
(MC) so profits would decline.
– The increase in costs (MC)would exceed the gain in revenue (MR) if output exceeds Q*.
– Hence, profits are maximized when MR = MC.
⚫ Given output level Q*, the firm chooses P* on the demand curve because that is what consumers
are willing to pay for Q*.
⚫ The market equilibrium is P*, Q*.

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 [slide 10] FIGURE 10.1: Profit Maximization and Price Determination in a Monopoly Market

[slide 12] Monopoly Supply Curve

⚫ With a fixed market demand curve, the supply “curve” for a monopoly is the one point where MR =
MC (point E in Figure 10.1.)
⚫ If the demand curve shifts, the marginal revenue curve will also shift and a new profit maximizing
output will be chosen.
⚫ Unlike perfect competition, these output, price points do not represent a supply curve.

[slide 13] Monopoly Profits

⚫ Monopoly profits are shown as the area of the rectangle P*EAC in Figure 10.1.
⚫ Profits equal (P - AC)Q*,
– If price exceeds average cost at Q* > 0, profits will be positive.
– Since entry is prohibited, these profits can exits in the long run.

[slide 14] Monopoly Rents

⚫ Monopoly rents are the profits a monopolist earns in the long run.
– These profits are a return to the factor that forms the basis of the monopoly.
⚫ Patent, favorable location, license, etc..
⚫ Others might be willing to pay up to the amount of this rent to operate the monopoly to obtain its
profits.

[slide 15, 17, 18] What’s Wrong with Monopoly?

⚫ Profitability
– Monopoly power is the ability to raise price above marginal cost.
– Profits are the difference between price and average cost.
⚫ In Figure 10.2, one firm earns positive economic profits (a) while the other (b) earns zero economic
profits.
- If monopoly rents accrue to inputs, the monopoly may appear to not earn a profit.
⚫ People may also be concerned that economic profits go to the wealthy.
- However, as with the Navajo blanket monopoly, the profits of the low-income Navajo are
coming from the more wealthy tourists.
⚫ Distortion of Resource Allocation
- Monopolists restrict their production to maximize profits.
⚫ Since price exceeds marginal cost, consumers are willing to pay more for extra output
than it costs to produce it.
- From societies point of view, output is too low as some mutually beneficial transactions are
missed.

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 [slide 16] FIGURE 10.2: Monopoly Profits Depend on the Relationship between the Demand and
Average Cost Curves

[slide 19, 20] Distortion of Resource Allocation

⚫ In Figure 10.3 the monopolist is assumed to produce under conditions of constant marginal cost.
⚫ Further, it is assumed that if the good where produced by a perfectly competitive industry, the long-
run cost curve would be the same as the monopolist’s.
⚫ In this situation, a perfectly competitive industry would produce Q* where demand equals long-run
supply.
⚫ A monopolist produces at Q** where marginal revenue equals marginal cost.
⚫ The restriction in output (Q* - Q**) is a measure of the harm done by a monopoly.

FIGURE 10.3: Allocational and Distributional Effects of Monopoly

[slide 21] [slide 23] [slide 25] [slide 27] [slide 28]

[slide 22] Monopolistic Distortions and Transfers of Welfare

⚫ The competitive output level (Q* in Figure 10.3) is produced at price P*.
– The total value to consumers is the area DEQ*0 Consumers’ pay P*EQ*0.
– Consumer surplus is DEP*.

[slide 24] Allocational Effects

⚫ A monopolist would product Q** at price P**.
– Total value to the consumer is reduced by the area BEQ*Q**.
– However, the area AEQ*Q** is money freed for consumers to spend elsewhere.
– The loss of consumer surplus is BEA which is often called the deadweight loss from
monopoly.

[slide 26] Distributional Effects

⚫ In Figure 10.3 monopoly profits equal the area P**BAP*.
– This would be consumer surplus under perfect competition.
– It does not necessarily represent a loss of social welfare.
⚫ This is the redistributional effects of monopoly that may or may not be desirable.

[slide 29, 30] Monopolists’ Costs

⚫ Monopolists costs may be higher due to:
– Resources spent to achieve monopoly profits such as ways to erect barriers to entry.

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 –Monopolists may expend resources for lobbying or legal fees to seek special favors from the
government such as restrictions on entry through licensing or favorable treatment from
regulatory agencies.
⚫ The possibility that costs may be higher for monopolists complicates the comparison of monopoly
with perfect competition.
⚫ Studies that have attempted to measure welfare losses from monopoly find estimates are sensitive
to assumptions.
– Estimates range from as little as 0.5 percent of GDP to as much as 5 percent of GDP.

[slide 31] Price Discrimination

⚫ Price discrimination occurs if identical units of output are sold at different prices.
⚫ If the monopolist could sell its product at different prices to different customers, new opportunities
exits as shown in Figure 10.4.
– Some consumer surplus still exists (area DBP**).
– The possibility of mutually beneficial trades exist as represented by the area BEA.

[slide 32] FIGURE 10.4: Targets for Price Discrimination

[slide 33, 34] Perfect Price Discrimination

⚫ Perfect price discrimination is selling each unit of output for the highest price obtainable.
– The firm would sell the first unit at slightly below 0D (Figure 10.4), the next for slightly less,
and so on until the firm reaches Q*, where a lower price would result in less profit.
– All consumer surplus (area P*DE) would be monopoly profit.
⚫ Since the monopolist would produce and sell Q* units of output, which is the competitive
equilibrium.
⚫ This pricing scheme requires a way to determine what each consumer would be willing to pay, and
⚫ The monopolist must be able to stop consumers from selling to each other.

[slide 35] Quantity Discounts

⚫ Quantity discounts allow some sales at the monopolist’s price (P** in Figure 10.4), and sales
beyond Q** at a lower price which increases profits.
– Examples include a second pizza for a lower price and supermarket coupons.
⚫ The monopolist must keep customers who buy at lower prices to sell to customers at a price less
than P**.

[slide 36] Two-Part Tariffs

⚫ In this pricing scheme, customers must pay an entry fee for the right to purchase a good.
⚫ A classic example is the pricing of movie popcorn.
– The entry fee, which should be set to obtain as much of the consumer surplus as possible, is
the price of movie itself.
– Popcorn is then priced to maximize admission so long as the price exceeds cost.

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[slide 37, 39] Market Separation
⚫ If the market can be separated into two or more categories the monopolist may be able to charge
different prices.
⚫ Figure 10.5 shows the separation into two markets.
– The profit-maximizing decision is to sell Q1* in the first market and Q2* in the second market
where, in both cases, MR = MC.
⚫ The two market prices will be P1and P2 respectively.
– As shown in Figure 10.5, the price-discriminating monopolist will charge a higher price in the
market with the more inelastic demand.
– Examples include book publishers charging higher prices in the U.S. or charging different
prices for a movie in the day than at night.

[slide 38] FIGURE 10.5: Separated Markets Raise the Possibility of Price Discrimination

[slide 40] Pricing for Multiproduct Monopolies

⚫ If a firm has pricing power in markets for several related products, other strategies can be used.
– Firms can require users of one product to also buy a related product such as coffee filters
bought with coffee machines.
⚫ Firms can also create pricing bundles such as option packages on cars or computers.

[slide 41] Marginal Cost Pricing Regulation and the Natural Monopoly Dilemma
⚫ By marginal cost pricing the deadweight loss from monopolies is minimized.
⚫ However, this would require a natural monopoly to operate at a loss.
– A unregulated monopoly would produce QA at price PA in Figure 10.6, yielding a profit of
PAABC.

[slide 42] FIGURE 10.6: Price Regulation for a Natural Monopoly

[slide 43] Marginal Cost Pricing Regulation and the Natural Monopoly Dilemma
– Marginal cost pricing of PR which results in QR demanded would generate an a loss equal to
the area GFEPR because PR < AC.
⚫ Either marginal cost pricing must be abandoned or the government must subsidize the monopoly.