MONOPOLY

•Monopoly-definition
•Profit maximisation
•Welfare effects
•Public policy towards monopoly
•Price discrimination
 Monopoly-Causes
• A firm is considered a monopoly if . . .
– it is the sole seller of its product.
– its product does not have close substitutes
• So a firm is a monopoly if it is the single seller
for a product with no close substitutes,
examples BPC, WUC, Debswana
• Pure monopolist is a price maker – it controls
the total quantity supplied & hence
considerable control over the market price
• Monopolies arise because of barriers to entry
 Barriers to entry
• Fundamental cause of monopoly is barriers to
entry
• economies of scale-the cost of production
make a single producer more efficient than a
large number of producers (natural monopoly)
• actions by firms-a key resource is owned by a
single firm (e.g. DeBeers, diamonds)
• actions by government-government gives a
single firm the exclusive right to produce some
good or service (patent & copyright)
 Natural Monopoly
• Monopoly that arises because a single firm can
supply a good or service to an entire market at a
lower cost than could two or more firms.
• Arises when there are economies of scale over
the relevant range of output
• Economies of scale as a cause of monopoly-
ATC declines continually as output rises.
– Distribution of water
 Actions by firms to create and
protect monopoly power
• patents and copyrights,
• high advertising expenditures result in high
sunk costs (costs that are not recoverable
on exit),
• Ownership of key resource
• Vertical integration, and
• illegal actions designed to restrict
competition – predatory pricing, refusal to
trade.
Monopolies created by government
action
• patents and copyrights,
– A patent is the exclusive right of an inventor to
use, or allow to another to use his invention.
Patent protects the inventor from potential
free riders
• government created franchises
(authorization to use or sell a company’s
product), and
• Licensing – government may limit entry
into an industry or occupation through
licensing (BTA)
 Local monopoly
• Local monopoly – a monopoly that exists
in a local geographical area (e.g., local
newspapers)
 Monopoly Vs Competition
• Monopoly versus Competition
– Monopoly
• Is the sole producer
• Faces a downward-sloping demand curve
• Is a price maker
• Reduces price to increase sales
– Competitive Firm
• Is one of many producers
• Faces a horizontal demand curve
• Is a price taker
• Sells as much or as little at same price
 Demand Curves for Competitive and Monopoly
Firms

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

Price Price

Demand

Demand

0 Quantity of Output 0 Quantity of Output

Copyright © 2004 South-Western

A Monopoly’s Total, Average,
and Marginal Revenue

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 Revenue
• Total Revenue
P  Q = TR
• Average Revenue
TR/Q = AR = P
• Marginal Revenue
DTR/DQ = MR
 Marginal revenue
• A Monopoly’s Marginal Revenue
– A monopolist’s marginal revenue is always
less than the price of its good.
• Its demand curve is downward sloping & is also
the market demand curve.
• When a monopoly drops the price to sell one more
unit, the revenue received from previously sold
units also decreases. Why?
• What point on the demand curve will the
monopolist choose to produce?
 MR
• A Monopoly’s Marginal Revenue
– When a monopoly increases the amount it
sells, it has two effects on total revenue (P 
Q).
• The output effect—more output is sold, so Q is
higher.
• The price effect—price falls, so P is lower.
 Price Elasticity and MR
• As noted earlier, since the demand curve
facing a monopoly firms is downward
sloping, MR < P
• MR > 0 when demand is elastic
• MR = 0 when demand is unit elastic
• MR < 0 when demand is inelastic
 Average Revenue
• As in all other market structures, AR=P
(note that AR = TR/Q = (PxQ) / Q = P)
• The price given by the demand curve is
the average revenue that the firm receives
at each level of output.
• By setting the quantity, the monopolist
indirectly sets the price of the product
• Monopolist will always set the price in the
elastic region of demand. Why?
• Will never choose a price-output
combination where price reductions cause
 Demand (Average Revenue) and Marginal-
Revenue Curves for a Monopoly
M
Price
11
10
9
8
7
6
5
4
3 Demand
2 Marginal (average
1 revenue revenue)
0
–1 1 2 3 4 5 6 7 8 Quantity of Water
–2
–3
–4

Copyright © 2004 South-Western

 Profit maximisation
• Comparing Monopoly and Competition
• We use the same MR=MC rule
– For a competitive firm, price equals marginal
cost.
P = MR = MC
– For a monopoly firm, price exceeds marginal
cost.
P > MR = MC
 Monopoly Profit
• Profit equals total revenue minus total
costs.
– Profit = TR - TC
– Profit = (TR/Q - TC/Q)  Q
– Profit = (P - ATC)  Q
• Monopolist seeks to maximize total profit,
not maximum unit profit.
 Profit maximisation
• A monopoly maximizes profit by producing
the quantity at which marginal revenue
equals marginal cost.
• It then uses the demand curve to find the
price that will induce consumers to buy
that quantity.
• The monopolist will receive economic
profits as long as price is greater than
average total cost
 Profit Maximization for a Monopoly
Profit
Costs and
Revenue 2. . . . and then the demand 1. The intersection of the
curve shows the price marginal-revenue curve
consistent with this quantity. and the marginal-cost
curve determines the
B profit-maximizing
Monopoly quantity . . .
price

Average total cost

A

Marginal Demand
cost

Marginal revenue

0 Q QMAX Q Quantity
Copyright © 2004 South-Western
Monopolist receiving Positive Profit
Zero-Profit monopolist
Monopolist receiving economic loss
 Monopolist Profit
• There is a unique profit-maximizing price
and output level for a monopoly firm.
• It is optimal to produce at the level of
output at which MR = MC and to charge
the price given by the demand curve at
this output level.
• Charging a higher (or lower) price results
in lower profits.
 The Welfare Cost of Monopoly
• In contrast to a competitive firm, the
monopoly charges a price above the
marginal cost (so it does not ensure allocative
efficiency)
• From the standpoint of consumers, this
high price makes monopoly undesirable.
• However, from the standpoint of the
owners of the firm, the high price makes
monopoly very desirable.
• Output is not necessarily produced at
minimum ATC (so does not ensure productive
efficiency)
 Deadweight loss
• Because a monopoly sets its price above
marginal cost, it places a wedge between the
consumer’s willingness to pay and the
producer’s cost.
• This wedge causes the quantity sold to fall short of
the social optimum
• Thus monopoly transfers income from consumers
to owners of the business in the form of higher
profits than PC
• This may increase income inequality
• Monopolist produces less than the socially
efficient quantity of output (repeat)
 The Inefficiency of Monopoly
Deadweight loss
Price
Deadweight Marginal cost
loss

Monopoly
price

Marginal
revenue Demand

0 Monopoly Efficient Quantity

quantity quantity

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 Deadweight loss
• The Inefficiency of Monopoly (repeat)
– The monopolist produces less than the socially
efficient quantity of output.
• The deadweight loss caused by a monopoly is
similar to the deadweight loss caused by a tax.
• The difference between the two cases is that the
government gets the revenue from a tax,
whereas a private firm gets the monopoly profit.
• So, monopoly transfers income from the
consumers to the owners of business (repeat)
 Public Policy Towards Monopoly
• Government responds to the problem of
monopoly in one of four ways.
– Making monopolized industries more
competitive.
– Regulating the behavior of monopolies.
– Turning some private monopolies into public
enterprises.
– Doing nothing at all.
 Increasing Competition through
Antitrust / competition laws
• Antitrust /competition laws are a collection
of statutes aimed at curbing monopoly
power.
• Antitrust laws give government various
ways to promote competition.
– They allow government to prevent mergers.
– They allow government to break up
companies.
– They prevent companies from performing
activities that make markets less competitive
 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.
 Marginal-Cost Pricing for a Natural Monopoly
Regulation
Price

Average total
cost Average total cost
Loss
Regulated
price Marginal cost

Demand

0 Quantity

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Regulation

• monopoly
outcome:
P(m), Q(m)
• marginal-cost
pricing: P(mc),
Q(mc)
• “fair-rate of
return” pricing
system: P(f),
Q(f)
 Regulation
• 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.
 Public ownership
• Rather than regulating a natural monopoly
that is run by a private firm, the
government can run the monopoly itself
(e.g. in Botswana, the government runs
the Postal Service, Water and electricity
utilities).
 Doing Nothing
• Government can do nothing at all if the
market failure is deemed small compared
to the imperfections of public policies.
 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.
 Price Discrimination
• 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.
• Perfect Price Discrimination
– Perfect price discrimination refers to the situation
when the monopolist knows exactly the willingness to
pay of each customer and can charge each customer
a different price.
 Price Discrimination
• Necessary conditions for price
discrimination:
– the firm must not be a price-taker
– firms must be able to sort customers by their
elasticity of demand
– resale must not be feasible
Example of Price Discrimination
Example: air travel
 Price Discrimination
• Two important effects of price
discrimination:
– It can increase the monopolist’s profits.
– It can reduce deadweight loss.
Welfare with and without Price Discrimination

(a) Monopolist with Single Price

Price

Consumer
surplus

Monopoly Deadweight
price loss
Profit
Marginal cost

Marginal Demand
revenue

0 Quantity sold Quantity

Welfare with and without Price Discrimination

(b) Monopolist with Perfect Price Discrimination

Price

Profit
Marginal cost

Demand

0 Quantity sold Quantity

 Dumping
• If firms practice price discrimination by charging
different prices in different countries, they are
often accused of dumping in the low-price
country.
• Predatory dumping occurs if a country charges
a low price initially in an attempt to drive out
domestic competitors and then raises prices
once the domestic industry is destroyed.
• There is little evidence of the existence of
predatory dumping.
Deadweight loss due to a
monopoly
 Other costs associated with
monopoly
• X-inefficiency – occurs if firms do not have an
incentive to engage in least-cost production
(since they are not faced with competitive
pressure).
• Rent-seeking behavior – the cost of using
resources (such as lawyers, lobbyists, etc.) in an
attempt to acquire monopoly power. This
behavior does not benefit society and diverts
resources away from productive activities.
 Price Discrimination
• Examples of Price Discrimination
– Movie tickets
– Airline prices
– Discount coupons
– Financial aid
– Quantity discounts
 CONCLUSION: THE
PREVALENCE OF MONOPOLY
• How prevalent are the problems of
monopolies?
– Monopolies are common.
– Most firms have some control over their prices
because of differentiated products.
– Firms with substantial monopoly power are
rare.
– Few goods are truly unique.
 Summary
• A monopoly is a firm that is the sole seller
in its market.
• It faces a downward-sloping demand
curve for its product.
• A monopoly’s marginal revenue is always
below the price of its good
 Summary
• Like a competitive firm, a monopoly
maximizes profit by producing the quantity
at which marginal cost and marginal
revenue are equal.
• Unlike a competitive firm, its price exceeds
its marginal revenue, so its price exceeds
marginal cost.
 Summary
• A monopolist’s profit-maximizing level of
output is below the level that maximizes
the sum of consumer and producer
surplus.
• A monopoly causes deadweight losses
similar to the deadweight losses caused
by taxes.
 Summary
• Policymakers can respond to the
inefficiencies of monopoly behavior with
antitrust laws, regulation of prices, or by
turning the monopoly into a government-
run enterprise.
• If the market failure is deemed small,
policymakers may decide to do nothing at
all.
 Summary
• Monopolists can raise their profits by
charging different prices to different buyers
based on their willingness to pay.
• Price discrimination can raise economic
welfare and lessen deadweight losses.