Monopoly

Contents:
● What is a monopoly?
● Why do monopolies arise?
● Revenue of a monopoly firm
● Profit maximization of a monopoly firm
● Monopoly versus perfect competition
● Policies toward monopolies
 What’s a monopoly?
● A firm is considered a monopoly if:
● it is the sole seller of its product.
● its product does not have close substitutes.

● While a competitive firm is a price taker, a monopoly

firm is a price maker.

● A competitive firm takes the price of its output as given

by the market and then chooses the quantity it will
supply so that price equals marginal cost. By contrast, a
monopoly charges a price that exceeds marginal cost.
 Why monopolies arise?
● The fundamental cause of monopoly is barriers to entry: A monopoly
remains the only seller in its market because other firms cannot enter
the market and compete with it.

● Barriers to entry have three sources:

➢ Monopoly resources: A key resource required for production is owned by
a single firm.

➢ Government regulation: The government gives a single firm the exclusive

right to produce some good or service.

➢ The production process: A single firm can produce output at a lower cost
than can a larger number of producers (natural monopolies).
 Monopoly resources
● The simplest way for a monopoly to arise is for a single firm to
own a key resource.

● A classic example is DeBeers, the South African diamond

company. Founded in 1888, DeBeers has at times controlled up to
80 percent of the production from the world’s diamond mines.
Because its market share is less than 100 percent, DeBeers is not
exactly a monopoly, but the company has nonetheless exerted
substantial influence over the market price of diamonds.

● Although exclusive ownership of a key resource is a potential cause

of monopoly, in practice monopolies rarely arise for this reason.
 Government created monopoly
● In many cases, monopolies arise because the government has
given one person or firm the exclusive right to sell some good
or service.

● Two important examples are the patent and copyright laws.

➢When a pharmaceutical company discovers a new drug, it

can apply to the government for a patent. If the
government deems the drug to be truly original, it approves
the patent, which gives the company the exclusive right to
manufacture and sell the drug for twenty years.
Natural monopoly
● An industry is a natural monopoly when a
single firm can supply a good or service to an
entire market at a smaller cost than could two or
more firms.

● A natural monopoly arises when there are

economies of scale over the relevant range of
output.
Economies of scale as a cause for
monopoly
 Natural monopoly
● An example of a natural monopoly is the distribution of water.

● To provide water to residents of a town, a firm must build a

network of pipes throughout the town.

● If two or more firms were to compete in the provision of this

service, each firm would have to pay the fixed cost of building
a network.

● Thus, the average total cost of water is lowest if a single firm

serves the entire market.
How monopolies make production
and pricing decisions?

• 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 as it wants at the same price
 The demand curve for competitive
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

The demand curve for monopoly
firms
● Because a monopoly is the sole producer in its market,
its demand curve is the market demand curve.

● The market demand curve provides a constraint on a

monopoly’s ability to profit from its market power.

● By adjusting the quantity produced (or equivalently, the

price charged), the monopolist can choose any point on
the demand curve, but it cannot choose a point off the
demand curve.
The revenue of monopoly firms

• Total Revenue
TR = P × Q

• Average Revenue
AR = TR/Q = P

• Marginal Revenue
MR= ΔTR/ΔQ = MR
The total, average and marginal revenue
of monopoly firms
 The marginal revenue of monopoly
firms
➢A monopolist’s marginal revenue is always less than
the price of its good. This is because:
● The demand curve is downward sloping.
● When a monopoly drops the price to sell one
more unit, the revenue received from previously
sold units also decreases.
 The demand & marginal revenue curves of
monopoly firms

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
Profit maximisation
● A monopoly maximizes profit by producing the
quantity at which marginal revenue equals
marginal cost (MR = MC).

● It then uses the demand curve to find the price

that will induce consumers to buy that quantity.
 Profit maximisation for a monopoly
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
 Profit maximisation
• Comparing Monopoly and Competition:
– For a competitive firm, price equals marginal cost.
P = MR = MC

– For a monopoly firm, price exceeds marginal cost.

P > MR = MC

• A monopoly’s profit:
– Profit = TR - TC
– Profit = (TR/Q - TC/Q) × Q
– Profit = (P - ATC) × Q

• The monopolist will receive economic profits as long as

price is greater than average total cost.
 The Monopolist’s Profit
The monopolist’s profit
Costs and
Revenue

Marginal cost

Monopoly E B
price

Monopoly Average total cost

profit

Average
total D C
cost Demand

Marginal revenue

0 QMAX Quantity
 TheThe
market for pharmaceutical
market for drugs: comparison
pharmaceuticals: between
comparison
monopoly and competitive market
between monopoly and competitive market

Costs and
Revenue

Price
during
patent life

Price after
Marginal
patent
cost
expires
Marginal Demand
revenue

0 Monopoly Competitive Quantity

quantity quantity
 The market for pharmaceuticals: comparison
between monopoly and competitive market

● When a patent gives a firm a monopoly over the

sale of a drug, the firm charges the monopoly price,
which is well above the marginal cost of making the
drug.

● When the patent on a drug runs out, new firms

enter the market, making it more competitive.

● As a result, the price falls from the monopoly price

to marginal cost.
 The welfare cost of monopoly

● In contrast to a competitive firm, the monopoly

charges a price above the marginal cost.

● 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.

● What is the welfare cost of monopoly?

 The welfare cost of monopoly

● Let’s consider what the monopoly firm would do if

it were run by a benevolent social planner.

● The social planner cares not only about the profit

earned by the firm’s owners but also about the
benefits received by the firm’s consumers.
The Efficient Level of Output
The efficient level of output
Price
Marginal cost

Value Cost
to to
buyers monopolist

Demand
Cost Value (value to buyers)
to to
monopolist buyers

0 Quantity

Value to buyers Value to buyers

is greater than is less than
cost to seller. cost to seller.
Efficient
quantity
 The efficient level of output

● The demand curve reflects the value of the good to

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

● The marginal-cost curve reflects the costs of the

monopolist.

● Thus, the socially efficient quantity is found where the

demand curve and the marginal-cost curve intersect.
This is the quantity that a benevolent social planner
would choose for the monopoly to produce.
The welfare cost of monopoly

● By comparing the efficient level of output which

would be chosen by a social planner (which is also
the output under perfect competition) with the
output that a monopoly will choose to produce, we
can evaluate the welfare effects of a monopoly.
 The Inefficiency of Monopoly
The efficiency of monopoly
Price
Deadweight Marginal cost
loss

Monopoly
price

Marginal
revenue Demand

0 Monopoly Efficient Quantity

quantity quantity
 The 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.

● The Inefficiency of Monopoly

● The monopolist produces less than the socially efficient
quantity of output.

● The deadweight loss: the reduction in economic well-being

that results from the monopoly’s use of its market power.
 Public policy towards monopoly
● Policy makers can respond to the problem of
monopoly by:
● Making monopolized industries more competitive.

● Regulating the behavior of monopolies.

● Turning some private monopolies into public

enterprises.
Increasing competition through
antitrust laws

● Antitrust 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.
Government regulation
● Government may regulate the prices that the
monopoly charges.

● This solution is common in the case of natural

monopolies, such as water and electric
companies. These companies are not allowed to
charge any price they want. Instead,
government agencies regulate their prices.
Government regulation
● What price should the government set for a natural
monopoly?

● The allocation of resources will be efficient if price

is set to equal marginal cost.

● There are, however, two practical problems with

marginal-cost pricing as a regulatory system.
Government regulation
Two problems with marginal cost pricing:
●The first arises from the logic of cost curves. By
definition, natural monopolies have declining ATC,
i.e. MC is less than ATC.

●If regulators were to set price equal to marginal

cost, that price must be less than the firm’s average
total cost, and the firm would lose money. Instead of
charging such a low price, the monopoly firm would
just exit the industry.
 Marginal-Cost Pricing for a Natural Monopoly
Marginal cost pricing for a natural monopoly
Price

Average total
cost Average total cost
Loss
Regulated
price Marginal cost

Demand

0 Quantity
 Government regulation
● Regulators can respond to this first problem in various ways,
none of which is perfect:

➢ One way is to subsidize the monopolist (The government picks

up the losses inherent in marginal-cost pricing. Yet to pay for the
subsidy, the government needs to raise money through taxation).

➢ Alternatively, regulators can allow the monopolist to charge a

price higher than marginal cost. If the regulated price equals
average total cost, the monopolist earns exactly zero economic
profit.
Government regulation
● The second problem with marginal-cost pricing
as a regulatory system (and with average-cost
pricing as well) is that it gives the monopolist no
incentive to reduce costs.

● 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. utilities such as
telephone, water, and electric companies).
Public policy towards monopoly
➢ The evolution of US antitrust law and what it means for
the biggest businesses:

https://www.youtube.com/watch?v=IcghGCBROR0
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.

● A monopolist’s profit-maximizing level of output is

below the level that maximizes the sum of
consumer and producer surplus.
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.
Summary
 Topic 7 - MCQ
1. The following are key features of a monopoly except
A) no market power.
B) no close substitutes.
C) in uence over price.
D) barriers to entry.

2. A market in which competition and entry are restricted by the granting of a government license,
patent, or copyright is called a
A) price-discriminating monopoly.
B) single-price monopoly.
C) natural monopoly.
D) legal monopoly.

3. Monopolists
A) face downward sloping demand curves.
B) are price takers.
C) have no short-run xed costs.
D) maximize revenue, not pro ts.

4. The marginal revenue curve for a single-price monopoly

A) lies below its demand curve.
B) is horizontal.
C) lies above its demand curve.
D) coincides with its demand curve.
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1. A rm is a natural monopoly if it exhibits the following as its output increases:
a. decreasing marginal revenue.
b. increasing marginal cost.
c. decreasing average revenue.
d. decreasing average total cost.

2. For a pro t-maximizing monopoly that charges the same price to all consumers, what is the relationship between price
P, marginal revenue MR, and marginal cost MC?
a. P=MR and MR=MC.
b. P>MR and MR=MC.
c. P=MR and MR>MC
d. P>MR and MR>MC.

3. If a monopoly’s xed costs increase, its price will _____ and its pro t will _____.
a. increase, decrease
b. decrease, increase
c. increase, stay the same
d. stay the same, decrease

4. Compared to the social optimum, a monopoly rm chooses

a. a quantity that is too low and a price that is too high.
b. a quantity that is too high and a price that is too low.
c. a quantity and a price that are both too high.
d. a quantity and a price that are both too low.

5. The deadweight loss from monopoly arises because

a. the monopoly rm makes higher pro ts than a competitive rm would.
b. some potential consumers who forgo buying the good value it more than its marginal cost.
c. consumers who buy the good have to pay more than marginal cost, reducing their consumer surplus.
d. the monopoly rm chooses a quantity that fails to equate price and average revenue.

6. When a monopolist switches from charging a single price to practicing perfect price discrimination, it reduces
a. the quantity produced.
b. the rm’s pro t.
c. consumer surplus.
d. total surplus.
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 Topic 7 - Problems #1
1. Hot Air Balloon Rides is a single-price monopoly. Columns 1 and 2 of the table set out the market
demand schedule and columns 2 and 3 set out the total cost schedule.

a) Construct Hot Air’s total revenue and marginal revenue schedules. = MR = %TR/%Q
b) Find Hot Air’s pro t-maximizing output and price and calculate the rm’s economic pro t. MR=MC

Price (dollars Quantity Total cost TR MR MC Profit

per ride) demanded (dollars per
(rides) per month)
month
220 US$ 0 80 US$ 0 US$ 0 US$ 0 US$ -80 US$
200 US$ 1 160 US$ 200 US$ 200 US$ 80 US$ 40 US$
180 US$ 2 260 US$ 360 US$ 160 US$ 100 US$ 100 US$
160 US$ 3 380 US$ 480 US$ 120 US$ 120 US$ 100 US$
140 US$ 4 520 US$ 560 US$ 80 US$ 140 US$ 40 US$
120 US$ 5 680 US$ 600 US$ 40 US$ 160 US$ -80 US$
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 Topic 7 - Problems #2
A publisher faces the following demand schedule for the next novel from one of its
Price (dollars Quantity
popular authors. The author is paid $2 million to write the book, and the marginal demanded
per book)
cost of publishing the book is a constant $10 per book.
100 US$ 0
a. Compute total revenue, total cost, and pro t at each quantity. What quantity
would a pro t-maximizing publisher choose? What price would it charge? 90 US$ 100 000
80 US$ 200 000
b. Compute marginal revenue. How does marginal revenue compare to the price? 70 US$ 300 000
Explain.
60 US$ 400 000
50 US$ 500 000
c. Graph the marginal-revenue, marginal-cost, and demand curves. At what quantity
do the marginal-revenue and marginal-cost curves cross? What does this signify? 40 US$ 600 000
d. In your graph, shade in the deadweight loss. Explain in words what this means. 30 US$ 700 000
20 US$ 800 000
e. If the author were paid $3 million instead of $2 million to write the book, how 10 US$ 900 000
would this affect the publisher’s decision regarding what price to charge? Explain.
0 US$ 1 000 000

f. Suppose the publisher was not pro t-maximizing but was concerned with
maximizing economic ef ciency. What price would it charge for the book? How
much pro t would it make at this price?
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a. Compute total revenue, total cost (FC = 2 000 000$, VC = 10$), and pro t at each quantity.
What quantity would a pro t-maximizing publisher choose? What price would it charge?

b. Compute marginal revenue. How does marginal revenue compare to the price? Explain.

Price (dollars Quantity TC TR P MR MC

per book) demanded

100 US$ 0 2 000 000 US$ 0 US$ -2 000 000 US$ 0 US$ 0 US$
90 US$ 100 000 3 000 000 US$ 9 000 000 US$ 6 000 000 US$ 90 US$ 10 US$
80 US$ 200 000 4 000 000 US$ 16 000 000 US$ 12 000 000 US$ 70 US$ 10 US$
70 US$ 300 000 5 000 000 US$ 21 000 000 US$ 16 000 000 US$ 50 US$ 10 US$
60 US$ 400 000 6 000 000 US$ 24 000 000 US$ 18 000 000 US$ 30 US$ 10 US$
50 US$ 500 000 7 000 000 US$ 25 000 000 US$ 18 000 000 US$ 10 US$ 10 US$
40 US$ 600 000 8 000 000 US$ 24 000 000 US$ 16 000 000 US$ -10 US$ 10 US$
30 US$ 700 000 9 000 000 US$ 21 000 000 US$ 12 000 000 US$ -30 US$ 10 US$
20 US$ 800 000 10 000 000 US$ 16 000 000 US$ 6 000 000 US$ -50 US$ 10 US$
10 US$ 900 000 11 000 000 US$ 9 000 000 US$ -2 000 000 US$ -70 US$ 10 US$
0 US$ 1 000 000 12 000 000 US$ 0 US$ -12 000 000 US$ -90 US$ 10 US$
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c. Graph the marginal-revenue, marginal-cost, and demand curves. At what quantity do the marginal-revenue
and marginal-cost curves cross? What does this signify?
d. In your graph, shade in the deadweight loss. Explain in words what this means.

100$

50$

10$

500 K 1M
 e. If the author were paid $3 million instead of $2 million to write the book, how would this affect the
publisher’s decision regarding what price to charge? Explain.
f. Suppose the publisher was not pro t-maximizing but was concerned with maximizing economic
ef ciency. What price would it charge for the book? How much pro t would it make at this price?

Price (dollars Quantity TC TR P MR MC

per book) demanded

100 US$ 0 3 000 000 US$ 0 US$ -3 000 000 US$ 0 US$ 10 US$
90 US$ 100 000 4 000 000 US$ 9 000 000 US$ 5 000 000 US$ 90 US$ 10 US$
80 US$ 200 000 5 000 000 US$ 16 000 000 US$ 11 000 000 US$ 70 US$ 10 US$
70 US$ 300 000 6 000 000 US$ 21 000 000 US$ 15 000 000 US$ 50 US$ 10 US$
60 US$ 400 000 7 000 000 US$ 24 000 000 US$ 17 000 000 US$ 30 US$ 10 US$
50 US$ 500 000 8 000 000 US$ 25 000 000 US$ 17 000 000 US$ 10 US$ 10 US$
40 US$ 600 000 9 000 000 US$ 24 000 000 US$ 15 000 000 US$ -10 US$ 10 US$
30 US$ 700 000 10 000 000 US$ 21 000 000 US$ 11 000 000 US$ -30 US$ 10 US$
20 US$ 800 000 11 000 000 US$ 16 000 000 US$ 5 000 000 US$ -50 US$ 10 US$
10 US$ 900 000 12 000 000 US$ 9 000 000 US$ -3 000 000 US$ -70 US$ 10 US$
0 US$ 1 000 000 13 000 000 US$ 0 US$ -13 000 000 US$ -90 US$ 10 US$
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 Price (dollars Quantity TC ATC
g. Show the pro t graphically per book) demanded

100 US$ 0 3 000 000 US$ 0 US$

90 US$ 100 000 4 000 000 US$ 40 US$
80 US$ 200 000 5 000 000 US$ 25 US$
70 US$ 300 000 6 000 000 US$ 20 US$
60 US$ 400 000 7 000 000 US$ 18 US$
50 US$ 500 000 8 000 000 US$ 16 US$
40 US$ 600 000 9 000 000 US$ 15 US$
100$
30 US$ 700 000 10 000 000 US$ 14 US$
20 US$ 800 000 11 000 000 US$ 14 US$
10 US$ 900 000 12 000 000 US$ 13 US$
0 US$ 1 000 000 13 000 000 US$ 13 US$

50$ Profit = (P - ATC) x Q = (50-16) x 500k = 17M

16$
10$

500 K 1M
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References
● Mankiw, G. (2017) Principles of Economics, 8th edition,
South-Western Cengage Learning, Chapter 15