Industrial economics

Monopoly

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 Barriers to Entry
A monopoly is the sole supplier of a
product with no close substitutes
The most important characteristic of a
monopolized market is barriers to entry 
new firms cannot profitably enter the
market
Barriers to entry are restrictions on the
entry of new firms into an industry
Legal restrictions
Economies of scale
Control of an essential resource

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 Legal Restrictions
One way to prevent new firms from
entering a market is to make entry illegal

Patents, licenses, and other legal

restrictions imposed by the government
provide some producers with legal
protection against competition

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 Patent and Invention Incentives
A patent awards an inventor the exclusive
right to produce a good or service for 20
years

Patent laws
Encourage inventors to invest the time and
money required to discover and develop new
products and processes
Also provide the stimulus to turn an invention
into a marketable product, a process called
innovation

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 Licenses and other Entry Restrictions
Governments often confer(grant)
monopoly status by awarding a single firm
the exclusive right to supply a particular
good or service

Broadcast TV and radio rights

State licensing of hospitals

Cable TV and electricity on local level

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 Economies of Scale
A monopoly sometimes emerges naturally
when a firm experiences economies of
scale as reflected by the downward-sloping,
long-run average cost curve

In these situations, a single firm can

sometimes supply market demand at a
lower average cost per unit than could two
or more firms at smaller rates of output

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 $
Put another way, market
demand is not great enough
to permit more than one
firm to achieve sufficient
economies of scale  a
single firm will emerge from
Cost per unit

the competitive process as

the sole seller in the market.

Long-run
average cost

Quantity per period

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 Natural Monopoly
Because such a monopoly emerges from
the nature of costs, it is called a natural
monopoly

A new entrant cannot sell enough output

to experience the economies of scale
enjoyed by an established natural
monopolist  entry into the market is
naturally blocked

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 Control of Essential Resources
Another source of monopoly power is a
firm’s control over some non reproducible
resource critical to production
Professional sports teams try to block the
formation of competing leagues by signing the
best athletes(team members) to long-term
contracts
Alcoa was the sole U.S. maker of aluminum for
a long period of time because it controlled the
supply of bauxite
China is the monopoly supplier of pandas
DeBeers controls the world’s diamond trade
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 Local Monopolies
Local monopolies are more common that
national or international monopolies

Numerous natural monopolies for

products sold in local markets

However, as a rule long-lasting

monopolies are rare because, as we will
see, a profitable monopoly attracts
competitors

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 Revenue for the Monopolist
Because a monopoly, by definition,
supplies the entire market, the demand for
goods or services produced by a
monopolist is also the market demand

The demand curve for the monopolist’s

output therefore slopes downward,
reflecting the law of demand

As seen in the following discussion this has

important implications for revenues
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 Demand, Average and Marginal Revenue
Suppose De Beers controls the entire
diamond market and suppose they can sell
three diamonds a day at $7,000 each 
total revenue of $21,000

Total revenue divided by quantity is the

average revenue per diamond which is also
$7,000

Thus, the monopolist’s price equals the

average revenue per diamond
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 Demand, Average and Marginal Revenue
To sell a fourth diamond, De Beers must
lower the price to $6,750  total revenue
for 4 diamonds is $27,000 and average
revenue is again $6,750

The marginal revenue from selling the

fourth diamond is $6,000  marginal
revenue is less than the price or average
revenue

Recall that these were equal for the

perfectly competitive firm
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 Exhibit 2: Loss or Gain from Selling One More
Unit
By selling another diamond, De Beers gains
the revenue from that sale, $6,750 from the
$7,00 4th diamond as shown by the blue-shaded
0 LOSS
6,750 vertical rectangle marked gain.
However, to sell that 4th unit, De Beers
Price per must sell all four diamonds for $6,750 each
Diamond  it must sacrifice $250 on each of the
first three diamonds which could have sold
G D = Average for $7,000 each.
revenue
A
I The loss in revenue from the first three
N units, $750, is shown by the red shaded
horizontal rectangle marked Loss.

The net change in total revenue from

selling the 4th diamond equals the gain
minus the loss  $6,750 - $750 = $6,000.
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0 3 4 1 - carat diamonds per day
 Exhibit 3: Revenue Schedule
Revenue for De Beers, a Monopolist The first two columns contain the
1-Carat Price pertinent price and quantity
diamonds (average Total Marginal information.
per day revenue) revenue revenue
(Q) (p) (TR = Q x p) (MR = TR /
Q) Total revenue (quantity times price) is
(1) (2) (3) =(1) x (2) (4) provided in the third column. As De
Beers expands output, total revenue
0 $7,750 0 - increases until quantity reaches 15
1 7,500 $7,500 $7,500 diamonds when total revenue tops out.
2 7,250 14,500 7,000
3 7,000 21,000 6,500
4 6,750 27,000 6,000 Marginal revenue (the change in total
5 6,500 32,500 5,500 revenue from selling one more diamond)
6 6,250 37,500 5,000 appears in the fourth column. Note that
7 6,000 42,000 4,500 for all units of output except the first,
8 5,750 46,000 4,000
marginal revenue is less than the price,
9 5,500 49,500 3,500
10 5,250 52,500 3,000
and the gap between the two widens as
11 5,000 55,000 2,500 the price declines because the loss from
12 4,750 57,000 2,000 selling all diamonds at this lower price
13 4,500 58,500 1,500 increases.
14 4,250 59,500 1,000
15 4,000 60,000 500 Exhibit 4 depicts this information
16 3,750 60,000 0 graphically.
17 3,500 59,500 -500
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 (a) Demand and Marginal Revenue
Demand and marginal revenue
are shown in the upper panel and
total revenue is in the lower panel. Elastic

Dollars per diamond

Unit elastic
$3,750
Note that the marginal revenue
curve is below the demand curve Inelastic

and total revenue is at a maximum

0
when marginal revenue equals D = Average revenue
Marginal revenue
zero. 16 32 1-carat diamonds per day
(b) Total Revenue
Notice also that when demand is
elastic, a decrease in price
$60,000
increases total revenue 
marginal revenue is positive.
Total dollars

Conversely, when demand is

Total revenue
inelastic, a decrease in price
reduces total revenue  marginal
revenue is negative
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0 16 32 1-carat diamonds per day
 Firm’s Costs and Profit Maximization
The monopolist can choose either the price
or the quantity, but choosing one
determines the other

Because the monopolist can select the price

that maximizes profit, we say the
monopolist is a price maker

More generally, any firm that has some

control over what price to charge is a price
maker
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 Profit Maximization
Exhibits 5 and 6 repeat the revenue data
from the previous exhibits and also include
short-run cost data

The key issue is which price-quantity

combination should De Beers select to
maximize profits

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 Exhibit 5: Short-Run Revenues and Costs for the
Monopolist

Short-run Costs and Revenue for a Monopolist

The profit-
Price Marginal Marginal Average Total
Diamonds (average Total Revenue Total Cost Total Cost Profit or maximizing
per day revenue) revenue (MR = Cost ( MC = (ACT = Loss = monopolist employs
the same decision
(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC
(1) (2) (3) =(1) x (2) (4) (5) (6) (7) rule as the
(8) competitive firm 
the monopolist
0 $7,750 0 - $15,000 - - -
$15,000 produces that
1 7,500 $7,500 $7,500 19,750 4,750 $19,750 - quantity where
12,250
total revenue
2 7,250 14,500 7,000 23,500 3,750 11,750
9,000 exceeds total cost
3 7,000 21,000 6,500 26,500 3,000 8,830 - by the greatest
5,500
amount  $12,500
4 6,750 27,000 6,000 29,000 2,500 7,750 -
2,000 per day when
5 6,500 32,500 5,500 31,000 2,000 6,200 output is 10 units
1,500
6 6,250 37,500 5,000 32,500 1,500 5,420
per day. Total
5,000 revenue is $52,500
7 6,000 42,000 4,500 33,750 1,250 4,820 and total cost is
8,250
$40,000
8 5,750 46,000 4,000 35,250 1,500 4,410
10,750
9 5,500 49,500 3,500 37,250 2,000 4,140 19
 Exhibit 5: Short-Run Revenues and Costs for the
Monopolist

Short-run Costs and Revenue for a Monopolist Applying the

Price Marginal Marginal Average Total marginal rule
Diamonds (average Total Revenue Total Cost Total Cost Profit or would imply that
per day revenue) revenue (MR = Cost ( MC = (ACT = Loss = the monopolist
(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC increases output as
(1) (2) (3) =(1) x (2) (4) (5) (6) (7) long as selling
(8) additional
0 $7,750 0 - $15,000 - - - diamonds adds
$15,000 more to total
1 7,500 $7,500 $7,500 19,750 4,750 $19,750 - revenue than to
12,250
2 7,250 14,500 7,000 23,500 3,750 11,750 total cost. Again
9,000 profit is maximized
3 7,000 21,000 6,500 26,500 3,000 8,830 - at $12,500 when
5,500
4 6,750 27,000 6,000 29,000 2,500 7,750 - output is 10
2,000 diamonds per day,
5 6,500 32,500 5,500 31,000 2,000 6,200 per unit costs are
1,500
6 6,250 37,500 5,000 32,500 1,500 5,420 $4,000 and the
5,000 price is $5,250.
7 6,000 42,000 4,500 33,750 1,250 4,820 Exhibit 6 provides
8,250
8 5,750 46,000 4,000 35,250 1,500 4,410 a graphical
10,750 illustration of this
9 5,500 49,500 3,500 37,250 2,000 4,140 process. 20
 (a) Per-Unit Cost and Revenue
The intersection of the two marginal curves
at point e in panel (a) indicates that profit Marginal cost
is maximized when 10 diamonds are sold. Average total cost
At this rate of output, we move up to the

Dollars per unit

a
$5,250
demand curve to find the profit- Profit b
maximizing price of $5,250. The average 4,000
total cost of $4,000 is identified by point b e
 the average profit per diamond equals
D  Average revenue
the price of $5,250 minus the average total MR
cost of $4,000  $1,250  economic profit 0 10 16 32 Diamonds per day
is the equal to $1,250 * 10 units sold  (b) Total Cost and Revenue
$12,500 as shown by the blue shaded area.
Total cost
Maximum
profit
In panel (b), the firm’s profit or loss is $52,500
measured by the vertical distance
Total dollars

between the total revenue and total cost 40,000

curves  again profit is maximized
where De Beers produces 10 diamonds
per day Total revenue
15,000

0 10 16 32 Diamonds per day

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 Short-Run Losses and the Shutdown Decision

A monopolist is not assured of profit

The demand for the monopolists good or
service may not be great enough to generate
economic profit in either the short run or the
long run
In the short run, the loss-minimizing
monopolist must decide whether to
produce or to shut down
If the price covers average variable cost, the
firm will produce
If not, the firm will shut down, at least in the
short run
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Recall that average variable cost and
average fixed cost sum to average Marginal cost
total cost .

Loss minimization occurs at

point e, where the marginal
revenue curve intersects the
marginal cost curve  Q and p
are the loss minimization
quantity and price, respectively.
a Average total cost
Loss
p b
Average variable cost
c
Dollars per unit

Notice that at point b, the firm is

covering its average variable cost e
 it is making some contribution
to its fixed costs. However, it is
not covering all of its costs. The Demand  Average revenue
average loss per unit, measured by Marginal revenue
ab, is identified by the yellow Quantity per period
0 Q
shaded area.
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 Monopolist’s Supply Curve
The intersection of a monopolist’s
marginal revenue and marginal cost curve
identifies the profit maximizing quantity,
but the price is found on the demand curve

Thus, there is no curve that shows both

price and quantity supplied  there is no
monopolist supply curve

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 Long-Run Profit Maximization
For a monopoly, the distinction between the
long and short run is not as important

If a monopoly is insulated(protected) from

competition by high barriers that block new
entry, economic profit can persist in the long
run

However, short-run profit is no guarantee of

long-run profit

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 Long-Run Profit Maximization
A monopolist that earns economic profit in
the short-run may find that profit can be
increased in the long run by adjusting the
scale of the firm

Conversely, a monopoly that suffers a loss

in the short run may be able to eliminate
that loss in the long run by adjusting to a
more efficient size

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 Price and Output
Comparison
When there is only one firm in the
industry, the industry demand curve
becomes the monopolist’s demand curve
 the price the monopolist charges
determines how much gets sold

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 Why the Welfare Loss Might Be Lower
If economies of scale are extensive
enough, a monopolist may be able to
produce output at a lower cost per unit
than could competitive firms

If this is true, the price or at least the cost

of production could be lower under
monopoly than under competition

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 Why the Welfare Loss Might Be Lower
The welfare loss may also overstate
(exaggerate ) the true cost of monopoly
because monopolists may, in response to
public scrutiny and political pressure, keep
prices below what the market could bear
Finally, a monopolist may keep the price
below the profit maximizing level to avoid
attracting new competitors
Another line of thought suggests that the
welfare loss of monopoly may, in fact, be
greater.

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 Why the Welfare Loss Might Be Higher
If resources must be devoted to securing and
maintaining a monopoly position, monopolies
may involve more of a welfare loss that simple
models suggest

Consider, for example, radio and TV

broadcasting rights confer on the recipient
the exclusive right to use a particular band of
the scarce broadcast spectrum(brand).

In the past, these rights have been given away

by government agencies to the applicants
deemed most deserving(worthy)

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 Why the Welfare Loss Might Be Higher
Because these rights are so valuable,
numerous applicants spend millions on
lawyers’ fees, lobbyying expenses, and
other costs associated with making
themselves appear the most deserving

The efforts devoted to securing and

maintaining a monopoly position are
largely a social waste because they use up
scarce resources but add not unit to output

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 Why the Welfare Loss Might Be Higher
Activities undertaken by individuals or
firms to influence public policy in a way
that will directly or indirectly redistribute
income to them are referred to as rent
seeking

Second, monopolists insulated from the

rigors of competition in the marketplace,
may also become efficient

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 Why the Welfare Loss Might Be Higher

Finally, monopolists have also been criticized

for being slow to adopt the latest production
techniques, to develop new products, and
generally lacking innovativeness

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 Price Discrimination
A monopolist can sometimes increase
economic profit by charging higher prices
to customers who value the product more

The practice of charging difference prices

to different customers when the price
differences are not justified by differences
in cost is called price discrimination

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 Conditions for Price Discrimination
Conditions
The demand curve for the firm’s product must
slope downward  the firm has some market
power and control over price
There are at least two groups of consumers for
the product, each with a different price
elasticity of demand
The producer must be able, at little cost, to
charge each group a different price for
essentially the same product
The producer must be able to prevent those
who pay the lower price from reselling the
product to those who pay the higher price
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 Model of Price
Discrimination
Exhibit 9 shows the effects of price
discrimination

Consumers are divided into two groups

with different demands

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 Examples of Price Discrimination
Because businesspeople face
unpredictable yet urgent demands for
travel and communication, and because
employers pay such expenses,
businesspeople are less sensitive to price
than householders

Telephone companies are able to sort out

their customers by charging different rates
based on the time of day

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 Perfect Price Discrimination
If a monopolist could charge a different
price for each unit sold, the firm’s marginal
revenue curve from selling one more unit
would equal the price of that unit  the
demand curve would become the marginal
revenue curve

A perfectly discriminating monopolist

charges a different price for each unit of
the good

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The Early Bird Gets a Lower Price
By discriminating, a monopoly firm makes greater profits
than it would make by charging both groups the same
price.

A firm with market power could collect the entire

consumer surplus if it could charge each customer exactly
the price that that customer was willing and able to pay.
This is called perfect price discrimination.

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Price Discrimination in Action

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