15

Monopoly

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University

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 Why Monopolies Arise
• Monopoly
– Firm that is the sole seller of a product
without close substitutes
– Price maker
– Charges a price that exceeds marginal
cost

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 Barriers to entry
• Monopoly resources
• Government regulation
• Natural monopoly

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 Table 1
A Monopoly’s Total, Average, and Marginal Revenue

Quantity
of Water Price Total Revenue Average Revenue Marginal Revenue
(Q) (P) (TR = P x Q) (AR = TR/Q) ( M R = ∆TR/∆Q)
0 gallons $ 11 $ 0

1 10 10 $10 $10
2 9 18 9 8

3 8 24 8 6

4 7 28 7 4
5 6 30 6 2

6 5 30 5 0

7 4 28 4 -2

8 3 24 3 -4

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 Production and Pricing Decisions
• Monopoly
– Price maker
– Sole producer
– Downward sloping demand: the market
demand curve
• Competitive firm
– Price taker
– One producer of many
– Demand is a horizontal line (Price)
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 Production and Pricing Decisions
• Increase in quantity sold
– Output effect
• Q is higher: increase total revenue
– Price effect
• P is lower: decrease total revenue
• Because MR < P
– Marginal-revenue curve is below the
demand curve

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 Figure 3
Demand and Marginal-Revenue Curves for a Monopoly

The demand curve shows how the quantity affects the price of the good. The marginal-revenue
curve shows how the firm’s revenue changes when the quantity increases by 1 unit. Because
the price on all units sold must fall if the monopoly increases production, marginal revenue is
always less than the price.

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 Production and Pricing Decisions
• Profit maximization
– If MR > MC: increase production
– If MC > MR: produce less
– Maximize profit
• Produce quantity where MR=MC
• Intersection of the marginal-revenue curve
and the marginal-cost curve
• Price: on the demand curve

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 Figure 4
Profit Maximization for a Monopoly

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals
marginal cost (point A). It then uses the demand curve to find the price that will induce
consumers to buy that quantity (point B).
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 Production and Pricing Decisions
• Profit maximization
– Perfect competition: P=MR=MC
• Price equals marginal cost
– Monopoly: P>MR=MC
• Price exceeds marginal cost
• A monopoly’s profit
– Profit = TR – TC = (P – ATC) ˣ Q

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 Figure 5
The Monopolist’s Profit

The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC)
is price minus average total cost, which equals profit per unit sold. The width of the box (DC)
is the number of units sold.
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 Figure 6
Monopoly to perfect competition

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.
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 The Welfare Cost of Monopolies

• Total surplus
– Economic well-being of buyers and sellers
in a market
– Sum of consumer surplus and producer
surplus
• Consumer surplus
– Consumers’ willingness to pay for a good
– Minus the amount they actually pay for it

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 The Welfare Cost of Monopolies

• Producer surplus
– Amount producers receive for a good
– Minus their costs of producing it
• Benevolent planner: maximize total
surplus
– Socially efficient outcome
– Produce quantity where
• Marginal cost curve intersects demand curve
– Charge P=MC
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 Figure 7
The Efficient Level of Output

A benevolent social planner maximizes total surplus in the market by choosing the level of output
where the demand curve and marginal-cost curve intersect. Below this level, the value of the
good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of
making the good. Above this level, the value to the marginal buyer is less than marginal cost.
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 The Welfare Cost of Monopolies

• Monopoly
– Produce quantity where MC = MR
– Produces less than the socially efficient
quantity of output
– Charge P > MC
– Deadweight loss
• Triangle between the demand curve and MC
curve

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 Figure 8
The Inefficiency of Monopoly

Because a monopoly charges a price above marginal cost, not all consumers who value the good at more
than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level.
The deadweight loss is represented by the area of the triangle between the demand curve (which reflects
the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly
producer).
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 The Welfare Cost of Monopolies

• The monopoly’s profit: a social cost?

– Monopoly - higher profit
• Not a reduction of economic welfare
– Bigger producer surplus
– Smaller consumer surplus
• Not a social problem
– Social loss = Deadweight loss
• From the inefficiently low quantity of output

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 Price Discrimination
• Price discrimination
– Business practice
– Sell the same good at different prices to
different customers
– Rational strategy to increase profit
– Requires the ability to separate customers
according to their willingness to pay
– Can raise economic welfare

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 Price Discrimination
• Perfect price discrimination
– Charge each customer a different price
• Exactly his or her willingness to pay
– Monopoly firm gets the entire surplus
(Profit)
– No deadweight loss

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 Price Discrimination
• Without price discrimination
– Single price > MC
– Consumer surplus
– Producer surplus (Profit)
– Deadweight loss

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 Figure 9
Welfare with and without Price Discrimination

Panel (a) shows a monopoly that charges the same price to all customers. Total surplus in this
market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a
monopoly that can perfectly price discriminate. Because consumer surplus equals zero, total
surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect
price discrimination raises profit, raises total surplus, and lowers consumer surplus.
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 Price Discrimination
• Examples of price discrimination
– Movie tickets
• Lower price for children and seniors
– Airline prices
• Lower price for round-trip with Saturday night
stay

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 Price Discrimination
• Examples of price discrimination
– Discount coupons
• Not all customers are willing to spend time
to clip coupons
– Financial aid
• High tuition and need-based financial aid
• Willingness to pay
– Quantity discounts
• Customer pays a higher price for the first
unit bought than for the last unit bought
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 Public Policy Toward Monopolies
• Increasing competition with
antitrust laws
– Sherman Antitrust Act, 1890
– Clayton Antitrust Act, 1914
– Prevent mergers
– Break up companies
– Prevent companies from
coordinating their activities
to make markets less
competitive
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 Public Policy Toward Monopolies

• Regulation
– Regulate the behavior of monopolists
• Price
– Common in case of natural monopolies
– Marginal-cost pricing
• May be less than ATC
• No incentive to reduce costs

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 Figure 10
Marginal-Cost Pricing for a Natural Monopoly

Because a natural monopoly has declining average total cost, marginal cost is less
than average total cost. Therefore, if regulators require a natural monopoly to
charge a price equal to marginal cost, price will be below average total cost, and
the monopoly will lose money.
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 Public Policy Toward Monopolies

• Public ownership
– How the ownership of the firm affects the
costs of production
– Private owners
• Incentive to minimize costs
– Public owners (government)
• If it does a bad job
– Losers are the customers and taxpayers

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 Table 2
Competition versus Monopoly: A Summary Comparison
Competition Monopoly
Similarities
Goal of firms Maximize profits Maximize profits
Rule for maximizing MR = MC MR= MC

Can earn economic profits in the

short run? Yes Yes
Differences
Number of firms Many One
Marginal revenue MR=P MR< P
Price P=MC P>MC

Produces welfare-maximizing level

of output? Yes No
Entry in long run? Yes No

Can earn economic profits in long

run? No Yes
Price discrimination possible? No Yes

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