Monopoly
15
Monopoly
• A firm is a monopoly if . . .
• it is the only seller of its product, and
• its product does not have close substitutes.
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CHAPTER 15 MONOPOLY
WHY MONOPOLIES ARISE
• The fundamental cause of monopoly is the existence of barriers
to entry.
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CHAPTER 15 MONOPOLY
WHY MONOPOLIES ARISE
• Barriers to entry have three sources:
• Ownership of a key resource.
• The government gives a firm the exclusive right to produce some good.
• Costs of production make one producer more efficient than a large
number of producers.
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CHAPTER 15 MONOPOLY
Monopoly Resources
• Although exclusive ownership of a key resource is a potential
source of monopoly, in practice monopolies rarely arise for this
reason.
• Example: The DeBeers Diamond Monopoly
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CHAPTER 15 MONOPOLY
Government-Created Monopolies
• Governments may restrict entry by giving one firm the exclusive
right to sell a particular good in certain markets.
• Example: Patent and copyright laws are two important examples of
how governments create monopoly to serve the public interest.
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CHAPTER 15 MONOPOLY
Natural Monopolies
• An industry is a natural monopoly when one firm can supply a
good or service to an entire market at a smaller cost than could
two or more firms.
• Example: delivery of electricity, phone service, tap water, etc.
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CHAPTER 15 MONOPOLY
Natural Monopolies
Cost
• A natural monopoly
arises when there are
economies of scale over
the relevant range of
output.
Average
tota
lcos
t
0 Quantity of
Output 8
CHAPTER 15 MONOPOLY
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
• Can reduce its sales to increase price
• 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 market price
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CHAPTER 15 MONOPOLY
Figure 2 Demand Curves for Competitive and Monopoly Firms
’
A firm’s demand curve under A monopolist’s demand curve
Price perfect competition Price
Demand
Demand
0 Quantity of Output 0 Quantity of Output
See Ch. 14 for a
review of perfect
competition. 10
Recap from Ch 14: A Firm’s Revenue
• Total Revenue
TR = P × Q
• Average Revenue
AR = TR/Q = P
• Marginal Revenue
MR = ΔTR/ΔQ
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CHAPTER 15 MONOPOLY
Table 1 A Monopoly’s Total, Average,
and Marginal Revenue
Note that P = AR > MR.
Recall that, in perfect
competition, P = AR =
MR.
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Why is MR < P?
When Q = 3, P = 8 but MR = 6.
Why is MR < P?
Output Effect: When the 3rd unit
is sold, the firm earns an
additional $8 for it. So, TR
increases by $8, which is P.
Price Effect: But to sell the 3rd
unit, the price had to be reduced
from $9 to $8. So, the total
revenue from the first two units
-- which would have been $18 if
only 2 units were sold --
decreases to $16 when 3 units
are sold. Thus, TR also decreases
by $2 when the 3rd unit is sold.
Therefore, the increase in total
revenue is $8 - $2 = $6, which is
less than P. In other words, MR <
P.
A Monopoly’s Total Revenue
• When a monopoly increases the amount it sells by one unit,
there are two effects on total revenue P × Q.
• The output effect: when an additional unit of output is sold, the
monopolist charges a price for it. Therefore, total revenue increases by
P, the price.
• The price effect: to sell the additional unit, the price must be reduced.
Therefore, total revenue from the units that the monopolist would
have decreases.
• The overall effect will depend on the price elasticity of demand; see chapter 5
• If demand is elastic—that is, PED > 1—an increase in output is accompanied by
an increase in total revenue
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CHAPTER 15 MONOPOLY
Figure 3 Demand and Marginal-Revenue Curves for a Monopoly
Price
$1 Note that P = AR > MR
110 at all quantities.
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
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CHAPTER 15 MONOPOLY
Profit Maximization
• For any firm, the profit-maximizing quantity supplied is that at
which marginal revenue equals marginal cost: MR = MC.
• We saw this in Chapter 14
• In equilibrium, quantity supplied = quantity demanded
• A monopoly firm then uses the demand curve to find the price
that will induce consumers to buy the profit-maximizing
quantity.
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CHAPTER 15 MONOPOLY
Figure 4 Profit Maximization 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 . . . 3. Note that P > MR = MC in
price equilibrium (point B).
4. Recall that in perfect
Average total cost competition P = MC and QD =
MC A QS (Ch. 14).
Can you pinpoint the perfect
competition outcome in this
Marginal Demand diagram?
cost That is, can you find the
price-and-quantity point in
this diagram at which P = MC
Marginal revenue and QD = QS?
0 Q QMAX Q Quantity
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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
• Note that the monopolist does not have a supply curve
• The monopolist is a price maker; it chooses what price to charge
• A perfectly competitive firm is a price taker; it responds to whatever the market
price happens to be and chooses what quantity to produce at that price
• This is why there is a supply curve in perfect competition, but not in monopoly.
• This is why the theory of supply and demand (chapter 4) works only under perfect
competition
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Recap from Ch 14: Profit
• Profit equals total revenue minus total costs.
• Profit = TR – TC
• Profit/Q = TR/Q – TC/Q
• Profit = (TR/Q – TC/Q) × Q
• Profit = (P – ATC) × Q
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CHAPTER 15 MONOPOLY
Figure 5 The Monopolist’s Profit
Costs
and
Revenu
e
Marginal cost
Monopol E B
y pric
e
Monopol Average total cost
y profit
Average
total D C
cost
Deman
d
Marginal
revenue
0 QMAX Quantity
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CHAPTER 15 MONOPOLY
A Monopolist’s Profit
• Recall that profit = (P – ATC) × Q
• Therefore, the monopolist will stay in business as long as price
(P) is greater than average total cost (ATC).
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CHAPTER 15 MONOPOLY
A monopolist will exit when P < ATC at all Q
Costs
and
Revenu
e
Average total cost
Deman
d
0 Quantity
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CHAPTER 15 MONOPOLY
Figure 6 The Market for Drugs (Pharmaceutical)
Costs and
Revenue
P > MC and QD = QS;
monopoly
Price
during
P = MC and QD = QS;
patent life
perfect competition
Price after
Marginal
patent
cost
expires
Marginal Demand
revenue
0 Monopoly Competitive Quantity
quantity quantity
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CHAPTER 15 MONOPOLY
Video: Generic Drugs
• Pharmaceutical drugs that are no longer under patent are called
generic drugs
• It is often assumed that the market for generic drugs is perfectly
competitive
• But the reality is very different
• Why generic drugs don’t necessarily mean lower prices by Megan
Thompson, PBS Newshour, December 23, 2013
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CHAPTER 15 MONOPOLY
THE WELFARE COST OF MONOPOLY
• In contrast to a competitive firm, the monopoly charges a price
above the marginal cost (P > MC).
• For consumers, this high price makes monopoly undesirable.
• For the monopolist, the high price makes monopoly profitable.
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CHAPTER 15 MONOPOLY
The height of the
Figure 7 The Efficient Level of Output Demand curve at any
quantity shows the
value of the
Price commodity to whoever
Marginal cost bought the last unit.
So, the height of the
Demand curve at any
quantity shows the
social benefit of the
Value Cost last unit.
to to
buyers When this is no less
monopolist
than the marginal cost
of the last unit, the last
unit is socially
Demand desirable.
Cost Value (marginal value to buyers)
to to
monopolist buyers
0 Quantity
Value to buyers Value to buyers
is greater than is less than
cost to cost to
seller. Efficient seller.
quantity 26
CHAPTER 15 MONOPOLY
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.
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CHAPTER 15 MONOPOLY
Figure 8 The Inefficiency of Monopoly
P > MC and QD = QS;
monopoly
Price
Deadweight Marginal cost
loss
Monopoly
price
P = MC and QD = QS;
perfect competition
and optimum
Note that the monopolist
Marginal
produces less than the socially
revenue Demand efficient/optimum quantity
0 Monopoly Efficient Quantity
quantity quantity
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CHAPTER 15 MONOPOLY
The Deadweight Loss
• The deadweight loss caused by a monopoly is similar to the
deadweight loss caused by a tax.
• See chapter 8
• The difference between the two cases is that the government
gets the revenue from a tax, whereas a private firm gets the
monopoly profit.
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CHAPTER 15 MONOPOLY
PUBLIC POLICY TOWARD MONOPOLIES
• Governments may respond 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.
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CHAPTER 15 MONOPOLY
Increasing Competition with Antitrust Laws
• Antitrust laws are laws 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.
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CHAPTER 15 MONOPOLY
Increasing Competition with Antitrust Laws
• Two Important Antitrust Laws
• Sherman Antitrust Act (1890)
• Reduced the market power of the large and powerful “trusts” of that time
period.
• Clayton Act (1914)
• Strengthened the government’s powers and authorized private lawsuits.
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CHAPTER 15 MONOPOLY
Regulation
• Government may regulate the prices that the monopoly
charges.
• Example: ConEd, LIPA, etc.
• The regulator may force the monopolist to implement the
efficient outcome
• Recall that the allocation of resources is efficient when price is set to
equal marginal cost (P = MC).
• But it might be difficult for government regulators to force the
monopolist to set P = MC
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Figure 10 Marginal-Cost Pricing for a Natural Monopoly
Price
The ideal policy is to force the
firm to produce Qoptimal and
Compromise then subsidize it for its loss.
outcome The compromise outcome is to
produce where P = ATC and the
monopolist breaks even
Average total
cost Average total cost
Loss
Regulated
price Marginal cost
Ideal outcome
Demand
Qoptimal
0 Quantity
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CHAPTER 15 MONOPOLY
Regulation
• In practice, regulators will allow monopolists to keep some of
the benefits from lower costs in the form of higher profit
• This requires some departure from marginal-cost pricing.
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CHAPTER 15 MONOPOLY
Public Ownership
• Rather than regulating a natural monopoly that is run by a
private firm, the government may run the monopoly itself
• e.g. in the United States, the government runs the U.S. Postal Service.
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CHAPTER 15 MONOPOLY
Doing Nothing
• Government may do nothing at all if the market failure is
deemed small compared to the imperfections of public policies.
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CHAPTER 15 MONOPOLY
PRICE DISCRIMINATION
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CHAPTER 15 MONOPOLY
PRICE DISCRIMINATION
• Price discrimination is the business practice of selling the same
good at different prices to different customers, even though the
cost of production is the same for all customers.
• What do you think of this practice?
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CHAPTER 15 MONOPOLY
PRICE DISCRIMINATION
• Price discrimination is not possible in a competitive market
• as there are many firms all selling the same product at the market
price.
• In order to price discriminate, the firm must have some market
power.
• That is, it must have the ability to set its prices without being afraid
that its customers will go to competing firms.
• Price discrimination won’t work if resale is easy
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CHAPTER 15 MONOPOLY
Perfect Price Discrimination
• Perfect price discrimination refers to the situation when
• the monopolist knows each customer’s willingness to pay, and
• can charge each customer exactly what he/she is willing to pay.
• Example:
• Suppose the Cable TV industry is a monopoly
• Suppose you are willing to pay up to $200 per month for a cable connection
• Suppose the cable company knows this and accordingly charges you $200
per month
• All other customers are also being charged the maximum they are willing to
pay
• What do you think of this state of affairs?
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PRICE DISCRIMINATION
• Important effects of price discrimination:
• It increases the monopolist’s profits.
• It reduces the consumer surplus.
• Under perfect price discrimination, consumer surplus is zero
• It reduces the deadweight loss.
• Under perfect price discrimination, deadweight loss is zero,
• Exactly as under perfect competition.
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CHAPTER 15 MONOPOLY
Figure 9 Welfare with and without Price Discrimination
(a) Monopolist with Single Price
Price
Total Surplus = Consumer Surplus + Profit
Consumer Monopoly outcome
surplus
Monopoly Deadweight
price loss Efficient outcome
Profit
Marginal cost
Marginal Demand
revenue
0 Quantity sold Quantity
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CHAPTER 15 MONOPOLY
Figure 9 Welfare with and without Price Discrimination
(b) Monopolist with Perfect Price Discrimination
Price
Total Surplus = Profit.
Consumer Surplus and
Deadweight Loss are both
ZERO!
Monopoly outcome under perfect price discrimination
Profit (also the efficient outcome)
Marginal cost
Demand
0 Quantity sold Quantity
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CHAPTER 15 MONOPOLY
Which outcome is better?
• One price for all • A different price for
every buyer
• P = AR is no longer true!
Examples of Price Discrimination
• Movie tickets
• Airline tickets
• Discount coupons
• Financial aid
• Quantity discounts
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CHAPTER 15 MONOPOLY
CONCLUSION: THE PREVALENCE OF MONOPOLY
• We have seen that monopoly is inefficient. But how widespread
is monopoly? How worried should we be?
• Monopolies are common.
• Most firms have some control over their prices because of differentiated
products. But
• Firms with substantial monopoly power are rare.
• Few goods are truly unique.
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CHAPTER 15 MONOPOLY
Competition v. Monopoly
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CHAPTER 15 MONOPOLY
Any Questions?
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CHAPTER 15 MONOPOLY
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.
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CHAPTER 15 MONOPOLY
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.
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CHAPTER 15 MONOPOLY
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.
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CHAPTER 15 MONOPOLY
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.
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CHAPTER 15 MONOPOLY
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.
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CHAPTER 15 MONOPOLY
Pricing Power
• While a competitive firm is a price taker, a monopoly firm is a
price maker.
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CHAPTER 15 MONOPOLY
Figure 1 Economies of Scale as a Cause of Monopoly
Cost
Average
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Output 56
CHAPTER 15 MONOPOLY
