Monopoly

Four Basic Market Structures

Perfectly Competitive: many firms, identical

products, free entry and exit, full and symmetric info
Monopoly: single firm, no close substitutes, barriers
to entry, full and symmetric info
Oligopoly: several firms, similar products, degree of
product differentiation varies depending upon the
market, might be barriers, full and symmetric info
Monopolistic competition: many firms, similar
products, slightly differentiated products, free entry
and exit, full and symmetric info

Competitive Market
This

is the classic
textbook market structure.
Firms in a competitive
market all make a product
that is perfectly
substitutable: all
demanders are equally
satisfied with any suppliers
product.

Monopoly
The

single seller makes

a product that has no
good substitute.
Other firms may be able
to produce the good or
service but choose not to
enter the market or are
barred from it.

Oligopoly
A

few sellers make

products that are good,
but not perfect,
substitutes.
Consumers can be
induced to change
suppliers but have only
a limited number of
choices.

Monopolistic Competition
The

market has
many firms but each
suppliers product is
differentiated.
Consumers can be
induced to change
brands but they
have brand
preferences.

Question
What

is the market structure for each of

these products or firms: competitive,
monopoly, oligopoly, monopolistic
competition?

The Campus Store

Kinkos
Pepperidge Farms Whole Wheat Bread
PowerMac computer
Windows computer
NYSEG (electricity utility)
Morton salt
AT&T long distance
7

Answer

The Campus Store: most products competitive, textbooks

oligopoly, but location is very important.
Kinkos: monopolistic competition (differentiated service)
Pepperidge Farms Whole Wheat Bread: competition or
monopolistic competition (slightly differentiated recipes)
PowerMac computer and clones: monopoly, under license.
Windows computer: monopolistic competition (differentiated
features)
NYSEG (electricity utility): monopoly
Morton salt: competitive
AT&T long distance: oligopoly

Monopoly
single

firm
no close substitutes
barriers to entry
full and symmetric
information
9

Sources of Monopoly Entry

Barriers

Natural monopoly: the most efficient scale of

production is so large, relative to market demand, that
a single firm dominates the market.
Patents, copyrights, licenses, franchises: government
protection of a firms right to produce a unique product.
Economic and/or legal restrictions, strategies or
situations that make entry more difficult for new
competitors than for the existing monopoly firm.

10

Natural Monopolies

Goods and services whose delivery requires the

construction of a physical network (wires, pipes, etc..)
In such industries (local phone service, water,
sewage removal, electricity, gas) the physical
networks display decreasing marginal cost over
essentially all quantities.
Thus, average total cost is always declining and the
minimum efficient scale is much larger than the size
of the market.
Natural monopolies are often regulated: they cannot
charge a higher price without government approval.

11

Patents: Are There Good

Monopolies?
Consider

the protease inhibitor Crixivan from

Merck.
A very effective AIDS therapy.
Development costs were more than one
billion dollars.
Annual revenue now from treating around
90,000 patients is $500,000,000.

12

What is a Good Monopoly?

Why

is Merck given a monopoly?

The granting of a patent on the drug
Crixivan guarantees that Merck can
earn monopoly profits on its sale.
These monopoly profits provide the
incentive to invest in the research and
development required to create the new
drug.
13

Good Monopolies
The

granting of patent protection (legal

monopoly) gives firms a strong incentive to
invest in new product development.
Would firms make the R&D investments if
they could not protect them through patents
and trade secrets?
Probably not because competitors could steal
the design at a fraction of the cost after the
product is brought to market.
14

Other Monopolies - Good?

Bad?
Input

Ownership

DeBeers and diamonds

Industry

Secret or Know-how

IBM and mainframes?

Strategic

Behavior

buy em up
blow em up
lets make a deal
Microsoft and operating systems?

15

Caveats
monopoly

does not => big

big does not => monopoly
monopoly does not => absolute and unlimited
control over price
monopoly does not => must have economic
profit
short run profit does not => monopoly power
monopoly does not => badly behaved firm

16

Classic Simple Monopoly

Polar

extreme from perfect competition.

Monopolist is a price maker.
Cost curves are pretty much the same
(except in the case of natural
monopoly).
The big change from before is in the
demand side of the profit function.

17

The Simple Monopolist

The

simple monopolist abides by the law of

one price. Everyone pays the same market
price for all units purchased.
A monopolist faces the declining market
demand curve for its product and
simultaneously chooses price and quantity.
Now P>MR (before P=MR) because the
simple monopolist must lower the price on all
preceding units to sell an additional unit.
A monopolist has no supply curve.
18

The Simple Monopolist: Rules

for Profit Maximization
Suppose

we are in the short run.

Rules for profit maximization are the same as
before.
If XSM maximizes profit, then
MR(XSM ) = MC(XSM )
very important note: for a simple monopolist
P>MR at all positive levels of X.

XSM is a max and not a min.

at XSM its worth operating.

19

Simple Monopoly

Economic profits equal

total revenue minus total
costs.
Marginal revenue is the
rate of change of total
revenue (just like marginal
cost is the rate of change
of total cost) as quantity
increases.
Economic profits are
maximized when marginal
revenue equals marginal
costs

Quantity
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200

Monopoly Selling in a Single Market at a Single Price

Marginal
Marginal
Market
Cost
Average
Revenue
Demand
Total
(midpoint
Total
Total
(midpoint Economic
Price
Costs
formula)
Cost
Revenue
formula)
Profits
100.00
800
0.00
-800
95.00
1,500
82.50 150.00
950.00
90.00
-550
90.00
2,450
65.00 122.50 1,800.00
80.00
-650
85.00
2,800
42.50
93.33 2,550.00
70.00
-250
80.00
3,300
32.50
82.50 3,200.00
60.00
-100
75.00
3,450
20.50
69.00 3,750.00
50.00
300
70.00
3,710
18.50
61.83 4,200.00
40.00
490
65.00
3,820
9.50
54.57 4,550.00
30.00
730
60.00
3,900
9.00
48.75 4,800.00
20.00
900
55.00
4,000
10.00
44.44 4,950.00
10.00
950
50.00
4,100
12.50
41.00 5,000.00
0.00
900
45.00
4,250
17.50
38.64 4,950.00
-10.00
700
40.00
4,450
20.00
37.08 4,800.00
-20.00
350
35.00
4,650
25.00
35.77 4,550.00
-30.00
-100
30.00
4,950
30.00
35.36 4,200.00
-40.00
-750
25.00
5,250
35.00
35.00 3,750.00
-50.00
-1,500
20.00
5,650
45.00
35.31 3,200.00
-60.00
-2,450
15.00
6,150
60.00
36.18 2,550.00
-70.00
-3,600
10.00
6,850
75.00
38.06 1,800.00
-80.00
-5,050
5.00
7,650
100.00
40.26
950.00
-90.00
-6,700
0.00
8,850
44.25
0.00
-8,850

20

Graphical Display of
Monopolists Solution

Market Demand Price

90.00

Exact Marginal Revenue

80.00

Marginal Cost
Average Total Cost

70.00
60.00
50.00 Monopoly Profits
40.00
30.00
20.00
10.00

200

190

180

170

160

150

140

130

120

110

90

80

70

60

50

40

100

-10.00

30

0.00

20

100.00

10

Natural Monopolist's Market

The monopolist sets marginal revenue

equal to marginal cost at MR=MC=$10.
The optimal quantity is thus 90 units,
which implies a market price of $55/unit.
The monopoly profits (light blue in the
graph) are the difference between price
($55) and average total cost ($44.44)
times the number of units sold.
Notice that our monopolist is a natural
monopoly the average total costs
decline over the entire relevant range of
production and the minimum efficient
scale (150) is bigger than the entire
market.
Notice that if our monopolist operated at
the competitive equilibrium
(Price=MC=$30, Quantity=140), the firm
would make a loss (ATC>Price).

Dollars/unit

-20.00
-30.00
-40.00
Quantity

21

Implications of the
Monopolists Profit Maximum

Price will exceed the competitive price.

Quantity will be less than the competitive quantity.
The monopolist sells the output at a price greater than marginal
costs but the monopoly price can be above or below average
total costs. Thus, the monopolist need not always make a profit.
In the long run, of course, unprofitable monopolists will either
stop production or raise the price further above marginal cost
until it covers average total costs.
The monopolist will always try to operate on the elastic portion
of the demand curve because when the elasticity of demand is
greater than -1 (inelastic, between 0 and 1 in absolute value),
marginal revenue is negative and, necessarily, less than
marginal cost.
Since there is no entry to consider monopolists can have
persistent long run economic profit.
22

Simple MonopolyPerformance
Efficiency:

Is the monopoly equilibrium Pareto Efficient?

That is, at XSM is net social surplus maximized?
Does $MB=$MC at XSM?
Is the monopolist productively efficient? Does the
monopolist operate at minimum efficient scale?
Equity:

Is the outcome of monopoly fair? Equitable?

Just?

23

Simple MonopolyPerformance Answers

The

simple monopoly equilibrium is not

Pareto Efficient.
The simple monopolist creates dead-weightloss.
At XSM, $MB>$MC . Recall: $MR=$MC at XSM
while $PSM>$MR at all X. So $PSM>$MC. Since
$P=$MB, then $MB>$MC.

The

simple monopolist may or may not be

productively efficient.
Compared to the competitive equilibrium,
there is a transfer of surplus from consumers
to producers.
24

Price Discriminating
Monopolists
A

monopolist might be able to charge different

prices for different units sold and enhance its
profits.
charge different people different prices
charge the same person different prices for different
units

price

discrimination

charging different prices for different units with no cost

basis
charging the same price for different units when there
are cost differences
25

Requirements for Price

Discrimination
Some

amount of monopoly power.

An ability to prevent resale.
Detailed information about who is buying
what unit and what demanders are
willing to pay.

26

Believe It Or Not
What would you do to prevent resale???
when: 1940s
market: plastic molding powder

industrial users: .85/pound

denture manufacturers: $22/pound

firm: Rohm and Haas

problem: resale from industrial users to
denture manufacturers
solution: rumor you are mixing arsenic in the
powder sold to industrial users!

27

Two classic forms of Price

Discrimination

Perfect or First Degree Price Discrimination

charge a different price for each unit sold
the most extreme form of price discrimination

Third Degree Price Discrimination

segment market and then charge a different price in
each market
exploit the observation that at the simple monopoly price
the own price elasticity of demand differs across the
defined segmented markets

Price discrimination comes in many other flavors

28

Question
The

data on your handout show the

demand curves for movie tickets of
adults and seniors. The market
described has only one movie theatre.
Find the best single price.
If the movie theater can charge separate
prices for adults and seniors, what are the
best two prices?

29

Two Prices are Better than

One for Movie Tickets
Price per
ticket
12.00
11.50
11.00
10.50
10.00
9.50
9.00
8.50
8.00
7.50
7.00
6.50
6.00
5.50
5.00
4.50
4.00
3.50
3.00
2.50
2.00

Price Discrimination in the Movie Theatre Market

Quantity Quantity
Total
Single
Adult
Senior
Single
adult
senior
Demand
Single
Price
Adult
Price
Price
Price
movie
movie
for
Price Total Marginal
Total
Marginal Senior Total Marginal Marginal Economic
tickets
tickets
Tickets Revenue Revenue Revenue Revenue Revenue Revenue
Cost
Profits
200
0
200
2,400
2,400
0
1.00
2,200
225
25
250
2,875
9.00
2,588
7.00
288
11.00
1.00
2,625
250
50
300
3,300
8.00
2,750
6.00
550
10.00
1.00
3,000
275
75
350
3,675
7.00
2,888
5.00
788
9.00
1.00
3,325
300
100
400
4,000
6.00
3,000
4.00
1,000
8.00
1.00
3,600
325
125
450
4,275
5.00
3,088
3.00
1,188
7.00
1.00
3,825
350
150
500
4,500
4.00
3,150
2.00
1,350
6.00
1.00
4,000
375
175
550
4,675
3.00
3,188
1.00
1,488
5.00
1.00
4,125
400
200
600
4,800
2.00
3,200
0.00
1,600
4.00
1.00
4,200
425
225
650
4,875
1.00
3,188
-1.00
1,688
3.00
1.00
4,225
450
250
700
4,900
0.00
3,150
-2.00
1,750
2.00
1.00
4,200
475
275
750
4,875
-1.00
3,088
-3.00
1,788
1.00
1.00
4,125
500
300
800
4,800
-2.00
3,000
-4.00
1,800
0.00
1.00
4,000
525
325
850
4,675
-3.00
2,888
-5.00
1,788
-1.00
1.00
3,825
550
350
900
4,500
-4.00
2,750
-6.00
1,750
-2.00
1.00
3,600
575
375
950
4,275
-5.00
2,588
-7.00
1,688
-3.00
1.00
3,325
600
400
1,000
4,000
-6.00
2,400
-8.00
1,600
-4.00
1.00
3,000
625
425
1,050
3,675
-7.00
2,188
-9.00
1,488
-5.00
1.00
2,625
650
450
1,100
3,300
-8.00
1,950
-10.00
1,350
-6.00
1.00
2,200
675
475
1,150
2,875
-9.00
1,688
-11.00
1,188
-7.00
1.00
1,725
700
500
1,200
2,400
1,400
1,000
1.00
1,200

The best single price in this market is $7.50/ticket, which makes economic profits of $4,225
(blue entries). Set marginal cost = marginal revenue with the single price.
The price discriminating monopolist can make more economic profits by charging adults $8.50
(yellow entries) and seniors $6.50 (green entries). Set marginal cost = marginal revenue
separately for each market.

30

Summary of Price
Discrimination Example
Profit Maximum with 2 Prices
Economic profits adult market
Economic profits senior market
Total with price discrimination
Total without price discrimination

2,813
1,513
4,325
4,225

Calculating

economic profits separately for

the two markets (adult and senior) shows that
the total is greater than with the best single
price.
Taking advantage of different elasticities of
demand.
31

Believe It Or Not
when:

early 1990s
market: contact lenses
firm: Bausch & Lomb
Lenses:

Optima @ $70/pair - wash and keep 1 year

Medalist @ $15/pair - wash and keep 2 months
SeeQuence 2 @ $8/pair - wash and keep 2 weeks
Occasions @ $3/pair - daily and disposable each day

Guess

what?
32

Believe It Or Not
They

were all the same lenses!

Just packaged differently!
What would you pay for a year?

Optima = $70/pair - wash and keep 1 year

Medalist = $15x6=$90 (last 2 months)
SeeQuence 2 = $8x26=$208 (last 2 weeks)
Occasions = $3x365 = $1095

What

would I do? Buy the Occasions and wash and

wear until my eyes hurt.

Class

action suits were eventually settled.

33

First Degree Price

Discrimination

The monopolist charges the demand price for each

unit sold.
In this case the market demand curve becomes the
monopolists marginal revenue curve.
The monopolist sets MR=MC to get XFDPD.
The monopolist charges a different price for each
unit according to the demand curve.
Performance: XFDPD is Pareto Efficient and all the net
social surplus goes to the monopolist as producer
surplus. Consumer surplus = $0!

34

Should the Government

Regulate Monopolies?
Essentially

all monopolies are regulated.

Natural monopolies are regulated by price
commissions that determine the rates the
monopolies may charge.
Patent, copyright and license protections are
a form of ex ante regulation: firms that follow
the rules for establishing the validity of their
innovations receive the protection of the
patent, copyright or license.
Should the government do more? Good
question.
35