Monopoly

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10

Definition
Monopoly is a market structure in which there
is a single seller
There is no close substitutes for the commodity
it produces
Barriers to entry

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WHY MONOPOLIES ARISE

Barriers to entry have three sources:
Ownership of a key resource.
The government gives a single firm the exclusive
right to produce some good.
Costs of production make a single producer more
efficient than a large number of producers.
Exclusive knowledge of production technique

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Examples
Microsoft windows: The company received
exclusive right to make windows operating
system
Aluminum Company of America (Alcoa) is a
classic example
Post office, electric, gas, water and local
transport companies

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About Alcoa
The monopoly was created in the late nineteenth century when Alcoa
acquired a patent on the method to remove oxygen from bauxite to obtain
aluminum.
This patent expired in 1909, but by this time Alcoa had signed long-term
contracts with producer of bauxite, prohibiting them for selling bauxite to
any other American firm.
In 1912, the courts invalidated all of these contracts and agreement
The monopoly was finally broken after World War II.
In 1960s, Reynolds and Kaiser came into existence.
On may 3, 2000, Alcoa acquired Reynolds Metal Company
In 2007, Alcoa had revenues of $30 billion, 1.23lakhs employees and nearly
16% of world aluminum market.

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Government-Created Monopolies
Governments may restrict entry by giving a
single firm the exclusive right to sell a
particular good in certain markets.
Patent and copyright laws are two important
examples of how government creates a
monopoly to serve the public interest.

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Natural Monopolies
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.

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Figure 1 Economies of Scale as a Cause of Monopoly

Cost

Average
total
cost
0

Quantity of Output
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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 at same price
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Figure 2 Demand Curves for Competitive and Monopoly

Firms

(a) A Competitive Firms Demand Curve

Price

(b) A Monopolists Demand Curve

Price

Demand

Demand

Quantity of Output

Quantity of Output

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A Monopolys Revenue
Total Revenue

P Q = TR
Average Revenue
TR/Q = AR = P
Marginal Revenue
DTR/DQ = MR

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Demand and Revenue

The demand curve under monopoly is downward sloping.
P
D
C
D/
o

MR

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Demand and Revenue.

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Profit Maximization
A monopoly maximizes profit by producing the
quantity at which marginal revenue equals
marginal cost.
It then uses the demand curve to find the price
that will induce consumers to buy that quantity.

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Figure 4 Profit Maximization for a Monopoly

Costs and
Revenue

2. . . . and then the demand

curve shows the price
consistent with this quantity.
B

Monopoly
price

1. The intersection of the

marginal-revenue curve
and the marginal-cost
curve determines the
profit-maximizing
quantity . . .

Average total cost

A

Demand

Marginal
cost

Marginal revenue
0

QMAX

Quantity
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Profit Maximization
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

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The monopolist will receive economic profits as

long as price is greater than average total cost.
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Figure 5 The Monopolists Profit

Costs and
Revenue
Marginal cost
Monopoly E
price

Monopoly
profit
Average
total D
cost

Average total cost

Demand

Marginal revenue
0

QMAX

Quantity
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Case Study: The Market for Drugs

Costs and
Revenue

Price
during
patent life
Price after
patent
expires

Marginal
cost

Marginal
revenue
0

Monopoly
quantity

Competitive
quantity

Demand

Quantity

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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.

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Figure: The Efficient Level of Output

Price
Marginal cost

Value
to
buyers

Cost
to
monopolist

Value
to
buyers

Cost
to
monopolist

Demand
(value to buyers)

Quantity

0
Value to buyers
is greater than
cost to seller.

Value to buyers
is less than
cost to seller.

Efficient
quantity
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The Deadweight Loss

Because a monopoly sets its price above
marginal cost, it places a wedge between the
consumers willingness to pay and the
producers cost.
This wedge causes the quantity sold to fall short of
the social optimum.

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Figure 8 The Inefficiency of Monopoly

Price
Deadweight
loss

Marginal cost

Monopoly
price

Marginal
revenue

Monopoly Efficient
quantity quantity

Demand

Quantity

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The Deadweight Loss

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

The deadweight loss caused by a monopoly is

similar to the deadweight loss caused by a tax.
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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PUBLIC POLICY TOWARD

MONOPOLIES
Government responds 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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Increasing Competition with 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.

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Regulation
Government may regulate the prices that the
monopoly charges.
The allocation of resources will be efficient if price
is set to equal marginal cost.

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Regulation
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.

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Public Ownership
Rather than regulating a natural monopoly that
is run by a private firm, the government can run
the monopoly itself (e.g. in the United States,
the government runs the Postal Service).

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Doing Nothing
Government can do nothing at all if the market
failure is deemed small compared to the
imperfections of public policies.

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PRICE DISCRIMINATION

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PRICE DISCRIMINATION
Price discrimination refers to the charging of different
prices for different quantities of the product, at
different times to different costumer groups in
different markets.
The cost of production is same or differ little bit but
not as much as the differences in the charged prices.
The market divided into sub-markets with different
price elasticity.
The seller charges high price where the price elasticity
is inelastic and vice-versa.
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PRICE DISCRIMINATION
Price discrimination is not possible when a
good is sold in a competitive market since there
are many firms all selling at the market price.
In order to price discriminate, the firm must
have some market power.
Perfect or Pure Price Discrimination
Pure price discrimination refers to the situation
when the monopolist charges each costumer the
maximum price that he/she is willing to pay.
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PRICE DISCRIMINATION
Examples of Price Discrimination

Movie tickets
Air travel industry
Premium pricing
International price discrimination (e.g. identical drugs)
Services of a doctor and lawyer
Electricity (companies charging lower prices to commercial
than to residential users)
Companies charging lower prices in abroad as compared to
domestic markets
Dual pricing: less for own citizen and more for non-citizen
IBM laser printer
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Conditions for practicing PD

1. The firm must have some control over the
price of the product (i.e. the firm must be an
imperfect competitor)
2. At least two groups of consumers with
different price elasticities
3. The quantities of the product and the consumer
groups or market for the products must be
separable.
4. Product demand curve must slope downward.
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Types of Price Discrimination

Three types of price discrimination (PD):
By applying any type of PD, the firms can increase total
revenue and profits by capturing all or part of consumer surplus.
First-degree of price discrimination: It involves selling each unit
of the product separately and charging the highest price that
every consumer willing to pay.
This practice is seldom encountered in real world. Example
markets where consumers bid for tenders, private university
adjust the amount of financial aid from students based on family
income
Second-degree of price discrimination: Charging of a uniform
price per unit for specific quantity sold to each customer, lower
price for additional batch or block of the product, and so on.
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Graph for 1st and 2nd Degree PD

This is more practical and common in real world

P
15
10

0 10 20

40

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Third Degree of PD
This refers to the charging of different prices for the
same product in different markets until the marginal
revenue of the last unit of the product sold in each
market equals the marginal cost of producing the
product.
MRA = MC
MRB = MC
MRA = MRB = MC

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PD Graph

P2

D
F

P1

e1

MC =MR

e2

MC

D=D1+D2

D2
0

X1

X2

MR X
MR1 2

D1

MR=MR1+MR2
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Explanation

It is assume that monopolist will sell his product in two segregated markets.
Each market having a demand curve with different elasticity
Total demand curve is found by horizontal summation of D1 and D2
Charges high price in the market where price elasticity is inelastic
MR differs in each market due to the differences in the elasticity of two
demand curve.
The profit of each market is maximized when:
MR1 = MC
MR2 = MC
Revenue under monopoly without Price Discrimination: R1= OPAX
Revenue with Price Discrimination: R2 = OP1FX + OX2EP2
But OP1FX = X2XBC (because of horizontal summation)
OX2EP2 = OX2DP + PDEP2
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Explanation.
Therefore,
Revenue under PD: R2 = OX2DP +X2XBC + PDEP2
Similarly R1 = OX2DP + X2XBC + ABCD
Subtracting R2 from R1, we obtain:
(OX2DP +X2XBC + PDEP2) (OX2DP + X2XBC + ABCD)
= PDEP2 ABCD
Which implies that, PDEP2 > ABCD and hence R2 > R1

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