Monopoly

Chapter 12
 Chapter outline
• Monopoly
• Monopoly Power
• Sources of Monopoly Power
• The Social Costs of Monopoly Power
• Monopsony
• Monopsony Power
• Limiting Market Power: The Antitrust
Laws
 The Theory of Monopoly
• A firm is a monopoly if . . .
• There is one seller
• The single seller sells a product for which there is
no close substitute
• There are extremely high barriers to entry

• ● Monopoly Market with only one seller

Monopsony Market with only one buyer.
Market power Ability of a seller or buyer to
affect the price of a good
 Monopoly

• For a monopoly firm, they need to reduce the

price to increase the sale and revenue.
• Monopoly firms can change the price because
the firm it self is the industry and is price maker.
 WHY MONOPOLIES ARISE……
Barriers To Entry
• Legal Barriers: a Public Franchise is a right granted to a firm by
government that permits the firm to provide a particular good
or service and excludes all others from doing the same. Public
franchise (like the Bangladesh Govt’s Postal Service, a public
franchise to deliver first-class mail)

• Economies of Scale: In some industries, low average total costs

are only obtained through large scale production. If only one
firm can survive in that industry, the firm is called a Natural
Monopoly.
• Exclusive Ownership of a Necessary Resource: Existing firms
may be protected from entry of new firms by the exclusive or
near-exclusive ownership of a resource needed to enter the
industry.
• Consumer lock-in
– Potential entrants can be deterred if they believe high
switching costs will keep them from inducing many
consumers to change brands

• Network externalities
– Occur when value of a product increases as more
consumers buy & use it
– Make it difficult for new firms to enter markets where
firms have established a large network of buyers

• Brand loyalties
– Strong customer allegiance to existing firms may keep
new firms from finding enough buyers to make entry
worthwhile
 Government Monopolies Vs. Market
Monopolies
Some economists use the term government monopoly to
refer to monopolies that are legally protected from
competition and the term market monopoly to refer to
monopolies that are not legally protected from
competition.

• 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.
 Monopoly and How It Arises

One firm can produce

4 millions units of output
at 5 cents per unit.

Two firms can produce

4 million units—2 units
each—at 10 cents per
unit.
Competition v. Monopoly

9
 Figure 2 Demand Curves for Competitive and Monopoly Firms

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

Price Price

Demand

Demand

0 Quantity of Output 0 Quantity of Output

11
 Competition Vs. Monopoly
• For the perfectly competitive firm, P=MR; for
the monopolist, P>MR. The perfectly
competitive firm’s demand curve is its
marginal revenue curve; the monopolist’s
demand curve lies above its marginal
revenue curve
• The perfectly competitive firm charges a
price equal to marginal cost; the monopolist
charges a price greater than marginal cost.
 MONOPOLY

• A Rule of Thumb for Pricing

(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand,
1/Ed, measured at the profit-maximizing output, and

Now, because the firm’s objective is to maximize profit, we

can set marginal revenue equal to marginal cost:

which can be rearranged to give us

Equivalently, we can rearrange this equation to express

price directly as a markup over marginal cost:
 MONOPOLY POWER

• Measuring Monopoly Power

Remember the important distinction between a perfectly competitive firm

and a firm with monopoly power: For the competitive firm, price equals
marginal cost; for the firm with monopoly power, price exceeds marginal
cost.

● Lerner Index of Monopoly Power Measure of monopoly power calculated as

excess of price over marginal cost as a fraction of price.

Mathematically:

This index of monopoly power can also be expressed in terms of the elasticity of
demand facing the firm.
Table 1 A Monopoly’s Total, Average,
and Marginal Revenue

Note that P = AR > MR.

Recall that, in perfect

competition, P = AR =
MR.

15
 Figure 3 Demand and Marginal-Revenue Curves for a Monopoly

Price
$11 Note that P = AR > MR
10 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
16
 Monopoly Pricing and Output
Decisions
• A monopolist is a price searcher; that is, it is a
seller that has the ability to control to some
degree the price of the product it sells.

• In the theory of monopoly, the monopoly firm

is the industry and the industry is the monopoly
firm. They are the same.
A Single-Price Monopoly’s Output
and Price Decision
 A Single-Price Monopoly’s Output
and Price Decision

The Figure illustrates the

profit-maximizing
choices of a single-price
monopoly.
The monopoly produces
the quantity that
maximizes total revenue
minus total cost.
 Monopolist output decision
• Profit is maximized
when MR = MC. In
this diagram, Q* is
the output level at
which MR = MC.
• But a note of
caution: price
should be
determined from
the AR or price
line.
 Mathematical examples
1. A firm faces the following average revenue (demand)
curve:
P = 120 – 0.02Q
where Q is weekly production and P is price, measured
in cents per unit. The firm’s cost function is given by
C = 60Q + 25,000. Assume that the firm maximizes
profits.
a. What is the level of production, price, and total
profit per week?
2. A monopolist firm faces a demand with constant
elasticity of –2.0. It has a constant marginal cost of
$20 per unit and sets a price to maximize profit. If
marginal cost should increase by 25 percent, would
the price charged also rise by 25 percent?
MATHEMATICAL EXAMPLE
A firm faces the following average revenue
(demand) curve:
P = 120 – 0.02Q
where Q is weekly production and P is price,
measured in cents per unit. The firm’s cost
function is given by C = 60Q + 25,000. Assume
that the firm maximizes profits.
a) What is the level of production, price, and total
profit per week?
b) If the government decides to levy a tax of 14
cents per unit on this product, what will be the
new level of production, price, and profit?
 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 . . .
price
3. Note that P > MR = MC in equilibrium.

Average total cost

MC A

Marginal Demand
cost

Marginal revenue

0 Q QMAX Q Quantity

4. Recall that in perfect competition P = MR = MC in equilibrium. Can you pinpoint the

perfect competition outcome in this diagram?23
 Figure 5 The Monopolist’s Profit

Costs and
Revenue

Marginal cost

Monopoly E B
price

Monopoly Average total cost

profit

Average
total D C
cost
Demand

Marginal revenue

0 QMAX Quantity
24
 A Single-Price Monopoly’s
Output and Price Decision
The firm produces the
output at which MR =
MC and sets the price
at which it can sell
that quantity.
The ATC curve tells us the
average total cost.
Economic profit is the
profit per unit multiplied by
the quantity produced—
the blue rectangle.
 For Monopolists:
• Note that the price of the good being sold is
greater than the marginal revenue. P>MR
• To sell an additional unit of a good (per time
period), the monopolist must lower price.
• The monopolist gains and loses by lowering
price.
• The gain equals the price of the product
times one.
• The loss equals the difference between the
new lower price and the old higher price
times the units of output sold before the
price was lowered.
The Dual Effects of a Price Reduction
on Total Revenue

To sell an additional unit of

the good, a monopolist
needs to lower price. This
price reduction both gains
revenue and loses revenue
for the monopolist. In the
exhibit, the revenue gained
and revenue lost are shaded
and labeled. Marginal
revenue is equal to the
larger shaded area minus
the smaller.
 The Case Against Monopoly
• The Deadweight Loss of Monopoly: Greater output is
produced under perfect competition than under
monopoly. The net value of the difference in these two
output levels is said to be the deadweight loss of
monopoly. This is the amount buyers value the
additional output over and above the opportunity
costs of producing the additional output.
• Rent Seeking: If firm A tries to get the government to
transfer “income” or consumers’ surplus from buyers
to itself it is undertaking a transfer seeking activity. In
economics, these activities are usually called Rent
Seeking.
 Social costs of monopoly
• The shaded rectangle
and triangles show
changes in consumer
and producer surplus
when moving from
competitive price and
quantity, Pc and Qc, to a
monopolist’s price and
quantity, Pm and Qm.
• Because of the higher
price, consumers lose A
+ B and producer gains
A − C. The deadweight
loss is B + C.
 X-Inefficiency
Refers to The increase in costs when monopolists
are operating at higher than lowest possible costs,
and to the organizational slack that is directly tied
to this.
 Price Discrimination
– Price discrimination occurs when the seller charges different
prices for the product it sells, and the price differences do not
reflect costs. Example: Movie tickets, Airline tickets ,Discount
coupons, Financial aid Quantity discounts

• Perfect Price Discrimination: sells each unit separately and charges

the highest price each consumer would be willing to pay for the
product.
• Second Degree Discrimination: it charges a uniform price per unit
for one specific quantity, a lower price for an additional quantity,
and so on.
• Third Degree Discrimination: it charges a different price in
different markets or charges a different price to different segments
of the buying population
 Why Price Discrimination?
• For the monopolist who practices perfect price
discrimination, price equals marginal revenue.
• Conditions of Price Discrimination:
– The seller must exercise some control over price; it
must be a price searcher.
– The seller must be able to distinguish among buyers
who would be willing to pay different prices.
– It must be impossible or too costly for one buyer to
resell the good at other buyers. The possibility of
arbitrage, or “buying low and selling high” must not
exist.
Profiting by Price
Discriminating

As a single-price
monopoly, this firm
maximizes profit by
producing 8 trips a
year and selling them
for $1,200 each.
THE MULTI-PLANT FIRM

 Step 1. Whatever the total output, it should

be divided between the two plants so that
marginal cost is the same in each plant.
Otherwise, the firm could reduce its costs and
increase its profit by reallocating production.
 ● Step 2. We know that total output must be
such that marginal revenue equals marginal
cost. Otherwise, the firm could increase its profit
by raising or lowering total output.
 The condition that should be satisfied is:

MR = MC1 = MC2
MATHEMATICAL EXAMPLE

 A firm has two factories for which costs are given

by: C1 = 10Q12 and C2 = 20Q22
The firm faces the following demand curve:
P = 700 – 5Q
where Q is total output – i.e., Q = Q1 + Q2.
a) Calculate the values of Q1, Q2, Q, and P that
maximize profit.
 Mathematical example
• The following table shows the demand
curve facing a monopolist who Price Quantity
produces at a constant marginal cost of 18 0
$10:
a) Calculate the firm’s marginal revenue 16 4
curve. 14 8
b) What are the firm’s profit-maximizing 12 12
output and price? What is its profit? 10 16
c) What would the equilibrium price and 8 20
quantity be in a competitive industry?
6 24
d) What would the social gain be if this
monopolist were forced to produce 4 28
and price at the competitive 2 32
equilibrium? Who would gain and 0 36
lose as a result?
MATHEMATICAL EXAMPLE
A firm faces the following average revenue
(demand) curve:
P = 120 – 0.02Q
where Q is weekly production and P is price,
measured in cents per unit. The firm’s cost
function is given by C = 60Q + 25,000. Assume
that the firm maximizes profits.
a) What is the level of production, price, and total
profit per week?
b) If the government decides to levy a tax of 14
cents per unit on this product, what will be the
new level of production, price, and profit?