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Monopoly and Dominant Firms
Chapter 8
"Monopoly" conjures images of huge profits,
great wealth, and indiscriminate power,
labeled robber barons.
• But some monopolies are not very profitable
• Others dominate their industry
• Still others are regulated by State Public Service or
Utility Commissions, and may have very low rates
of return on invested capital.
• Regulated monopolies are known as utilities.
2005 South-Western Publishing
Slide 1
Sources of Market Power for a Monopolist
• Legal restrictions -- copyrights & patents.
• Control of critical resources creates market
power.
• Government-authorized franchises, such as
provided to cable TV companies.
• Economies of size allow larger firms to produce at
lower cost than smaller firms.
• Brand loyalty and extensive advertising
makes entry highly expensive.
• Increasing returns in network-based
businesses - compatibilities increase market
penetration.
Slide 2
What Went Wrong
With Apple?
• Apple tried to pursue increasing returns by
trying to be the industry standard
• Tried to protect is graphical interface code
(GIC) from infringement
• Lead to Apple being less compatible with
software being developed
• Microsoft recognized and became the
industry standard
Slide 3
An Unregulated Monopoly
Monopoly is a single seller
P = 100 - Q
where entry is prohibited and
there are no close substitutes
1. FIRM = INDUSTRY
2. MR < P
TR1 = 60•40 = 2400
TR2 = 59•41 = 2419
19
60
59
D
40 41
Q
So. MR = 19
where MR <
Slide 4
3. At output where MR = MC,
profit is maximized
MC
Proof: Max  = TR – TC
Find where d/dQ = 0
PM
D
d/dQ = dTR/dQ - dTC/dQ = 0
MR – MC = 0
So: MR = MC
4.
QM
Charge highest price
that the market will bear, PM
MR
Slide 5
If we use a linear demand curve:
MARGINAL REVENUE is twice as steep
as a linear demand curve
If P = a - b•Q, then
TR = aQ - bQ2
so
MR = a - 2b•Q
This is twice as steep
Slide 6
A MONOPOLY PROBLEM
• Find the monopoly quantity if: P = 100 - Q,
and where MC = 20.
Answer this by starting where MR = MC
» TR = P•Q = 100•Q - Q2
» MR = 100 - 2•Q = 20
» 80 = 2•Q
» QM = 40
Find Monopoly Price:
» PM = 100 - 40 = 60
The highest price
that the market will
bear.
Slide 7
The Importance of Price Elasticity of
Demand for a Monopoly
MONOPOLY has MR = MC
TR = Q•P(Q)
dTR/dQ = MR = P + (dP/dQ)Q = P [ 1 + (dP/dQ)(Q/P) ]
= P[ 1 + 1/ EP ]
As EP goes to
negative infinity,
MR approaches P
P [ 1 + 1/ EP ] = MC
Marginal Revenue
Slide 8
Optimal Markups
• The optimal markup can be found using this same
formula. P = [ED /( ED+1)]•MC.
• The optimal markup m is: (1+m) = [ED /( ED+1)]
• For example, if ED = -3, the markup is 50%, since
= [-3/( -3 +1)] = 1.5.
• If ED = -4, the markup is 33.3%, since his is where
[-4/( -4 +1)] = 1.333.
• If the price elasticity is infinite, the markup is zero.
This occurs in competition.
Slide 9
Find the Monopoly Price in these
Problems
ANSWER
If EP = - 3
& MC = 100
What’s PM ?
• P[ 1 + 1/( - 3) ] = 100
• P[ 2/3 ] = 100
So, P = $150.
• If EP = -5, then optimal
monopoly price falls to
$125.
• The more elastic is the
demand, the closer is
price to MC.
Slide 10
A Monopoly Pricing Problem
• Regression results for Land’s End
Women’s light-weight coats:
• Log Q = - .4 -1.7 Log P + 1.2 Log Y
( 3 . 2)
( 4. 5)
• Let MC of imported women’s light-weight
coats be $19.50.
• Find the Monopoly Price for a Land’s End
light-weight coats.
• ANSWER: P( 1 + 1/EP ) = MC
» P ( 1 + 1/(-1.7) ) = 19.50
» P = $47.36
Slide 11
Limit Pricing
• An established firm considers the
possibility of new entrants with distaste.
• Suppose a new entrant would have a
U-shaped average cost curves.
• Suppose also that the established firm has
created some brand loyalty, such that
entrants must under-price them to take
away their customers.
AC
Slide 12
The potential competitor (PC) has no demand at
limit price PL as DPC is below ACPC
Profit Profile
PL
ACPC
D
ACestablished
DPC
Q
II
I
time
Which profit profile (I or II) represents monopoly pricing?
Would a stockholder prefer profile I or II?
Slide 13
Regulated Monopolies
•
•
•
•
Electric Power Companies
Natural Gas Companies
Communication Companies
Often, Water Companies
» All are examples of regulated companies
» They are all “naturally monopolistic” as they all
have significant declining cost curves.
» Suppose we examine railroads before regulation
as an example of a nature monopoly.
Slide 14
Natural Monopolies
• Declining Cost
Industries
» economies in
distribution
» economies of scale
• Without Regulation
they face Cyclical
Competition with
prices gyrating
between PM and PC.
» railroad history includes
periods of huge profits
then bankruptcies
DEMAND
PM
AC
MC
PR = AC
PC = MC
QM
QR QC
MR
Slide 15
Solutions to the
Problem of Natural Monopolies
• PREVENT ENTRY, set
P = MC and subsidize.
• REGULATE, prevent
entry, & set P = AC
» common in US for local
» subsidies require some form of
telephone, electricity,
taxation, which will tend to distort
water
work effort.
» subsidies to AMTRAK
• FRANCHISE through
• NATIONALIZE, prevent entry,
set price typically low
» governments find changing price a
highly political event
» once popular solution in Europe
a bidding war, likely
P = AC
» Cable T.V.
» concessions at various
stadiums
Slide 16
Peak Load Pricing
• Examples: Long Distance Calls,
Electrical Prices, Seasonally Pricing
at Amusement Parks
• Conditions
» Not Storable
» Same Facilities
» Demand Variation
Slide 17
Peak and Off-Peak Demand
What price
should we
charge for peak
and off-peak
users?
price
Pp
Po
Off Peak
Demand
Peak Load Demand
Q0 QP
Slide 18
General Solution
• P(peak) = variable costs + capital costs
• P(off-peak) = variable costs only
• Some argue that off-peak users benefit from
capacity
» Electrical Case: Less chance of a brown out
» Amusement Park: Off peak users enjoy more
space
» Then off-peak users should pay
for some part of the capacity
Slide 19