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Chapter 7:
Monopoly
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Monopoly Structure: Monopoly =
Industry
o The essence of market power is the
ability to alter the price of a good or
service.
o A monopoly is one firm that produces the
entire market supply of a particular good
or service.
o Since there is only one firm in a monopoly
industry, the firm is the industry.
7-2
LO-1
Monopoly = Industry
o The firm’s demand curve is identical to the
market demand curve for the product.
o Market demand is the total quantities of a
good or service people are willing and able to
buy at alternative prices in a given time
period.
7-3
LO-1
Price versus Marginal Revenue
o Marginal revenue (MR) is the change in
total revenue that results from a one-unit
increase in quantity sold.
o Price equals marginal revenue only for
perfectly competitive firms.
o Marginal revenue is always less than price
for a monopolist.
7-4
LO-1
Price versus Marginal Revenue
o A monopolist can sell additional output
only if it reduces prices.
o The MR curve lies below the demand
(price) curve at every point but the first.
7-5
LO-2
Price versus Marginal Revenue
o Total revenue before price reduction
= 1 ton x $6,000/ton = $6,000
• Total revenue after price reduction
= 2 tons x $5,000/ton = $10,000
• Marginal revenue
= $10,000 – $6,000 = $4,000
7-6
LO-2
Where Price Exceeds Marginal Revenue
7-7
LO-2
Where Price Exceeds Marginal Revenue
7-8
LO-2
Monopoly Behavior
o A monopolist must make a pricing
decision that perfectly competitive firms
never make.
7-9
LO-3
Profit Maximization
o The monopolist uses the profitmaximization rule to determine its rate of
output.
o According to the rule, a monopolist
maximizes profit at the rate of output
where MR = MC.
7-10
LO-3
Profit Maximization
o The profit maximization rule applies to all
firms:
– A perfectly competitive firm produces the
quantity where MC = MR (= p).
– A monopolist produces the quantity where
MC = MR (<P).
7-11
LO-3
The Production Decision
o Choosing a rate of output is a firm’s
production decision.
o It is the selection of the short-term rate of
output (with existing plant and equipment).
o A monopolist finds the rate of output
where the marginal revenue and marginal
cost curves intersect.
7-12
LO-3
The Monopoly Price
o The intersection of the marginal revenue
and marginal cost curves establishes the
profit-maximizing rate of output.
o The demand curve tells us the highest
price consumers are willing to pay for that
specific quantity of output.
o Only one price is compatible with the
profit-maximizing rate of output.
7-13
LO-3
The Monopoly Price and Profit
Maximization
7-14
LO-3
Monopoly Profits
o Total profit equals profit per unit times the
number of units produced.
o Profit per unit = price minus average total
cost
Profit per unit = p – ATC
•Total profit = profit per unit times quantity
Total profit = (p – ATC) x q
7-15
LO-3
Monopoly Profits
o Profit can also be calculated by
subtracting total cost from total revenue:
Total profit = TR - TC
7-16
LO-3
Monopoly versus Competitive Outcomes
o A monopolist
produces
less and
charges a
higher price
than a
competitive
industry.
7-17
LO-4
Barriers to Entry
o Barriers to entry are obstacles that make
it difficult or impossible for would-be
producers to enter a particular market,
e.g., patents.
7-18
LO-4
Threat of Entry
o A monopoly attains higher prices and
profits by restricting output.
o The threat of entry does not affect a
monopolist due to high barriers to entry.
7-19
LO-4
Barriers to Entry
o Patent Protection
o Legal Harassment
o Exclusive Licensing
o Bundled Products
o Government Franchises
7-20
LO-4
Patent Protection
o A patent is a government grant of
exclusive ownership of an innovation.
o A patent is a source of monopoly power.
o Polaroid’s patents forced Kodak out of the
instant-photography business.
7-21
LO-4
Legal Harassment
o Suing potential new entrants can deter
entry into an industry.
o Lengthy legal battles are so expensive
that the threat of legal action may deter
entry into a monopolized market.
7-22
LO-4
Exclusive Licensing
o Lack of a license makes it difficult for
potential competitors to acquire the
factors of production they need.
7-23
LO-4
Bundled Products
o Forcing consumers to purchase
complementary products thwarts
competition.
o Bundling products makes it difficult for
competitors to sell their products
profitably:
o Microsoft bundles software applications with
its Windows operating systems.
7-24
LO-4
Government Franchises
o A monopoly granted by a government
license:
o These include local power, telephone, and
cable TV companies.
o Another example is the U.S. Postal Service in
providing first-class mail.
7-25
LO-4
Comparative Outcomes
o A monopoly’s market power allows it to
change the way the market responds to
consumer demands.
7-26
LO-4
Competition versus Monopoly
o In competition, as well as monopoly, high
prices and profits signal consumers’
demand for more output.
o In competition, the high profits attract new
suppliers.
o In monopoly, barriers to entry are erected
to exclude potential competition.
7-27
LO-4
Competition versus Monopoly
o In competition, production and supplies
expand and prices slide down the market
demand curve.
o In monopoly, production and supplies are
constrained and prices don’t move down
the market demand curve.
7-28
LO-4
Competition versus Monopoly
o In competition, a new equilibrium is
established and average costs of
production approach their minimum.
o In monopoly, no new equilibrium is
established and average costs are not
necessarily at or near a minimum.
7-29
LO-4
Competition versus Monopoly
o In competition, economic profits approach
zero and price equals marginal cost
throughout the process.
o In monopoly, economic profits are at a
maximum and price exceeds marginal
cost at all times.
7-30
LO-4
Competition versus Monopoly
o In competition, the profit squeeze
pressures firms to reduce costs or
improve product quality.
o In monopoly, there is no profit squeeze to
pressure the firm to reduce costs or
improve product quality.
7-31
LO-4
Near Monopolies
o Two or more firms may rig the market to
replicate monopoly outcomes and profits.
7-32
LO-4
Near Monopolies
o In duopoly two firms together produce the
industry output.
• In oligopoly several firms dominate the
market.
• In monopolistic competition many firms
each have a monopoly on its own brand
image but still must contend with
competing brands.
7-33
LO-4
WHAT Gets Produced
o There is a basic tendency for monopolies
to inhibit economic growth.
o There is no pressure to produce at
minimum average cost.
7-34
LO-5
WHAT Gets Produced
o Monopolies do not engage in marginal
cost pricing:
– Marginal cost pricing means firms offer
(supply) goods at prices equal to their
marginal cost.
Monopolies do not deliver the most utility
with the available resources.
7-35
LO-5
FOR WHOM
o Higher prices charged by monopolists
favor purchases by higher-income
consumers.
o Monopolists get fat profits and thus
access to more goods and services.
7-36
LO-5
HOW
o Monopolists have less of an incentive to
innovate.
o They can continue to make profits with
existing equipment and technology.
o There is a tendency to inhibit technological
improvement by keeping competition out of
the market.
7-37
LO-5
Any Redeeming Qualities?
o Despite the strong and general case to be
made against monopoly, monopolies
could also benefit society.
7-38
LO-5
Research and Development
o In principle, monopolies have a greater
ability to pursue research and
development.
o They have the resources available to invest
in expensive R&D functions.
o They have no clear incentive for invention
and innovation and can continue to make
profits by maintaining market power.
7-39
LO-5
Entrepreneurial Incentives
o The promise of even greater profits is a
strong incentive for monopolies to
innovate.
o Innovators in perfect competition also
have the ability to earn large profits.
7-40
LO-5
Economies of Scale
o Economies of scale are present if
average costs fall as the size (scale) of
plant and equipment increases.
7-41
LO-5
Economies of Scale
o A large firm can produce goods at a lower
unit cost than a small firm because of
economies of scale.
o Consumers may not benefit from the
lower costs if the monopolist doesn’t lower
its prices.
7-42
LO-5
Diseconomies of Scale
o Even though large size may result in
greater efficiencies, there is no assurance
that it actually will.
o Monopolies may generate diseconomies
of scale, producing at higher cost than a
competitive industry.
7-43
LO-5
Natural Monopoly
o A natural monopoly is an industry in
which one firm can achieve economies of
scale over the entire range of market
supply.
o Examples include local telephone, cable, and
utility services.
7-44
LO-1
Natural Monopoly
o Economies of scale are a natural barrier
to entry.
o There exists a potential for abuse in a
natural monopoly.
o Government regulation may be necessary to
ensure that the benefits of increased
efficiency are shared with consumers.
7-45
LO-1
Contestable Markets
o Potential competition is a threat even to
monopolies.
o This may cause them to behave more
competitively.
7-46
LO-5
Contestable Markets
o A contestable market is an imperfectly
competitive industry subject to potential
entry if prices or profits increase.
o How contestable a market is depends not
so much on its structure as on entry
barriers.
7-47
LO-5
Structure versus Behavior
o If potential rivals force a monopolist to
behave like a competitive firm, then
monopoly imposes no cost on consumers
or on society at large.
o The experience with the Model T suggests
that potential competition can force a
monopoly to change its ways.
7-48
LO-5
Structure versus Behavior
o Critics argue that even if markets are
contestable, there will always exist a gap
between a monopoly and a competitive
outcome.
o This gap can be very costly to consumers.
7-49
LO-5
Flying Monopoly Air
o Market structure explains why it is cheap
to fly to one place and expensive to fly
somewhere else of equal distance.
7-50
LO-5
Industry Structure
o From a national perspective, the airline
industry looks pretty competitive.
o However, all of these companies do not fly
to the same place.
7-51
LO-5
Industry Structure
o When assessing market structure, it is
essential to specify the relevant market.
o In many markets, there is only one or two
air carriers, thus the firms in this market
act like duopolies or monopolies.
7-52
LO-5
Industry Behavior
o Air fares from airports dominated by one
or two carriers are 45-85 percent higher
than at more competitive airports.
7-53
LO-5
Entry Effects
o How fares change when airlines enter or
exit a specific market can be used to
assess the impact of market structure on
prices.
o American Airlines cut its fares when lowcost carriers entered a market it
dominated – then raised them when they
left.
7-54
LO-5
Entry Effects
o Predatory pricing – temporary price
reductions designed to drive out
competition.
7-55
LO-5
Barriers to Entry
o One of the most formidable entry barriers
to the airline industry is the ownership of
landing rights and gates.
o At Washington, D.C.’s National Airport, the
six largest carriers owned 97 percent of
available takeoff/landing slots in 2000.
7-56
LO-5
Barriers to Entry
o To offer service from that airport, a new
entrant would have to buy or lease a slot
from one of these firms.
o If existing firms are unwilling to sell or
lease their slots, then competition is
thwarted.
7-57
LO-5
Monopoly
End of Chapter 7
7-58