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Econ 2113: Principles of
Microeconomics
Spring 2009
ECU
Chapter 12
Monopoly
Market Power
  Market
power is the ability to influence the market, and in
particular the market price, by influencing the total quantity offered
for sale.
  A
monopoly is an industry that produces a good or service for
which no close substitute exists and in which there is one supplier
that is protected from competition by a barrier preventing the entry
of new firms.
Market Power
How Monopoly Arises:
  A
monopoly has two key features:
  No
close substitutes
  Barriers to entry
  Barriers
  Legal
to Entry
or natural constraints that protect a firm
from potential competitors are called barriers to
entry.
Market Power
Legal Barriers to Entry
  Legal barriers to entry create a legal
monopoly, a market in which competition and
entry are restricted by the granting of a
  Public
franchise (like the U.S. Postal Service, a
public franchise to deliver first-class mail)
  Government license (like a license to practice law
or medicine)
  Patent or copyright
Market Power
Natural Barriers to Entry
  Natural barriers to entry create
a natural monopoly, which is
an industry in which one firm
can supply the entire market at
a lower price than two or more
firms can.
Market Power
Natural Monopoly:
  One firm can produce 4 units
of output at 5 cents per unit.
  Two firms can produce 4 units
—2 units each—at 10 cents per
unit.
  Four firms can produce 4 units
—1 unit each—at 15 cents per
unit.
Market Power
  In
a natural monopoly,
economies of scale are so
powerful that they are still being
achieved even when the entire
market demand is met.
  The LRAC curve is still sloping
downward when it meets the
demand curve.
  Therefore, typically one firm
prevails in the market and gains
monopoly power.
Market Power
Monopoly Price-Setting Strategies
  There are two types of monopoly price-setting strategies:
  A
single-price monopoly is a firm that sells each unit of its output for the
same price to all its customers.
  Price discrimination is the practice of selling different units of a good or
service for different prices.
A Single-Price Monopoly’s Output and
Price Decision
Price and Marginal Revenue
  A monopoly is a price setter, not a price taker like a firm in
perfect competition.
  The reason is that the demand for the monopoly’s output is the
market demand.
  To sell a larger output, a monopoly must lower its price.
The demand curves facing a perfectly
competitive firm and a single price monopoly
D
Market
price
(equil.
price)
Monopolist
Price
$/unit of output
Perfectly competitive firm
D
Quantity
Quantity
Profit Maximization for
the Monopolist
 
In perfect competition: MR = P
 
 
 
The demand for the firm is horizontal, i.e. infinitely elastic
The firm can sell any quantity it wants at the equilibrium
price
How do we compute the Marginal Revenue curve for
the Monopolist?
 
 
 
The demand for the monopolist is the market demand (only
seller), so it is downward sloping
This means that if the monopolist wants to sell more, it has
to lower the price
Then an increase in production of one unit increases
revenues by less than the price
The Monopolist’s Change in Revenue
from Selling an Additional Unit (MR)
Loss from
lower price
Price ($/unit)
8
6
• If P = $6, then TR = $6 x 2 = $12
• If P = $5, then TR = $5 x 3 = $15
• The MR of selling the 3rd unit = $3
=$15-$12
• For the 3rd unit, MR = $3 < P = $5
Gain from
higher quantity
5
D
2
3
Quantity (units/week)
8
The Marginal Revenue Curve
Example: Demand curve
given by Q = 8 - P
P
Q
TR
6
2
12
5
3
15
4
4
16
3
5
15
MR
3
1
-1
 
Observations
MR < P because price must
be lowered to sell an
additional unit
  MR declines as quantity
increases
 
The Marginal Revenue Curve for a
Monopolist with a Straight-Line Demand Curve
Price
a
a/2
D
MR
Q0/2
Quantity
Observations
• The vertical intercept a, is the same for MR and D
• MR has twice the slope than D
• The horizontal intercept for MR, Q0/2 =a/2b, is one
half the demand intercept, Q0=a/b.
Q0
Total Revenue, Marginal Revenue and Elasticity
Demand: Q = 50 - P/2
Price
Quantity
Own Price Elasticity
Total Revenue
0
50
0.00
0
20
40
-0.25
800
40
30
-0.67
1200
50
25
-1.00
1250
60
20
-1.50
1200
80
10
-4.00
800
100
0
0
Total Revenue, Marginal Revenue and Elasticity
Demand: Q = 50 – (P/2)
P
100
TR
Elastic
80
Unit elastic
1200
60
Inelastic
40
800
20
0
10
20 25 30
40
MR
50
Q
0
10
20 25 30
40
50
Q
A Single-Price Monopoly’s
Output and Price Decision
  A
single-price monopoly never produces an
output at which demand is inelastic.
  If
it did produce such an output, the firm
could increase total revenue, decrease total
cost, and increase economic profit by
decreasing output.
A Single-Price Monopoly’s Output
and Price Decision
Price and Output Decision
  The monopoly selects the profit-maximizing quantity in the same
manner as a competitive firm, where MR = MC.
  But for the monopolist MR does not equal price.
  The monopoly sets its quantity according to MR = MC, and then
it sets its price at the highest level at which it can sell the profitmaximizing quantity.
A Single-Price Monopoly’s Output
and Price Decision
  The
firm produces the output at which MR = MC and sets the
price at the maximum 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.
Single-Price Monopoly and
Competition Compared
  Equilibrium
in perfect
competition occurs where
the quantity demanded
equals the quantity supplied
at quantity QC and price PC.
  Competitive
equilibrium is
efficient: MSB = MSC.
Single-Price Monopoly and
Competition Compared
  The
sum of the two surpluses
is maximized and the efficient
quantity is produced.
Single-Price Monopoly and
Competition Compared
  Equilibrium
output for a
monopoly, QM, occurs where
marginal revenue equals
marginal cost, MR = MC.
  Equilibrium
price for a
monopoly, PM, occurs on the
demand curve at the profitmaximizing quantity.
Single-Price Monopoly and
Competition Compared
  Compared
to perfect
competition, monopoly
produces a smaller
output and charges a
higher price.
Single-Price Monopoly and
Competition Compared
  In
monopolistic markets
price exceeds marginal
social cost, marginal social
benefit exceeds marginal
social cost, and a
deadweight loss arises.
Single-Price Monopoly and
Competition Compared
Redistribution of
Surpluses: Monopoly
redistributes a portion of
consumer surplus by
changing it to producer
surplus.
Price Discrimination
  Price
discrimination is the practice of selling different units of a
good or service for different prices.
  To
be able to price discriminate, a monopoly must:
1. Identify and separate different buyer types.
2. Sell a product that cannot be resold.
  Price
differences that arise from cost differences are not price
discrimination.
Price Discrimination
Price Discrimination and Consumer Surplus
  Price discrimination converts more consumer surplus
into economic profit than in the single price case
  A monopoly can discriminate:
  Among
units of a good. Quantity discounts are an example.
  Among groups of buyers. Advance purchase and other
restrictions on airline tickets are an example.
Price Discrimination
Profiting by Price Discriminating:
Airline example
  As a single-price monopoly, this
firm maximizes profit by producing
8000 trips a year and selling them
for $1,200 each.
Price Discrimination
Perfect Price Discrimination
  Perfect price
discrimination occurs if a
firm is able to sell each unit
of output for the highest
price anyone is willing to
pay.
  Marginal revenue now
equals price and the
demand curve is also the
marginal revenue curve.
Price Discrimination
With perfect price
discrimination:
  The
profit-maximizing output
increases to the quantity at
which price equals marginal
cost.
 Economic profit increases
above that made by a singleprice monopoly.
 Deadweight loss is eliminated
Price Discrimination
  The
more finely a monopoly can price discriminate, the closer its
output is to the competitive output (P = MC) and the more efficient
is the outcome.
 But
the monopoly captures the entire consumer surplus
Monopoly Policy Issues
  A
single-price monopoly creates inefficiency and a
price-discriminating monopoly captures consumer
surplus and converts it into producer surplus and
economic profit.
  But
monopoly could also bring benefits:
  Incentives
to innovation
  Economies of scale
Monopoly Policy Issues
  Incentives
to Innovation
  Patents and copyrights provide protection from competition and
let the monopoly enjoy the profits stemming from innovation for a
longer period of time.
  Economies
of Scale
  Where economies of scale exist, a monopoly can produce at a
lower average total cost than what a large number of competitive
firms could achieve.
Monopoly Policy Issues
  Regulating
  When
Natural Monopoly
demand and cost conditions create
natural monopoly, government agencies
typically regulate the monopoly.
Monopoly Policy Issues
Profit Maximization
  The natural monopoly
maximizes economic profit
by producing the quantity at
which marginal revenue
equals marginal cost and
charging the highest price at
which that quantity will be
bought.
Monopoly Policy Issues
The Efficient Regulation:
Marginal cost pricing
  Regulating a natural
monopoly in the social
interest sets the quantity
where MSB = MSC.
  The demand curve is the
MSB curve.
  The marginal cost curve is
the MSC curve.
  Efficient regulation sets the
price equal to marginal cost.
Monopoly Policy Issues
  Regulation
that sets the price
equal to marginal cost is called the
marginal cost pricing rule.
  The
marginal cost pricing rule is
efficient but with average cost
exceeding price, the firm incurs an
economic loss.
  Therefore
the monopolist must
be subsidized in this case
Monopoly Policy Issues
Average Cost Pricing
  Another alternative is to permit
the firm to produce the quantity
at which price equals average
cost and to set the price equal to
average cost—the average cost
pricing rule.
  The
quantity is still not efficient,
but it is closer to the efficient one
  The
monopoly does not need a
subsidy in this case, and
therefore no taxes have to be
collected to support the subsidy