Download A Monopoly`s Profit

Monopoly
Introduction
You will now learn:

why some markets have only one seller.

how a monopoly determines the quantity to produce and the price to charge.

how the monopoly’s decisions affect economic well-being.

why monopolies try to charge different prices to different customers.

the various public policies aimed at solving the problem of monopoly.
A competitive firm is a price taker; a monopoly firm is a price maker.
Why Monopolies Arise

monopoly: a firm that is the sole seller of a product without close substitutes.

The fundamental cause of monopoly is barriers to entry.
o Monopoly Resources



A monopoly could have sole ownership or control of a key resource
that is used in the production of the good.

A key example is DeBeers which has at times controlled about 80%
of the diamonds in the world.
Government-Created Monopolies

Monopolies can arise because the government grants one person or one firm
the exclusive right to sell some good or service.

Patents are issued by the government to give firms the exclusive right to
produce a product for 20 years.

Patents involve trade-offs; they restrict competition but encourage research
and development.
Natural Monopolies

natural monopoly: a monopoly that arises because 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 occurs when there are economies of scale, implying that
average total cost falls as the firm's scale becomes larger.

Other examples of natural monopolies are club goods – goods that are
excludable but not rival in consumption.
How Monopolies Make Production and Pricing Decisions

Monopoly versus Competition
o The key difference between a competitive firm and a monopoly is the
monopoly's ability to influence the price of its output.
o The demand curves that each of these types of firms faces is different as
well.

A competitive firm faces a perfectly elastic demand at the market
price. The firm can sell all that it wants to at this price.

A monopoly faces the market demand curve because it is the only
seller in the market. If a monopoly wants to sell more output, it
must lower the price of its product.
A Monopoly's Revenue
o Example: sole producer of water in a town.
Quanti
ty
0
1
2
3
4
5
6
7
8

Price
$11
10
9
8
7
6
5
4
3
Total
Revenue
$0
10
18
24
28
30
30
28
24
Average
Revenue
---$10
9
8
7
6
5
4
3
Marginal
Revenue
---$10
8
6
4
2
0
-2
-4
A monopoly's marginal revenue will always be less than the price of the good
(other than at the first unit sold).
o If the monopolist sells one more unit, his total revenue (P × Q) will rise
because Q is getting larger. This is called the output effect.
o If the monopolist sells one more unit, he must lower price. This means
that his total revenue (P × Q) will fall because P is getting smaller. This is
called the price effect.
o Note that, for a competitive firm, there is no price effect.

When graphing the firm's demand and marginal revenue curve, they always start
at the same point (because P = MR for the first unit sold); for every other level of
output, marginal revenue lies below the demand curve (because MR < P).
Profit Maximization

The monopolist's profit-maximizing quantity of output occurs where marginal
revenue is equal to marginal cost.
o If marginal revenue is greater than marginal cost, profit can be increased
by raising the firm’s level of output.
o If marginal revenue is less than marginal cost, profit can be increased by
lowering the firm’s level of output.

Even though MR = MC is the profit-maximizing rule for both competitive firms
and monopolies, there is one important difference.
o In competitive firms, P = MR; at the profit-maximizing level of output, P =
MC.
o In a monopoly, P > MR; at the profit-maximizing level of output, P > MC.

The monopolist's price is determined by the demand curve (which shows us how
much buyers are willing to pay for the product).
FYI: Why a Monopoly Does Not Have a Supply Curve

A supply curve tells us the quantity that a firm chooses to supply at any given
price.

But a monopoly firm is a price maker; the firm sets the price at the same time it
chooses the quantity to supply.

It is the market demand curve that tells us how much the monopolist will supply
because the shape of the demand curve determines the shape of the marginal
revenue curve (which in turn determines the profit-maximizing level of output).
A Monopoly's Profit

We can find profit using the following equation:
Profit = TR – TC.

Because TR = P × Q and TC = ATC × Q, we can rewrite this equation:
Profit = (P – ATC) × Q.
Case Study: Monopoly Drugs versus Generic Drugs

The market for pharmaceutical drugs takes on both monopoly characteristics and
competitive characteristics.

When a firm discovers a new drug, patent laws give the firm a monopoly on the
sale of that drug. However, the patent eventually expires and any firm can make
the drug, which causes the market to become competitive.

Analysis of the pharmaceutical industry has shown us that prices of drugs fall
after patents expire and new firms begin production of that drug.
The Welfare Cost of Monopolies

The Deadweight Loss
o The demand curve represents the value that buyers place on each
additional unit of a good or service. The marginal-cost curve represents
the additional cost of producing each unit of a good or service.
o The socially efficient quantity of output is found where the demand curve
and the marginal cost curve intersect. This is where total surplus is
maximized.

Because the monopolist sets marginal revenue equal to marginal cost to
determine its output level, it will produce less than the socially efficient quantity
of output.

The price that a monopolist charges is also above marginal cost. Although some
potential customers value the good at more than its marginal cost but less than
the monopolist’s price, they do not purchase the good even though that is
inefficient because total surplus is not maximized.


The deadweight loss can be seen on the graph as the area between the
demand and marginal cost curves for the units between the monopoly
quantity and the efficient quantity.
The Monopoly's Profit: A Social Cost?

Welfare in a market includes the welfare of both consumers and
producers.

The transfer of surplus from consumers to producers is therefore not a
social loss.

The deadweight loss from monopoly stems from the fact that monopolies
produce less than the socially efficient level of output.

If the monopoly incurs costs to maintain (or create) its monopoly power,
those costs would also be included in deadweight loss.
Price Discrimination

price discrimination: the business practice of selling the same good at
different prices to different customers.

A Parable about Pricing
o Example: Readalot Publishing Company
o The firm pays an author $2 million for the right to publish a book.
(Assume that the cost of printing the book is zero.)
o The firm knows that there are two types of readers.
o There are 100,000 die-hard fans (living in Australia) of the author
willing to pay up to $30 for the book.
o There are 400,000 other readers (living in the United States) who are
willing to pay up to $5 for the book.

How should the firm set its price?
o If the firm sets its price equal to $30, it will sell 100,000 copies of the
book, receive total revenue of $3 million, and earn $1 million in profit.
o If the firm sets its price equal to $5, it will sell 500,000 copies, receive
total revenue of $2.5 million, and earn only $500,000 in profit.
o It will choose to set its price at $30 and sell 100,000 books. Note that
there is a deadweight loss from this decision because there are
400,000 other customers willing to pay $5, which is more than the
marginal cost of producing the book ($0).

Since it would be difficult for Australian readers to buy a copy of the book in
the United States, the company could make even more profit by selling
100,000 copies to the die-hard fans at $30 each, and then selling 400,000
copies to the other readers for $5 each.
o The total revenue from selling 100,000 copies at $30 each is $3
million.
o The total revenue from selling 400,000 copies at $5 each is $2 million.
o Because the firm's costs are $2 million, profit will be $3 million.

The Moral of the Story
o By charging different prices to different customers, a monopoly firm can
increase its profit.
o To price discriminate, a firm must be able to separate customers by their
willingness to pay.
o Arbitrage (the process of buying a good in one market at a low price and
then selling it in another market at a higher price) will limit a monopolist's
ability to price discriminate.
o Price discrimination can increase economic welfare. Producer surplus rises
(because price exceeds marginal cost for all of the units sold) while
consumer surplus is unchanged (because price is equal to the consumers’
willingness to pay).

The Analytics of Price Discrimination
o Perfect price discrimination describes a situation where a monopolist
knows exactly the willingness to pay of each customer and can charge each
customer a different price.
o Without price discrimination, a firm produces an output level that is lower
than the socially efficient level.
o If a firm perfectly price discriminates, each customer who values the good
at more than its marginal cost will purchase the good and be charged his
or her willingness to pay.

There is no deadweight loss in this situation.

Because consumers pay a price exactly equal to their willingness to
pay, all surplus in this market will be producer surplus.

Examples of Price Discrimination
o Movie Tickets
o Airline Prices
o Discount Coupons
o Financial Aid
o Quantity Discounts
Public Policy toward Monopolies
Increasing Competition with Antitrust Laws
o Antitrust laws are a collection of statutes that give the government the
authority to control markets and promote competition.

The Sherman Antitrust Act was passed in 1890 to lower the market
power of the large and powerful "trusts” that were viewed as
dominating the economy at that time.

The Clayton Act was passed in 1914; it strengthened the
government's ability to curb monopoly power and authorized
private lawsuits.
o Antitrust laws allow the government to prevent mergers and break up
large, dominating companies.
o Antitrust laws also impose costs on society. Some mergers may provide
synergies, which occur when the costs of operations fall because of joint
operations.
Regulation
o Regulation is often used when the government is dealing with a natural
monopoly.
o Most often, regulation involves government limits on the price of the
product.
o While we might believe that the government can eliminate the deadweight
loss from monopoly by setting the monopolist's price equal to its marginal
cost, this is often difficult to do.

If the firm is a natural monopoly, its average total cost curve will be
declining because of its economies of scale.

When average total cost is falling, marginal cost must be lower than
average total cost.

Therefore, if the government sets price equal to marginal cost, the price
will be below average total cost and the firm will earn a loss, causing
the firm to eventually leave the market.

Therefore, governments may choose to set the price of the monopolist's
product equal to its average total cost. This gives the monopoly zero
profit, but assures that it will remain in the market.

There is still a deadweight loss in this situation because the level of
output will be lower than the socially efficient level of output.

Average-cost pricing also provides no incentive for the monopolist
to reduce costs.
Public Ownership

Rather than regulating a monopoly run by a private firm, the government can run
the monopoly itself.

However, economists generally prefer private ownership of natural monopolies.
o Private owners have an incentive to keep costs down to earn higher profits.
o If government bureaucrats do a bad job running a monopoly, the political
system is the taxpayers’ only recourse.

Doing Nothing
o Sometimes the costs of government regulation outweigh the benefits.
o Therefore, some economists believe that it is best for the government to
leave monopolies alone.