Download Market Structure: Monopoly

AP Economics
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Monopoly. Industry controlled by one
person, the monopolist.
Monopolist. Only producer of a good with
no close substitutes.
Barrier to entry. An obstacle that prevents
other firms from entering the industry. To
earn economic profits, a monopolist has to be
protected by barriers to entry.
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Why do monopolies exist?
 Control of a scarce resource or input
 Economies of scale
▪ large fixed costs combined with a falling ATC in a large
industry; larger firms drive out the smaller ones
▪ Natural monopoly. Monopoly created and sustained by
economies of scale. They possess economies of scale
over the entire range of output. When large fixed costs
are required to operate a given quantity of output is
produced at lower ATC by one large firm rather than a
bunch of small ones.
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Why do monopolies exist?
 Technological advantages
 Government barriers
▪ patents and copyrights
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Monopolies are rare in the United States
because they are illegal for the most part,
with the exception of natural and
government-granted monopolies.
Monopolist’s Demand
Curve and
Marginal Revenue
Optimal output rule: MR = MC
In perfect competition, the
demand curve is perfectly
elastic. In that market
structure, there are lots of
competitors selling identical
products. No one competitor
can affect the price.
Competitors can sell as much
as they like at that price. MR in
this case is P, which is also D.
MR = P = D.
Monopolies are the sole
producer. They are the
industry. The demand curve for
monopolies is simply the
market demand curve. In
short, because they are the sole
producer, they control the
price. To sell more output, it
must lower the price. When it
produces less output, the
monopolist raises the price.
Monopolist’s Demand
Curve and
Marginal Revenue
Optimal output rule: MR = MC
It should be noted that the
monopoly demand curve
creates a different MR curve,
and it lies below the demand
curve. This creates a gap
between P and MR.
Monopolist’s Demand
Curve and
Marginal Revenue
Taking a look at this demand and
revenue schedule, what do you
notice about TR and MR and the
quantity of diamonds increases?
Monopolist’s Demand
Curve and
Marginal Revenue
After the 1st diamond is sold, MR
that monopolist receives from
selling one more unit is less than
the price at which that unit is sold.
1st diamond: P = $950, MR = $950
2nd diamond: P = $900, MR = $850
3rd diamond: P = $850, MR = $750
…
10th diamond: P = $500, MR = $50
MR is decreasing with each
diamond sold. Eventually MR
becomes negative because TR
begins declining after 10 diamonds
are sold.
Monopolist’s Demand
Curve and
Marginal Revenue
Key point: After the first diamond,
the MR of the next diamond is
ALWAYS less than the price of
selling it.
In perfect competition, P = MR, but
with monopoly, P > MR. Why?
The answer has to deal with price
and quantity.
Monopolist’s Demand
Curve and
Marginal Revenue
Quantity effect. First off, with the
extra diamond being sold, TR
increases by the price the diamond
is sold at, $500.
Price effect. However, in order to
sell that last diamond, monopolist
must cut the market price on all of
the diamonds. This decreases total
revenue. Remember, the
monopolist still has to deal with
consumer demand.
$500 - $550 = -$50(9) = -$450.
Let’s look at a graph! Graphs are
cool.
Monopolist’s Demand
Curve and
Marginal Revenue
If the monopolist increases
diamond sales from 9
diamonds to 10, this is
represented on the market
demand curve on points A to B.
To meet market demand, the
monopolist has to drop the
price from $550 to $500.
By increasing the quantity, the
monopolist gets an increase in
TR of $500. If you calculate the
green area for TR, it would
equal the $500 increase.
But this occurs with the
lowering of the price from $550
to $500. Losing that extra $50
on 9 diamonds is a loss of $450. If you calculate the
yellow area for TR, it would
equal the -$450 loss.
The MR = $50, found at point C
on the graph.
Monopolist’s Demand
Curve and
Marginal Revenue
Key point: In monopoly, the
MR curve is ALWAYS below D.
The price effect causes this.
The monopoly’s MR from
selling an additional unit is
ALWAYS less than P monopoly
gets for the unit. The price
effect creates a wedge
between MR and D. In order to
sell the additional unit, the
monopoly MUST lower the
market price on all units sold.
Monopolist’s Demand
Curve and
Marginal Revenue
Perfect competition: No
market power, no ability to
control price. QED, no price
effect when a perfectly
competitive firm increases
quantity. MR = D = P. P and MR
are ALWAYS equal.
Monopoly: Market power,
complete control over price. At
low levels of production,
quantity effect > price effect.
As production increases,
monopolies only have to lower
the price on a few units, so
price effect (loss) is limited by
the monopolist. At high levels
of production,
price effect > quantity effect.
Monopolists have to lower the
price on more units, making the
price effect (loss) large.
Monopolist’s Demand
Curve and
Marginal Revenue
Compare. Putting the graphs side by side, and using
data from the TR column of the previous table, we see
that these graphs line up where MR declines into the
negative.
At lower levels of production, the quantity effect
dominates (is larger) up to the peak of TR. At 10
diamonds, the TR gained is $500 when the monopolist
drops the price from $550 to $500. That gain is offset by
the price effect, which lowers the TR on the 9 diamonds
by -$450. This provides our MR at $50. Comparing this
to the TR graph, we see TR increase up to 10 as quantity
dominates price.
But what about when price dominates quantity? At that
point, we would see TR fall.
Monopolist’s Demand
Curve and
Marginal Revenue
Using the data from the table above, once we move past the
10th diamond, say to 11, the monopolist has to lower the
price on all diamonds even further to $450. TR would fall to
$4,950 = 11($450).
At higher levels of production, the price effect dominates (is
larger) past the peak of TR. At 11 diamonds, the TR falls to
$450 (1 diamond at a price of $450). That loss is
compounded by the quantity effect, which lowers the TR on
the 10 diamonds by -$500. 10($50) = $500.
MR = $450 - $500 = - $50. TR decreases after 10 diamonds.
Here, the price effect is dominating.
Taking it one more step from 11 to 12 diamonds. Here, the
monopoly has to lower the price to $400, which again
reduces TR. At $12 diamonds, TR falls to $400 (1 diamond at
$400). That loss is compounded by the quantity effect,
which lowers the TR on the other 11 diamonds by $550.
11($50) = $550.
MR = $400 - $550 = -$150. TR continues to decrease because
of the dominant price effect.
Monopolist’s Demand
Curve and
Marginal Revenue
What we’re seeing is that the price effect is
a “loss” and that the quantity effect is a
“gain.”
The game the monopoly has to play is to
make sure that whatever losses that
occur with each quantity produced are
offset by the gains made in price.
Monopolist’s ProfitMaximizing Output
and Price
Up to this point, we’ve ignored
MC because we need to see the
motivation behind a
monopolist’s actions.
Remember, monopolies are not
your friend. They are out for
themselves out of self-interest,
and because they control price
and production, they use that
control to manipulate the
market, and thus their own
profit. This is the very reason
why they are outlawed in
modern economies.
In any case, now we’re going to
add MC. In this particular
example, we assume no FC and
that MC is constant at $200, no
matter how many diamonds
are produced, which in turn
means that MC = ATC. This
gives us a perfectly elastic
curve on this graph.
Monopolist’s ProfitMaximizing Output
and Price
So, you’re an evil monopolist
out to manipulate the market
of the product you control.
What do you do to maximize
profit?
HINT: Remember the optimal
output rule for profit!
Monopolist’s ProfitMaximizing Output
and Price
MR = MC for maximum profit.
No matter what.
So, you’re looking to see where
MR and MC meet.
If MR > MC, produce more.
If MR < MC, produce less.
Combine this with the market
demand curve, and we get to
game the system.
Assuming you, the monopolist,
were behaving yourself and
acting like a good perfect
competitor (even though you
have none), you would find
yourself at point C on the
graph, where D and MC
intersect. Why?
Monopolist’s ProfitMaximizing Output
and Price
Because ATC and MC are the
same in this example.
Remember, in perfect
competition, firms earn normal
profit as ATC, MR and MC are
equal in the long run. In that
market, as a good little
monopolist, you would produce
16 diamonds and earn a normal
profit, because you’re a special
little obedient snowflake.
Or are you?
Gooby pls, you’re better than
those little people. Little
swarthy people. Because you
control price and production.
So even though the market
price that would be paid in a
perfectly competitive market,
you’re all like “lol.” So what do
you do?
Monopolist’s ProfitMaximizing Output
and Price
Well, you could do something
amazingly stupid and say, “Hey,
I’m going to charge $400 more
than what the market price
actually is since I control the
production. YOLO.”
At that point, you’d get a nice
little visit from the Department
of Justice and they will break up
your beautiful monopoly with
the hammers and anvils of
antitrust law. *tear* *forever
alone*
In practice, however,
monopolists in the past did
exactly this, and got away with
it before the U.S. government
began its anti-monopoly
movement in the late 1800s.
Monopolist’s ProfitMaximizing Output
and Price
Or you could do the clever
thing. Remember, you control
production. If you shorten up
your production, you can
manipulate price without
having to do anything.
So produce half as many
diamonds up to where
MR = MC, some 8 diamonds.
This would fall in line with the
optimal output rule.
But wait, if you only produce 8
diamonds, people would be
willing to buy those 8 diamonds
at $600 instead of $200.
Exactly. You’re manipulating
the market by creating a
shortage.
Monopolist’s ProfitMaximizing Output
and Price
What’s happening here? Well,
compare monopoly with
perfect competition.
In perfect competition, MR = P
because of the number of
competitors in the market. By
extension, P = MC at optimal
output for profit.
That’s point C on the graph.
PC = $200 = MC. Profit output
should be 16 under perfect
competition.
Remember though, no
economic profit is being earned
here because ATC = MC = MR.
$200 = ATC.
Monopolist’s ProfitMaximizing Output
and Price
In a monopoly, however, MR is
influenced by the price effect
so that MR is less than price.
P > MR = MC at optimal profit
output.
As you produce less diamonds,
you can push up the price
artificially corresponding to the
demand curve. At 8 diamonds,
the demand price is $600. And
that’s what the monopolist is
going to charge, PM.
Monopolists do the following
to manipulate the market:
1.
Produce less: QM < QC
2.
Charge more: PM > PC
3.
Profit.
Monopolist’s ProfitMaximizing Output
and Price
To calculate the profit, just
simply find the area of the
rectangle:
($400)(8) = $3,200.
In short, the monopolist gets to
make a profit by producing less
(not working as hard), and does
so at the expense of the market
as a whole.
What a real monopoly
curve looks like
Be familiar with both the
abstract and realistic forms on
the AP exam, and mine.
The same rules apply here.
Optimal output is still MR = MC
(point A). But ATC is lower than
this point, so the monopolist
earns a profit.
But remember, the monopolist
does so by not actually meeting
market demand at ATC.
Instead, his lower production
puts him at a higher point along
the curve, point B.
Π = TR – TC
Π = (PM – ATCM) x QM
Long Run vs.
Short Run
In perfect competition,
firms can’t earn a
positive economic profit
in the long run, as new
firms enter the market
and push any profitable
market price down to
long run equilibrium at
normal profit.
In monopoly, the
monopolist can earn
positive profits in the
long run, because the
barriers to entry into the
market are so high that
it prevents others from
entering the market.
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Monopolists benefit at the expense of
consumers and, by extension, society at
large.
They do so by reducing what could actually
be produced, if they were producing at a level
of perfect competition, and, as we have seen,
this raises prices.
But so what?
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Inefficiency!
Monopolies hold output below where MC = P.
Monopolists increase profits at the expense of
consumers.
Consumers lose out in a monopoly because the gains
monopolists get are larger than the losses to
consumers.
This leads to net losses to the overall economy and
society.
And governments don’t like that. They will intervene.
Let’s look at it in terms of our friend, consumer
surplus.
Welfare Effects
of Monopoly
If you remember, CS is that
level of satisfaction we get that
can be measured between the
demand curve (D) and the price
(P).
Looking CS in a perfectly
competitive market, we see
that CS is maximized between
P and D. We should expect this
because in perfect competition,
in the long run, firms in this
market make a normal profit.
This leaves our CS intact. Note
that CS and producer surplus
are the same here. CS is the
total surplus (TS).
Now, let’s look at it when our
dirty evil little monopolist
decides to manipulate the
market.
Welfare Effects
of Monopoly
Remember, the
monopolist reduces
production so that he
can raise price. And let’s
face it. The monopolist
has to be a man. Only a
man would do
something so
manipulative.
Anyway, he does this so
he can make a profit. PM
is higher than his
ATC…much higher.
Welfare Effects
of Monopoly
Looking at the result,
we see the following:
1. Because the monopolist
is charging PM the D is
lower for the product. This
creates a DWL because
now we have consumers
who want the product but
are not willing to pay the
price.
2. The monopolist makes a
nice hefty profit.
3. CS has shrunk
significantly. Which in turn
means PS (profit) has to
have increased by
extension.
Welfare Effects
of Monopoly
Putting them side by side, the decrease in CS is dramatic, while PS increases, and now
some mutually beneficial transactions do not occur. PS used to be part of the CS. What’s
more, TS has also decreased because of the DWL.
In other words, the monopoly acts exactly like a tax on consumers, producing the same
kind of DWL.
This represents the monopolist benefitting at the expense of the consumer.
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Antitrust policy. Governments intervene in
the monopoly market structure by law, and
act to break it up.
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Natural monopoly. Occurs when economies
of scale provide a large cost advantage to a
single firm that produces all of an industry’s
output.
Here, large firms have lower ATCs than
smaller ones. The problem is that if you
break up natural monopolies, this would raise
ATC.
So what do we do?
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The first option is public ownership of the
monopoly. G/S supplied by government or by
a firm owned by government.
Good news: Publicly owned natural
monopolies can set prices based on efficiency
rather than profit. In other words, perfect
competition.
 In perfect competition, profit is efficient because
producers set P = MC.
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Bad news: No incentives to keep costs down
or high quality products.
More bad news: Tend towards political
corruption and cronyism.
Not to mention you get to add a layer of
bureaucracy to local government.
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Second, and preferred option, is regulation.
Think for a second. What are the two
elements that governments would want to
regulate?
Quantity
Price
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Price regulation. Limits the price that a
monopolist is allowed to charge. This should
sound familiar, because this is a price ceiling.
Because price is limited, there’s now no
incentive for monopolists to produce less.
Awesome. Where should we put price then?
Natural Monopoly
Regulation
First, let’s take a look at what
happens when you have a natural
monopoly that’s not regulated.
For MC, we assume that FC and
VC for each unit is the same,
making MC constant and
horizontal.
ATC slopes downward because of
the lower AFC. Because ATC
slopes downward over the entire
range of output for market
demand, this is a natural
monopoly.
AP Note: Recognize this
particular graph as a natural
monopoly. The key is that ATC
slopes downward the entire
range of output for market
demand.
Natural Monopoly
Regulation
In the case of an unregulated
natural monopoly, the
monopolist will produce at QM
so as to increase/create profit
(P > ATC). Again, notice CS
shrinks, and some DWL occurs.
Again, we’re looking at a
monopolist who is profiting at
the expense of the consumer
and society.
A government would frankly
be stupid to allow this to occur.
Again, its actions act like a tax.
Natural Monopoly
Regulation
Now, let’s look at it when
government does something smart,
and regulates it.
In this case, the government puts a
price limitation at PR, which also
happens to be where ATC = D.
That’s not a coincidence. What is
the government trying to force
here?
Natural Monopoly
Regulation
Now, let’s look at it when
government does something smart,
and regulates it.
In this case, the government puts a
price limitation at PR, which also
happens to be where ATC = D.
That’s not a coincidence. The
government is creating a perfectly
competitive market, where
ATC = D = P (PR).
But where’s the incentive to
produce?
Natural Monopoly
Regulation
Now, let’s look at it when
government does something smart,
and regulates it.
In this case, the government puts a
price limitation at PR, which also
happens to be where ATC = D.
That’s not a coincidence. The
government is creating a perfectly
competitive market, where
ATC = D = P (PR).
Natural Monopoly
Regulation
If P is fixed at PR, the natural
monopoly can sell any quantity
between zero and QR for the same
price, PR. The monopolist no longer
has to lower P to sell more. No
price effect to make MR < P.
PR = MR for the monopoly, just like
in perfect competition.
Since MR > MC and P > ATC, the
monopoly is now willing to expand
output to QR. At PR, the monopolist
produces more at the lower price.
But what if the local government
does something stupid and sets
price at PR?
Natural Monopoly
Regulation
If P is fixed at PR, the natural
monopoly can sell any quantity
between zero and QR for the same
price, PR. The monopolist no longer
has to lower P to sell more. No
price effect to make MR < P.
PR = MR for the monopoly, just like
in perfect competition.
Since MR > MC and P > ATC, the
monopoly is now willing to expand
output to QR. At PR, the monopolist
produces more at the lower price.
If the local government does set
price at PR, then the monopolist
would produce at a loss. The price
ceiling has to be set high enough to
meet ATC.
Natural Monopoly
Regulation
In any case, the best result for
regulation is setting PR at ATC
= D. The monopoly is willing to
operate and produce at QR,
and consumers and society
both gain.
Can we set PR higher than ATC?
Of course, but what would this
mean?
It means that the natural
monopoly would make a profit.
Would the government do
this?
Probably not, it ultimately
depends on the situation, but
not likely.
Natural Monopoly
Regulation
Putting them side by side, what we’re ultimately doing with regulation is trying to maximize CS—
the highest benefit to society as a whole.
But why not do regulation at the perfectly competitive outcome, where MC = D?
Because the monopoly would suffer losses as P < ATC. Government does this, and they bankrupt
the natural monopoly. This is technically the most efficient outcome, but would ultimately be a
poor choice in reality.
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Price discrimination. Sellers charging
different prices to consumers for the same
good.
Single-price monopolist. Charges all
consumers the same price.
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Why charge different prices?
Because we can increase our profits by doing
so.
Price discrimination happens in monopoly,
oligopoly, and monopolistic competition, but
not perfect competition.
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Bob has routes between New York and
Orlando, with lots and lots of passengers in
between.
Assume no capacity problems with the
airplane.
Assume no fixed costs.
Assume two kinds of passengers: business
travelers and students, 2000 a piece.
Price Discrimination
Abato Airlines
Business travelers need
to fly, it’s urgent! They
will fly as long as P ≤
$550. Cutting the price
will make no difference.
Students are broke, and
will only fly if price is at
$150 or less. If P > $150,
students won’t fly.
This is represented by D.
Price Discrimination
Abato Airlines
MC = $125. Knowing the
MC, we can calculate profit.
Business:
TR = ($550)(2,000)
TR = $1,100,000
TC = ($125)(2,000)
TC = $250,000
Π = TR – TC
Π = $1,100,000 - $250,000
Π = $850,000
You can also find Π by area.
Π = ($425)(2,000)
Π = $850,000
Price Discrimination
Abato Airlines
But at $550, only 2,000
people would fly with Bob.
How can we capture the
students?
Well, we can charge $125 to
the students, MC. But let’s
face it. Bob wants to make
money. So Bob will charge P
> ATC to make the profit,
$150.
Students:
Π = ($25)($2,000)
Π = $50,000
Price Discrimination
Abato Airlines
Because Bob is using price
discrimination, instead of
making a profit of only
$850,000 from half the
market, he’s able to capture
another $50,000 from the
entire market, for a total of
$900,000.
That’ll do, Bob. That’ll do.
The key idea is elasticity.
With different elasticities
between consumer groups,
monopolists will price
discriminate to increase
profit. And in turn, this gives
more CS to the monopolist.
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Two options for monopolists
 Option 1. Monopolist charges higher prices for
those with inelastic demand, and a lower price for
those with elastic demand. (Reality).
 Option 2. Announce different prices for different
customers. This is illegal, and even if it weren’t, it
would be impossible to enforce. (What’s to stop
business travelers dressing like students?)
So we know that a monopolist will follow option 1, but
how do they do it?
 Look at airlines. Airlines set up several rules that provide
an effective filter.
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 Saturday Night Stays. How often does a business traveler stay
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over the weekend?
One-Way vs. Round Trip. Business people tend to make several
one-way trips, so the price is higher.
Standby vs. Guaranteed Seating. Cheaper to fly standby.
Business people want a guaranteed seat.
Booking in Advance. Business travelers need to travel on short
notice. Booking a few weeks in advance makes it cheaper.
No resale of tickets. That’s why airline require identification.
(And you thought it was about public safety, ha!).
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Look at restaurants.
 Senior discounts. Pretty easy to tell if someone is
old, but an ID will work.
 Early bird specials. It’s a good bet that retirees
will come before 5:00 to eat, and not people who
are working.
 Family specials. Kids eat free, but adults don’t 
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Perfect price discrimination. When a
monopolist charges each consumer his or her
willingness to pay (maximum).
Perfect Price
Discrimination
Perfect price discrimination.
When a monopolist charges each
consumer his or her willingness to
pay (maximum).
Still assuming that MC = ATC, if
everyone was willing to pay the
maximum amount, and
monopolists were able to charge
that amount, then there would be
no CS, only profit.
Going back to Bob Airlines, that
graph is an example of perfect price
discrimination. CS is completely
taken up by Bob’s profit.
But getting everybody to pay what
they’re willing to pay and the
monopolist charging that amount is
not realistic. However, the more
prices the monopolist is able to
charge, the closer he gets to
maximizing profits.
Perfect Price
Discrimination
Look at the market when there’s
price discrimination with two
different prices.
This graph is a more realistic graph
of Bob’s Airlines. Bob is able to
increase profit by charging two
different prices.
Notice that CS exists in two areas,
above Phigh and Plow. DWL also
occurs for those transactions that
don’t occur.
Perfect Price
Discrimination
Look at the market when there’s
price discrimination with three
different prices.
A monopolist who is able to charge
three different prices, for low,
medium and high willingness to pay
is able to capture even more profit
than before.
Notice that CS exists in three areas,
above Phigh, Pmedium and Plow. DWL
also occurs for those transactions
that don’t occur.
Greater number of prices the
monopolist charges, lower the
lowest price. Some consumers will
pay prices that approach MC.
Greater number of prices
monopolist charges, more profit he
gets from consumers (and CS
shrinks).
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Advance purchase restrictions. Prices are
lower for those that purchase in advance as
opposed to last minute.
Volume discounts. Lower prices for higher
volume. If you buy a lot of a good, the cost of
the last unit is less than the average price. In
other words, MC < P.
Two-part tariffs. Annual fee and items you
purchase. Sam’s Club!
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Governments focus on preventing DWL, not
price discrimination, unless there’s an equity
issue (race, gender, sexuality).
Unlike a single-price monopolist, one who
charges multiple prices can increase
efficiency.
 When a single price is replaced by a high and low
price system, consumers who were priced out can
now afford it.
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Price discrimination increases efficiency
because more of the units for which the
willingness to pay exceeds MC of production.