Download Chapter 8: Pure Monopoly

Chapter 8: Pure Monopoly
What is a Pure Monopoly?
A pure monopoly exists when a single
firm is the sole producer of a product for
which there are no close substitutes.

Examples: local telephone company, local gas
and electric company, small town gas station
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Characteristics of
Pure Monopoly



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Single supplier – the firm and the industry
are synonymous.
No close substitutes – the product is
unique and unlike any others.
Price maker – the firm has considerable
control over price since it controls the total
quantity supplied.
Blocked entry – barriers to entry exist
because there is no immediate
competition.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Barriers to Entry
Barriers to entry are factors that prohibit
firms from entering an industry. They
include:

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
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Economies of scale
Legal barriers to entry
Ownership or control of essential
resources
Pricing and other strategic barriers to entry
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Economies of Scale



If as a firm expands average total cost
falls, then economies of scale exist.
Only a few large firms, or even a single
firm, can achieve low average total costs,
given market demand.
A natural monopoly exists because
economies of scale are large and the firm
can achieve minimum efficient scale.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Economies of Scale
If the market is controlled by a pure
monopolist, economies of scale serve as
an entry barrier.

New firms face very large start up costs which
result in high average total costs. This makes
it hard to compete with a monopolist that is
already well established.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Legal Barriers to Entry:
Patents and Licenses
Government-created barriers include
patents and licenses.


A patent is the exclusive right of an inventor
to use, or to allow another to use, her or his
invention.
Licensing also limits the production of a
product at the federal, state, or municipal
level.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Ownership or Control of
Essential Resources
A firm that owns or controls an essential
resource can prohibit the entry or rival
firms.
Private property serves as an obstacle to
potential rivals.
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Pricing and Other Strategic
Barriers to Entry

Monopolists can bar entry into a market in
other ways, including

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Price cutting
Increase funding for advertising
Exclusive contracts with distributors
The legality of such behavior may be
challenged in court according to laws and
regulations.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Monopoly Demand

Recall that in pure competition, a firm faces a
perfectly elastic demand since it is a price
taker.


The market supply and demand curves determine
price, which determines the firm’s demand curve.
In pure monopoly, the firm’s demand curve is
the market demand curve.

The pure monopolist is the industry; therefore, the
demand curve is downward-sloping.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Demand
Pure Competition
Price
P
Price
firm’s demand
Quantity
McGraw-Hill/Irwin
Pure Monopoly
Market
Demand
Quantity
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Monopoly Marginal Revenue
Because market demand slopes downward,
in order for a monopolist to increase sales it
must lower its price.
Consequently, marginal revenue is less than
price for every level of output except the
first.
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Monopoly Marginal Revenue
If the monopolist increases output by one
more unit, the price charged for all units sold
will fall.

Each additional unit of output sold increases
total revenue by an amount equal to its own
price less the sum of the price cuts that apply to
all price units of output.
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Monopoly Marginal Revenue
Example: An increase
in production from 2 to
3 units causes price to
fall from $46 to $44.
Total revenue rises
from $92 to $132.
Quantity Price
Total
(AR) Revenue
0
$50
$0
1
48
48
2
46
92
3
44
132
For the third unit, marginal revenue = $40 < Price = $44.
(MR = $44 for 3rd unit minus $2*2 for price cuts of the first two units.)
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The Monopolist Is
a Price Maker
A pure monopolist can influence market
supply through its output decisions.
Subsequently, it can also influence the
product price.

Each output is associated with a unique price;
by changing the market output, a monopolist
is indirectly determining the market price.
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Output and Price Determination
To determine the price-quantity
combination that will maximize profit, cost
data is needed.
Furthermore, a monopolist will employ the
MR = MC Rule in order to maximize profit.
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Determining Monopoly
Price and Quantity
A monopolist produces a level of output
where MR = MC. This determines the
profit maximizing output, Qm.
Price is determined by the market demand
curve.

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A vertical line is drawn from Qm to the demand
curve.
Pm is the profit-maximizing price.
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Finding Pm and Qm
Price
MC
Pm
Cost data will determine
a monopolist’s profit.
MC = MR
Market Demand
Qm
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MR
Quantity of output
Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
A Profitable Monopolist
Price
Pm
Profit per unit
MC
Economic
Profit
ATC
D
Qm
McGraw-Hill/Irwin
MR
Quantity of output
Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Misconceptions Concerning
Monopoly Pricing
Three fallacies concerning monopoly
behavior include:
 Not Highest Price
 Total, Not Unit, Profit
 Profitability Not Assured
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Misconceptions Concerning
Monopoly Pricing
Higher prices often yield smaller-thanmaximum total profit.

The “highest price possible” is not ideal
because it results in lower output and reduces
total revenue.
The monopolist seeks to maximize total
profit, not unit profit.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Misconceptions Concerning
Monopoly Pricing
A monopolist suffers from weak demand,
bad market conditions or resource cost
increases.
Thus, profit is not always guaranteed.
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Economics Effects
of Monopoly
Compared to pure competition, a
monopoly lacks productive efficiency and
allocative efficiency.
 It is considered inefficient.
A monopolist charges a higher price and
sells a smaller level of output than firms in
a purely competitive industry.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Inefficiency of Pure Monopoly
Because the monopolist’s MR curve lies
below demand and it produces output
where MR = MC, price exceeds MC.
In pure competition, entry and exit of firms
ensure that P = MC = min. ATC.
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Inefficiency of Pure Monopoly
Pure Competition
Price
Pure Monopoly
Price
MC
S = MC
Pm
Pc
Pc
D
D
MR
Qc
P = MC = min. ATC
McGraw-Hill/Irwin
Quantity
MR = MC
Qm Qc
Quantity
Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Economics Effects
of Monopoly
Monopoly increases income inequality
because monopoly profits are not equally
distributed.

Monopolists levy a “private tax” on consumers
by transferring income from consumers to
shareholders who own the monopoly.
Cost may vary in monopoly because of
economies of scale, X-inefficiency, rentseeking expenditures, and technological
advance.
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Cost Complications
Some firms achieve large economies of
scale due to specialized inputs, the
spreading of product developing costs,
simultaneous consumption and network
effects.
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Cost Complications
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Cost also vary because firms produce a
level of output that is higher than the
lowest ATC. This is called X-efficiency.
Rent-seeking behavior alters costs when
firms gain special benefits from the
government at the expense of taxpayers.
In the very long run, firms can reduce their
costs through technological advances.
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Price Discrimination
Price discrimination is the business
practice of selling the same good at
different prices to different consumers
when the price differences are not justified
by differences in costs.
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Price Discrimination
Price discrimination is not possible when
a good is sold in a purely competitive
market since there are many firms all
selling at the market price.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Price Discrimination
In order to price discriminate, the firm
must:
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have monopoly power
be able to segregate the market into
difference groups
be able to prevent resale of the product
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Monopoly and Antitrust Policy
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Monopoly is not widespread because
barriers to entry are seldom completely
successful.
Governments deal with monopoly behavior
through antitrust laws if the monopoly
arises through anticompetitive actions or
creates substantial economic
inefficiencies. Otherwise, the government
can do nothing.
McGraw-Hill/Irwin
Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.