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Survey of ECON
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Robert L. Sexton
Chapter 8
Monopoly
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Chapter 8 Sections
– Monopoly: The Price Maker
– Demand and Marginal Revenue in
Monopoly
– The Monopolist’s Equilibrium
– Monopoly and Welfare Loss
– Monopoly Policy
– Price Discrimination
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Monopoly:
The Price Maker
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Section 1
SECTION 1 QUESTIONS
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Monopoly
• A true or pure monopoly exists when
there is only one seller of a product for
which no close substitute is available.
• The firm and “the industry” are one and
the same.
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Monopoly: Price Makers
• Because a monopoly firm faces the
industry demand curve, it can pick the
most profitable point on that demand
curve.
• Monopolists are price makers (rather
than takers) that try to pick the price
that will maximize their profits.
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Pure Monopoly is a Rarity
• Pure monopolies are a rarity because few
goods and services truly have only one
producer.
• Near-monopoly conditions may exist, such as
many public utilities, but absolute total
monopoly is rather unusual.
• However, the number of situations in which
monopoly conditions are fairly closely
approximated are numerous enough to make
the study of monopoly useful.
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Barriers to Entry
• For a monopoly to persist, it must be
virtually impossible for other firms to
overcome barriers to entry.
• Barriers to entry
– legal barriers
– economies of scale
– control of important inputs
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Legal Barriers
• Legal barriers include franchising (the
postal service), licensing to ensure quality
(trade industries), and patents.
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Economies of Scale
• The situation in which one large firm can
provide the output of the market at a lower
cost than two or more smaller firms is called
a natural monopoly. With a natural
monopoly, it is more efficient to have one
firm produce the good. The reason for the
cost advantage is economies of scale
throughout the relevant output range.
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Exhibit 8.1: Economies of Scale
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Control of Important
Inputs
• Another barrier to entry is control over an
important input.
– Alcoa’s control over aluminum in the 1940s
– De Beers’ control over much of the world’s
output of diamonds
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Section 1
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Demand and Marginal
Revenue in Monopoly
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Section 2
SECTION 2 QUESTIONS
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Demand and Marginal
Revenue in Monopoly
• In monopoly, the market demand curve may be
regarded as the demand curve for the firm’s
product because the monopoly firm is the market
for that particular product.
• Unlike in perfect competition, monopolists (and all
other firms that are price makers) face a
downward-sloping demand curve.
• If the monopolist raises its price, it will lose some,
but not all of its customers.
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Exhibit 8.2: Comparing Demand Curves: Perfect
Competition versus Monopoly
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Exhibit 8.3: Total, Marginal, and Average
Revenue
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Demand and Marginal
Revenue in Monopoly
• Because a monopolist’s marginal revenue
is always less than the price, the marginal
revenue curve will always lie below the
demand curve.
• If the seller wants to expand output, it will
have to lower the price on all units.
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Demand and Marginal
Revenue in Monopoly
• The monopolist receives additional
revenue from the new unit sold (the
output effect), but will receive less
revenue on all the units it was
previously selling (the price effect).
• So when the monopolist cuts prices to
attract new customers, the old
customers benefit.
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Exhibit 8.4: Demand and Marginal Revenue for
the Monopolist
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Marginal Revenue: The Competing
Firm and the Monopolist
• In Exhibit 8.5, we can compare
marginal revenue for the competing firm
with the marginal revenue for the
monopolist.
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Exhibit 8.5: Marginal Revenue—Competitive
Firm versus Monopolist
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The Monopolist’s Price in the
Elastic Portion of the Demand Curve
• The relationship between the elasticity of demand
and marginal and total revenue are shown in
Exhibit 8.6.
– In the elastic portion of the curve, when the price
falls, total revenue rises, so that marginal
revenue is positive.
– In the inelastic portion of the curve, when the
price falls, total revenue falls, so that marginal
revenue is negative.
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Exhibit 8.6: The
Relationship
between the
Elasticity of
Demand and
Total and
Marginal
Revenue
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The Monopolist’s Price in the
Elastic Portion of the Demand Curve
• A monopolist will never knowingly operate
in the inelastic portion of its demand curve.
• Increased output will lead to lower total
revenue and higher total cost in that region.
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Beyond the Book: The Cable Car
• Cable cars in San Francisco are one of the
main tourist attractions. Consider a cable car
company that decided to increase prices from
$3 to $5. Consequently, the number of users
would fall, as locals would substitute into buses
and other forms of transportation. The demand
by tourists for cable car rides, however, would
be relatively inelastic. So as cable car fares
rose, so would total revenue; so the firm must
have been operating in the inelastic portion of
its demand curve.
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Beyond the Book: The Cable Car
• Of course, as we just learned, this is
clearly not the profit-maximizing part of
the demand curve; monopolists can
improve their profits by operating on the
elastic portion of their demand curve.
• However, one might argue that there are
positive externalities from keeping cable
car fares low. Lower fares could attract
more visitors and help local businesses.
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Section 2
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The Monopolist’s
Equilibrium
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Section 3
SECTION 3 QUESTIONS
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The Monopolist‘s
Equilibrium
• The monopolist, like the perfect
competitor, will maximize profits at that
output where MR = MC. Profits continue
to grow until that output is reached.
• Therefore, the equilibrium output is
where MR = MC.
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Exhibit 8.7: Equilibrium Output and Price for a
Monopolist
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Three-Step Method for
Monopolists
• The three-step method for determining
economic profits, economic losses, or zero
economic profits:
– Find where MR equals MC, which is the profitmaximizing output level.
– Go straight up to the demand curve, then left to
find the corresponding market price.
– Find TC as ATC times the quantity produced.
TC = ATC  Q
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Profits for a Monopolist
• If TR > TC (the price exceeds average
total cost), the monopolist is generating
economic profits.
• If TR < TC (the price is less than
average total cost), the monopolist is
generating economic losses.
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Exhibit 8.8: A Monopolist’s Profits
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Profits for a Monopolist
• In perfect competition, profits in an
economic sense will persist only in the
short run because in the long run,
– new firms will enter the industry,
– increasing industry supply,
– and thus driving down the price of the
good.
– Thus, profits are eliminated.
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Profits for a Monopolist
• In monopoly, profits are not eliminated
because barriers to entry exist.
• Other firms cannot enter, so economic
profits can persist in the long run.
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Losses for the Monopolist
• Being a sole supplier does not guarantee
that consumers will demand your
product.
• A monopolist will incur a loss if there is
insufficient demand to cover average
total costs at any price and output
combination along the demand curve.
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Exhibit 8.9: A Monopolist’s Losses
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Patents
• Patents and copyrights
– examples of monopoly power
– designed to provide an incentive to
develop new products
• The fall in the price of a patented good
when the patent expires illustrates the
effect of introducing competition.
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Exhibit 8.10: Impact of Patent Protection on
Equilibrium Price and Quantity
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Section 3
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Monopoly and
Welfare Loss
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Section 4
SECTION 4 QUESTIONS
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Does Monopoly Promote
Inefficiency?
• The major objections to monopoly:
– Not “fair” for monopoly owners to have
persistent economic profits
– Monopoly leads to lower output and higher
prices than would exist under perfect
competition
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Does Monopoly Promote
Inefficiency?
• Efficiency objection: monopolists charge higher
prices and produce less output.
– monopolist produces an output where the price is
greater than its cost,
– so that the value to society from the last unit
produced is greater than its cost,
– so the monopoly is not producing enough of the
good from society’s perspective, creating a
welfare loss.
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Exhibit 8.11: Perfect Competition versus
Monopoly
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Welfare Loss in Monopoly
• The actual amount of the welfare loss in
monopoly is of considerable debate
among economists.
• Estimates vary from 0.1 percent to 6
percent of national income.
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Does Monopoly Retard
Innovation?
• Some argue that a lack of competition retards
technological advance.
– Already reaping monopolistic profits, firms do not
work at:
• product improvement
• technical advances designed to promote
efficiency
• Notion that monopoly retards innovation can be
disputed.
– Many near-monopolists are important innovators.
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Does Monopoly Retard
Innovation?
• Indeed, innovation helps firms initially
obtain a degree of monopoly status.
• Even monopolists want more profits, and
any innovation that lowers costs or
expands revenues creates profits for a
monopolist.
• Therefore, the incentive to innovate may
well exist in monopolistic market
structures.
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Section 4
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Monopoly Policy
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Section 5
SECTION 5 QUESTIONS
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Monopoly Policy
• Two major approaches to dealing with
the monopoly problem:
– antitrust policies
– regulation
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Antitrust Policies
• By imposing monetary and nonmonetary
costs on monopolists, antitrust policies
reduce the profitability of monopoly.
– The fear of lawsuits
– Jail sentences
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Antitrust Laws
• The first important law regulating
monopoly was the Sherman Antitrust
Act.
• The Sherman Act prohibited “restraint of
trade”—price fixing and collusion—but
narrow court interpretation of the
legislation led to a number of large
mergers, such as U.S. Steel.
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Antitrust Acts Strengthened
• Antitrust efforts were strengthened by
subsequent legislation, the most
important of which was the Clayton Act
in 1914.
• Additional legislation in the same year
created the Federal Trade Commission
(FTC), which became the second
government agency concerned with
antitrust actions.
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The Clayton Act
• The Clayton Act made it illegal to engage
in predatory pricing—setting prices to
drive out competitors or deter potential
entrants in order to ensure higher prices
in the future.
• The Clayton Act also prohibited mergers
if it led to weakened competition.
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Further Antitrust Legislation
• Not all of the later legislation actually
served to enhance competition.
– The Robinson-Patman Act of 1936
(forbade most forms of price
discrimination)
– The Cellar-Kefauver Act in 1950,
(toughened restrictions on mergers that
reduced competition)
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Promoting More Price
Competition
• Many professional associations restrict
the promotion of price competition by
prohibiting advertising among their
members.
• Both the FTC and the Justice Department
successfully attacked these types of
restrictions on the grounds that they
violate the antitrust laws.
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Have Antitrust Policies
Been Successful?
• The success of antitrust policies can be
debated.
• It is very likely that at least some
anticompetitive practices have been
prevented simply by the very existence
of laws prohibiting monopoly-like
practices.
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Have Antitrust Policies
Been Successful?
• Although the laws were probably
enforced in an imperfect fashion, on
balance they impeded monopoly
influences to at least some degree.
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Government Regulation
• Government regulation is an alternative
approach to dealing with monopolies.
• The goal is to achieve the efficiency
of large-scale production without
permitting the high monopoly prices
and low output that can promote
allocative inefficiency.
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Government Regulation
• Regulators often face a basic policy
dilemma.
• Without regulation, profit-maximizing
monopolists will produce where
MR = MC.
– At that output, the price exceeds average
total cost, so economic profits exist.
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Government Regulation
• The monopolist is
– producing relatively little output
– charging a relatively high price
– producing at a point where price is above
marginal cost
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Exhibit 8.12: Marginal Cost Pricing versus
Average Cost Pricing
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Allocative Efficiency
• Socially allocative efficiency
– where P = MC
• With natural monopoly,
– where P = MC, the ATC > P
• The optimal output, then, is an output that
produces losses for the producer.
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Allocative Efficiency
• Any regulated business that produced
for long at this “optimal” output would
go bankrupt; it would be impossible to
attract new capital to the industry.
• Therefore, the “optimal” output from a
welfare perspective really is not viable.
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Average Cost Pricing
• A compromise between unregulated
monopoly and marginal cost pricing is
average cost pricing, where price
equals average total cost.
• The monopolist is permitted to price the
product where economic profits are zero,
meaning that a normal return is being
permitted, like firms experience in perfect
competition in the long run.
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Difficulties in Average
Cost Pricing
• The actual implementation of a rate
(price) that permits a “fair and
reasonable” return is more difficult than
the graphical analysis suggests.
• The calculations of costs and values is
very difficult, often forcing regulatory
agencies to use profits as a guide
instead.
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Difficulties in Average
Cost Pricing
• Another problem is that average cost
pricing gives the monopolist no
incentive to reduce costs (which
regulators have tackled by letting the
firm keep some of the profits that come
from lower costs).
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Exhibit 8.13: Changes in Average Costs
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Difficulties in Average
Cost Pricing
• Also, consumer groups are constantly battling
for lower rates, while the utilities themselves are
lobbying for higher rates so that they can
achieve some monopoly profits.
• The temptation is great for the commissioners to
be generous to the utilities.
• On the other hand, there may be a tendency for
regulators to bow to pressure from consumer
groups.
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Section 5
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Price Discrimination
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Section 6
SECTION 6 QUESTIONS
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Price Discrimination
PRICE DISCRIMINATION
the practice of charging different
consumers different prices for the
same good or service
• Under certain conditions, the monopolist finds
it profitable to discriminate among various
buyers, charging higher prices to those that are
more willing to pay and lower prices to those
less willing to pay.
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Conditions for Price
Discrimination
• Three conditions are necessary for the
monopolist to practice price discrimination:
1. Monopoly Power
2. Market Segregation
3. No Resale
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Monopoly Power
• Price discrimination is possible only with
monopoly or where members of a small
group of firms follow identical pricing
policies.
• When there are a number of competing
firms, discrimination is less likely because
competitors tend to undercut higher prices
charged by the firms engaging in price
discrimination.
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Market Segregation
• Price discrimination can only occur if the
demand curve for markets, groups, or
individuals are different. If the demand
curves are not different, a profit-maximizing
monopolist would charge the same price in
both markets.
• In short, price discrimination requires the
ability to separate customers according to
their willingness to pay.
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No Resale
• For price discrimination to work, the
purchaser buying the product at a discount
must have difficulty in reselling the product
to customers being charged more.
Otherwise, consumers would buy extra
product at the discounted price and sell it
at a profit to others, reducing the number
of customers paying the higher price.
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Why Does Price
Discrimination Exist?
• Price discrimination results from the
profit-maximization motive.
• Different groups of people have
different demand curves and therefore
react differently to price changes.
• A producer can make more money by
charging these different buyers different
prices.
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Exhibit 8.14: Price Discrimination in Movie
Ticket Prices
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Price Discrimination
Examples: Airline Tickets
• Seats on airlines usually go for different prices.
• The airlines can discriminate against business
travelers who usually have little advance
warning and often travel on weekdays—
preferring to be home on the weekends.
• Because the business traveler has a high
willingness to pay (a relatively inelastic
demand curve) the airlines can charge them a
higher price.
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Price Discrimination
Examples: Coupons
• The coupon cutter, who spends an hour
looking through the Sunday paper for
coupons, will probably have a relatively
more elastic demand curve than, say, a
busy and wealthy physician or executive.
• Consequently, firms charge a lower price
to customers with a lower willingness to
pay (more elastic demand)—the coupon
cutter—and a higher price to those who
don’t use coupons (less elastic demand).
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Price Discrimination Examples:
College and University Tuition
• Students who are well off financially
tend to pay more for their education
than do students who are less well
off because of different financial aid
packages.
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Price Discrimination
Examples: Quantity Discounts
• The seller charges a higher price for the first
unit than for later units, allowing the
producer to extract some consumer surplus.
• A six-pack of soda might be less expensive
than buying each separately. Or you might
be able to buy a baker’s dozen of donuts—
13 for the price of 12.
• With this type of price discrimination, you
are charging more for the first units than,
say, for the 20th unit.
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Section 6
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