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Chapter 17
Monopoly
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
Market power
Monopoly pricing
Welfare effects of monopoly pricing
Distinguishing monopoly from perfect
competition
Nonprice effects of monopoly
Monopsony
Regulation of monopolies
17-2
Market Power
 In many situations, competition is not intense
 A firm has market power when it can profitably charge
a price that is above its marginal cost
 Most firms have some market power, though it may be
very slight
 Depends on whether their competitors’ products are close
substitutes
 Two market structures in which firms have market
power:
 A monopoly market has a single seller
 An oligopoly market has a few, but not many, producers
 Determining what is and is not a monopoly market can
be trickier than simple definitions might suggest
17-3
How Do Firms Become
Monopolists?
Firms get to be monopolists in various ways:
Government grants a monopoly position to a firm
(cable TV companies in local communities, drug
patents)
Economies of scale (concrete supply in a small
town)
Being first to produce a new product (iPod)
Owning all of an essential input (De Beers diamond
producer)
Many of these ways of initially capturing market
power tend to erode over time
17-4
Figure 17.1: Scale Economies
and Monopoly
Monopolist can make
a profit because AC
lies below the
demand curve at
some quantities
Two firms cannot
make positive profits
AC lies above Dhalf for
all quantities
17-5
Monopoly Pricing
 Monopolist will choose the price that maximizes its
profit, given the demand for its product
 Whenever the firm’s profit-maximizing sales quantity is
positive, marginal revenue equals marginal cost at that sales
quantity
 Marginal cost curve applies as usual
 Need to examine the shape of the marginal revenue
curve
 Recall that a firm’s marginal revenue curve captures
the additional revenue it gets from the marginal units it
sells, measured on a per-unit basis
17-6
Marginal Revenue for a
Monopolist
 An increase in sales quantity (DQ) changes revenue in two ways
 Firm sells DQ additional units of output, each at a price of P(Q),
the output expansion effect
 Firm also has to lower price as dictated by the demand curve;
reduces revenue earned from the original (Q-DQ) units of output,
the price reduction effect
 The overall effect on marginal revenue is:
 DP 
Q
MR  PQ   
 DQ 
 So the price reduction effect makes the monopolist’s marginal
revenue less than price
17-7
Figure 17.2: Marginal Revenue
and Price
17-8
Monopoly Profit Maximization
 When a monopolist maximizes its profit by selling a positive
amount, its marginal revenue must equal its marginal cost at that
quantity
 If marginal revenue exceeded marginal cost the firm would be better
off selling more
 If marginal revenue were less than marginal cost the firm would be
better off selling less
 Two-step procedure for finding the profit-maximizing sales quantity
 Step 1: Quantity Rule
 Identify positive sales quantities at which MR=MC
 If more than one, find one with highest profit
 Step 2: Shut-Down Rule
 Check whether the quantity from Step 1 yields higher profit than
shutting down
17-9
Figure 17.4: Monopoly Profit
Maximization
17-10
Markup
 A monopolist facing a downward sloping demand
curve will set its price above marginal cost
 Firm in a perfectly competitive market sets price equal to
marginal cost, meaning that the firm has no market power
 Extent to which price exceeds marginal cost is a
measure of monopolist’s market power
 A firm’s markup, price-cost margin, or Lerner
index equals the difference between its price and its
marginal cost, as a percentage of its price
P  MC
1
 d
P
E
17-11
Markup
A monopolist’s markup at its profit-maximizing
price always equals the reciprocal of the
elasticity of demand, times negative one
The less elastic the demand curve, the greater
the firm’s markup over its marginal cost
When demand is less elastic, raising the price
is more attractive because fewer sales are lost
This also implies that demand must be elastic
at the profit-maximizing price
17-12
Welfare Effects of
Monopoly Pricing
 By charging a price above marginal cost, the
monopolist makes consumers worse off than under
perfect competition
 Consumers who buy the product pay more for it
 Some who would have bought it under perfect competition will
not buy it at the higher price
 Welfare effects of monopoly pricing:
 Firm gains
 Consumers lose
 Deadweight loss incurred
 Deadweight loss from monopoly pricing is the amount
by which aggregate surplus falls short of its maximum
possible level, which is attained in a competitive
market
17-13
Figure 17.5: Welfare Effects of
Monopoly Pricing
17-14
Distinguishing Monopoly from
Perfect Competition
Existence of more than one firm in a market
does not guarantee perfect competition
How can we tell whether multiple firms in a
market are behaving like price takers or
colluding and acting like a monopoly?
Easy to answer if we could observe marginal costs
and compare to price
Monopolists and perfectly competitive
industries behave differently in responses to
changes in demand and changes in costs
17-15
Response to Changes in Demand
Monopolist’s profit-maximizing price depends
on elasticity of demand
Price in perfectly competitive market depends
on level of demand
If elasticity of demand changes but level of
demand does not, provides a way to
distinguish between market structures
Can investigate this through data collection
over time and statistical analysis
17-16
Figure 17.7: Response to a
Change in Demand
17-17
Response to Changes in Cost
 How do monopolies and perfectly competitive markets
differ in their response to changes in costs?
 Consider the case of a marginal cost increase by a
given amount at every level of output
 Example: a specific tax, T, on firms
 The pass-through rate is the increase in price that
occurs in response to a small increase in marginal
cost, measured per dollar of increase in marginal cost
 In a competitive market, the pass-through rate is never
greater than one
 The monopolist’s pass-through rate depends on the
shape of the demand curve
 Can be greater than one with a constant-elasticity demand
curve
17-18
Nonprice Effects of Monopoly:
Product Quality
 Product quality is a decision firms make
 Raising a product’s quality increases the consumer’s
willingness to pay
 Producing a higher-quality product usually costs more
 The firm must decide whether the extra benefit is worth the
extra cost
 How does the quality provided by a monopolist
compare to the level that would maximize aggregate
surplus?
 If different consumers value quality differently, the
monopolist may not choose to offer the quality that
maximizes aggregate surplus
 May over- or under-produce quality
17-19
Product Quality: Car Wash
Example
 Suppose the only car wash in town is deciding whether to provide hand
washing
 Without hand washing the firm maximizes profit by selling 100 washes at $15
each, profit is $1,000
 Hand washing costs $5 more per wash
 Consumers whose willingness to pay is above $22 value a car wash $15
more if done by hand
 All other consumers value a hand wash $5 more
 With hand washes, firm’s profit-maximizing quantity is 100 washes at $20
each, with profit of $1,000
 Aggregate surplus:
 Without hand washes: $1,500
 With hand washes: $1,800
 Firm is indifferent between providing and not providing the higher quality
product
 If cost of hand washing were $5.01, monopolist would choose not to provide it
even though aggregate surplus would be greater with it
17-20
Figure 17.9: Monopolist and
Product Quality
17-21
Nonprice Effects of Monopoly:
Advertising
 Spending on advertising is another important decision for many
firms
 Because the monopolist’s marginal cost is less than the price,
each additional sale increases its profit
 Firms in perfectly competitive markets have no individual incentive
to advertise
 Each firm perceives itself as capable of selling as much as its desires
at the market price
 Marginal benefit of advertising equals the increase in sales times
the firm’s profit on additional sales
 At the profit-maximizing level of advertising, this marginal benefit
must equal the extra dollar expended
 For a monopolist, the ratio of the amount spend on advertising to
the firm’s total sales revenue, the advertising-sales ratio, equals
the advertising elasticity divided by the elasticity of demand, times
negative one
17-22
Nonprice Effects of Monopoly:
Investments
 Firms can also make investments in an effort to become a
monopolist
 Example: cable TV firms lobbying government officials to award them
franchises
 If firms compete to become a monopolist, they will spend up to the
full monopoly profit less avoidable fixed costs
 If spend on socially wasteful things (e.g., golf outings for local
officials) the loss from monopoly may be larger than deadweight loss
and include all monopoly profit
 Rent seeking is socially useless effort devoted to securing a
monopoly position
 Welfare effects of monopoly need not always be so bad
 Expenditures firms make to gain monopoly positions can be socially
valuable (e.g., R&D spending in the search for patentable drugs)
17-23
Monopsony
 Market power isn’t limited to the sellers of a product: it
also can be held by buyers
 A monopsony market has a single buyer
 Analysis of monopsony parallels the analysis of
monopoly
 A monopsonist faces an upward-sloping supply curve
 By lowering the quantity he buys, can pay less
 Monopsonist can think either in terms of what price to
pay or in terms of how many units to employ
17-24
Marginal Expenditure
 A monopsonist’s marginal expenditure, ME, is the
extra cost per marginal unit of an input
 Consider a small city in which the hospital is the only
employer of nurses
 The hospital’s marginal expenditure has two parts
 The input expansion effect: the marginal nurse costs W
 Given the upward-sloping supply curve, the hospital must
increase the wage by (DW/DQ) to hire another nurse
 Since the hospital must pay Q nurses this higher wage, the
wage increase raises nursing costs by (DW/DQ) Q
 So ME is larger than W since the total effect is:
ME  W  DW / DQQ
17-25
Monopsony Profit Maximization
The monopsonist’s profit-maximizing choice
equates its marginal benefit with its marginal
cost
Maximizes its profit by choosing the quantity at
which its demand and ME curves cross
Result is lower price and quantity than if the
firm was a price taker
Can solve for the equilibrium algebraically by
setting marginal benefit equal to marginal
expenditure and solving for quantity
17-26
Figure 17.10: Monopsony
Profit-maximizing
outcome:
Occurs where
marginal expenditure
curve crosses the
demand curve
Firm hires 200 nurses
Wage is $50,000
Deadweight loss is
red-shaded area
17-27
Welfare Effects of
Monopsony Pricing
Like with monopoly, monopsony price setting
creates deadweight loss
Monopsonist uses too little of the input
Potential net benefits from the input are lost
Deadweight loss is created between the
marginal benefit and market supply curves
See the red-shaded region in Figure 17.10
Can compute the dollar value of the
deadweight loss using algebra
17-28
Regulation of Monopolies
 Deadweight loss from monopoly pricing provides a
justification for government intervention
 Government actions that keep prices closer to marginal
cost can protect consumers and increase economic
efficiency
 Intervention can take many forms
 Antitrust legislation (see Chapter 19)
 Direct regulation of prices
 Price regulation not common in U.S. today
 More prevalent in the past
 Still used for electricity, natural gas, local telephone service
 More common in some other countries
17-29
Why Are Some Monopolies
Regulated?
 Regulation arises out of political pressure and
economic concern about market dominance
 When governments create monopolies they may then
regulate them to deal with the negative consequences
 May create a monopoly to ensure that goods are
produced at least cost
 A market is a natural monopoly when a good is
produced most economically through a single firm
 Average cost falls as quantity increases
 Second firm may enter but this would cause costs to rise
 Government can designate one firm to be the provider
 Institute price regulation to protect consumers
17-30
Figure 17.11: A Natural Monopoly
17-31
First-Best vs. Second-Best
Price Regulation
 Under regulation, ideally prices will be set at the competitive price
 Price at which demand and supply curves intersect
 Aggregate surplus will be maximized
 First-best solution to problem of price regulation
 Two problems with achieving this lead to second-best regulation
 Regulator may not know the firm’s marginal costs
 First-best solution would cause the monopolist to lose money
 If P < AC
 Best the regulator can do is set a price that makes aggregate
surplus as large as possible, allow the firm to break even
 Set P = AC
17-32