Download Monopoly

Managerial Economics
Session 3
Monopoly
Professor Changqi Wu
Topics for Today

What is a monopoly?

How does a monopolist behave?

How to sustain a monopoly position?

Monopsony

Consequences of monopoly
Monopoly
Slide 2
1. What is A Monopoly?

One firm supplies a good or a service
that has no close substitute in a welldefined market

A monopolist enjoys market power
 market
power measures a firm’s ability to
set price
Monopoly
Slide 3
Monopoly

Facing a downward-sloping demand curve, a
monopolist’s marginal revenue curve lies below her
average revenue curve.

How to find marginal revenue

As the sole producer, the monopolist works with
the market demand to determine output and price.

Assume a firm with demand:

Monopoly
P=6-Q
Slide 4
Total, Marginal, and Average Revenue
Price
P
Quantity
Q
$6
5
4
3
2
1
0
1
2
3
4
5
Monopoly
Total
Revenue
R
$0
5
8
9
8
5
Marginal
Revenue
MR
--$5
3
1
-1
-3
Average
Revenue
AR
--$5
4
3
2
1
Slide 5
Average and Marginal Revenue
$ per
unit of
output
7
6
5
Average Revenue (Demand)
4
3
2
Monopoly
1
Marginal
Revenue
0
1
2
3
4
5
6
7 Output
Slide 6
2. Behavior of a Monopolist

A monopolist sets the marginal revenue
equal to the marginal cost to maximize
her profit.

A monopolist has no supply curve.

Price elasticity of demand influences
price setting power of a monopolist.
Monopoly
Slide 7
Maximizing Profit When Marginal
Revenue Equals Marginal Cost
$ per
unit of
output
MC
P1
P*
AC
P2
Lost
profit
D = AR
MR
Q1
Monopoly
Q*
Q2
Lost
profit
Quantity
Slide 8
Elasticity of Demand and Price Markup
$/Q
$/Q
The more elastic is
demand, the less the
markup.
P*
MC
MC
P*
AR
P*-MC
MR
AR
MR
Q*
Quantity
Q*
Quantity
Elasticity of Demand and Price Markup

The ratio of incremental profit margin
and price is equivalent to the absolute
value of the reverse of price elasticity of
demand

The markup pricing is based on this
principle.
Monopoly
Slide 10
Monopoly Power and Profit

Monopoly power does not guarantee
profits.

The profit depends on average cost
relative to price.
Monopoly
Slide 11
3. How does Monopoly Arise?

Monopoly comes into existence
because of barriers to entry

Barriers to entry
 factors
that allow the incumbent firm to
earn positive economic profits and make it
costly for new comers to enter the same
market
Monopoly
Slide 12
Type of Barriers to Entry

Institutional barriers to entry

Technical barriers to entry

Strategic barriers to entry
Monopoly
Slide 13
Institutional Barriers to Entry

Exclusive franchising

Licenses

Patent protection
Monopoly
Slide 14
Technical Barriers to Entry

Unique resources

Economies of scale and scope

Economy of experiences
Monopoly
Slide 15
Strategic Barriers to Entry

Limit pricing

Excess capacity

Product differentiation (brand proliferation)
Monopoly
Slide 16
Barriers to Exit

Barriers to exit are the opportunities that a
firm must give up by leaving the industry.

Barriers to exit can have a similar effect as
barriers to entry.
Monopoly
Slide 17
Restraining Competition

Horizontal merger

Joint ventures

Strategic alliance

Trade associations
Monopoly
Slide 18
Cartel: A Virtual Monopoly

A cartel is an association of firms that coordinates
explicitly the activities of its members

An effective cartel must find ways to restrain
competition

Factors facilitating cartel formation

market concentration
 Concentration ratio: sum of market shares of the largest
4 firms in the same market
 Herfindale index: sum of market shares squared of all
firms

low organizational cost

homogenous good
Monopoly
Slide 19
4. Monopsony

A monopsonist is the twin sister of a
monopolist

a single buyer faces a lot of competitive sellers

A monopsonist’s marginal expenditure curve
lies above the supply curve

A monopsonist sets its marginal expenditure
(ME) equal to its marginal value (MV) to
maximize her profit
Monopoly
Slide 20
Monopsonist Buyer
$/Q
The market supply curve is the monopsonist’s
average expenditure curve
ME
Monopsony
•ME > P & above S
S = AE
Competitive
•P = PC
•Q = Q+C
PC
P*m
MV
Q*m
Monopoly
QC
Quantity
Slide 21
Business in Action

The role of major banks
 Banks

set deposit rates and lending rates
Does the bank act as a monopolist or a
monopsonist ?
Monopoly
Slide 22
5. Social Cost of Monopoly

Deadweight loss occurs, but it appears to be
small

It is costly to create and to sustain
monopolistic position


Rent seeking
Price mechanism becomes less effective
when market conditions change.
Monopoly
Slide 23
Deadweight Loss from Monopoly Power
$/Q
Lost Consumer Surplus
Deadweight
Loss
Because of the higher
price, consumers lose
A+B and producer
gains A-C.
MC
Pm
A
B
C
PC
AR
MR
Qm
Monopoly
QC
Quantity
Slide 24
Effect of Cost Change on
Monopolist
$/Q
Increase in P: P0P1 > increase in cost
P1
P
P0
MC’
D = AR
MC
MR
c
Q1
Monopoly
Q0
Quantity
Slide 25
Why Is Monopoly Not Necessarily Bad?

Monopoly profit is a carrot

Monopoly profit may stimulate innovation


Monopolies are only temporary


Does the government’s effort of cracking down
software piracy protect the monopoly interest of
Microsoft?
The case of Polaroid
When the economy of scale is significant, a
natural monopoly is technically efficient
Monopoly
Slide 26
Natural Monopoly

A firm that can produce the entire output
of an industry at a cost lower than what
it would be if there were several firms.
Monopoly
Slide 27
Regulating the Price
of a Natural Monopoly
$/Q
Unregulated, the monopolist
would produce Qm and
charge Pm.
If the price were regulate to be PC,
the firm would lose money
and go out of business.
Pm
Setting the price at Pr
yields the largest possible
output;excess profit is zero.
AC
Pr
MC
PC
AR
MR
Qm
Monopoly
Qr
QC
Quantity
Slide 28
Limiting Market Power

Rules and regulations designed to
promote a competitive economy by:
 Prohibiting
actions that restrain or are likely
to restrain competition
 Restricting
the forms of market structures
that are allowable
 Makes
it illegal to monopolize or attempt to
monopolize a market. Merger guidelines.
Monopoly
Slide 29
Key Learning Points

Monopoly arises because of the existence of
barriers to entry

A monopolist sets her marginal revenue equal
to her marginal cost to maximize profit.

Firms can gain market power by restraining
competition.

Monopoly reduces social welfare

Attempt to gain monopoly profit may
encourage innovation.
Monopoly
Slide 30