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Chapter 17
Monopoly
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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
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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)
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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
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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
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Marginal Revenue for a
Monopolist
 An increase in sales quantity (Q) changes revenue in two ways
 Firm sells Q 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-Q) units of output,
the price reduction effect
 The overall effect on marginal revenue is:
 So the price reduction effect makes the monopolist’s marginal
revenue less than price
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Figure 17.2: Marginal Revenue
and Price
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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
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Figure 17.4: Monopoly Profit
Maximization
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Markup
 A monopolist facing a downward sloping demand
curve will set its P above MC
 Firm in a perfectly competitive market sets price = MC,
meaning that the firm has no market power
 Extent to which P exceeds MC is a measure of
monopolist’s market power
 A firm’s markup, price-cost margin, or Lerner
index equals the difference between its P and its MC,
as a % of its P
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Markup
A monopolist’s markup at its profit-maximizing
P 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
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Welfare Effects of
Monopoly Pricing
 By charging a P above MC, 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
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Figure 17.5: Welfare Effects of
Monopoly Pricing
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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 MCs and
compare to P
Monopolists and perfectly competitive
industries behave differently in responses to
changes in demand and changes in costs
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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
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Figure 17.7: Response to a
Change in Demand
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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 P that occurs
in response to a small increase in MC, measured per
dollar of increase in MC
 In a competitive market, the pass-through rate is never
greater than one (cannot increase P by more than T)
 The monopolist’s pass-through rate depends on the
shape of the D curve
 Can be greater than one with a constant-elasticity demand
curve:
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P=(Ed / (Ed+1)) MC
or: PM is a multiple of its MC
if Ed=-2, then P=2MC
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Price Paid by Consumers ($/gallon)
Effects of a Specific Tax – Shifting the
Supply Curve
ST
Increase in
Consumer Cost
per Gallon
S
Po + T
Pb
B
T
A
Po
Ps = Pb - T
Decrease in
Firms’ Receipts
per Gallon
D
QT
Qo
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Gallons of Gas per Month
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
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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
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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)
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Monopsony
 Read monopsony section: p:648-652
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Regulation of Monopolies
 Deadweight loss from monopoly pricing provides a
justification for government intervention
 Government actions that keep prices closer to MC 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
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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
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Figure 17.11: A Natural Monopoly
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