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Chapter Ten
Monopoly
Monopoly
•
Monopoly – One firm in an industry selling a
product for which there are no close
substitutes
Examples of Monopolies
1) De Beers, the company that controls most (80
percent) of the world’s diamond market.
2) Intel, before AMD became a major competitor.
3) Your local utilities companies.
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Monopoly (cont’d)
• Barriers to Entry – Anything that prevents firms
from entering a market.
• Market power – A firm’s power to set its price
without losing its entire share of the market.
• Price-maker – A firm that has the power to set its
price, rather than taking the price set by the
market; the opposite of a price-taker.
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Market Power
•
Differences between a Monopoly and
Competition:
1) There is no one to undercut a
Monopolist’s Price – In a monopoly, there
is only one seller. If that seller chooses
to sell at a higher price, it does not need
to worry about being undercut by other
sellers.
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Market Power (cont’d)
2) Impact of Quantity Decisions on the Price
– In a competitive market, if a firm
increases or decreases the quantity that it
will sell, it has very little or no effect on the
price, because each competitive firm is
small relative to the market. In a
monopoly, a decrease or an increase in
the firm’s quantity will have an effect on
the equilibrium price in the market,
because it is the only seller.
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Market Power (cont’d)
• Figure 10.1 graphically illustrates the
contrasting market power of a monopoly
and a competitive firm. The demand curve
faced by a monopoly is downward sloping,
showing that a change in quantity will
change prices. This is illustrated by the
graph on the left in Figure 10.1. Note that
the demand curve of a monopoly is the
same as the market demand curve.
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Market Power (cont’d)
• The demand curve faced by a competitive
firm is horizontal, implying that a change in
quantity will have no effect on prices. This
is illustrated by the graph on the right in
Figure 10.1.
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Market Power (cont’d)
Figure 10.1
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Effects of a Monopoly’s
Decision on Revenues
• From Chapter 6, we learned that for a
competitive firm, the marginal revenue or
the additional revenue that the firm gets
from selling one more unit equals the price
of the good. The competitive firm’s
demand curve represented by the graph
on the right on Figure 10.1 is also the
firm’s marginal revenue curve.
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
• For a monopoly, MR = P does not hold, because
the firm faces a downward sloping demand
curve. If the firm charges a single price to all its
customers, then a decision to sell one more unit
will require that the firm must decrease the price
of all the units that the firm will try to sell. As a
result, the marginal revenue of a monopoly will
be lower than the price of the good (P>MR).
This is best illustrated by the example on Table
10.1.
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
• The first two columns on Table 10.1 represent
the market demand curve, where increases in
quantity correspond to lower prices. The third
column calculates the total revenue that the firm
generates by selling each quantity. Recall that
total revenue (TR) is calculated by multiplying
the price of the good with the quantity of the
good sold.
TR = P X Q
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
• The fourth column on Table 10.1 shows the
marginal revenue brought about by the quantity
sold.
TR
Marginal Revenue = MR 
Q
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
• Note that the value of the marginal
revenue (fourth column) is consistently
lower than the price of the good (second
column), once the quantity is higher than
1. Further, the marginal revenue drops
two times faster than the price as quantity
is increased.
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
• Figure 10.2 graphically illustrates the
relationship between total revenue,
marginal revenue, and demand faced by a
monopoly.
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
Figure 10.2
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
• The graph on the left on Figure 10.2
shows the total revenue curve of the
monopoly. Notice that unlike the total
revenue curve faced by the competitive
firm, the total revenue curve of a monopoly
is not a straight line, and the curve
becomes flatter as the quantity sold
increases.
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
• Since the slope of the total revenue curve
is the marginal revenue, the curve shows
that the marginal revenue of the monopoly
increases as quantity increases. Further,
since the total revenue slopes downward
after Q = 8, it implies that the marginal
revenue of a monopoly can be negative.
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Effects of a Monopoly’s
Decision on Revenues (cont’d)
The graph on the right on Figure 10.2 shows
1) The marginal revenue of a monopoly is a
straight line that lies below the demand curve.
2) The marginal revenue curve is steeper than
the demand curve (in fact, two times steeper).
3) The marginal revenue curve can be negative.
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Why is the Marginal
Revenue Declining?
•
When a monopoly raises output, the
effect of the increase in quantity on total
revenue is two-fold:
1) A positive effect, since one more
additional unit is sold.
2) A negative effect, since selling one more
item forces the firm to lower prices.
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Why is the Marginal
Revenue Declining? (cont’d)
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Why the Marginal Revenue
can be Negative?
• The positive effect of an increase in output is
represented with the blue rectangle in the
previous graph. The negative effect of a
decrease in output is represented with the red
rectangle.
• The net effect of an increase in output on
marginal revenue depends on the sizes of the
positive (blue) effect and the negative (red)
effect.
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Why the Marginal Revenue
can be Negative? (cont’d)
• If the positive effect (or the blue rectangle) is
larger than the negative effect (or the red
rectangle), then an increase in output results in
a larger total revenue, and the marginal revenue
is positive.
• If the positive effect (or the blue rectangle) is
smaller than the negative effect (or the red
rectangle), then an increase in output results in
a smaller total revenue, and the marginal
revenue is negative.
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The Average Revenue
• Average Revenue (AR)= total revenue divided
by the price.
AR = TR/Q =
PQ
P
Q
• The average revenue is represented by the
demand curve.
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The Average Revenue (cont’d)
• Since the average revenue is declining, it
must be true that the marginal revenue is
lower than the average revenue (recall
chapter 8).
• Hence, as illustrated in Figure 10.2, the
marginal revenue curve must lie below the
average revenue (or demand) curve.
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Finding the Profit Maximizing Output
Recall from Chapter 6:
• Profits – The total revenue received from
selling the product minus the total costs of
producing the product, or:
• Profits = total revenue – total costs
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Finding the Profit Maximizing Output
(cont’d)
• One way to find profit is to plot a firm’s total
revenue and total cost curves, with dollars on
the Y-axis and quantity on the X-axis. This is
shown in the graph on the right in Figure 10.3.
• The profit maximizing quantity is the point when
the distance between TR and TC is maximized,
and TR > TC.
Note: If TR<TC, then profit maximization requires the distance between TR
and TC to be minimized.
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Finding the Profit Maximizing Output
(cont’d)
Figure 10.3
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Finding the Profit Maximizing Output
(cont’d)
• In Figure 10.3, any quantity to the left (a
lower quantity) or to the right (a higher
quantity) of the profit maximizing quantity
will result in a lower profit. The graph on
the right of Figure 10.3 illustrates this
point.
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Finding the Profit Maximizing Output
(cont’d)
• One characteristic of the profit maximizing level of
quantity is that the slopes of the total revenue and the
slope of the total cost curves are the same.
• Since the slope of the total revenue curve is the marginal
revenue and the slope of the total cost curve is the
marginal cost, then profit maximization requires that
marginal revenue equals marginal cost, or:
MR = MC
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Finding the Profit Maximizing Output
(cont’d)
• Notice that the rule for finding the profit
maximizing output for a monopoly is the same
as in a competitive market. In both markets, the
rule for profit maximization is:
MR = MC
• Figure 10.5 graphically compares and contrasts
profit maximization in a competitive market and
in a monopoly.
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Finding the Profit Maximizing Output
(cont’d) Figure 10.5
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Profit Maximization: a Monopoly and a
Competitive Firm
• In Figure 10.5, we can see that the
difference in profit maximization for a
monopoly and a competitive firm lies only
in the shape of the total revenue curve. In
a competitive firm, the total revenue curve
is linear. In a monopoly, the total revenue
curve has a much steeper slope.
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Profit Maximization: a Monopoly and a
Competitive Firm (cont’d)
• In Figure 10.5, both the competitive firm
and the monopoly find the profit
maximizing output by equating marginal
revenue with marginal cost.
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The Generic Diagram of a Monopoly
and its Profits
• Figure 10.6 shows the generic diagram of
how to determine profits of a monopoly.
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The Generic Diagram of a Monopoly
and its Profits (cont’d)
Figure 10.6
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The Generic Diagram of a Monopoly
and its Profits (cont’d)
• To determine the profits and the profit
maximizing quantity of a monopoly, we need to
follow these steps, as illustrated in Figure 10.6:
– Step 1. Find the intersection of the marginal revenue
curve and the marginal cost. This is the profit
maximizing rule.
– Step 2. The quantity coordinate of the intersection
between marginal revenue and marginal cost is the
profit maximizing quantity.
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The Generic Diagram of a Monopoly
and its Profits (cont’d)
– Steps 3 and 4. Use the demand curve to find
the profit maximizing price. This is done by
finding the point on the demand curve that
corresponds to the profit maximizing quantity
and finding the price coordinate of that point.
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The Generic Diagram of a Monopoly
and its Profits (cont’d)
– Step 5. Use the average total cost curve to
find the average total cost of production. This
is done by finding the point on the average
total cost curve that corresponds to the profit
maximizing quantity and finding the price ($)
coordinate of that point.
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The Generic Diagram of a Monopoly
and its Profits (cont’d)
– Step 6. The profit earned by the firm is the
rectangle formed with the difference between
price and the average total cost (P-ATC) with
the height and the profit maximizing quantity
as the width. This rectangle is the dark
shaded area in Figure 10.6.
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The Generic Diagram of a Monopoly
and its Profits (cont’d)
• If the ATC is higher than the profit maximizing
price, then the firm is earning negative profits.
This is illustrated in Figure 10.7. The size of the
firm’s losses in Figure 10.7 is represented by the
area of the unshaded hash-marked rectangle.
• Note: As in Chapter 8, earning negative profits
does not automatically imply that the firm should
shut down in the short run.
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Competition, Monopoly and
Deadweight Loss
• Are monopolies harmful to society? One
way to answer that question is to compare
the consumer surplus and producer
surplus in both markets.
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Competition, Monopoly and
Deadweight Loss (cont’d)
• When comparing the market equilibrium in
a monopoly and in a competitive market,
notice that prices are higher and quantities
are lower in a monopoly. This higher price
and lower quantity in a monopoly may
lower the total surplus (consumer +
producer surplus) for society. This is
illustrated in detail in Figure 10.8.
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Competition, Monopoly and
Deadweight Loss (cont’d)
Figure 10.8
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Competition, Monopoly and
Deadweight Loss (cont’d)
• The monopolist’s price increase raises the
producer surplus in the monopoly, at the
expense of a lower consumer surplus for
buyers in the market. This is merely a
transfer of surplus from the consumers to
producers, and is not considered
deadweight loss. The deadweight loss
resulting from a monopoly is illustrated by
the dark shaded triangle in Figure 10.8.
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Marginal Benefit > Marginal Cost
• Since the monopoly is producing below
the competitive equilibrium quantity, the
marginal benefit is greater than the
marginal cost of production. This is
inefficient because increasing production
will result in an improvement in society’s
welfare.
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Marginal Benefit > Marginal Cost (cont’d)
• The size of the inefficiency brought about by
having a monopoly can be measured by the
difference between the price and the marginal
cost. This difference, in turn, is affected by the
elasticity of the demand curve.
• The more inelastic the demand curve, the larger
the difference between the price and the
marginal cost. The more elastic the demand
curve, the smaller the difference between the
price and the marginal cost.
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Marginal Benefit > Marginal Cost (cont’d)
• One index used to measure market power
is the price-cost margin.
• Price cost margin – The difference
between price and the marginal cost,
divided by the price.
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Price Cost Margin
= Price minus marginal cost
Price
=
1
price elasticity of demand
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Price Cost Margin (cont’d)
• If the price cost margin is zero, then the
firm has no market power. The higher the
price cost margin, the greater a firm’s
market power.
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Why Monopolies Exist
Reasons Why Monopolies Exist
1) Natural Monopolies – Economies of
scale (declining average total cost
resulting from increasing output) can
lead to a monopoly. Specifically, if the
minimum efficient scale is larger than
the size of the market, then the market
will likely be serviced by only one firm, a
natural monopoly.
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Why Monopolies Exist (cont’d)
• Natural Monopolies – A single firm in an
industry in which the average total cost is
declining over the entire range of
production and the minimum efficient scale
is larger than the market size.
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Why Monopolies Exist (cont’d)
2) Patents and Copyrights – Grant the
holder of a patent or a copyright the sole
right to produce goods within a specified
time period. Patents are awarded to
inventions, while copyrights are awarded
movies, books, computer software, and
songs.
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Peter Pan and the Great Ormond
Street Hospital Children’s Charity
• Sir J.M. Barrie’s story of Peter Pan and
Neverland has been a part of every
childhood – and many adulthoods too.
Barrie gave the rights to the story to Great
Ormond Street Hospital in 1929. Since
then, the hospital has received royalties
every time a production of the play is put
on, as well as from the sale of Peter Pan
books and other products.
Source: copied from gosh.org
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Peter Pan and the Great Ormond
Street Hospital Children’s Charity (cont’d)
• Although UK copyrights expire 50 years
after an author’s death, Great Ormond
Street has the unique right to royalties
from Peter Pan forever.
• Throughout the European Union, Peter
Pan’s copyright is good until 2007; it
extends until 2023 in the United States.
Source: copied from gosh.org
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Peter Pan and the Great Ormond
Street Hospital Children’s Charity (cont’d)
• Because the European Union’s copyright
of Peter Pan will expire in Europe in 2007,
author Geraldine McCaughrean has been
chosen by the Great Ormond Street
Hospital Children’s Charity (GOSHCC) to
write the authorized sequel to the story.
Copyrights to the story will be shared by
both McCaughrean and the GOSHCC.
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Why Monopolies Exist
Why award patents and copyrights?
• Monopoly rights through patents and
copyrights stimulate innovation by giving
inventors more incentives to devote
resources to invent new products or take a
risk and try new ideas.
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Creating Other Barriers to Entry
•
Barriers to entry allow monopolies to
persist.
Examples of Barriers to Entry:
1) Professional Certification, such as
passing the California Bar Exam
2) Threats of potential entry, where a firm
keeps prices low when a potential
entrant to the market exists.
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Price Discrimination
• Our discussion on monopolies focused on those
that charge a single price to all customers.
However, some monopolies can practice price
discrimination.
• Price Discrimination – A situation in which
different groups of consumers are charged
different prices for the same good (and the
source of the price difference cannot be
differences in the cost of providing the product).
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Price Discrimination (cont’d)
Examples of Price Discrimination
1) Senior citizen discounts at a restaurants
2) Lower airline ticket prices for flights with
Saturday-night stayovers
3) Lower college tuition for students from
low income families
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Why Does Price Discrimination Exist?
Reasons why some firms price discriminate
1) Consumers have different price
elasticities of demand. Figure 10.9 shows
the profit maximizing price for customers
with different price elasticities of demand.
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Why Does Price Discrimination Exist?
(cont’d) Figure 10.9
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Why Does Price Discrimination Exist?
(cont’d)
• The graph on the left side in Figure 10.9
shows the derivation of the profit
maximizing price if customers have a high
elasticity of demand. Notice that the price
is lower than the price derived on the right
graph on Figure 10.9 where the demand
curve is more inelastic.
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Why Does Price Discrimination Exist?
(cont’d)
• Figure 10.9 shows that customers who are
price sensitive (budget vacation travelers,
for example) are charged lower prices as
opposed to customers who are not price
sensitive (business travelers).
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Why Does Price Discrimination Exist?
(cont’d)
•
In order to successfully price discriminate, the
monopoly must be able to identify and separate the
customers with a low elasticity of demand from those
with a high elasticity.
Ways to separate customers
1) Senior citizens show ID before getting a discount at
movie theaters
2) Saturday night stay is required of budget travelers
3) Students need to show parents’ income tax returns as
proof of low income
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Quantity Discounts
•
Another form of price discrimination is by
charging a lower price to those that buy more.
Examples
1) Amtrak offers monthly passes that are cheaper
than if you purchase tickets individually.
2) Buying toothbrushes are cheaper per unit in
warehouse clubs than in convenience stores,
as long as you buy a lot at a time.
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Quantity Discounts (cont’d)
• Figure 10.10 graphically illustrates how
monopolies generate higher revenues if
they price discriminate (the top two
graphs) as opposed to when they do not
(the bottom graph).
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Quantity Discounts (cont’d)
Figure 10.10
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Quantity Discounts (cont’d)
• The graph on the top left corner of Figure 10.10
shows that by charging a higher price to those
who are willing to pay a high price (and buy
less), a firm will generate a higher profit.
• The graph on the top right corner of Figure
10.10 shows that by charging a lower price to
those who are able or willing to buy only at a
lower price, a firm will also generate a higher
profit.
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Quantity Discounts (cont’d)
• The bottom graph on Figure 10.10 shows
the profits of a monopoly that does not
price discriminate.
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Key Points
•
•
•
•
•
•
•
•
Monopoly
Barriers to entry
Market power
Price-maker
Average revenue
Price-cost margin
Natural monopoly
Price discrimination
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