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A Lecture Presentation
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Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0030342333
Copyright © 2002 by Thomson Learning, Inc.
Chapter 10
Monopoly
Copyright © 2002 by Thomson Learning, Inc.
10.1 Monopoly: The Price Maker


A true or pure monopoly exists where
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.
Copyright © 2002 by Thomson Learning, Inc.
10.1 Monopoly: The Price Maker


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) who try to pick the price
that will maximize their profits.
Copyright © 2002 by Thomson Learning, Inc.
10.1 Monopoly: The Price Maker

Pure monopolies are a rarity because
few goods and services truly have only
one producer.
Copyright © 2002 by Thomson Learning, Inc.
10.1 Monopoly: The Price Maker


Near-monopoly conditions may exist,
such as many public utilities, but
absolute total monopoly is rather
unusual.
However, the number of situations
where monopoly conditions are fairly
closely approximated are numerous
enough to make the study of monopoly
useful.
Copyright © 2002 by Thomson Learning, Inc.
10.1 Monopoly: The Price Maker


For a monopoly to persist, it must be
virtually impossible for other firms to
overcome barriers to entry.
Barriers to entry

legal barriers
franchising
 licensing
 patents



economies of scale
control of important inputs
Copyright © 2002 by Thomson Learning, Inc.
10.1 Monopoly: The Price Maker

Natural monopoly



one large firm can provide the output of the
market at a lower cost than two or more
smaller firms
With 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.
Copyright © 2002 by Thomson Learning, Inc.
Cost
Economies of Scale
ATC
QSMALL FIRM
QLARGE FIRM
Quantity of Output
Copyright © 2002 by Thomson Learning, Inc.
10.1 Monopoly: The Price Maker

Another barrier to entry is control over
an important input.


Alcoa's control over bauxite in the 1940s
DeBeers control over much of the world's
output of diamonds
Copyright © 2002 by Thomson Learning, Inc.
10.2 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.
Copyright © 2002 by Thomson Learning, Inc.
10.2 Demand and Marginal Revenue
in Monopoly

Unlike perfect competition, the demand
curve for a monopolist’s product is
downward sloping because the market
demand curve is downward sloping.


If the monopolist reduces output, the price
will rise.
If the monopolist expands output, the price
will fall.
Copyright © 2002 by Thomson Learning, Inc.
D
Price
Price
Comparing Demand Curves: Perfect
Competition Versus Monopoly
D
0
0
Quantity of Output
Copyright © 2002 by Thomson Learning, Inc.
Quantity of Output
Total, Average, and Marginal Revenue
Quantity Price
0
1
2
3
4
5
$6
5
4
3
2
1
Copyright © 2002 by Thomson Learning, Inc.
Total
Revenue
(TR =
P  q)
–
$5
8
9
8
5
Average
Revenue
(AR =
TR/q)
–
$5
4
3
2
1
Marginal
Revenue
(MR =
TR/q)
–
$3
1
–1
–3
10.2 Demand and Marginal Revenue
in Monopoly

The marginal revenue curve for a
monopolist lies below the demand
curve.


In order to get revenue from marginal
customers, the firm has to lower the price.
So marginal revenue is always less than
price.
Copyright © 2002 by Thomson Learning, Inc.
10.2 Demand and Marginal Revenue
in Monopoly

In monopoly, if the seller wants to
expand output, it will have to lower its
price on all units.
Copyright © 2002 by Thomson Learning, Inc.
10.2 Demand and Marginal Revenue
in Monopoly


That means that the monopolist
receives additional revenue from the
new unit sold, but it will receive less
revenue on all of the units it was
previously selling.
So when the monopolist cuts price to
attract new customers, the old
customers benefit.
Copyright © 2002 by Thomson Learning, Inc.
Demand and Marginal Revenue for the
Monopolist
$7
Price
6
5
4
Marginal Revenue
3
Demand
(Average Revenue)
2
1
0
1
2
3
4
5
6
Quantity of Output
Copyright © 2002 by Thomson Learning, Inc.
10.2 Demand and Marginal Revenue
in Monopoly

The relationship between the elasticity
and marginal and total revenue can be
shown graphically.


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.
Copyright © 2002 by Thomson Learning, Inc.
Total Revenue
The Relations Between Elasticity of Demand
and Total and Marginal Revenue
MR = 0
Total
Revenue
$250
MR > 0
Quantity
Price
0
$100
90
80
70
60
50
40
30
20
10
Copyright © 2002 by Thomson Learning, Inc.
0
Elastic
Unit Elastic
Inelastic
Marginal
Revenue
Demand
1 2 3 4 5 6 7 8 9 10
Quantity
10.2 Demand and Marginal Revenue
in Monopoly

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.
Copyright © 2002 by Thomson Learning, Inc.
10.3 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.
Copyright © 2002 by Thomson Learning, Inc.
Price (dollars per unit)
Equilibrium Output and Price for a Pure
Monopolist
MC
P*
Lost total profits from
Producing too little
output; MR < MC
Lost total profits from
Producing too
much output; MC > MR
MR
0
D
Q1 Q* Q2
Quantity of Output
Copyright © 2002 by Thomson Learning, Inc.
10.3 The Monopolist's Equilibrium

The three-step method for determining
economic profits, economic losses, or
zero economic profits



Find where MR equals MC, which is the
profit-maximizing 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
Copyright © 2002 by Thomson Learning, Inc.
10.3 The Monopolist's Equilibrium


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.
Copyright © 2002 by Thomson Learning, Inc.
A Monopolist’s Profits
MC
Price
Total
Profit
A
P*
C
ATC
B
D
0
Q*
MR
Quantity
Copyright © 2002 by Thomson Learning, Inc.
10.3 The Monopolist's Equilibrium

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.
Copyright © 2002 by Thomson Learning, Inc.
10.3 The Monopolist's Equilibrium


In monopoly, profits are not eliminated
because barriers to entry exist.
Other firms cannot enter, so economic
profits can persist in the long run.
Copyright © 2002 by Thomson Learning, Inc.
10.3 The Monopolist's Equilibrium


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.
Copyright © 2002 by Thomson Learning, Inc.
A Monopolist’s Losses
Price
Total
Loss
MC
A
C
P*
B
D
0
Q
MR
Quantity
Copyright © 2002 by Thomson Learning, Inc.
ATC
10.3 The Monopolist's Equilibrium

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.
Copyright © 2002 by Thomson Learning, Inc.
Impact of Patent Protection on Equilibrium
Price and Quantity
Price
PM
MC
PPC
MR
0
QPATENT
QNO PATENT
Quantity
Copyright © 2002 by Thomson Learning, Inc.
D
10.4 The Welfare Costs of a
Monopoly

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
Copyright © 2002 by Thomson Learning, Inc.
10.4 The Welfare Costs of a
Monopoly

Efficiency objection: monopolist 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.
Copyright © 2002 by Thomson Learning, Inc.
Perfect Competition Versus Monopoly
Welfare loss
due to monopoly
Price
MC = S
PM
PPC
MCM
MR
0
Copyright © 2002 by Thomson Learning, Inc.
QM QPC
Quantity
D
10.4 The Welfare Costs of a
Monopoly


The actual amount of the welfare loss in
monopoly is of considerable debate
among economists.
Estimates vary between 0.1 percent to 6
percent of national income.
Copyright © 2002 by Thomson Learning, Inc.
10.4 The Welfare Costs of a
Monopoly

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, and so forth.


The notion that monopoly retards
innovation can be disputed. Many
near-monopolists are important
innovators.
Copyright © 2002 by Thomson Learning, Inc.
10.4 The Welfare Costs of a
Monopoly



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.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy

Three major approaches to dealing with
the monopoly problem:



antitrust policies,
regulation, and
public ownership.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy

By imposing monetary and
nonmonetary costs on monopolists
antitrust policies reduce the profitability
of monopoly.



the fear of lawsuits
even jail sentences
Policies include attempts to keep firms
from getting “too big” and eliminating
restrictions on price competition.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy


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.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy

While the laws have been enforced in
an imperfect fashion, on balance, they
have probably successfully impeded
monopoly influences.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy


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.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy


Regulators often face a basic policy
dilemma.
Without regulation, profit-maximizing
monopolist will produce where MR =
MC.

At that output, the price exceeds average
total cost, so economic profits exist.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy

The monopolist is



producing relatively little output,
charging a relatively high price, and
producing at a point where price is above
marginal cost.
Copyright © 2002 by Thomson Learning, Inc.
Marginal Cost Pricing Versus Average Cost
Pricing
A Monopoly pricing
Price
PM
Average cost pricing
Marginal cost pricing
B
PAC
PMC
ATC
MC
Losses with MC pricing
C
MR
0
QM
QAC QMC
Quantity
Copyright © 2002 by Thomson Learning, Inc.
D
10.5 Monopoly Policy

Socially allocative efficiency


With natural monopoly,


where P = MC.
where P = MC, the ATC > P.
The optimal output, then, is an output
that produces losses for the producer.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy


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.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy


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.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy


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.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy

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).
Copyright © 2002 by Thomson Learning, Inc.
Changes in Average Costs
P1
ATC1
ATC0
P0
0
Q1 Q0
Quantity
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy

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.
Copyright © 2002 by Thomson Learning, Inc.
10.5 Monopoly Policy


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.
Copyright © 2002 by Thomson Learning, Inc.
10.6 Price Discrimination

Price discrimination


when sellers charge different customers
different prices for the same good or
service when the cost does not differ.
is possible only with monopoly or where
members of a small group of firms
(oligopolists, to be considered later) follow
identical pricing policies.
Copyright © 2002 by Thomson Learning, Inc.
10.6 Price Discrimination

When there are a number of competing
firms, discrimination is less likely
because competitors tend to undercut
the high prices charged those
discriminated against.
Copyright © 2002 by Thomson Learning, Inc.
10.6 Price Discrimination

Price discrimination results from the
profit-maximization motive.


Sometimes, different groups of people
have different demand curves, so that they
react differently to price changes.
A producer can make more money by
charging those different buyers different
prices.
Copyright © 2002 by Thomson Learning, Inc.
10.6 Price Discrimination

A profit-maximizing seller will price
where MR = MC for each different group
of demanders, resulting in


a higher price for more inelastic
demanders (such as adult movie-goers)
and
a lower price for more elastic demanders
(such as children).
Copyright © 2002 by Thomson Learning, Inc.
Price Discrimination in Movie Ticket Prices
a. Adults
b. Children
Price
Price
PA
MCC
MCA
MRA
0
PC
DC
MRC
DA
0
QA
Quantity
Copyright © 2002 by Thomson Learning, Inc.
MCC
MCC
QC
Quantity
10.6 Price Discrimination


For price discrimination to work, the
purchaser 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.
Copyright © 2002 by Thomson Learning, Inc.
10.6 Price Discrimination

Price discrimination is usually limited to
services and to some goods where it is
inherently difficult to resell or where the
producer can effectively prevent resale.
Copyright © 2002 by Thomson Learning, Inc.
10.6 Price Discrimination

Quantity discounts are another form of
price discrimination.

The seller charges a higher price for the
first unit than for later units, allowing the
producer to extract some consumer
surplus.
Copyright © 2002 by Thomson Learning, Inc.