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Monopoly
Hall and Lieberman, 3rd edition,
Thomson South-Western, Chapter 9
Overview
 What you will learn in this lecture





What is a monopoly?
Why does a monopoly exist?
How is monopolized optimal output / price
level determined?
How is a monopoly different from a perfect
competitive firm?
What happens when things change?
2
Part I. Monopoly
 Negative reputation of monopoly is in
many ways deserved


Unfairly prices, extraordinary power, etc
This negative characterization goes too far
 Monopolies
should be avoided in many
markets, but in some it may be best to
organize the production
 We do better by managing monopoly problem,
rather than eliminating it
3
What Is A Monopoly?
 A monopoly firm is the only seller of a good or
service with no close substitutes



Monopoly market is the one where the monopoly firm
operates
Key concept is notion of substitutability
Example
 How “close” are the substitutes in the real world?
 Depends on how broadly or how narrowly we define a
market when trying to decide if it is a monopoly
 Example
 the only doctor, attorney or food market in a small
town
4
Figure 1 What A Monopolist Does?
Price
S
M
P2
C
P1
D
Q2
Q1
Quantity
5
What A Monopolist Does?
 Compared with a firm in perfectly
competitive market, a monopolist moves
along the demand curve to produce less
but charge a higher price


To earn higher profit rather than zero profit
The ability of a monopolist to raise its price
above the competitive level by reducing
output is known as market power
 Example
 Why
don’t profit get competed away?
6
The Sources of Monopoly
 Existence of a monopoly means that
something is causing other firms to stay out
of the market
 What barrier prevents additional firms from
entering the market?

Several possible answers
 Economies of scale
 Legal barriers
 Network externalities
7
I. Economies of Scale
 Economies of scale: the higher output, the
lower LRATC or the lower unit cost

Example
 If economies of scale persist to the point
where the monopoly is producing for entire
market, the market is a natural monopoly
 one firm can operate at lower average
cost than can two or more firms
8
Figure 2: A Natural Monopoly from
Economy of Scale
Dollars
Natural monopolist’s
break-even price
M
P
LRATC
DMarket
Relevant output range
Q
Quantity
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I. Economies of Scale
 Why natural monopoly may exist?


Incumbent advantages
Example: dry cleaning in a small town,
Figure 2
 Small local monopolies are often natural
monopolies

Because they continue to enjoy economies
of scale up to point at which they are
serving entire market
10
II. Legal Barriers
 Sometimes public interest is best served by
having a single seller in a market

Purposely creating barriers leading to monopoly
 Many monopolies arise because of legal
barriers including


Protection of intellectual property
Government franchise
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II. Legal Barrier
-- Protection of Intellectual Property
 Most important kinds of legal protection
for intellectual property are

Patents
 Temporary
grant of monopoly rights over a
new product or scientific discovery

Copyrights
 Grant
of exclusive rights to sell a literary,
musical, or artistic work
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II. Legal Barrier
-- Protection of Intellectual Property
 Government strikes a compromise
 Allows creators of intellectual property to enjoy a
monopoly and earn economic profit, but only for
a limited period of time
 Once time is up, other sellers are allowed to
enter the market, and it is hoped that competition
among them will bring down prices
 Free usage if not having purpose of making profit
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II. Legal Barrier
-- Government Franchise
 Large firms we usually think of as
monopolies have their monopoly status
guaranteed through government franchise

Grant of exclusive rights over a product
 Governments usually grant franchises when
they think market is a natural monopoly
 Example?
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III. Network Externalities
 Exist when an increase in network’s
membership increases its value to current and
potential members
 Advantages of joining a large network

more beneficial than joining a small network
 The value to consumers of a good rises as the
number of people who also use the good rises

Example: computer operating systems
 Microsoft Windows
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Monopoly Goals & Constraints
 Goal of a monopoly—Maximize profit
 like that of any firm
 Noncompetitive firms make ONE decision
 Once firm determines its output level, it has also
determined its price
 Constraints


Cost constraint for any level of possible Q
 Technology of production
 Price it must pay for its inputs
Demand constraint
 maximum price monopolist can charge, given Q
16
Demand Constraints and MR
 Monopoly firm faces a downward sloping
demand curve, marginal revenue is less than
price of output


Graphically, marginal revenue curve will lie below
demand curve (figure 3a)
Why?
 By Intuition
 By Mathematics
 Monopoly will always produce at an output level
where marginal revenue is positive
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Figure 3a: Demand and Marginal
Revenue
Monthly $60
Price per
Subscriber 50
48
38
30
A
B
C
F
20
18
G
Demand
5,000
6,000
15,000 20,000
30,000
MR 21,000
Number of Subscribers
18
Figure 3b:Profit Maximization by Monopoly
-- MC curve crosses MR curve from below
Monthly $60
Price per
Subscriber
40
MC
E
D
10,000
30,000
MR
Number of Subscribers
19
Profit And Loss
 A monopoly earns a profit whenever P > ATC

Profit is the shadow area in the Figure 4(a)
 Height equal to P - ATC
 Width equal to level of output
 A monopoly suffers a loss whenever P < ATC

Loss is the shadow area in the Figure 4(b)
 Height equal to ATC - P
 Width equal to level of output
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Figure 4: Monopoly Profit and Loss
(a)
Dollars
MC
(b)
ATC
MC AVC
Dollars
ATC
$50
E
$40
40
32
E
Total Loss
Total
Profit
D
D
10,000
Number of
MR Subscribers
10,000
Number of
MR Subscribers
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Part II. Equilibrium in Monopoly
Markets
 A monopoly market is in equilibrium
when this only firm in market is
maximizing profit
 For monopoly—as for perfect
competition—we have different
expectations about equilibrium in shortrun and equilibrium in long-run
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Short-Run Equilibrium
 Monopoly may earn an economic profit or suffer
an economic loss
 What if a monopoly suffers a loss in short-run?

Any firm should shut down if P < AVC at output
level where MR = MC
 If monopoly suddenly finds that P < AVC,
government will usually not allow it to shut
down,

Instead use tax revenue to make up for firm’s
losses
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Long-Run Equilibrium
 Remember that perfectly competitive
firms earn zero profit in the long-run
equilibrium
 However, monopolies may earn
economic profit in the long-run

May still benefit from economies of scale
 A privately owned monopoly suffering an
economic loss in long-run will exit the
industry
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Part III. Comparing Monopoly to
Perfect Competition
 In perfect competition, economic profit is relentlessly
reduced to zero by entry of other firms
 In monopoly,


economic profit can continue indefinitely
have a higher price and lower output than an
otherwise similar perfectly competitive market
 earns economic profit due to this reason
 Consumers lose in two ways


Pay more for output they buy
Due to higher prices they buy less output
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Figure 5a/b: Comparing Monopoly
and Perfect Competition
(a) Competitive Market
Price
per
Unit
(b) Competitive Firm
Dollars
per
Unit
S
2. and each firm produces
1,000 units, where P = MC.
MC
ATC
E
$10
3. When monopoly $10
takes over, the old
market supply
curve . . .
d
D
100,000
1. In this competitive
market of 100 firms,
equilibrium price is $10
Quantity of
Output
1,000
Quantity of
Output
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Figure 5c: Comparing Monopoly
and Perfect Competition
(c) Monopoly
Price
per
Unit
$15
S = MC
4. becomes the monopoly's MC curve.
F
E
5. The monopoly produces where MR = MC,
10
6. with a higher price and lower market
output than under perfect competition.
MR
100,000
D
Quantity of
Output
60,000
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Figure 5d Comparison of the social loss
between Monopoly and Perfect Competition
Monopolistic
equilibrium
PM
MC
Competitive
equilibrium
PC
Demand
MR
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Comparing Monopoly to Perfect
Competition
Perfect Competition
Monopoly
Firm’s choice
Q
P or Q
Profit
maximization
P = MC
MR=MC
Maximized
Profit
Zero in the long run
Profit / loss in the short run
Technology’s
effect
Still zero profit; usually P
goes down and Q goes up
Profit / loss in short run /
long run with lower Q and
higher P than those in
perfect competitive market
Characteristics Many firms; free entry & exit; Entry barrier; only one firm;
undifferentiated goods
differentiated goods;
Generate higher profits; P
and Q change is not
determined
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Why Monopolies Often Earn Zero
Economic Profit ?
 Government regulation
 Rent-seeking activity

Any costly action a firm undertakes to establish or
maintain its monopoly status



Example: Bribes to government officials in corrupt
bureaucracies
Or time and money spent lobbying legislators and
public for favorable polices in less corrupt
governments
Rent-seeking activity is part of firm’s costs. It can
reduce economic profit of a monopoly, even reduce
it to zero.
30
Part IV. What Happens When
Things Change?
 Once a monopoly is maximizing profit, it
has no incentive to change its price or its
level of output

Unless something that affects these
decisions changes
 Possible events


Change in demand for monopolist’s product
Change in its costs
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I. An Increase in Demand
 Monopolist’s reactions

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Producing more output
Charging a higher price
Earning a larger profit
Figure 6
 It will react to a decrease of demand by
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
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Reducing output
Lowering price
Suffering a reduction in profit
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Figure 6: A Change in Demand
(a)
Monthly
Price per
Subscriber
MC
(b)
Monthly
Price per
Subscriber
$47
40
A
$40
MC
B
A
D1
10,000 MR1 30,000
Number of Subscribers
D1 D2
10,000 MR1
11,000
MR2 Number of
Subscribers
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II. Cost-Saving Technological Advance
 Benefits perspective:

Monopoly’s profits will be higher after adoption

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Only part of benefits are passed to consumers
In perfect competitive market, all of the benefits are
passed to consumers
 Costs perspective:



After its cost increase, monopoly’s profits will be lower
Only part of a cost increase onto consumers in form of a
higher price
In perfect competitive market, all of the costs are passed
to consumers – have to pay higher prices
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Figure 7: Monopoly Profit and Loss
-- Increased Cost
Dollars
MC1
$40
38
E
D
MC2
D
10,000
MR
Number of Subscribers
12,000
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Summary
 Monopoly has market power
 Possible reasons for existence of monopoly:
 Economies
 Legal
barriers
 Network


of scale – natural monopoly
externalities
Standard profit maximization approach (MR =MC)
Profit or loss both in short run and long run
 Rent seeking activity and zero profit
 Increase in demand / technology adoption
effects on monopolist’s decision
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