In this lecture,

look for the answers to these questions

• Why do monopolies arise?

• Why is MR < P for a monopolist?
• How do monopolies choose their P and Q?
• How do monopolies affect society’s well-being?
• What can the government do about monopolies?
• What is price discrimination?

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 Introduction
▪ A monopoly is a firm that is the sole seller of a
product without close substitutes.
▪ In this chapter, we study monopoly and contrast
it with perfect competition.
▪ The key difference:
A monopoly firm has market power, the ability
to influence the market price of the product it
sells. A competitive firm has no market power.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Why Monopolies Arise
The main cause of monopolies is barriers
to entry—other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws

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 Why Monopolies Arise
3. Natural monopoly: a single firm can produce
the entire market Q at lower cost than could
several firms.
Example: 1000 homes
Cost Electricity
need electricity
ATC slopes
ATC is lower if downward due
one firm services to huge FC and
all 1000 homes $80 small MC
than if two firms $50 ATC
each service
Q
500 homes. 500 1000
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 Monopoly vs. Competition: Demand Curves
In a competitive market,
the market demand curve
slopes downward.
A competitive firm’s
But the demand curve demand curve
for any individual firm’s P
product is horizontal
at the market price.
The firm can increase Q D
without lowering P,
so MR = P for the
competitive firm. Q

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Monopoly vs. Competition: Demand Curves

A monopolist is the only

seller, so it faces the
market demand curve.
A monopolist’s
To sell a larger Q, demand curve
P
the firm must reduce P.
Thus, MR ≠ P.

D
Q

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 ACTIVE LEARNING 1
A monopoly’s revenue
Common Grounds
is the only seller of Q P TR AR MR
cappuccinos in town. 0 $4.50 n.a.
The table shows the 1 4.00
market demand for
2 3.50
cappuccinos.
Fill in the missing 3 3.00
spaces of the table. 4 2.50
What is the relation 5 2.00
between P and AR?
6 1.50
Between P and MR?
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 1
Answers

Here, P = AR, Q P TR AR MR
same as for a 0 $4.50 $0 n.a.
competitive firm. $4
1 4.00 4 $4.00
Here, MR < P, 3
whereas MR = P 2 3.50 7 3.50
2
for a competitive 3 3.00 9 3.00
firm. 1
4 2.50 10 2.50
0
5 2.00 10 2.00
–1
6 1.50 9 1.50

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 Common Grounds’ D and MR Curves
P, MR
$5
Q P MR
4
0 $4.50 Demand curve (P)
$4 3
1 4.00 2
3
2 3.50 1
2 0
3 3.00
1 -1 MR
4 2.50
0 -2
5 2.00 -3
–1 0 1 2 3 4 5 6 7 Q
6 1.50
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Understanding the Monopolist’s MR
▪ Increasing Q has two effects on revenue:
▪ Output effect: higher output raises revenue
▪ Price effect: lower price reduces revenue
▪ To sell a larger Q, the monopolist must reduce
the price on all the units it sells.
▪ Hence, MR < P
▪ MR could even be negative if the price effect
exceeds the output effect

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Profit-Maximization
▪ Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR = MC.
▪ Once the monopolist identifies this quantity,
it sets the highest price consumers are willing to
pay for that quantity.
▪ It finds this price from the D curve.

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 Profit-Maximization

Costs and
1. The profit- Revenue MC
maximizing Q
is where P
MR = MC.
2. Find P from
the demand D
curve at this Q. MR

Q Quantity

Profit-maximizing output
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 The Monopolist’s Profit

Costs and
Revenue MC

As with a P
ATC
competitive firm, ATC
the monopolist’s
profit equals D
(P – ATC) x Q MR

Q Quantity

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 A Monopoly Does Not Have an S Curve
A competitive firm
▪ takes P as given
▪ has a supply curve that shows how its Q depends
on P.
A monopoly firm
▪ is a “price-maker,” not a “price-taker”
▪ Q does not depend on P;
Q and P are jointly determined by
MC, MR, and the demand curve.
Hence, no supply curve for monopoly.
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 CASE STUDY: Monopoly vs. Generic Drugs

Patents on new drugs The market for

Price a typical drug
give a temporary
monopoly to the seller.
PM
When the
patent expires,
the market PC = MC
becomes competitive, D
generics appear.
MR

QM Quantity
QC

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 The Welfare Cost of Monopoly
▪ Recall: In a competitive market equilibrium,
P = MC and total surplus is maximized.
▪ In the monopoly eq’m, P > MR = MC
▪ The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to
produce that unit (MC).
▪ The monopoly Q is too low –
could increase total surplus with a larger Q.
▪ Thus, monopoly results in a deadweight loss.

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 The Welfare Cost of Monopoly
Competitive eq’m:
Price Deadweight
quantity = QC loss MC
P = MC
total surplus is P
maximized P = MC

Monopoly eq’m: MC
quantity = QM D
P > MC MR
deadweight loss
QM QC Quantity

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.