Chapter 15: Monopoly

Objectives
• 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?
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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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 ATC than could several firms.

Example: 1000 homes

need electricity. Cost Electricity
Economies of
ATC is lower if scale due to
one firm services huge FC
all 1000 homes $80
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.
but the demand curve A competitive firm’s
for any individual firm’s demand curve
P
product is horizontal
at the market price.
The firm can increase Q
without lowering P, D
so MR = P for the
competitive firm.

Q
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 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
the firm must reduce P. P
Thus, MR ≠ P.

D
Q
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ACTIVE LEARNING 1:
A monopoly’s revenue
Moonbucks is
the only seller of Q P TR AR MR
cappuccinos in town.
0 $4.50 n.a.
The table shows the
market demand for 1 4.00
cappuccinos. 2 3.50
Fill in the missing
spaces of the table. 3 3.00

What is the relation 4 2.50

between P and AR?
5 2.00
Between P and MR?
6 1.50

8
ACTIVE LEARNING 1:
Answers

Q P TR AR MR
Here, P = AR,
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
for a competitive firm. 2
3 3.00 9 3.00
1
4 2.50 10 2.50
0
5 2.00 10 2.00
–1
6 1.50 9 1.50

9
Moonbuck’s D and MR Curves
P, MR
$5
4
Demand curve (P)
3
2
1
0
-1 MR
-2
-3
0 1 2 3 4 5 6 7 Q

CHAPTER 15 MONOPOLY
 Understanding the Monopolist’s MR
• Increasing Q has two effects on revenue:
• The output effect:
More output is sold, which raises revenue
• The price effect:
The price falls, which lowers 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
(e.g., when Moonbucks increases Q from 5 to 6).

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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.

CHAPTER 15 MONOPOLY
Profit-Maximization
Costs and
1. The profit- Revenue MC
maximizing Q
is where P
MR = MC.
2. Find P from
the demand curve
D
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
competitive firm, ATC
ATC
the monopolist’s
profit equals
D
(P – ATC) x Q
MR

Q Quantity

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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;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.

So there is no supply curve for monopoly.

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Case Study: Monopoly vs. Generic Drugs
Patents on new drugs give The market for
a temporary monopoly to Price a typical drug
the seller.
When the PM
patent expires,
the market
becomes competitive, PC = MC
generics appear. D
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 = QE
loss MC
P = MC
total surplus is P
maximized P = MC

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

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 Public Policy Toward Monopolies
• Increasing competition with antitrust laws
• Examples: Sherman Antitrust Act (1890), Clayton Act
(1914)
• Antitrust laws ban certain anticompetitive practices, allow
govt to break up monopolies.
• Regulation
• Govt agencies set the monopolist’s price
• For natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
• If so, regulators might subsidize the monopolist or set P =
ATC for zero economic profit.

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 Public Policy Toward Monopolies
• Public ownership
• Example: U.S. Postal Service
• Problem: Public ownership is usually less efficient since no
profit motive to minimize costs
• Doing nothing
• The foregoing policies all have drawbacks,
so the best policy may be no policy.

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Price Discrimination
• Discrimination is the practice of treating people differently based on
some characteristic, such as race or gender.
• Price discrimination is the business practice of selling the same good
at different prices to different buyers.
• The characteristic used in price discrimination
is willingness to pay (WTP):
• A firm can increase profit by charging a higher price to buyers with higher
WTP.

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 Perfect Price Discrimination vs.
Single Price Monopoly

Here, the monopolist Consumer

charges the same price Price
surplus
(PM) to all buyers.
Deadweight
A deadweight loss
results. PM loss

MC
Monopoly
profit D
MR

QM Quantity

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 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
produces the Price
competitive quantity, but Monopoly
charges each buyer his or profit
her WTP.
This is called perfect
price discrimination.
MC
The monopolist captures
all CS D
as profit. MR
But there’s no DWL.
Quantity
Q
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Price Discrimination in the Real World

• In the real world, perfect price discrimination is not possible:

• no firm knows every buyer’s WTP
• buyers do not announce it to sellers
• So, firms divide customers into groups
based on some observable trait
that is likely related to WTP, such as age.

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Examples of Price Discrimination
Movie tickets
Discounts for seniors, students, and people
who can attend during weekday afternoons.
They are all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices
Discounts for Saturday-night stayovers help distinguish business
travelers, who usually have higher WTP, from more price-sensitive
leisure travelers.

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Examples of Price Discrimination
Discount coupons
People who have time to clip and organize coupons are more likely to
have lower income and lower WTP than others.
Need-based financial aid
Low income families have lower WTP for
their children’s college education.
Schools price-discriminate by offering
need-based aid to low income families.

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Examples of Price Discrimination
Quantity discounts
A buyer’s WTP often declines with additional units, so firms charge
less per unit for large quantities than small ones.
Example: A movie theater charges $4 for
a small popcorn and $5 for a large one that’s twice as big.

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 CONCLUSION: The Prevalence of Monopoly

• In the real world, pure monopoly is rare.

• Yet, many firms have market power, due to
• selling a unique variety of a product
• having a large market share and few significant competitors
• In many such cases, most of the results from this chapter apply,
including
• markup of price over marginal cost
• deadweight loss

CHAPTER 15 MONOPOLY