CHAPTER

15

Monopoly

Economics
PRINCIPLES OF

N. Gregory Mankiw

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Outline:

1. Monopoly market power

2. Monopoly profit maximization
3. Inefficiency of monopolies
4. Price discrimination

1
 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.

MONOPOLY 2
 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
need electricity Cost 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
MONOPOLY 4
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

MONOPOLY 5
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

MONOPOLY 6
Table 1
A monopoly’s total, average, and marginal revenue

Quantity of water Price Total revenue Average revenue Marginal revenue

(Q) (P) (TR=P ˣ Q) (AR=TR/Q) (MR=ΔTR/ΔQ)
0 gallons $11 $0 -
$10
1 10 10 $10
8
2 9 18 9
6
3 8 24 8
4
4 7 28 7
2
5 6 30 6
0
6 5 30 5
-2
7 4 28 4
-4
8 3 24 3

7
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?
8
 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
MONOPOLY 9
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 (e.g., when Common
Grounds increases Q from 5 to 6).

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Outline:

1. Monopoly market power

2. Monopoly profit maximization
3. Inefficiency of monopolies
4. Price discrimination

11
 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.

MONOPOLY 12
 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
MONOPOLY 13
 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

MONOPOLY 14
 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.
MONOPOLY 15
 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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Outline:

1. Monopoly market power

2. Monopoly profit maximization
3. Inefficiency of monopolies
4. Price discrimination

17
 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.

MONOPOLY 18
 The Welfare Cost of Monopoly
Competitive eq’m:
Price Deadweight
quantity = QC loss MC
P = MC
total surplus is P
maximized P = MC
MC
Monopoly eq’m:
quantity = QM D
P > MC MR
deadweight loss
Q M QC Quantity

MONOPOLY 19
Outline:

1. Monopoly market power

2. Monopoly profit maximization
3. Inefficiency of monopolies
4. Price discrimination

20
 Price Discrimination
▪ Discrimination: treating people differently based
on some characteristic, e.g. race or gender.
▪ Price discrimination: 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.

MONOPOLY 21
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist Consumer
charges the same Price
surplus
price (PM) to all
Deadweight
buyers. PM loss
A deadweight loss
results. MC
Monopoly
profit D
MR

QM Quantity

MONOPOLY 22
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
produces the Price
competitive quantity, Monopoly
profit
but charges each
buyer his or her WTP.
This is called perfect
MC
price discrimination.
D
The monopolist
captures all CS MR
as profit.
Quantity
But there’s no DWL. Q
MONOPOLY 23
 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

Airline prices

MONOPOLY 25
 Examples of Price Discrimination
Discount coupons

Need-based financial aid

MONOPOLY 26
 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.

MONOPOLY 27
 Public Policy Toward Monopolies
▪ Increasing competition with antitrust laws
▪ Ban some anticompetitive practices,
allow govt to break up monopolies.
▪ E.g., Sherman Antitrust Act (1890),
Clayton Act (1914)
▪ 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.

MONOPOLY 28
 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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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

MONOPOLY 30
Table 2
Competition versus monopoly: A summary comparison
Competition Monopoly
Similarities
Goal of firms Maximize profits Maximize profits
Rule for maximizing MR=MC MR=MC
Can earn economic profits
in short run? Yes Yes

Differences
Number of firms Many One
Marginal revenue MR=P MR<P
Price P=MC P>MC
Produces welfare-maximizing
level of output? Yes No
Entry in long run? Yes No
Can earn economic profits
in long run? No Yes
Price discrimination possible? No Yes

31
 What we did?
✓ Learn why some markets have only one seller
✓ Analyze how a monopoly determines the quantity to
produce and the price to charge → Graph a monopolist’s
cost curves and the demand curve to find profit
✓ See how the monopoly’s decisions affect economic well-
being → deadweight loss
✓ See why monopolies try to charge different prices to
different customers (price discrimination → raise economic
welfare)
✓ Consider the various public policies aimed at solving the
problem of monopoly

MONOPOLY 32