MONOPOLY

1
 Monopoly

• A monopoly is a single supplier to a

market
• This firm may choose to produce at any
point on the market demand curve

2
 Barriers to Entry
• The reason a monopoly exists is that
other firms find it unprofitable or
impossible to enter the market
• Barriers to entry are the source of all
monopoly power
– there are two general types of barriers to
entry
• technical barriers
• legal barriers
3
 Technical Barriers to Entry
• The production of a good may exhibit
decreasing marginal and average costs
over a wide range of output levels
– in this situation, relatively large-scale firms
are low-cost producers
• firms may find it profitable to drive others out of
the industry by cutting prices
• this situation is known as natural monopoly
• once the monopoly is established, entry of new
firms will be difficult
4
 Technical Barriers to Entry
• Another technical basis of monopoly is
special knowledge of a low-cost
productive technique
– it may be difficult to keep this knowledge
out of the hands of other firms
• Ownership of unique resources may
also be a lasting basis for maintaining a
monopoly
5
 Legal Barriers to Entry
• Many pure monopolies are created as a
matter of law
– with a patent, the basic technology for a
product is assigned to one firm
– the government may also award a firm an
exclusive franchise to serve a market

6
Creation of Barriers to Entry
• Some barriers to entry result from actions
taken by the firm
– research and development of new products
or technologies
– purchase of unique resources
– lobbying efforts to gain monopoly power
• The attempt by a monopolist to erect
barriers to entry may involve real
resource costs
7
 Profit Maximization
• To maximize profits, a monopolist will
choose to produce that output level for
which marginal revenue is equal to
marginal cost
– marginal revenue is less than price because
the monopolist faces a downward-sloping
demand curve
• he must lower its price on all units to be sold if it
is to generate the extra demand for this unit
8
 Profit Maximization
• Since MR = MC at the profit-maximizing
output and P > MR for a monopolist, the
monopolist will set a price greater than
marginal cost

9
 Profit Maximization
Price MC The monopolist will maximize
profits where MR = MC

P*
AC
The firm will charge a price
of P*
C

Profits can be found in

the shaded rectangle
D
MR
Quantity
Q*

10
 The Inverse Elasticity Rule
• The gap between a firm’s price and its
marginal cost is inversely related to the
price elasticity of demand facing the firm

P  MC 1

P eQ,P

where eQ,P is the elasticity of demand for

the entire market
11
 The Inverse Elasticity Rule
• Two general conclusions about monopoly
pricing can be drawn:
– a monopoly will choose to operate only in
regions where the market demand curve is
elastic
• eQ,P < -1
– the firm’s “markup” over marginal cost
depends inversely on the elasticity of market
demand
12
 Monopoly Profits
• Monopoly profits will be positive as long
as P > AC
• Monopoly profits can continue into the
long run because entry is not possible
– some economists refer to the profits that a
monopoly earns in the long run as
monopoly rents
• the return to the factor that forms the basis of
the monopoly
13
 Monopoly Profits
• The size of monopoly profits in the long
run will depend on the relationship
between average costs and market
demand for the product

14
 Monopoly Profits
Price Price
MC MC
AC

AC
P* P*=AC

D D
MR MR

Q* Quantity Q* Quantity

Positive profits Zero profit

15
No Monopoly Supply Curve
• With a fixed market demand curve, the
supply “curve” for a monopolist will only
be one point
– the price-output combination where MR =
MC
• If the demand curve shifts, the marginal
revenue curve shifts and a new profit-
maximizing output will be chosen
16
Monopoly with Linear Demand
• Suppose that the market for frisbees
has a linear demand curve of the form
Q = 2,000 - 20P
or
P = 100 - Q/20
• The total costs of the frisbee producer
are given by
C(Q) = 0.05Q2 + 10,000
17
Monopoly with Linear Demand
• To maximize profits, the monopolist
chooses the output for which MR = MC
• We need to find total revenue
TR = PQ = 100Q - Q2/20
• Therefore, marginal revenue is
MR = 100 - Q/10
while marginal cost is
MC = 0.01Q
18
Monopoly with Linear Demand
• Thus, MR = MC where
100 - Q/10 = 0.01Q
Q* = 500 P* = 75
• At the profit-maximizing output,
C(Q) = 0.05(500)2 + 10,000 = 22,500
AC = 22,500/500 = 45
 = (P* - AC)Q = (75 - 45)500 = 15,000

19
Monopoly with Linear Demand
• To see that the inverse elasticity rule
holds, we can calculate the elasticity of
demand at the monopoly’s profit-
maximizing level of output

Q P  75 
eQ,P    20   3
P Q  500 

20
Monopoly with Linear Demand
• The inverse elasticity rule specifies that
P  MC 1 1
 
P eQ,P 3

• Since P* = 75 and MC = 50, this

relationship holds

21
 Monopoly and Resource
Allocation
• To evaluate the allocational effect of a
monopoly, we will use a perfectly
competitive, constant-cost industry as a
basis of comparison
– the industry’s long-run supply curve is
infinitely elastic with a price equal to both
marginal and average cost

22
 Monopoly and Resource
Allocation
Price
If this market was competitive, output would
be Q* and price would be P*

Under a monopoly, output would be Q**

P**
and price would rise to P**

P* MC=AC

D
MR

Q** Q* Quantity
23
 Monopoly and Resource
Allocation
Price Consumer surplus would fall

Producer surplus will rise

P** Consumer surplus falls by more
than producer surplus rises.
P* MC=AC
There is a deadweight
loss from monopoly
D
MR

Q** Q* Quantity
24
 Price Discrimination
• A monopoly engages in price discrimination if
it is able to sell otherwise identical units of
output at different prices
• Whether a price discrimination strategy is
feasible depends on the inability of buyers to
practice arbitrage
– profit-seeking middlemen will destroy any
discriminatory pricing scheme if possible
• price discrimination becomes possible if resale is costly

25
Perfect Price Discrimination
• If each buyer can be separately
identified by the monopolist, it may be
possible to charge each buyer the
maximum price he would be willing to
pay for the good
– perfect or first-degree price discrimination
• extracts all consumer surplus
• no deadweight loss

26
 Perfect Price Discrimination
Under perfect price discrimination, the monopolist
Price charges a different price to each buyer
The first buyer pays P1 for Q1 units
P1
P2 The second buyer pays P2 for Q2-Q1 units

MC
The monopolist will
continue this way until the
marginal buyer is no
D longer willing to pay the
good’s marginal cost
Quantity
Q1 Q2
27
Perfect Price Discrimination
• Recall the example of the frisbee
manufacturer
• If this monopolist wishes to practice
perfect price discrimination, he will want
to produce the quantity for which the
marginal buyer pays a price exactly
equal to the marginal cost

28
Perfect Price Discrimination
• Therefore,
P = 100 - Q/20 = MC = 0.1Q
Q* = 666
• Total revenue and total costs will be
666
2
Q* Q
R P (Q )dQ  100Q   55,511
0 40 0

c (Q )  0.05Q 2  10,000  32,178

• Profit is much larger (23,333 > 15,000) 29
 Third-Degree Price
Discrimination
• Suppose that the demand curves in two
separated markets are given by
Q1 = 24 – P1
Q2 = 24 – 2P2
• Suppose that MC = 6
• Profit maximization requires that
MR1 = 24 – 2Q1 = 6 = MR2 = 12 – Q2
30
 Third-Degree Price
Discrimination
• Optimal choices and prices are
Q1 = 9 P1 = 15
Q2 = 6 P2 = 9
• Profits for the monopoly are
 = (P1 - 6)Q1 + (P2 - 6)Q2 = 81 + 18 = 99

31
 Third-Degree Price
Discrimination
• The allocational impact of this policy can be
evaluated by calculating the deadweight
losses in the two markets
– the competitive output would be 18 in market 1
and 12 in market 2
DW1 = 0.5(P1-MC)(18-Q1) = 0.5(15-6)(18-9) = 40.5

DW2 = 0.5(P2-MC)(12-Q2) = 0.5(9-6)(12-6) = 9

32
 Third-Degree Price
Discrimination
• If this monopoly was to pursue a single-
price policy, it would use the demand
function
Q = Q1 + Q2 = 48 – 3P
• So marginal revenue would be
MR = 16 – 2Q/3
• Profit-maximization occurs where
Q = 15 P = 11 33