1. Market Power: Monopoly
Chapter 10
Market Power:
Monopoly 1

2. Topics to be Discussed Monopoly Monopoly Power
Sources of Monopoly Power
The Social Costs of Monopoly Power
Chapter 10 2

3. Perfect Competition Review of Perfect Competition P = LMC = LRAC
Normal profits or zero economic profits in the long run
Large number of buyers and sellers
Homogenous product
Perfect information
Firm is a price taker
Chapter 10 3

4. Perfect Competition P Market P Individual Firm D S LRAC LMC P0q0
LRAC
LMC Q0 P0
D = MR = P Q Q 3

5. Monopoly Monopoly 1) One seller - many buyers
2) One product (no good substitutes)
3) Barriers to entry
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6. Monopoly
The monopolist is the supply-side of the market and has complete control over the amount offered for sale.
Profits will be maximized at the level of output where marginal revenue equals marginal cost.
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7. Monopoly Finding Marginal Revenue
As the sole producer, the monopolist works with the market demand to determine output and price.
Assume a firm with demand:
P = 6 - Q
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8. Total, Marginal, and Average Revenue
Total Marginal Average
Price Quantity Revenue Revenue Revenue
P Q R MR AR
$6 0 $
5 1 5 $5 $5
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9. Average and Marginal Revenue
$ per
unit of
output 7 6
Marginal
Revenue
Average Revenue (Demand) 5 4 3 2 1 1 2 3 4 5 6 7
Output
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10. Monopoly Observations 1) To increase sales the price must fall
2) MR < P
3) Compared to perfect competition
No change in price to change sales
MR = P
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11. Monopoly Monopolist’s Output Decision
1) Profits maximized at the output level where MR = MC
2) Cost functions are the same
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12. Maximizing Profit When Marginal Revenue Equals Marginal Cost
The Monopolist’s Output Decision
At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC).
At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC)
Chapter 10

13. Maximizing Profit When Marginal Revenue Equals Marginal Cost
$ per
unit of
output
D = AR MR MC AC P1 Q1
Lost
profit P* Q* P2 Q2
Lost
profit
Quantity
Chapter 10

14. The Monopolist’s Output Decision
Monopoly
The Monopolist’s Output Decision
An Example
Chapter 10 3

15. The Monopolist’s Output Decision
Monopoly
The Monopolist’s Output Decision
An Example
Chapter 10 3

16. The Monopolist’s Output Decision
Monopoly
The Monopolist’s Output Decision
An Example
Chapter 10 3

17. The Monopolist’s Output Decision
Monopoly
The Monopolist’s Output Decision
An Example
By setting marginal revenue equal to marginal cost, it can be verified that profit is maximized at P = $30 and Q = 10.
This can be seen graphically:
Chapter 10 3

18. Example of Profit Maximization$ C t t' c c’ R
400
Profits
300
200
150
100 50 5 10 15 20
Quantity
Chapter 10

19. Example of Profit Maximization
Observations
Slope of rr’ = slope cc’ and they are parallel at 10 units
Profits are maximized at 10 units
P = $30, Q = 10, TR = P x Q = $300
AC = $15, Q = 10, TC = AC x Q = 150
Profit = TR - TC
$150 = $300 - $150
Quantity $ 5 10 15 20
100
150
200
300
400 50 R C
Profits t t' c
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20. Example of Profit Maximization
$/Q 40 MC AC AR MR
Profit 30 20 15 10 5 10 15 20
Quantity
Chapter 10

21. Example of Profit Maximization
Observations
AC = $15, Q = 10, TC = AC x Q = 150
Profit = TR = TC = $300 - $150 = $150 or
Profit = (P - AC) x Q = ($30 - $15)(10) = $150
Quantity
$/Q 5 10 15 20 30 40 MC AR MR AC
Profit
Chapter 10

22. Monopoly A Rule of Thumb for Pricing
We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice.
This can be demonstrated using the following steps:
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23. A Rule of Thumb for Pricing
Chapter 10 3

24. A Rule of Thumb for Pricing
Chapter 10 3

25. A Rule of Thumb for Pricing
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26. A Rule of Thumb for Pricing
= the markup over MC as a percentage of price (P-MC)/P
8. The markup should equal the
inverse of the elasticity of demand.
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27. A Rule of Thumb for Pricing
Chapter 10 3

28. Monopoly Monopoly pricing compared to perfect competition pricing:
P > MC
Perfect Competition
P = MC
Chapter 10 3

29. Monopoly Monopoly pricing compared to perfect competition pricing:
The more elastic the demand the closer price is to marginal cost.
If Ed is a large negative number, price is close to marginal cost and vice versa.
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30. Monopoly Power Measuring Monopoly Power
In perfect competition: P = MR = MC
Monopoly power: P > MC
Chapter 10

31. Monopoly Power Lerner’s Index of Monopoly Power L = (P - MC)/P
The larger the value of L (between 0 and 1) the greater the monopoly power.
L is expressed in terms of Ed
L = (P - MC)/P = -1/Ed
Ed is elasticity of demand for a firm, not the market
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32. Monopoly Power Monopoly power does not guarantee profits.
Profit depends on average cost relative to price.
Question:
Can you identify any difficulties in using the Lerner Index (L) for public policy?
Chapter 10

33. Monopoly Power The Rule of Thumb for Pricing
Pricing for any firm with monopoly power
If Ed is large, markup is small
If Ed is small, markup is large
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34. Elasticity of Demand and Price Markup
$/Q
$/Q MC Q* P*
P*-MC
The more elastic is
demand, the less the
markup. AR MR
Quantity
Quantity

35. Sources of Monopoly Power
Why do some firm’s have considerable monopoly power, and others have little or none?
A firm’s monopoly power is determined by the firm’s elasticity of demand.
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36. Sources of Monopoly Power
The firm’s elasticity of demand is determined by:
1) Elasticity of market demand
2) Number of firms
3) The interaction among firms
Chapter 10

37. The Social Costs of Monopoly Power
Monopoly power results in higher prices and lower quantities.
However, does monopoly power make consumers and producers in the aggregate better or worse off?
Chapter 10

38. Deadweight Loss from Monopoly PowerB A
Lost Consumer Surplus
Deadweight
Loss
Because of the higher
price, consumers lose
A+B and producer
gains A-C. C
$/Q AR MR MC Pm Qm QC PC
Quantity
Chapter 10

39. The Social Costs of Monopoly Power
Rent Seeking
Firms may spend to gain monopoly power
Lobbying
Advertising
Building excess capacity
Chapter 10

40. The Social Costs of Monopoly Power
The incentive to engage in monopoly practices is determined by the profit to be gained.
The larger the transfer from consumers to the firm, the larger the social cost of monopoly.
Chapter 10

41. The Social Costs of Monopoly Power
Price Regulation
Recall that in competitive markets, price regulation created a deadweight loss.
Question:
What about a monopoly?
Chapter 10

42. Price Regulation Marginal revenue curve when price is regulatedQ1
Marginal revenue curve
when price is regulated
to be no higher that P1.
$/Q AR MR MC Pm Qm AC
P2 = PC Qc P3 Q3
Q’3
Any price below P4 results
in the firm incurring a loss. P4
For output levels above Q1 ,
the original average and
marginal revenue curves apply.
If price is lowered to PC output
increases to its maximum QC and
there is no deadweight loss.
If left alone, a monopolist
produces Qm and charges Pm.
If price is lowered to P3 output
decreases and a shortage exists.
Quantity
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43. The Social Costs of Monopoly Power
Natural Monopoly
A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms.
Chapter 10

44. Regulating the Price of a Natural Monopoly
$/Q
Natural monopolies occur
because of extensive
economies of scale
Quantity
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45. Regulating the Price of a Natural MonopolyPm Qm
Unregulated, the monopolist
would produce Qm and
charge Pm.
$/Q AR MR PC QC
If the price were regulate to be PC,
the firm would lose money
and go out of business. MC AC
Setting the price at Pr
yields the largest possible
output;excess profit is zero. Qr Pr
Quantity
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46. The Social Costs of Monopoly Power
Regulation in Practice
It is very difficult to estimate the firm's cost and demand functions because they change with evolving market conditions
Chapter 10

47. The Social Costs of Monopoly Power
Regulation in Practice
An alternative pricing technique---rate-of-return regulation allows the firms to set a maximum price based on the expected rate or return that the firm will earn.
P = AVC + (D + T + sK)/Q, where
P = price, AVC = average variable cost
D = depreciation, T = taxes
s = allowed rate of return, K = firm’s capital stock
Chapter 10

48. The Social Costs of Monopoly Power
Regulation in Practice
Using this technique requires hearings to arrive at the respective figures.
The hearing process creates a regulatory lag that may benefit producers (1950s & 60s) or consumers (1970s & 80s).
Question
Who is benefiting in the 1990s?
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49. Limiting Market Power: The Antitrust Laws
Promote a competitive economy
Rules and regulations designed to promote a competitive economy by:
Prohibiting actions that restrain or are likely to restrain competition
Restricting the forms of market structures that are allowable
Chapter 10

50. Limiting Market Power: The Antitrust Laws
Sherman Act (1890)
Section 1
Prohibits contracts, combinations, or conspiracies in restraint of trade
Explicit agreement to restrict output or fix prices
Implicit collusion through parallel conduct
Chapter 10

51. Limiting Market Power: The Antitrust Laws
Sherman Act (1890)
Section 2
Makes it illegal to monopolize or attempt to monopolize a market and prohibits conspiracies that result in monopolization.
Chapter 10

52. Limiting Market Power: The Antitrust Laws
Clayton Act (1914)
1) Makes it unlawful to require a buyer or lessor not to buy from a competitor
2) Prohibits predatory pricing
Chapter 10

53. Limiting Market Power: The Antitrust Laws
Clayton Act (1914)
3) Prohibits mergers and acquisitions if they “substantially lessen competition” or “tend to create a monopoly”
Chapter 10