What Is A Monopoly? A monopoly firm is the only seller of a good or service with no close substitutes Key concept is notion of substitutability Hall & Leiberman; Economics: Principles And Applications, 2004

The Sources of Monopoly Existence of a monopoly means that something is causing other firms to stay out of the market What barrier prevents additional firms from entering the market? Several possible answers Economies of scale Legal barriers Network externalities Hall & Leiberman; Economics: Principles And Applications, 2004

Economies of Scale If economies of scale persist to the point where a single firm is producing for entire market, the market is a natural monopoly Unless government intervenes, only one seller would survive—market would naturally become a monopoly Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 1: A Natural Monopoly Pieces of Clothing per Week Dollars A 15 B 12 LRATC C 5 DMarket 300 350 Hall & Leiberman; Economics: Principles And Applications, 2004

Legal Barriers Many monopolies arise because of legal barriers including Protection of intellectual property Government franchise Hall & Leiberman; Economics: Principles And Applications, 2004

Protection of Intellectual Property Most important kinds of legal protection for intellectual property are Patents Copyrights Copyrights and patents are often sold to another person or firm, but this does not change monopoly status of the market, since there is still just one seller Hall & Leiberman; Economics: Principles And Applications, 2004

Government Franchise Large firms we usually think of as monopolies have their monopoly status guaranteed through government franchise Governments usually grant franchises when they think market is a natural monopoly Hall & Leiberman; Economics: Principles And Applications, 2004

Network Externalities Exist when an increase in network’s membership increases its value to current and potential members When network externalities are present, joining a large network is more beneficial than joining a small network Hall & Leiberman; Economics: Principles And Applications, 2004

Monopoly Goals And Constraints Goal of a monopoly—like that of any firm—is to earn highest profit possible However, a monopolist faces constraints Constraint on monopoly’s cost Technology of production Price it must pay for its inputs Demand constraint Hall & Leiberman; Economics: Principles And Applications, 2004

Monopoly Price or Output Decision When any firm—including a monopoly—faces a downward sloping demand curve, marginal revenue is less than price of output Monopoly will always produce at an output level where marginal revenue is positive Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 2: Demand and Marginal Revenue Number of Subscribers Monthly Price per Subscriber $60 50 A B 48 C 38 30 20 F G 18 Demand 5,000 15,000 20,000 30,000 6,000 MR 21,000 Hall & Leiberman; Economics: Principles And Applications, 2004

The Profit-Maximizing Output Level To maximize profit, the firm should produce level of output where MC = MR and MC curve crosses MR curve from below For a monopoly, price and output are not independent decisions Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 3: Monopoly Price and Output Determination Number of Subscribers Monthly Price per Subscriber 40 $60 MC E D 10,000 30,000 MR Hall & Leiberman; Economics: Principles And Applications, 2004

Profit And Loss A monopoly earns a profit whenever P > ATC A monopoly suffers a loss whenever P < ATC Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 4: Monopoly Profit and Loss Dollars (a) Number of Subscribers (b) ATC MC ATC MC AVC $50 E E $40 40 32 Total Loss Total Profit D D 10,000 10,000 MR MR Hall & Leiberman; Economics: Principles And Applications, 2004

Short-Run Equilibrium Monopoly may earn an economic profit or suffer an economic loss What if a monopoly suffers a loss in short-run? If monopoly suddenly finds that P < AVC, government will usually not allow it to shut down Hall & Leiberman; Economics: Principles And Applications, 2004

Long-Run Equilibrium Perfectly competitive firms cannot earn a profit in long-run equilibrium Monopolies may earn economic profit in long-run A privately owned monopoly suffering an economic loss in long-run will exit the industry Hall & Leiberman; Economics: Principles And Applications, 2004

Comparing Monopoly to Perfect Competition In perfect competition, economic profit is relentlessly reduced to zero by entry of other firms In monopoly, economic profit can continue indefinitely But monopoly differs from perfect competition in another way Can expect a monopoly market to have a higher price and lower output than an otherwise similar perfectly competitive market By raising price and restricting output, new monopoly earns economic profit Consumers lose in two ways Pay more for output they buy Due to higher prices they buy less output Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 5a/a: Comparing Monopoly and Perfect Competition Quantity of Output Price per Unit (a) Competitive Market (b) Competitive Firm Dollars per Unit 2. and each firm produces 1,000 units, where P = MC. S MC ATC E $10 3. When monopoly takes over, the old market supply curve . . . $10 d D 100,000 1,000 1. In this competitive market of 100 firms, equilibrium price is $10 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 5c: Comparing Monopoly and Perfect Competition (c) Monopoly Price per Unit S = MC 4. becomes the monopoly's MC curve. F $15 E 5. The monopoly produces where MR = MC, 10 6. with a higher price and lower market output than under perfect competition. MR D Quantity of Output 100,000 60,000 Hall & Leiberman; Economics: Principles And Applications, 2004

Comparing Monopoly to Perfect Competition Changeover from perfect competition to monopoly benefits owners of monopoly and harms consumers of the product if all else is equal Monopolization of a competitive industry leads to two opposing effects For any given technology of production, monopolization leads to higher prices and lower output Changes in technology of production made possible under monopoly may lead to lower prices and higher output Hall & Leiberman; Economics: Principles And Applications, 2004

What Happens When Things Change? Possible events Change in demand for monopolist’s product Change in its costs What might cause a monopolist to experience a shift in demand? Possible causes are the same as for perfect competition Hall & Leiberman; Economics: Principles And Applications, 2004

An Increase in Demand and a Cost-Saving Technological Advance Monopolist will react to an increase in demand by Producing _____ output Charging a _____ price Earning a _______ profit In general, monopoly will pass to consumers only part of benefits from a cost-saving technological change After change in technology, monopoly’s profits will be _______ Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 6: A Change in Demand Number of Subscribers Monthly Price per Subscriber A D1 MR1 (b) 10,000 40 MC Monthly Price per Subscriber Number of Subscribers MC B A $47 $40 D1 D2 10,000 MR1 30,000 MR2 11,000 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 7: Monopoly Profit and Loss Number of Subscribers Dollars E D MR 10,000 12,000 $40 MC2 MC1 38 Hall & Leiberman; Economics: Principles And Applications, 2004

Price Discrimination Price discrimination occurs when a firm charges different prices to different customers for reasons other than differences in costs Price-discriminating monopoly it divides its customers into different categories based on their willingness to pay for good Hall & Leiberman; Economics: Principles And Applications, 2004

Requirements for Price Discrimination Must be a downward-sloping demand curve for the firm’s output Firm must be able to identify consumers willing to pay more Firm must be able to prevent low-price customers from reselling to high-price customers Hall & Leiberman; Economics: Principles And Applications, 2004

Price Discrimination That Harms Consumers Price discrimination always benefits owners of a firm Can use this ability to increase its profit When price discrimination raises price for some consumer above price they would pay under a single-price policy it harms consumers Additional profit for the firm is equal to monetary loss of consumers Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 8a: Price Discrimination Number of Round-trip Tickets Dollars per Ticket MC E ATC $120 80 MR D 30 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 8b: Price Discrimination Dollars per Ticket Additional profit from price discrimination MC $160 120 MR D Number of Round-trip Tickets 10 30 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 8c: Price Discrimination Dollars per Ticket MC Additional profit from price discrimination $120 F G 100 H MR D Number of Round-trip Tickets 30 30 Hall & Leiberman; Economics: Principles And Applications, 2004

Price Discrimination That Benefits Consumers Price discrimination benefits monopoly at the same time it benefits a group of consumers Since no one’s price is raised, no one is harmed by this policy Hall & Leiberman; Economics: Principles And Applications, 2004

Perfect Price Discrimination Suppose a firm could somehow find out maximum price customers would be willing to pay for each unit of output it sells It could increase profits even further by practicing perfect price discrimination Firm charges each customer the most the customer would be willing to pay for each unit he or she buys Increases profit at expense of consumers Perfect price discrimination is very difficult to practice in the real world Would require firm to read its customers’ minds Marginal revenue is equal to price of additional unit sold Firm’s MR curve is same as its demand curve Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 9: Perfect Price Discrimination Number of Dolls per Day Dollars per Doll E 20 $30 25 10 30 60 J B MC = ATC H D MR MR curve before price discrimination Hall & Leiberman; Economics: Principles And Applications, 2004