1. Econ 101: Microeconomics
Chapter 9:
Monopoly

2. Hall & Leiberman; Economics: Principles And Applications, 2004
What Is A Monopoly?
A monopoly firm is the only seller of a good or service with no close substitutes
Market in which the monopoly firm operates is called a monopoly market
Existence of a monopoly means that something is causing other firms to stay out of the market
Rather than enter and compete with firm already there
What barrier prevents additional firms from entering the market?
Several possible answers
Economies of scale
Network externalities
Legal barriers
Hall & Leiberman; Economics: Principles And Applications, 2004

3. 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
Market in which, due to economies of scale, one firm can operate at lower average cost than can two or more firms
Unless government intervenes, only one seller would survive—market would naturally become a monopoly
Small local monopolies are often natural monopolies
Because they continue to enjoy economies of scale up to point at which they are serving entire market
Hall & Leiberman; Economics: Principles And Applications, 2004

4. 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

5. 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
Even if product in larger network is somewhat inferior to product in smaller one
In addition to advantages of joining a larger network
Advantage in not leaving it once you’ve joined
Avoiding switching costs
Hall & Leiberman; Economics: Principles And Applications, 2004

6. Network Externalities
All of this clearly applies to the market for computer operating systems
When you buy a computer already loaded with Microsoft Windows, you benefit
By having a large number of people with whom you can easily share documents
Huge number of computers everywhere you can easily operate
You gain access to many more software programs, like Microsoft Word, Excel, or Outlook, since many more programs are designed for Windows than for the few alternatives
You can save time by just calling knowledgeable friends or coworkers
Rather than attempting to contact technical support
Hall & Leiberman; Economics: Principles And Applications, 2004

7. Hall & Leiberman; Economics: Principles And Applications, 2004
Legal Barriers
Sometimes public interest is best served by having a single seller in a market
Many monopolies arise because of legal barriers including
Protection of intellectual property
Government franchise
Hall & Leiberman; Economics: Principles And Applications, 2004

8. Protection of Intellectual Property
The words you are reading right now are an example of intellectual property, which includes literary, artistic and musical works, and scientific inventions
In dealing with intellectual property government strikes a compromise
Allows creators of intellectual property to enjoy a monopoly and earn economic profit, but only for a limited period of time
Once time is up, other sellers are allowed to enter the market, and it is hoped that competition among them will bring down prices
Most important kinds of legal protection for intellectual property are
Patents
Temporary grant of monopoly rights over a new product or scientific discovery
Copyrights
Grant of exclusive rights to sell a literary, musical, or artistic work
Copyrights and patents are often sold to another person or firm, but this does not change monopoly status of the market.
Hall & Leiberman; Economics: Principles And Applications, 2004

9. 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
Grant of exclusive rights over a product
Barrier to entry is
Any other firm that enters the market will be prosecuted
Governments usually grant franchises when they think market is a natural monopoly
Hall & Leiberman; Economics: Principles And Applications, 2004

10. 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
For any level of output it might produce, total cost is determined by
Technology of production
Price it must pay for its inputs
Demand constraint
Monopolist’s demand curve tells us maximum price monopolist can charge to sell any given quantity of output
And for any level of output it might produce, maximum price it can charge is determined by market demand curve for its product
Hall & Leiberman; Economics: Principles And Applications, 2004

11. Monopoly Price or Output Decision
Noncompetitive firms—such as monopolies—do not make two separate decisions about price and quantity, but rather one decision
Once firm determines its output level, it has also determined its price
When any firm—including a monopoly—faces a downward sloping demand curve, marginal revenue is less than price of output
Therefore, marginal revenue curve will lie below demand curve
Monopoly will always produce at an output level where marginal revenue is positive
Hall & Leiberman; Economics: Principles And Applications, 2004

12. 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

13. 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
But different ways of expressing the same decision
Hall & Leiberman; Economics: Principles And Applications, 2004

14. 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

15. Hall & Leiberman; Economics: Principles And Applications, 2004
Profit And Loss
A monopoly earns a profit whenever P > ATC
Its total profit at best output level equals area of a rectangle
Height equal to distance between P and ATC
Width equal to level of output
A monopoly suffers a loss whenever P < ATC
Its total loss at best output level equals area of a rectangle
Height equal to distance between ATC and P
Hall & Leiberman; Economics: Principles And Applications, 2004

16. 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

17. Equilibrium in Monopoly Markets
A monopoly market is in equilibrium when the only firm in market
The monopoly firm is maximizing profit
For monopoly—as for perfect competition—we have different expectations about equilibrium in short-run and equilibrium in long-run
Hall & Leiberman; Economics: Principles And Applications, 2004

18. Short-Run Equilibrium
Monopoly may earn an economic profit or suffer an economic loss
What if a monopoly suffers a loss in short-run?
Any firm should shut down if P < AVC at output level where MR = MC
If monopoly suddenly finds that P < AVC, government will usually not allow it to shut down,
Instead use tax revenue to make up for firm’s losses
Hall & Leiberman; Economics: Principles And Applications, 2004

19. Hall & Leiberman; Economics: Principles And Applications, 2004
Long-Run Equilibrium
Important insights of previous chapter—perfectly competitive firms cannot earn a profit in long-run equilibrium
However, monopolies may earn economic profit in long-run
A privately owned monopoly suffering an economic loss in long-run will exit the industry
Should not find privately owned monopolies suffering economic losses in long-run
Hall & Leiberman; Economics: Principles And Applications, 2004

20. 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

21. Figure 5a/b: 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

22. 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

23. Comparing Monopoly to Perfect Competition
Changeover from perfect competition to monopoly benefits owners of monopoly and harms consumers of the product
In comparing monopoly and perfect competition, price is higher and output is lower under monopoly if all else is equal
General conclusion
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
Ultimate effect on price and quantity depends on relative strengths of two effects
Hall & Leiberman; Economics: Principles And Applications, 2004

24. Why Monopolies Often Earn Zero Economic Profit
Forces tending to cut monopoly profits
Government regulation
Rent-seeking activity
Any costly action a firm undertakes to establish or maintain its monopoly status is called rent-seeking activity
In countries with corrupt bureaucracies, rent-seeking activity includes bribes to government officials
In less corrupt governments, it includes time and money spent lobbying legislators and public for favorable polices
Rent-seeking activity that helps establish or maintain a firm’s monopoly position is part of firm’s costs
As a result, rent-seeking activity can reduce economic profit of a monopoly
May even reduce it to zero
Hall & Leiberman; Economics: Principles And Applications, 2004

25. What Happens When Things Change?
Once a monopoly is maximizing profit, it has no incentive to change its price or its level of output
Unless something that affects these decisions changes
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

26. An Increase in Demand and a Cost-Saving Technological Advance
Monopolist will react to an increase in demand by
Producing more output
Charging a higher price
Earning a larger profit
It will react to a decrease of demand by
Reducing output
Lowering price
Suffering a reduction in 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 higher
In general, a monopoly will pass only part of a cost increase onto consumers in form of a higher price
After its cost increase, monopoly’s profits will be lower
Hall & Leiberman; Economics: Principles And Applications, 2004

27. 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

28. 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

29. Hall & Leiberman; Economics: Principles And Applications, 2004
Price Discrimination
Single-price monopoly
Firm that is limited to charging same price for each unit of output sold
Price discrimination occurs when a firm charges different prices to different customers for reasons other than differences in costs
Price-discriminating monopoly does not discriminate based on prejudice, stereotypes, or ill-will toward any person or group
Rather, it divides its customers into different categories based on their willingness to pay for good
Hall & Leiberman; Economics: Principles And Applications, 2004

30. Requirements for Price Discrimination
Although every firm would like to practice price discrimination, not all of them can
To successfully price discriminate, three conditions must be satisfied
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

31. 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

32. 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

33. 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

34. 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 40
Hall & Leiberman; Economics: Principles And Applications, 2004

35. 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
When price discrimination lowers price for some consumers below what they would pay under a single-price policy, it benefits consumers as well as firm
Hall & Leiberman; Economics: Principles And Applications, 2004

36. 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

37. 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

38. Hall & Leiberman; Economics: Principles And Applications, 2004
Using the Theory
Movie tickets
Have local monopoly power
Lower price for children, students and senior citizens than for other patrons.
Raise profit by price discrimination
Airline prices
Seats sold at many different prices
Lower prices for round-trip if the traveler stays over a Saturday night. Why?
Helps to separate business traveler from personal traveler
Business traveler has higher willingness to pay and most likely does not want to stay over a Saturday night
Financial aid
Many colleges and universities give financial aid to students.
Wealthy students have higher willingness to pay than needy students.
By charging higher tuition and selectively offering financial aid schools charge prices to customers based on the value they place on going to school.
Financial aid has been used as an effective method of price discrimination
Designed to increase revenue of the college
Hall & Leiberman; Economics: Principles And Applications, 2004