1. Understanding Monopoly10
Understanding Monopoly
Pre-class music: Urinetown, “It’s a Privilege to Pee” (see Tip #354)
This song, from the musical Urinetown, includes the basics of supply and demand played out, as well as how a monopolist can interfere with the market.

2. How Are Monopolies Created?
A monopoly is a single firm that:
Sells a product without close substitutes
It can prevent entry by new firms.
Monopoly power:
Ability to set the price of a good or service
Barriers to entry:
Restrictions that make it difficult for new firms to enter a market
Lecture tip:
You could point out the difference between a pure monopoly and an effective monopoly, and what it means to have no “close substitutes.”
Microsoft’s monopoly over operating systems is a good example, since it’s power eroded over time due to new substitutes.
Monopoly power is sometimes referred to as market power.
Also, some economists would argue that monopoly power would also include the ability of firms to earn economic profit in the long run.
We will discuss two types of entry barriers:
Natural
Government created

3. Natural Barriers to Entry
Control of resources
Problems raising capital
Economies of scale
Natural monopoly
Lecture notes:
Control of resources:
ALCOA (Aluminum Company of America) came to dominate aluminum since they owned around 90 percent of world’s bauxite mines.
DeBeers controls over 90 percent of the world’s diamond supply.
You could discuss how DeBeers maintained its market power.
Faced with used diamonds as substitutes for new diamonds, DeBeers developed the “Diamonds are Forever” slogan.
Ask students how the reduction of used diamonds and the slogan affected the demand for new diamonds.
Raising capital:
Difficult to compete with an established monopoly that already has a huge amount of capital and equipment
To compete effectively, an entrant would have a difficult time finding a lender willing to lend it sufficient capital
Could also note that entrants would face higher debt costs since they might be perceived as a riskier investment
Economies of scale: Occur when long-run average costs fall as production expands
Text uses the distribution of electricity as example.
With economies of scale, smaller entrants would be at a cost disadvantage compared to larger incumbents.
A natural monopoly exists because a single large firm has lower costs than any potential competitor.
[Nguyen Thai | Dreamstime.com]

4. Government-Created Barriers
Licensing
Exclusive right to sell a good or service
Pros and cons?
Patents and copyright law
Lecture notes:
Licenses:
Pros:
Minimize negative externalities (e.g., medical licenses)
Economies of scale (e.g., one firm can provide the good at a lower cost than multiple firms can)
Cons:
Limit supply so consumers have less choice and pay higher prices
Corruption and bribery to obtain license
Patents:
Create stronger incentives to develop new goods (e.g., new drugs, new music)
Unintended consequences
Justin Bieber was able to use his Internet fame to launch his career without his music being tightly controlled by music studio copyrights.
Length of drug patents can postpone the introduction of generic drugs
When discussing patents and copyright law, specifically file sharing and/or music and movie pirating, ask how many of your students are in favor of the MPAA or RIAAF.
[Taylor Swift: ROBYN BECK/AFP/Getty Images; pills: Michelle Del Guercio/Photo Researchers/Getty Images]

5. The Monopolist’s Pricing and Output Decisions
Perfectly competitive firms
Price takers cannot affect the price
Monopoly
Price maker sets the price by choosing output level
Lecture notes:
What does this say about each firm’s demand curve?

6. Comparing Demand Curves
Image: Animated Figure 10.1
Lecture notes:
First click:
Draws demand curve for competitive firm
Perfectly elastic or horizontal at the market price
Firm can sell all it wants without lowering price
Second click:
Draws demand curve for monopolists
Since only firm, its demand curve is the market demand curve
Because of the law of demand, the higher the price a monopolist charges, the less it sells
Whether the monopolist charges a relatively high price or low price will depend on the elasticity of demand

7. Profit-Maximizing Rule for Monopoly
Profit-maximizing rule for any firm:
MR = MC
Under perfect competition: P = MR
With a monopoly: P > MR
Lecture notes:
Under perfect competition, the firm’s marginal revenue was simply the market price.
Since a monopolist is the only firm in the market, its marginal revenue will depend on what price it decides to charge.

8. Monopoly Marginal Revenue—1
Quantity
of Customers
(Q)
Price
(P)
Total Revenue
(TR) = Q  P
Marginal Revenue per 1,000 Customers
(MR) = ΔTR
$100
$0.00
1,000 90
90,000
$90,000
2,000 80
160,000
70,000
3,000 70
210,000
50,000
4,000 60
240,000
30,000
5,000 50
250,000
10,000
6,000 40
-10,000
7,000 30
-30,000
8,000 20
-50,000
9,000 10
-70,000
0.00
-90,000
Table 10.2, Calculating the Monopolist’s Marginal Revenue
Lecture notes:
Notice the inverse relationship between output (quantity) and price since the monopolist faces a downward-sloping demand curve.
Total revenue is calculated by multiplying output by price: (TR = Q  P).
From P = $100 to P = $50, TR increases.
Then from P = $50 to P = $0, TR decreases.
To get marginal revenue, calculate the change in revenue as the price falls each time.
Go over a few examples with students.
Note the following:
When total revenue is increasing, marginal revenue is positive and gets smaller and smaller; this is indicated by the green numbers.
When total revenue is decreasing, marginal revenue is negative and gets larger and larger (negative); this is indicated by the red numbers.

9. Monopoly Marginal Revenue—2
Why does TR increase and then decrease?
Price effect
All units are now sold at a lower price. By itself, this is a loss for the firm.
Output effect
More units are sold. By itself, this is a gain for the firm.
Lecture notes:
In the most simplistic form, you could tell your students to imagine the following: “I’m a monopoly and have all the market power. Do I want to sell a small amount at very high prices, a lot of output at low prices, or something in between?”
The firm would need to examine the marginal consequences of placing too high or too low of a price.

10. Monopoly MR and Demand Image: Animated Figure 10.2 Lecture notes:
First click:
If the monopoly charges $70, it sells 3,000 units.
Second click:
If the monopoly cuts the price to $60, it sells 4,000 units.
Third click:
Price effect
By cutting the price by $10, the monopolist loses $30,000 in revenue: $10 x 3,000.
Fourth click:
Output effect
But by cutting price, the monopolist sells an additional 1,000 units.
Therefore, it gains $60,000 in revenue.
Putting the price effect and output effect together:
Revenue increases by $30,000.
So when the firm cuts prices from $70 to $60, marginal revenue is $30,000.

11. Deciding How Much to Produce
Image: Animated Figure 10.3
Lecture notes:
A monopolist will maximize profits by producing the output where MR = MC.
First click:
Draws vertical line at Q = 1,000
The monopolist will then set the profit-maximizing price off the demand curve.
At the quantity Q = 1,000, the monopolist charges a price equal to the height of the demand, or equal to the WTP of the consumers at that quantity.
Second click:
Draws horizontal line to P = $50

12. The Monopolist’s Profit—1
Image: Animated Figure 10.3
Lecture notes:
To determine whether the firm is making a profit or a loss, we need the ATC curve.
First click:
Adds ATC curve
At 1,000 units of output, P = $50 > ATC = $35, so the monopolist makes an economic profit.
Second click:
Shades in profit box
The length of the green profit rectangle is the number of units the monopoly sells.
The height of the rectangle is the average profit per unit.
Profit = (number of units sold) * (average profit per unit)
Profit = 1,000 x $15 = $15,000

13. The Monopolist’s Profit—2
Image: Animated Figure 10.3
Lecture notes:
A monopolist is not guaranteed an economic profit.
First click:
Adds ATC curve and shades in loss box
At 1,000 units of output, P = $50 < ATC = $65, so the monopolist makes an economic loss.
Loss = 1,000 x -$15 = -$15,000

14. Contrasting Competition and Monopoly
Competitive Markets
Monopoly
Many firms
One firm
Produces efficient level of output
(since P = MC)
Produces less than the efficient level of output (since P > MC)
Cannot earn long-run economic profits
May earn long-run economic profits
Has no market power
(is a price taker)
Has significant market power
(is a price maker)
Lecture notes:
Point out to students that perfect competition and monopoly are on polar opposite ends of the market structure spectrum.
In reality, we don’t often see perfect competition or pure monopoly.
Most real-world markets lie in between these two market structures.
Later we will discuss:
Monopolistic competition—a large number of firms and no barriers to entry, but products are differentiated
Oligopoly—a small number of large firms, and barriers to entry may exist

15. The Problems with Monopolies—1
Three main problems:
Produce an inefficient level of output and charge an inefficient price
Less choice for consumers
Rent-seeking behavior
Lecture notes:
The word “monopoly” often has a negative connotation. With a bad economy, we often hear people complaining about “greedy companies,” “Wall Street,” “banks,” and so on.
However, these entities are often not monopolies.
Monopolies are often economically inefficient. This comes from the fact that P > MC and that output is restricted compared to competitive markets.

16. Competitive Markets versus Monopoly
Image: Animated Figure 10.4
Lecture notes:
The text uses the fishing industry as an example.
Left diagram: Competitive industry
First click:
In a competitive industry, the intersection of supply and demand determines the price, PC, and quantity, QC.
Each firm is a price taker, taking the market prices as given and maximizing profits where P = MC.
In the long run, firms earn no economic profit since there is free entry.
Firms are efficient and produce output at the lowest point on their ATC curve.
Right diagram: Monopoly
Second click:
Draws demand, marginal revenue, and marginal cost
Note that the MC curve is the monopolist’s supply curve.
Third click:
If the market was competitive, the price would be PC and output QC.
Fourth click:
The monopolist maximizes profit by producing where MR = MC: QM, and sets price off the demand curve, PM.
Comparing the two markets:
Fifth and Sixth clicks:
The monopolist charges a higher price and produces less output than would occur under perfect competition.

17. Deadweight Loss of Monopoly
Image: Animated Figure 10.5
Lecture notes:
First click:
Labels the competitive price and output
Second click:
Labels the monopoly price and output
Welfare effects:
Look at the output between QM and QC.
Societies’ willingness to pay is greater than the marginal cost.
So society would be better off by producing those units.
Third click:
Since a monopoly restricts output, there is a welfare loss (deadweight loss).
Fourth click:
Since PM > PC, there is also a transfer in surplus from the consumer to the producer.
Some may not consider this as a “problem” with monopoly.
The real problem is the DWL.

18. Monopoly versus Competition
Output (quantity)
QMonopoly < Qcompetition
Price
PCompetition < Pmonopoly
Deadweight loss
Monopoly DWL > 0
Competition DWL = 0
Lecture notes:
A monopolist produces less output and charges a higher price than competitive markets do.

19. The Problems with Monopolies—2
Few choices
Cable companies and bundling
Forces you to buy more to get what you want
Rent seeking
Occurs when resources are used to secure monopoly rights through the political process
Rival firms may compete to become a monopolist
Resources used to monopolize rather than become a more competitive firm
Lecture notes:
Choices:
Since a monopoly sells goods with no substitutes, consumers pay higher prices than if there were other choices available.
With bundling you have to buy products (channels) you don’t want to get the products you do.
Rent seeking:
Time, effort, and resources are used in ways that attempt to gain monopoly or keep your existing monopoly.
Rather than spending money on making a better product or improving production, you spend money defending your monopoly.
This is an economically inefficient use of resources in this market.
You may want to discuss the “social cost” of a monopoly.
DWL + value of resources used to seek monopoly position
Possible benefits of monopoly: It may be worthwhile expanding upon this, since the text does not go into too much detail, so spend some time discussing some of the issues.
Analysis so far has assumed that marginal costs under perfect competition and monopoly are the same.
A monopolist may have lower MC and/or can take advantage of economies of scale. It is possible that price ends up being lower and output higher than under perfect competition.
Schumpeter and “creative destruction”
Monopoly power tends to be short-lived since there is another firm that will try to take over the market.
There is always a firm out there that can “build a better mousetrap.”
You could also discuss rent extraction as it relates to rent seeking.

20. Conclusion
Monopolies do not always earn profits. They control supply but not demand.
Competitive markets generally maximize social welfare. Monopolies lead to a welfare loss: dead weight loss.
Government seeks to limit monopoly outcomes and promote competitive markets.
Perfectly competitive markets and monopolies are market structures at opposite extremes.
Lecture notes:
We can think of perfect competition (PC) and pure monopoly in the theoretical sense because they are very rare (by strict definition and assumptions) in real life. Many firms have some competitive characteristics and some monopolistic characteristics. This will be studied in the upcoming chapters.
You can conclude this lecture by reiterating the following points:
On monopolies:
Single seller
Produces a product with few good substitutes
High barriers to entry
Emphasize the importance of barriers to entry as the main source of a monopoly’s market power.
May earn long-run profits
A monopoly maximizes profit by producing where MR = MC.
A monopoly is inefficient, and leads to a deadweight loss.
Government grants of monopoly power encourage rent seeking.
There are three potential solutions to the problem of monopoly.
Ask students whether they think there is a “fourth solution.”