1. Walter Nicholson Christopher Snyder
Amherst College
Christopher Snyder
Dartmouth College
PowerPoint Slide Presentation | Philip Heap, James Madison University
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2. CHAPTER 11
Monopoly
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3. Chapter Preview Under perfect competition:
Firms are price takers, and max profit where P=MC.
In the long run firms earn zero economic profit.
Market is efficient.
What happens if firms have market power?
In this chapter we will focus on a monopoly.
How does a monopolist set its price and output?
What is wrong with monopoly?
What are some other pricing strategies a monopolist can use?
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4. Causes of a Monopoly
Monopolies exist because there are barriers to entry.
Technical barriers to entry
Decreasing average cost over a broad range of output like a natural monopoly.
Special knowledge of a low-cost method of production.
Ownership of a key resource
Possession of unique managerial talent.
Legal barriers to entry.
Patents and copyrights.
Exclusive franchise or license.
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5. Profit Maximization in a Monopoly
Price
The monopolist maximizes output by producing an output where MR = MC. MC
And sets price off the demand curve. P* D MR Q*
Quantity per week
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6. No Supply Curve Under Monopoly
Price S
As the demand curve rotates the equilibrium price and quantity stay the same. P* D2 D1 Q*
Quantity per week
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7. Profit Maximization in a Monopoly
Price MC
Under a monopoly the equilibrium price and quantity change. P1 P2 D2 D1
MR2
MR1 Q1 Q2
Quantity per week
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8. Economic Profits For A Monopoly
Price MC
Since there are barriers to entry, the monopolist can earn positive profits even in the long run. P*
Profit > 0;
P > AC AC D MR Q*
Quantity per week
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9. What’s Wrong With Monopoly
Two main criticisms:
Monopolies produce too little output: allocatively inefficient.
There is a redistribution of wealth from consumers to “fat cat” owners.
The first criticism is true; the second may not be.
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10. What’s Wrong With A Monopoly: Efficiency Effects
Three things to consider:
Compared to perfect competition, a monopoly produces less output and charges a higher price.
Some of the consumer surplus under perfect competition is transferred to the monopolist.
There is also a deadweight loss under monopoly.
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11. What’s Wrong With A Monopoly: Efficiency Effects
Price PM
Transfers from
consumers to firm
DWL
PPC
MC = AC MR D QM
QPC
Quantity per week
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12. What’s Wrong With A Monopoly: Redistribution
Why might there be a problem with the “fat cat” argument? Is it really a transfer from the “poor” to the “rich”?
The owners of the firm may be ordinary people.
The people running the monopoly may be less wealthy than the average citizen: Navajo Indians.
Also, a monopolist is not guaranteed large or any profits.
Market power gives it the ability to set P > MC.
Profits depend on P vs. AC
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13. Economic Profits For A Monopoly
Price MC AC
With higher AC, the monopoly earns no profit. P*
Profit > 0;
P > AC AC D MR Q*
Quantity per week
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14. An Example of Deadweight Loss: Perfect Competition
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15. An Example of Deadweight Loss
So under perfect competition:
P = $3 and Q = 7
CS = $21 and PS = $0
And under a monopoly:
P = $6 and Q = 4
CS = $6, Profits (PS) = $12
DWL = $3
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16. What’s Wrong With A Monopoly: Efficiency Effects
Why might the actual cost of a monopoly be higher than measured by the DWL triangle?
If the costs faced by the monopolist are higher than perfect competition, DWL would be bigger.
A monopoly may spend resources to maintain its market power and long run profits: advertising, lobbying.
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17. Price Discrimination Price discrimination.
The selling of identical units of output at different prices.
Price discrimination allows the monopoly to earn more profit than under a single pricing scheme.
Price discrimination is a way to extract more surplus from consumers.
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18. Price Discrimination Price
This is consumer surplus from consumers who buy the good at PM. PM
This is surplus than can be extracted from selling additional units at a price < PM .
DWL
PPC MC MR D QM
QPC
Quantity per week
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19. Perfect Price Discrimination (First Degree)
Each consumer is charged a price equal to the amount they are willing and able to pay.
The monopolist will serve all consumers as long as they are willing to pay a price greater than or equal to marginal cost.
The monopolist is able to extract all the surplus in the market.
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20. Perfect Price Discrimination
Charge P1 for the first unit P1
PROFIT P1
Charge P2 for the second unit PM
Monopolist extracts all CS.
DWL
Charge P=MC for the last unit
PPC MC MR D 1 2 QM
QPC
Quantity per week
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21. Perfect Price Discrimination
What can we say about efficiency?
It is economically efficient. Output is produced up to the point that P = MC. Welfare is maximized.
What may prevent the monopoly from being able to successfully price discriminate?
Information problems: how does the firm know what you are willing to pay.
Resale.
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22. Price Discrimination: Market Separation
Suppose the firm does not know how individual demands.
Possible that the firm can separate the entire market into groups: seniors and non-seniors, business and vacation travelers etc.
Each group has its own demand, and the monopolist sets a different profit maximizing price for each group.
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23. Price Discrimination: Market Separation
Uniform price P2 MC D2 D1
MR1
MR2 Q1 Q2
Output Market 1
Output Market 2
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24. Price Discrimination: Market Separation
Compared to a uniform price, one group pays a higher price and one group pays a lower price.
What is the relationship between the price charged to each group and the elasticity of demand?
The group with the more inelastic demand (Group 1) pays a higher price.
The group with the more elastic demand (Group 2) pays a lower price.
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25. Price Discrimination: Market Separation
Group w/ inelastic demand pays a higher price.
Group w/ elastic demand pays a lower price. P1
Uniform price P2 MC D2 D1
MR1
MR2 Q1 Q2
Output Market 1
Output Market 2
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26. Price Discrimination: Nonlinear Pricing
Problem with separating markets is that it requires the monopolist to be able to distinguish between the two markets.
In this is not possible the monopolist can use nonlinear pricing, which is a schedule of quantities sold at different per unit prices.
8 oz. coffee for $1.60 vs. 16 oz. for $2.00
20 cents per oz. vs cents per oz.
With linear pricing there would be the same cost of 15 cents per ounce.
With nonlinear pricing, the average price per unit falls as you consume more.
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27. Price Discrimination: Nonlinear Pricing
The monopolist can adjust the nonlinear pricing scheme to take advantage of the variation in consumer valuations.
A given consumer has diminishing valuation for extra units of the good.
Different consumers value the good differently.
Two common examples of nonlinear pricing:
Two-Part pricing: a fixed fee and a per unit charge
Quantity discounts
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28. Nonlinear Pricing: Two Part Pricing
With a linear price the monopolist charges $1 and the consumer buys 10 units. Profit = $10.
Price $3
If the monopolist charged $1, the consumer would buy 20 units and get CS = $40.
The monopolist would charge a fee equal to that CS, $40, which would be its profit. $2
Profit = $40 $1 MC MR d 10 20
Quantity per week
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29. Price Discrimination: Two Part Pricing
Two part pricing allows the monopolist to increase profits by $30.
This is the same outcome as would occur under perfect price discrimination.
In reality not that simple. Since consumers have different demands would need to:
Reduce the fee so as not to lose low demand consumers.
Increase the per-unit price to make up for lost revenue.
Firm can use multiple two part tariffs and allow consumers to choose the tariff best for them.
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30. Price Discrimination: Quantity Discounts
With two part pricing there is an implicit quantity discount.
With a $40 fee and $1 per unit:
Buy 10 units pay, on average, $5 per unit
Buy 20 units pay, on average, $3 per unit.
By reducing the marginal price paid by the consumer, the monopolist can extra more surplus.
Quantity discounts can be used in a similar way.
Small, medium, and large: the additional cost to go from one size to the next gets smaller and smaller.
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31. Price Discrimination: Other Strategies
Pricing for Multiproduct Firms
Require that users of one product also buy a related, complementary product.
Pricing of bundled products may induce consumers to purchase some goods that they wouldn’t buy individually.
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32. Price Discrimination: Other Strategies
Durability
Do monopolists practice “planned obsolescence”?
Do monopolists practice dynamic pricing: charge a high price initially, and then gradually reduce it over time?
But consumers may anticipate lower prices and delay purchase.
By reducing durability, the monopolist could generate return sales from high demand consumers.
Leasing vs. selling.
Frequent upgrades.
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33. Natural Monopolies and Regulation
With a natural monopoly, average cost falls over the entire range of output. Ignoring monopoly power, it would be efficient to have only one firm producing the product.
The solution is to regulate the market: allow only one firm but regulate the price it charges.
Marginal cost pricing.
Two-Tier Pricing
Rate of Return Pricing
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34. Natural Monopolies: Marginal Cost Pricing
Price
Unregulated outcome (MR=MC). PA
Regulated outcome (P=MC). AC
Economic Losses: P < AC MC PR MR D QA QR
Quantity per week
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35. Natural Monopolies: Two Tier Pricing
Price
One class of consumers pay PA and demand QA. PA
Another class pays PR and demand QR -QA AC
AC of QR MC PR MR D QA QR
Quantity per week
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36. Natural Monopolies: Two Tier Pricing
Price
Under this scheme the monopolist produces the efficient level of output, QR.
Prices are discriminatory (cross subsidization).
Profits from high price customers cover losses from low price customers. PA
Profits earned
from high price
consumers AC
AC of QR
Losses from low price
consumers MC PR MR D QA QR
Quantity per week
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37. Natural Monopolies and Regulation
Rate of return regulation.
Prices are set that allows the firm to just cover its costs including a “fair” rate of return on capital investment.
Debate over a “fair” rate of return.
Incentive effects: suppose allowed return > competitive return.
Firms have an incentive to use too much capital relative to what is cost minimizing.
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38. Summary
A monopolist maximizes profit by producing a level of output where MR = MC and sets price off the demand curve.
Since the demand curve is downward sloping, P > MC
A monopoly is inefficient since buyers are willing to pay more for one more unit than it costs to produce. There is a dead weight loss.
The long run profits earned by a monopoly may have undesirable distributional effects.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

39. Summary
A monopolist may be able to increase profits using price discrimination: perfect price discrimination, separating markets and non-linear pricing.
Pricing decisions for multiproduct monopolies and durable goods monopolies are more complicated. These complications may lead to more or less market power.
Governments may choose to allow a monopoly but regulate its price. Marginal cost pricing leads to an efficient level of output, but the firm would not be able to cover its costs. Under average cost pricing an inefficient quantity is produced and the firm may have an incentive to inflate its costs.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.