1

Monopoly

CHAPTER

9

© 2003 South-Western/Thomson Learning

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Barriers to EntryA monopoly is the sole supplier of a product with no close substitutesThe most important characteristic of a monopolized market is barriers to entry new firms cannot profitably enter the marketBarriers to entry are restrictions on the entry of new firms into an industry

Legal restrictionsEconomies of scaleControl of an essential resource

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Legal Restrictions

One way to prevent new firms from entering a market is to make entry illegal

Patents, licenses, and other legal restrictions imposed by the government provide some producers with legal protection against competition

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Patent and Invention IncentivesA patent awards an inventor the exclusive right to produce a good or service for 20 years

Patent lawsEncourage inventors to invest the time and money required to discover and develop new products and processesAlso provide the stimulus to turn an invention into a marketable product, a process called innovation

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Licenses and other Entry Restrictions

Governments often confer monopoly status by awarding a single firm the exclusive right to supply a particular good or service

Broadcast TV and radio rights

State licensing of hospitals

Cable TV and electricity on local level

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Economies of ScaleA monopoly sometimes emerges naturally when a firm experiences economies of scale as reflected by the downward-sloping, long-run average cost curve

In these situations, a single firm can sometimes supply market demand at a lower average cost per unit than could two or more firms at smaller rates of output

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Exhibit 1: Economies of Scale as a Barrier to Entry

Co

st

per

un

it

Quantity per period

$

Long-runaverage cost

Put another way, market demand is not great enough to permit more than one firm to achieve sufficient economies of scale a single firm will emerge from the competitive process as the sole seller in the market.

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Natural Monopoly

Because such a monopoly emerges from the nature of costs, it is called a natural monopoly

A new entrant cannot sell enough output to experience the economies of scale enjoyed by an established natural monopolist entry into the market is naturally blocked

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Control of Essential ResourcesAnother source of monopoly power is a firm’s control over some nonreproducible resource critical to production

Professional sports teams try to block the formation of competing leagues by signing the best athletes to long-term contractsAlcoa was the sole U.S. maker of aluminum for a long period of time because it controlled the supply of bauxiteChina is the monopoly supplier of pandasDeBeers controls the world’s diamond trade

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Local MonopoliesLocal monopolies are more common that national or international monopolies

Numerous natural monopolies for products sold in local markets

However, as a rule long-lasting monopolies are rare because, as we will see, a profitable monopoly attracts competitors

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Revenue for the MonopolistBecause a monopoly, by definition, supplies the entire market, the demand for goods or services produced by a monopolist is also the market demand

The demand curve for the monopolist’s output therefore slopes downward, reflecting the law of demand

As seen in the following discussion this has important implications for revenues

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Demand, Average and Marginal Revenue

Suppose De Beers controls the entire diamond market and suppose they can sell three diamonds a day at $7,000 each total revenue of $21,000

Total revenue divided by quantity is the average revenue per diamond which is also $7,000

Thus, the monopolist’s price equals the average revenue per diamond

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Demand, Average and Marginal Revenue

To sell a fourth diamond, De Beers must lower the price to $6,750 total revenue for 4 diamonds is $27,000 and average revenue is again $6,750

The marginal revenue from selling the fourth diamond is $6,000 marginal revenue is less than the price or average revenue

Recall that these were equal for the perfectly competitive firm

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Exhibit 2: Loss or Gain from Selling One More Unit

$7,000 6,750

3 0 4

Price perDiamond

1 - carat diamonds per day

D = Average revenue

LOSS

GAIN

By selling another diamond, De Beers gains the revenue from that sale, $6,750 from the 4th diamond as shown by the blue-shaded vertical rectangle marked gain.

The loss in revenue from the first three units, $750, is shown by the red shaded horizontal rectangle marked Loss.

However, to sell that 4th unit, De Beers must sell all four diamonds for $6,750 each it must sacrifice $250 on each of the first three diamonds which could have sold for $7,000 each.

The net change in total revenue from selling the 4th diamond equals the gain minus the loss $6,750 - $750 = $6,000.

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Revenue for De Beers, a Monopolist1-Carat Price diamonds (average Total Marginal per day revenue) revenue revenue (Q) (p) (TR = Q x p) (MR = TR / Q) (1) (2) (3) =(1) x (2) (4)

0 $7,750 0 - 1 7,500 $7,500 $7,500 2 7,250 14,500 7,000 3 7,000 21,000 6,500 4 6,750 27,000 6,000 5 6,500 32,500 5,500 6 6,250 37,500 5,000 7 6,000 42,000 4,500 8 5,750 46,000 4,000 9 5,500 49,500 3,50010 5,250 52,500 3,00011 5,000 55,000 2,50012 4,750 57,000 2,00013 4,500 58,500 1,50014 4,250 59,500 1,00015 4,000 60,000 50016 3,750 60,000 017 3,500 59,500 -500

Exhibit 3: Revenue ScheduleThe first two columns contain the pertinent price and quantity information.

Total revenue (quantity times price) is provided in the third column. As De Beers expands output, total revenue increases until quantity reaches 15 diamonds when total revenue tops out.

Marginal revenue (the change in total revenue from selling one more diamond) appears in the fourth column. Note that for all units of output except the first, marginal revenue is less than the price, and the gap between the two widens as the price declines because the loss from selling all diamonds at this lower price increases.

Exhibit 4 depicts this information graphically.

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Exhibit 3: Monopoly Demand and Marginal and Total Revenue

(b) Total Revenue

$60,000

0 16 32

Total revenue

1-carat diamonds per day

Tota

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lars

Do l

lars

per

dia

mon

d

$3,750 0

16 32

Marginal revenue

Elastic

Inelastic

Unit elastic

D = Average revenue

1-carat diamonds per day

(a) Demand and Marginal RevenueDemand and marginal revenue are shown in the upper panel and total revenue is in the lower panel.

Note that the marginal revenue curve is below the demand curve and total revenue is at a maximum when marginal revenue equals zero.

Notice also that when demand is elastic, a decrease in price increases total revenue marginal revenue is positive. Conversely, when demand is inelastic, a decrease in price reduces total revenue marginal revenue is negative

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Firm’s Costs and Profit Maximization

The monopolist can choose either the price or the quantity, but choosing one determines the other

Because the monopolist can select the price that maximizes profit, we say the monopolist is a price maker

More generally, any firm that has some control over what price to charge is a price maker

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Profit MaximizationExhibits 5 and 6 repeat the revenue data from the previous exhibits and also include short-run cost data

The cost data are similar to those already introduced in the preceding chapters

The key issue is which price-quantity combination should De Beers select to maximize profits

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Exhibit 5: Short-Run Revenues and Costs for the Monopolist

Price Marginal Marginal Average TotalDiamonds (average Total Revenue Total Cost Total Cost Profit or per day revenue) revenue (MR = Cost ( MC = (ACT = Loss =

(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC (1) (2) (3) =(1) x (2) (4) (5) (6) (7) (8)

0 $7,750 0 - $15,000 - - -$15,000

1 7,500 $7,500 $7,500 19,750 4,750 $19,750 -12,250

2 7,250 14,500 7,000 23,500 3,750 11,750 9,000

3 7,000 21,000 6,500 26,500 3,000 8,830 -5,500

4 6,750 27,000 6,000 29,000 2,500 7,750 -2,000

5 6,500 32,500 5,500 31,000 2,000 6,200 1,500 6 6,250 37,500 5,000 32,500 1,500 5,420

5,000 7 6,000 42,000 4,500 33,750 1,250 4,820

8,250 8 5,750 46,000 4,000 35,250 1,500 4,410

10,750 9 5,500 49,500 3,500 37,250 2,000 4,140

12,25010 5,250 52,500 3,000 40,000 2,750 4,000

12,50011 5,000 55,000 2,500 43,250 3,250 3,930

11,75012 4,750 57,000 2,000 48,000 4,750 4,000

9,00013 4,500 58,500 1,500 54,500 6,500 4,190

4,00014 4,250 59,500 1,000 64,000 9,500 4,570 -

4,500 15 4,000 60,000 500 77,500 13,500 5,170 -7,50016 3,750 60,000 0 96,000 18,500 6,000

-36,00017 3,500 59,500 -500 121,000 25,000 7,120

-61,500

Short-run Costs and Revenue for a MonopolistThe profit-maximizing monopolist employs the same decision rule as the competitive firm the monopolist produces that quantity where total revenue exceeds total cost by the greatest amount $12,500 per day when output is 10 units per day. Total revenue is $52,500 and total cost is $40,000

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Exhibit 5: Short-Run Revenues and Costs for the Monopolist

Price Marginal Marginal Average TotalDiamonds (average Total Revenue Total Cost Total Cost Profit or per day revenue) revenue (MR = Cost ( MC = (ACT = Loss =

(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC (1) (2) (3) =(1) x (2) (4) (5) (6) (7) (8)

0 $7,750 0 - $15,000 - - -$15,000

1 7,500 $7,500 $7,500 19,750 4,750 $19,750 -12,250

2 7,250 14,500 7,000 23,500 3,750 11,750 9,000

3 7,000 21,000 6,500 26,500 3,000 8,830 -5,500

4 6,750 27,000 6,000 29,000 2,500 7,750 -2,000

5 6,500 32,500 5,500 31,000 2,000 6,200 1,500 6 6,250 37,500 5,000 32,500 1,500 5,420

5,000 7 6,000 42,000 4,500 33,750 1,250 4,820

8,250 8 5,750 46,000 4,000 35,250 1,500 4,410

10,750 9 5,500 49,500 3,500 37,250 2,000 4,140

12,25010 5,250 52,500 3,000 40,000 2,750 4,000

12,50011 5,000 55,000 2,500 43,250 3,250 3,930

11,75012 4,750 57,000 2,000 48,000 4,750 4,000

9,00013 4,500 58,500 1,500 54,500 6,500 4,190

4,00014 4,250 59,500 1,000 64,000 9,500 4,570 -

4,500 15 4,000 60,000 500 77,500 13,500 5,170 -7,50016 3,750 60,000 0 96,000 18,500 6,000

-36,00017 3,500 59,500 -500 121,000 25,000 7,120

-61,500

Short-run Costs and Revenue for a Monopolist Applying the marginal rule would imply that the monopolist increases output as long as selling additional diamonds adds more to total revenue than to total cost. Again profit is maximized at $12,500 when output is 10 diamonds per day, per unit costs are $4,000 and the price is $5,250. Exhibit 6 provides a graphical illustration of this process.

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Exhibit 6: Monopoly Costs and Revenue

0

MR

Marginal cost

D Average revenue

Average total cost

$5,250

4,000Profit

a

b

e

Diamonds per day10 16 32

(a) Per-Unit Cost and Revenue

$52,500

40,000

15,000

0 10 16 32

Total revenue

Total costMaximum profit

Diamonds per day

(b) Total Cost and Revenue

The intersection of the two marginal curves at point e in panel (a) indicates that profit is maximized when 10 diamonds are sold. At this rate of output, we move up to the demand curve to find the profit-maximizing price of $5,250. The average total cost of $4,000 is identified by point b the average profit per diamond equals the price of $5,250 minus the average total cost of $4,000 $1,250 economic profit is the equal to $1,250 * 10 units sold $12,500 as shown by the blue shaded area.

In panel (b), the firm’s profit or loss is measured by the vertical distance between the total revenue and total cost curves again profit is maximized where De Beers produces 10 diamonds per day

Dol

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per

un

itT

otal

dol

lars

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Short-Run Losses and the Shutdown Decision

A monopolist is not assured of profit The demand for the monopolists good or service may not be great enough to generate economic profit in either the short run or the long run

In the short run, the loss-minimizing monopolist must decide whether to produce or to shut down

If the price covers average variable cost, the firm will produceIf not, the firm will shut down, at least in the short run

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Exhibit 7: The Monopolist Minimizes Losses in the Short Run

p

Marginal cost

Average total cost

Average variable cost

Demand Average revenue

Marginal revenue

0 Q

e

c

b

a

Loss

Quantity per period

Recall that average variable cost and average fixed cost sum to average total cost .

Loss minimization occurs at point e, where the marginal revenue curve intersects the marginal cost curve Q and p are the loss minimization quantity and price, respectively.

Notice that at point b, the firm is covering its average variable cost it is making some contribution to its fixed costs. However, it is not covering all of its costs. The average loss per unit, measured by ab, is identified by the yellow shaded area.

Do

llars

per

un

it

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Monopolist’s Supply Curve

The intersection of a monopolist’s marginal revenue and marginal cost curve identifies the profit maximizing quantity, but the price is found on the demand curve

Thus, there is no curve that shows both price and quantity supplied there is no monopolist supply curve

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Long-Run Profit MaximizationFor a monopoly, the distinction between the long and short run is not as important

If a monopoly is insulated from competition by high barriers that block new entry, economic profit can persist in the long run

However, short-run profit is no guarantee of long-run profit

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Long-Run Profit Maximization

A monopolist that earns economic profit in the short-run may find that profit can be increased in the long run by adjusting the scale of the firm

Conversely, a monopoly that suffers a loss in the short run may be able to eliminate that loss in the long run by adjusting to a more efficient size

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Price and Output ComparisonPurpose here is to compare monopoly using the benchmark established in our discussion of perfect competition

When there is only one firm in the industry, the industry demand curve becomes the monopolist’s demand curve the price the monopolist charges determines how much gets sold

Exhibit 8 provides our comparison

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Exhibit 8: Perfect Competition and Monopoly

p' m

p

0 Q'mQuantity per period

c Sc = MC = ATC

D = AR

MRm

m

b

a

c

Q'c

The horizontal supply curve is based on the assumption of a constant-cost industry. Equilibrium in perfect competition is at point c, where market demand and supply intersect to yield price pc and

quantity Qc. The monopolist maximizes profit by equating marginal revenue with marginal cost point b equilibrium price pm and output Qm.

The price shows the consumers’ marginal benefit at that output rate, point m, which exceeds the marginal cost, point b. Because the marginal benefit consumers attach to additional units exceeds the marginal cost of producing those additional units, society would be better off if output were expanded beyond Qm the monopolist restricts output below the level that maximizes social welfare consumer surplus is shown by the yellow triangle ampm

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per

un

it

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Exhibit 8: Perfect Competition and Monopoly

p' m

p

0 Q'mQuantity per period

c Sc = MC = ATC

D = AR

MRm

m

b

a

c

Q'c

Do

llars

per

un

it

Consumer surplus under perfect competition is the large triangle acpc while under monopoly it shrinks to the smaller triangle ampm

The monopolist earns economic profit equal to the shaded rectangle a transfer from consumer surplus to monopoly profit this amount is not lost to society and so is not considered a welfare loss from monopoly.

Notice that consumer surplus has been reduced by more than the profit triangle. Consumers have also lost the triangle mcb which was part of the consumer surplus under perfect competition the deadweight loss of monopoly because it is a loss to consumers but a gain to nobody. This loss results from the allocative inefficiency arising from the higher price and reduced output.

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Why the Welfare Loss Might Be Lower

If economies of scale are extensive enough, a monopolist may be able to produce output at a lower cost per unit than could competitive firms

If this is true, the price or at least the cost of production could be lower under monopoly than under competition

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Why the Welfare Loss Might Be Lower

The welfare loss shown in Exhibit 8 may also overstate the true cost of monopoly because monopolists may, in response to public scrutiny and political pressure, keep prices below what the market could bear

Finally, a monopolist may keep the price below the profit maximizing level to avoid attracting new competitors

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Why the Welfare Loss Might Be Higher

Another line of thought suggests that the welfare loss of monopoly may, in fact, be greater than shown in our example

If resources must be devoted to securing and maintaining a monopoly position, monopolies may involve more of a welfare loss that simple models suggest

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Why the Welfare Loss Might Be Higher

Consider, for example, radio and TV broadcasting rights confer on the recipient the exclusive right to use a particular band of the scarce broadcast spectrum

In the past, these rights have been given away by government agencies to the applicants deemed most deserving

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Why the Welfare Loss Might Be Higher

Because these rights are so valuable, numerous applicants spend millions on lawyers’ fees, lobbying expenses, and other costs associated with making themselves appear the most deserving

The efforts devoted to securing and maintaining a monopoly position are largely a social waste because they use up scarce resources but add not unit to output

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Why the Welfare Loss Might Be Higher

Activities undertaken by individuals or firms to influence public policy in a way that will directly or indirectly redistribute income to them are referred to as rent seeking

Second, monopolists insulated from the rigors of competition in the marketplace, may also become efficient

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Why the Welfare Loss Might Be Higher

Finally, monopolists have also been criticized for being slow to adopt the latest production techniques, to develop new products, and generally lacking innovativeness

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Price DiscriminationA monopolist can sometimes increase economic profit by charging higher prices to customers who value the product more

The practice of charging difference prices to different customers when the price differences are not justified by differences in cost is called price discrimination

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Conditions for Price DiscriminationConditions

The demand curve for the firm’s product must slope downward the firm has some market power and control over priceThere are at least two groups of consumers for the product, each with a different price elasticity of demandThe producer must be able, at little cost, to charge each group a different price for essentially the same productThe producer must be able to prevent those who pay the lower price from reselling the product to those who pay the higher price

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Model of Price Discrimination

Exhibit 9 shows the effects of price discrimination

Consumers are divided into two groups with different demands

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Exhibit 9: Price Discrimination D

ol l

ar s

pe

r u

nit

0 400 Quantity per period 0 500 Quantity per period

$3.00

1.00 LRAC, MC

MR D

(a)

$1.50 1.00 LRAC, MC

MR'D'

(b)

Do

ll ars

pe

r u

nit

At a given price, the price elasticity of demand in panel b(elastic) is greater than in panel a (inelastic). For simplicity, assume the firm produces at a constant long-run average and marginal cost of $1. This firm maximizes profits by finding the price in each market that equates marginal revenue with marginal cost consumers with the lower price elasticity pay $3 and those with the higher price elasticity pay $1.50 in markets with elastic demand the price will be lower than in markets where demand is inelastic.

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Examples of Price Discrimination

Because businesspeople face unpredictable yet urgent demands for travel and communication, and because employers pay such expenses, businesspeople are less sensitive to price than householders

Telephone companies are able to sort out their customers by charging different rates based on the time of day

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Perfect Price DiscriminationIf a monopolist could charge a different price for each unit sold, the firm’s marginal revenue curve from selling one more unit would equal the price of that unit the demand curve would become the marginal revenue curve

A perfectly discriminating monopolist charges a different price for each unit of the good

Exhibit 10 provides our example

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Exhibit10: Perfect Price Discrimination D

oll

ars

pe

r u

nit

c

0 Q Quantity per period

e

D = Marginal revenue

a

Long-runaverage cost= marginal cost

P r o f i t

A perfectly discriminating monopolist would maximize profits at point e where marginal revenue equals marginal cost price set at point e

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Perfect Price DiscriminationPerfect price discrimination gets high marks based on allocative efficiency

Because such a monopolist does not have to lower price to all customers when output expands, there is no reason to restrict output

In fact, because this is a constant-cost industry, Q is the same quantity produced in perfect competition

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Perfect Price DiscriminationAs in perfect competition, the marginal benefit of the final unit of output produced just equals its marginal cost

And although perfect price discrimination yields no consumer surplus, the total benefits consumers derive just equal the total amount they pay for the good

Since the monopolist does not restrict output, there is no deadweight loss