Unit 4: Monopolies, Monopolistic Competition, and Oligopolies

4.1 MonopolyMain Topics: Structural Characteristics, Monopoly Demand, Profit Maximization, Efficiency Analysis, Price Discrimination

Structural Characteristics of MonopolySince monopoly is the very opposite of perfect competition in the range of market structures, we can expect that

the structural characteristics are also quite different.

• A single producer. This is pretty self-explanatory, but a strict definition of monopoly requires that there are no other firms in the industry.

• No close substitutes. Consumers cannot find a similar product in other markets.• Barriers to entry. Perhaps the most important characteristic of monopoly is that there exists something that

prevents rival firms from entering the market to provide competition to the monopolist and choice to consumers.

• Market power. This is the result of the first three characteristics. With no competitionand barriers to entry, the unregulated monopolist has market power, or monopoly price-setting ability.

Again, it is rare to find a firm that satisfies all of the characteristics of monopoly, but the DeBeers firm holds a near monopoly on global diamond production. The only gas station or bank in a small town might also act as a local monopolist.

Barriers to EntryIf there were no barrier to entry, a monopolist earning positive economic profits would be history and this

chapter would be done. So before moving on to the behavior of monopoly, let’s talk a little more about this necessary condition for the existence of monopoly.

• Legal barriers. In your local television market only one firm is given the right to broad- cast on a specific frequency. There might be only one firm given the right to sell liquor in a small community. There are patents, trademarks, and copyright laws to protect inventions and intellectual property. In a move popular with 14-year-old boys every- where, Carmen Electra was recently given the sole right to the Internet address bearing her name. These legal protections do not provide for absolute monopoly for there are often viable substitutes available to consumers.

• Economies of scale. In Chapter 8 this concept was introduced. As a firm grows larger inthe long run, average total costs fall, providing the larger firm a cost advantage over smaller firms. If extensive economies of scale exist, an industry could evolve into one with only one enormous producer. A natural monopoly is a case where economies of scale are so extensive that it is less costly for one firm to supply the entire range of demand. Power plants are a good example of natural monopoly within a local area.

• Control of key resources. If a firm controlled most of the available resources in the productionof a good, it would be very difficult for a competitor to enter the market. For example, if a producer of granulated sugar wanted to monopolize the market, the firm might wish to control all of the sugarcane plantations.

Monopoly DemandThe perfectly competitive firm is a price taker and faces perfectly elastic demand for the product. The firm

sells all it wants at the going market price; this decision does not affect the market price. The monopolist is the only provider of that good, making the demand for the product the market demand for that product. The monopolist must pay attention to the Law of Demand, which means that if it wishes to sell more, the monopolist must decrease the price.

Demand, Price, and Marginal Revenue

Price exceeds marginal revenue because the monopolist must lower price to boost sales. The added revenue from selling one more unit is the price of the last unit less the sum of the price cuts that must be taken on all prior units of output. For example, the demand curve for the monopolist’s product is: P 7 Qd.

The monopolist begins at a price of $6 and sells one unit of the good. A price cut to$5 results in one more unit sold, so total revenue increases by $5 on this second unit. However, the first unit previously sold at $6, must also now be sold at $5, which costs the firm $1 in total revenue. With $5 gained (P) from the second and $1 lost in total revenue from the first unit, the net or marginal increase (MR) in total revenue is $4 for the second unit. Graphically we can see the revenue effect of selling the second unit in Figure 9.10

Chapter 7 examined the effect that price elasticity of demand (Ed) has on total revenue. Demand is elastic above the midpoint of a linear demand curve like the one in Figure 9.10, so cuts in price increase total revenue. Demand is inelastic below the midpoint; further cuts in price decrease total revenue. At the midpoint, total revenue is maximized and demand is unit elastic. Recognizing this connection, the price-making monopolist is going to avoid the inelastic portion of the demand curve and operate at some point to the left of the mid- point. Figure 9.11 combines demand, marginal revenue, and the total revenue function. You can see that when total revenue is at the maximum, marginal revenue is zero and further price cuts decrease total revenue, making marginal revenue negative.

Table 9.6

P Q TR MR7 0 06 1 6 65 2 10 44 3 12 23 4 12 02 5 10 -2

1 6 6 -40 7 0 -6

TIPS• Demand is horizontal and P = MR in perfect competition.• Demand is downward sloping and P > MR in monopoly.• The monopolist operates in the elastic (or upper) range of demand.

Profit MaximizationWhile demand looks different for the monopolist, the mechanism for maximizing profit is the same for both

the monopolist and the perfectly competitive firm. The firm must set output at the level where MR = MC. At this level of output (Qm), the monopolist sets the price (Pm) from the demand curve. Profit is found in the same way by creating the profit rectangle with average total cost. This is seen in Figure 9.12.

The positive monopoly profits illustrated in Figure 9.12 are likely, due to the entry barrier, to last into the long run. Though > 0 is usually the case for a monopoly firm, you might imagine a case where demand plummets, or perhaps production costs increase, to the point where P < ATC and losses are incurred. In the event of persistent losses, we expect the monopolist to exit the industry.

TIPS• Find Qm where MR = MC. Once you have found Q m, never leave it.• Find Pm vertically from the demand curve above MR = MC.• Find ATC vertically at Qm. If you move downward, > 0. If you move upward, < 0.• Move horizontally from ATC to the y axis to complete the rectangle and clearly label it as positive or negative.

Efficiency AnalysisWe refer to efficiency in a couple of different sections of this book and now that we have com- pared perfect competition to monopoly, it is time for another discussion. Allocative efficiency is achieved when the market produces a level of output where the marginal cost (MC) to society exactly equals the marginal benefit (P) received by society. Total welfare to society is maximized at this outcome, so any movement away from this level of output results in dead weight loss. Productive efficiency is achieved if society has produced a level of output with the lowest possible cost. In perfect competition, the long-run market outcome achieves both of these criteria for efficiency. Figure 9.13 illustrates the competitive and monopoly outcomes.

Allocative efficiency exists because Pc =MR =MC at Qc and productive efficiency exists because firms produce at minimum ATC.

On the other hand, the monopolist produces at a quantity Qm where Pm > MR = MC. This result tells us that consumers would like to consume more of the product; but the monopolist does not produce as much as consumers want. Failing to achieve allocative efficiency creates the dead weight loss (DWL) shown in Figure 9.13. The monopoly output is not at the point where ATC is minimized; thus the monopolist is not productively efficient. A profit earned by the monopolist is a transfer of consumer surplus from consumers to the firm.TIPS• Qm < Qc• Pm > Pc• Pm > MC so monopoly is not allocatively efficient.• Dead weight loss exists with monopoly.• Pm > minimum ATC so monopoly is not productively efficient.• m > 0 is a transfer of lost consumer surplus from consumers to the firm.

Price DiscriminationThough it carries a nasty stereotype, price discrimination is the selling of the same good at different prices to different consumers. Successful price discrimination is possible if three conditions exist:

1. The firm must have monopoly pricing power.2. The firm must be able to identify and separate groups of consumers.3. The firm must be able to prevent resale between consumers.

Common examples of price discrimination include:

• Child and senior discounts at the movie theatre or restaurants• Airline tickets that are bought three weeks in advance compared to tickets bought one hour in advance• Long distance calling plans that offer a lower per minute rate at night than during the working day• Coupons that separate price-sensitive consumers (those who use the coupon) from those who are less price

sensitive• A lower per unit price paid by consumers who buy items in large quantities (like a case of soda) than those paid

by consumers who buy in lesser quantities (like a six-pack of soda, or one can from a vending machine).

The airline industry is clearly not perfectly competitive so there must be a degree of monopoly pricing power. The firm creates groupings based upon when consumers purchase tickets. The photo identification requirement for all passengers is an important security measure, but it also prevents the resale of a low-priced ticket to a consumer who is willing to pay a higher price. If resale were possible, the pricing system might break down. It should not surprise you that price

discrimination allows firms to earn more profit than if they charged a single price.