Monopoly

“Give ‘em any color they want so long as it is black”-Henry Ford’s response to requests for more colors on the

popular Model T

Slide 1 of 23

We now continue in our study of firm behavior…

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We now turn our attention to an environment where there is not any competition.

In this module, we’ll explore how monopolies behave, how they make decisions, and how they compete (or

more specifically how they do not!).

It covers a key learning outcome and if you continue to study economics, you will see it all again.

Monopoly…one firm…lots of market power. If you want to buy it, you have to buy it from

them.

We now turn our attention to the second market structure - monopolies

Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly

Slide 3 of 23

Recall the characteristics of monopoly

Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly

At this end of this spectrum, there is no competition. Mono means one. Only one firm exists.

Characteristics of a monopoly:

A single firm produces the entire supply of a product

This means that the producer does not face competitors.

Examples might include a cable or power provider in a rural area.

The producer’s product does not have substitute

Firms are price makers

There are substantial, often insurmountable barriers to entry

This means that buyers cannot switch to another product. If you

want to buy it, you must buy it from the monopolist.

Examples include Windows or diamonds.

This means that producers can set the price as high as the

market will bear.

Examples include property owners.

This means that it is very difficult to begin producing this product.

Imagine trying to start a professional sports league.

Examples include the NFL and NBA.

Monopolies

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Monopolistic industries also have unique qualities

• The product has no substitutes• There is one supplier-the firm is the

industry• There are substantial, sometimes

insurmountable barriers to entry

• Firms are “price makers”• Producers face a downward sloping

demand curve

The Characteristics of a Monopolistic Industry

These characteristic will be described a little later.

Monopolies

The next slide will provide an example for these.

Slide 5 of 23

Microsoft acts as a monopolist

The product has no substitutes

Some of you might say, “what about Red Hat”, but most of us have never even seen it.

There is only one supplier

If you want a PC operating system, you must buy it from Windows (for 90+% of us)

There are insurmountable barriers to entry

Go ahead and design an operating system and try to compete with Microsoft. How do you think you’ll do?

Here are some other’s who have competed with Microsoft and lost:

Monopolies

Monopolistic Characteristic Comment

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Key characteristics of a monopoly as compared to perfect competition

Monopolies

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The monopolist’s demand curve is downward sloped

Monopolies

We saw that a perfectly competitive firm’s demand curve was perfectly elastic.

For a monopolist the demand curve is downward sloped. It is the same as the industry’s demand curve.

Why? Because the monopolist is the industry. If a good or service is demanded and it is produced by a monopolist, it

is demanded from the monopolist.

Monopolist’s Demand

Slide 8 of 23

A monopolist’s production decision

Monopolists determine their profit maximizing rate of output the

same way a perfectly competitive firms do:

The profit maximizing rate of output is where MR=MC

Monopolies

They determine price differently.

My perfectly competitive

counterparts take the price that the market

gives them.

I am the market. I don’t have to take the

market price, I can choose the price that maximizes MY profit.

I am a “Price Maker”.

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To see how a monopolist determines price, we first need to calculate their marginal revenue

For a perfectly competitive firm, the market would buy as much as the firm could produce. They had no influence on price because they were an insignificant part of the

market.

Monopolies

For a monopolist, they can lure more buyers with a lower price. They do have an impact on the market because

they are the market.

In this scenario, for each ten dollar reduction in price, an additional unit is demanded.

Unlike perfectly competitive firms, monopolists must consider price.

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To see how a monopolist determines price, we need to first calculate their marginal revenue

With a perfectly competitive firm, marginal revenue was constant. Each successive unit sold brought in the same

revenue. Specifically, it brought in the market price.

Monopolies

For a monopolist, marginal revenue varies as you can see in the table. Be sure you understand how the last

two columns are calculated. Recall:

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Monopolists do not have unlimited pricing power

Let’s review one important point.

We call monopolists price makers because they influence

price – they get to select the price that maximizes their profit.

That does not mean they have unlimited power to charge

anything they want.

Remember that we as consumers still have one

choice…we can go with out this good!

At a price of $190, there is no demand. A monopolist must

lower price to “lure in” customers.

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Marginal revenue, seen graphicallyMonopolies

Again, note the downward sloping demand curve that the

monopolist faces.Recall that for a perfectly competitive firm, Demand

equaled MR. They were the same curve. For a monopolist

they are not!

The MR curve will be more steep. As price is lowered for

one unit, it is lowered for all the units and that reduces marginal

revenue.

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Let’s analyze the production decision of a monopolist

Monopolies

Henry Ford, 1919

Using the price, demand, and revenue data we looked at in the last few slides, we can illustrate how a monopolist such as Henry Ford may have

made two key decisions:

#1 – How many units do I want to produce?

#2 – What price do I want to charge for each one?

In order to analyze these decisions we need some costs data- specifically marginal cost (MC) and Average Total Cost (ATC). I’ll make those

up for the next slide…

Slide 14 of 23

Determining profit maximizing output and price for a monopolist

Here we have added the MC curve

Monopolies

Like the perfectly competitive firm, the monopolist will maximize profit

where MR=MC.

But what price will the

monopolist charge?

The monopolist will charge as much as the market will bear. Follow the intersection of MR=MC all the way

up to the demand curve.

So how much profit will this monopolist earn? We need to add the ATC curve to determine that.

Much like the perfectly competitive firm, the monopolist’s profit will be

measured by this profit box.

It is the difference between the price of the good and the average cost per unit (i.e. profit

per unit)…

…times the number of units sold.

In this case it is about $38 (profit per unit)

times 6 units…

which is $230 in economic profit.

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Now we see how a monopolist makes a decision based on marginal benefit

(revenue) – marginal cost

analysis….a key learning outcome!

Let’s conduct the same analysis from a table.

Monopolies

Determining profit maximizing output and price for a monopolist, in a table

With no units produced, profit will be -$100, which are the fixed costs.With one unit produced, profit will be

-$10, but MR>MC so expand production.

With two units produced, profit will be $70, but MR>MC so expand

production.

With six units produced, profit will be $230, and MR=MC. The monopolist

should stop there.With output above 6 units, MC>MR. The monopolist should not produce these units - they cost more to make

than they bring in!

One additional note- You might notice that profit is the same if the monopolist

produced 5 units or 6 units. In these cases, always choose the higher output.

This happens whenever MR=MC at a whole unit of output, such as 6.

You could argue that the monopolist should not produce the 6th unit and have a good

case. But think of it this way: the additional unit might expand your market and provide word of mouth advertising!

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Individual Exercise

What is the profit maximizing level of output for this monopolist?

What is the profit at that output?

Monopolies

5 units

$225

Please fill in the blank cells and answer the two questions below. Click to see the answers.

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Individual Exercise

Profit

Monopolies

Please graph the following : The demand, MR, MC, and ATC curves, and the profit box.

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Barriers to entry allow the monopolist to exist

Monopolies

Recall, for perfectly competitive industries, the existence of economic profits would lure other

firms into competition.

For monopolistic industries, this doesn’t happen because there are barriers to entry.

And with no barriers to entry, there is nothing stopping those

firms from jumping in!

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Examples of barriers to entry

• Legal Harassment– In the 1990s, a small Massachusetts firm was caught

hacking into Microsoft code– Microsoft filed a lawsuit against it for hacking into their

software.– The army of lawyers that Microsoft is capable of

unleashing upon you certainly could act as a barrier to entry!

Monopolies

• Patent Protection– Polaroid developed the Instant camera. They quickly

patented it– Kodak, copied it and sold their own– Polaroid sued Kodak and won a $910 million verdict– The lawsuit put Kodak out of the instant camera

market for good (that is some barrier!)

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Examples of barriers to entry (Part 2)Monopolies

• Exclusive licensing– As a consultant, I was required to sign a no-compete

agreement upon hiring– Upon leaving the company, I could not compete with

them for 7 years– That is a serious barrier for me to enter an industry

• Bundled products– Producers can sell packages of products to ensure

users avoid a competitors product– Bundling Explorer and Office products allowed

Microsoft to obtain 96% of the browser market (Over Netscape) and 94% of the word processor market (over WordPerfect)

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Examples of barriers to entry (Part 3)Monopolies

• Government Franchises– In some cases, government’s allow monopolies– Why, it would be silly to have multiple sets of power

lines all over town– If the government gives you a franchise that means

others can’t enter the market, another example of a barrier to entry

• Predatory actions– These are my favorite– Predatory action are borderline unethical or illegal

actions designed to keep competitors out– The next 2 slides give a good example

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A real world application of predatory actions as a barrier to entry

John D. Rockefeller was the Chairman of Standard Oil.

Monopolies

He dominated the oil and fuel industries in the early 1900s.

He was known to arrive in a town and offer a gas station owner shares of his company in exchange for their station.

Those that agreed became rich.

Those that did not woke up to find him opening a gas station near theirs.

He gave the gas away until the gas station owner went out of business.

Then, as the only producer (monopolist) he restricted output and drove prices higher.

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In Summary

Unlike perfectly competitive firms, monopolies are the only sellers.

This gives them market power – allowing them to have some control over price

(They are price takers)

As a result, they can earn significant economic profits.

In perfect competition, the entry of new firms causes that economic profit to

eventually fade away.

For a monopoly, barriers to entry ensure that they get to continue to

enjoy those profits!Slide 24 of 23