Monopoly CHAPTER 12. After studying this chapter you will be able to Explain how monopoly arises and...

Monopoly

CHAPTER12

After studying this chapter you will be able to

Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly

Explain how a single-price monopoly determines its output and price

Compare the performance and efficiency of single-price monopoly and competition

Explain how price discrimination increases profit

Explain how monopoly regulation influences output, price, economic profit, and efficiency

Dominating the Internet

eBay and Google are dominant players in the markets they serve.

These firms are not like the firms in perfect competition.

How do firms that dominate their markets behave?

Students get lots of price breaks—at the movies, hairdresser, and on the airlines.

Why?

How can it be profit maximizing to offer lower prices to some customers?

Market Power

Market power and competition are the two forces that operate in most markets.

Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale.

A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

Market Power

How Monopoly Arises

A monopoly has two key features:

No close substitutes

Barriers to entry

Barriers to Entry

Legal or natural constraints that protect a firm from potential competitors are called barriers to entry.

There are two types of barriers to entry: legal and natural.

Market Power

Legal Barriers to Entry

Legal barriers to entry create a legal monopoly, a market in which competition and entry are restricted by the granting of a

Public franchise (like the U.S. Postal Service, a public franchise to deliver first-class mail)

Government license (like a license to practice law or medicine)

Patent and copyright

Market Power

Natural Barriers to Entry

Natural barriers to entry create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can.

Figure 12.1 illustrates a natural monopoly.

Market Power

One firm can produce 4 units of output at 5 cents per unit.

Two firms can produce 4 units—2 units each—at 10 cents per unit.

Four firms can produce 4 units—1 unit each—at 15 cents per unit.

Market Power

In a natural monopoly, economies of scale are so powerful that they are still being achieved even when the entire market demand is met.

The LRAC curve is still sloping downward when it meets the demand curve.

Market Power

Monopoly Price-Setting Strategies

For a monopoly firm to determine the quantity it sells, it must choose the appropriate price.

There are two types of monopoly price-setting strategies:

A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers.

Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

A Single-Price Monopoly’s Output and Price Decision

Price and Marginal Revenue

A monopoly is a price setter, not a price taker like a firm in perfect competition.

The reason is that the demand for the monopoly’s output is the market demand.

To sell a larger output, a monopoly must set a lower price.


Total revenue, TR, is the price, P, multiplied by the quantity sold, Q.

Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold.

For a single-price monopoly, marginal revenue is less than price at each level of output. That is,

MR < P


Figure 12.2 illustrates the relationship between price and marginal revenue and derives the marginal revenue curve.

Suppose the monopoly sets a price of $16 and sells 2 units.


Now suppose the firm cuts the price to $14 to sell 3 units.

It loses $4 of total revenue on the 2 units it was selling at $16 each.

And it gains $14 of total revenue on the 3rd unit.

So total revenue increases by $10, which is marginal revenue.


The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 units and at $10.

You can see that MR < P at each quantity.

A Single-Price Monopoly’sOutput and Price Decision

Marginal Revenue and Elasticity

A single-price monopoly’s marginal revenue is related to the elasticity of demand for its good:

If demand is elastic, a fall in price brings an increase in total revenue.


The increase in revenue from the increase in quantity sold outweighs the decrease in revenue from the lower price per unit, and MR is positive.

As the price falls, total revenue increases.


If demand is inelastic, a fall in price brings a decrease in total revenue.

The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit, and MR is negative.


As the price falls, total revenue decreases.


If demand is unit elastic, a fall in price does not change total revenue.

The rise in revenue from the increase in quantity sold equals the fall in revenue from the lower price per unit, and MR = 0.

Total revenue is maximized when MR = 0.


A single-price monopoly never produces an output at which demand is inelastic.

If it did produce such an output, the firm could increase total revenue, decrease total cost, and increase economic profit by decreasing output.


Price and Output Decision

The monopoly faces the same types of technology constraints as the competitive firm, but the monopoly faces a different market constraint.

The monopoly selects the profit-maximizing quantity in the same manner as a competitive firm, where MR = MC.

The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity.


Table 12.1 (p. 268) provides a numerical example to illustrate the profit-maximizing output and price decision.

The monopoly might make an economic profit, even in the long run, because the barriers to entry protect the firm from market entry by competitor firms.


Figure 12.4 illustrates the profit-maximizing choices of a single-price monopoly.

In part (a), the monopoly produces the quantity that maximizes total revenue minus total cost.


In part (b), the firm produces the output at which MR = MC and sets the price at which it can sell that quantity.

The ATC curve tells us the average total cost.

Economic profit is the profit per unit multiplied by the quantity produced—the blue rectangle.

Single-Price Monopoly and Competition Compared

Comparing Price and Output

Figure 12.5 compares the price and quantity in perfect competition and monopoly.

The market demand curve, D, in perfect competition is the demand curve that the firm faces in monopoly.


The market supply curve in perfect competition is the horizontal sum of the individual firm’s marginal cost curves, S = MC.

This curve is the monopoly’s marginal cost curve.


Equilibrium in perfect competition occurs where the quantity demanded equals the quantity supplied at quantity QC and price PC.


Equilibrium output for a monopoly, QM, occurs where marginal revenue equals marginal cost, MR = MC.

Equilibrium price for a monopoly, PM, occurs on the demand curve at the profit-maximizing quantity.


Compared to perfect competition, monopoly produces a smaller output and charges a higher price.


Efficiency Comparison

Figure 12.6(a) shows the efficiency of perfect competition.

The market demand curve is the marginal social benefit curve, MSB, and the market supply curve is the marginal social cost curve, MSC.

So competitive equilibrium is efficient: MSB = MSC.


Consumer surplus is the area below the demand curve and above the price.

Producer surplus is the area below the price and above the supply curve.

The sum of the two surpluses is maximized and the efficient quantity is produced.


Figure 12.6(b) shows the inefficiency of monopoly.

Because price exceeds marginal social cost, marginal social benefit exceeds marginal social cost,and a deadweight loss arises.


Redistribution of Surpluses

Monopoly redistributes a portion of consumer surplus by changing it to producer surplus.


Rent Seeking

The social cost of monopoly may exceed the deadweight loss through an activity called rent seeking—the pursuit of wealth by capturing economic rent.

Any surplus—consumer surplus, producer surplus, or economic profit—is called economic rent.

Rent seekers pursue their goals in two main ways:

Buy a monopoly—transfers rent to creator of monopoly.

Create a monopoly—uses resources in political activity.


Rent-Seeking Equilibrium

The resources used in rent seeking can exhaust the monopoly’s economic profit and the monopoly breaks even.

Figure 12.7 shows the rent seeking equilibrium.


A potential profit shown by the blue area gets used up in rent seeking.

Average total cost increases and the profits disappear to become part of the enlarged deadweight loss from rent seeking.

Price Discrimination

Price discrimination is the practice of selling different units of a good or service for different prices.

To be able to price discriminate, a monopoly must:

1. Identify and separate different buyer types.

2. Sell a product that cannot be resold.

Price differences that arise from cost differences are not price discrimination.


Price Discrimination and Consumer Surplus

Price discrimination converts consumer surplus into economic profit.

A monopoly can discriminate

Among units of a good. Quantity discounts are an example. (But quantity discounts that reflect lower costs at higher volumes are not price discrimination.)

Among groups of buyers. (Advance purchase and other restrictions on airline tickets are an example.)


Profiting by Price Discriminating

Figures 12.8 and 12.9 show the same market with a single price and price discrimination.

As a single-price monopoly, this firm maximizes profit by producing 8 trips a year and selling them for $1,200 each.


By price discriminating, the firm can increase its profit.

In doing so, it converts consumer surplus into economic profit.


Perfect Price Discrimination

Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay.

Marginal revenue now equals price and the demand curve is also the marginal revenue curve.


With perfect price discrimination:

The profit-maximizing output increases to the quantity at which price equals marginal cost.

Economic profit increases above that made by a single-price monopoly.

Deadweight loss is eliminated.


The airlines have perfected price discrimination.


Efficiency and Rent Seeking with Price Discrimination

The more perfectly a monopoly can price discriminate, the closer its output is to the competitive output (P = MC) and the more efficient is the outcome.

But this outcome differs from the outcome of perfect competition in two ways:

1. The monopoly captures the entire consumer surplus.

2. The increase in economic profit attracts even more rent-seeking activity that leads to an inefficient use of

resources.

Monopoly Policy Issues

A single-price monopoly creates inefficiency and a price-discriminating monopoly captures consumer surplus and converts it into producer surplus and economic profit.

And monopoly encourages rent-seeking, which wastes resources.

But monopoly brings benefits.

Gains from Monopoly Incentives to innovation

Economies of scale and economies of scope


Incentives to Innovation

Patents and copyrights provide protection from competition and let the monopoly enjoy the profits stemming from innovation for a longer period of time.

Economies of Scale and Scope

Where economies of scale or scope exist, a monopoly can produce at a lower average total cost than what a large number of competitive firms could achieve.


Regulating Natural Monopoly

When demand and cost conditions create natural monopoly, government agencies regulate the monopoly.

Figure 12.11 shows how a natural monopoly might be regulated.


Profit Maximization

The monopoly maximizes economic profit by producing the quantity at which marginal revenue equals marginal cost …

and charging the highest price at which that quantity will be bought.


The Efficient Regulation

Regulating a natural monopoly in the social interest sets the quantity where MSB = MSC.

With no external benefits, the demand curve is the MSB curve.

With no external costs, the marginal cost curve is the MSC curve.

Efficient regulation sets the price equal to marginal cost.


Regulation that sets the price equal to marginal cost is called the marginal cost pricing rule.

The marginal cost pricing rule is efficient but with average cost exceeding price, the firm incurs an economic loss.


If the monopoly receives a subsidy to cover its loss, taxes must be imposed on other economic activity, which create deadweight loss.

Where possible, a regulated natural monopoly might be permitted to price discriminate to cover the loss from marginal cost pricing.


Average Cost Pricing

Another alternative is to permit the firm to produce the quantity at which price equals average cost and to set the price equal to average cost—the average cost pricing rule.

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Monopoly CHAPTER 12. After studying this chapter you will be able to Explain how monopoly arises and...

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