PowerPoint Lecture Notes for Chapter 15: Monopoly Principles of Microeconomics 4th edition, by N.

Gregory Mankiw PowerPoint Slides by Ron Cronovich

15

Monopoly

PRINCIPLES OF

MICROECONOMICS
F OURT H E DITIO N

The most important concept in this chapter is the relation between MR and P for a monopolist. Everything else in the chapter markup pricing, economic profit, deadweight loss, public policy response, etc all flow from the relationship between P and MR. This relationship is also important because P > MR for firms with market power in other market structures, such as monopolistically competitive firms. Since P > MR for these firms, many of the same issues arise. For most students, the relationship between P and MR is the most challenging topic in the chapter. This PowerPoint includes an Active Learning exercise requiring students to calculate marginal revenue at various quantities from a demand schedule, so students will see for themselves that MR < P. The PowerPoint also includes careful explanation on the relation between MR and P. I hope your students find it helpful. Another tricky concept for some students is identifying the monopolists price on a graph. Students generally can find the profit-maximizing quantity, where the MR and MC curves intersect. But they sometimes forget to go up to the D curve to find the highest price the market will bear at that quantity.

N. G R E G O R Y M A N K I W
PowerPoint Slides by Ron Cronovich
2006 Thomson South-Western, all rights reserved

In this chapter, look for the answers to these questions:

Why do monopolies arise? Why is MR < P for a monopolist? How do monopolies choose their P and Q? How do monopolies affect societys well-being? What can the government do about monopolies? What is price discrimination?

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MONOPOLY

Introduction A monopoly is a firm that is the sole seller of a

product without close substitutes.

In this chapter, we study monopoly and contrast

it with perfect competition.

The key difference:

A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power.

Most students already know that monopoly means the firm is the only seller of its product. But the definition here has another very important part: In order for the firm to be considered a monopoly, the product it sells must have no close substitutes available from other firms.

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Why monopolies arise

The main cause of monopolies is barriers to entry other firms cannot enter the market. Three sources of barriers to entry: 1. A single firm owns a key resource. E.g., DeBeers owns most of the worlds diamond mines 2. The govt gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws
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Why monopolies arise

3. Natural monopoly: a single firm can produce the entire market Q at lower ATC than could several firms.
Example: 1000 homes need electricity. ATC is lower if one firm services all 1000 homes than if two firms each service 500 homes.
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The horizontal axis of the graph measures number of homes provided electricity. The vertical axis measures the average total cost of providing electricity per home.

Cost

Electricity
Economies of scale due to huge FC

$80 $50 500 1000 ATC Q

4

Monopoly vs. Competition: Demand Curves

In a competitive market, the market demand curve slopes downward. but the demand curve for any individual firms product is horizontal at the market price. The firm can increase Q without lowering P, so MR = P for the competitive firm.
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A competitive firm is a price-taker, can sell as much as it wants at the market price. In effect, the competitive firm sells a product for which there are many perfect substitutes, so demand for its product is perfectly elastic; if it raises its price above the market price, demand for its product falls to zero.

A competitive firms demand curve

Q
5

The relationship between P and MR is what distinguishes a competitive firm from a monopoly firm, in terms of both firm behavior and welfare implications. This slide introduces the notion that MR is not equal to P for the monopolist. The next slide presents an exercise to lead students to see for themselves what this relationship looks like.

Monopoly vs. Competition: Demand Curves

A monopolist is the only seller, so it faces the market demand curve. To sell a larger Q, the firm must reduce P. Thus, MR P. P

A monopolists demand curve

D Q
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ACTIVE LEARNING

1: A monopolys revenue monopoly

Moonbucks is the only seller of cappucinos in town. The table shows the market demand for cappucinos. Fill in the missing spaces of the table. What is the relation between P and AR? Between P and MR?
Q 0 1 2 3 4 5 6 P $4.50 4.00 3.50 3.00 2.50 2.00 1.50
7

TR

AR n.a.

MR

ACTIVE LEARNING

Answers

1:

When the AR column appears, note that AR = P at every quantity. This, of course, is a tautology.
P TR $0 4 7 9 10 10 9 AR n.a. $4.00 3.50 2 3.00 1 2.50 2.00 1.50
8

Here, P = AR, same as for a competitive firm. Here, MR < P, whereas MR = P for a competitive firm.

Q 0 1 2 3 4 5 6

MR $4 3

$4.50 4.00 3.50 3.00 2.50 2.00 1.50

0 1

When the MR column appears, note that MR is less than P. This is not as easy to see, because the MR numbers are offset from the rows of the table, just as if you were in an elevator stuck between two floors. But students can still see that MR < P. For example, in the range of output of Q=2 to Q=3, the price ranges from $3.50 to $3.00, but MR is only $2.

Moonbucks D and MR curves

P, MR $5 4 3 2 1 0 -1 -2 -3 0
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These curves are based on the preceding exercise. This graph shows visually what the table showed with columns of numbers: MR < P.

Demand curve (P)

MR

Q
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MONOPOLY

Understanding the monopolists MR Increasing Q has two effects on revenue:

The output effect: More output is sold, which raises revenue The price effect: The price falls, which lowers revenue

Note that a competitive firm has the output effect but not the price effect: the competitive firm does not need to reduce its price in order to sell a larger quantity, so, for the competitive firm, MR = P.

To sell a larger Q, the monopolist must reduce the

price on all the units it sells.

Hence, MR < P MR could even be negative if the price effect

exceeds the output effect (e.g. when Moonbucks increases Q from 5 to 6).
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Profit-maximization Like a competitive firm, a monopolist maximizes

profit by producing the quantity where MR = MC.

Once the monopolist identifies this quantity,

it sets the highest price consumers are willing to pay for that quantity.

It finds this price from the D curve.

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Profit-maximization
1. The profitmaximizing Q is where MR = MC. 2. Find P from the demand curve at this Q.
Q
Costs and Revenue

MC

D MR Quantity

Profit-maximizing output
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The monopolists profit

Costs and Revenue

MC ATC

As with a competitive firm, the monopolists profit equals (P ATC) x Q

P ATC

D MR

Quantity

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13

A monopoly does not have a S curve

A competitive firm takes P as given has a supply curve that shows how its Q depends on P A monopoly firm is a price-maker, not a price-taker Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and the demand curve. So there is no supply curve for monopoly.
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Case study: monopoly vs. generic drugs

Patents on new drugs Price give a temporary monopoly to the seller. PM When the patent expires, PC = MC the market becomes competitive, generics appear. QM QC
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Here, we assume constant marginal cost, for simplicity. PM and QM denote the monopoly price and quantity, respectively. PC and QC denote the competitive price and quantity, respectively.

The market for a typical drug

D MR Quantity

The welfare cost of monopoly Recall: In a competitive market equilibrium,

P = MC and total surplus is maximized.

In the monopoly eqm, P > MR = MC The value to buyers of an additional unit (P)

exceeds the cost of the resources needed to produce that unit (MC). The monopoly Q is too low: could increase total surplus with a larger Q. Thus, monopoly results in a deadweight loss.

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The welfare cost of monopoly

Competitive eqm: quantity = QE P = MC total surplus is maximized Monopoly eqm: quantity = QM P > MC deadweight loss
Price Deadweight MC loss

Its worth mentioning the following: Most people know that monopoly changes the way the economic pie is divided: by charging higher prices, the monopoly gets more surplus and consumers get less surplus.
D

P P = MC MC

MR

QM QE

Quantity

The analysis on this slide shows that the monopoly also reduces the size of the economic pie by producing less than the socially efficient quantity and causing a deadweight loss.

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17

Public policy toward monopolies Increasing competition with Antitrust Laws

Examples: Sherman Antitrust Act (1890), Clayton Act (1914) Antitrust laws ban certain anticompetitive practices, allow govt to break up monopolies. Govt agencies set the monopolists price For natural monopolies, MC < ATC at all Q, so marginal cost pricing would result in losses. If so, regulators might subsidize the monopolist or set P = ATC for zero economic profit.
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Regulation

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Public policy toward monopolies Public ownership

Example: US Postal Service Problem: Public ownership is usually less efficient since no profit motive to minimize costs The foregoing policies all have drawbacks, so the best policy may be no policy.

Doing nothing

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Price Discrimination Discrimination is the practice of treating people

differently based on some characteristic, such as race or gender.

Price discrimination is the business practice of

selling the same good at different prices to different buyers.

The characteristic used in price discrimination

is willingness to pay (WTP): A firm can increase profit by charging a higher price to buyers with higher WTP.
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Perfect price discrimination vs. single price monopoly

Here, the monopolist charges the same price (PM) to all buyers.
Price Consumer surplus Deadweight loss

To keep the graph simple, this example assumes constant marginal cost.

PM

A deadweight loss MC results. Monopoly

profit MR D

QM
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Quantity
21

Perfect price discrimination vs. single price monopoly

Here, the monopolist produces the competitive quantity, but charges each buyer his or her WTP. This is called perfect price discrimination. The monopolist captures all CS as profit. But theres no DWL.
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Here, there is no horizontal price line. The price line, if you will, is the demand curve: at each Q, the height of the demand curve shows the marginal buyers willingness to pay, which is the price the monopolist charges that buyer under perfect price discrimination.
D Quantity

Price

Monopoly profit

MC

MR

Q
22

Price discrimination in the real world In the real world, perfect price discrimination is
not possible: no firm knows every buyers WTP buyers do not announce it to sellers

So, firms divide customers into groups

based on some observable trait that is likely related to WTP, such as age.

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Examples of price discrimination

Movie tickets Discounts for seniors, students, and people who can attend during weekday afternoons they are all more likely to have lower WTP than people who pay full price on Friday night. Airline prices Discounts for Saturday-night stayovers helps distinguish business travelers, who usually have higher WTP, from more price-sensitive leisure travelers.
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Examples of price discrimination

Discount coupons People who have time to clip and organize coupons are more likely to have lower income and lower WTP than others. Need-based financial aid Low income families have lower WTP for their childrens college education. Schools price-discriminate by offering need-based aid to low income families.

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Examples of price discrimination

Quantity discounts A buyers WTP often declines with additional units, so firms charge less per unit for large quantities than small ones. Example: A movie theater charges $4 for a small popcorn and $5 for a large one thats twice as big.

In this example, the firm is not charging different prices to different customers, but charging different prices to the same customer based on that customers declining willingness to pay for additional units.

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Conclusion: the prevalence of monopoly

In the real world, pure monopoly is rare. Yet, many firms have market power, due to selling a unique variety of a product having a large market share and few significant
competitors

In many such cases, most of the results from

this chapter apply, including markup of price over marginal cost deadweight loss
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CHAPTER SUMMARY A monopoly firm is the sole seller in its market.

Monopolies arise due to barriers to entry, including: government-granted monopolies, the control of a key resource, or economies of scale over the entire range of output.

A monopoly firm faces a downward-sloping

demand curve for its product. As a result, it must reduce price to sell a larger quantity, which causes marginal revenue to fall below price.

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CHAPTER SUMMARY Monopoly firms maximize profits by producing the

quantity where marginal revenue equals marginal cost. But since marginal revenue is less than price, the monopoly price will be greater than marginal cost, leading to a deadweight loss.

Policymakers may respond by regulating

monopolies, using antitrust laws to promote competition, or by taking over the monopoly and running it. Due to problems with each of these options, the best option may be to take no action.
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CHAPTER SUMMARY Monopoly firms (and others with market power) try
to raise their profits by charging higher prices to consumers with higher willingness to pay. This practice is called price discrimination.

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