Monopoly

Slides by: John & Pamela Hall

ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN 2005 Thomson Business and Professional Publishing

Monopoly
Monopoly is as close as economics comes to a dirty word
Negative reputation of monopoly is in many ways deserved At the same time a mythology has developed around monopolies This negative characterization goes too far
We do better by managing monopoly problem, rather than eliminating it

What Is A Monopoly?
A monopoly firm is the only seller of a good or service with no close substitutes
Market in which the monopoly firm operates is called a monopoly market

Key concept is notion of substitutability Definition of monopoly firm or market may seem precise
But in real world, definition is not always so clear-cut

Because we all have different tastes and characteristics, we can have different opinions about what is, and what is not, a close substitute
As a result, we can have different ideas about how broadly or how narrowly we should define a market when trying to decide if it is a monopoly

The Sources of Monopoly

Existence of a monopoly means that something is causing other firms to stay out of the market
Rather than enter and compete with firm already there

What barrier prevents additional firms from entering the market?

Several possible answers
Economies of scale Legal barriers Network externalities

Economies of Scale
If economies of scale persist to the point where a single firm is producing for entire market, the market is a natural monopoly
Market in which, due to economies of scale, one firm can operate at lower average cost than can two or more firms

Unless government intervenes, only one seller would survivemarket would naturally become a monopoly Small local monopolies are often natural monopolies
Because they continue to enjoy economies of scale up to point at which they are serving entire market 5

Figure 1: A Natural Monopoly

Dollars

15 12

A B LRATC

C DMarket 300 350 Pieces of Clothing per Week

Legal Barriers
Sometimes public interest is best served by having a single seller in a market Many monopolies arise because of legal barriers including
Protection of intellectual property Government franchise

Protection of Intellectual Property

The words you are reading right now are an example of intellectual property, which includes literary, artistic and musical works, and scientific inventions In dealing with intellectual property government strikes a compromise
Allows creators of intellectual property to enjoy a monopoly and earn economic profit, but only for a limited period of time Once time is up, other sellers are allowed to enter the market, and it is hoped that competition among them will bring down prices

Most important kinds of legal protection for intellectual property are

Patents
Temporary grant of monopoly rights over a new product or scientific discovery

Copyrights
Grant of exclusive rights to sell a literary, musical, or artistic work

Copyrights and patents are often sold to another person or firm, but this does not change monopoly status of the market, since there is still just one seller

Government Franchise
Large firms we usually think of as monopolies have their monopoly status guaranteed through government franchise
Grant of exclusive rights over a product

Barrier to entry is
Any other firm that enters the market will be prosecuted

Governments usually grant franchises when they think market is a natural monopoly

Network Externalities
Exist when an increase in networks membership increases its value to current and potential members When network externalities are present, joining a large network is more beneficial than joining a small network
Even if product in larger network is somewhat inferior to product in smaller one

In addition to advantages of joining a larger network

Advantage in not leaving it once youve joined
Avoiding switching costs

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Network Externalities
All of this clearly applies to the market for computer operating systems
When you buy a computer already loaded with Microsoft Windows, you benefit
By having a large number of people with whom you can easily share documents Huge number of computers everywhere you can easily operate

You gain access to many more software programs, like Microsoft Word, Excel, or Outlook, since many more programs are designed for Windows than for the few alternatives You can save time by just calling knowledgeable friends or coworkers
Rather than attempting to contact technical support

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Monopoly Goals And Constraints

Goal of a monopolylike that of any firmis to earn highest profit possible However, a monopolist faces constraints
Constraint on monopolys cost
For any level of output it might produce, total cost is determined by
Technology of production Price it must pay for its inputs

Demand constraint
Monopolists demand curve tells us maximum price monopolist can charge to sell any given quantity of output And for any level of output it might produce, maximum price it can charge is determined by market demand curve for its product

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Monopoly Price or Output Decision

Noncompetitive firmssuch as monopoliesdo not make two separate decisions about price and quantity, but rather one decision
Once firm determines its output level, it has also determined its price

When any firmincluding a monopolyfaces a downward sloping demand curve, marginal revenue is less than price of output
Therefore, marginal revenue curve will lie below demand curve

Monopoly will always produce at an output level where marginal revenue is positive

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Figure 2: Demand and Marginal Revenue

Monthly $60 Price per Subscriber 50 48 38 30 20 18

Demand 5,000 6,000 15,000 20,000 30,000 MR 21,000 Number of Subscribers

14

The Profit-Maximizing Output Level

To maximize profit, the firm should produce level of output where MC = MR and
MC curve crosses MR curve from below

For a monopoly, price and output are not independent decisions

But different ways of expressing the same decision

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Figure 3: Monopoly Price and Output Determination

Monthly $60 Price per Subscriber 40 E MC

D 10,000 MR 30,000 Number of Subscribers

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Profit And Loss

A monopoly earns a profit whenever P > ATC
Its total profit at best output level equals area of a rectangle
Height equal to distance between P and ATC Width equal to level of output

A monopoly suffers a loss whenever P < ATC

Its total loss at best output level equals area of a rectangle
Height equal to distance between ATC and P Width equal to level of output

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Figure 4: Monopoly Profit and Loss

(a) Dollars

MC
E

ATC

Dollars $50

(b) ATC MC AVC E

$40 32 Total Profit D 10,000 Number of MR Subscribers

40

Total Loss

D 10,000 Number of MR Subscribers

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Equilibrium in Monopoly Markets

A monopoly market is in equilibrium when the only firm in market
The monopoly firm is maximizing profit

For monopolyas for perfect competition we have different expectations about equilibrium in short-run and equilibrium in long-run

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Short-Run Equilibrium
Monopoly may earn an economic profit or suffer an economic loss What if a monopoly suffers a loss in short-run?
Any firm should shut down if P < AVC at output level where MR = MC

If monopoly suddenly finds that P < AVC, government will usually not allow it to shut down,
Instead use tax revenue to make up for firms losses

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Long-Run Equilibrium
Important insights of previous chapter perfectly competitive firms cannot earn a profit in long-run equilibrium However, monopolies may earn economic profit in long-run A privately owned monopoly suffering an economic loss in long-run will exit the industry
Should not find privately owned monopolies suffering economic losses in long-run
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Comparing Monopoly to Perfect Competition

In perfect competition, economic profit is relentlessly reduced to zero by entry of other firms
In monopoly, economic profit can continue indefinitely

But monopoly differs from perfect competition in another way

Can expect a monopoly market to have a higher price and lower output than an otherwise similar perfectly competitive market

By raising price and restricting output, new monopoly earns economic profit Consumers lose in two ways
Pay more for output they buy Due to higher prices they buy less output

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Figure 5a/a: Comparing Monopoly and Perfect Competition

(a) Competitive Market Price per Unit Dollars per Unit (b) Competitive Firm 2. and each firm produces 1,000 units, where P = MC. MC ATC S

E
$10 3. When monopoly $10 takes over, the old market supply curve . . . D 100,000 1. In this competitive market of 100 firms, equilibrium price is $10 Quantity of Output 1,000 Quantity of Output

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Figure 5c: Comparing Monopoly and Perfect Competition

(c) Monopoly Price per Unit S = MC F 4. becomes the monopoly's MC curve.

$15
10

5. The monopoly produces where MR = MC,

6. with a higher price and lower market output than under perfect competition. MR 100,000 60,000 D Quantity of Output

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Comparing Monopoly to Perfect Competition

Changeover from perfect competition to monopoly benefits owners of monopoly and harms consumers of the product
Important proviso concerning this result
In comparing monopoly and perfect competition, price is higher and output is lower under monopoly if all else is equal

General conclusion
Monopolization of a competitive industry leads to two opposing effects
For any given technology of production, monopolization leads to higher prices and lower output Changes in technology of production made possible under monopoly may lead to lower prices and higher output

Ultimate effect on price and quantity depends on relative strengths of two effects

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Why Monopolies Often Earn Zero Economic Profit

Forces tending to cut monopoly profits
Government regulation Rent-seeking activity

Any costly action a firm undertakes to establish or maintain its monopoly status is called rent-seeking activity In countries with corrupt bureaucracies, rent-seeking activity includes bribes to government officials
In less corrupt governments, it includes time and money spent lobbying legislators and public for favorable polices

Rent-seeking activity that helps establish or maintain a firms monopoly position is part of firms costs
As a result, rent-seeking activity can reduce economic profit of a monopoly
May even reduce it to zero

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What Happens When Things Change?

Once a monopoly is maximizing profit, it has no incentive to change its price or its level of output
Unless something that affects these decisions changes

Possible events
Change in demand for monopolists product Change in its costs

What might cause a monopolist to experience a shift in demand?

Possible causes are the same as for perfect competition 27

An Increase in Demand and a CostSaving Technological Advance

Monopolist will react to an increase in demand by
Producing more output Charging a higher price Earning a larger profit

It will react to a decrease of demand by

Reducing output Lowering price Suffering a reduction in profit

In general, monopoly will pass to consumers only part of benefits from a cost-saving technological change
After change in technology, monopolys profits will be higher

In general, a monopoly will pass only part of a cost increase onto consumers in form of a higher price
After its cost increase, monopolys profits will be lower

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Figure 6: A Change in Demand

(a)
Monthly Price per Subscriber A $40 Monthly Price per Subscriber $47 40 B A

(b)

MC

MC

D1
10,000 MR1 30,000 Number of Subscribers 10,000 MR1 11,000

D1 D2 MR2 Number of Subscribers

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Figure 7: Monopoly Profit and Loss

Dollars

MC1 E D

MC2

$40 38

D 10,000 12,000 MR Number of Subscribers

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Price Discrimination
Single-price monopoly
Firm that is limited to changing same price for each unit of output sold

Price discrimination occurs when a firm charges different prices to different customers for reasons other than differences in costs Price-discriminating monopoly does not discriminate based on prejudice, stereotypes, or ill-will toward any person or group
Rather, it divides its customers into different categories based on their willingness to pay for good 31

Requirements for Price Discrimination

Although every firm would like to practice price discrimination, not all of them can To successfully price discriminate, three conditions must be satisfied
Must be a downward-sloping demand curve for the firms output Firm must be able to identify consumers willing to pay more Firm must be able to prevent low-price customers from reselling to high-price customers
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Price Discrimination That Harms Consumers

Price discrimination always benefits owners of a firm
Can use this ability to increase its profit

When price discrimination raises price for some consumer above price they would pay under a single-price policy it harms consumers
Additional profit for the firm is equal to monetary loss of consumers Till here

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Figure 8a: Price Discrimination

(a) Dollars per Ticket MC E ATC

$120 80

MR 30

D
Number of Round-trip Tickets

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Figure 8b: Price Discrimination

(b) Dollars per Ticket Additional profit from price discrimination $160 120 MC

MR 10 30

D
Number of Round-trip Tickets

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Figure 8c: Price Discrimination

(c) Dollars per Ticket MC Additional profit from price discrimination

$120 100

G H

MR 30 30

D
Number of Round-trip Tickets

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Price Discrimination That Benefits Consumers

Price discrimination benefits monopoly at the same time it benefits a group of consumers Since no ones price is raised, no one is harmed by this policy
When price discrimination lowers price for some consumers below what they would pay under a single-price policy, it benefits consumers as well as firm
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Perfect Price Discrimination

Suppose a firm could somehow find out maximum price customers would be willing to pay for each unit of output it sells It could increase profits even further by practicing perfect price discrimination
Firm charges each customer the most the customer would be willing to pay for each unit he or she buys Increases profit at expense of consumers

Perfect price discrimination is very difficult to practice in the real world

Would require firm to read its customers minds

Marginal revenue is equal to price of additional unit sold

Firms MR curve is same as its demand curve

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Figure 9: Perfect Price Discrimination

Dollars per Doll $30 25 E H MR curve before price discrimination

10

MC = ATC D Number of Dolls per Day

MR 20 30 60

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The Decline of Monopoly?

Past century was not kind to monopolies Today, monopolies face a different threat
Relentless advance of technology

The world of monopolies is changing rapidly

But monopolies in many forms will be with us for some time

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Using the Theory: Price Discrimination at Colleges and Universities

Most colleges and universities give some kind of financial aid to a large proportion of their students Financial aid has been used as an effective method of price discrimination
Designed to increase revenue of the college

Colleges have long been in an especially good position to benefit from price discrimination, because they satisfy all three requirements
Face downward-sloping demand curves Able to identify consumers willing to pay more Able to prevent low-price customers from reselling to high-price customers

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Using the Theory: Price Discrimination at Colleges and Universities

Most colleges have been active price discriminators for decades Under newer systems, those who can signal a lower willingness to pay have benefited from reduced prices
While those signaling greater willingness to pay have suffered a price increase

Result is vastly different prices for different students

Highly correlated to their families willingness to pay

Increased price discrimination at colleges, like so many other economic issues, is a matter of tradeoffs

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