Monopoly

CHAPTER 9

2003 South-Western/Thomson Learning

Barriers to Entry
A monopoly is the sole supplier of a product with no close substitutes The most important characteristic of a monopolized market is barriers to entry new firms cannot profitably enter the market

Barriers to entry are restrictions on the entry of new firms into an industry
Legal restrictions Economies of scale Control of an essential resource
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Legal Restrictions
One way to prevent new firms from entering a market is to make entry illegal

Patents, licenses, and other legal restrictions imposed by the government provide some producers with legal protection against competition

Patent and Invention Incentives

A patent awards an inventor the exclusive right to produce a good or service for 20 years Patent laws
Encourage inventors to invest the time and money required to discover and develop new products and processes Also provide the stimulus to turn an invention into a marketable product, a process called innovation

Licenses and other Entry Restrictions

Governments often confer monopoly status by awarding a single firm the exclusive right to supply a particular good or service
Broadcast TV and radio rights State licensing of hospitals

Cable TV and electricity on local level

Economies of Scale
A monopoly sometimes emerges naturally when a firm experiences economies of scale as reflected by the downward-sloping, long-run average cost curve In these situations, a single firm can sometimes supply market demand at a lower average cost per unit than could two or more firms at smaller rates of output
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Exhibit 1: Economies of Scale as a Barrier to Entry

$

Cost per unit

Put another way, market demand is not great enough to permit more than one firm to achieve sufficient economies of scale a single firm will emerge from the competitive process as the sole seller in the market.

Long-run average cost

Quantity per period

7

Natural Monopoly
Because such a monopoly emerges from the nature of costs, it is called a natural

monopoly

A new entrant cannot sell enough output to experience the economies of scale enjoyed by an established natural monopolist entry into the market is naturally blocked

Control of Essential Resources

Another source of monopoly power is a firms control over some nonreproducible resource critical to production
Professional sports teams try to block the formation of competing leagues by signing the best athletes to long-term contracts Alcoa was the sole U.S. maker of aluminum for a long period of time because it controlled the supply of bauxite China is the monopoly supplier of pandas DeBeers controls the worlds diamond trade
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Local Monopolies
Local monopolies are more common that national or international monopolies Numerous natural monopolies for products sold in local markets However, as a rule long-lasting monopolies are rare because, as we will see, a profitable monopoly attracts competitors
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Revenue for the Monopolist

Because a monopoly, by definition, supplies the entire market, the demand for goods or services produced by a monopolist is also the market demand The demand curve for the monopolists output therefore slopes downward, reflecting the law of demand As seen in the following discussion this has important implications for revenues
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Demand, Average and Marginal Revenue

Suppose De Beers controls the entire diamond market and suppose they can sell three diamonds a day at $7,000 each total revenue of $21,000

Total revenue divided by quantity is the average revenue per diamond which is also $7,000
Thus, the monopolists price equals the

average revenue per diamond

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Demand, Average and Marginal Revenue

To sell a fourth diamond, De Beers must lower the price to $6,750 total revenue for 4 diamonds is $27,000 and average revenue is again $6,750 The marginal revenue from selling the fourth diamond is $6,000 marginal revenue is less than the price or average revenue Recall that these were equal for the perfectly competitive firm
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Exhibit 2: Loss or Gain from Selling One More Unit

$7,000

LOSS
6,750

Price per Diamond D = Average revenue

G A I N

By selling another diamond, De Beers gains the revenue from that sale, $6,750 from the 4th diamond as shown by the blue-shaded vertical rectangle marked gain. However, to sell that 4th unit, De Beers must sell all four diamonds for $6,750 each it must sacrifice $250 on each of the first three diamonds which could have sold for $7,000 each. The loss in revenue from the first three units, $750, is shown by the red shaded horizontal rectangle marked Loss. The net change in total revenue from selling the 4th diamond equals the gain minus the loss $6,750 - $750 = $6,000.

1 - carat diamonds per day

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Exhibit 3: Revenue Schedule

Revenue for De Beers, a Monopolist
1-Carat Price diamonds (average per day revenue) (Q) (p) (1) (2) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 $7,750 7,500 7,250 7,000 6,750 6,500 6,250 6,000 5,750 5,500 5,250 5,000 4,750 4,500 4,250 4,000 3,750 3,500 Total revenue (TR = Q x p) (3) =(1) x (2) 0 $7,500 14,500 21,000 27,000 32,500 37,500 42,000 46,000 49,500 52,500 55,000 57,000 58,500 59,500 60,000 60,000 59,500 Marginal revenue (MR = TR / Q) (4) $7,500 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500

The first two columns contain the pertinent price and quantity information. Total revenue (quantity times price) is provided in the third column. As De Beers expands output, total revenue increases until quantity reaches 15 diamonds when total revenue tops out.

Marginal revenue (the change in total revenue from selling one more diamond) appears in the fourth column. Note that for all units of output except the first, marginal revenue is less than the price, and the gap between the two widens as the price declines because the loss from selling all diamonds at this lower price increases.
Exhibit 4 depicts this information graphically.
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Exhibit 3: Monopoly Demand and Marginal and Total Revenue

Demand and marginal revenue are shown in the upper panel and total revenue is in the lower panel. Note that the marginal revenue curve is below the demand curve and total revenue is at a maximum when marginal revenue equals zero. Notice also that when demand is elastic, a decrease in price increases total revenue marginal revenue is positive. Conversely, when demand is inelastic, a decrease in price reduces total revenue marginal revenue is negative
(a) Demand and Marginal Revenue

Dollars per diamond

Elastic Unit elastic $3,750 Inelastic

0 16

D = Average revenue Marginal revenue 32 1-carat diamonds per day

(b) Total Revenue

$60,000
Total dollars

Total revenue

16

32

1-carat diamonds per day

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Firms Costs and Profit Maximization

The monopolist can choose either the price or the quantity, but choosing one determines the other Because the monopolist can select the price that maximizes profit, we say the monopolist is a price maker

More generally, any firm that has some control over what price to charge is a price maker
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Profit Maximization
Exhibits 5 and 6 repeat the revenue data from the previous exhibits and also include short-run cost data The cost data are similar to those already introduced in the preceding chapters The key issue is which price-quantity combination should De Beers select to maximize profits
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Exhibit 5: Short-Run Revenues and Costs for the Monopolist

Short-run Costs and Revenue for a Monopolist Diamonds per day (Q) (1) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Price (average Total revenue) revenue (p) (TR = Q x p) (2) (3) =(1) x (2) $7,750 7,500 7,250 7,000 6,750 6,500 6,250 6,000 5,750 5,500 5,250 5,000 4,750 4,500 4,250 4,000 3,750 3,500 0 $7,500 14,500 21,000 27,000 32,500 37,500 42,000 46,000 49,500 52,500 55,000 57,000 58,500 59,500 60,000 60,000 59,500 Marginal Revenue (MR = TR / Q) (4) $7,500 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500 Total Cost (TC) (5) $15,000 19,750 23,500 26,500 29,000 31,000 32,500 33,750 35,250 37,250 40,000 43,250 48,000 54,500 64,000 77,500 96,000 121,000 Marginal Average Total Cost Total Cost Profit or ( MC = (ACT = Loss = TC / Q) TC/Q) TR - TC (6) (7) (8) 4,750 3,750 3,000 2,500 2,000 1,500 1,250 1,500 2,000 2,750 3,250 4,750 6,500 9,500 13,500 18,500 25,000 $19,750 11,750 8,830 7,750 6,200 5,420 4,820 4,410 4,140 4,000 3,930 4,000 4,190 4,570 5,170 6,000 7,120 -$15,000 -12,250 9,000 -5,500 -2,000 1,500 5,000 8,250 10,750 12,250 12,500 11,750 9,000 4,000 -4,500 -7,500 -36,000 -61,500

The profitmaximizing monopolist employs the same decision rule as the competitive firm the monopolist produces that quantity where total revenue exceeds total cost by the greatest amount $12,500 per day when output is 10 units per day. Total revenue is $52,500 and total cost is $40,000
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Exhibit 5: Short-Run Revenues and Costs for the Monopolist

Short-run Costs and Revenue for a Monopolist Diamonds per day (Q) (1) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Price (average Total revenue) revenue (p) (TR = Q x p) (2) (3) =(1) x (2) $7,750 7,500 7,250 7,000 6,750 6,500 6,250 6,000 5,750 5,500 5,250 5,000 4,750 4,500 4,250 4,000 3,750 3,500 0 $7,500 14,500 21,000 27,000 32,500 37,500 42,000 46,000 49,500 52,500 55,000 57,000 58,500 59,500 60,000 60,000 59,500 Marginal Revenue (MR = TR / Q) (4) $7,500 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500 Total Cost (TC) (5) $15,000 19,750 23,500 26,500 29,000 31,000 32,500 33,750 35,250 37,250 40,000 43,250 48,000 54,500 64,000 77,500 96,000 121,000 Marginal Average Total Cost Total Cost Profit or ( MC = (ACT = Loss = TC / Q) TC/Q) TR - TC (6) (7) (8) 4,750 3,750 3,000 2,500 2,000 1,500 1,250 1,500 2,000 2,750 3,250 4,750 6,500 9,500 13,500 18,500 25,000 $19,750 11,750 8,830 7,750 6,200 5,420 4,820 4,410 4,140 4,000 3,930 4,000 4,190 4,570 5,170 6,000 7,120 -$15,000 -12,250 9,000 -5,500 -2,000 1,500 5,000 8,250 10,750 12,250 12,500 11,750 9,000 4,000 -4,500 -7,500 -36,000 -61,500

Applying the marginal rule would imply that the monopolist increases output as long as selling additional diamonds adds more to total revenue than to total cost. Again profit is maximized at $12,500 when output is 10 diamonds per day, per unit costs are $4,000 and the price is $5,250. Exhibit 6 provides a graphical illustration of this process. 20

Exhibit 6: Monopoly Costs and Revenue

The intersection of the two marginal curves at point e in panel (a) indicates that profit is maximized when 10 diamonds are sold. At this rate of output, we move up to the demand curve to find the profitmaximizing price of $5,250. The average total cost of $4,000 is identified by point b the average profit per diamond equals the price of $5,250 minus the average total cost of $4,000 $1,250 economic profit is the equal to $1,250 * 10 units sold $12,500 as shown by the blue shaded area. In panel (b), the firms profit or loss is measured by the vertical distance between the total revenue and total cost curves again profit is maximized where De Beers produces 10 diamonds per day
(a) Per-Unit Cost and Revenue Marginal cost Average total cost

$5,250 4,000
Profit

a b e MR D = Average revenue
32 Diamonds per day

10

16

(b) Total Cost and Revenue Maximum profit $52,500 40,000 Total cost

Total revenue
15,000

10

16

32 Diamonds per day

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Short-Run Losses and the Shutdown Decision

A monopolist is not assured of profit
The demand for the monopolists good or service may not be great enough to generate economic profit in either the short run or the long run

In the short run, the loss-minimizing monopolist must decide whether to produce or to shut down
If the price covers average variable cost, the firm will produce If not, the firm will shut down, at least in the short run
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Exhibit 7: The Monopolist Minimizes Losses in the Short Run

Recall that average variable cost and average fixed cost sum to average total cost . Loss minimization occurs at point e, where the marginal revenue curve intersects the marginal cost curve Q and p are the loss minimization quantity and price, respectively.
Marginal cost

a Loss p b

Average total cost Average variable cost

Notice that at point b, the firm is covering its average variable cost it is making some contribution to its fixed costs. However, it is not covering all of its costs. The average loss per unit, measured by ab, is identified by the yellow 0 shaded area.

e Demand = Average revenue Marginal revenue Q Quantity per period

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Monopolists Supply Curve

The intersection of a monopolists marginal revenue and marginal cost curve identifies the profit maximizing quantity, but the price is found on the demand curve Thus, there is no curve that shows both price and quantity supplied there is no monopolist supply curve

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Long-Run Profit Maximization

For a monopoly, the distinction between the long and short run is not as important If a monopoly is insulated from competition by high barriers that block new entry, economic profit can persist in the long run However, short-run profit is no guarantee of long-run profit
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Long-Run Profit Maximization

A monopolist that earns economic profit in the short-run may find that profit can be increased in the long run by adjusting the scale of the firm Conversely, a monopoly that suffers a loss in the short run may be able to eliminate that loss in the long run by adjusting to a more efficient size

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Price and Output Comparison

Purpose here is to compare monopoly using the benchmark established in our discussion of perfect competition When there is only one firm in the industry, the industry demand curve becomes the monopolists demand curve the price the monopolist charges determines how much gets sold Exhibit 8 provides our comparison
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Exhibit 8: Perfect Competition and Monopoly

The horizontal supply curve is based on the assumption of a constant-cost industry. Equilibrium in perfect competition is at point c, where market demand and supply intersect to yield price pc and quantity Qc. a m

Dollars per unit

p' m

p c

Sc = MC = ATC D = AR

The monopolist maximizes profit by equating marginal revenue with marginal cost point b equilibrium price pm and output Qm.

MRm 0

Q'm Q'c Quantity per period The price shows the consumers marginal benefit at that output rate, point m, which exceeds the marginal cost, point b. Because the marginal benefit consumers attach to additional units exceeds the marginal cost of producing those additional units, society would be better off if output were expanded beyond Qm the monopolist restricts output below the level that maximizes social welfare consumer surplus is shown by the yellow triangle ampm 28

Exhibit 8: Perfect Competition and Monopoly

a Consumer surplus under perfect competition is the large triangle acpc while under monopoly it shrinks to the smaller triangle ampm p' m The monopolist earns economic profit equal to the shaded rectangle a transfer from consumer surplus to monopoly profit this amount is not lost to society and so is not considered a welfare loss from monopoly.
Dollars per unit

p c

Sc = MC = ATC D = AR

MRm 0

Q'm Q'c Quantity per period Notice that consumer surplus has been reduced by more than the profit triangle. Consumers have also lost the triangle mcb which was part of the consumer surplus under perfect competition the deadweight loss of monopoly because it is a loss to consumers but a gain to nobody. This loss results from the allocative inefficiency arising from the higher price and reduced output.
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Why the Welfare Loss Might Be Lower

If economies of scale are extensive enough, a monopolist may be able to produce output at a lower cost per unit than could competitive firms If this is true, the price or at least the cost of production could be lower under monopoly than under competition

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Why the Welfare Loss Might Be Lower

The welfare loss shown in Exhibit 8 may also overstate the true cost of monopoly because monopolists may, in response to public scrutiny and political pressure, keep prices below what the market could bear Finally, a monopolist may keep the price below the profit maximizing level to avoid attracting new competitors

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Why the Welfare Loss Might Be Higher

Another line of thought suggests that the welfare loss of monopoly may, in fact, be greater than shown in our example If resources must be devoted to securing and maintaining a monopoly position, monopolies may involve more of a welfare loss that simple models suggest

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Why the Welfare Loss Might Be Higher

Consider, for example, radio and TV broadcasting rights confer on the recipient the exclusive right to use a particular band of the scarce broadcast spectrum In the past, these rights have been given away by government agencies to the applicants deemed most deserving

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Why the Welfare Loss Might Be Higher

Because these rights are so valuable, numerous applicants spend millions on lawyers fees, lobbying expenses, and other costs associated with making themselves appear the most deserving The efforts devoted to securing and maintaining a monopoly position are largely a social waste because they use up scarce resources but add not unit to output
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Why the Welfare Loss Might Be Higher

Activities undertaken by individuals or firms to influence public policy in a way that will directly or indirectly redistribute income to them are referred to as rent seeking Second, monopolists insulated from the rigors of competition in the marketplace, may also become efficient

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Why the Welfare Loss Might Be Higher

Finally, monopolists have also been criticized for being slow to adopt the latest production techniques, to develop new products, and generally lacking innovativeness

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Price Discrimination
A monopolist can sometimes increase economic profit by charging higher prices to customers who value the product more

The practice of charging difference prices to different customers when the price differences are not justified by differences in cost is called price

discrimination

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Conditions for Price Discrimination

Conditions
The demand curve for the firms product must slope downward the firm has some market power and control over price There are at least two groups of consumers for the product, each with a different price elasticity of demand The producer must be able, at little cost, to charge each group a different price for essentially the same product The producer must be able to prevent those who pay the lower price from reselling the product to those who pay the higher price
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Model of Price Discrimination

Exhibit 9 shows the effects of price discrimination Consumers are divided into two groups with different demands

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Exhibit 9: Price Discrimination

(a) (b)
Do llars p er unit $1.50 1.00

D o lla rs p e r u nit

$3.00

1.00 MR D

LRAC, MC

400

Quantity per period

LRAC, MC D' MR' 500 Quantity per period

At a given price, the price elasticity of demand in panel b(elastic) is greater than in panel a (inelastic). For simplicity, assume the firm produces at a constant long-run average and marginal cost of $1. This firm maximizes profits by finding the price in each market that equates marginal revenue with marginal cost consumers with the lower price elasticity pay $3 and those with the higher price elasticity pay $1.50 in markets with elastic demand the price will be lower than in markets where demand is inelastic. 40

Examples of Price Discrimination

Because businesspeople face unpredictable yet urgent demands for travel and communication, and because employers pay such expenses, businesspeople are less sensitive to price than householders Telephone companies are able to sort out their customers by charging different rates based on the time of day

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Perfect Price Discrimination

If a monopolist could charge a different price for each unit sold, the firms marginal revenue curve from selling one more unit would equal the price of that unit the demand curve would become the marginal revenue curve A perfectly discriminating monopolist charges a different price for each unit of the good Exhibit 10 provides our example
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Exhibit10: Perfect Price Discrimination

a

D o l la r s p e r u n i t

A perfectly discriminating monopolist would maximize profits at point e where marginal revenue equals marginal cost price set at point e

Profit
c

Long-run average cost = marginal cost

D = Marginal revenue

43 Quantity per period

Perfect Price Discrimination

Perfect price discrimination gets high marks based on allocative efficiency Because such a monopolist does not have to lower price to all customers when output expands, there is no reason to restrict output In fact, because this is a constant-cost industry, Q is the same quantity produced in perfect competition
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Perfect Price Discrimination

As in perfect competition, the marginal benefit of the final unit of output produced just equals its marginal cost And although perfect price discrimination yields no consumer surplus, the total benefits consumers derive just equal the total amount they pay for the good Since the monopolist does not restrict output, there is no deadweight loss

45