Understanding Monopoly

Credit
N. Gregory Mankiw
 TABLE OF CONTENTS

1. Why do monopolies arise?

2. Why is MR < P for a monopolist?
3. How do monopolies choose their P and Q?
4. How do monopolies affect society’s well-being?
5. What can the government do about monopolies?
6. What is price discrimination?
 INTRODUCTION

A monopoly is a firm that is the sole seller of a product without close

substitutes.

In this lecture, 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.
 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 world’s diamond
mines).

2. The government gives a single firm the exclusive right to produce the good. (E.g., patents,
copyright laws).

3. Natural monopoly: a single firm can produce the entire market Q at lower cost than
could several firms.
 WHY MONOPOLIES ARISE

Example: 1000 homes need electricity

Cost Electricity
ATC is lower if one
ATC slopes
firm services all 1000 downward due
homes than if two to huge FC and
$80 small MC
firms each service
$50 ATC
500 homes.
Q
500 1000
 MONOPOLY VS. COMPETITION: DEMAND CURVES

• In a competitive market, the

market demand curve slopes A competitive firm’s
downward. demand curve
P
• But the demand curve for any
individual firm’s product is
horizontal at the market price. D

• The firm can increase Q without

lowering P, so MR = P for the Q
competitive firm.
MONOPOLY VS. COMPETITION: DEMAND CURVES

A monopolist is the only seller, so

A monopolist’s demand
it faces the market demand curve.
curve
P
To sell a larger Q, the firm must
reduce P.

Thus, MR ≠ P.

D
Q
A MONOPOLY’S REVENUE

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

Q P TR AR MR
Here, P = AR,
0 $4.50 $0 n.a.
same as for a competitive $4
1 4.00 4 $4.00
firm. 3
2 3.50 7 3.50
Here, MR < P, whereas 2
3 3.00 9 3.00
MR = P 1
4 2.50 10 2.50
for a competitive firm. 0
5 2.00 10 2.00
–1
6 1.50 9 1.50
COMMON GROUNDS’ D AND MR CURVES
P, MR
Q P MR $5
4
0 $4.50 Demand curve (P)
$4 3
1 4.00
3 2
2 3.50 1
2
3 3.00 0
1
4 2.50 -1 MR
0 -2
5 2.00
–1 -3
6 1.50 0 1 2 3 4 5 6 7 Q
 UNDERSTANDING THE MONOPOLIST’S MR

❖ Increasing Q has two effects on revenue:

▪ Output effect: higher output raises revenue

▪ Price effect: lower price reduces revenue

❖ 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
Common Grounds increases Q from 5 to 6).
 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.

 PROFIT-MAXIMIZATION

1. The profit-maximizing Q Costs and

Revenue MC
is where
P
MR = MC.

2. Find P from the demand

curve at this Q. D
MR

Q Quantity

Profit-maximizing output
 THE MONOPOLIST’S PROFIT

As with a competitive firm, Costs and

Revenue MC
the monopolist’s profit equals
P
(P – ATC) x Q ATC
ATC

D
MR

Q Quantity
 A MONOPOLY DOES NOT HAVE AN 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;

Q and P are jointly determined by
MC, MR, and the demand curve.

Hence, no supply curve for monopoly.

 CASE STUDY: MONOPOLY VS. GENERIC DRUGS

Patents on new drugs give a The market for

Price a typical drug
temporary monopoly to the
seller.
PM
When the patent expires, the
market becomes competitive, PC = MC
D
generics appear.
MR

QM Quantity
QC
 THE WELFARE COST OF MONOPOLY

❖ Recall: In a competitive market equilibrium,

P = MC and total surplus is maximized.

❖ In the monopoly equilibrium, 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.

 THE WELFARE COST OF MONOPOLY

Competitive equilibrium:
Price Deadweight
quantity = QC
loss MC
P = MC
P
total surplus is maximized P = MC
Monopoly equilibrium: MC
D
quantity = QM
MR
P > MC

deadweight loss
QM QC Quantity
 PRICE DISCRIMINATION

❖ Discrimination: treating people differently based on some characteristic, e.g.

race or gender.

❖ Price discrimination: 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.
PERFECT PRICE DISCRIMINATION VS. SINGLE PRICE MONOPOLY

Here, the monopolist charges Consumer

Price
the same price (PM) to all surplus

buyers. Deadweight
PM loss
A deadweight loss results.
MC
Monopoly
profit D
MR

QM Quantity
PERFECT PRICE DISCRIMINATION VS. SINGLE PRICE MONOPOLY

Here, the monopolist produces the

Price
competitive quantity, but charges each buyer Monopoly
profit
his or her WTP.

This is called perfect price discrimination.

MC
The monopolist captures all CS as profit.
D
But there’s no DWL. MR

Quantity
Q
 PRICE DISCRIMINATION IN THE REAL WORLD

❖ In the real world, perfect price discrimination is not possible:

▪ No firm knows every buyer’s WTP

▪ Buyers do not reveal it to sellers

❖ So, firms divide customers into groups based on some observable trait that is
likely related to WTP, such as age.
 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 help distinguish business travelers, who usually have higher WTP, from more price-
sensitive leisure travelers.
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 children’s college education. Schools price-discriminate by offering need-
based aid to low -ncome families.
Quantity Discounts:
▪ A buyer’s WTP often declines with additional units, so firms charge less per unit for large quantities than small ones. A movie
theater charges $4 for a small popcorn and $5 for a large one that’s twice as big.
 PUBLIC POLICY TOWARD MONOPOLIES
1. Increasing competition with antitrust laws:

▪ Ban some anticompetitive practices, allow government to break up monopolies.

2. Regulation:

▪ Government agencies set the monopolist’s 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.

3. Public Ownership:

▪ Example: Department of Post and Telegraph

▪ Problem: Public ownership is usually less efficient since no profit motive to minimize costs

4. Doing Nothing

▪ The foregoing policies all have drawbacks, so the best policy may be no policy.
 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 lecture apply, including:

▪ Markup of price over marginal cost

▪ Deadweight loss
 SUMMARY
1. 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.

2. 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.

3. 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.

4. 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.

5. 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
25
be to take no action.