Microeconomics
Chapter 12
Monopoly
Microeconomics 1
Chapter Preview
• Under perfect competition:
– Firms are price takers, and max profit where P=MC.
– In the long run firms earn zero economic profit.
– Market is efficient.
• What happens if firms have market power?
• In this chapter we will focus on a monopoly.
– How does a monopolist set its price and output?
– What is wrong with monopoly?
– What are some other pricing strategies a monopolist can use?
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Causes of a Monopoly
• Monopolies exist because there are barriers to entry.
• Technical barriers to entry
– Decreasing average cost over a broad range of output like a
natural monopoly.
– Special knowledge of a low-cost method of production.
– Ownership of a key resource
– Possession of unique managerial talent.
• Legal barriers to entry.
– Patents and copyrights.
– Exclusive franchise or license.
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Profit Maximization in a Monopoly
Price
MC The monopolist maximizes profit
by producing an output where
MR = MC.
And sets price off the demand
P*
curve.
MR
Q* Quantity
per week
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No Supply Curve Under Monopoly
Price
S
As the demand curve rotates the
equilibrium price and quantity stay
the same.
P*
D2
D1
Q* Quantity
per week
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Profit Maximization in a Monopoly
Price
MC
Under a monopoly the equilibrium
price and quantity change.
P1
P2
D2
D1
MR2
MR1
Q1 Q2 Quantity
per week
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Economic Profits For A Monopoly
Price
MC
Since there are barriers to entry, the
monopolist can earn positive profits
even in the long run.
P*
Profit > 0; AC
P > AC
MR
Q* Quantity
per week
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What’s Wrong With Monopoly
• Two main criticisms:
– Monopolies produce too little output: allocatively inefficient.
– There is a redistribution of wealth from consumers to “fat cat”
owners.
– The first criticism is true; the second may not be.
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What’s Wrong With A Monopoly:
Efficiency Effects
• Three things to consider:
– Compared to perfect competition, a monopoly produces less
output and charges a higher price.
– Some of the consumer surplus under perfect competition is
transferred to the monopolist.
– There is also a deadweight loss under monopoly.
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What’s Wrong With A Monopoly:
Efficiency Effects
Price
PM
Transfers from
consumers to firm DWL
PPC MC = AC
MR D
QM QPC Quantity
per week
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What’s Wrong With A Monopoly:
Redistribution
• Why might there be a problem with the “fat cat” argument? Is it
really a transfer from the “poor” to the “rich”?
– The owners of the firm may be ordinary people.
– The people running the monopoly may be less wealthy than
the average citizen: Navajo Indians.
• Also, a monopolist is not guaranteed large or any profits.
– Market power gives it the ability to set P > MC.
– Profits depend on P vs. AC
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Economic Profits For A Monopoly
Price
MC
AC With higher AC, the monopoly
earns no profit.
P*
Profit > 0; AC
P > AC
MR
Q* Quantity
per week
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An Example of Deadweight Loss: Perfect
Competition
Demand Conditions Consumer Surplus
Quantity Average Under
(CDs and Perfect
per Total Marginal Marginal Compe- Under Monopoly
Price Week) Revenue Revenue Cost tition Monopoly Profits
$9 1 $9 $9 $3 $6 $3 $3
8 2 16 7 3 5 2 3
7 3 21 5 3 4 1 3
6 4 24 3 3 3 0 3
5 5 25 1 3 2 -- --
4 6 24 -1 3 1 -- --
3 7 21 -3 3 0 -- --
2 8 16 -5 3 -- -- --
1 9 9 -7 3 -- -- --
0 10 0 -9 3 -- -- --
Totals $21 $6 $12
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An Example of Deadweight Loss
• So under perfect competition:
– P = $3 and Q = 7
– CS = $21 and PS = $0
• And under a monopoly:
– P = $6 and Q = 4
– CS = $6, Profits (PS) = $12
– DWL = $3
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What’s Wrong With A Monopoly:
Efficiency Effects
• Why might the actual cost of a monopoly be higher than
measured by the DWL triangle?
– If the costs faced by the monopolist are higher than perfect
competition, DWL would be bigger.
– A monopoly may spend resources to maintain its market
power and long run profits: advertising, lobbying.
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Price Discrimination
• Price discrimination.
– The selling of identical units of output at different prices.
– Price discrimination allows the monopoly to earn more profit
than under a single pricing scheme.
– Price discrimination is a way to extract more surplus from
consumers.
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Price Discrimination
Price
This is consumer surplus from
consumers who buy the good at PM.
PM
This is surplus than can be extracted from
selling additional units at a price < PM .
DWL
PPC MC
MR D
QM QPC Quantity per week
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Perfect Price Discrimination (First Degree)
• Perfect price discrimination
– Each consumer is charged a price equal to the amount they
are willing and able to pay.
– The monopolist will serve all consumers as long as they are
willing to pay a price greater than or equal to marginal cost.
– The monopolist is able to extract all the surplus in the market.
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Perfect Price Discrimination
Price
P1 Charge P1 for the first unit
P2 Charge P2 for the second unit
PM Monopolist extracts all CS.
PROFIT DWL
Charge P=MC for the last unit
PPC MC
MR D
1 2 QM QPC Quantity per week
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Perfect Price Discrimination
• What can we say about efficiency?
– It is economically efficient. Output is produced up to the point
that P = MC. Welfare is maximized.
• What may prevent the monopoly from being able to successfully
price discriminate?
– Information problems: how does the firm know what you are
willing to pay.
– Resale.
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Price Discrimination: Market Separation
• Suppose the firm does not know how individual demands.
• Possible that the firm can separate the entire market into groups:
seniors and non-seniors, business and vacation travelers etc.
• Each group has its own demand, and the monopolist sets a
different profit maximizing price for each group.
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Price Discrimination: Market Separation
Price
P1
Uniform price
P2
MC
D1 MR1 D2
MR2
Output Market 1 Q1 Q2 Output Market 2
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Price Discrimination: Market Separation
• Compared to a uniform price, one group pays a higher price and
one group pays a lower price.
• What is the relationship between the price charged to each group
and the elasticity of demand?
– The group with the more inelastic demand (Group 1) pays a
higher price.
– The group with the more elastic demand (Group 2) pays a
lower price.
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Price Discrimination: Market Separation
Price
Group w/ inelastic Group w/ elastic
demand pays a demand pays a lower
higher price. price.
P1
Uniform price
P2
MC
D1 MR1 D2
MR2
Output Market 1 Q1 Q2 Output Market 2
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Price Discrimination: Nonlinear Pricing
• Problem with separating markets is that it requires the
monopolist to be able to distinguish between the two markets.
• If this is not possible the monopolist can use nonlinear pricing,
which is a schedule of quantities sold at different per unit prices.
– 8 oz. coffee for $1.60 vs. 16 oz. for $2.00
– 20 cents per oz. vs. 12.5 cents per oz.
– With linear pricing there would be the same cost of 15 cents
per ounce.
– With nonlinear pricing, the average price per unit falls as you
consume more.
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Price Discrimination: Nonlinear Pricing
• The monopolist can adjust the nonlinear pricing scheme to take
advantage of the variation in consumer valuations.
– A given consumer has diminishing valuation for extra units of
the good.
– Different consumers value the good differently.
• Two common examples of nonlinear pricing:
– Two-Part pricing: a fixed fee and a per unit charge
– Quantity discounts
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Nonlinear Pricing: Two Part Pricing
With a linear price the monopolist charges $2
Price and the consumer buys 10 units. Profit = $10.
$3
If the monopolist charged $1, the consumer
would buy 20 units and get CS = $20.
The monopolist would charge a fee equal
$2 to that CS, $20, which would be its profit.
Profit = $20
$1 MC
MR d
10 20 Quantity per week
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Price Discrimination: Two Part Pricing
• Two part pricing allows the monopolist to increase profits by $10.
• This is the same outcome as would occur under perfect price
discrimination.
• In reality not that simple. Since consumers have different
demands would need to:
– Reduce the fee so as not to lose low demand consumers.
– Increase the per-unit price to make up for lost revenue.
– Firm can use multiple two part tariffs and allow consumers to
choose the tariff best for them.
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Price Discrimination: Quantity Discounts
• With two part pricing there is an implicit quantity discount.
• With a $20 fee and $1 per unit:
– Buy 10 units pay, on average, $3 per unit
– Buy 20 units pay, on average, $2 per unit.
– By reducing the marginal price paid by the consumer, the
monopolist can extra more surplus.
• Quantity discounts can be used in a similar way.
– Small, medium, and large: the additional cost to go from one
size to the next gets smaller and smaller.
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Price Discrimination: Other Strategies
• Pricing for Multiproduct Firms
– Require that users of one product also buy a related,
complementary product.
– Pricing of bundled products may induce consumers to
purchase some goods that they wouldn’t buy individually.
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Price Discrimination: Other Strategies
• Durability
– Do monopolists practice “planned obsolescence”?
– Do monopolists practice dynamic pricing: charge a high price
initially, and then gradually reduce it over time?
• But consumers may anticipate lower prices and delay
purchase.
• By reducing durability, the monopolist could generate
return sales from high demand consumers.
• Leasing vs. selling.
• Frequent upgrades.
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Natural Monopolies and Regulation
• With a natural monopoly, average cost falls over the entire range
of output. Ignoring monopoly power, it would be efficient to have
only one firm producing the product.
• The solution is to regulate the market: allow only one firm but
regulate the price it charges.
– Marginal cost pricing.
– Two-Tier Pricing
– Rate of Return Pricing
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Natural Monopolies: Marginal Cost
Pricing
Price
Unregulated
outcome (MR=MC).
PA
Regulated
AC outcome
Economic Losses: P < AC MC (P=MC).
PR MR
D
QA QR Quantity per week
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Natural Monopolies: Two Tier Pricing
Price
One class of
consumers pay PA
and demand QA.
PA
Another class
AC of QR AC pays PR and
MC demand QR -QA
PR MR
D
QA QR Quantity per week
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Natural Monopolies: Two Tier Pricing
Price Under this scheme the monopolist
produces the efficient level of output, QR.
Prices are discriminatory (cross
subsidization).
PA Profits from high price customers cover
losses from low price customers.
Profits earned
from high price
consumers
AC of QR AC
Losses from low price
PR consumers MC
MR
D
QA QR Quantity per week
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Natural Monopolies and Regulation
• Rate of return regulation.
– Prices are set that allows the firm to just cover its costs
including a “fair” rate of return on capital investment.
• Debate over a “fair” rate of return.
• Incentive effects: suppose allowed return > competitive return.
– Firms have an incentive to use too much capital relative to
what is cost minimizing.
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Summary
• A monopolist maximizes profit by producing a level of output
where MR = MC and sets price off the demand curve.
• Since the demand curve is downward sloping, P > MC
• A monopoly is inefficient since buyers are willing to pay more for
one more unit than it costs to produce. There is a dead weight
loss.
• The long run profits earned by a monopoly may have undesirable
distributional effects.
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Summary
• A monopolist may be able to increase profits using price
discrimination: perfect price discrimination, separating markets
and non-linear pricing.
• Pricing decisions for multiproduct monopolies and durable goods
monopolies are more complicated. These complications may lead
to more or less market power.
• Governments may choose to allow a monopoly but regulate its
price. Marginal cost pricing leads to an efficient level of output,
but the firm would not be able to cover its costs. Under average
cost pricing an inefficient quantity is produced and the firm may
have an incentive to inflate its costs.
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