Market Structure

CHAPTER Pure Monopoly Market

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

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• Monopoly
– is a market structure in which there is a single seller of goods
and services which has no close substitutes in the market
– is a market that has only one seller, but many buyers.
– Examples: local telephone company, Hydro electric company,
Ethiopian airlines, etc.
• 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
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 Characteristics of Monopoly
1. Single supplier
– the firm and the industry are synonymous.
2. No close substitutes
– If substitute products were available, the monopolist would
not ​be able to exert control over the product's price, its
existence
3. Price maker :
– the firm has considerable control over price since it controls the total
quantity supplied.
4. Blocked entry :
– barriers to entry exist because there is no immediate competition
5. No collusion and competition:
– Because there is only one firm there is no competition exists and no
collusion among firms also.
• It is not a desirable structure for consumers or governments.
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 Why Monopolies Arise

• The main cause of monopolies is barriers to entry

– other firms cannot enter the market.
• Barriers to entry are factors that prohibit firms from
entering an industry. They include:
1. Legal barriers to entry
2. Ownership or control of essential resources
3. Economies of scale
4. Technical Superiority
5. Pricing and other strategic barriers to entry

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  Legal Barriers to Entry: Patents and Licenses
• Government-created barriers include patents and licenses.
– A patent is the exclusive right of an inventor to use, or to allow
another to use, her or his invention.
– Licensing also limits the production of a product at the federal,
state, or municipal level.
 Ownership or Control of Essential Resources
• A firm that owns or controls an essential resource can prohibit the entry or
rival firms.
• Private property serves as an obstacle to potential rivals.

3. Technical Superiority:
• A firm whose technological expertise vastly exceeds that of any potential
competitor can maintain a monopoly for a period of time.

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4. Economies of Scale
• If the size of a firm gives a cost advantage over a smaller rival, it
may be impossible for anyone to compete with largest firm in the
industry.
• If the market is controlled by a pure monopolist, economies of
scale serve as an entry barrier.
– New firms face very large start up costs which result in high
average total costs. This makes it hard to compete with a
monopolist that is already well established.
5. Pricing and Other Strategic Barriers to Entry
• Monopolists can bar entry into a market in other ways, including
– Price cutting
– Increase funding for advertising
– Exclusive contracts with distributors
• The legality of such behavior may be challenged in court
according to laws and regulations.
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 Monopoly vs. Competition: Demand Curves
• Recall that in pure competition, a
firm faces a perfectly elastic
demand since it is a price taker.
– The market supply and demand Price Monopoly
curves determine price, which Demand
determines the firm’s demand
curve. Competitive
• In pure monopoly, the firm’s firm demand
demand curve is the market
demand curve. Why? Market
– The pure monopolist is the Demand
industry; therefore, the demand
curve is downward-sloping. Quantity
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Monopoly Average and Marginal Revenue
$ per 7 • marginal revenue is downward sloping and fall less
unit of
output
demand curve .Why ?
6 • Because , monopolists set price on demand curve
and to increase sales the price must fall, MR < P
5

4 Average Revenue (Demand)

2
Marginal
1 Revenue

0 1 2 3 4 5 6 7 Output
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 Monopoly Profit Maximization
• Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR = MC.
– A perfectly competitive firm produces the quantity where
MC = MR (= p)
– A monopolist produces the quantity where MC = MR (< p)
• 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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 Monopoly Profit Maximization(cont’d)
Costs and
Monopoly profit Revenue MC
maximizing rules;
P
1. The profit-
maximizing Q
is where
MR = MC. D
MR
2. Find P from
the demand curve at Q Quantity
this Q.
Profit-maximizing output
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 A Monopoly Does Not Have an S Curve. Why?
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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 Monopoly Profits
• Total profit equals profit per unit times the number
of units produced.
– Profit per unit = price minus average total cost
– Profit per unit = p – ATC
– Total profit = profit per unit times quantity
– Total profit = (p – ATC) x q
• Alternatively, Profit can also be calculated by
subtracting total cost from total revenue:
Total profit = TR – TC
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 Monopoly earning profit

Monopoly
earn Positive
profit if
P>ATC

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 Monopolists can have Negative Profits

Monopoly
earn
negative
profit if
P<ATC

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 Suppose that an industry is characterized as follows:

C= 100 + 2𝑞 2 each firm’s total cost function

MC = 4q firm’s marginal cost function
P= 90 − 2Q industry demand curve
MR = 90 − 4Q industry marginal revenue curve

a) If there is only one firm in the industry, find the monopoly price, quantity,
and level of profit.
b) Find the price, quantity, and level of profit if the industry is competitive.
c) Graphically illustrate the demand curve, marginal revenue curve, marginal
cost curve, and average cost curve. Identify the difference between the
profit level of the monopoly and the profit level of the competitive industry
in two different ways.
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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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 Types of Price Discrimination
• 1st-degree: Each output unit is sold at a different price. Prices
may differ across buyers.
– Also called “personalized pricing”.
• 2nd-degree: The price paid by a buyer can vary with the
quantity demanded by the buyer. But all customers face the same
price schedule.
– E.g. bulk-buying discounts.
– Also called “menu pricing”.
• 3rd-degree: Price paid by buyers in a given group is the same for
all units purchased. But price may differ across buyer groups.
– E.g., senior citizen and student discounts vs. no discounts for
middle-aged persons.
– Also call “group pricing”.
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 Requirements to price discriminate
• In order for a firm to price discriminate successfully,
several requirements must be met.
– The firm must have some market power.
– There must be different “types” of consumers with
different marginal willingness to pay, and the firm must
know this.
– Ability to sort/identify consumers
– No possibility of resale or arbitrage.
– Need market power.
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 The Multi-plant Firm
• For some firms, production takes place in more than one plant,
each with different costs
• Firm must determine how to distribute production between
both plants
1. Production should be split so that the MC in the plants is the same
2. Output is chosen where MR=MC. Profit is therefore maximized
when MR=MC at each plant.
• We can show this algebraically:
– Q1 and C1 is output and cost of production for Plant 1
– Q2 and C2 is output and cost of production for Plant 2
– QT = Q1 + Q2 is total output
– Profit is then:
 = PQT – C1(Q1) – C2(Q2)
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 Production with Two Plants
The firm should choose to produce
$/Q
MC1 MC2 where MR = MC1 = MC2= MCT
MCT

• MR crosses MC1 and

P* MC2 shows the output
for each firm

MR* D = AR

MR

Q1 Q2 QT Quantity

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 Numerical Example
• A firm has two factories, for which costs are given by:
– Factory # 1: C1 (Q1) = 10𝑄12
– Factory # 2: C2 (Q2) = 20𝑄12
• The firm faces the following demand curve:
P = 700 - 5Q
where Q is total output—i.e., Q= Q1 +Q2.
i. On a diagram, draw the marginal cost curves for the two
factories, the average and marginal revenue curves, and the total
marginal cost curve (i.e., the marginal cost of producing
Q =Q1 +Q2).
ii. Indicate the profit-maximizing output for each factory, total
output, and price.
iii. Calculate the values of Q1, Q2, Q, and P that maximize profit.
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The Social Costs of Monopoly Power
• Monopoly power results in higher prices and lower
quantities
• However, does monopoly power make consumers
and producers in the aggregate better or worse
off ?
• We can compare producer and consumer surplus when
in a competitive market and in a monopolistic market

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 Perfect Competition and Monopoly
Suppose that :
PC and QC Perfectly competitive firm price and quantity
respectively
a
PM and QM Monopoly price and quantity respectively
Dollars per unit

m Monopoly
pm Qm where MRm=MC (point b)
pm on D (point m)
b c
pc Consumer surplus: ampm
Sc=MC=ATC
Economic profit: pmmbpc
D=AR
MRm Deadweight loss: mbc
Quantity Monopoly
0 Qm Qc
per period
higher price
Perfect competitive industry lower quantity
Qc and pc where D intersects Sc (point c)
Consumer surplus: acpc
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 The Social Costs of Monopoly(Cont’d..)
• Social cost of monopoly is likely to exceed the deadweight
loss. Because firm engage in Rent Seeking activities.
– Spending money in socially unproductive efforts to acquire,
maintain, or exercise monopoly. For instance;
• Lobbying
• Advertising
• Building excess capacity
• Government can regulate monopoly power through price
regulation
– In competitive markets, price regulation creates a deadweight
loss
– Price regulation can eliminate deadweight loss with a monopoly
– Reduce price to competitive levels
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