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Chapter 9 ECON4 William A. McEachern
1
Monopoly
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Barriers to Entry
• Monopoly
– Sole supplier of a product with no close
substitutes
• Barrier to entry
– Any impediment that prevents new firms
• From entering an industry
• And competing on an equal basis with
existing firms
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Barriers to Entry
• Barriers to entry
– Legal restrictions
– Economies of scale
– Control of essential resources
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Barriers to Entry
• Legal restrictions
– Patents and invention incentives
• Exclusive right to sell a product for 20 years
from the date the patent application is filed
• Incentive for innovation
– Licenses and other entry restrictions
• Government awarding an individual firm the
exclusive right to supply a particular good or
service
• Federal and state license
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Barriers to Entry
• Economies of scale
– Natural monopoly
– Downward-sloping long-run average cost
curve
• One firm can supply market demand at a
lower average cost per unit than could two
firms
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Exhibit 1
6
Economies of Scale as a Barrier to Entry
Quantity
per period
Cost
per
unit
$
Long-run
average cost
A monopoly sometimes emerges
naturally when a firm
experiences economies of scale
as reflected by a downward-
sloping long-run average cost
curve. One firm can satisfy
market demand at a lower
average cost per unit than could
two or more firms, each
operating at smaller rates of
output.
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Barriers to Entry
• Control of essential resources
– Firm’s control over some resource critical
to production
– Alcoa (aluminum)
• Control the supply of bauxite
– Professional sports leagues
– China (pandas)
– DeBeers Consolidated Mines (diamonds)
7
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Barriers to Entry
• Supplying something that other
producers can’t match
– Unique experience
• Monopolies
– Local, national, international
• Long-lasting monopolies
– Rare - economic profit attracts
competitors
– Technological change8
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Revenue for the Monopolist
• Monopoly
– Supplies the market demand
• Downward-slopping (law of demand)
– To sell more: must lower the price on all
units sold
• Total revenue TR=pˣQ
• Average revenue AR=TR/Q
– For monopolist: p=AR
• Demand curve = average revenue curve9
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Exhibit 2
10
A Monopolist’s Gain and Loss in Total Revenue from Selling
a Fourth Unit
D = Average revenue
Dolla
rs p
er
dia
mon
d
$7,0006,750
1-carat diamonds
per day3 40
Loss
Gain
If De Beers increases
quantity supplied from 3 to 4
diamonds per day, the gain in
revenue from the fourth
diamond is $6,750. But the
monopolist loses $750 from
selling the first 3 diamonds
for $6,750 each instead of
$7,000 each. Marginal
revenue from the fourth
diamond equals the gain
minus the loss, or $6,750
$750 $6,000. Thus, the
marginal revenue of $6,000 is
less than the price of $6,750.
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Revenue for the Monopolist
• Marginal revenue MR=∆TR/∆Q
– For monopolist: MR<p
– Declines, can be negative
• Marginal revenue curve
– Downward sloping
– Below the demand curve (average
revenue curve)
11
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Exhibit 3
12
Revenue for De Beers, a Monopolist
To sell more, the
monopolist must
lower the price on
all units sold.
Because the
revenue lost from
selling all units at a
lower price must be
subtracted from the
revenue gained
from selling another
unit, marginal
revenue is less than
the price. At some
point, marginal
revenue turns
negative, as shown
here when the price
is reduced to
$3,500.
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Exhibit 4
13
Monopoly Demand, Marginal Revenue, and Total Revenue
Dolla
rs p
er
dia
mond
$3,750
0
(a) Demand and marginal revenue
(b) Total revenue
1-carat diamonds per day0 16 32
Tota
l dolla
rs
$60,000
1-carat diamonds per day16 32
D=Average revenue
Elastic
Unit elastic
Inelastic
MR
Total revenue
Where demand is price elastic,
marginal revenue is positive, so total
revenue increases as the price falls.
Where demand is price inelastic,
marginal revenue is negative, so total
revenue decreases as the price falls.
Where demand is unit elastic,
marginal revenue is zero, so total
revenue is at a maximum, neither
increasing nor decreasing.
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Revenue for Monopolist
• Total revenue curve
• Reaches maximum where MR=0
• Demand curve: p=AR
• Where demand is elastic, as price falls
– Total revenue increases
– MR>0
14
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Revenue for Monopolist
• Where demand is inelastic, as price falls
– Total revenue decreases
– MR<0
• Where demand is unit elastic
– Total revenue is maximized
– MR=0
15
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Costs and Profit Maximization
• Monopolist
– Choose the price
– OR the quantity
– ‘Price maker’
• Price maker
– Firm with some power to set the price
– Demand curve for its output slopes
downward
– Firms with market power16
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Costs and Profit Maximization
• Profit maximization
– Profit = total revenue minus total cost
– Supply the quantity where
• Total revenue exceeds total cost by the
greatest amount
• Marginal revenue equals marginal cost
17
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Exhibit 5
18
Short-Run Costs and Revenue for a Monopolist
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Exhibit 6
19
Monopoly Costs and Revenue
Dolla
rs p
er
dia
mond
$5,250
4,000
(a) Per-unit cost and revenue
(b) Total cost and revenue
D=Average
revenueMR
Total revenue
Diamonds per day0 16 3210
Total cost
Tota
l dolla
rs
$52,500
40,000
15,000
Average total cost
Marginal cost
Diamonds
per day16 32100
a
b
e
Profit
Maximum
profit
Profit is maximized by producing where
marginal cost equals marginal revenue, which
is point e in panel (a). A profit-maximizing
monopolist supplies 10 diamonds per day and
charges $5,250 per diamond. Total profit,
shown by the blue rectangle in panel (a), is
$12,500, the profit per unit multiplied by the
number of units sold. In panel (b), profit is
maximized by producing where total revenue
exceeds total cost by the greatest amount,
which occurs at an output rate of 10 diamonds
per day.
Maximum profit is total revenue ($52,500)
minus total cost ($40,000), or $12,500. In
panel (a) profit is measured by an area and
in panel (b) by a vertical distance. That’s
because panel (a) measures cost, revenue,
and profit per unit of output while panel (b)
measures them as totals.
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Short-Run Losses
• If the price exceeds average total cost,
p>ATC
– Economic profit
• If the price is between average total cost
and average variable cost, ATC>p>AVC
– Economic loss
– Produce in short run
20
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Shutdown Decision
• If the price is below the average variable
cost, p<AVC
– Average variable cost curve is above the
demand curve
– Economic loss
– Shut down in short run
21
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Exhibit 7
22
The Monopolist Minimizes Losses in the Short Run
0 Q Quantity per period
pDolla
rs p
er
unit
Average total cost
Average variable cost
Marginal cost
Demand=Average revenue
Marginal revenue
a
b
c
e
Loss
Marginal revenue equals marginal cost at point e. At quantity Q, price p (at point b) is
less than average total cost (at point a), so the monopolist suffers a loss, identified by
the pink rectangle. But the monopolist continues to produce rather than shut down in the
short run because price exceeds average variable cost (at point c)
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Long-Run profit Maximization
• Short-run profit
– No guarantee of long-run profit
• High barriers that block new entry
– Economic profit
• Erase a loss or increase profit
– Adjust the scale of the firm
• If unable to erase a loss
– Leave the market
23
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Monopoly & Allocation of Resources
• Perfect competition
– Long run equilibrium
– Constant-cost industry
– Marginal benefit (p) = marginal cost
– Allocative efficient market
– Maximize social welfare
– Consumer surplus
24
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Monopoly & Allocation of Resources
• Monopoly
– Marginal benefit (p) > marginal cost
– Restrict quantity below what would
maximize social welfare
– Smaller consumer surplus
– Economic profit
– Deadweight loss of monopoly
– Allocative inefficiency
25
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Monopoly & Allocation of Resources
• Deadweight loss of monopoly
– Net loss to society
– When a firm with market power restricts
output and increases the price
26
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Sc=MC=ATC
Exhibit 8
27
Perfect Competition and Monopoly Compared
Quantity
per periodQm Qc0
Dolla
rs p
er
unit
pm
pc
D
c
a
MRm
b
m
A perfectly competitive industry
would produce output QC,
determined by the intersection of
the market demand curve D and
the market supply curve SC. The
price would be pC. A monopoly
that could produce output at the
same minimum average cost as
a perfectly competitive industry
would produce output Qm,
determined at point b, where
marginal cost intersects marginal
revenue. The monopolist would
charge price pm. Thus, given the
same costs, output is lower and
price is higher under monopoly
than under perfect competition.
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Estimating Deadweight Loss
• Deadweight loss of monopoly might be
lower
– Substantial economies of scale
• Lower cost per unit
– Keep price below the profit maximizing
value
• Public scrutiny, political pressure
• Avoid attracting competition
28
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Estimating Deadweight Loss
• Deadweight loss of monopoly might be
higher
– Secure and maintain monopoly position
• Use resources; social waste
• Influence public policy (Rent seeking)
– Inefficiency
– Slow to adopt new technology
– Reluctant to develop new products
– Lack innovation
29
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Price Discrimination
• Price discrimination
– Increasing profit
– Charging different groups of consumers
• Different prices
• For the same product
30
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Price Discrimination
• Conditions for price discrimination
– Downward sloping demand curve
• Some market power
– At last two groups of consumers
• With different price elasticity of demand
– Ability to charge different prices
• At low cost
– Prevent reselling of the product
31
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A Model of Price Discrimination
• Two groups of consumers
– One group (a): less elastic demand
– The other (b): more elastic demand
• Maximize profit
– MR=MC in each market
– Lower price for group (b)
32
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Exhibit 9
33
Price Discrimination with Two Groups of Consumers
D
(a) Consumer group
with less elastic demand
LRAC, MC
(b) Consumer group
with more elastic demand
400 Quantity per period0 500 Quantity per period0
A monopolist facing two groups of consumers with different demand elasticities may be
able to practice price discrimination to increase profit or reduce loss. With marginal
cost the same in both markets, the firm charges a higher price to the group in panel
(a), which has a less elastic demand than group in panel (b).
Dolla
rs
per
unit
$3.00
1.00LRAC, MC
MR
Dolla
rs
per
unit
$1.50
1.00
D’MR’
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Examples of Price Discrimination
• Airline travel
• Businesspeople (business class)
– Less elastic demand
– Higher price
• Even within the same class
– Different prices
– Discount fares
– Weekend stay
34
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Examples of Price Discrimination
• IBM laser printer
• 5 pages/minute: home; cheaper
– Extra chip to insert pauses between pages
• 10 pages/minute: business; expensive
• Intel - two versions of the same
computer chip
– Cheaper version
• Same as the expensive version
• Some extra work done to reduce its speed
35
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Examples of Price Discrimination
• Adobe
– Photoshop Elements
• Cheaper version of Photoshop CD
• Amusement parks
• Out-of-towners: less elastic demand
– Higher prices
• Locals: more elastic demand
– Discount coupons available at local businesses
36
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Perfect Price Discrimination
• Perfectly discriminating monopolist
– Monopolist who charges a different price
– For each unit sold
– The monopolist’s dream
• Charge different price for each unit sold
– D curve becomes MR curve
– Convert consumer surplus into economic
profit
– Allocative efficiency: No deadweight loss37
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Exhibit 10
38
Perfect Price Discrimination
Quantity per periodQ0
Dolla
rs p
er
unit
cLong-run average
cost = Marginal cost
D=Marginal revenue
c
a
Profit
If a monopolist can charge a different price for each unit sold, it may be able to
practice perfect price discrimination. By setting the price of each unit equal to the
maximum amount consumers are willing to pay for that unit (shown by the height of
the demand curve), the monopolist can earn a profit equal to the area of the shaded
triangle. Consumer surplus is zero. Ironically, this outcome is efficient because the
monopolist has no incentive to restrict output, so there is no deadweight loss.