Causes of Monopolies

Monopolistic Markets

The causes of monopolization• Monoplositic resources

Only one firm owns a resource which is crucial for production (e.g. diamond monopol of DeBeers).

• Monopols created by the government Patents and copyrights (e.g. pharma industry).

• Natural monopols One single firm is able to produce the aggregate output of an industry at a lower cost than if there were multiple firms. Economies of scale (e.g.

MC

AC

MR

P

Q

PM

QM

The natural monopolSuppose there are economies of scale in the interval relevant for production (AC decreasing).

If production was shared amongst several firms, each firm would produce less than the monopolistic quantity and would therefore have higher average costs. One single firm can produce any given output at the lowest possible cost. For such a market a monopol is therefore the natural industry structure.

Example: Large fixed costs.

Competitive• Many buyers and sellers.

Price-taking behaviour.

• Homogeneous products

• Free entry and exit

Monopolistic• One seller and many

buyers. The seller can determine the price.

• The product does not have close substitutes

• Barriers to entry

Comparison of market-structures

Monopol versus competition

P

Q

dP

The demand curve faced by a competitive firm is horizontal.

The demand curve faced by a monopolist is identical to market demand

P

q

D

The production of the individual firm does not affect the market price.

The output decision of the monopolist influences the market price.

Equilibrium in a Monopoly

Monopolistic Markets

The monopolist`s decision

• The objectives of a monopolistic and a competitive firm are the same: Maximization of profits.

• Profits = Total revenue – Total cost

π(Q) = R(Q) - C(Q)

Total revenue R(Q) = P(Q) Q

Profit maximization

• The firm chooses Q to maximize π: π (Q) = R(Q) - C(Q) = P(Q)Q - C(Q)

• First order condition:

Marginal revenue = Marginal cost

The marginal revenue of a monopolist

When Q increases, total revenue changes for two reasons:

1. For every additional unit sold total revenue increases by P (Quantity effect)

2. When Q increases, P(Q) decreases. This implies that total revenue decreases as all units of output are sold at a lower price. (Price effect)

Profits are maximized when

P(Q) + Q P’(Q) = MC(Q)

The marginal revenue of a monopolist

Q

P

R(Q)=P(Q)Q

Profit maximization of a monopolist

C(Q)

(Slope = MC)

(Slope = MR)

π (Q)

Q*

Average revenue and marginal revenue

Q

P

Average revenue (demand)

Marginal revenue

Average revenue = revenue per unit produced:

AR = R/Q = P(Q)

Marginal revenue = revenue from one additional unit:

MR = P(Q)+P’(Q)Q

Given the negative slope of the demand curve, P’(Q)<0, the marginal revenue curve always lies below the demand curve P(Q).

MC

Q

PMRMC

D MR

PM

QM

Profits are maximized when marginal revenue is equal to marginal cost

MC

Q

PMRMC

D = AR

MRPM

QM

P1

P2

Q2Q1

Profit loss Profit loss

Profits are maximized when marginal revenue is equal to marginal cost

MC

Revenue = PM QMCost = AC(QM)QM Profits = (PM - AC(QM) ) QM

The profits of a monopolist

Q

D

MR

PM

QM

P

AC

AC(QM)

π

Example

• The demand for the product of a monopolist is given by P(Q)=23-Q. His total costs are C(Q)=3Q.

• Calculate monopoly price and output.• Calculate monopoly profits and consumer surplus.• Calculate the competitive equilibrium price and

output.• What is the welfare loss associated with the

existence of the monopol?

Example• MR = 23-2Q; MC=AC=3;• MR=MC→ QM=10; PM = 13;

• EP=Profits: (PM-AC)QM=100;

• EC= 0.5(23-PM)QM = 50;

• P=MC→ QC=20; PC=3;

• EP=0;

• EC= 0.5(23-PC)QC=200;

The Lerner Index

Monopolistic Markets

The monopoly price-cost margen

Profits are maximized when

MR = MC

Therefore the condition MR=MC can be written as

The monopoly price-cost margen

The elasticity of demand Ed serves as a measure of market power.

The monopoly price-cost margen

P P

Q Q

D

MR

MR

D

MC MC

QM QM

PM

PM

If demand is very elastic (Ed large), the margen is small.

If demand is very inelastic (Ed small), The margen is large.

MC(QM)

MC(QM)

The monopoly price-cost margen

The Lerner index • The Lerner index measures the monopoly

power.• L = (P - MC) / P = 1 / Ed

• It`s value lies between 0 and 1• The larger L the greater is the monopoly

power (If the firm was perfectly competitive L would be zero)