1

Monopoly

Chapter 9

© 2006 Thomson/South-Western

2

Barriers to Entry

Sole supplier of a product with no close substitutes

Barriers to entry restrictions on the entry of new firms into an industry Legal restrictions Economies of scale Control of an essential resource

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Legal Restrictions

Patents award an inventor the exclusive right to produce a good or service for 20 years Provide the stimulus to turn an invention into a

marketable product, a process called innovation

Governments often confer monopoly status by awarding a single firm the exclusive right to supply a particular good or service

4

Exhibit 1: Economies of ScaleC

os

t p

er u

nit

Quantity per period

$

Long-run average cost

Monopoly emerges when a firm experiences economies of scale as reflected by the downward-sloping, long-run average cost curve

5

Economies of Scale

Market demand is not great enough to permit more than one firm to achieve sufficient economies of scaleA single firm will emerge from the competitive process as the sole seller in the market.

6

Control of Essential Resources

Control over some nonreproducible resource critical to productionProfessional sports teams Alcoa was the sole U.S. maker of aluminum for

a long period of time because it controlled the supply of bauxite

China is the monopoly supplier of pandasDeBeers controls the world’s diamond trade

7

Demand, Average and Marginal Revenue

De Beers controls the entire diamond market and suppose they can sell three diamonds a day at $7,000 each total revenue of $21,000

Total revenue divided by quantity is the average revenue per diamond which is also $7,000 monopolist’s price equals the average revenue per diamond

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Exhibit 2: Loss or Gain from Selling One More Unit

$7,000 6,750

3 0

4

Pri

ce p

er D

iam

on

d

1 - carat diamonds per day

D = Average revenue

LOSS

GAIN

By selling another diamond, De Beers gains the revenue from the sale of the 4th diamondTo sell the 4th unit, De Beers must sell all four diamonds for $6,750 each, sacrificing $250 on each of the first three diamonds that could have been sold for $7,000 eachThe loss in revenue from the first three units is $750The net change in total revenue from selling the 4th diamond is $6,750 - $750 = $6,000

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Exhibit 3: Revenue Schedule

As De Beers expands output, total revenue increases until quantity reaches 15 diamonds when total revenue tops outFor all units of output except the first, marginal revenue is less than price and the gap widens as the price declines because the loss from selling all diamonds at the lower price increases

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Exhibit 4: Monopoly Demand and Marginal and Total Revenue

(b) Total Revenue

$60,000

0 16 32

Total revenue

$3,750 0

16 32

Marginal revenue

Elastic

Inelastic

Unit elastic

D = Average revenue

1-carat diamonds per day

(a) Demand and Marginal Revenue

Total revenue is maximized when marginal revenue equals zeroWhen demand is elastic, a decrease in price increases total revenue marginal revenue is positiveWhen demand is inelastic, a decrease in price reduces total revenue marginal revenue is negative

$ p

er d

iam

on

dD

oll

ars

1-carat diamonds per day

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Firm’s Costs and Profit Maximization

Monopolist can choose either the price or the quantity, but choosing one determines the other

Because the monopolist can select the price that maximizes profit, we say the monopolist is a price maker

More generally, any firm that has some control over what price to charge is a price maker

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Exhibit 5: Short-Run Revenues and Costs for the Monopolist

Price Marginal Marginal Average TotalDiamonds (average Total Revenue Total Cost Total Cost Profit or per day revenue) revenue (MR = Cost ( MC = (ACT = Loss =

(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC (1) (2) (3) =(1) x (2) (4) (5) (6) (7) (8)

0 $7,750 0 - $15,000 - - -$15,000

1 7,500 $7,500 $7,500 19,750 4,750 $19,750 -12,250

2 7,250 14,500 7,000 23,500 3,750 11,750 9,000

3 7,000 21,000 6,500 26,500 3,000 8,830 -5,500

4 6,750 27,000 6,000 29,000 2,500 7,750 -2,000

5 6,500 32,500 5,500 31,000 2,000 6,200 1,500 6 6,250 37,500 5,000 32,500 1,500 5,420

5,000 7 6,000 42,000 4,500 33,750 1,250 4,820

8,250 8 5,750 46,000 4,000 35,250 1,500 4,410

10,750 9 5,500 49,500 3,500 37,250 2,000 4,140

12,25010 5,250 52,500 3,000 40,000 2,750 4,000

12,50011 5,000 55,000 2,500 43,250 3,250 3,930

11,75012 4,750 57,000 2,000 48,000 4,750 4,000

9,00013 4,500 58,500 1,500 54,500 6,500 4,190

4,00014 4,250 59,500 1,000 64,000 9,500 4,570 -

4,500 15 4,000 60,000 500 77,500 13,500 5,170 -7,50016 3,750 60,000 0 96,000 18,500 6,000

-36,00017 3,500 59,500 -500 121,000 25,000 7,120

-61,500

Short-run Costs and Revenue for a Monopolist

Profit-maximizing monopolist

produces that quantity where

total revenue exceeds total cost

by the greatest amount

$12,500 per day when output is 10

units per day. Total revenue is

$52,500 and total cost is $40,000MR = MC at

this same level of output

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Exhibit 6: Monopoly Costs and Revenue

0

MR

Marginal cost

D = Average revenue

Average total cost

$5,250

4,000Profit

a

b

e

Diamonds per day10 16 32

(a) Per-Unit Cost and Revenue

$52,500

40,000

15,000

0 10 16 32

Total revenue

Total costMaximum profit

Diamonds per day

(b) Total Cost and Revenue

The intersection of the two marginal curves at point e in panel (a) indicates that profit is maximized when 10 diamonds are sold. ATC of $4,000 is identified by point b: the average profit per diamond equals the price of $5,250 minus the ATC of $4,000 = $1,250 – the economic profit is the equal to $1,250 * 10 units sold = $12,500 In panel (b), the firm’s profit or loss is measured by the vertical distance between the TR and TC: profit is maximized where 10 diamonds are produced per day

Do

llar

s p

er u

nit

To

tal

do

lla

rs

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Exhibit 7: The Monopolist Minimizes Losses in the Short Run

p

Marginal cost

Average total cost

Average variable cost

Demand = Average revenue

Marginal revenue

0 Q

e

c

b

a

Loss

Quantity per period

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)The monopolist suffers a loss.But the monopolist will continue to produce rather than shut down in the short run because price exceeds average variable cost (at point c).

Do

llars

per

un

it

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Long-Run Profit Maximization

If a monopoly is insulated from competition by high barriers that block new entry, economic profit can persist in the long run

A monopolist that earns economic profit in the short-run may find that profit can be increased in the long run by adjusting the scale of the firm

Conversely, a monopoly that suffers a loss in the short run may be able to eliminate that loss in the long run by adjusting to a more efficient size

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Exhibit 8: Perfect Competition and Monopoly

pm

pc

0 Qm

Quantity per period

c Sc = MC = ATC

D = AR

MRm

m

b

a

Qc

Equilibrium in perfect competition is at point c, where market demand and supply intersect to yield price pc and quantity Qc

Monopolist maximizes profit by equating MR with MC: point b and price pm and output Qm

Consumer surplus is shown by the shaded triangle ampm

Do

llars

per

un

it

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Exhibit 8: Perfect Competition and Monopoly

p m

p

0 Qm

Quantity per period

c Sc = MC = ATC

D = AR

MRm

m

b

a

c

Qc

Do

llars

per

un

itConsumer surplus under perfect competition is the large triangle acpc while under monopoly it shrinks to the smaller triangle ampm

Consumer surplus has been reduced by more than the profit triangleConsumers have also lost the triangle mcb – the deadweight loss of monopoly – allocative inefficiency arising from the higher price and reduced output

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Why the Welfare Loss Might Be Lower

If economies of scale are extensive enough, a monopolist may be able to produce output at a lower cost per unit than could competitive firms, thus costs may be lower than under competition

Monopolists may, in response to public scrutiny and political pressure, keep prices below what the market could bear

A monopolist may keep the price below the profit maximizing level to avoid attracting new competitors

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Why the Welfare Loss Might Be Higher

If resources must be devoted to securing and maintaining a monopoly position, monopolies may involve more of a welfare loss that simple models suggest

Efforts devoted to securing and maintaining a monopoly position are largely a social waste because they use up scarce resources but add nothing to output

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Why the Welfare Loss Might Be Higher

Activities undertaken by individuals or firms to influence public policy to directly or indirectly redistribute income to them are called rent seeking

Without competition, monopolists may become inefficient

Monopolists are criticized for being slow to adopt the latest production techniques, develop new products, and for generally lacking innovation

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Price Discrimination

Charging difference prices to different customers when the price differences are not justified by differences in cost

Conditions: Demand curve must slope downward – the firm has

some market power and control over price At least two groups of consumers for the product, each

with a different price elasticity of demand Ability, at little cost, to charge each group a different

price for essentially the same product Ability to prevent those who pay the lower price from

reselling the product to those who pay the higher price

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Exhibit 9: Price Discrimination

•At a given price, price elasticity of demand (panel b, elastic) is greater than in panel a (inelastic).

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Perfect Price Discrimination

If a monopolist could charge a different price for each unit sold, the firm’s marginal revenue curve from selling one more unit would equal the price of that unit the demand curve would become the

marginal revenue curveA perfectly discriminating monopolist charges

a different price for each unit of the good

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Exhibit 10: Perfect Price Discrimination D

oll

ars

pe

r u

nit

c

0 Q Quantity per period

e

D = Marginal revenue

a

Long-runaverage cost= marginal cost

P r o f i t

A perfectly discriminating monopolist would maximize profits at point e, where MR = MC