BySudarshan Kadariya

JMC

What is Monopoly??

A firm is a monopoly if . . .◦ it is the only seller of its product, and◦ its product does not have close substitutes.

The fundamental cause of monopoly is the existence of barriers to entry.

Barriers to entry have three sources:◦ Ownership of a key resource.◦ The government gives a firm the exclusive right

to produce some good.◦ Costs of production make one producer more

efficient than a large number of producers (Natural Monopoly)

Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason. Example: Diamond

Governments may restrict entry by giving one firm the exclusive right to sell a particular goods in certain markets.

Example: Patent and copyright laws are two important examples of how governments create monopoly to serve the public interest.

An industry is a natural monopoly when one firm can supply a good or service to an entire market at a lower cost than could two or more firms.

In other words, natural monopoly is an industry in which economies of scale are so important so that only one firm can survive.

Example: delivery of electricity, phone service, tap water, etc.

A natural monopoly arises when there are economies of scale over the relevant range of output.

Quantity of Output

Averagetotalcost

0

Cost

Quantity of Output

Demand

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

0

Price

Quantity of Output0

Price

Demand

Quantity of Water

Price

$1110

9876543210

–1–2–3–4

Demand(averagerevenue)

Marginalrevenue

1 2 3 4 5 6 7 8

Note that P = AR > MR at all quantities.

Unregulated natural monopoly

Regulated natural monopoly

An unregulated natural monopoly would attempt to maximize profits by producing the quantity of output where marginal revenue equals marginal cost. (MC=MR)

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PUN

$

Quantity (thousands)

D = PQUNMR

MC

ATC

Exploitation to customers Excessive profitability strengthen the

monopoly power Inequitable distribution of resources Operational inefficiency, etc

If so, How to curve????

The optimal quantity of output occurs where price equals marginal cost. (P=MC)

Thus, marginal social benefit equals marginal social cost.

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PUN

$

Quantity (thousands)

D = PQUNMR

MC

ATC

QOPT

POPT

Producing the profit-maximizing output causes a deadweight loss.

The deadweight loss is equal to the area between the demand curve and the marginal cost curve for the amount of underproduction.

Deadweight loss: The costs to society created by market inefficiency due to inefficient allocation of resources. Price ceilings, price floors, and taxation are all said to create deadweight losses. Deadweight loss occurs when supply and demand are not in equilibrium.

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׀ 0 ׀ ׀ ׀ ׀ ׀ ׀ ׀ ׀ ׀ 0 10 20 30 40 50 60 70 80 90 100

PUN

POPT

$

Quantity (thousands)

D = PQUN QOPTMR

MC

ATC

DeadweightLoss

Monopolyprofit

Averagetotalcost

Quantity

Monopolyprice

QMAX0

Costs andRevenue

Demand

Marginal cost

Marginal revenue

Average total cost

B

C

E

D

Quantity0

Price

Deadweightloss

DemandMarginalrevenue

Marginal cost

Efficientquantity

Monopolyprice

Monopolyquantity

P > MC; monopoly

P = MC; optimum

The monopolist produces less than the socially efficient quantity

P = MC; Profit maximizing

If a natural monopoly is regulated to produce the optimal quantity of output, the firm will suffer an economic loss.

To keep the monopoly firm to survive would require a government subsidy to the firm to eliminate the economic loss.

Economic loss: The difference between the revenue received from the sale of an output and the opportunity cost of the inputs used.

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PUN

POPT

$

Quantity (thousands)

D = PQUN QOPTMR

MC

ATC

Subsidy

Regulated price

GOVERNMENT SUBSIDY TO FIRM

Loss/Subsidy

Quantity0

Price

Demand

Average total cost

Regulatedprice Marginal cost

Average totalcost

The ideal public policy is to force the firm to produce Qoptimal and then subsidize for its economic loss.

Qoptimal

Ideal outcome

Compromise outcome

To avoid the need for a subsidy, natural monopolies are often regulated to earn zero economic profit (a normal rate of return).

But, this leads the following problems:1. The natural monopoly lacks incentives to control costs. (price may go up as cost)2. The regulators may not be able to obtain accurate information.

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׀ 0 ׀ ׀ ׀ ׀ ׀ ׀ ׀ ׀ ׀ 0 10 20 30 40 50 60 70 80 90 100

PUN

POPT

$

Quantity (thousands)

D = PQUN QOPTMR

MC

ATC

Subsidy

Compromise price

To overcome the monopoly power or the

inefficiency of monopoly firm or the inefficient

allocation of resources, government can play a

significant role to balance the social benefits

and the costs through subsidy to the firm or

determining the zero economic profit. (Profit

constraints – normal rate of return, price

ceiling, etc.

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