Chapter 25

Monopoly

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Introduction
Economists have found that when nations’ governments proclaim that a single church denomination represents the “official” state religion, the church loses attendance equal to an average of about 15% of the nation’s population. Lower attendance at such churches is a prediction of the theory of monopoly applied to religious institutions. In this chapter, you will learn why a monopoly produces less output of a good or service that we would observe in a perfectly competitive market.

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Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Learning Objectives
• Identify situations that can give rise to monopoly • Describe the demand and marginal revenue conditions a monopolist faces • Discuss how a monopolist determines how much output to produce and what price to charge • Evaluate the profits earned by a monopolist • Understand price discrimination • Explain the social cost of monopolies

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Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter Outline
• • • • • • • Definition of a Monopolist Barriers to Entry The Demand Curve a Monopolist Face Elasticity and Monopoly Cost and Monopoly Profit Maximization Calculating Monopoly Profit On Making Higher Profits: Price Discrimination • The Social Cost of Monopolies
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Did You Know That...
• Many chefs are now patenting specific dishes? • Some chefs now have dozens of patents, all aimed at preventing other chefs from competing against them with copies of their own products. • This creates a situation called monopoly.

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Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Definition of a Monopolist
• Monopolist
– A single supplier of a good or service for which there is no close substitute – The monopolist therefore constitutes the entire industry.

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All rights reserved. 25-9 Copyright © 2010 Pearson Addison-Wesley. 25-7 Copyright © 2010 Pearson Addison-Wesley. Barriers to Entry (cont'd) • Barriers to entry include – Ownership of resources without close substitutes – Economies of scale – Legal or governmental restrictions 25-8 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. All rights reserved.Barriers to Entry • Question – How does a firm obtain monopoly power? • Answer – Barriers to entry that allow the firm to make long-run economic profits – Barriers to entry are restrictions on who can start as well as stay in business. . Barriers to Entry (cont'd) • Ownership of resources without close substitutes – The Aluminum Company of America (ALCOA) at one time owned most of of the world’s bauxite.

Barriers to Entry (cont'd) • Natural Monopoly – A monopoly that arises from the peculiar production characteristics in an industry – It usually arises when there are large economies of scale – One firm can produce at a lower average cost than can be achieved by multiple firms 25-11 Copyright © 2010 Pearson Addison-Wesley.Barriers to Entry (cont'd) • Economies of scale – Low unit costs and prices drive out rivals. 25-10 Copyright © 2010 Pearson Addison-Wesley. . Figure 25-1 The Cost Curves That Might Lead to a Natural Monopoly 25-12 Copyright © 2010 Pearson Addison-Wesley. – The largest firm can produce at the lowest average total cost. All rights reserved. All rights reserved. All rights reserved.

All rights reserved. All rights reserved. decreed that chimney sweeps were required to be German and had to be assigned to “districts. Thus. International Policy Example: German Chimney-Sweep Competition Goes Up in Smoke • In 1937.000 districts were geographic regions in which only a single chimney sweep was allowed to practice the trade. Barriers to Entry (cont'd) • Legal or governmental restrictions – Patents • Intellectual property – Tariffs • Taxes on imported goods – Regulation • Government enforcement of safety and quality 25-15 Copyright © 2010 Pearson Addison-Wesley. within each district. • What is the basic shape of each of the demand curves faced by the 8.000 German chimney sweeps? 25-14 Copyright © 2010 Pearson Addison-Wesley.Barriers to Entry (cont'd) • Legal or governmental restrictions – Licenses. franchises. All rights reserved. and certificates of convenience – Examples include • Electrical utilities • Radio and television broadcasting 25-13 Copyright © 2010 Pearson Addison-Wesley. .” • The 8. a chimney sweep has a monopoly strictly enforced by German law. • The requirement of only one chimney sweep per district still remains in force today. the acting interior minister of German. Heinrich Himmler.

The Demand Curve a Monopolist Faces • The monopolist faces the industry demand curve because the monopolist is the entire industry. and price are all the same 25-17 Copyright © 2010 Pearson Addison-Wesley. average revenue. All rights reserved. The Demand Curve a Monopolist Faces (cont'd) • Recall that under perfect competition – Firm faces perfectly elastic demand curve. 25-16 Copyright © 2010 Pearson Addison-Wesley. it is a price taker – The forces of supply and demand establish the price per unit – Marginal revenue. The Demand Curve a Monopolist Faces (cont'd) • Marginal revenue equals the change in total revenue due to a one-unit change in the quantity produced and sold 25-18 Copyright © 2010 Pearson Addison-Wesley. . All rights reserved. All rights reserved.

the firm accounts for a small part of the market. Figure 25-2 Demand Curves for the Perfect Competitor and the Monopolist 25-21 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.The Demand Curve a Monopolist Faces (cont'd) • Perfect competition versus monopoly – The perfect competitor doesn’t have to worry about lowering price to sell more. • It can sell its entire output. 25-20 Copyright © 2010 Pearson Addison-Wesley. 25-19 Copyright © 2010 Pearson Addison-Wesley. the monopolist has to lower the price because it is facing a downward sloping demand curve. The Demand Curve a Monopolist Faces (cont'd) • Perfect competition versus monopoly – The more the monopolist wants to sell. whatever that may be. at the same price. . All rights reserved. the lower the price it has to charge on the last unit sold. – To sell the last unit. – In a purely competitive situation. All rights reserved.

All rights reserved. 25-24 Copyright © 2010 Pearson Addison-Wesley. • That means that it cannot charge just any price with no changes in quantity (a common misconception) because. Perfect Competition Many sellers Faces perfectly elastic demand Must produce more to sell more All units sold for same price (P = MR) 25-22 Figure 25-3 Marginal Revenue: Always Less Than Price 25-23 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. a different quantity will be demanded. Elasticity and Monopoly • The monopolist faces a downward-sloping demand curve (its average revenue curve). depending on the price charged.The Demand Curve a Monopolist Faces (cont'd) Monopoly Single seller Faces entire industry demand Must lower price to sell more Not all units sold for same price (MR < P) Copyright © 2010 Pearson Addison-Wesley. . All rights reserved.

which the monopolist alone faces in this situation. slopes downward because individuals compare the marginal satisfaction they will receive to the cost of the commodity to be purchased. what will happen to quantity demanded? • Hint – Remember how consumers respond to a change in price. 25-25 Copyright © 2010 Pearson Addison-Wesley. . 25-26 Copyright © 2010 Pearson Addison-Wesley. – The demand curve slopes downward because individuals compare marginal satisfaction to cost. Elasticity and Monopoly (cont'd) • Recall – A monopolist is a single seller of a well-defined good or service with no close substitute. • The market demand curve. 25-27 Copyright © 2010 Pearson Addison-Wesley. Elasticity and Monopoly (cont'd) • After all. consumers have limited incomes and unlimited wants. • Think of some imperfect substitutes. All rights reserved. All rights reserved.Elasticity and Monopoly (cont'd) • Question – If a monopoly raises price. All rights reserved.

. All rights reserved. – The perfect competitor is a price taker. • For the pure monopolist. 25-29 Copyright © 2010 Pearson Addison-Wesley. Costs and Monopoly Profit Maximization (cont'd) • Perfect competitor has only to decide on the profit-maximizing output rate because price is given. All rights reserved. just as it is for the perfect competitor.Costs and Monopoly Profit Maximization • We assume profit maximization is the goal of the pure monopolist. 25-28 Copyright © 2010 Pearson Addison-Wesley. – The monopolist is a price searcher. All rights reserved. Costs and Monopoly Profit Maximization (cont'd) • Price Searcher – A firm that must determine the price-output combination that maximizes profit because it faces a downward-sloping demand curve 25-30 Copyright © 2010 Pearson Addison-Wesley. we must seek a profit-maximizing price output combination.

. Costs and Monopoly Profit Maximization (cont'd) • Total revenues-total costs approach – Maximize the positive difference between total revenues and total costs • Marginal revenue-marginal cost approach – Profit maximization will also occur where marginal revenue equals marginal cost. All rights reserved. 25-32 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. All rights reserved.Costs and Monopoly Profit Maximization (cont'd) • We can determine the profit-maximizing price-output combination with either of two equivalent approaches: – By looking at total revenues and total costs or – By looking at marginal revenues and marginal costs 25-31 Copyright © 2010 Pearson Addison-Wesley. Costs and Monopoly Profit Maximization (cont'd) • Question – Why produce where marginal revenue equals marginal cost? • Answer – This is where the greatest positive difference between total revenue and total cost occurs. 25-33 Copyright © 2010 Pearson Addison-Wesley.

Figure 25-4 Monopoly Costs. Panel (a) 25-34 Copyright © 2010 Pearson Addison-Wesley. . Revenues. All rights reserved. All rights reserved. Figure 25-4 Monopoly Costs. Revenues. All rights reserved. Panels (b) and (c) 25-35 Copyright © 2010 Pearson Addison-Wesley. Costs and Monopoly Profit Maximization (cont'd) • Producing past where MR = MC – Result is that incremental cost will exceed incremental revenue • Producing less than where MR = MC – The monopolist is not maximizing profits through this approach either 25-36 Copyright © 2010 Pearson Addison-Wesley. and Profits. and Profits.

Cost and Monopoly Profit Maximization (cont’d) • Real-World Informational Limitations – Price searching by a less-than perfect competitor is a process. Calculating Monopoly Profit • Monopoly profit is given by the shaded area in Figure 25-6. – For the perfect competitor. 25-39 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.Figure 25-5 Maximizing Profits 25-37 Copyright © 2010 Pearson Addison-Wesley. 25-38 Copyright © 2010 Pearson Addison-Wesley. . – A monopolist can only estimate the actual demand curve and make an educated guess when it sets its profit-maximizing profit. All rights reserved. All rights reserved. price is given already by the intersection of market demand and supply. which is equal to total revenues (P × Q) minus total costs (ATC × Q).

Figure 25-7 Monopolies: Not Always Profitable 25-42 Copyright © 2010 Pearson Addison-Wesley. . or demand – No price-output combination allows the monopolist to cover costs 25-41 Copyright © 2010 Pearson Addison-Wesley. Calculating Monopoly Profit (cont'd) • No guarantee of profits – The term monopoly conjures up the notion of a greedy firm ripping off the public. • If ATC is everywhere above AR. All rights reserved. All rights reserved. All rights reserved.Figure 25-6 Monopoly Profit 25-40 Copyright © 2010 Pearson Addison-Wesley.

with the difference being unrelated to differences in cost 25-43 Copyright © 2010 Pearson Addison-Wesley. The firm must be able to prevent resale of the product or service. 3. All rights reserved. 25-45 Copyright © 2010 Pearson Addison-Wesley. . All rights reserved. 2. The firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand. On Making Higher Profits: Price Discrimination (cont'd) • Price Differentiation – Establishing different prices for similar products to reflect differences in marginal cost in providing those commodities to different groups of buyers 25-44 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. On Making Higher Profits: Price Discrimination (cont'd) • Necessary conditions for price discrimination 1.On Making Higher Profits: Price Discrimination • Price Discrimination – Selling a given product at more than one price. The firm must face a downward-sloping demand curve.

students must provide detailed information about family income and wealth. All rights reserved.” • To document their “need” for financial aid. – Notice the monopolist produces a smaller quantity and sells at a higher price. • Figure 25-8 shows how this collegiate price-discrimination process works. The Social Cost of Monopolies • Comparing monopoly with perfect competition – Let’s assume a monopolist comes in and buys up every single perfect competitor.Example: Why Students Pay Different Prices to Attend College • Out-of-pocket tuition rates for any two college students can differ by considerable amounts. 25-46 Copyright © 2010 Pearson Addison-Wesley. • The reason for this is that colleges offer students diverse financial aid packages depending on their “financial need. This information. . helps the college determine the prices that different families are most likely to be willing and able to pay. even if the students happen to major in the same subjects and enroll in many of the same courses. All rights reserved. 25-48 Copyright © 2010 Pearson Addison-Wesley. of course. All rights reserved. Figure 25-8 Toward Perfect Price Discrimination in College Tuition Rates 25-47 Copyright © 2010 Pearson Addison-Wesley. so that it can engage in price discrimination.

Issues and Applications: The Predictable Consequences of European State Religion Monopolies • For years. All rights reserved. • The key to understanding the low Sunday service attendance by members of the Church of Sweden is its traditional status as a state monopoly. the regular attendance at Sunday church services is low. though about 75% of the population of Sweden remain official members. the church of Sweden was the official institution of the Swedish state. • The reason for this is that granting a religion monopoly has a very predictable effect: restriction of religious output and higher-priced services. Today.The Social Cost of Monopolies (cont'd) • Comparing monopoly with perfect competition – Monopolists raise the price and restrict production compared to a perfectly competitive situation. 25-49 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 25-51 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. • Economists who study the economics of religion have found that the pattern of low attendance experienced by Sweden holds true in all nations in which a single church predominates through state favors. . Figure 25-9 The Effects of Monopolizing an Industry 25-50 Copyright © 2010 Pearson Addison-Wesley. – Consumers pay a price that exceeds the marginal cost of production and resources are misallocated in such a situation.

– Marginal revenue is less than price.Issues and Applications: The Predictable Consequences of European State Religion Monopolies (cont’d) • Religious competition gradually is developing across Europe. 25-53 Copyright © 2010 Pearson Addison-Wesley. Summary Discussion of Learning Objectives (cont'd) • Why a monopoly can occur – Barriers to entry • Demand and marginal revenue conditions faced by a monopolist – Because the monopolist constitutes the entire industry. All rights reserved. Summary Discussion of Learning Objectives (cont'd) • How a monopolist determines how much output to produce and what price to charge – Seeks to maximize its economic profits – Produces where marginal revenue equals marginal cost – Charges maximum price for the amount of output where MR = MC 25-54 Copyright © 2010 Pearson Addison-Wesley. • Why might economists disagree about the appropriateness of using rates of church attendance as a proxy measure of “religious output”? 25-52 Copyright © 2010 Pearson Addison-Wesley. . • For this reason. All rights reserved. it faces the entire market demand curve. All rights reserved. many economists predict that religious output is likely to increase in Europe in the coming years.

Summary Discussion of Learning Objectives (cont'd) • Social cost of monopolies – Price exceeds marginal cost. Summary Discussion of Learning Objectives (cont'd) • Price discrimination – Selling at more than one price with the price differences being unrelated to differences in production costs. 25-56 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. – Monopolist typically earns positive economic profits.Summary Discussion of Learning Objectives (cont'd) • A monopolist’s profits – Profit earned by monopolist is equal to the difference between the price it charges and its average production cost times the amount of output it produces and sells. All rights reserved. – Monopolist sells some of its output at higher prices to consumers with less elastic demand. All rights reserved. – The price is higher and output is lower for a monopolist as compared to a perfectly competitive industry. . 25-55 Copyright © 2010 Pearson Addison-Wesley. 25-57 Copyright © 2010 Pearson Addison-Wesley.

Figure F-1 Consumer Surplus 25-58 Copyright © 2010 Pearson Addison-Wesley. . Figure F-2 Consumer Surplus in a Perfectly Competitive Market 25-59 Copyright © 2010 Pearson Addison-Wesley. All rights reserved. All rights reserved. All rights reserved. Figure F-3 Losses Generated by Monopoly 25-60 Copyright © 2010 Pearson Addison-Wesley.

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