29-Nov-16

SS 132: Microeconomics

Monopoly

Dr Arshad Ali Bhatti

Fall 2016

In this lecture you will…

• Learn why some markets have only one
seller.
• Analyze how monopoly determines the
quantity to produce and the price to
charge.
• See how monopoly’s decisions affect
economic well-being.
• Consider the various public policies aimed
at solving the monopoly problem.
• See why monopolies try to charge
different prices to different customers.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 2

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MONOPOLY
• While a competitive firm is a
price taker, a monopoly firm is a
price maker.
• A firm is considered a monopoly if . .
.
– it is the sole seller of its product.
– its product does not have close
substitutes.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 3

Why Monopolies Arise

• The fundamental cause of

monopoly is barriers to entry.
• Barriers to entry have three sources:
– Ownership of a key resource.
– The government gives a single firm the
exclusive right to produce some good.
– Costs of production make a single
producer more efficient than a large
number of producers.

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Why Monopolies Arise

• Monopoly resources
– Although exclusive ownership of a key
resource is a potential source of
monopoly, in practice monopolies rarely
arise for this reason.
• Government created monopolies
– Governments may restrict entry by giving a
single firm the exclusive right to sell a
particular good in certain markets.
– Patent and copyright laws are two important
examples of how government creates a
monopoly to serve the public interest.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 5

Why Monopolies Arise

• Natural Monopolies
– An industry is a natural monopoly when
a single firm can supply a good or
service to an entire market at a smaller
cost than could two or more firms.
– A natural monopoly arises when there
are economies of scale over the
relevant range of output.

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Figure 1: Economies of Scale as a Cause of

Monopoly
Cost

Average
total
cost

0
Quantity of Output

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 7

Pricing and Production Decisions

• Monopoly versus Competition
– Monopoly
• Is the sole producer
• Faces a downward-sloping demand curve
• Is a price maker
• Reduces price to increase sales
– Competitive Firm
• Is one of many producers
• Faces a horizontal demand curve
• Is a price taker
• Sells as much or as little at same price

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 8

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Figure 2: Demand Curves for Competitive

and Monopoly Firms
(a) Competitive Firm (b) Monopoly
Price Price

Demand

Demand

0 0
Quantity of Output Quantity of Output

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 9

A Monopoly’s Revenue

• Total Revenue
P × Q = TR
• Average Revenue
TR/Q = AR = P
• Marginal Revenue
∆TR/∆Q = MR

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 10

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Table 1: A Monopoly’s Total, Average, and

Marginal Revenue.

Quantity of Total Average Marginal

Water Price Revenue Revenue Revenue
(Q) (P) (TR = P x Q) AR = (P x Q)/Q (MR = ∆TR/∆Q)

0 $ 11 $0 ------
$ 10
1 10 10 $ 10
8
2 9 18 9
6
3 8 24 8
4
4 7 28 7
2
5 6 30 6
0
6 5 30 5
-2
7 4 28 4
-4
8 3 24 3

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 11

A Monopoly’s Revenue
• A Monopoly’s Marginal Revenue
– A monopolist’s marginal revenue
is always less than the price of its
good.
• The demand curve is downward
sloping.
• When a monopoly drops the price to
sell one more unit, the revenue
received from previously sold units
also decreases.

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A Monopoly’s Revenue
• A Monopoly’s Marginal Revenue
– When a monopoly increases the
amount it sells, it has two effects
on total revenue (P × Q).
• The output effect—more output is
sold, so Q is higher.
• The price effect—price falls, so P is
lower.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 13

Figure 3: The Demand and Marginal

Revenue Curves for a Monopoly
Price
11
10
9
8
7
6
5
4
Demand
3
(average
2 Marginal revenue)
1 revenue
0
–1 1 2 3 4 5 6 7 8
–2
–3
–4

Quantity of Water
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Profit Maximization
• A monopoly maximizes profit by
producing the quantity at which marginal
revenue equals marginal cost, that is,
MR=MC.

• It then uses the demand curve to find the

price that will induce consumers to buy
that quantity.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 15

Figure 4: Profit Maximization for a Monopoly

Costs and 2. … and then the

Revenue demand curve shows
the price consistent
with this quantity. 1. The intersection of
the MR curve and the
Monopoly B MC curve determines
price the profit maximizing
quantity…
ATC

A
Demand

Marginal cost
Marginal revenue

0 Q1 QMAX Q2
Quantity

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 16

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Profit Maximization
• Comparing Monopoly and Competition
– For a competitive firm, price equals
marginal cost.
P = MR = MC
– For a monopoly firm, price exceeds
marginal cost.
P > MR = MC

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 17

A Monopoly’s Profit
• Profit equals total revenue minus
total costs.
– Profit = TR - TC
– Profit = (TR/Q - TC/Q) × Q
– Profit = (P - ATC) × Q

• The monopolist will receive

economic profits as long as price is
greater than average total cost.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 18

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Figure 5: The Monopoly’s Profit

Costs and
Marginal cost
Revenue

Monopoly E B
price

Monopoly Average total cost

profit

Average Demand
total cost
D C

Marginal revenue

0 QMAX
Quantity

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 19

CASE STUDY: The Market for Drugs

• A new drug discovery gives rise to a

patent and gives the firm a monopoly on
the sale of that drug.

• When the patent expires and any company

can make or sell the drug.

• The market switches from being

monopolistic to being competitive.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 20

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Figure 6: The Market for Drugs

Costs and
Revenue

Price
during
patent life

Price after MC
patent Demand
expires

MR

Monopoly Competitive
0 quantity quantity Quantity

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 21

THE WELFARE COST OF

MONOPOLY
• In contrast to a competitive firm, the
monopoly charges a price above the
marginal cost.
• From the standpoint of consumers,
this high price makes monopoly
undesirable.
• However, from the standpoint of the
owners of the firm, the high price
makes monopoly very desirable.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 22

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Figure 7: The Efficiency Level of Output

Price
Marginal cost

Value to Cost to
buyers monopolist

Cost to Value to Demand

monopolist buyers
(Value to buyers)

0 Efficient Quantity
quantity

Value to buyers is Value to buyers is

greater than cost to less than cost to
sellers sellers
Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 23

Deadweight Loss
• Because a monopoly sets its price above
marginal cost, it places a wedge between
the consumer’s willingness to pay and the
producer’s cost.
– This wedge causes the quantity sold to
fall short of the social optimum.
• The Inefficiency of Monopoly
– The monopolist produces less than the
socially efficient quantity of output.
– The “economic pie” shrinks.

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Figure 8: The Inefficiency of Monopoly

Price
Deadweight Marginal cost
loss

Monopoly
price

Demand

Marginal revenue

Monopoly Efficiency
0 Quantity
quantity quantity

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 25

Deadweight Loss
• The deadweight loss caused by a
monopoly is similar to the
deadweight loss caused by a tax.

• The difference between the two

cases is that the government gets
the revenue from a tax, whereas a
private firm gets the monopoly profit.

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PUBLIC POLICY TOWARD

MONOPOLIES
• Government responds to the
problem of monopoly in one of four
ways.
– Making monopolized industries
more competitive.
– Regulating the behaviour of
monopolies.
– Turning some private monopolies
into public enterprises.
– Doing nothing at all.
Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 27

Competition Law

• Legislation designed to encourage competition

and discourage the use of monopoly practices
can curb the inefficiencies resulting from market
power in general and monopoly in particular.

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Competition Law
• Competition laws have costs and benefits.
– Sometimes companies merge not to
reduce competition but to lower costs
through joint production.
– The benefits of greater efficiencies
through mergers are called synergies.

• If the competition laws are to raise social

welfare, the government must determine
which mergers are desirable and which
are not.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 29

Regulation
• Government may regulate the prices that
the monopoly charges. This is often the
case with natural monopolies where
governments regulate the price.
– The allocation of resources will be
efficient and total surplus maximized if
price is set to equal marginal cost.

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Regulation
• Two practical problems associated with
marginal-cost pricing.
1. Natural monopolies often have declining
average total cost. (See Figure 9)
– The price is less than ATC thus creating
losses.
2. No incentive for monopolist to reduce costs.
– Reducing costs will reduce prices.
– In practice, regulators will allow
monopolists to keep some of the benefits
from lower costs in the form of higher
profit, a practice that requires some
departure from marginal-cost pricing.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 31

Figure 9: Marginal Cost Pricing

Price

Average
total cost
Average total cost
Regulated Loss
price
Marginal cost

Demand

0 Quantity

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Public Ownership
• Rather than regulating a natural
monopoly that is run by a private
firm, the government can run the
monopoly itself.
– PTCL
– CDA- water

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 33

Doing Nothing
• Government can do nothing at all if the
market failure is deemed small compared
to the imperfections of public policies.

• Government intervention such as

regulation can cause average costs to
inflate (Political failure), increasing the
deadweight loss above its “do nothing”
level. (See Figure 10)

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Figure 10: Political Failure and Average

Costs Curves
Price

F
Pinflated
P0 A ATCinflated

D
Ptrue ATCtrue
G B
C
E Marginal cost

Demand

Marginal revenue

0 Qinflated Q0 Qtrue
Quantity

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 35

PRICE DISCRIMINATION
• Price discrimination is the business
practice of selling the same good at
different prices to different customers,
even though the costs for producing for
the two customers are the same.

• Price discrimination is not possible when

a good is sold in a competitive market
since there are many firms all selling at
the market price. In order to price
discriminate, the firm must have some
market power.
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PRICE DISCRIMINATION
• Perfect Price Discrimination refers to the
situation when the monopolist knows exactly
the willingness to pay of each customer and can
charge each customer a different price.
• Three important effects of price discrimination:
– It can increase the monopolist’s profits.
– Need to separate customers according to
their ability to pay.
• No arbitrage, the process of buying a good in one
market at a low price and selling it in another
market at a higher price.
– It can reduce deadweight loss.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 37

Figure 11: Welfare with and without Price

Discrimination
(a) Single price monopolist (b) Perfectly discriminating monopolist
Price Price

Consumer
surplus

Monopol Deadweight
y price loss

Profit Profit
MC MC

DD DD
MR

0 Quantity 0 Quantity
Quantity Quantity
sold sold

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 38

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PRICE DISCRIMINATION
• Examples of Price Discrimination
– Movie tickets
– Airline prices
– Discount coupons
– Financial aid
– Quantity discounts

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 39

Conclusion
• How prevalent are the problems of
monopolies?
– Monopolies are common.
– Most firms have some control over their
prices because of differentiated
products.
– Firms with substantial monopoly power
are rare.
– Few goods are truly unique.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 40

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Summary
• A monopoly is a firm that is the sole seller
in its market.
• It faces a downward-sloping demand
curve for its product.
• A monopoly’s marginal revenue is always
below the price of its good.
• Like a competitive firm, a monopoly
maximizes profit by producing the
quantity at which marginal cost and
marginal revenue are equal.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 41

Summary
• Unlike a competitive firm, its price
exceeds its marginal revenue, so its price
exceeds marginal cost.
• A monopolist’s profit-maximizing level of
output is below the level that maximizes
the sum of consumer and producer
surplus.
• A monopoly causes deadweight losses
similar to the deadweight losses caused
by taxes.

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Summary
• Policymakers can respond to the
inefficiencies of monopoly behaviour with
competition laws, regulation of prices, or
by turning the monopoly into a
government-run enterprise.
• If the market failure is deemed small,
policymakers may decide to do nothing at
all.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 15: Page 43

Summary
• Monopolists can raise their profits by
charging different prices to different
buyers based on their willingness to pay.
• Price discrimination can raise economic
welfare and lessen deadweight losses.

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The End

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