Monopoly

In this Topic, we will discuss the following:

 Why do monopolies arise?

 Why is MR < P for a monopolist?
 How do monopolies choose their P and Q?
 How do monopolies affect society’s well-being?
 What is price discrimination?

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 Introduction
 A monopoly is a firm that is the sole seller of a
product without close substitutes.
 The key difference:
A monopoly firm has market power, the ability
to influence the market price of the product it
sells. A competitive firm has no market power.

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 Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws

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 Why Monopolies Arise
3. Natural monopoly: a single firm can produce
the entire market Q at lower ATC than could
several firms.
Example: 1000 homes
need electricity. Cost Electricity
Economies of
ATC is lower if scale due to
one firm services huge FC
all 1000 homes $80
than if two firms $50 ATC
each service
Q
500 homes. 500 1000
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Monopoly vs. Competition: Demand Curves
In a competitive market,
the market demand curve
slopes downward.
A competitive firm’s
but the demand curve demand curve
for any individual firm’s P
product is horizontal
at the market price.
The firm can increase Q D
without lowering P,
so MR = P for the
competitive firm. Q

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Monopoly vs. Competition: Demand Curves

A monopolist is the only

seller, so it faces the
market demand curve.
A monopolist’s
To sell a larger Q, demand curve
P
the firm must reduce P.
Thus, MR ≠ P.

D
Q

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 1: Calculate
You Try
A monopoly’s revenue
Moonbucks is
Q P TR AR MR
the only seller of
cappuccinos in town. 0 $4.50 n.a.
The table shows the 1 4.00
market demand for
2 3.50
cappuccinos.
3 3.00
Fill in the missing
spaces of the table. 4 2.50
What is the relation 5 2.00
between P and AR?
6 1.50
Between P and MR?
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 1:
You Try
Answers

Q P TR AR MR
Here, P = AR,
same as for a 0 $4.50 $0 n.a.
$4
competitive firm. 1 4.00 4 $4.00
3
Here, MR < P, 2 3.50 7 3.50
whereas MR = P 2
for a competitive 3 3.00 9 3.00
1
firm. 4 2.50 10 2.50
0
5 2.00 10 2.00
–1
6 1.50 9 1.50

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Moonbuck’s D and MR Curves

P, MR
$5
4
Demand curve (P)
3
2
1
0
-1 MR
-2
-3
0 1 2 3 4 5 6 7 Q

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 Understanding the Monopolist’s MR
 Increasing Q has two effects on revenue:
• The output effect:
More output is sold, which raises revenue
• The price effect:
The price falls, which lowers revenue
 To sell a larger Q, the monopolist must reduce the
price on all the units it sells.
 Hence, MR < P

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 Profit-Maximization
 Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR = MC.
 Once the monopolist identifies this quantity,
it sets the highest price consumers are willing to
pay for that quantity.
 It finds this price from the D curve.

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 Profit-Maximization

Costs and
1. The profit- Revenue MC
maximizing Q
is where P
MR = MC.
2. Find P from
the demand D
curve at this Q. MR

Q Quantity

Profit-maximizing output
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 The Monopolist’s Profit

Costs and
Revenue MC

As with a P
ATC
competitive firm, ATC
the monopolist’s
profit equals D
(P – ATC) x Q MR

Q Quantity

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 Does a Monopolist Have S Curve
A competitive firm
 takes P as given
 has a supply curve that shows how its Q depends
on P
A monopoly firm
 is a “price-maker,” not a “price-taker”
 Q does not depend on P;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.
So there is no supply curve for monopoly.
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Case Study: Monopoly vs. Generic Drugs

Patents on new drugs The market for

Price a typical drug
give a temporary
monopoly to the seller.
PM
When the
patent expires,
the market PC = MC
becomes competitive, D
generics appear.
MR

QM Quantity
QC

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 The Welfare Cost of Monopoly
 Recall: In a competitive market equilibrium,
P = MC and total surplus is maximized.
 In the monopoly eq’m, P > MR = MC
• The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to
produce that unit (MC).
• The monopoly Q is too low –
could increase total surplus with a larger Q.
• Thus, monopoly results in a deadweight loss.

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 The Welfare Cost of Monopoly
Competitive eq’m:
Price Deadweight
quantity = QE loss MC
P = MC
total surplus is P
P = MC
maximized
MC
Monopoly eq’m:
D
quantity = QM
P > MC MR
deadweight loss QM QE Quantity

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 Problems and Applications
 A publisher faces the following demand
schedule for the next novel from one of its
popular authors:

 The author is paid $2 million to write the book,

and the marginal cost of publishing the book is a
constant $10 per book. 18
 Problems and Applications
 A publisher faces the following demand
schedule for the next novel from one of its
popular authors:
 The author is paid $2 million to write the book,
and the marginal cost of publishing the book is a
constant $10 per book.
 a Compute total revenue, total cost and profit at
each quantity. What quantity would a
profitmaximising publisher choose? What price
would it charge?

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 You Try
 Aqua owns the only well in town that produces clean
drinking water. It faces the following demand, marginal-
revenue and marginal-cost curves:
 Demand: P = 70 – Q
 Marginal revenue: MR = 70 – 2Q
 Marginal cost: MC = 10 + Q
 Graph these three curves. Assuming that Aqua
maximises profit, what quantity does it produce? What
price does it charge? Show these results on your graph.

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 Price
Discrimination

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 Who can do Price Discrimination?


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 Price Discrimination
 Discrimination in practice: treating people
differently
 Price discrimination is the business practice of
selling the same good at different prices to
different buyers.

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 Examples of Price Discrimination
Movie tickets
Discounts for seniors, students, and people
who can attend during weekday afternoons.
They are all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices
Discounts for Saturday-night stayovers help
distinguish business travelers, who usually have
higher WTP, from more price-sensitive leisure
travelers.

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 Examples of Price Discrimination
Discount coupons
People who have time to clip and organize
coupons are more likely to have lower income
and lower WTP than others.
Need-based financial aid
Low income families have lower WTP for
their children’s college education.
Schools price-discriminate by offering
need-based aid to low income families.

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 Examples of Price Discrimination
Quantity discounts
A buyer’s WTP often declines with additional
units, so firms charge less per unit for large
quantities than small ones.
Example: A movie theater charges $4 for
a small popcorn and $5 for a large one that’s
twice as big.

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 Perfect Price Discrimination
 Discrimination in practice: treating people
differently
 Price discrimination is the business practice of
selling the same good at different prices to
different buyers.
 The characteristic used in price discrimination
is willingness to pay (WTP):
• A firm can increase profit by charging a higher
price to buyers with higher WTP.
• Perfect price discrimination is also called 1st
degree price discrimination
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 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist Consumer
charges the same Price
surplus
price (PM) to all
Deadweight
buyers. PM loss
A deadweight loss
results. MC
Monopoly
profit D
MR

QM Quantity

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 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
produces the Price
competitive quantity, Monopoly
profit
but charges each
buyer his or her WTP.
This is called perfect
MC
price discrimination.
D
The monopolist
captures all CS MR
as profit.
Quantity
But there’s no DWL. Q
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 Price Discrimination in the Real World
 In the real world, perfect price discrimination is
not possible:
• no firm knows every buyer’s WTP
• buyers do not announce it to sellers
 Another type: 2nd degree Price Discrimination
• Seller charges different price for different blocks
of same good/service
 3rd degree Price Discrimination
• Firms also divide customers into groups
based on some observable trait, such as price
sensitivity (elasticity), or likely related to WTP,
such as age. 32
 Decision Making in Price Discrimination
 How much to produce to maximize profit in 1st
Degree price discrimination:
• MC = AR
 How much to produce to maximize profit in 2nd
Degree price discrimination:
• AC = AR
 How much to produce to maximize profit in 3rd
Degree price discrimination:
• MC = MR1 ; MC = MR2 ; …MC = MRn

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CONCLUSION: The Prevalence of Monopoly
 In the real world, pure monopoly is rare.
 Yet, many firms have market power, due to
• selling a unique variety of a product
• having a large market share and few significant
competitors
 In many such cases, most of the results from
this topic apply, including
• markup of price over marginal cost
• deadweight loss

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 Coke in Japan
Companies continually seek new methods to achieve
near perfect (first degree) price discrimination.
Some vending machines in Japan use wireless
modems to adjust their prices according to outside
temperature. Coca Cola started with a vending
machine with a computer-chip brain that can
automatically raise drink prices (somehow matching
a price which consumers are willing to pay) in hot
weather or lower prices (somehow matching again)
during off-hours to boost sales. Trying to match with
willingness to pay is purely an economic concept.

1st Deg. Price Discrimination

Microeconomics
 Google is Price Discriminating –
Perfectly.
When you do a search using Google, paid advertising appears
next to your results. The ads that appear vary according to your
search term. By making searches for unusual topics easy and
fast, Google helps firms reach difficult-to-find potential
customers with targeted ads. Such focused advertising has
higher payoff per view than traditional print and broadcast ads
that reach much larger, nontargeted Groups.
Advertisers are willing to bid higher to be listed first on
Google’s result pages. Google uses Bidding for Ads, thus,
varying the price according to advertisers’ willingness to pay,
Google is essentially perfectly price discriminating.

1st Deg. Price Discrimination

Microeconomics
 Public & Private Utilities
Public & private utilities (such as electricity and
telephone companies) regularly charge different
prices for different blocks of units of sales. They
not only reap the benefit of economies of scale
but also make more profit.

nd
2 Deg. Price Discrimination
Microeconomics
 Disneyland Does Not Miss Chance
Disneyland indeed mints money. Started in 1998,
Disney charged most adults $38 to enter the park but
charged southern Californians only $28. This policy
makes sense if visitors from far off places are willing
to pay more than locals and if Disneyland can
prevent locals from selling discount tickets (Disney
managed that by checking a purchaser’s driving
license and requiring that the tickets be used for same
day entrance) to non-locals. Imagine a person
travelling from east coast wants to visit Disneyland,
so an extra $10 doesn’t greatly affect that person’s
decision whether or not to go.

rd
3 Deg. Price Discrimination
Microeconomics
SUMMARY
 A monopoly firm is the sole seller in its market.
Monopolies arise due to barriers to entry,
including: government-granted monopolies, the
control of a key resource, or economies of scale
over the entire range of output.
 A monopoly firm faces a downward-sloping
demand curve for its product. As a result, it must
reduce price to sell a larger quantity, which causes
marginal revenue to fall below price.

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SUMMARY
 Monopoly firms maximize profits by producing the
quantity where marginal revenue equals marginal
cost. But since marginal revenue is less than
price, the monopoly price will be greater than
marginal cost, leading to a deadweight loss.
 Policymakers may respond by regulating
monopolies, using antitrust laws to promote
competition, or by taking over the monopoly and
running it. Due to problems with each of these
options, the best option may be to take no action.

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SUMMARY
 Monopoly firms (and others with market power) try
to raise their profits by charging higher prices to
consumers with higher willingness to pay. This
practice is called price discrimination.

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 Problems and Applications
 You live in a town with 300 adults and 200 children, and you are
thinking about putting on a play to entertain your neighbours and
make some money. A play has a fixed cost of $2000, but selling an
extra ticket has zero marginal cost. Here are the demand schedules
for your two types of customer:

 To maximise profit, what price would you charge for an adult ticket? For a child’s
ticket? How much profit do you make?
 The city council passes a law prohibiting you from charging different prices to
different customers. What price do you set for a ticket now? How much profit do42
you make?
 Problems and Applications
 Ted has just finished recording his latest CD. His
record company’s marketing department
determines that the demand for the CD is as
follows:

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 Problems and Applications
 The company can produce the CD with no fixed
cost and a variable cost of $5 per CD.
 Find total revenue associated with each quantity
listed in the table. What is the marginal revenue
for each 10 000 increase in the quantity sold?
 b What quantity of CDs would maximise profit?
What would the price be? What would the profit
be?
 c If you were Ted’s agent, what recording fee
would you advise Ted to demand from the record
company? Why?
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