Market Power: Monopoly

1
MARKET POWER: MONOPOLY
Chapter 11
Topics to be Discussed
2
 Monopoly and Monopoly Power

 The Social Costs of Monopoly Power
 Sources of Monopoly Power
 Limiting Market Power
©2005 Pearson Education, Inc.

Review of Perfect Competition
3
 P = LMC = LRAC
 Normal profits or zero economic profits in the long
run
 Large number of buyers and sellers
 Homogenous product
 Perfect information
 Firm is a price taker

Review of Perfect Competition
4
P Market P Individual Firm

D S
LMC LRAC
P0 P0
D = MR = P
Q0 Q q0 Q

Monopoly
5
 Monopoly
1. One seller - many buyers
2. One product (no good substitutes)
3. Barriers to entry
4. Price Maker

Monopoly
6
 A monopoly is a market with only one firm

 Entry into the market is blocked by technological
or legal barriers.
 e.g. Patents, trademarks, copyrights, or need a
license from the government to produce
 A natural monopoly is a monopoly that occurs
because a firm benefits from economies of scale.
This situation is likely to occur either when the
market is small or when fixed costs are
necessarily very large.
 e.g. Utilities (electricity, water and sanitation, etc.)
Monopoly
7
 Until a few years ago it had been argued that the

telecoms market was a natural monopoly. The
massive fixed costs of laying cables into millions of
homes meant that it was sensible to allow one
company to have a monopoly. However, in recent
years governments have deliberately broken up
these monopolies or allowed new firms to enter the
market. Technological advances, such as the
invention of mobile phones, have removed the
necessary conditions of natural monopoly.

The Monopolist
8
 The monopolist has market power. In other words,

the monopolist is a price maker.
 The monopolist is the supply-side of the market and
has complete control over the amount offered for
sale
 The monopolist chooses price and quantity
conditional on the consumers’ willingness to pay that
price for that quantity of the good.
 Essentially, the monopolist chooses a point on the
demand curve.
The Monopolist
9
 The monopolist cannot choose any point

above the demand curve because the
consumers would not be willing to pay that
price for that quantity of the good. Not willing to
pay
 Likewise, the monopolist would not want
to choose a point below the demand curve
Willing to
because the consumers would be willing to pay more D
pay a higher price for that quantity of the
good.
 Therefore, the monopolist chooses a point (a price and quantity) on

the demand curve, since the demand tells us the willingness to pay for
each quantity.

Revenue Effects
10
When a monopolist increases output, Monopoly

Price, p
price decreases, and there are two $ per unit
effects on revenue:
1. Revenue increases by the extra
output times the price (area B). p1
C
2. Revenue decreases by output times p2
Demand curve
the change in price (area C).
A B
With Monopoly,
Initial Revenue (at p1): A+C Q Q+1 Quantity, Q
Revenue with one more unit: A+B Units per year
Marginal Revenue: B – C = p2 – C
For a monopolist, since p is given by the demand curve, p = AR.

However, as we see here, p is NOT equal to MR for the monopolist.
Revenue Effects
11
Recall that for a Competitive Firm:

Price, p
$ per unit
Demand curve
p1
A B
q q+1 Quantity (units per year)

Average and Marginal Revenue
12
 The monopolist’s average revenue, price received

per unit sold, is the market demand curve
 Monopolist also needs to find marginal revenue,
change in revenue resulting from a unit change in
output

13
 Finding Marginal Revenue

 As the sole producer, the monopolist works with the
market demand to determine output and price
 An example can be used to show the relationship
between average and marginal revenue
 Assume a monopolist with demand:
P=6-Q

Total, Marginal, and Average Revenue
14

15
$ per 7
unit of
output
6
4 Average Revenue (Demand)
2
Marginal
1 Revenue
0 1 2 3 4 5 6 7 Output
Monopoly
16
 Observations
1. To increase sales the price must fall
2. MR < P
3. Compared to perfect competition
 No change in price to change sales
 MR = P

The Monopolist’s Profit Maximization Problem
17
 For a monopolist, price is a function of quantity, specifically

the demand curve. Therefore,
TR = PQ = P(Q)*Q
MR = (d/dQ)P(Q)*Q = P(Q) + P'(Q)*Q
 MR is always below the demand curve. Reason: Since

demand curve is also AR curve, then for AR to be falling (in
other words, for demand to be downward sloping), the MR
must be below the AR.
 If the demand curve is a straight line, the MR curve is also a
straight line, with: i) same vertical intercept as demand curve,
and ii) slope of MR is twice the slope of the demand curve.
18
 Like all firms, the monopolist chooses output by

setting marginal revenue equal to marginal cost.
1. Profits maximized at the output level where MR =
MC
2. Cost functions are the same
 (Q)  R(Q)  C (Q)

 / Q  R / Q  C / Q  0  MC  MR
or MC  MR

19
 At output levels below MR = MC, incremental

revenue is greater than incremental cost (MR > MC)
 At output levels above MR = MC, incremental cost is
greater than incremental revenue (MR < MC)

20
$ per
unit of
output MC
P1
P*
Lost
Profit from AC
producing
too little
P2
and selling
at too high
a price
D = AR
Lost
Profit from
producing too
MR much and
selling at too
Q1 Q* Q2 Quantity low a price

Monopoly: An Example
21
Cost  C (Q )  50  Q 2
C
MC   2Q
Q
Demand : P (Q )  40  Q
R(Q )  P (Q )Q  40Q  Q 2
R
MR   40  2Q
Q
22
MC  MR P (Q )  40  Q
2Q  40  2Q P (Q )  40  10
4Q  40 P (Q )  30
Q  10

23
 By setting marginal revenue equal to marginal cost,

we verified that profit is maximized at P = $30 and
Q = 10
 This can be seen graphically by plotting cost,
revenue and profit
 Profit is initially negative when produce little or no
output
 Profit increase and q increase, maximized at Q*=10

Example of Profit Maximization
24
$ C
r' R
400
When profits are

maximized, slope of
300 rr’ and cc’ are equal:
MR=MC
c’
200 r
Profits
150
100
50
c
0 5 10 15 20 Quantity
Example of Profit Maximization
25
$/Q
40 MC Profit = (P - AC) x Q
= ($30 - $15)(10) =
$150
P=30
Profit
AC
20
AR
AC=15
10
MR
0 5 10 15 20 Quantity
Exercise
26
 Let the demand curve be given by: P = 24 – Q Also

let MC = ATC = $6
 Solve for profit maximizing Q and P, and calculate
the profit

Elasticity of Demand and Total, Average,
and Marginal Revenue
27
 When demand is elastic, increasing quantity will increase total

revenue.
Marginal revenue is positive.
 When demand is inelastic, increasing quantity will decrease
total revenue.
Marginal revenue is negative.
 We already know that marginal cost is always positive.
 Therefore, a profit maximizing monopolist will always choose an
output in the elastic portion of the demand curve. (MR = MC)
 If a monopolist were producing in the inelastic portion of the
demand curve it could always increase profits by decreasing
output, because TC would decrease and TR would increase.
28
p, $ per unit
24 Perfectly elastic
Elastic, e < –1
Δ MR = – 2 Δ p = –1
ΔQ = 1 Δ Q = 1
e= –1
12
Inelastic, –1 < e < 0
Demand ( p = 24 – Q)
Perfectly
inelastic
0 12 24
MR = 24 – 2Q Q , Units per day

29

Monopoly-Pricing in Practice
30
 A Rule of Thumb for Pricing

 We want to translate the condition that marginal
revenue should equal marginal cost into a rule of thumb
that can be more easily applied in practice
TR = P(Q)*Q

A Rule of Thumb for Pricing
31
R ( PQ)
1. MR  
Q Q
 Looking at Marginal Revenue we know that it has two

components
 Producing (and selling) one more unit brings in revenue
(1)(P) = P
 With downward sloping demand, producing and selling
one more unit results in small drop in price P/Q,
which reduces revenue from all units sold, causing
change in revenue: Q(P/Q)

32
Thus
P
2. MR  P  Q
Q
 Q  P 
 P  P 
 

 P  Q 
3. E d   P  Q 
 Q  
P 
 
33

4.  Q 

 P 
 
1
 P  Q  Ed
 1 
5. MR  P P
E 
 d 
Remember: Ed is a negative number.
If demand is inelastic, so that -1 < Ed < 0, then MR < 0.
If demand is unit elastic, so that ed = -1, then MR = 0.
If demand is elastic, so that ed < -1, then MR > 0.

34
 is maximized where MR  MC
P  P 1   MC
 E D 
P  MC 1

P ED
MC
P
1  1 E D 
Measuring Monopoly Power
35
 (P – MC)/P is the markup over MC as a percentage of price

which should equal the inverse of the elasticity of demand
 This is also known as the Lerner index
 Notice that the mark-up depends inversely on Ed. If Ed is large,
markup is small (the closer is the monopolist’s price to the
competitive price.). If Ed is small, markup over price is large
 For this reason, as Ed  - infinity, MR  price, so the
monopolist’s price becomes closer and closer to the MC, P 
MC. In other words, when demand is perfectly elastic, the
monopolist has no market power – it’s like were in the perfectly
competitive case.
 Therefore, the Lerner Index is used as a way to measure
monopoly power.

36

Elasticity of Demand and Price Markup
37
The more elastic is $/Q

$/Q demand, the less the
markup.
MC P* MC
P*
P*-MC
D
P*-MC
MR
D
MR
Q* Quantity Q* Quantity

Shifts in Demand
38
 In perfect competition, the market supply curve is determined

by marginal cost. For a monopoly, output is determined by
marginal cost and the shape of the demand curve
 There is no supply curve for monopolistic market
 Shifts in demand usually cause a change in both price and
quantity
 Examples show how monopolistic market differs from perfectly
competitive market
 Competitive market supplies specific quantity at every price.
This relationship does not exist for a monopolistic market

Effects of a Shift of the Demand Curve in a
Competitive Market
39
(a) Competition
p, $ per
unit
MC, Supply curve

e2
p2
p1
e1
D2 D1
Q1 Q2 Q, Units per year
In a competitive market, there’s a one-for-one relationship between

P and Q for suppliers. In this graph, as demand increases, both P
and Q rise.
Effects of a Shift of the Demand Curve in a
Monopoly
40
(b) Monopoly However, with a monopolist, NO supply

Shift in demand curve exists, because there’s no one-for-
leads to change in
price but same one relationship between P and Q. For
p, $ per unit quantity example, when there’s an increase in
E2 demand, any of the three can happen:
p2 MC
•P rises but Q stays the same
E1 •Q rises but P stays the same
p1 •both P and Q rise
MR 1
MR 2 D2 D1
Q 1= Q 2 Q , Units per year

The reason there’s no one-for-one relationship between P and Q: The
monopolist’s P and Q decision depend on the shapes of both MC and
the demand curve.
Shifts in Demand
41
$/Q
MC Shift in demand
leads to change in
quantity but same
price
P1 = P2
D2
MR2
D1
MR1
Q1 Q2 Quantity

The Social Costs of Monopoly Power
42
 Monopoly power results in higher prices and lower

quantities
 However, does monopoly power make consumers
and producers in the aggregate better or worse
off?
 We can compare producer and consumer surplus
when in a competitive market and in a monopolistic
market

The Social Costs of Monopoly
43
 The competitive market solution (where the MC curve

crosses the demand, so that MC = P) is always the
combination of price and quantity that gives the
consumers and producers the most total surplus.
 Monopoly produces where MR = MC, getting their
price from the demand curve  PM and QM
 There is a loss in consumer surplus when going from
perfect competition to monopoly
 Deadweight Loss is the difference in total surplus
between an inefficient market (e.g. monopoly) and an
efficient market (competitive).
Deadweight Loss from Monopoly Power
44
p, $ per unit
24
MC
Because of the
em higher price,
A = $18
C =$ 2
p m = 18
B = $12
consumers lose
ec
p c = 16 B+C and
producer gains
E = $4
MR = MC = 12 D =$60
B-E.
Demand
MR
0 Q m =6 Q c= 8 12 24
Q , Units per day

The Social Costs of Monopoly
45
 Social cost of monopoly is likely to exceed the

deadweight loss
 Rent Seeking
 Firms may spend to gain monopoly power
 Lobbying
 Advertising
 Building excess capacity
 The incentive to engage in monopoly practices is

determined by the profit to be gained
 The larger the transfer from consumers to the firm, the
larger the social cost of monopoly
The Effect of a Tax
46
 In competitive market, a per-unit tax causes price to

rise by less than tax: burden is shared by producers
and consumers
 Under monopoly, Price may or may not increase by
more than the tax
 The amount the price increases with implementation
of a tax depends on elasticity of demand
 Profits for monopolist will fall with a tax
 To determine the impact of a tax:
t = specific tax
 MC = MC + t
The Effect of a Tax
47
 From our rule-of-thumb pricing formula from earlier, we have:

P = MC/[1 + 1/ed]
 The price depends on both the MC and the elasticity of
demand.
 If the government levies a specific tax, t, then we have: P =
(MC+t)/[1 + 1/ed]
 if MC is constant, then the price will increase by more than the
amount of the tax. This is because for any demand that is less
than perfectly elastic, 1/[1 + 1/ed] > 1.
 If MC is an increasing curve, then the price will not necessarily
increase by more than the tax, because by lowering Q, MC

will fall.
Effect of Excise Tax on Monopolist
48
$/Q
Increase in P:
P1
P0 to P1 > tax
P
P0 MC + tax
t D = AR
MC
MR
Q1 Q0 Quantity

p , $ per unit
2
MC (after tax)
24
1
e MC (before tax)
p 2 = 20
A 2 t =$ 8
B C e
1
p 1 = 18
E F
D Result: Taxing a monopolist
increases the deadweight
loss of monopoly.
8
G
Demand
MR
0 Q 2 =4 Q 1 =6 12 24
Q , Units per day
©2005 Pearson Education, Inc. 49

The Multi-plant Firm
50
 For some firms, production takes place in more than

one plant, each with different costs
 Firm must determine how to distribute production
between both plants
1. Production should be split so that the MC in the plants
is the same. If not, the firm could reduce the production
at the plant with the higher MC and increase production
at the plant with lower MC, thus lowering total costs. For
example, if MC1(Q1’) > MC2(Q2’), then lower Q1 and
raise Q2 to lower total cost while keeping the same total
output, QT = Q1+Q2
2. Output is chosen where MR=MC. Profit is therefore
maximized when MR=MC at each plant.
51
 We can show this algebraically:

 Q1 and C1 is output and cost of production for Plant 1
 Q2 and C2 is output and cost of production for Plant 2
 QT = Q1 + Q2 is total output
 Profit is then:
 = PQT – C1(Q1) – C2(Q2)

52
 Firm should increase output from each plant until the

additional profit from last unit produced at Plant 1
equals 0
 ( PQT ) C1
  0
Q1 Q1 Q1
MR  MC 1  0
MR  MC 1
53
 We can show the same for Plant 2

 Therefore, we can see that the firm should choose to
produce where
MR = MC1 = MC2
 We can show this graphically
 MR = MCT gives total output
 This point shows the MR for each firm
 Where MR crosses MC1 and MC2 shows the output for
each firm
Hint: Write Qi as a function of MCi for each plant, then add them to get QT as a function of MCT.
Where the MCT curve intersects MRT determines the total output of the firm.

Production with Two Plants
54
$/Q
MC1 MC2
MCT
P*
MC=MR* D = AR
MR
Q1 Q2 QT Quantity

55
 Our firm would have more monopoly power, of

course, if it could get rid of the other firms
 But the firm’s monopoly power might still be substantial
 How can we measure monopoly power to compare
firms?
 What are the sources of monopoly power?
 Why do some firms have more than others?

Monopoly Power
56
 Pure monopoly is rare

 However, a market with several firms, each facing a
downward sloping demand curve, will produce so
that price exceeds marginal cost
 Firms often produce similar goods that have some
differences, thereby differentiating themselves from
other firms

57
 Could measure monopoly power by the extent to

which price is greater than MC for each firm
 Lerner’s Index of Monopoly Power
 L = (P - MC)/P
 Thelarger the value of L (between 0 and 1) the
greater the monopoly power
 L is expressed in terms of Ed
L = (P - MC)/P = -1/Ed
 Ed is elasticity of demand for a firm, not the
market
Monopoly Power
58
 Monopoly power, however, does not guarantee profits

 Profit depends on average cost relative to price
 One firm may have more monopoly power but lower
profits due to high average costs
 Why do some firms have considerable monopoly
power, and others have little or none?
 Monopoly power is determined by ability to set price
higher than marginal cost
 A firm’s monopoly power, therefore, is determined by
the firm’s elasticity of demand
Sources of Monopoly Power
59
 The less elastic the demand curve, the more

monopoly power a firm has
 The firm’s elasticity of demand is determined by:
1) Elasticity of market demand
2) Number of firms in market
3) The interaction among firms

1) Elasticity of Market Demand
60
 With one firm, their demand curve is market

demand curve
 Degree of monopoly power is determined completely
by elasticity of market demand
 With more firms, individual demand may differ
from market demand
 Demand for a firm’s product is more elastic than the
market elasticity

2) Number of Firms
61
 The monopoly power of a firm falls as the number

of firms increases; all else equal
 More important are the number of firms with significant
market share
 Market is highly concentrated if only a few firms
account for most of the sales
 Firms would like to create barriers to entry to keep
new firms out of market
 Patent, copyrights, licenses, economies of scale

3) Interaction Among Firms
62
 If firms are aggressive in gaining market share by,

for example, undercutting the other firms, prices
may reach close to competitive levels
 If firms collude (violation of antitrust rules), could
generate substantial monopoly power
 Markets are dynamic and therefore, so is the
concept of monopoly power

Public Policy: Limiting Monopoly Power
63
 Market power harms some players in the market –

buyer or seller
 Market power reduces output, leading to
deadweight loss
 Excessive market power could raise problems of
equity and fairness

Public Policy: Limiting Market Power
64
 What can we do to limit market power and keep it

from being used anti-competitively?
 Tax away monopoly profits and redistribute to
consumers
 Difficult to measure and find all those who lost
 Monopoly power may be limited by breaking up
monopolies into multiple companies, or by preventing
firms from merging (so that monopoly power is not
achieved).
 In the U.S., this is referred to as “anti-trust” policy.
 Monopoly power may also be limited by policies
regulating the price that can be charged.
Limiting Market Power
65
 There may be instances when monopoly power is

permitted, such as:
 Patents – firms would have no incentive to innovate
without a patent protecting the invention. Monopoly
profits earned on an innovation pay for the investment to
create it.
 Natural monopolies: can take advantage of the
economies of scale when a single producer supplies the
good or service.
 However, even in cases where monopoly is allowed,
government may take steps to regulate it.
Application: A Drug Patent
66
p, ¢per
daily dose Patents may be necessary to
143.0
stimulate innovation
A ≈ $0.44
million
em
75.0
Demand
B ≈ $0.88 million
C ≈ $0.44 million
ec MC = AVC
7.5
0 1.30 2.61 2.75

MR Q, Million daily doses of Tagamet

Natural Monopoly
67
AC, MC, In the case of a natural

$ per unit
40
monopoly, for example
local utility companies, ATC
is falling over a long range
of output. This means that
the service can be provided
20 AC = 10 + 60/Q to the population for a
15 lower cost if there is only
10 one provider. In this way, a
MC = 10
single provider can take
advantage of the
0 6 12 15 economies of scale.
Q, Units per day

Price Regulation
68
 Government can regulate monopoly power through

price regulation
 Recall that in competitive markets, price regulation
creates a deadweight loss
 Price regulation can eliminate deadweight loss with a
monopoly
 The effect of the regulation can be shown graphically

Price Regulation
69 Marginal revenue curve
when price is regulated
$/Q to be no higher that P1.
MR
Pm MC
P1
P2 = P C
AC
P3
P4
AR
AnyIfprice
left alone,
below Pa4 monopolist
results
Ifthe
price
For
Ifinprice is
outputlowered
levels
is lowered
firm
produces incurring
Q to to
PCPoutput
above
a loss. 3 output
QP1 , .
m and charges m
decreases andmaximum
the original
increases to its aaverage
shortage
and
Q exists.
C and
marginal
there revenue
is no curves
deadweight apply.
loss. Qm Q1 Q3 Qc Q’3 Quantity
Price Regulation: An Illustration
70
p, $ per unit MC
24
Market demand Since the government
e Regulated demand
regulation sets the maximum
A
18
B
m
C
price that the monopolist can
e
16
E
o charge at P = 16, the regulated
D MR curve (MRr) is now the
MR
r
horizontal line at P = 16 (for
MR
0<Q<8) and then the old MR
curve for Q>8.
0 6 8 12 24 At the regulated price, the

Q , Units per day
monopolist sets MRr = MC, and
chooses Q= 8, the competitive
outcome.
Consumers gain and producers

lose surplus. However, the net
result is that total welfare
improves by the amount C + E.
Price Regulation: An Illustration
p , $ per unit Market demand MC
A B
e Regulated demand
p1 D 1
p2
C However, if the regulated
e2
price is set too low, then
E there will be a shortage.
MR
MR r
Q 2 Q1 Qd Q , Units per day
Excess demand
©2005 Pearson Education, Inc. 71

Regulating the Price of a Natural
72
Monopoly
$/Q
If the price
Unregulated, were regulate to be Pc,
the monopolist
the firmQwould
would produce m and
lose money
and go P
charge out
m.
of business. Can’t
cover average costs
Setting the price at Pr
giving profits as large as
Pm possible without going
Therefore, in out of business
regulating a
natural
monopoly, AC
government
Pr
must ensure
that the firm is MC
PC
not losing
money AR
MR
Qm Qr QC Quantity

Difficulties of Regulating Monopoly
73
 It may be difficult for government regulators to determine

monopolist’s costs – therefore, it’s difficult for the government
to calculate the correct regulated price. There are no
incentives for the monopolist to give the government the most
accurate information! The monopolist will try to keep the real
costs as private information.
 Even if the government can calculate a regulated price, this
price may need to change, depending on demand conditions
and the costs of production. If MC curve shifts, the regulated
price will be incorrect.
 Problem of “regulatory lag” in updating the government set price.

Difficulties of Regulating Monopoly
74
 Regulation may reduce incentives for innovation. If

innovation reduces MC, then government setting P = MC
(and lowering the regulated price whenever the firm’s MC
falls) means that the firm does not benefit from lower costs –
they are passed directly to consumers – and the firm has no
incentive to invest in cost reducing measures.
 This may be dealt with by: allowing firms to keep some of the
benefits of innovation; or enforcing regular reductions in the
regulated price, p, to force firms to engage in cost cutting
measures.

Market Power: Monopoly

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Market Power: Monopoly

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MARKET POWER: MONOPOLY

 Monopoly and Monopoly Power

©2005 Pearson Education, Inc.

©2005 Pearson Education, Inc.

P Market P Individual Firm

©2005 Pearson Education, Inc.

©2005 Pearson Education, Inc.

 A monopoly is a market with only one firm

 Until a few years ago it had been argued that the

©2005 Pearson Education, Inc.

 The monopolist has market power. In other words,

 The monopolist cannot choose any point

 Therefore, the monopolist chooses a point (a price and quantity) on

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When a monopolist increases output, Monopoly

For a monopolist, since p is given by the demand curve, p = AR.

Recall that for a Competitive Firm:

q q+1 Quantity (units per year)

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 The monopolist’s average revenue, price received

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 Finding Marginal Revenue

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©2005 Pearson Education, Inc.

4 Average Revenue (Demand)

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 For a monopolist, price is a function of quantity, specifically

 MR is always below the demand curve. Reason: Since

 Like all firms, the monopolist chooses output by

 (Q)  R(Q)  C (Q)

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 At output levels below MR = MC, incremental

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©2005 Pearson Education, Inc.

©2005 Pearson Education, Inc.

 By setting marginal revenue equal to marginal cost,

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When profits are

 Let the demand curve be given by: P = 24 – Q Also

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 When demand is elastic, increasing quantity will increase total

Inelastic, –1 < e < 0

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 A Rule of Thumb for Pricing

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 Looking at Marginal Revenue we know that it has two

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©2005 Pearson Education, Inc.

 (P – MC)/P is the markup over MC as a percentage of price

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©2005 Pearson Education, Inc.

The more elastic is $/Q

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 In perfect competition, the market supply curve is determined

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MC, Supply curve

In a competitive market, there’s a one-for-one relationship between

(b) Monopoly However, with a monopolist, NO supply

Q 1= Q 2 Q , Units per year

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 Monopoly power results in higher prices and lower