Chapter 12

Monopoly

We discuss the theory of monopolies from

monopoly power to profit max graphically
and mathematically. We also look at some
of the policy aspects of monopoly.

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 !ntentions
‡ Sources of Monopoly Power
‡ The Profit Maximising Monopolist
‡ Monopolist and Marginal Revenue
‡ Monopolist and Elasticities
‡ Price Discrimination
‡ Natural Monopolies
‡ Monopolies and !nnovation

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 Monopoly Power:
Exclusive Control
‡ !f a firm has exclusive control over an input for
a specific good then it can have monopoly
power in the sale of the output.
‡ This exclusive control can also be over ideas or
brands ² not necessarily a physical input.
‡ Eg 1: Perrier Water (water spring input)
‡ Eg 2: De Beers & Diamonds (own all the
diamond mines, own all the diamonds).
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 Monopoly Power:
Economies of Scale
‡ When the LAC is downward sloping the least costly way of
serving the market is to operate at the Min of the LAC curve.
‡ A firm that can most cheaply service the market by itself (i.e.
with no competitors) is called a à
 à .
‡ Sometimes there can be a downward sloping LAC curve that
does not give rise to a natural monopoly.
‡ Strictly speaking it is the degree of returns to scale, not the slope
of the LAC curve (but that could just be pedantic) that defines a
natural monopoly.
‡ E1: Telecommunications providers in many countries.

_
 Monopoly Power:
Patents
‡ Many inventions are given protection through some
form of patent system
² a patent confers the right to exclusive benefit from all
exchanges involving said invention.
‡ Leads to higher costs for consumers
² also results in incentives to create inventions which can
benefit consumers.
² Reason: A firm has an R&D outlay which it needs to recoup,
if not it will not research or develop new products.
‡ E1: Patents on A!DS medication
(think of Zackie Achmat importing illegal ARVs)
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 Monopoly Power:
Network Economies
‡ As the demand for a specific good increases then the
provider of that good can begin to obtain monopoly
power
² i.e. the word about a specific product spreads and more
people want it
² as consumers we give power to producers.
‡ Demand is a determinant of monopolistic power for
the supplier
² even though the supplier may have been operating previously
in a semi-competitive market
‡ E1: VHS vs. BetaMax
‡ E2: Windows vs. Linux.
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 Monopoly Power:
Government Licences
‡ !n certain markets, the law prevents the production of goods by
organisations that don·t have government permission.
‡ Government can license a specific area to another franchise
(think Petrol Stations & their allied food franchises).
‡ Government licenses often come at a premium and thus transfer
costs to the consumer through prices.
‡ Retailer is often not the one to blame for high prices government
is because of their pricing of specific areas/locations.
‡ E1: Think Wimpy/McDonalds at specific stops ² they have
monopolies over that specific area and can (if they want to)
charge premium prices

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 Monopoly and Profit Max
‡ Monopoly wants max profit ² at max Total
Revenue, MR = 0.
‡ They want the largest distance between total
cost and total revenue.
‡ MR < D for a Monopolist (we say why later)
‡ As you will see later, they set the price in the
elastic area of demand (i.e. ƥ < -1)

 
 D Three Part
a Monopoly Graph
Demand & MR b
Marginal
Revenue c

Quantity
e
d f
TR
Total
Revenue

Quantity

-1/3 Quantity
-1 i
Elasticity h
-3
g Monopolist
operates here
ƥ †
 Vnderstanding the Graphs
‡ D curve is downward sloping
² Why? The monopolist must charge a lower price to get more consumers
to buy the good.
‡ The MR curve is beneath the demand curve
² Why? The monopolist must apply this reduced price to each previous
item.
‡ The point of maximum Total Revenue is where Marginal
Revenue is zero and where the elasticity curve is at -1 (i.e. unit
elasticity).
² Monopolist always operates in the elastic area of demand,
² conversely they never operate in the inelastic area of the demand.
‡ °
They don·t maximise profits where TR is at a maximum ²
we are trying to maximise the D!STANCE between TR and TC
which is total PROF!T (w or pi)

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 MR and MC
‡ Marginal Revenue (MR)
² by definition it·s the additional revenue obtained
from producing an extra unit at the margin
² it is also the slope of the Total Revenue curve
‡ Marginal Cost (MC)
² by definition is the additional cost incurred from
producing an extra unit at the margin,
² it is also the slope of the Total Cost curve

cc
 Marginal Revenue
‡ !f we are trying to maximise Total Profit (w ) then we
are trying to maximise the distance between TR and
TC, which is where the two slopes MR and MC are
equal.
‡ Hence, in equilibrium, we seek the output level QÚ
where MR(Q*)=MC(Q*) .
‡ This is the point of optimal production for a
monopolist, or the 

 

à


àfor a monopolist
(provided that the MR curve intersects the MC curve
from above).

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 Marginal Revenue
‡ What does the equation for MR look like?
þ



þ
‡ This is just the equation for the slope of the demand curve.
‡ Also: þ


Î Î
þ
(To be precise MR approaches this)
‡ This equation means that as we move along the demand curve
there are going to be different levels of revenue for the
monopolist:
² As we approach the higher points of the demand curve MR > 0,
² at the middle of the demand curve MR=0
² and on the bottom part of the demand curve, MR <0. cï
 Monopolist and Elasticity
‡ We know that elasticity is given by the equation:
þ 


þ 

‡ This term is normally negative as the terms for ƅQ and

P move in opposite directions
² Reason: we observe movements DOWN the demand curve.
² (
change in P, 
change in Q)

‡ Now let's assume that they have the same sign giving us
the new equation for the absolute value of elasticity:
þ 


þ  c_
 Monopolist and Elasticity 2
‡ Now we can relate this back to the equation we had for
marginal revenue (because we have made ƅQ and ƅP
both positive), the above transforms to: þ  
þ 

‡ We can substitute this into the Marginal Revenue
equation we found previously, obtaining  

 c c 


 
‡ This tells us that the less elastic demand is w.r.t. price,
the more price will exceed marginal revenue.
‡ !n a very simple case if Ȑ=1 then MR=0
² This is how we related MR and elasticity on the D curve.
cº
 Profit Maximising Monopolist
Price MC

P* ATC

MR

Q* Quantity
cÿ
 Vnderstanding the Graphs
‡ Equilibrium price is where MR=MC
² Practically: extend a line to the demand curve, take that line
along to the price axis to find P* at this Q*.
‡ The monopolist never operates in the inelastic area of
demand!
² !f they did it would mean that they could increase their price
and consequently increase their total revenue
² They should have been operating at a higher price in the first
place.
‡ The monopolist shuts down if the price that they would
charge is lower than the AVC curve
² they cannot cover their variable costs, therefore they
shutdown.
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 Vnderstanding the Graphs More
‡ A monopolist doesn't have a supply curve
² they produce where the given D and MR of a specific time period make
them produce in order to attain their maximum profits.
² !nstead of a supply curve the monopolist has a u  of operating at
the price that corresponds to the equation of MR=MC.
‡ The efficiency loss of a monopolist is where the areas of
consumer and producer surplus are lost relative to a perfectly
competitive model. (see next slide for graph)
² This loss is the  

uuà —
² ° : this does not include possibilities for increased economies of scale in
our comparison, or for instances such as 1st Degree Price Discrimination
² Conversely, think of the benefit of a good such as a patented medication
which may not have been there had it not been for the monopoly power.
‡ Notice further how consumer surplus will be absorbed by the
monopolist.
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 Profit Maximising Monopolist
Price MC
Lost CS

P* ATC CS absorbed
into PS by
PC Monopolist

Lost PS
D

MR

Q* Quantity
c†
 Price Discrimination
‡ Definition:
² the basic practice of being able to separate/segment consumers into
difference groups
² charge these groups the prices that these groups/individuals are willing to
pay
² Why? To make an additional profit relative to a normal-non-
discriminating monopolist.
‡ For Price Discrimination to be effective people of different
groups must not be allowed to sell the product that they
obtained at a lower price to someone who would have paid a
higher price.
² Why? !t would create distortions in the market giving individuals who
should have been buying at their (generally higher price) the possibility o
getting a lower price on the ¶black market·.
² Ever wonder why your gym contract, or your airline tickets, are non-
transferable?
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 First Degree Discrimination
‡ Monopolist can segment the market perfectly
² there are ° segments and
² each n of N can be charged the specific price that they are
willing to pay
² (everyone pays a different price that they want to pay)
‡ This means that the Monopolist's MR=D
² the reason: they no longer have to charge every previous
individual the new, lower price.
‡ Thus the monopolist absorbs ã of the consumer
surplus.
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 First Degree Discrimination
Price at MC
each Q All CS absorbed
into PS

ư
ATC

MR

Q* Quantity
mm
 First Degree Discrimination
‡ The graph indicates that the profit-maximising perfect
discriminator is going to make a much larger profit
² They absorb consumer surplus that existed previously into
their producers surplus it becomes profit.
‡ Additionally, in the hypothetical situation in which the
SMC=ATC=D«
² a monopolist is being both productively and allocatively
efficient.
² This could not occur in a normal monopolistic market, but
 à (but won't necessarily) occur for a first degree price
discriminating monopolist
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 Second Degree Discrimination
‡ =

it·s a situation in which one obtains a lower
price the more that one consumes.
‡ !n the Vnited States there are certain electricity
providers that allow one to have a lower rate per
kilowatt as one consumes more electricity.
‡ This means that further 'blocks' of electricity make the
entire amount of electricity consumed cheaper
‡ (!t is pertinent to note that in SA we have the opposite
situation with water ² you pay higher prices per litre the
more that you consume ² Why is this?).

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 Second Degree Discrimination
Price

P1 Captured CS

P2

P3

Q1 Q2 Q3 Quantity
mº
 1st vs. 2nd Degree Discrimination
‡ There are two distinct differences between the two
basic types of discrimination.
1) Structure:
‡ in Second Degree price discrimination structure is the same
for everyone
‡ This means that the monopolist is obviously not able to
utilise the fact that there are differential elastic responses
among all buyers ² they have specific categories.
2) CS Absorption:
‡ The second degree price discriminator is unlikely to be able
to capture as much of the consumer surplus as the first
degree
‡ Why? There are limited categories.
mÿ
 Hurdle Model of Discrimination
‡ There is a 'hurdle' for buyers who wish to buy a good at
a lower price.
‡ Hurdles:
² must not be too costly in resources,
² but should only be taken up by those people who would not
have bought the product at the higher price.
‡ This hurdle allows consumers to self-identify and for
more goods to be sold by the monopolist.
‡ Hence the monopolist will make higher profit through
absorption of CS.

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 Hurdle Model of Discrimination
‡ Typical examples of hurdles include:
² rebate forms for the good such as may appear in certain
appliances (hurdle: filling out the form and waiting for money
back)
² hardback vs. soft-cover books (hurdle: the wait)
² cheap flights booked far in advance (hurdle: finding out you
are flying early and booking)
² discount coupons (hurdle: finding them, filling them out and
using them before their due dates)
‡ But, this cannot:
² capture all consumer surplus
² properly separate all segments of the market
² always select differential elasticities of consumers
‡ Not limited to a two price model, but in most cases
appears so. m 
 Hurdle Model of Discrimination
Price

PH

PL

QL
D

QH Q L + QH Quantity
m†
Public Policy and Natural Monopoly
‡ The question·s not always about a Monopolist·s
efficiency, it is also about the product!
‡ Two main criticisms of monopolies:
1. The 
à uu 

à: the monopolist makes an unjustifiable
economic profit.
2. The 

à  

à: the price is above marginal cost
resulting in lost consumer surplus.
‡ Policymakers make context-based decisions w.r.t.
Natural Monopolies to assess regulatory procedures.

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 Natural Monopolies:
State Ownership
‡ Efficiency requires that price be equal to MC
² but for a natural monopoly, MC is below ATC.
‡ Private firms can't charge prices below LAC because
they·ll shut down in the LR. They charge more than
MC.
‡ Govt. can intervene and take ownership of a private
firm charging prices higher than MC.
² Why? They can absorb the costs through tax revenue.
‡ Result: >

à 

à 
² because govt. bureaucracy not motivated by profit & cost
concerns they are often less efficient than private companies.
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 Natural Monopolies:
State Ownership
‡ Extent of

à 

à depends on power of economic
incentives
² it increases profits for an entrepreneur to decrease costs,
² but if a person in charge of govt. budget decreases their
budget they 'lose power' (at least so they believe).
‡ E.g. 1: Private vs. govt. construction and road works.
‡ E.g. 2: Anyone been to the dept of home affairs? What
if it were run like a private business?

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 Natural Monopolies:
State Regulation
‡ Monopoly controlled by private individuals, but
regulated by government through legal systems.
‡ Generally use 



à 

à which stipulates
a fair rate of return for the monopolist.
‡ Why?
² A monopolist could justifiably be in another industry
obtaining a higher ror there
² !f the ror is too low in the industry under interrogation they
would just reduce service quality and go out of business with
low ror
² with high ror they get ¶too high· a profit.

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 Natural Monopolies:
State Regulation
‡ Hence, a 'competitive' ror is adopted so that they can continue to
operate in the monopolistic market, but not make ridiculous and
unfair profits (fairness objection).
‡ Problem with defining a 'competitive ror'
² Difficult to assess what constitutes a ¶competitive· ror
‡ Problem 1: [

   

² Dodgy incentives to buy expensive capital (inefficiently)
² for no reason than that it will get them a higher return than cheaper
capital which would perform the same function but not get as high a
return.
‡ Problem 2: uu
uu
   

² a monopolist may operate in two markets,
² one in which MR=MC, make economic profits there and use these
profits
² invest in lots of capital in the second market ² the regulated monopoly
with the high ror and make ¶unfair· profits overriding the regulation. ï_
 Natural Monopolies:
Exclusive Contracting
‡ Harold Demsetz ´Why Regulate Monopoly?µ
‡ Solution proposed:
² Create competition in the contracting phase where the most
inexpensive and efficient proposal wins the contract and
must adhere to contracted conditions.
‡ Typical examples include:
² fire services, garbage disposal, postal services, etc.
‡ Note:
² There must be accountability for the contractor to fulfil its
obligations
² The state must be able to remove a given contractor if they
become inefficient and select new contracts on that basis.
² This is sometimes very costly.
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 Natural Monopolies:
Exclusive Contracting
‡ Problem 1:
² Contracts may include escape clauses with higher prices in 'exceptional
conditions' which are difficult to observe/regulate.
‡ Problem 2:
² Problems of bribery/corruption/cronyism 'the friend of the politician'
getting the job rather than the most efficient operator.
‡ Problem 3:
² Extra conditions in the contract, such as BEE in South Africa, may result
in less efficient operators getting jobs.

(°

Not a problem with BEE itself, just a note that BEE
contractors have been known to obtain jobs which could have
been given to less expensive non-BEE compliant operators).
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 Natural Monopolies:
Antitrust Laws
‡ Antitrust law
² enforceable law to ensure that monopolies either don't exist or
² that competition is not jeopardised in an industry.
‡ Different countries assess mergers, acquisitions, etc which could
increase a single company's market power to such that it would
become a monopoly.
‡ Different political perspectives/ideologies often inform different
assessments of these laws
² Neo-Con vs. Neo-Keynesian.
‡ For industries with declining LAC, costs of production would be
higher with many firms rather than a few larger ones.
‡ Specific economic methods used to assess whether society 'gains'
or 'loses' when mergers occur.
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 Natural Monopolies:
v
uu 


‡ Here the objections remain the same (fairness and
efficiency), but we do this to observe whether
outcomes may favour the consumer.
‡ First, consider a hurdle price discriminator:
² They are more 'efficient' as the loss of consumer surplus is
less because they are selling at different prices to different
consumers.
² !n terms of 'fairness' it's more difficult and it comes down to
individual preferences w.r.t. what constitutes transfers of
income to which groups.
² Here it doesn't necessarily make monopoly 'fair', but it does
make moves to make it more socially acceptable.

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 Natural Monopolies:
v
uu 


‡ !f we should always be thinking about the consumer, is it not
also possible that we need to ensure that companies make profits
so that they can continue to invest and that this investment will
create jobs and benefit society?
‡ Profits are taxed
² The larger the profit to the individual company
² The more tax they will pay to the treasury
² The greater the benefit to the consumer
‡ !t all depends on how incomes, taxes and profits are distributed,
what is done with them and how ethically/responsibly they are
dealt with in most environments.

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 Monopolies and !nnovation
‡ = 



  



‡ Proposition 1: The converse could be true:
² for example a monopolist could continually invest in R&D
² Why? To ensure that there are barriers to entry
² How? Technology/sunk costs in investment preventing others from
entering
² But maintains innovation. (good for ¶mix· of goods)
‡ Proposition 2: Monopolist assess ways to decrease costs
² Why? To obtain higher profits! (as usual)
² Monopoly has a distinct advantage: it is capable of producing large amounts
of a specific good because of its large capacity
² Not as viable for a non-monopoly without EOS.
‡ Proposition 3: Evidence of monopolists maintaining control of
their monopoly by buying out innovators
² think of the oil industry and alternatives to oil, (re: Thom Friedman on this)
_
² or the software industry and its alternatives.
 Math Problem
‡ Basic Concepts:
² One producer capturing entire market using market
demand.
² Demand  ÎÎ â m 
² Total Costs  Ν
² Profit 
â 
  â  
 ÎÎ â m    â Î 

Î  â m m
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 Math Problem
‡ As usual, we differentiate the profit function
w.r.t. quantity and set it equal to zero.


Î â Ν Î

Ν
Î
 †
‡ The monopolist·s quantity output is 9 units.
‡ !ts profit: 
Ά â m †m

Î Î â mÎm
mÎm
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 Math: !n General
‡ Basically:
² Demand   â ð
² Total Costs 

² Profit 


 

 𝠝 

 ð m 
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 Math: !n General 2

‡ Take FOCs and find the  â mð â  Î

profit maximising Q.
mð
 
â

mð
  â ð m ⠝
‡ Now for profit:

 â  â ð 
  â     â  
  â  â ð  
mð   mð  
  â  m
__

ð
 Summary
‡ Monopoly Power
‡ Profit Max Monopolist
‡ MR & Elasticities
‡ Price Discrimination
‡ Natural Monopolies
‡ Math Problem
‡ Real world issues?

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