Business and Economics

ECW1101
Introductory Microeconomics

ECW1101 - Lecture Week 10 1

 Business and Economics

Week 10: Monopoly

Chapter 15: Monopoly

2
Week 10 – Learning objectives
On completing Week 10 you will be able to:
list the key assumptions underlying a monopoly market
explain how a monopoly (one seller) market structure may
arise
discuss why a monopolist generally chooses to restrict
output
analyse the social impact (welfare cost) of monopoly
markets

ECW1101 - Lecture Week 10 3

The monopoly firm
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.
Examples:
Microsoft Windows Operating System; Local
telephone service; Water service; Cable television;
The U.S. Postal Service; Pos Malaysia Berhad;
Railways
ECW1101 - Lecture Week 10 4
Why do monopolies arise?
Arise due to barriers to entry
• This means other firms cannot enter the market
to compete with it
• There are usually three barriers

ECW1101 - Lecture Week 10 5

 Three Barriers to Entry
1. Monopoly resources
– A single firm owns a key resource.
• E.g., DeBeers owns most of the world’s
diamond mines
2. Government regulation
– The government gives a single firm the
exclusive right to produce the good.
• E.g., patents, copyright laws

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 3. The production process
A single firm can produce the entire market Q at lower cost than could
several firms. The market has a natural monopoly

Costs

Economies
of Scale as
a Cause of
Monopoly

Average total cost

0 Quantity of output
When a firm’s average-total-cost curve continually declines, the firm has what is
called a natural monopoly. In this case, when production is divided among more
firms, each firm produces less, and average total cost rises. As a result, a single firm
can produce any given amount at the smallest cost 7
 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
Example
Metro: Public Transport
Telstra: Fixed line phones
A single firm can supply a good or service to an entire market
At a smaller cost than could two or more firms
Economies of scale over the relevant range of output
Club goods
• Excludable but not rival in consumption
ECW1101 - Lecture Week 10 8
Monopoly production and pricing decisions

Monopoly versus Competition

Monopoly Competitive firm
sole producer one of many producers
faces a downward-sloping faces a horizontal demand
demand curve curve
is a price maker is a price taker
reduces price to increase sales. sells as much or as little at same
price.

ECW1101 - Lecture Week 10 9

Monopoly vs. Perfect Competition
Perfect competition Monopoly

Price taker – firms small in Price maker

size and large in number, Firm = industry
take price from market
Can set price by varying Q
Demand curve for firm Demand curve downward
Perfectly elastic sloping
D = P = AR = MR P > MR, D = AR
P = MR = MC P > MR
MR = MC

ECW1101 - Lecture Week 10 10

 Demand Curves for Competitive and Monopoly Firms

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

Price Price

Demand

Demand

0 Quantity of output 0 Quantity of output

Because competitive firms are price takers, they in effect face horizontal demand
curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it
faces the downward-sloping market demand curve, as in panel (b). As a result, the
monopoly has to accept a lower price if it wants to sell more output.
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A monopolist's revenue

Total revenue
P  Q = TR

Average revenue Marginal revenue

TR/Q = AR = P ∆TR/∆Q = MR

ECW1101 - Lecture Week 10 12

A Monopoly’s Total, Average, and Marginal Revenue

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 Active Learning 1 A monopoly’s revenue
Common Grounds is
the only seller of
cappuccinos in town. Q P TR AR MR
The table shows the 0 $4.50 n.a.
market demand for
cappuccinos. 1 4.00

Fill in the missing 2 3.50

spaces of the table. 3 3.00
What is the relation 4 2.50
between P and AR?
Between P and MR? 5 2.00
6 1.50

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 Active Learning 1 Answers

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

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Common Grounds’ D and MR Curves
P, MR
Q P MR
$5
0 $4.50
$4 4
Demand curve (P)
1 4.00 3
3
2 3.50 2
2 1
3 3.00
1 0
4 2.50
0 -1 MR
5 2.00 -2
–1
6 1.50 -3
0 1 2 3 4 5 6 7 Q

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 A monopoly's revenue
A monopolist’s MR is < An increase in a
price of its good monopoly’s sales has two
The demand curve is effects on TR (or PQ):
downward sloping 1. The output effect –
If a price fall sells one more output is sold,
more unit, the revenue so Q is higher.
received from previously 2. The price effect –
sold units also decreases price falls, so P is
lower.

ECW1101 - Lecture Week 10 17

 Demand and Marginal-Revenue Curves for a Monopoly

Price
$11
10
9
8
7
6
5
4
3 Demand
2
(average revenue)
1
0
-1 1 2 3 4 5 6 7 8 Quantity
-2 of water
-3
-4 Marginal revenue

The demand curve shows how the quantity affects the price of the good. The marginal-revenue
curve shows how the firm’s revenue changes when the quantity increases by 1 unit. Because
the price on all units sold must fall if the monopoly increases production, marginal revenue is
always less than the price.
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Profit maximisation
A monopoly maximises profit by producing the
quantity at which marginal revenue equals
marginal cost
It uses the demand curve to find the price that
will induce consumers to buy that quantity.

ECW1101 - Lecture Week 10 19

 Profit Maximization for a Monopoly

Costs 2. . . . and then the demand

and curve shows the price consistent
Revenue with this quantity.
Marginal cost

Monopoly B
price
Average total cost
A

Demand
1. The intersection of the marginal-revenue
curve and the marginal-cost curve
determines the profit-maximizing quantity . . .

Marginal revenue
0 Q1 QMAX Q2 Quantity
A monopoly maximizes profit by choosing the quantity at which marginal revenue equals
marginal cost (point A). It then uses the demand curve to find the price that will induce
consumers to buy that quantity (point B).
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Profit maximisation

Comparing monopoly to competition

Monopoly Competition
P > MR = MC P = MR = MC

Monopoly profit = TR – TC
= (TR/Q – TC/Q)  Q
= (P – ATC)  Q

ECW1101 - Lecture Week 10 21

 Profit-Maximization The profit-
maximizing Q is
Costs where MR = MC.
and Find P from the
Revenue Marginal cost
demand curve at
this Q.
Monopoly E
price

Demand

Marginal revenue

0 QMAX Quantity

Profit-maximizing output

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 The Monopolist’s Profit

Costs
and
Revenue Marginal cost

Monopoly E B
Average total cost
price

Monopoly
profit
Average Demand
total
cost D C

Marginal revenue

0 QMAX Quantity

The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is
price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the
number of units sold.
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ECW1101 - Lecture Week 10 24
 The Market for Drugs

Costs
and
Revenue

Price
during
patent life

Price after Marginal cost

patent
expires

Demand
Marginal revenue

0 Monopoly Competitive Quantity

quantity quantity

When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly
price, which is well above the marginal cost of making the drug. When the patent on a drug runs
out, new firms enter the market, making it more competitive. As a result, the price falls from the
monopoly price to marginal cost.
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The welfare cost of monopoly
In contrast to a competitive firm, a 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.

ECW1101 - Lecture Week 10 26

 The Efficient Level of Output

Costs
and Marginal cost
Revenue

Value Cost to
to monopolist
buyers

Value
to Demand
Cost to
buyers (value to buyers)
monopolist
0 Quantity
Value to buyers is greater Efficient Value to buyers is less
than cost to sellers quantity than cost to sellers

A benevolent social planner who wanted to maximize total surplus in the market would choose the level
of output where the demand curve and marginal-cost curve intersect. Below this level, the value of the
good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the
good. Above this level, the value to the marginal buyer is less than marginal cost.
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The Welfare Cost of Monopolies
Monopoly
Produce quantity where MC = MR
Produces less than the socially efficient quantity
of output
A monopoly sets its price above marginal cost,
this 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.
Deadweight loss
• Triangle between the demand curve and MC
curve
ECW1101 - Lecture Week 10 28
The Welfare Cost of Monopolies
The monopoly’s profit: a social cost?
Monopoly - higher profit
Not a reduction of economic welfare
Bigger producer surplus
Smaller consumer surplus
• Not a social problem
Social loss = Deadweight loss
• From the inefficiently low quantity of output

ECW1101 - Lecture Week 10 2

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 The Inefficiency of Monopoly

Costs
and
Revenue
Marginal cost
Deadweight loss

Monopoly
price

Demand

Marginal revenue

0 Monopoly Efficient Quantity

quantity quantity
Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than
its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The
deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value
of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer).
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The inefficiency of monopoly
The monopolist produces less than the socially efficient quantity of output.
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.

ECW1101 - Lecture Week 10 3

1
Price discrimination
 Price discrimination is when the same good is sold
at different prices to different customers, even
though the production costs for the two customers
are the same.
– Price discrimination is not possible in a competitive
market since there are many firms all selling a good at
the market price.
– In order to price discriminate, the firm must have
some market power.

ECW1101 - Lecture Week 10 32

Price discrimination
 Perfect 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.
 Two important effects of price discrimination:
– it can increase the monopolist’s profits
– it can reduce deadweight loss.

ECW1101 - Lecture Week 10 33

Welfare with and without price
discrimination

<Insert Figure 15.9a from Gans 5/e pg

342>

(a) Monopolist with single price

ECW1101 - Lecture Week 10 34
Copyright © 2004 South-Western
Welfare with and without price
discrimination

<Insert Figure 15.9b from Gans 5/e

pg 342

(b) Monopolist with perfect price discrimination

ECW1101 - Lecture Week 10 35
Copyright © 2004 South-Western
 Price discrimination
 Examples of price
discrimination
– movie tickets
– store brands
– airline prices
– discount coupons
– quantity discounts.

ECW1101 - Lecture Week 10 36

The prevalence of monopoly

 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.

ECW1101 - Lecture Week 10 37

 Week 10 - Summary
the monopolist is both the firm and the industry
the monopolist is a price maker, exercising market
power
profit maximising means the monopolist must produce
at MR = MC
there are welfare costs associated with monopoly;
o loss of consumer surplus
o creation of a dead weight loss
monopoly can also create benefits

ECW1101 - Lecture Week 10 3

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 Next Week

Monopolistic Competition
Chapter 16

Oligopoly
Chapter 17

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