Chapter 8

Monopoly, Oligopoly, and

Monopolistic Competition

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
distribution without the prior written consent of McGraw-Hill Education.
 Learning Objectives
1. Distinguish among three types of imperfectly
competitive industries and describe how imperfect
competition differs from perfect competition.
2. Identify the five sources of market power.
3. Describe how economies of scale are affected by
how large fixed costs are in relation to marginal
cost.
4. Apply the concepts of marginal cost and marginal
revenue to find the output level and price that
maximize a monopolist's profits.
5. Explain why the profit-maximizing output level for a
monopolist is too small from society's perspective.
6. Discuss why firms often offer discounts to buyers
who are willing to jump some form of hurdle.
7. Discuss public policies that are often applied to
natural monopolies.
© 2019 McGraw-Hill Education. 2
 Imperfect Competition 1

Imperfectly competitive firms have

some ability to set their own price:
they are price setters
• Long-run economic profits possible
• Reduce economic surplus
Three types:
1. Monopoly has only one seller, no close
substitutes
2. Monopolistic competition has many firms
producing slightly differentiated products
that are reasonably close substitutes
3. Oligopoly has a small number of large
© 2019 McGraw-Hill Education. 3
 Monopoly

Perfect
Monopoly
Competition
Number of Firms One firm Many firms
Price Complete flexibility Price taker
Entry and Exit Difficult or impossible Free
Product Unique Standardized
Economic Profits Possible Zero in long run
Decisions P, Q Q only

© 2019 McGraw-Hill Education. 4

 Monopolistic Competition

Monopolistic Perfect
Competition Competition
Number of Firms Many firms Many firms
Price Limited flexibility Price taker
Entry and Exit Free Free
Product Differentiated Standardized
Economic Profits Zero in long run Zero in long run
P, Q, product
Decisions Q only
differentiation

© 2019 McGraw-Hill Education. 5

 Oligopoly

Perfect
Oligopoly
Competition
Few firms,
Number of Firms Many firms
each large
Price Some flexibility Price taker
Entry and Exit Difficult Free
Differentiated or
Product Standardized
standardized
Economic Profits Possible Zero in long run
P, Q, differentiation,
Decisions Q only
advertising

© 2019 McGraw-Hill Education. 6

 Imperfect Competition 2

Examples of monopoly
• Electricity and Magic Cards
Examples of monopolistic
competition
• Retail gas stations
• Convenience stores
Examples of oligopoly
• Wireless phone service
• Cement
• Automobiles and tobacco
© 2019 McGraw-Hill Education. 7
 The Essential Difference between
Perfectly and Imperfectly
Competitive Firms
Market power is the firm's ability to raise its
price without losing all its sales
Any firm facing a downward sloping demand
curve
• Firm picks P and Q on the demand curve
Market power comes from factors that limit
competition

© 2019 McGraw-Hill Education. 8

 Five Sources of Market
Power
1. Exclusive control over inputs
2. Patents and copyrights
3. Government licenses or
franchises
4. Economies of scale (natural
monopolies)
5. Network economies

© 2019 McGraw-Hill Education. 9

 Market Power: Economies

of Scale
Returns to scale refers to the
percentage change in output from a
given percentage change in ALL
inputs
• Long-run idea
• Constant returns to scale: doubling all
inputs doubles output
• Increasing returns to scale: output
increases by a greater percentage than
the increase in inputs
• Average costs decrease as output increases
• Natural monopoly: a monopoly that results
© 2019 McGraw-Hill Education. from economies of scale 10
 Market Power: Network
Economies
Network economies occur when
the value of the product
increases as the number of
users increases
• Blu-Rays vs. DVDs
• Telephones
• Windows operating system
• eBay
• Facebook and Instagram
© 2019 McGraw-Hill Education. 11
 Economies of Scale and
Start-Up Costs 1

New products can have a large fixed

development cost
Variable cost: sum of payments made to the
variable factors, such as labor
Fixed cost: sum of payments made to the
fixed factors, such as capital
Start-up costs can be thought of as a fixed
cost
Average total cost (ATC): total cost divided
by output
A good whose production has a large start-
up cost and low variable cost is subject to
economies of scale
© 2019 McGraw-Hill Education. 12
 Economies of Scale and
Start-Up Costs 2

Consider an example:
Assume marginal cost (M) is constant
Variable cost is M*Q
Total cost is fixed cost (F) plus
variable cost
TC = F + M*Q
• Total cost increases as output increases
Average total cost is
ATC = F / Q + M
• Average total cost decreases as output
increases
© 2019 McGraw-Hill Education. 13
 Economies of Scale

© 2019 McGraw-Hill Education. 14

 Example: Video Game
Producers – Different
Volumes
Nintendo Sony
Annual Production
1,000 1,200
(1000s)
Fixed Cost ($1000s) $200 $200
Variable Cost
$800 $960
($1000s)
Total Cost ($1000s) $1,000 $1,160
ATC per game $1.00 $0.97

© 2019 McGraw-Hill Education. 15

 Example: Video Game
Producers – Lower Marginal
Costs
Nintendo Sony
Annual Production
1,000 1,200
(1000s)
Fixed Cost ($1000s) $200 $200
Variable Cost
$200 $240
($1000s)
Total Cost ($1000s) $400 $440
ATC per game $0.40 $0.37

© 2019 McGraw-Hill Education. 16

 Example: Video Game
Producers – Higher Fixed
Cost
Nintendo Sony
Annual Production
1,000 1,200
(1000s)
Fixed Cost ($1000s) $10,000 $10,000
Variable Cost
$200 $240
($1000s)
Total Cost ($1000s) $10,200 $10,240
ATC per game $10.20 $8.53

© 2019 McGraw-Hill Education. 17

 Example: Video Game
Producers – Different
Production Levels
Nintendo Sony
Annual Production
500 1,700
(000s)
Fixed Cost ($000s) $10,000 $10,000
Variable Cost
$100 $340
($000s)
Total Cost ($000s) $10,100 $10,240
ATC per game $20.20 $6.08

© 2019 McGraw-Hill Education. 18

 Intel's Advantage
Intel can spend $2 billion to
develop a new chi
Once developed, the marginal
cost of each one is pennies
Intel supplies more than 80% of
the processors for PCs
And before anyone can even try
to compete, they need to spend
billions too!
© 2019 McGraw-Hill Education. 19
 Profit Maximization for
the Monopolist 1

Like all other firms, a monopolist:

• Maximizes profits
• Applies the Cost-Benefit Principle:
• Increase output if marginal benefit > marginal
cost
• Decrease output is marginal benefit < marginal
cost
Marginal benefit is called marginal
revenue:
• Change in total revenue from a one-unit
change in output
• Equal to price for the perfectly
competitive firm
© 2019 McGraw-Hill Education. 20
 Profit Maximization for
the Monopolist 2

To sell another unit the monopolist must

lower price
• Total revenue from 2 units = $12
• Total revenue from 3 units = $15
• Marginal revenue = $3

© 2019 McGraw-Hill Education. 21

 Monopolist's Marginal
Revenue

Price Quantity Total Revenue Marginal Revenue

$6 2 $12 3
$5 3 $15 1
$4 4 $16 -1
$3 5 $15
© 2019 McGraw-Hill Education. 22
 Monopoly Demand and
Marginal Revenue
The monopolist's
marginal revenue
curve:
• Has the same
intercept as the
straight-line
demand curve
• Has twice the
slope of the
demand curve
• Lies below the
demand curve
© 2019 McGraw-Hill Education. 23
 Deciding Quantity
Profit is maximized
at the level of output
where marginal cost
equals marginal
revenue
At P = $3 and Q = 12,
MC > MR
• Decrease output
• At Q = 8, MC = MR = 2
• The demand curve
sets the price at P =
$4
• At any output below 8,
© 2019 McGraw-Hill Education. 24
 Monopoly Profit
Profit = Total revenue – total cost
Total cost = ATC × Q
Profit = P × Q – ATC × Q
Profit = (P−ATC) × Q
If P > ATC then the firm earns a profit
If P < ATC then the firm suffers a loss
This can be graphically illustrated

© 2019 McGraw-Hill Education. 25

 Monopoly Losses and
Profits

Access the text alternative for these

© 2019 McGraw-Hill Education.
images 26
 The Invisible Hand Fails

Access the text alternative for these

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images 27
 Monopoly and Perfect
Competition

© 2019 McGraw-Hill Education. 28

 Managing Monopoly: The
Breakdown of the Invisible
Hand
Monopolies exist for economic
reasons
• Patents, copyrights, and innovation
• Economies of scale
• Network economies
Anti-trust laws attempt to limit
deadweight loss
• Limiting monopoly has costs
• Patents encourage innovation
• Economies of scale minimize ATC
• Network economies increase benefits
© 2019 McGraw-Hill Education. 29
 Price Discrimination
Price discrimination means charging
different buyers different prices for
essentially the same good or service
• Separate the groups
• No side trades among buyers
Many forms of price discrimination
• Hurdle method: discounts for identifiable
groups
(e. g., students, AARP)
• Perfect discrimination: negotiate
separate deals with each customer
© 2019 McGraw-Hill Education. 30
 Carla the Editor: Social
Optimum
Opportunity cost of Carla's time is
$29
Reservation Total
Student
Price Revenue
A $40 $40 What if
B 38 $76 Carla is a
C 36 $108 profit
D 34 $136 maximizer
E 32 $160 ? What is
F 30 $180 Carla's
G 28 $196 total
revenue?

© 2019 McGraw-Hill Education. 31

 Carla the Editor: Marginal
Revenue
What is Carla's marginal 3 papers with an
revenue? economic profit of $21

Opportunity cost of Carla's time is $29

Reservation Total
Student MR
Price Revenue
A $40 $40 $40
B 38 $76 $36
C 36 $108 $32
D 34 $136 $28
E 32 $160 $24
F 30 $180 $20
G 28 $196 $16
© 2019 McGraw-Hill Education. 32
 Carla the Editor: Price
Discriminator
Opportunity cost of Carla's time is 6 papers
$29 with an
economic
profit of
Reservation Total Marginal
Student $36
Price Revenue Revenue
A $40 $40
B 38 $78 38
C 36 $114 36
D 34 $148 34
E 32 $180 32
F 30 $210 30
G 28 $238 28
© 2019 McGraw-Hill Education. 33
 Hurdle Method of Price
Discrimination
The hurdle method of price
discrimination is the practice of
offering a discount to all buyers
who overcome some obstacle.
• Temporary sales
• Hard cover and paperback books
• Multiple car models from one
manufacturer
• Commercial air carriers
• Movie producers and phased releases
• Scratch and Dent appliance sales
© 2019 McGraw-Hill Education. 34
 Carla Offers a Rebate
If reservation price < $36, student will mail
in rebate
Total
Student Reservation Price MR
Revenue
A $40 $40 $40
B 38 76 36
C 36 108 32

Discounted Price Submarket

D $34 $34 $34
E 32 64 30
F 30 90 26

© 2019 McGraw-Hill Education. 35

 Carla's Choices
Social Single Perfect
Program Hurdle
Optimum Price Discriminator

Papers Edited 6 3 6 5 = (3 + 2)

$36, $4
Price $30 $36 Reservation
rebate

Total Revenue $180 $108 $210 $172

Carla's Time $174 $87 $174 $145

Economic Profit $6 $21 $36 $27

Total Surplus $26 $27 $36 $35

© 2019 McGraw-Hill Education. 36

 Monopoly and Public
Policy
Challenge: create the greatest
increase in total surplus
Policy options
• Government ownership and
operation
• Regulation
• Competitive bids for natural
monopoly services
• Break up

© 2019 McGraw-Hill Education. 37

 State-Owned Natural
Monopoly
Marginal cost is always less than
average cost
• Marginal cost pricing produces losses
Options
• Fund losses from tax revenues
• Fixed monthly fee plus usage fee
• Fixed fee covers losses
Limited incentives to innovate and cut
costs
Commonly used for water, Post Office,
and some electricity
© 2019 McGraw-Hill Education. 38
 Regulated Monopolies
Cost-plus regulation sets price at
per unit explicit costs plus a
mark-up for implicit costs
Used for electricity, telephone,
and cable
• Policies vary by state
Disadvantages
• High administrative cost
• Reduced incentive for cost-saving
innovation
© 2019 McGraw-Hill Education. 39
 Exclusive Contracting for
Natural Monopolies
Government awards contract to
low bidder for natural monopoly
services
• Garbage collection, fire protection,
road construction, Department of
Defense
Could achieve marginal cost
pricing IF government pays the
resulting losses
Asset transfer for large fixed
© 2019 McGraw-Hill Education. 40
 Enforcement of Anti-Trust
Laws
Two landmark laws
• Sherman Act of 1890
• Declared conspiracy to create a
monopoly illegal
• Clayton Act of 1914
• Outlawed transactions that would
"substantially lessen competition"
Applies to mergers and
acquisitions today
• IBM avoided break-up; AT&T did not
• Microsoft survived; will Google?
© 2019 McGraw-Hill Education. 41
 Another Policy Option:
Ignore Monopoly
Two objections to monopolies
• Restrict output, decrease total surplus
• Raise price, earn economic profits
Analysis
• Discount offers allow some customers to
pay less than average cost, though more
than marginal cost
• Economic profits generated by customers who
pay list price – their choice
• About two-thirds of economic profits are
taxed away
• Remainder accrues to shareholders
© 2019 McGraw-Hill Education. 42
 Imperfect Competition

© 2019 McGraw-Hill Education. 43

Chapter 8
Appendix
The Algebra of Monopoly
Maximization

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
distribution without the prior written consent of McGraw-Hill Education.
 From Demand to Marginal
Revenue
Given a demand curve such as
P = 15 − 2 Q
We can write the marginal revenue
curve as
MR = 15 − 4 Q
• Suppose marginal cost is a line with zero
intercept and a slope of 1
MC = Q

The remaining step is to set marginal

revenue equal to marginal cost
© 2019 McGraw-Hill Education. 45
 MR = MC
Let Q* be the profit maximizing level of
output
MC = MR
Q* = 15 − 4 Q*
5 Q* = 15
Q* = 3

To find P, substitute Q = 3 into the

demand equation
P = 15 − 4 Q*
P = 15 − 4 (3)
P=3
© 2019 McGraw-Hill Education. 46