Introduction to Economics – 11175

Week 6

Market Structures - Monopoly

 Week 6 Lecture

• Understand what a monopoly

market is and how it arises.
• Identify the profit maximising level
of output and price for a
monopoly.
• Evaluate the efficiency of monopoly
markets.
• Understand the public policy
responses to monopoly.
 Monopoly
• Monopoly: The only seller of a good or
service that does not have a close
substitute.
➢ High barriers to entry
➢ Price maker
➢ Single price or price discrimination
➢ Usually earns economic profit both in the short run
and the long run
Why do monopolies arise?
• Lack of competition created by barriers to entry.
• The main reasons for high barriers to entry are:
➢ Government blocks the entry of more than one firm
into a market (eg:-patent or copyright ; public
franchise).
➢ One firm has control of a key resource material/
technology necessary to produce a good.
Why do monopolies arise?
• The main reasons for high barriers to entry are:
➢ There are important network externalities in
supplying the good or service.
➢ Economies of scale are so large that one firm has a
natural monopoly.
 Monopoly
• Monopoly is a price maker. It does not face a
horizontal demand curve.
➢ In fact, both its demand curve and marginal
revenue curve are downward-sloping; and
➢ Marginal revenue curve is positioned below its
demand curve.
Monopoly Demand and Marginal
Revenue
• Monopolist has two opposing effects on
revenue:
➢ Quantity effect: One more unit is sold, increasing
total revenue by the price at which the unit is sold.
➢ Price effect: In order to sell the last unit, the
monopolist must cut the market price on all units
sold. This decreases total revenue.
❑Therefore, marginal revenue will be less than price
for a monopoly.
Monopoly Demand and Marginal Revenue
Profit maximizing monopoly
• Profit maximising monopolies will never
produce at an output in the inelastic range
of its demand curve.
➢ It could charge a higher price, produce a
smaller quantity, and earn a larger profit.
Profit maximizing monopoly
Monopoly’s Output & Price Decision
Marginal Marginal
Price Quantity Total revenue Total cost
(P) demanded revenue cost Profit
20 0 0 20 -20
18 1 18 18 21 1 -3
16 2 32 14 24 3 +8
14 3 42 10 30 6 +12
12 4 48 6 40 10 +8
10 5 50 2 55 15 -5
Monopoly’s Output & Price Decision
• The monopolist’s profit maximising
output is determined by the intersection
of the marginal revenue curve and the
marginal cost curve.
➢ For a competitive firm: P = MR = MC
➢ For a monopolist: P > MR = MC
Effect of increase in demand
 Monopoly and Efficiency
• We have already seen that: equilibrium in a
perfectly competitive market results in the
greatest amount of economic surplus, or total
benefit to society, from the production of a
good or service.
• However, a monopoly will produce less and
charge a higher price than would a perfectly
competitive industry producing the same good.
Monopoly versus Perfect competition
Inefficiency of Monopoly
Inefficiency of Monopoly
• The effects of monopoly:
➢Monopoly causes a reduction in consumer
surplus.
➢ Monopoly causes an increase in producer
surplus.
➢ Monopoly causes a deadweight loss, which is
a reduction in economic. efficiency
Inefficiency of Monopoly
• Since MR=MC and MR<P, then P>MC at the
monopoly output.
• The degree to which P is above MC is a
measure of market power. The gap between
P and MC is called ‘Mark-up’.
Rent seeking
• Rent seeking behavior is activity directed
toward acquiring monopoly power.
➢Rent seeking is profitable and widely
pursued.
➢Rent seeking is a complete loss to society
since it uses resources but does not
produce any output.
 Natural Monopoly
• A situation in which economies of scale are so
large that one firm can supply the entire market
at a lower average cost than can two or more
firms.
 Natural Monopoly

• Declining average total cost (ATC) & marginal cost

(MC) over a large range of output.
Government policy toward
Monopoly
• One approach is regulating natural monopolies
➢ In Australia, state regulatory commissions normally
set the prices for natural monopolies.
➢ The question is what the price should be? The
common options are:
❑Marginal cost pricing rule: Price = Marginal Cost.
❑Average cost pricing rule: Price = Average Total Cost.
Government Policy toward
Monopoly
Government policy toward
Monopoly
• Another approach is to increase competition with
anti-trust laws.
➢In Australia, competitive behaviour is monitored by
the Australian Competition and Consumer
Commission (ACCC).
Government policy toward
Monopoly
 Price Discrimination
• Thus far, we have assumed a monopolist must charge a
linear price (same price for every good it sells). What if
it can sell its goods for different prices?

• Price discrimination – practice of selling the same good

at different prices to different customers (when the
price differences are not due to differences in
production costs).
Price Discrimination
• A monopoly must be able to:
➢identify and separate different buyer types.
➢sell a product which cannot be resold: If
customers can resell the product then the
ones who bought at the lower price can
undercut the monopoly as monopoly tries to
sell to other customers at the higher price.
Price Discrimination
• Key idea behind price discrimination is to convert
consumer surplus into economic profit.
• Large firms and monopolies try to do this in two
broad ways:
➢ Discriminate among units of goods
➢ Discriminate among groups of buyers.
 Price discrimination
First-degree (perfect) price discrimination
• The monopolist knows each consumer’s willingness to
pay and charges each consumer exactly their willingness to
pay (i.e. requires extreme level of demand information
(unrealistic))

• As a result, with perfect price discrimination the

monopolist extracts all of the consumer’s surplus (the
monopolist gets all of the surplus in such a transaction)
Price discrimination
Second-degree price discrimination
• Firm takes advantage of the fact that demand curves are
downward sloping.
• Consumers are willing to pay a higher price for the first few
units.
➢ Firms price discriminate by charging different prices based
on the amount bought by customers.
• Price varies with quantity
Eg 1: ‘block pricing’ in utility markets (water, electricity, gas)
Eg 2: ‘quantity discounts’ whereby a single AA battery is sold
for $2, but a pack of 10 is sold for $10.
Price discrimination
Third-degree price discrimination
• Divide potential customers into groups and
set a different price for each group.
• The prices depend on the elasticity of
demand of the groups.
➢ High elasticity: charge low price
➢ Low elasticity: charge high price
Price Discrimination
Inter-temporal price discrimination
• Charging consumers different prices at
different times.
➢ e.g. technologically advanced equipment such as
digital camera; high price for first run movie and
lower price after a year
➢ e.g. hardcover (higher price, immediate release)
and paperbacks (lower price, later release)

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 Price Discrimination
Peak-load pricing
• Charging higher prices during peak period when
the firm is operating close to capacity
➢ Examples include lower off-peak electricity prices.

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Lecture Revision Questions
1. A monopoly is characterised by all of the
following except
A. there are only a few sellers each selling a
unique product.
B. entry barriers are high.
C. there are no close substitutes to the firm's
product.
D. the firm has market power.

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Lecture Revision Questions
2. A monopolist faces
A. a perfectly elastic demand curve.
B. a perfectly inelastic demand curve.
C. a horizontal demand curve.
D. a downward-sloping demand curve.

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Lecture Revision Questions
3. A patent or copyright is a barrier to entry
based on
A. Ownership of a key necessary raw material.
B. Lage economies of scale as output increases.
C. Government action to protect a producer.
D. Widespread network externalities.

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Lecture Revision Questions
4. The demand curve for the monopoly's product
is
A. the market demand for the product.
B. more elastic than the market demand for the
product.
C. more inelastic than the market demand for the
product.
D. undefined.

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Lecture Revision Questions
5. Refer to the figure below. The profit maximising output
and price for the monopolist are:
Lecture Revision Questions
6. Refer to the figure below. What is the profit of
the firm:
Lecture Revision Questions
7. A profit-maximising monopoly's price is
A. the same as the price that would prevail if the
industry was perfectly competitive.
B. less than the price that would prevail if the industry
was perfectly competitive.
C. greater than the price that would prevail if the
industry was perfectly competitive.
D. not consistently related to the price that would
prevail if the market was perfectly competitive

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Lecture Revision Questions
8. Compared to perfect competition, the consumer
surplus in a monopoly
A. is unchanged because price and output are the
same.
B. is lower because price is higher and output is
lower.
C. is higher because price is higher and output is
the same.
D. is eliminated.
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Lecture Revision Questions
9. Which of the following undermines a firm's
ability to engage in price discrimination?
A. The seller's market power.
B. The inability to prevent resale of the product
from one market segment to another.
C. The seller's ability to segment the total market.
D. The seller's ability to segment the total market.

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Lecture Revision Questions
10. A firm that can effectively price discriminate will
charge a higher price to
A. customers who have the more elastic demand for
the product.
B. customers who have the more inelastic demand for
the product.
C. buyers who belong to the largest market segment.
D. buyers who are members of the smallest market
segment.

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