Market Structures l:

14
Monopoly
 IMPERFECT COMPETITION
Imperfect competition is where firms
differentiate their product in some way and so
can have some influence over price.
There are different degrees of imperfect
competition.
• At one end of the spectrum is the monopoly.
• Strictly, a monopoly is a market structure with only
one firm and no close substitutes.
• In reality firms can exercise monopoly power by
being the dominant firm in the market.
 IMPERFECT COMPETITION
• Market power is where a firm is able to raise the
price of its product and not lose all its sales to
rivals.
• While a competitive firm is a price taker, a
monopoly firm is a price maker.
 WHY MONOPOLIES ARISE
A monopoly is a firm that is the sole seller of a
product without close substitutes.
HOW MONOPOLIES MAKE PRODUCTION
AND PRICING DECISIONS
The key difference between a competitive firm
and a monopoly is the monopoly's ability to
control price.
• A monopoly faces a downward sloping demand
curve
• A monopoly can increase price and not lose all its
sales.
 Figure 2 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

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 Monopoly versus Competition

Monopoly
• Is the sole producer
• Faces a downward-sloping demand curve
• Is a price maker
• Reduces price to increase sales
Competitive Firm
• Is one of many producers
• Faces a horizontal demand curve
• Is a price taker
• Sells as much or as little at same price
A Monopoly’s Revenue
TR(Q) =P(Q)*Q
A Monopoly’s Marginal Revenue
• A monopolist’s marginal revenue is always
less than the price of its good.
𝜕𝑇𝑅 𝑄 𝜕𝑃 𝑄
𝑀𝑅 𝑄 = = 𝑄+𝑃 𝑄
𝜕𝑄 𝜕𝑄
𝜕𝑃 𝑄
• Hence since < 0, it follows that:
𝜕𝑄
MR(Q)<P(Q)
o The demand curve is downward sloping.
o When a monopoly drops the price to sell one more
unit, the revenue received from previously sold units
also decreases.
A Monopoly’s Revenue

A Monopoly’s Marginal Revenue

• When a monopoly increases the amount it sells, it
has two effects on total revenue (P(Q)  Q).
o The output effect—more output is sold, so Q is higher.
o The price effect—price falls, so P is lower.
Linear demand curve
 Figure 3 Demand and Marginal Revenue Curves for a
Monopoly

Price
€11
10
9
8
7
6
5
4
3 Demand
2 Marginal (P(Q))
1 revenue
0
–1 1 2 3 4 5 6 7 8 Quantity of Water
–2
–3
–4

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Profit Maximization
 Figure 4 Profit Maximization for a Monopoly

Costs and
Revenue 2. . . . and then the demand 1. The intersection of the
curve shows the price marginal-revenue curve
consistent with this quantity. and the marginal-cost
curve determines the
B profit-maximizing
Monopoly quantity . . .
price

Average total cost

A

Marginal Demand
cost

Marginal revenue

0 Q QMAX Q Quantity
Copyright©2014 Cengage
Profit Maximization

Comparing Monopoly and Competition

• For a competitive firm, price equals marginal cost.
P = MR = MC
• For a monopoly firm, price exceeds marginal cost.
P > MR = MC
A Monopoly’s Profit

Profit equals total revenue minus total costs.

• Profit = TR - TC
• Profit = (TR/Q - TC/Q)  Q
• Profit = (P - ATC)  Q
 Figure 5 The Monopolist’s Profit

Costs and
Revenue

Marginal cost

Monopoly E B
price

Monopoly Average total cost

profit

Average
total D C
cost
Demand

Marginal revenue

0 QMAX Quantity

Copyright©2014 Cengage
A Monopolist’s Profit

The monopolist will receive economic profits

as long as price is greater than average total
cost.
 Market power
18

Definition: An economic agent has market power if she

is able to influence the market price

This translates in the possibility of charging a price

above marginal cost.
19 Mark-up (Lerner Index)

𝑷 − 𝑴𝑪
𝑷
𝑷−𝑴𝑪
• is the mark-up (the difference between the profit
𝑷
maximizing price and the marginal cost of the
monopolist, expressed as a percentage over the price)

• It is also called “Lerner Index”: The Lerner-Index

quantifies the market power of a firm.
(0 in perfect competition)
20 Inverse elasticity price rule

𝑷 − 𝑴𝑪 𝟏
=−
𝑷 𝜺𝑸,𝑷

IEPR: the mark-up is equal to the (negative) inverse of the

price elasticity of the demand

The higher the price elasticity of the demand (in absolute

value), the lower the monopolist’s mark-up
The monopolist does not have a supply curve

The optimal supply from the monopolist’s perspective

depends on the demand curve

A monopolist may find optimal to supply the same

quantity at different prices depending on the demand
curve that he faces
The Monopolist Optimal Supply depends on the Demand
….and charging a price P = €15

If the market demand is D1…

The monopolist ….the monopolist maximizes its

may sell the same profits by producing Q = 5…
quantity at
different prices
….and charging the price P = €20
according to the
demand curve

If the market demand is D2…

….the monopolist maximizes its

profits by producing Q= 5…

22
 THE WELFARE COST OF
MONOPOLY
In contrast to a competitive firm, the 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.
The Deadweight Loss

Because a monopoly sets its price above

marginal cost, it 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.
 Monopoly vs. perfect competition

Price
Marginal cost

Monopoly
price

Marginal
revenue Demand

0 Monopoly Quantity
quantity

Copyright©2014 Cengage
 The Inefficiency of Monopoly (comparison with Perfect
Competition)

Price
Marginal cost
(= Firm Supply Curve
in Perfect competition)

Monopoly
price
Perfect
Competition
price

Marginal
revenue Demand

0 Monopoly Perfect Quantity

quantity Competition
quantity
Copyright
Copyright©2014
© 2014 Cengage
Cengage
Learning
 The Inefficiency of Monopoly (comparison with Perfect
Competition)

Price
Marginal cost
(= Firm Supply Curve
in Perfect competition)

A
Monopoly
price
Perfect
B D
Competition
price F
C
Marginal
revenue Demand

0 Monopoly Perfect competition Quantity

quantity quantity

Copyright
Copyright©2014
© 2014 Cengage
Cengage
Learning
Welfare

Perfect competition
• CS=A+B+D
• PS=C+F
Monopoly
• CS=A
• PS=B+C
• DWL=D+F
The Deadweight Loss

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.
 PUBLIC POLICY TOWARD
MONOPOLIES
Government may respond to the problem of
monopoly in one of three ways.
• Antitrust authorities:
o Making monopolized industries more competitive.
o Regulating the behavior of monopolies.
• Turning some private monopolies into public
enterprises.
Increasing Competition

Governments have various ways to promote

competition by using competition laws.
• Governments may prevent mergers.
• Governments may break up companies.
• Competition laws prevent companies from
undertaking activities that make markets less
competitive.
 Market Structures ll:
15
Monopolistic Competition
 Monopolistic Competition
Imperfect competition refers to those market
structures that fall between perfect
competition and pure monopoly.
Figure 1 The Four Types of Market Structure

Number of Firms?

Many
firms

Type of Products?

One Few Differentiated Identical

firm firms products products

Monopolistic Perfect
Monopoly Oligopoly Competition Competition
(Chapter 14) (Chapter 16 (Chapter 15) (Chapter 6)

• Tap water • Chocolate • Novels • Wheat

• Cable TV • Crude oil • Restaurants • Milk

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 MONOPOLISTIC COMPETITION
Monopolistic Competition
• Many firms selling products that are similar but not
identical.
• Markets that have some features of competition
and some features of monopoly.
 CHARACTERISTICS OF
MONOPOLISTIC COMPETITION
Many sellers
• There are many firms competing for the same group of
customers e.g. books, restaurants,
Product differentiation
• Each firm produces a product that is at least slightly
different from those of other firms.
• Rather than being a price taker, each firm faces a
downward-sloping demand curve.
Free entry and exit
• Firms can enter or exit the market without restriction.
Monopolistic Competition in the Short Run: Case 1,
Profits>0

(a) Firm Makes Profit

Price

MC

ATC

Price
Average
total cost
Profit Demand

MR

0 Profit- Quantity
maximizing
quantity
Copyright©2014 Cengage
 Monopolistically Competitive Firm
Short Run vs. Long Run
Short-run economic profits encourage new
firms to enter the market. This:
• Increases the number of products offered.
• Reduces demand faced by firms already in the
market.
• Incumbent firms’ demand curves shift to the left.
• Demand for the incumbent firms’ products fall, and
their profits decline.
The Long-Run Equilibrium

Firms will enter until the firms are making

exactly zero economic profits.
That is: until the demand curve for the
firm’s product is tangent to the average
total cost curve
 Figure 2 A Monopolistic Competitor in the Long Run

Price

MC
ATC

P = ATC

Demand
MR
0
Profit-maximizing Quantity
quantity

Copyright©2014 Cengage
Monopolistic Competitors in the Short Run: Case 2,
Profits<0

(b) Firm Makes Losses

Price

MC
ATC
Losses

Average
total cost
Price

MR Demand

0 Loss- Quantity
minimizing
quantity
Copyright©2014 Cengage
Monopolistically Competitive Firm in
the Short Run
Short-run economic losses encourage firms to
exit the market. This:
• Decreases the number of products offered.
• Increases demand faced by the remaining firms.
• Shifts the remaining firms’ demand curves to the
right.
• Increases the remaining firms’ profits.
The Long-Run Equilibrium

Firms will exit until the remaining firms are

making exactly zero economic profits.
That is: until the demand curve for the
firm’s product is tangent to the average
total cost curve
 Figure 2 A Monopolistic Competitor in the Long Run

Price

MC
ATC

P = ATC

Demand
MR
0
Profit-maximizing Quantity
quantity

Copyright©2014 Cengage
Long-Run Equilibrium

Two Characteristics
• As in a monopoly, price exceeds marginal
cost.
o Profit maximization requires marginal revenue to equal
marginal cost.
o The downward-sloping demand curve makes marginal
revenue less than price.
• As in a competitive market, price equals
average total cost.
o Free entry and exit drive economic profit to zero.
Monopolistic versus Perfect Competition

There are two noteworthy differences between

monopolistic and perfect competition:
① excess capacity (output is less than the
efficient scale)
② mark-up (price above marginal cost).
Monopolistic versus Perfect Competition:
Excess Capacity vs. Efficient Scale

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC

P
P = MC P = MR
(demand
curve)

MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

Copyright©2014 Cengage
Monopolistic versus Perfect Competition

① Excess Capacity
• There is no excess capacity in perfect competition
in the long run.
• Free entry results in competitive firms producing at
the point where average total cost is minimized,
which is the efficient scale of the firm.
• There is excess capacity in monopolistic
competition in the long run.
• In monopolistic competition, output is less than the
efficient scale of perfect competition.
 Monopolistic versus Perfect Competition:
Positive Markup vs. Zero markup

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC
mark-up

P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

0 Quantity Quantity 0 Quantity produced Quantity

produced

Copyright©2014 Cengage
Monopolistic versus Perfect Competition

② Mark-up Over Marginal Cost

• For a competitive firm, price equals marginal cost.
• For a monopolistically competitive firm, price
exceeds marginal cost.
• Because price exceeds marginal cost, an extra
unit sold at the posted price means more profit for
the monopolistically competitive firm.
 Figure 3 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC
mark-up

P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

Excess capacity

Copyright©2014 Cengage
MATHEMATICAL APPENDIX
(not required for the exam)
53 Elasticity and Marginal Revenue

Since the marginal revenue is:

𝜕𝑇𝑅 𝑄 𝜕𝑃 𝑄
𝑀𝑅 𝑄 = =𝑃 𝑄 + 𝑄
𝜕𝑄 𝜕𝑄
We can re-arrange it as:
𝜕𝑃 𝑄 𝑄
MR 𝑄 = 𝑃(𝑄) 1 +
𝜕𝑄 𝑃(𝑄)
1
=𝑃 1+
𝜀𝑄,𝑃

where: 𝜺𝑸,𝑷 is the price elasticity of demand

54 Inverse elasticity price rule
Profit maximizing condition:
1
𝑀𝐶 = 𝑀𝑅 𝑄 = 𝑃 1 +
𝜀𝑄,𝑃
Which is clearly equivalent to:
1
−𝑀𝐶 = −𝑃 1 +
𝜀𝑄,𝑃
By adding P on both sides:
1
𝑃 − 𝑀𝐶 = 𝑃 − 𝑃 1 +
𝜀𝑄,𝑃
𝑃 − 𝑀𝐶 1
=1−1−
𝑃 𝜀𝑄,𝑃
𝑷 − 𝑴𝑪 𝟏
=−
𝑷 𝜺𝑸,𝑷