Market Structures I: Monopoly

Different types of 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. (google, amazon, Microsoft,
Facebook)
Different types of Imperfect
Competition
Firms might be investigated by regulators if they
account for over 25 per cent of market share,
because there is a risk that they have too much
market power.
◦ A competitive firm is a price taker, a monopoly firm is
a price maker
◦ Market share is the proportion of total sales in a
market accounted for by a particular firm.
◦ Market power is where a firm is able to raise the price
of its product and not lose all its sales to rivals.
II. Why Monopolies Arise
Definition of a Monopoly
A monopoly is a firm that is the sole seller of a product
without close substitutes.

The fundamental cause of monopoly is the presence

of barriers to entry.
The Fundamental Cause of Monopoly is
barriers to entry
Barriers to entry have four sources:
◦ Ownership of a key resource.
◦ The government gives a single firm the exclusive right to
produce some good.
◦ Costs of production make a single producer more efficient
than a large number of producers.
◦ A firm is able to gain control of other firms in the market
and thus grow in size.
Monopoly Resources
Although exclusive ownership of a key resource is
a potential source of monopoly, in practice
monopolies rarely arise for this reason.
Government-Created Monopolies
Governments may restrict entry by giving a single firm the
exclusive right to sell a particular good in certain markets.

Patent and copyright laws are two important examples of

how government creates a monopoly to serve the public
interest.
◦ Laws governing patents and copyrights have benefits and
costs.
◦ The benefits are the increased incentive for creative activity and
must be set against….
◦ Costs of monopoly pricing.
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 occurs when there are

economies of scale, implying that average total
cost falls as the firm’s scale becomes larger.
Natural Monopolies
Cost Economies of Scale as a Cause of Monopoly

Average
tota
lcos
t
0 Quantity of
Output
External Growth
o Many of the largest firms in the world have grown
partly through acquisition, merger or takeover of
other firms.
o Consequently industry becomes more
concentrated.
o One effect of this is that a firm might be able to
develop monopoly power over its rivals and erect
barriers to entry to make it harder for new firms to
enter.
III. How Monopolies Make
Production And Pricing
Decisions
Monopoly Versus Competition
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.
 Monopoly Versus Competition
Demand Curves for Competitive and Monopoly Firms
(a) A Competitive ’s Demand (b) A Monopolist’s Demand
Firm Curve Curve
Pric Pric
e e

Deman
d

Deman
d

0 Quantity of Output 0 Quantity of Output

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
Total Revenue

P × Q = TR

Average Revenue

TR/Q = AR = P

Marginal Revenue

ΔTR/ΔQ = MR
A Monopoly’s Revenue
A Monopoly’s Total, Average, and Marginal Revenue
A Monopoly’s Revenue
A Monopoly’s Marginal Revenue
◦ A monopolist’s marginal revenue is always less than the
price of its good.
◦ The demand curve is downward sloping.
◦ When a monopoly drops the price to sell one more unit, the revenue
received from previously sold units also decreases.

◦ When a monopoly increases the amount it sells, it has two

effects on total revenue (P × Q).
◦ The output effect—more output is sold, so Q is higher.
◦ The price effect—price falls, so P is lower.
A Monopoly’s Revenue
Demand and Marginal Revenue Curves for a Monopoly
Price
€11
10
9
8
7
6
5
4
3 Demand
2 Marginal (average
1 revenue revenue)
0
–1 1 2 3 4 5 6 7 8 Quantity of Water
–2
–3
–4
Profit Maximization
o A monopoly maximizes profit by producing the
quantity at which marginal revenue equals
marginal cost.
o It then uses the demand curve to find the price
that will induce consumers to buy that quantity.
Profit Maximization
Profit Maximization for a Monopoly
Costs
and
Revenu 2. . . . and then the demand 1. The intersection of the
e curve shows the price marginal-revenue
consistent with this quantity. curve
and the marginal-cost
curve determines the
B profit-maximizin
Monopol g
quantity . . .
y pric
e
Average total cost
A

Margina Deman
l cost d

Marginal
revenue
0 Q QMAX Q Quantity
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
A Monopoly’s Profit
Monopolist’s Profit
Costs
and
Revenu
e

Marginal
cost
Monopol E B
y pric
e
Monopol Average total cost
y profit

Averag
e total D C
cost
Deman
d

Marginal
revenue
0 QMAX Quantity
A Monopoly’s Profit

The monopoly will receive economic profits as long as

price is greater than average total cost.
Example

Q: Inverse demand function for a monopolist’s product is given by P = 100 –

2Q and cost function is given by C(Q) = 10 + 2Q. Determine profit
maximizing price and quantity (hint: MC(Q) = MR(Q) at QM) and maximum
Profits.

QM = 24.5; PM = 51 Profit = $1190.50

TR = PxQ = (100 – 2Q) x Q Profit = Revenue – Cost
MR = dR/dQ = 100 – 4Q = QM PM - C(QM)
MC = dC/dQ = 2 = (51)(24.5) – [10+2(24.5)]
Set MR = MC: 100 – 4Q = 2 = $1190.5
QM = 24.5; PM = 51
 Absence of Supply Curve
• No well-defined supply curve for a monopoly firm
• Supply curve: shows unique relationship between price
and quantity
• Supply determined at P=MC under perfect competition
• Supply determined at MR=MC under monopoly
• Takes into account shape of demand curve/elasticity
of demand
• No unique relationship b/w price and quantity supplied
by monopolist
Multi-plant Decisions

• Situation: identical product, sold at P(Q), produced at multiple plant

• Profit maximization for two-plant monopolist:

MR(Q) = MC1(Q1)
MR(Q) = MC2(Q2)
Where MR: Marginal revenue of total product Q;
MC1(Q1): Marginal cost of producing in Q1 plant 1
MC2(Q2): Marginal cost of producing in Q2 plant 2
• Example
Suppose a monopolist’s analytics team estimated inverse demand as P(Q) = 70
− .5Q The monopolist can produce output in two plants. The marginal cost of
producing in plant 1 is MC1 = 3Q1, and the marginal cost of producing in
plant 2 is MC2 = Q2. How much output should be produced in each plant to
maximize profits, and what price should be charged for the product?
(Hint: Substitute Q with (Q1+Q2) in MR(Q))

• Answer:
Q1 = 10, Q2 = 30, P = $50
IV. The Welfare Cost Of
Monopoly
The Deadweight Loss
o In contrast to a competitive firm, the monopoly charges a price
above the marginal cost.

o From the standpoint of consumers, this high price makes

monopoly undesirable.

o However, from the standpoint of the owners of the firm, the

high price makes monopoly very desirable.
The Deadweight Loss
Figure 6. The Efficient Level of Output
Price
Marginal
cost

Valu Cos
et tt
o
buyer o
monopolis
s t

Deman
Cos Valu d to
(value
tt et buyers)
o
monopolis o
buyer
t s
0 Quantit
y
Value to Value to
buyers
is greater buyers
is less
than
cost to than
cost to
seller. Efficien seller.
tquantit
y
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
The Deadweight Loss
Figure 7. The Inefficiency of Monopoly
Pric
e Deadweigh Marginal
t los cost
s
Monopol
y pric
e

Margina
lrevenu Deman
e d

0 Monopol Efficien Quantity

yquantit tquantit
y y
The Deadweight Loss
The Inefficiency of Monopoly
o The monopolist produces less than the socially
efficient quantity of output.
o The deadweight loss caused by a monopoly is similar to the
deadweight loss caused by a tax.
o The difference between the two cases is that the
government gets the revenue from a tax, whereas a
private firm gets the monopoly profit.
The Monopoly's Profit: A Social
Cost?
Welfare in a market includes the welfare of both
consumers and producers.
The transfer of surplus from consumers to
producers is therefore not a social loss.
The deadweight loss from monopoly stems monopolies
producing less than the socially efficient level of output.
If the monopoly incurs costs to maintain (or create) its
monopoly power, those costs would also be included in
deadweight loss.
V. Price Discrimination
Definition of Price Discrimination
Price discrimination is selling the same good at
different prices to different customers, even though the
costs for producing for the two customers are the
same.

Arbitrage will limit a monopolist's ability to

price discriminate.
◦ Arbitrage is the process of buying a good in one market at a
low price and then selling it in another market at a higher price.
The Analytics of Price Discrimination
In order to price discriminate, the firm must have some
market power .

Perfect Price Discrimination occurs when a

monopoly can sperate customers by the
willingness to pay 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.
The Analytics of Price Discrimination
Figure 8a. Welfare with and without Price Discrimination: For a monopolist
with single price

Price

Consumer
surplus

Monopoly Deadweight
price loss
Profit
Marginal cost

Marginal
Demand
revenue

0 Quantity sold Quantity

The Analytics of Price Discrimination
Figure 8b. Welfare with and without Price Discrimination: For a monopolist
with perfect price discrimination.
Price

Profit
Marginal cost

Demand

0 Quantity sold Quantity

Examples of price Discrimination
1. Cinema tickets
2. Airline prices
3. Discount coupons
4. Quantity discounts
VI. Public Policy Toward
Monopolies
Policy Makers Response to
Monopolies
Government responds to the problem of monopoly in
one of four ways.
◦ Making monopolized industries more competitive.
◦ Regulating the behaviour of monopolies.
◦ Turning some private monopolies into public enterprises.
◦ Doing nothing at all.
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.
Increasing Competition
USA Competition law is known as anti-trust law.

In the UK and elsewhere in Europe such laws are

usually referred to as competition laws.

Competition legislation covers:

◦ Acting against cartels and restrictive business practices.
◦ Banning pricing strategies which are anti-competitive such as
price fixing, predatory pricing.
◦ Monitoring and supervising acquisitions and joint ventures.
Regulation
Government may regulate the prices that the monopoly
charges.
◦ The allocation of resources will be efficient if price is set to
equal marginal cost.
 Regulation
Pric
e

Average
total cost Average total cost
Los
Regulate s
d pric Marginal
e cost

Deman
d
0 Quantity
Regulation
In practice, regulators will allow monopolists to keep some of the
benefits from lower costs in the form of higher profit, a practice
that requires some departure from marginal cost pricing.
Public Ownership
Rather than regulating a natural monopoly that is run
by a private firm, the government can run the
monopoly itself.
Doing Nothing
Government may do nothing at all if the market failure
is deemed small compared to the imperfections of
public policies.
A thumb rule for pricing

• Price and output are chosen so that MR=MC.

• Managers have knowledge about elasticity of demand.

• MR = ∆R / ∆Q = ∆(PQ) / ∆Q

• MR basically has two components:

• Increase in in 1-unit and selling it at price (P) brings and additional revenue = 1*P=P.
• Producing and selling extra unit also result in drop in price ∆P / ∆Q, which results in decrease
of revenue from all units sold= Q (∆P / ∆Q).

• MR = P + Q ∆P / ∆Q = P + P (Q/P) (∆P / ∆Q)

• MR = P+P(1/Ed) =MC
• P = MC/(1+(1/Ed)
A thumb rule for pricing

• MC = P (1+(1/Ed)
• (P- MC)/P = -1/Ed

• Monopolist’s optimal markup of price over marginal cost, expressed as a

percentage of the price is negative of the inverse of the price elasticity of
demand.
• Inverse elasticity pricing rule (IEPR)
• The monopoly’s market power is inversely proportional to the price elasticity
of demand
• This measure is called the Lerner Index of market power.
• For a perfect competition, it is zero.
• For a monopolist, it is higher than zero.
Price Discrimination
Price Discrimination: Charging different price for same good

• Pricing Strategy for firms :

• Charging different prices to different customers.
A MC

Rs. Per unit of output

• Capturing consumer surplus and transferring it to the producers.
P1
• The firm can increase its profit by capturing consumer surplus P* B
from them who are willing to pay more than P*.
• Some customers are out of the market due to higher price, but P2

can pay up to MC.

MRlr Dlr
0
Q1 Q* Q2 Output
• For region A, higher price P1 can be charged,
• For region B, lower price P2 can be charged.
 Price Discrimination
• Reservation price: Maximum price that a customer is
willing to pay for a good.

Consumer surplus
• First-degree Price Discrimination- Practice of charging when single price P* MC

Rs. Per unit of output

each customer her reservation price. is charged

P*

• Perfect price discrimination: Each consumer is charged P2

exactly what they are willing to pay.
• MR curve is no longer relevant to the firm. MRlr Dlr
• Additional profit by selling incremental unit is the difference 0
Output
Q* Q2
between demand and Marginal Cost.
Imperfect price discrimination

• It is difficult to practically charge each customer

differently
• A firm is not aware of the reservation price of each
customer. MC

Rs. Per unit of output

P1
• In imperfect price discrimination, a set of prices is P2
P3
charged. P*
4P5
• Customers who are willing to pay lesser than P*4 P6

are better off.

MR D
• Price discrimination brings new customers to the 0
Output
market and increase consumer welfare.
 Second-Degree Price Discrimination
• Second-degree price discrimination: Practice of
charging different prices per unit for different quantities
of the same good or service. P1

Rs. Per unit of output

A
• Consumer purchase many units of a good over a given period,
P0
reservation price declines with no. of units.
P2 B

• Block Pricing: Practice of charging different prices per unit P3 AC

for different quantities or block of a good. MC

D
• It lead to expansion of output and greater scale economies MR
0
Q1 Q0 Q2 Q3 Output

1st Block 2nd Block 3rd Block

 Third-Degree Price Discrimination
• Third-degree price discrimination: Practice of dividing consumers into two or more groups with
separate demand curves and charging different prices to each group.

• Creating Consumer groups

• Some characteristic is used to divide

Rs. Per unit of output

consumers into distinct groups.
P1
• Total output must be such that the MR of each MC
group is equal to MC. P2
D2=AR2

MRt
• Prices of goods for each group depend on elasticity of D1=AR1 MR2
demand for that group. MR1
0
Q1 Q2 Qt Output
 Intertemporal price discrimination
• Intertemporal price discrimination: Practice of
separating consumers with different demand functions
into different groups by charging different prices at
different points in time.

Rs. Per unit of output

P1
• Divide consumers into high-demand and low-demand groups by P2
charging a price that is high at first but falls later.
D2=AR2

• Customers who value the product more- inelastic demand curve. AC=MC
D1=AR1 MR2
• After 1st group brought the product, price is lowered. MR1
0
• Second group of customers have elastic demand curve. Q1 Q2 Output
 Peak Load Pricing
• Peak Load Pricing: Practice of charging higher prices
during peak periods when capacity constraints cause MC
marginal costs to be high. P1

Rs. Per unit of output

D1=AR1

• Objective is to increase economic efficiency by charging prices P2

close to MC.
• Demand for the good is peak at particular time.
MR1
• MC is also high during this period due to capacity constraint.
D2=AR2
• It involves charging different prices at different points in time. MR2
0
Q2 Q1 Output

• D1 shows demand at peak hours. At MR=MC, firm charges

higher price P1.
• Sum of producer and consumer surplus is more because price is
closer to MC.
VII. Conclusion: The
Prevalence Of Monopoly
Conclusion: 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.
 Summary
1. A monopoly is an extreme example of imperfect competition.

2. A monopoly is a firm that is the sole seller in its market.

3. A monopoly has barriers to entry.

4. It faces a downward-sloping demand curve for its product.

5. A monopoly’s marginal revenue is always below the price of

its good.
 Summary
6. Like a competitive firm, a monopoly maximizes profit by
producing the quantity at which marginal cost and marginal
revenue are equal.

7. Unlike a competitive firm, its price exceeds its marginal

revenue, so its price exceeds marginal cost.

8. A monopolist’s profit-maximizing level of output is below the

level that maximizes the sum of consumer and producer
surplus.

9. A monopoly causes deadweight losses similar to the

deadweight losses caused by taxes.
 Summary
10. Monopolists can raise their profits by charging different
prices to different buyers based on their willingness to pay.

11. Price discrimination can raise economic welfare and reduce

deadweight losses.

12. Policy makers can respond to the inefficiencies of

monopoly behaviour with antitrust laws, regulation of
prices, or by turning the monopoly into a government-run
enterprise.

13. If the market failure is deemed small, policymakers may

decide to do nothing at all.