Monopoly

Four Basic Market

Structures
• Perfectly Competitive: many firms, identical products, free
entry and exit, full and symmetric info
• Monopoly: single firm, no close substitutes, barriers to
entry, full and symmetric info
• Oligopoly: several firms, similar products, degree of product
differentiation varies depending upon the market, might be
barriers, full and symmetric info
• Monopolistic competition: many firms, similar products,
slightly differentiated products, free entry and exit, full and
symmetric info
 Competitive Market
• This is the classic “textbook”
market structure.
• Firms in a competitive market
all make a product that is
perfectly substitutable: all
demanders are equally
satisfied with any supplier’s
product.
 Monopoly
• The single seller makes a
product that has no “good”
substitute.
• Other firms may be able to
produce the good or service
but choose not to enter the
market or are barred from
it.
Oligopoly
• A few sellers make
products that are good,
but not perfect,
substitutes.
• Consumers can be induced
to change suppliers but
have only a limited
number of choices.
Monopolistic Competition
• The market has many
firms but each
supplier’s product is
differentiated.
• Consumers can be
induced to change
brands but they have
brand preferences.
Question
• What is the market structure for each of these
products or firms: competitive, monopoly,
oligopoly, monopolistic competition?
• The Campus Store
• Kinko’s
• Pepperidge Farm’s Whole Wheat Bread
• PowerMac computer
• Windows computer
• NYSEG (electricity utility)
• Morton salt
• AT&T long distance
 Answer
• The Campus Store: most products competitive, textbooks oligopoly,
but location is very important.
• Kinko’s: monopolistic competition (differentiated service)
• Pepperidge Farm’s Whole Wheat Bread: competition or monopolistic
competition (slightly differentiated recipes)
• PowerMac computer and clones: monopoly, under license.
• Windows computer: monopolistic competition (differentiated
features)
• NYSEG (electricity utility): monopoly
• Morton salt: competitive
• AT&T long distance: oligopoly
Monopoly
• single firm
• no close substitutes
• barriers to entry
• full and symmetric
information
Sources of Monopoly Entry
Barriers
• Natural monopoly: the most efficient scale of production is
so large, relative to market demand, that a single firm
dominates the market.
• Patents, copyrights, licenses, franchises: government
protection of a firm’s right to produce a unique product.
• Economic and/or legal restrictions, strategies or situations
that make entry more difficult for new competitors than for
the existing monopoly firm.
Natural Monopolies
• Goods and services whose delivery requires the
construction of a physical network (wires, pipes, etc..)
• In such industries (local phone service, water, sewage
removal, electricity, gas) the physical networks display
decreasing marginal cost over essentially all quantities.
• Thus, average total cost is always declining and the
minimum efficient scale is much larger than the size of the
market.
• Natural monopolies are often regulated: they cannot
charge a higher price without government approval.
Patents: Are There “Good”
Monopolies?
• Consider the protease inhibitor Crixivan from
Merck.
• A very effective AIDS therapy.
• Development costs were more than one billion
dollars.
• Annual revenue now from treating around 90,000
patients is $500,000,000.
What is a “Good”
Monopoly?
• Why is Merck given a monopoly?
• The granting of a patent on the drug Crixivan
guarantees that Merck can earn monopoly profits
on its sale.
• These monopoly profits provide the incentive to
invest in the research and development required to
create the new drug.
“Good” Monopolies
• The granting of patent protection (legal monopoly)
gives firms a strong incentive to invest in new
product development.
• Would firms make the R&D investments if they
could not protect them through patents and trade
secrets?
• Probably not because competitors could steal the
design at a fraction of the cost after the product is
brought to market.
“Other” Monopolies -
Good? Bad?
• Input Ownership
• DeBeer’s and diamonds
• Industry Secret or Know-how
• IBM and mainframes?
• Strategic Behavior
• buy ‘em up
• blow’ em up
• let’s make a deal
• Microsoft and operating systems?
Classic Simple Monopoly
• Polar extreme from perfect competition.
• Monopolist is a “price maker.”
• Cost curves are pretty much the same (except in
the case of natural monopoly).
• The big change from before is in the demand side
of the profit function.
The Simple Monopolist
• The simple monopolist abides by the “law of one
price.” Everyone pays the same market price for
all units purchased.
• A monopolist faces the declining market demand
curve for its product and simultaneously chooses
price and quantity.
• Now P>MR (before P=MR) because the simple
monopolist must lower the price on all preceding
units to sell an additional unit.
• A monopolist has no “supply curve.”
The Simple Monopolist:
Rules for Profit
Maximization
• Suppose we are in the short run.
• Rules for profit maximization are the same as
before.
• If XSM maximizes profit, then
• MR(XSM ) = MC(XSM )
• very important note: for a simple monopolist P>MR at all
positive levels of X.
• XSM is a max and not a min.
• at XSM it’s worth operating.
 Simple Monopoly
Monopoly Selling in a Single Market at a Single Price
Marginal Marginal
• Economic profits equal total Market Cost Average Revenue
revenue minus total costs. Quantity
Demand
Price
Total
Costs
(midpoint
formula)
Total
Cost
Total
Revenue
(midpoint Economic
formula) Profits

• Marginal revenue is the rate of 0

10
100.00
95.00
800
1,500 82.50 150.00
0.00
950.00 90.00
-800
-550
change of total revenue (just 20 90.00 2,450 65.00 122.50 1,800.00 80.00 -650
30 85.00 2,800 42.50 93.33 2,550.00 70.00 -250
like marginal cost is the rate of 40 80.00 3,300 32.50 82.50 3,200.00 60.00 -100
change of total cost) as 50 75.00 3,450 20.50 69.00 3,750.00 50.00 300
60 70.00 3,710 18.50 61.83 4,200.00 40.00 490
quantity increases. 70 65.00 3,820 9.50 54.57 4,550.00 30.00 730
80 60.00 3,900 9.00 48.75 4,800.00 20.00 900
• Economic profits are 90 55.00 4,000 10.00 44.44 4,950.00 10.00 950
maximized when marginal 100
110
50.00
45.00
4,100
4,250
12.50
17.50
41.00 5,000.00
38.64 4,950.00
0.00
-10.00
900
700
revenue equals marginal costs 120 40.00 4,450 20.00 37.08 4,800.00 -20.00 350
130 35.00 4,650 25.00 35.77 4,550.00 -30.00 -100
140 30.00 4,950 30.00 35.36 4,200.00 -40.00 -750
150 25.00 5,250 35.00 35.00 3,750.00 -50.00 -1,500
160 20.00 5,650 45.00 35.31 3,200.00 -60.00 -2,450
170 15.00 6,150 60.00 36.18 2,550.00 -70.00 -3,600
180 10.00 6,850 75.00 38.06 1,800.00 -80.00 -5,050
190 5.00 7,650 100.00 40.26 950.00 -90.00 -6,700
200 0.00 8,850 44.25 0.00 -8,850
 Graphical Display of
Monopolist’s Solution
• The monopolist sets marginal revenue equal
Natural Monopolist's Market
to marginal cost at MR=MC=$10.
100.00
• The optimal quantity is thus 90 units, which 90.00
Market Demand Price
implies a market price of $55/unit. Exact Marginal Revenue
80.00
Marginal Cost
• The monopoly profits (light blue in the graph) 70.00 Average Total Cost
are the difference between price ($55) and
60.00
average total cost ($44.44) times the number
50.00 Monopoly Profits
of units sold.
40.00

Dollars/unit
• Notice that our monopolist is a “natural
monopoly” the average total costs decline 30.00

over the entire relevant range of production 20.00

and the minimum efficient scale (150) is 10.00

bigger than the entire market. 0.00
0
10
20
30
40
50
60
70
80
90
100

120
130
140
150
160
170
180
190
200
110
• Notice that if our monopolist operated at the -10.00
competitive equilibrium (Price=MC=$30, -20.00
Quantity=140), the firm would make a loss
-30.00
(ATC>Price).
-40.00
Quantity
Implications of the
Monopolist’s Profit
Maximum
• Price will exceed the competitive price.
• Quantity will be less than the competitive quantity.
• The monopolist sells the output at a price greater than marginal costs
but the monopoly price can be above or below average total costs.
Thus, the monopolist need not always make a profit. In the long run,
of course, unprofitable monopolists will either stop production or
raise the price further above marginal cost until it covers average total
costs.
• The monopolist will always try to operate on the elastic portion of the
demand curve because when the elasticity of demand is greater than -
1 (inelastic, between 0 and 1 in absolute value), marginal revenue is
negative and, necessarily, less than marginal cost.
• Since there is no entry to consider monopolists can have persistent
long run economic profit.
Simple Monopoly-
Performance
• Efficiency:
• Is the monopoly equilibrium Pareto Efficient? That is, at
XSM is net social surplus maximized? Does $MB=$MC at
XSM?
• Is the monopolist productively efficient? Does the
monopolist operate at minimum efficient scale?
• Equity:
• Is the outcome of monopoly fair? Equitable? Just?
Simple Monopoly-
Performance Answers
• The simple monopoly equilibrium is not Pareto
Efficient.
• The simple monopolist creates “dead-weight-loss.”
• At XSM, $MB>$MC . Recall: $MR=$MC at XSM while
$PSM>$MR at all X. So $PSM>$MC. Since $P=$MB, then
$MB>$MC.
• The simple monopolist may or may not be
productively efficient.
• Compared to the competitive equilibrium, there is
a transfer of surplus from consumers to
producers.
 Price Discriminating
Monopolists
• A monopolist might be able to charge different prices
for different units sold and enhance its profits.
• charge different people different prices
• charge the same person different prices for different units
• price discrimination
• charging different prices for different units with no cost basis
• charging the same price for different units when there are
cost differences
Requirements for Price
Discrimination
• Some amount of monopoly power.
• An ability to prevent resale.
• Detailed information about who is buying what unit
and what demanders are willing to pay.
 Believe It Or Not
• What would you do to prevent resale???
• when: 1940’s
• market: plastic molding powder
• industrial users: .85/pound
• denture manufacturers: $22/pound
• firm: Rohm and Haas
• problem: resale from industrial users to denture
manufacturers
• solution: rumor you are mixing arsenic in the
powder sold to industrial users!
Two classic forms of Price
Discrimination
• Perfect or First Degree Price Discrimination
• charge a different price for each unit sold
• the most extreme form of price discrimination
• Third Degree Price Discrimination
• segment market and then charge a different price in each
market
• exploit the observation that at the simple monopoly price the
own price elasticity of demand differs across the defined
segmented markets
• Price discrimination comes in many other “flavors”
Question
• The data on your handout show the demand curves
for movie tickets of adults and seniors. The market
described has only one movie theatre.
• Find the best single price.
• If the movie theater can charge separate prices for
adults and seniors, what are the best two prices?
 Two Prices are Better than
One for Movie Tickets
Price Discrimination in the Movie Theatre Market
Quantity Quantity Total Single Adult Senior Single
adult senior Demand Single Price Adult Price Price Price
Price per movie movie for Price Total Marginal Total Marginal Senior Total Marginal Marginal Economic
ticket tickets tickets Tickets Revenue Revenue Revenue Revenue Revenue Revenue Cost Profits
12.00 200 0 200 2,400 2,400 0 1.00 2,200
11.50 225 25 250 2,875 9.00 2,588 7.00 288 11.00 1.00 2,625
11.00 250 50 300 3,300 8.00 2,750 6.00 550 10.00 1.00 3,000
10.50 275 75 350 3,675 7.00 2,888 5.00 788 9.00 1.00 3,325
10.00 300 100 400 4,000 6.00 3,000 4.00 1,000 8.00 1.00 3,600
9.50 325 125 450 4,275 5.00 3,088 3.00 1,188 7.00 1.00 3,825
9.00 350 150 500 4,500 4.00 3,150 2.00 1,350 6.00 1.00 4,000
8.50 375 175 550 4,675 3.00 3,188 1.00 1,488 5.00 1.00 4,125
8.00 400 200 600 4,800 2.00 3,200 0.00 1,600 4.00 1.00 4,200
7.50 425 225 650 4,875 1.00 3,188 -1.00 1,688 3.00 1.00 4,225
7.00 450 250 700 4,900 0.00 3,150 -2.00 1,750 2.00 1.00 4,200
6.50 475 275 750 4,875 -1.00 3,088 -3.00 1,788 1.00 1.00 4,125
6.00 500 300 800 4,800 -2.00 3,000 -4.00 1,800 0.00 1.00 4,000
5.50 525 325 850 4,675 -3.00 2,888 -5.00 1,788 -1.00 1.00 3,825
5.00 550 350 900 4,500 -4.00 2,750 -6.00 1,750 -2.00 1.00 3,600
4.50 575 375 950 4,275 -5.00 2,588 -7.00 1,688 -3.00 1.00 3,325
4.00 600 400 1,000 4,000 -6.00 2,400 -8.00 1,600 -4.00 1.00 3,000
3.50 625 425 1,050 3,675 -7.00 2,188 -9.00 1,488 -5.00 1.00 2,625
3.00 650 450 1,100 3,300 -8.00 1,950 -10.00 1,350 -6.00 1.00 2,200
2.50 675 475 1,150 2,875 -9.00 1,688 -11.00 1,188 -7.00 1.00 1,725
2.00 700 500 1,200 2,400 1,400 1,000 1.00 1,200

• The best single price in this market is $7.50/ticket, which makes economic profits of $4,225 (blue
entries). Set marginal cost = marginal revenue with the single price.
• The price discriminating monopolist can make more economic profits by charging adults $8.50 (yellow
entries) and seniors $6.50 (green entries). Set marginal cost = marginal revenue separately for each
market.
Summary of Price
Discrimination Example
Profit Maximum with 2 Prices
Economic profits adult market 2,813
Economic profits senior market 1,513
Total with price discrimination 4,325
Total without price discrimination 4,225

• Calculating economic profits separately for the

two markets (adult and senior) shows that the
total is greater than with the best single price.
• Taking advantage of different elasticities of
demand.
First Degree Price
Discrimination
• The monopolist charges the demand price for each unit
sold.
• In this case the market demand curve becomes the
monopolist’s marginal revenue curve.
• The monopolist sets MR=MC to get XFDPD.
• The monopolist charges a different price for each unit
according to the demand curve.
• Performance: XFDPD is Pareto Efficient and all the net social
surplus goes to the monopolist as producer surplus.
Consumer surplus = $0!
Should the Government
Regulate Monopolies?
• Essentially all monopolies are regulated.
• Natural monopolies are regulated by price
commissions that determine the rates the
monopolies may charge.
• Patent, copyright and license protections are a
form of ex ante regulation: firms that follow the
rules for establishing the validity of their
innovations receive the protection of the patent,
copyright or license.
• Should the government do more? Good question.