CHAPTER 14

Monopoly
What you will learn in this
chapter:
The significance of monopoly, where a
single monopolist is the only producer of a
good
How a monopolist determines its profit-
maximizing output and price
The difference between monopoly and
perfect competition, and the effects of that
difference on society’s welfare
How policy makers address the problems
posed by monopoly
What price discrimination is, and why it is
so prevalent when producers have market
power 2
Types of Market Structure
In order to develop principles and make
predictions about markets and how producers
will behave in them, economists have
developed four principal models of market
structure:
perfect competition
monopoly
oligopoly
monopolistic competition
3
 Types of
Market
Structure

This system of market structures is based on two

dimensions:
The number of producers in the market (one, few, or
many)
Whether the goods offered are identical or differentiated
.
4
The Meaning of Monopoly
Our First Departure from Perfect Competition…
A monopolist is a firm that is the only
producer of a good that has no close
substitutes. An industry controlled by a
monopolist is known as a monopoly. e.g. De
Beers
The ability of a monopolist to raise its price
above the competitive level by reducing
output is known as market power.
What do monopolists do with this market
power? Let’s take a look at the following 5
 What a
Monopolist
Does

Under perfect competition, the price and quantity are

determined by supply and demand. Here, the equilibrium
is at C, where the price is PC and the quantity is QC. A
monopolist reduces the quantity supplied to QM, and
moves up the demand curve from C to M, raising the 6
 Why Do Monopolies Exist?
A monopolist has market power and as a
result will charge higher prices and produce less
output than a competitive industry. This
generates profit for the monopolist in the short
run and long run.
Profits will not persist in the long run unless
there is a barrier to entry. This can take the
form of
control of natural resources or inputs,
economies of scale,
technological superiority, or
legal restrictions imposed by governments, 7
Economies of Scale and Natural
Monopoly
A monopoly created and sustained by
economies of scale is called a natural
monopoly.
It arises when economies of scale provide a
large cost advantage to having all of an
industry’s output produced by a single firm.
Under such circumstances, average total cost
is declining over the output range relevant for
the industry.
This creates a barrier to entry because an
established monopolist has lower average total
cost than any smaller firm. 8
 Economies
of Scale
Create
Natural
Monopoly

A natural monopoly can arise when fixed costs required to

operate are very high  the firm’s ATC curve declines
over the range of output at which price is greater than or
equal to average total cost. This gives the firm economies
of scale over the entire range of output at which the firm
would at least break even in the long run. As a result, a
given quantity of output is produced more cheaply by one 9
How a Monopolist Maximizes Profit
The price-taking firm’s optimal output rule is
to produce the output level at which the
marginal cost of the last unit produced is
equal to the market price.
A monopolist, in contrast, is the sole supplier
of its good. So its demand curve is simply the
market demand curve, which is downward
sloping.
This downward slope creates a “wedge”
between the price of the good and the
marginal revenue of the good—the change in
revenue generated by producing one more 10
 Comparing the Demand Curves of a
Perfectly Competitive Firm and a
Monopolist
An individual perfectly competitive firm cannot affect the
market price of the good  it faces a horizontal demand
curve DC , as shown in panel (a). A monopolist, on the
other hand, can affect the price (sole supplier in the
industry)  its demand curve is the market demand
curve, DM, as shown in panel (b). To sell more output it
must lower the price; by reducing output it raises the 11
How a Monopolist Maximizes Profit
An increase in production by a monopolist has
two opposing effects on revenue:
A quantity effect. One more unit is sold,
increasing total revenue by the price at which
the unit is sold.
A price effect. In order to sell the last unit,
the monopolist must cut the market price on
all units sold. This decreases total revenue.
The quantity effect and the price effect are
illustrated by the two shaded areas in panel
(a) of the following figure based on the
numbers on the table accompanying it. 12
A Monopolist’s Demand, Total Revenue, and Marginal
Revenue Curves

13
The Monopolist’s Demand Curve and
Marginal Revenue
Due to the price effect of an increase in
output, the marginal revenue curve of a firm
with market power always lies below its
demand curve. So a profit-maximizing
monopolist chooses the output level at which
marginal cost is equal to marginal revenue—
not to price.
As a result, the monopolist produces less and
sells its output at a higher price than a
perfectly competitive industry would. It earns
a profit in the short run and the long run.
14
The Monopolist’s Demand Curve and
Marginal Revenue
To emphasize how the quantity and price
effects offset each other for a firm with market
power, notice the hill-shaped total revenue
curve:
This reflects the fact that at low levels of
output, the quantity effect is stronger than the
price effect: as the monopolist sells more, it has
to lower the price on only very few units, so the
price effect is small.
As output rises beyond 10 diamonds, total
revenue actually falls. This reflects the fact that
at high levels of output, the price effect is
stronger than the quantity effect: as the
15
monopolist sells more, it now has to lower the
The Monopolist’s Profit-
Maximizing Output and Price
To maximize profit, the monopolist compares
marginal cost with marginal revenue.
If marginal revenue exceeds marginal cost,
De Beers increases profit by producing more;
if marginal revenue is less than marginal
cost, De Beers increases profit by producing
less. So the monopolist maximizes its profit
by using the optimal output rule:
At the monopolist’s profit-maximizing
quantity of output,
MR = MC
16
 The
Monopolist’s
Profit-
Maximizing
Output and
Price

The optimal output rule: the profit maximizing level of

output for the monopolist is at MR = MC, shown by point
A, where the marginal cost and marginal revenue curves
cross at an output of 8 diamonds. The price De Beers can
charge per diamond is found by going to the point on the
demand curve directly above point A, (point B here) —a
price of $600 per diamond. It makes a profit of $400 ×178
Monopoly versus Perfect
Competition
P = MC at the perfectly competitive firm’s
profit-maximizing quantity of output
P > MR = MC at the monopolist’s profit-
maximizing quantity of output
Compared with a competitive industry, a
monopolist does the following:
 Produces a smaller quantity: QM < QC
 Charges a higher price: PM > PC
 Earns a profit
18
 The
Monopolist’s
Profit
Profit = TR − TC

= (PM × QM) −
(ATCM × QM)

= (PM − ATCM) × QM

In this case, the marginal cost curve is upward sloping and the
average total cost curve is U-shaped. The monopolist maximizes
profit by producing the level of output at which MR = MC, given by
point A, generating quantity QM. It finds its monopoly price, PM , from
the point on the demand curve directly above point A, point B here.
The average total cost of QM is shown by point C. Profit is given by the
19
area of the shaded rectangle.
Monopoly and Public Policy

By reducing output and raising price above

marginal cost, a monopolist captures some
of the consumer surplus as profit and causes
deadweight loss. To avoid deadweight loss,
government policy attempts to prevent
monopoly behavior.
When monopolies are “created” rather than
natural, governments should act to prevent
them from forming and break up existing
ones.
The government policies used to prevent or 20
 Monopoly Causes
Inefficiency
Panel (a) depicts a perfectly competitive industry: output is Q C and market
price, PC , is equal is to MC. Since price is exactly equal to each producer’s
cost of production per unit, there is no producer surplus. Total surplus is
therefore equal to consumer surplus, the entire shaded area.

Panel (b) depicts the industry under monopoly: the monopolist decreases
output to QM and charges PM. Consumer surplus (blue area) has shrunk
because a portion of it is has been captured as profit (green area). Total
surplus falls: the deadweight loss (orange area) represents the value of
mutually beneficial transactions that do not occur because of monopoly
behavior. 21
Preventing Monopoly
Dealing with Natural Monopoly
Breaking up a monopoly that isn’t natural is
clearly a good idea, but it’s not so clear
whether a natural monopoly, one in which
large producers have lower average total
costs than small producers, should be broken
up, because this would raise average total
cost.
Yet even in the case of a natural monopoly, a
profit-maximizing monopolist acts in a way
that causes inefficiency—it charges
consumers a price that is higher than
marginal cost, and therefore prevents some
potentially beneficial transactions. 22
Dealing with Natural Monopoly

What can public policy do about this? There

are two common answers…
One answer is public ownership, but publicly
owned companies are often poorly run.
A common response in the United States is
price regulation. A price ceiling imposed on a
monopolist does not create shortages as
long as it is not set too low.
There always remains the option of doing
nothing; monopoly is a bad thing, but the
cure may be worse than the disease.
23
Regulated and Unregulated Natural
Monopoly
In panel (a), if the monopolist is allowed to charge P , it makes a profit,
M
shown by the green area; consumer surplus is shown by the blue area. If
it is regulated and must charge the lower price PR, output increases from
QM to QR, and consumer surplus increases.

Panel (b) shows what happens when the monopolist must charge a price
equal to average total cost, the price PR*. Output expands to QR*, and
consumer surplus is now the entire blue area. The monopolist makes
zero profit. This is the greatest consumer surplus possible when the
monopolist is allowed to at least break even, making PR* the best
regulated price. 24
Price Discrimination

Up to this point we have considered only the

case of a single-price monopolist, one
who charges all consumers the same price.
As the term suggests, not all monopolists do
this.
In fact, many if not most monopolists find
that they can increase their profits by
charging different customers different prices
for the same good: they engage in price
discrimination.
25
Price Discrimination (continued)

Example: Airline tickets

If you are willing to buy a nonrefundable
ticket a month in advance and stay over a
Saturday night, the round trip may cost only
$150,but if you have to go on a business trip
tomorrow, and come back the next day, the
round trip might cost $550.

26
The Logic of Price Discrimination

Price discrimination is profitable when

consumers differ in their sensitivity to the
price. A monopolist would like to charge high
prices to consumers willing to pay them
without driving away others who are willing
to pay less.

It is profit-maximizing to charge higher

prices to low-elasticity consumers and lower
prices to high elasticity ones.

27
 Two Types
of Airline
Customers

Air Sunshine has two types of customers, business travelers

willing to pay $550 per ticket and students willing to pay $150
per ticket. There are 2,000 of each kind of customer. Air
Sunshine has constant marginal cost of $125 per seat. If Air
Sunshine could charge these two types of customers different
prices, it would maximize its profit by charging business travelers
$550 and students $150 per ticket. It would capture all of the 28
consumer surplus as profit.
Price Discrimination and Elasticity

A monopolist able to charge each consumer

his or her willingness to pay for the good
achieves perfect price discrimination and
does not cause inefficiency because all
mutually beneficial transactions are
exploited.
In this case, the consumers do not get any
consumer surplus! The entire surplus is
captured by the monopolist in the form of
profit.
The following graphs depict different types of
price discrimination…
29
Price Discrimination
By increasing the number of different prices charged,
the monopolist captures more of the consumer
surplus and makes a large profit.
30
 Perfect Price
Discriminatio
n

In the case of perfect price discrimination, a

monopolist charges each consumer his or her
willingness to pay; the monopolist’s profit is given by
the shaded triangle.

31
Perfect Price Discrimination
Perfect price discrimination is probably never
possible in practice. The inability to achieve
perfect price discrimination is a problem of
prices as economic signals because
consumer’s true willingness to pay can easily
be disguised.
However, monopolists do try to move in the
direction of perfect price discrimination
through a variety of pricing strategies.
Common techniques for price discrimination
are:
Advance purchase restrictions
Volume discounts 32
The End of Chapter 14

coming attraction:
Chapter 15:
Oligopoly

33