Chapter 15: Monopoly WHY MONOPOLIES ARISE HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS

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Lillian Conley
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1 Chapter 15: While a competitive firm is a taker, a monopoly firm is a maker. A firm is considered a monopoly if... it is the sole seller of its product. its product does not have close substitutes. The fundamental cause of monopoly is barriers to entry, essentially other firms cannot enter the market. WHY MONOPOLIES ARISE Barriers to entry have three sources: A single firms owns a key resource (ie- DeBeers Diamond ). The government gives a single firm the exclusive right to produce some good (ie- Network Solutions). Costs of production make a single producer more efficient than a large number of producers, basically a natural monopoly (ie- Cable TV). A natural monopoly arises when there are economies of scale over the relevant range of output. Figure 1 Economies of Scale as a Cause of Cost Average total of Output HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS versus Competition Is the sole producer Faces a downward-sloping demand curve (selling of additional units, s must be reduced) Is a maker Reduces to increase sales Competitive Firm Is one of many producers Faces a horizontal demand curve (can t change s) Is a taker Sells as much or as little at same 1

WHY MONOPOLIES ARISE Barriers to entry have three sources: A single firms owns a key resource (ie- DeBeers Diamond ).

2 Figure 2 Curves for Competitive and Firms Table 1 A s Total, Average, and Revenue (a) A Competitive Firm s Curve (b) A Monopolist s Curve of Output of Output Since a monopoly is the sole producer in its market, it faces the market demand curve. A s Revenue Figure 3 and -Revenue Curves for a A s Revenue A monopolist s marginal is always less than the of its good. The demand curve is downward sloping. When a monopoly drops the to sell one more unit, the received from previously sold units also decreases. When a monopoly increases the amount it sells, it has two effects on total (P Q). The output effect more output is sold, so Q is higher. The effect falls, so P is lower. $ If a monopoly wants to sell more, it must lower. falls for ALL units sold. This is why MR is < P (average ) of Water 2

The demand curve is downward sloping. When a monopoly drops the to sell one more unit, the received from previously sold units also decreases.

3 Profit Maximization Figure 4 Profit Maximization for a A monopoly maximizes profit by producing the at which marginal equals marginal. It then uses the demand curve to find the that will induce consumers to buy that. Costs and Revenue and then the demand curve shows the consistent with this. B A 1. The intersection of the marginal- curve and the marginal- curve determines the profit-maximizing... Average total Q Q MAX Q Profit Maximization Comparing and Competition For a competitive firm, equals marginal. P = MR = MC For a monopoly firm, exceeds marginal. P > MR = MC Remember, all profit-maximizing firms set MR = MC. A s Profit Profit equals total minus total s. Profit = TR TC Profit = (TR/Q TC/Q) Q Profit = (P ATC) Q 3

The intersection of the marginal- curve and the marginal- curve determines the profit-maximizing.

4 Figure 5 The Monopolist s Profit: Must Be Greater Than Average Total Cost. Costs and Revenue Average total E D profit Profit = (P ATC) Q B C Average total Shifting from to Competitive Market for Drugs Initially, a firm receives a patent law, which gives a firm a monopoly on the sale of that drug. Eventually, the firm s patent runs out, and any company can make and sell that drug. As a result, the market switches from being monopolist to being competitive. Q MAX Figure 6 The Market for Drugs Costs and Revenue during patent life after patent expires THE WELFARE COST OF MONOPOLY Is monopoly a good way to organize a market? In contrast to a competitive firm, the monopoly charges a above the marginal. From the standpoint of consumers, this high makes monopoly undesirable. However, from the standpoint of the owners of the firm, the high makes monopoly very desirable. Competitive 4

the sale of that drug. Eventually, the firm s patent runs out, and any company can make and sell that drug. As a result, the market switches from being monopolist to being competitive.

5 The Deadweight Loss Figure 8 The Inefficiency of : MC = MR Because a monopoly sets its above marginal, it places a wedge between the consumer s willingness to pay and the producer s. This wedge causes the sold to fall short of the social optimum. The Inefficiency of The monopolist produces less than the socially efficient of output. Deadweight loss Efficient The s Profit: A Social Cost? 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 from a tax, whereas a private firm gets the monopoly profit. PUBLIC POLICY TOWARD MONOPOLIES Government responds to the problem of monopoly in one of four ways. Making monopolized industries more competitive (Antitrust Laws). Regulating the behavior of monopolies (Government regulates s, ie water). Turning some private monopolies into public enterprises (Postal Services). Doing nothing at all (Imperfections of political failures much greater than economic failures). 5

Deadweight loss Efficient The s Profit: A Social Cost? The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax.

6 Increasing Competition with Antitrust Laws Antitrust laws are a collection of statutes aimed at curbing monopoly power. Antitrust laws give government various ways to promote competition. They allow government to prevent mergers. They allow government to break up companies. They prevent companies from performing activities that make markets less competitive. Regulation In practice, regulators will allow monopolists to keep some of the benefits from lower s in the form of higher profit, a practice that requires some departure from marginal- pricing. PRICE DISCRIMINATION discrimination is the business practice of selling the same good at different s to different customers, even though the s for producing for the two customers are the same. discrimination not possible when a good is sold in a competitive market. Why? In order to discriminate, the firm must have some market power. The Analytics of Discrimination Perfect Discrimination Perfect discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different. Two important effects of discrimination: It can increase the monopolist s profits. It can reduce deadweight loss. 6

Regulation In practice, regulators will allow monopolists to keep some of the benefits from lower s in the form of higher profit, a practice that requires some departure from marginal- pricing.

7 Figure 1 Welfare with and without Discrimination (a) Monopolist with Single Figure 1 Welfare with and without Discrimination (b) Monopolist with Perfect Discrimination Profit Consumer surplus Deadweight loss Consumer surplus and deadweight loss have both been converted into profit. Profit Every consumer gets charged a different -- the highest they are willing to pay -- so in this special case, the demand curve is also MR! sold sold Examples of Discrimination Movie tickets Airline s Discount coupons Financial aid discounts Table 2 Competition versus : A Summary Comparison 7

Profit Every consumer gets charged a different -- the highest they are willing to pay -- so in this special case, the demand curve is also MR!

Monopoly WHY MONOPOLIES ARISE

Monopoly WHY MONOPOLIES ARISE In this chapter, look for the answers to these questions: Why do monopolies arise? Why is MR < P for a monopolist? How do monopolies choose their P and Q? How do monopolies affect society s well-being?