Lecture 10: Monopoly

What is a monopoly?

A monopoly is a firm that is the only seller of a product without close substitutes

What is the difference between monopoly and perfect competition?

Monopoly and perfect competition are different, since a monopoly has market power and can influence the market price

Market Power

The ability to influence the market price of the product it sells

• Monopolies have this ability and not competitive firms 

What is the main cause of monopolies?

The main cause of monopolies is barriers to entry, which prevents other firms from entering the market.

What are three sources of barriers to entry?

1. A single firm owns a key resource.

2. The government gives a single firm the exclusive right to produce the good.

3. Natural monopoly (one firm can make the entire market Q at a lower ATC than could several firms)

How does ATC look like for a natural monopoly?

ATC slopes downwards due to a huge fixed cost and a small MC

• Fixed cost is large, change in total cost, as quantity increases by 1 is small

• So ATC is lower if only one firm supplies

How does the market demand curve look like in a competitive market?

In a competitive market, the demand curve slopes downward

How does the demand curve for a competitive firm look like?

The demand curve for any individual firm’s product is horizontal at the market price

• Firm can increase Q without effect on P

• MR= P 

What demand curve does a monopolist face?

A monopolist is the only seller, so it faces the market demand curve

• To sell more Quantity (Q), the firm, must reduce Price (P)

• So MR doesn’t equal P

What is the relationship between the demand curve (price) and MR (marginal revenue) for a monopoly?

The MR curve is always below the Demand curve (price)

• To sell more, the monopolist must lower the price on all units, so the extra revenue from the last unit is less than its price.

How does increasing Q (quantity) affect revenue?

Increasing Q has two effects on revenue

• Output effect (Higher output raises revenue)

• Price effect (Lower price reduces revenue)

Output effect

Effect when Q increases and the higher output increases revenue

Price Effect

Effect when Q increases and the lower price reduces revenue

What must a monopolist do to sell a larger Q?

To see a larger Q, a monopolist must decrease the price on all of the units it sells

• MR<P

• MR could even be negative if the price effect is greater than the output effect

How does a monopolist maximize profit? 

A monopolist maximizes profit by producing at the quantity where MR= MC

• Monopolist sets the highest price consumers are willing to pay from the D curve

How to find the profit maximizing quantity?

• The profit maximizing quantity is there MR= MC

• Find P from the demand curve at this Q

What is a monopolist’s profit equal to?

• Similar to a competitive firm

The monopolist’s profit is equal to

• (P- ATC) x Q

What does a competitive firm have in terms of supply?

A competitive firm:

• Takes Price (P) as given

• Has a supply curve is the portion of its MC curve above the AVC curve, showing how Q increases as P rises as long as P ≥ AVC.

Why does a monopoly not have a supply curve?

A monopoly doesn’t have a supply curve

• It’s a price maker

• Q doesn’t depend on P, but Q and P are determined by MC, MR, and the demand curve (It’s quantity depends on both price and demand, not just price)

What happens in a perfect competitive equilibrium?

In a perfect competitive equilibrium, P= MC and total surplus is maximized

What happens in the monopoly equilibrium?

In the monopoly equilibrium,

P > MR = MC

• Value to the buyers of an additional unit (P) exceeds the cost of the resources needed to produce that unit (MC)

• Monopolist produces less than the socially efficient quantity, because it restricts output to raise price.

• Monopoly Q is too low, could increase total surplus with a larger Q

• Monopoly results in deadweight loss

In a competitive equilibrium, what is P equal to?

P= MC and total surplus is maximized

In a monopoly equilibrium, what is P equal to?

P > MC, causing deadweight loss

• The firm faces a downward-sloping demand curve, so selling more requires lowering price on all units, making marginal revenue less than price while profit is maximized where MR = MC.

Price Discrimination

Selling the same good at different prices to different buyers

What is the characteristic used in price discrimination?

WTP is used in price discrimination

• A firm can increase profit by charging a higher price to buyers with higher WTP

Single Price Monopoly

Where the monopolist charges the same price (PM) to all buyers

• Causes a deadweight loss

Perfect Price Discrimination

Monopolist produces the competitive quantity, but charges each buyer his or her WTP

• Monopolist captures all CS as PS, no deadweight loss, or consumer surplus

Why is perfect price discrimination not possible in the real world?

In the real world, perfect price discrimination isn’t possible, since:

• No firm knows every buyer’s WTP

• Buyers don’t announce their WTP to sellers

What do firms do to price discriminate to their best ability?

Firms divide customers into groups based on some observable trait, like age, that is likely related to WTP

• Do this to try to price discriminate

Example of price discrimination (movie tickets)

For movie tickets, there are student discounts, since students are more likely to have a lower WTP than people who pay full price

Example of price discrimination (need based financial aid)

Low income families have a lower WTP for their children’s college education

• Schools price discriminate by offering need- based aid to low income families

In the real world, why do many firms have market power, even though a pure monopoly is rare?

Many firms have market power since they sell a unique variety of a product, have a large market share and few competitors

Why isn’t a monopoly’s profits unlimited?

A monopoly’s profits aren’t unlimited, since a high price decreases the quantity

• Even though a monopoly can control the price of the good it sells, a high price decreases quantity

What is the benefit of allowing monopoly producers to charge higher prices and earn higher profits?

The benefit of allowing for monopolies, is an increase in desirable behaviors, like the creation of new drugs during research

Natural Monopoly (Full definition)

A type of monopoly, where 1 firm can supply a good or a service to an entire market at a lower cost than two or more firms

• A single firm can produce any amount of output at the lowest cost

What happens to a firm’s ATC if it’s a natural monopoly?

For a natural monopoly, the firm’s ATC curve continually declines

• When production is divided between more firms, each firm produces less and ATC increases

When does a natural monopoly become a competitive market?

A natural monopoly becomes a competitive market when a market increases

What can a monopoly do that a competitive firm can’t?

A competitive firm is small and has no power to influence the price of its output, while a monopoly can change the price of its good by adjusting the quantity to the market

How does the demand curve look like for competitive firms?

The demand curve= horizontal line at the market price, meaning it is perfectly elastic. This is because the firm is a price taker; it can sell any quantity it produces at the market price

How does the demand curve look like for a monopoly?

The demand curve for a monopoly is the market demand curve

• Downward sloping’

• As price increases, consumers buy less

• As a result, the monopoly has to accept a lower price if it wants to sell more output

How does a monopoly’s revenue look like?

As quantity increases, the price decreases for a monopoly, since it’s demand curve is the market’s demand curve

• A monopolist’s marginal revenue is less than the price of its good

• Due to downward sloping demand curve

• To increase the amount sold, a monopoly has to lower the price it charges to all customers

What is the demand curve also for a monopoly?

The demand curve for a monopoly is also the price curve, and also the average revenue curve

What happens when a monopoly produces a low level of output (Q)?

When a monopoly produces a low level of output