Monopoly

CHAPTER 10: Monopoly

Learning Objectives

• Understand how a monopolist sets price and output.

• Differentiate between monopoly and competitive outcomes.

• Evaluate pros and cons of monopoly.

Chapter Goals

• Determine what price a monopolist will charge.

• Ascertain how much output the monopolist will produce.

• Analyze whether consumers are better or worse off under monopoly control of a market.

Market Power

• Definition: Market power is the ability to alter the market price of a good or service.

• Firms with market power face downward-sloping demand curves for their own output.

Figure 10.1: Firm vs. Industry Demand

• Competitive firms can sell their entire output at the prevailing market price.

• A monopolist confronts the industry (market) demand curve.

Monopoly

• Definition: A monopoly is a firm that produces the entire market supply of a particular good or service.

• A monopolistic firm is the industry itself.

• The demand curve facing a monopolistic firm is identical to the market demand curve.

Price and Marginal Revenue

• The profit maximization rule: Produce at the output level where marginal revenue (MR) equals marginal cost (MC).

• Marginal Revenue (MR): The change in total revenue resulting from a one-unit increase in quantity sold.

• For competitive industries, marginal revenue equals price.

• Key Point: For a monopolist, marginal revenue is not equal to price.

Implications of Downward-Sloping Demand Curve

• A monopolist must lower its price to sell additional output.

• As a result, marginal revenue is always less than price.

• The marginal revenue curve lies below the demand (price) curve at every point except the first.

Figure 10.2: Price Exceeds Marginal Revenue in Monopoly

Profit Maximization (MR = MC)

• In monopolistic markets, we look for the intersection of the marginal cost and marginal revenue (not price).

• Only one price aligns with the profit-maximizing rate of output.

Figure 10.3: Profit Maximization (MR = MC)

• Example Calculation: The intersection of MR and MC establishes 4 bushels as the profit-maximizing rate of output.

  • Consumers will pay $10 per bushel for this output.

  • Total profits can be calculated as:
    ext{Total profits} = ( ext{Price} - ext{Average Total Cost}) imes ext{Quantity Sold}

  • In this case:

    • Price = $10

    • Average Total Cost = $8

    • Quantity Sold = 4

  • Total profits = ($10 - $8) * 4 = $8.

The Production Decision

• Monopolists predict the impact of increased production on market price and can prevent such increases through separate plants.

• Only firms facing a horizontal demand curve (perfect competitors) set marginal cost equal to price.

Figure 10.4: Initial Conditions in the Monopolized Computer Market

• A monopolist produces less output than a competitive industry and charges a higher price.

Monopoly Profits

• Profit Calculation Formula:
  ext{Total profit} = ext{Profit per unit} imes ext{Quantity sold}

• The profit-maximizing rate of output is determined where the marginal cost and marginal revenue curves intersect.

• A monopoly garners larger profits than a competitive industry by reducing quantity supplied and increasing prices.

Figure 10.5: Monopoly Profits

• Example: The total profit is shaded, where price (W) minus average total cost (K) is multiplied by the quantity sold (475).

Figure 10.6: Monopoly Profit

• Visual representation of total profits of the monopolist, including all plants, determined by the intersection of industry MR and MC curves.

  • Price of output is decided by the market demand curve (point A).

A Comparative Perspective of Market Power

Competitive Industry:

• High prices and profits indicate consumers’ demand for more output.

• High profits draw new suppliers into the market.

• Production and supplies expand due to entry.

• Prices decrease as output increases.

• Results in new equilibrium with increased output and lower prices.

• Average costs of production approach their minimum.

• Economic profits tend towards zero.

• Price equals marginal cost throughout the process.

• Firms face pressure to reduce costs or enhance quality to remain competitive.

Monopoly Industry:

• High prices and profits indicate consumers’ demand for output.

• Barriers to entry prevent any potential competition.

• Constrained production and supplies without market entry.

• Prices do not decrease as they do in competitive settings.

• Lack of new equilibrium established.

• Average production costs may not be near their minimum.

• Economic profits are maximized.

• Price consistently exceeds marginal cost.

• Little to no pressure to reduce costs or improve quality due to absence of competition.

The Limits of Power

• Every monopolist must navigate the market demand curve.

• The extent of constraints imposed by the demand curve is significantly influenced by the price elasticity of demand.

Price Discrimination

• Definition: Price discrimination refers to selling an individual good at different prices to different consumers.

• A monopolist can enhance total profits by selling each unit at a price each consumer is willing to pay.

• With perfect price discrimination, the monopolist charges the maximum price an individual consumer is willing to pay based on their position on the demand curve.

• This approach completely eliminates consumer surplus, allowing the monopolist to capture maximum extra revenue.

Entry Barriers

• Maintaining monopoly power relies on preventing potential competitors from entering the market.

• Specific entry barriers include:

  • Patents

  • Monopoly franchises

  • Control over key inputs

  • Legal barriers/lawsuits

  • Acquisitions

  • Economies of scale

Pros and Cons of Market Power

Research and Development:

• Monopolies can theoretically conduct valuable research and development since they are insulated from competition and possess required resources.

• However, they lack the incentive to pursue R&D as sustained market power allows for continuation of profits without innovation.

Entrepreneurial Incentives:

• The greater potential profits of a monopoly may encourage entrepreneurial activities.

• However, the potential for substantial profits is not exclusive to monopolies; innovators in competitive markets can also achieve similar results.

• Barriers to entry may constrain not only competitors but also innovative ideas.

Economies of Scale:

• Large firms can produce goods at lower average costs compared to smaller firms due to economies of scale.

• Definition of Economies of Scale: Reductions in minimum average costs due to increases in scale of production facilities.

• While monopolies can exploit size to achieve efficiency, efficiency does not inherently correlate with size, as some industries may lack scale advantages.

Natural Monopoly:

• A natural monopoly occurs in industries where one firm can achieve economies of scale over the entire market supply range.

• This acts as a natural barrier to entry.

• Consumers may not experience benefits if monopolists do not reduce prices, expand output, or enhance service.

Contestable Market:

• A contestable market is an imperfectly competitive industry subject to potential entry if prices or profits rise.

• Monopolistic behavior in contestable markets may be restrained due to the threat of potential competition.

• The level of contestability in a market is contingent upon entry barriers.

Potential Competition:

• Potential competition can compel monopolies to operate similarly to competitive firms, mitigating costs to consumers and society.

• Without actual competitors, monopolies risk stagnation concerning product innovation and productivity improvements.

• Monopolies modify behavior only when potential competition transitions to actual competition.

Policy Decisions: Microsoft and Google - Bullies or Geniuses?

• Antitrust allegations against Microsoft include erecting entry barriers to deter potential competitors.

• Dominance led to reduced consumer incentives to purchase competing products.

• Courts identified Microsoft as more of a bully than a genius, arguing its dominance stifled product improvement and price reductions.

Google’s Market Dominance

• Google's dominance in the search engine market has turned its services into monopolized offerings.

• Google employs barriers such as unique search keywords, advertising contracts, and suppression of competitor search results.

• European courts viewed Google's bundling tactics as bullying.

• As of October 2020, the U.S. Justice Department also launched a lawsuit against Google regarding abuses of its monopoly.

Table 10.1: Key Antitrust Laws

• Antitrust Definition: Refers to government intervention aimed at altering market structure or preventing abuse of market power.

• Landmark antitrust laws include:

  • The Sherman Act (1890)

  • The Clayton Act (1914)

  • The Federal Trade Commission Act (1914)