Pure Monopoly Notes

Introduction to Pure Monopoly

Characteristics of Pure Monopoly (LO11.1)

Pure monopoly exists when a single firm is the sole producer of a product with no close substitutes. Key characteristics include:

• Single Seller: The firm is the industry.

• No Close Substitutes: Consumers have no similar alternatives.

• Pricemaker: The monopolist controls the quantity supplied and thus has significant control over the price. Unlike a pure competitor, which is a price taker, the monopolist can influence the price by changing the quantity produced.

• Blocked Entry: Barriers prevent potential competitors from entering the industry. These barriers can be economic, technological, or legal.

• Nonprice Competition: The product can be standardized (e.g., natural gas) or differentiated (e.g., Windows). Standardized products involve public relations advertising, while differentiated products may advertise specific attributes.

Examples of Monopoly

Pure monopolies are rare, but near-monopolies are more common. Examples include:

• Public Utilities: Government-owned or regulated entities like natural gas, electric, water, and cable TV companies.

• Near-Monopolies: Firms with the majority of sales in a market, such as Intel (microprocessors), Illumina (gene-sequencing machines), and Google (Android operating system).

• Professional Sports Teams: Sole suppliers of specific services in large geographic areas.

• Geographic Monopolies: Single providers in isolated areas, like a barber shop or grocery store in a small town.

Even with monopolies, some competition almost always exists. For example, Starlink is a substitute for terrestrial internet, and Linux is a substitute for Windows. However, these substitutes are often more costly or less appealing.

Barriers to Entry (LO11.2)

Barriers to entry prevent firms from entering an industry. Strong barriers lead to pure monopoly, weaker barriers to oligopoly or monopolistic competition, and no barriers to pure competition.

The five most prominent barriers to entry are:

Economies of Scale

Modern technology allows for extensive economies of scale, where average total cost (ATC) declines as firm size increases. In such cases, only a few large firms or a single firm can achieve low average total costs.

Figure 11.1 illustrates economies of scale. A monopolist can produce 200 units at a lower per-unit cost (10 each, total cost = $2000) than two firms producing 100 units each (15 each, total cost = $3000), or four firms producing 50 units each (20 each, total cost = $4000).

When long-run ATC is declining, a monopolist can produce output at the lowest total cost per unit.

Natural Monopoly

A firm is a natural monopoly if the market demand curve intersects the long-run ATC curve at a point where ATC is declining. A natural monopoly could set its price where market demand intersects long-run ATC, resulting in lower prices compared to a more competitive industry. However, a natural monopolist may set its price far above ATC to obtain substantial economic profit. Government regulation may specify the price charged by natural monopolies.

Network Effects

Network effects occur when the value of a product increases as more people use it. Social networking apps are standard examples: the more users, the more valuable the network. Industries subject to network effects tend toward monopoly because customers prefer networks with more users leaving smaller networks to fail. Startups struggle to compete with established firms like Instagram and TikTok due to these network effects.

Network effects also provide a first-mover advantage. Early entrants can gain substantial monopoly power as more users join their network.

Legal Barriers to Entry: Patents and Licenses

Government-created legal barriers include patents and licenses.

• Patents: Exclusive right to use an invention, protecting inventors from rivals and providing a monopoly position for 20 years from the time of application. Patents have been crucial for giants like Apple, Pfizer, and Intel.

• Licenses: Government limits entry into an industry or occupation through licensing, such as the Federal Communications Commission licensing radio and television stations. Sometimes, the government licenses itself to provide a product, creating a public monopoly (e.g., state-owned liquor outlets or lotteries).

Ownership or Control of Essential Resources

A firm that owns or controls a resource essential to the production process can prohibit the entry of rival firms. For example, the International Nickel Company of Canada once controlled 90% of the world's nickel reserves. Existing professional sports leagues have contracts with the best players and long-term leases on major stadiums.

Pricing and Other Strategic Barriers to Entry

Monopolists may deter entry by slashing prices, increasing advertising, or taking other strategic actions. For example, American Express was found guilty of preventing merchants from promoting rival credit cards. Endo Pharmaceuticals bribed Impax Laboratories to prevent the production of a generic rival to Opana ER.

Monopoly Demand (LO11.3)

To analyze monopoly price and output decisions, certain assumptions are made:

• Patents, economies of scale, network effects, or resource ownership secures the firm's monopoly.

• No government regulation of the firm.

• The firm is a single-price monopolist, charging the same price for all units of output.

The key difference between a pure monopolist and a purely competitive seller is on the demand side. A purely competitive seller faces a perfectly elastic demand curve, while the monopolist faces the market demand curve, which is downward sloping. Columns 1 and 2 in Table 11.1 illustrate this concept, showing that quantity demanded increases as price decreases.

Marginal Revenue Is Less Than Price

With a downward-sloping demand curve, the monopolist can increase sales only by charging a lower price. Marginal revenue (MR) is less than price (average revenue) for every unit of output except the first. The lower price of the extra unit applies to all prior units. Each additional unit sold increases total revenue by its price, less the price cuts on prior units.

Figure 11.2 illustrates this point. Selling one more unit at 132 instead of $142 yields $132 of extra revenue, but requires selling the first three units at 132 instead of $142, resulting in a $30 revenue loss. The net difference (MR) is $$102, less than the $132 price.

Column 4 in Table 11.1 shows that marginal revenue is always less than the corresponding product price, except for the first unit. Total revenue increases at a diminishing rate.

Figure 11.3 shows the relationship between the MR curve and the total revenue (TR) curve. Marginal revenue is positive while total revenue is increasing. When total revenue reaches its maximum, marginal revenue is zero. When total revenue is diminishing, marginal revenue is negative.

The Monopolist Is a Pricemaker

Imperfect competitors, including pure monopolists, oligopolists, and monopolistic competitors, face downward sloping demand curves and are thus pricemakers. By controlling output, they can influence the price.

The Monopolist Sets Prices in the Elastic Region of Demand

A monopolist will avoid the inelastic segment of the demand curve, as price reductions in this region reduce total revenue. The profit-maximizing monopolist operates in the elastic region, where lowering the price increases total revenue. Within this segment, the monopolist sets MR = MC to decide how much to produce.

• A pure monopolist is the sole supplier of a product with no close substitutes.

• Monopolies survive due to entry barriers such as economies of scale, network effects, patents, and strategic actions.

• The monopolist's demand curve is downward sloping, and its MR curve lies below its demand curve.

• The downward sloping demand curve means the monopolist is a pricemaker.

• To maximize profit, the monopolist operates in the elastic region of demand.

Output and Price Determination (LO11.4)

To determine the profit-maximizing price-quantity combination, production costs must be added to the analysis.

Cost Data

Assume the firm hires resources competitively and has the same cost structure as a purely competitive firm (as in Chapter 10).

MR = MC Rule

A monopolist maximizes profit by producing where marginal revenue equals marginal cost (MR = MC), provided producing is preferable to shutting down. Table 11.1 indicates that the profit-maximizing output is 5 units, where MR exceeds MC. The corresponding price on the demand schedule is $122.

Figure 11.4 graphs the demand, MR, ATC, and MC data. Profit-maximizing output is at Qm = 5 units where MR = MC. To find the price, extend a vertical line from Qm up to the demand curve D to the point Pm = $122.

At 5 units of output, the product price ($122) exceeds the average total cost ($94), yielding an economic profit of $28 per unit and a total economic profit of $140 (= 5 units × $28).

Another method to determine the profit-maximizing output is comparing total revenue and total cost at each level and choosing the output with the greatest positive difference.

Table 11.2 outlines the steps to graphically determine the profit-maximizing output, price, and economic profit in pure monopoly:

1. Determine the profit-maximizing output by finding where MR = MC.

2. Determine the profit-maximizing price by extending a vertical line upward from the output determined in step 1 to the pure monopolist's demand curve.

3. Determine the pure monopolist's economic profit using:

   • Method 1: Find profit per unit by subtracting the average total cost of the profit-maximizing output from the profit-maximizing price. Then multiply the difference by the profit-maximizing output to determine economic profit.

   • Method 2: Find total cost by multiplying the average total cost of the profit-maximizing output by that output. Find total revenue by multiplying the profit-maximizing output by the profit-maximizing price. Then subtract total cost from total revenue to determine economic profit.

No Monopoly Supply Curve

Unlike competitive firms, the pure monopolist has no supply curve. There is no unique relationship between price and quantity supplied. While the monopolist equates marginal revenue and marginal cost to determine output, marginal revenue is less than price. Different demand conditions can lead to different prices for the same output.

Misconceptions Concerning Monopoly Pricing

• Not Highest Price: Monopolists do not charge the highest possible price, but rather the price that maximizes total profit.

• Total, Not Unit, Profit: Monopolists seek maximum total profit, not maximum unit profit. Lower per-unit profit may be accepted if additional sales compensate for it.

Possibility of Losses by Monopolist

Monopolies are not immune to changes in tastes or rising costs. Losses can occur in the short run if demand is weak or costs are high. The firm will continue to operate as long as the price exceeds average variable cost. However, in the long run, the monopolist must obtain a minimum normal profit or it will go out of business.

Economic Effects of Monopoly (LO11.5)

Pure monopoly is evaluated from the standpoint of society as a whole, using long-run efficiency in a purely competitive market as a reference point (P = MC = minimum ATC).

Price, Output, and Efficiency

Figure 11.6 contrasts pure monopoly and a purely competitive industry. In a purely competitive industry (Figure 11.6a), the market supply curve S is the sum of the MC curves of all firms. Equilibrium occurs at price Pc and output Qc, resulting in productive and allocative efficiency. Productive efficiency is achieved because free entry and exit force firms to operate where ATC is minimized.

Allocative efficiency results when P = MC = minimum ATC.

When the industry becomes a pure monopoly (Figure 11.6b), the market supply curve S becomes the monopolist's MC curve. Marginal revenue is less than price, and the MR curve lies below the demand curve D. The monopolist selects output Qm and price Pm, selling a smaller output at a higher price than competitive producers.

Monopoly yields neither productive nor allocative efficiency. Output Qm is less than Qc, and price Pm is higher than Pc. The monopoly price exceeds minimum average total cost, meaning the monopoly is not productively efficient.

At output level Qm, the monopoly price Pm exceeds the marginal cost of production, resulting in allocative inefficiency. Consumers value additional units more than the alternative products that could be produced. The efficiency loss (deadweight loss) is the area of the gray triangle labeled abc in Figure 11.6b.

Income Transfer

Monopolies transfer income from consumers to the owners of the monopoly by charging higher prices. This