Chapter 15 MonopolyMonopoly © 2002 by Nelson, a division of Thomson Canada Limited

Chapter 15Chapter 15Chapter 15Chapter 15

MonopolyMonopolyMonopolyMonopoly

©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 15: Page 2

• Learn why some markets have only one seller.

• Analyze how monopoly determines the quantity to produce and the price to charge.

• See how monopoly’s decisions affect economic well-being.

• Consider the various public policies aimed at solving the monopoly problem.

• See why monopolies try to charge different prices to different customers.

• Learn why some markets have only one seller.

• Analyze how monopoly determines the quantity to produce and the price to charge.

• See how monopoly’s decisions affect economic well-being.

• Consider the various public policies aimed at solving the monopoly problem.

• See why monopolies try to charge different prices to different customers.

In this chapter you will…In this chapter you will…


• While a competitive firm is a price taker, a monopoly firm is a price maker.

• A firm is considered a monopoly monopoly if . . .– it is the sole seller of its product.– its product does not have close

substitutes.

• While a competitive firm is a price taker, a monopoly firm is a price maker.

• A firm is considered a monopoly monopoly if . . .– it is the sole seller of its product.– its product does not have close

substitutes.

MONOPOLYMONOPOLY


• The fundamental cause of monopoly is barriers to entry.

• Barriers to entry have three sources:– Ownership of a key resource.– The government gives a single firm the

exclusive right to produce some good.– Costs of production make a single

producer more efficient than a large number of producers.

• The fundamental cause of monopoly is barriers to entry.

• Barriers to entry have three sources:– Ownership of a key resource.– The government gives a single firm the

exclusive right to produce some good.– Costs of production make a single

producer more efficient than a large number of producers.

Why Monopolies AriseWhy Monopolies Arise


• Monopoly resources– Although exclusive ownership of a key

resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.

• Government created monopolies– Governments may restrict entry by giving a

single firm the exclusive right to sell a particular good in certain markets.

– Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.

• Monopoly resources– Although exclusive ownership of a key

resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.

• Government created monopolies– Governments may restrict entry by giving a

single firm the exclusive right to sell a particular good in certain markets.

– Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.



• Natural Monopolies– An industry is a natural monopoly when

a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.

– A natural monopoly arises when there are economies of scale over the relevant range of output.

• Natural Monopolies– An industry is a natural monopoly when

a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.

– A natural monopoly arises when there are economies of scale over the relevant range of output.



Cost

Quantity of Output0

Averagetotalcost

Figure 15-1: Economies of Scale as a Cause Figure 15-1: Economies of Scale as a Cause of Monopolyof Monopoly


• Monopoly versus Competition– Monopoly

• Is the sole producer• Faces a downward-sloping demand curve• Is a price maker• Reduces price to increase sales

– Competitive Firm• Is one of many producers• Faces a horizontal demand curve• Is a price taker• Sells as much or as little at same price

• Monopoly versus Competition– Monopoly

• Is the sole producer• Faces a downward-sloping demand curve• Is a price maker• Reduces price to increase sales

– Competitive Firm• Is one of many producers• Faces a horizontal demand curve• Is a price taker• Sells as much or as little at same price

Pricing and Production DecisionsPricing and Production Decisions


(a) Competitive Firm (b) Monopoly

Price

0 0

Price

Demand

Demand

Quantity of OutputQuantity of Output

Figure 15-2: Demand Curves for Competitive Figure 15-2: Demand Curves for Competitive and Monopoly Firmsand Monopoly Firms


• Total Revenue

P Q = TR

• Average Revenue

TR/Q = AR = P

• Marginal Revenue

TR/Q = MR

• Total Revenue

P Q = TR

• Average Revenue

TR/Q = AR = P

• Marginal Revenue

TR/Q = MR

A Monopoly’s RevenueA Monopoly’s Revenue


Table 15-1: A Monopoly’s Total, Average, Table 15-1: A Monopoly’s Total, Average, and Marginal Revenue.and Marginal Revenue.

- 4 32438

- 242847

053056

263065

472874

682483

891892

$ 10 $ 1010101

------$ 0$ 110

(MR = ∆TR/∆Q)(AR = P x Q)(TR = P x Q)(P)(Q)

Marginal Revenue

Average Revenue

Total RevenuePrice

Quantity of Water


• A Monopoly’s Marginal Revenue– A monopolist’s marginal revenue

is always less than the price of its good.• The demand curve is downward

sloping.• When a monopoly drops the price to

sell one more unit, the revenue received from previously sold units also decreases.

• A Monopoly’s Marginal Revenue– A monopolist’s marginal revenue

is always less than the price of its good.• The demand curve is downward

sloping.• When a monopoly drops the price to

sell one more unit, the revenue received from previously sold units also decreases.



• A Monopoly’s Marginal Revenue

– When a monopoly increases the amount it sells, it has two effects on total revenue (P Q).• The output effect—more output is

sold, so Q is higher.• The price effect—price falls, so P is

lower.

• A Monopoly’s Marginal Revenue

– When a monopoly increases the amount it sells, it has two effects on total revenue (P Q).• The output effect—more output is

sold, so Q is higher.• The price effect—price falls, so P is

lower.



Price

Quantity of Water

1 2 3 4 5 6 7 8

11

10

9

8

7

6

5

4

3

2

1

0

–1

–2

–3

–4

Marginal revenue

Demand (average revenue)

Figure 15-3: The Demand and Marginal Figure 15-3: The Demand and Marginal Revenue Curves for a Monopoly Revenue Curves for a Monopoly


• A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.

• It then uses the demand curve to find the price that will induce consumers to buy that quantity.

• A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.

• It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Profit MaximizationProfit Maximization


Costs and Revenue

Quantity0

Marginal cost

Marginal revenue

Demand

Average total cost

Q1 Q2

2. … and then the demand curve shows the price consistent with this quantity.

Monopoly price

B

A

1. The intersection of the MR curve and the MC curve determines the profit maximizing quantity…

QMAX

Figure 15-4: Profit Maximization for a Figure 15-4: Profit Maximization for a Monopoly Monopoly


• Comparing Monopoly and Competition – For a competitive firm, price equals

marginal cost.

P = MR = MC– For a monopoly firm, price exceeds

marginal cost.

P > MR = MC

• Comparing Monopoly and Competition – For a competitive firm, price equals

marginal cost.

P = MR = MC– For a monopoly firm, price exceeds

marginal cost.

P > MR = MC

Profit MaximizationProfit Maximization


• Profit equals total revenue minus total costs.– Profit = TR - TC– Profit = (TR/Q - TC/Q) Q– Profit = (P - ATC) Q

• The monopolist will receive economic profits as long as price is greater than average total cost.

• Profit equals total revenue minus total costs.– Profit = TR - TC– Profit = (TR/Q - TC/Q) Q– Profit = (P - ATC) Q

• The monopolist will receive economic profits as long as price is greater than average total cost.

A Monopoly’s ProfitA Monopoly’s Profit


Costs and Revenue

Quantity0

Monopoly price

QMAX

Monopolyprofit

Marginal cost

Marginal revenue

Demand

Average total cost

D

BE

C

Average total cost

Figure 15-5: The Monopoly’s Profit Figure 15-5: The Monopoly’s Profit


• A new drug discovery gives rise to a patent and gives the firm a monopoly on the sale of that drug.

• When the patent expires and any company can make or sell the drug.

• The market switches from being monopolistic to being competitive.

• A new drug discovery gives rise to a patent and gives the firm a monopoly on the sale of that drug.

• When the patent expires and any company can make or sell the drug.

• The market switches from being monopolistic to being competitive.

CASE STUDY:CASE STUDY: The Market for DrugsThe Market for Drugs


Costs and Revenue

Quantity0

Marginal revenue

Demand

Price during

patent life

Marginal costPrice after patent

expires

Monopoly quantity

Competitive quantity

Figure 15-6: The Market for Drugs Figure 15-6: The Market for Drugs


• In contrast to a competitive firm, the monopoly charges a price above the marginal cost.

• From the standpoint of consumers, this high price makes monopoly undesirable.

• However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.

• In contrast to a competitive firm, the monopoly charges a price above the marginal cost.

• From the standpoint of consumers, this high price makes monopoly undesirable.

• However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.

THE WELFARE COST OF THE WELFARE COST OF MONOPOLYMONOPOLY


Demand (Value to buyers)

Marginal cost

Quantity

Price

0 Efficient quantity

Value to buyers is greater than cost to sellers

Value to buyers is less than cost to sellers

Cost to monopolist

Value to buyers

Value to buyers

Cost to monopolist

Figure 15-7: The Efficiency Level of Output Figure 15-7: The Efficiency Level of Output


• Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost.– This wedge causes the quantity sold to

fall short of the social optimum.• The Inefficiency of Monopoly

– The monopolist produces less than the socially efficient quantity of output.

– The “economic pie” shrinks.

• Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost.– This wedge causes the quantity sold to

fall short of the social optimum.• The Inefficiency of Monopoly

– The monopolist produces less than the socially efficient quantity of output.

– The “economic pie” shrinks.

Deadweight LossDeadweight Loss


Price

Quantity0

Marginal revenue

Demand

Marginal cost

Monopoly price

Monopoly quantity

Efficiency quantity

Deadweightloss

Figure 15-8: The Inefficiency of Monopoly Figure 15-8: The Inefficiency of Monopoly


• 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 revenue from a tax, whereas a private firm gets the monopoly profit.

• 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 revenue from a tax, whereas a private firm gets the monopoly profit.

Deadweight LossDeadweight Loss


• Government responds to the problem of monopoly in one of four ways.– Making monopolized industries

more competitive.– Regulating the behaviour of

monopolies.– Turning some private monopolies

into public enterprises.– Doing nothing at all.

• Government responds to the problem of monopoly in one of four ways.– Making monopolized industries

more competitive.– Regulating the behaviour of

monopolies.– Turning some private monopolies

into public enterprises.– Doing nothing at all.

PUBLIC POLICY TOWARD PUBLIC POLICY TOWARD MONOPOLIESMONOPOLIES


• Legislation designed to encourage competition and discourage the use of monopoly practices can curb the inefficiencies resulting from market power in general and monopoly in particular.

• Competition law has a long history in Canada:– 1889: The Act for the Prevention and

Suppression of Combinations Formed in Restraint of Trade.

– 1910: Combines Investigation Act– 1986: Competition Act and the Competition

Tribunal Act

• Legislation designed to encourage competition and discourage the use of monopoly practices can curb the inefficiencies resulting from market power in general and monopoly in particular.

• Competition law has a long history in Canada:– 1889: The Act for the Prevention and

Suppression of Combinations Formed in Restraint of Trade.

– 1910: Combines Investigation Act– 1986: Competition Act and the Competition

Tribunal Act

Competition LawCompetition Law


• The Competition Act:• “… maintain and encourage competition in

Canada in order to promote the efficiency and adaptability of the Canadian economy… …. and in order to provide consumers with competitive prices and product choices.”

• Competition law in Canada is enforced by the Commissioner of Competition of the Competition Bureau, a unit within the Federal government’s Industry Canada.

• The Competition Act:• “… maintain and encourage competition in

Canada in order to promote the efficiency and adaptability of the Canadian economy… …. and in order to provide consumers with competitive prices and product choices.”

• Competition law in Canada is enforced by the Commissioner of Competition of the Competition Bureau, a unit within the Federal government’s Industry Canada.



• Competition laws have costs and benefits.– Sometimes companies merge not to

reduce competition but to lower costs through joint production.

– The benefits of greater efficiencies through mergers are called synergies.

• If the competition laws are to raise social welfare, the government must determine which mergers are desirable and which are not.

• Competition laws have costs and benefits.– Sometimes companies merge not to

reduce competition but to lower costs through joint production.

– The benefits of greater efficiencies through mergers are called synergies.

• If the competition laws are to raise social welfare, the government must determine which mergers are desirable and which are not.



• Government may regulate the prices that the monopoly charges. This is often the case with natural monopolies where governments regulate the price. – The allocation of resources will be

efficient and total surplus maximized if price is set to equal marginal cost.

• Government may regulate the prices that the monopoly charges. This is often the case with natural monopolies where governments regulate the price. – The allocation of resources will be

efficient and total surplus maximized if price is set to equal marginal cost.

RegulationRegulation


• Two practical problems associated with marginal-cost pricing.1. Natural monopolies often have declining

average total cost. (See Figure 15-9)– The price is less than ATC thus creating

losses.2. No incentive for monopolist to reduce costs.

– Reducing costs will reduce prices.– In practice, regulators will allow

monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing.

• Two practical problems associated with marginal-cost pricing.1. Natural monopolies often have declining

average total cost. (See Figure 15-9)– The price is less than ATC thus creating

losses.2. No incentive for monopolist to reduce costs.

– Reducing costs will reduce prices.– In practice, regulators will allow

monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing.

RegulationRegulation


Price

Quantity0

Loss

Demand

Average total cost

Average total cost

Marginal cost

Regulated price

Figure 15-9: Marginal Cost Pricing Figure 15-9: Marginal Cost Pricing


• Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself.– Crown Corporations

• Canada Post• CBC• Hydro-Québec• Saskatchewan Tel and B.C. Tel.• Ontario Hydro.

• Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself.– Crown Corporations

• Canada Post• CBC• Hydro-Québec• Saskatchewan Tel and B.C. Tel.• Ontario Hydro.

Public OwnershipPublic Ownership


• Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies.

• Government intervention such as regulation can cause average costs to inflate (Political failure), increasing the deadweight loss above its “do nothing” level. (See Figure 15-10)

• Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies.

• Government intervention such as regulation can cause average costs to inflate (Political failure), increasing the deadweight loss above its “do nothing” level. (See Figure 15-10)

Doing NothingDoing Nothing


Price

Quantity0

Marginal revenue

ATCtrue

ATCinflated

Demand

Marginal cost

C

E

Ptrue

D

Qtrue

G

FPinflated

Qinflated

AP0

B

Q0

Figure 15-10: Political Failure and Average Figure 15-10: Political Failure and Average Costs Curves Costs Curves


• Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.

• Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power.

• Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.

• Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power.

PRICE DISCRIMINATIONPRICE DISCRIMINATION


• Perfect Price Discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.

• Three important effects of price discrimination:– It can increase the monopolist’s profits.– Need to separate customers according to

their ability to pay. • No arbitrage, the process of buying a good in one

market at a low price and selling it in another market at a higher price.

– It can reduce deadweight loss.

• Perfect Price Discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.

• Three important effects of price discrimination:– It can increase the monopolist’s profits.– Need to separate customers according to

their ability to pay. • No arbitrage, the process of buying a good in one

market at a low price and selling it in another market at a higher price.

– It can reduce deadweight loss.



(a) Single price monopolist

Price

Quantity 0 0

Price

(b) Perfectly discriminating monopolist

MR

D

MC

Profit

Deadweight loss

Consumer surplus

Monopoly price

Quantity sold

Quantity 0

Profit

D

MC

Quantity sold

Figure 15-11: Welfare with and without Price Figure 15-11: Welfare with and without Price Discrimination Discrimination


• Examples of Price Discrimination– Movie tickets– Airline prices– Discount coupons– Financial aid– Quantity discounts

• Examples of Price Discrimination– Movie tickets– Airline prices– Discount coupons– Financial aid– Quantity discounts



ConclusionConclusion

• How prevalent are the problems of monopolies?– Monopolies are common. – Most firms have some control over their

prices because of differentiated products.

– Firms with substantial monopoly power are rare.

– Few goods are truly unique.

• How prevalent are the problems of monopolies?– Monopolies are common. – Most firms have some control over their

prices because of differentiated products.

– Firms with substantial monopoly power are rare.

– Few goods are truly unique.


SummarySummary

• A monopoly is a firm that is the sole seller in its market.

• It faces a downward-sloping demand curve for its product.

• A monopoly’s marginal revenue is always below the price of its good.

• Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal.

• A monopoly is a firm that is the sole seller in its market.

• It faces a downward-sloping demand curve for its product.

• A monopoly’s marginal revenue is always below the price of its good.

• Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal.


SummarySummary

• Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost.

• A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus.

• A monopoly causes deadweight losses similar to the deadweight losses caused by taxes.

• Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost.

• A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus.

• A monopoly causes deadweight losses similar to the deadweight losses caused by taxes.


SummarySummary

• Policymakers can respond to the inefficiencies of monopoly behaviour with competition laws, regulation of prices, or by turning the monopoly into a government-run enterprise.

• If the market failure is deemed small, policymakers may decide to do nothing at all.

• Policymakers can respond to the inefficiencies of monopoly behaviour with competition laws, regulation of prices, or by turning the monopoly into a government-run enterprise.

• If the market failure is deemed small, policymakers may decide to do nothing at all.


SummarySummary

• Monopolists can raise their profits by charging different prices to different buyers based on their willingness to pay.

• Price discrimination can raise economic welfare and lessen deadweight losses.

• Monopolists can raise their profits by charging different prices to different buyers based on their willingness to pay.

• Price discrimination can raise economic welfare and lessen deadweight losses.


The EndThe End

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Chapter 15 MonopolyMonopoly © 2002 by Nelson, a division of Thomson Canada Limited