Chapter 10

Challenge To Market Effectiveness 1: Monopolies

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Learning Objectives

• What is monopoly?

• What are the barriers to entry?

• How is the demand curve for a monopoly?

• How does a monopoly decide quantity of output to produce?

• What are the social costs of monopoly?

• What is price discrimination?

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Monopoly

• A pure monopoly is a firm without any competition.

• Pure monopolies do not exist in the real world. • The fewer the substitutes there are for a firm’s

products, the more monopolistic the firm is.• A monopolist can earn long term profits if it

keeps other firms from entering its market.• Entry barriers stop firms from entering a market

and destroying monopoly profits.

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Barriers To Entry

The Government:• Licenses: By limiting entry licenses allow

members of protected professions to earn monopoly profits, e.g. teachers, lawyers.

• Outlawing competition: Government can outlaw competition to a monopolist e.g. U.S. post office.

• State religion: Government can create religious monopolies.

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Barriers To Entry

Unions: • Unions are organization of workers.• Unions engage in collective bargaining

with employers.

Control of a vital resource:• Firms can maintain a monopoly by

controlling a vital resource, e.g. silk in ancient China, alum in Ottoman empire.

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Barriers To Entry

Incompatibility: • By making its products incompatible with the

complementary goods of its rival, a firm can create and maintain its monopoly.

• Software: Incompatibility-based barriers to entry are a prime source of Microsoft’s riches.

• Sports leagues: Incompatibility provides a strong barrier to entry, protecting all professional sports leagues.

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Barriers To Entry

Economies of scale:• If in an industry average total

costs decrease as output increases, then a new firm’s costs are extremely high compared to the monopolist’s costs.

• In industries with significant economies of scale, it is difficult for a new firm to challenge a monopoly.

• Monopolies based on economies of scale are called “natural monopolies,” e.g. utility companies.

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Barriers To Entry

Intellectual property:• Owning intellectual property gives legal right to

demand payment from all who would use that property.

• Copyrights: No one but the copyright’s holder can legally sell the copyright-protected work.

• Patents: A patent gives one exclusive right to sell the invention. Patents confer a benefit on innovators proportional to the social benefits of their innovation.

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Monopolist Pricing

• A monopolist can set its own price.

• The Law of Demand constraints a monopolist’s price-setting powers.

• If a monopolist wants to increase sales, it must lower its price.

• Unlike a firm in perfect competition, monopolist’s output influences the market price.

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Marginal Revenue and Monopolist Pricing

Marginal Revenue

= The increase in total revenue a firm receives by selling one more good.

For a competitive firm:

• Marginal Revenue = Price

For a monopolist:

• Marginal Revenue Price

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Marginal Revenue and Monopolist Pricing

Customer Most Willing to Pay

Total Revenue Marginal Revenue

A $100 $100 $100

B $90 $90X2 = $180 $180-$100 = $80

C $80 $80X3 = $240 $240-$180 = $60

D $70 $70X4 = $280 $280-$240 = $40

E $60 $60X5 = $300 $300-$280 = $20

F $50 $50X6 = $300 $300-$300 = $0

G $40 $40X7 = $280 $280-$300 = -$20

H $1 $1X8 = $8 $8-$280 = -$272

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Monopolist’s Profit Maximization

• If Marginal Revenue > Marginal Cost, Profits will increase by producing more.

• If Marginal Revenue < Marginal Cost, Profits will increase by producing less.

• Profits are maximum when Marginal Revenue = Marginal Cost.

This intersection between marginal revenue and marginal cost determines the monopolist’s optimal price and quantity.

Marginal Cost

Demand

Quantity

Price

MarginalRevenue

$14

$8

100

The output the monopolist will choose.

The price the monopolist will choose.

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The Social Cost of Monopolies• Monopolists do not produce at the lowest possible

average total cost.• Monopolies usually produce output below the level that

maximizes the wealth of society.

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Deadweight Loss of Monopoly

Price

Quantity

Marginal Cost

Demand

$12

150

• A monopolist will produce until Marginal cost = marginal revenue.

• The wealth maximizing level of output is where Marginal cost = demand.

• Adam Smith’s invisible hand breaks down.

CS

PS

Marginal Revenue

$14

100

If the monopolist produces 150 units. The monopolist will not produce this much output.

D

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Ways to Reduce Deadweight Loss

• Competition

• Price discrimination

• Antitrust laws

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Competition and Deadweight Loss of Monopoly

• Competition lowers prices and expands output, thereby reducing deadweight loss.For example:

• U.S. post office and fax, email, FedEx. • Microsoft and Linux.• Cable television and satellite television.• De Beers’ diamonds and artificial diamonds.• Even the mere threat of potential competition

can induce a monopolist to expand output and reduce deadweight loss.

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Price Discrimination

• Price discrimination occurs when a firm charges separate customers different prices.

• With price discrimination, a firm can charge its old customers high prices, but still attract new customers by selling to them at lower prices.

• For economists, price discrimination is beneficial because it increases the wealth of society.

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Price Discrimination

Perfect price discrimination: • The monopolist charges every customer the maximum

they are willing to pay.• The total consumer surplus becomes zero.• The deadweight loss of monopoly is completely

eliminated.

Imperfect price discrimination: • Monopolists separate customers into groups and then

charge separate groups different price.• The deadweight loss of monopoly is reduced but not

completely eliminated, e.g. student discounts, financial aid, airline tickets.

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Price Discrimination To profitably price discriminate for and against different groups, a monopolist must overcome three challenges:

• It must determine the value each group places on the monopolist’s product.

• It must figure out how to sell to separate groups at different prices.

• It must prevent customers who paid a low price from reselling the good to those customers who paid a high price.

Self selection of customers:• Firms induce different groups of consumers to take

different visible actions. By inducing customers to voluntarily self-select into separate groups, firms can price discriminate e.g. coupons, airline tickets.

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Antitrust Laws

• Antitrust laws regulate, restrict and punish monopolies.

• Antitrust laws rely on the government, not the market, to reduce the harm on monopolies.

Coming up in Chapter 11

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Innovation and Monopoly

• Because it does not have to share its benefits, a monopolist gets great monetary rewards from innovation. Hence, monopolies encourage innovations.

• However, strong entry barriers protect a monopoly even without innovation. A monopolist’s employees may not have incentives to work hard to innovate.

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Do You Know?

• How can economies of scale create barriers to entry?Economies of scale means average total costs decrease as output increases. Since its costs are extremely high compared to the monopolist’s costs, it is difficult for a new firm to challenge a monopoly.

• Why must a monopolist who can’t price discriminate give a discount to old customers if it wants to sell to new customers?The Law of Demand constraints a monopolist’s price-setting powers. As consumers buy more only at lower price monopolist must lower its price to increase sales.

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Do You Know?

• How can price discrimination reduce the deadweight loss of a monopolist?A monopolist creates deadweight loss by producing less output. Price discrimination allows a monopolist to charge different prices to different consumers to produce and sell more output.

• Why are coupons a form of price discrimination?Coupons induce consumers to self-select into two groups: price-sensitive and price-insensitive. Coupons allow price-sensitive consumers to trade time for money.

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Summary

• A pure monopoly is a firm without any competition.• The fewer the substitutes there are for a firm’s products,

the more monopolistic the firm is.• Entry barriers stop firms from entering a market and

destroying monopoly profits such as government regulations, unions, control of vital resource, incompatibility, economies of scale and intellectual property.

• If a monopolist wants to increase sales, it must lower its price.

• Monopolist’s profits are maximum when marginal revenue = marginal cost.

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Summary

• Monopolies usually produce output below the level that maximizes the wealth of society and creates deadweight loss.

• Competition, price discrimination and antitrust laws can reduce the social cost of monopolies.

• Price discrimination occurs when a firm charges separate customers different prices.

• Price discrimination is beneficial because it increases the wealth of society.

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Coming Up

What is the other challenge to market effectiveness?

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